These are the words of John Bogle, the granddaddy of index funds. They talk very succinctly to the South African investment landscape, where the fee difference between the two main ways to invest is 2%. This may sound like a meagre difference but the above quote is a singularly articulate expression of why one should care about paying the 2% extra in fees that is the norm with active funds.
We’ll get to those reasons soon. But first, in case you’re unfamiliar with the jargon: there are, generally speaking, two different kinds, or styles, of fund management – actively managed funds and index (or passively managed) funds. Active funds have fund managers “actively” making decisions about what shares to buy and sell, and when.
This stock-picking is almost always informed by expensive research teams, which is one of the (many, poor) reasons given for why active management usually costs around 3% of your investment value each year (along with performance fees, advisor fees and other fees).
Index funds don’t try to outfox the market. Rather than looking for the few, elusive winning shares, index funds buy a little bit of all the shares in an index, and deliver the returns of the market as a whole. This management style is much more “passive” and much less expensive – typically less than 1% annually.
Although index funds have been around for 40 years in the US (and around 10 years in South Africa), active funds are still the default. But the tide is turning toward index funds in a big way globally as awareness increases. These are some of the reasons why.
Paying 2% more can mean you get 60% less
Paying a 3% fee doesn’t sound like much. Even when there is the option to pay only 1%, our irrational and unmathematical minds go, “well, it’s only a 2% difference”. In fact, it’s a two-thirds difference – a massive 67% “discount” that, were we looking at the price tag of a sale item, would be very seductive.
That difference compounds over time, and the longer you invest the more it compounds. Over 40 years, which is an average working career, every 1% more that you pay in fees can mean a 30% lower return.
Of course, this comparison assumes that both the active (3% fee) fund and the index (1% fee) have the same return. It’s almost common sense to believe that active funds outperform index funds consistently. They don’t.
You don’t get what you pay for
Purveyors of active funds want you to believe that their high fee is worth it, and that their expertise will get you a higher return than the index or market. It’s not, and it won’t.
Though the numbers change every year, roughly 80% of active funds – that’s four out of five
– do worse than the index each year.
The obvious retort is that you simply need to find one of the funds or fund managers that does manage to beat the market. But, just as stock pickers can’t successfully pick stocks, you can’t pick stock pickers. The ones who do beat the index one year are not the same ones who beat it last year, or will beat it again next year. If it’s hard to beat the index, it’s harder to beat the index consistently.
The SPIVA (S&P Indices Versus Active) website shows that of 703 US funds initially in the top quartile, only 146 were still there a year later. Of those, 49 were still there after two years. 13 remained after three years and just two were there after four years. That’s right: out of thousands of funds, how many were in the top 25% just four short years in a row? Two.
A bad, bad deal
Who, in their right mind, would knowingly put up all the money, take all the risk, and be happy with only a third of the return? Or even half of the return?
Most of us would consider ourselves to be in our right mind. But most of us are unknowing when it comes to investing. And we don’t think of investing the same way we think of other business deals, which should be mutually beneficial, and reward risk proportionately. Instead, we think we are paying a reasonable fee for a reasonable service.
Not only are both the fee and the service unreasonable, for reasons already outlined, but the transaction borders on abuse.
Consider these three scenarios:
First, if you’re paying a 3% fee, and inflation is 6%, your investment has to grow at 9% just to break even, or to keep pace with the cost of living.
Second, if inflation is 6% and your investment grows at 12%, then your investment is growing at 6%. But if you’re paying a 3% fee, your investment company is taking half your wealth-building growth.
Third, if your investment drops in value, your investment company still takes its fee. You can lose money, and your investment company may still be charging you performance fees due to historical returns. This is one thing if it’s part of the market’s expected short-term cycles, but it is quite another if your loss is due to an active fund manager’s poor decisions and bad picks.
No good reason to love
There is little solid ground on which to defend active funds. History, evidence and rationality support index funds. Investors are “voting with their feet”, and last year moved roughly $2 trillion out of active funds and into index funds. The depth and breadth and height that reason can reach says it’s a no-brainer.
