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The Cost of Active Investing

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Presidential Address: The Cost of Active Investing

In this paper, Kenneth R. French compares the fees, expenses, and trading costs, what society pays to invest in the U.S. stock market along with an estimate of what would be paid if everyone invested passively.


I. Allocations

The author estimates the allocation of publicly traded U.S. equity among groups of investors. Direct holdings by individuals decline a lot over time. Individuals hold 47.9% of the market in 1980 and only 21.5% in 2007. This decline is matched by an increase in the holdings of open-end mutual funds, from 4.6% in 1980 to 32.4% in 2007.

II. Average Fees and Expenses for Mutual Funds

The cost of mutual funds is examined. Owing to a steady decline in the loads open-end fund investors pay, the fees and expenses for mutual funds fall from 2.08% of assets under management in 1980 to 0.95% in 2006.

III. Institutional Costs

The author estimates the investment management costs for institutions, which are significantly lower. Their value-weight average cost is only 34 basis points in 1980 and 23 basis points in 2006. Institutional costs decline mainly over time for two reasons. First, the costs they pay for active and passive investments decline. Secondly, institutions shift a large portion of their U.S. equity holdings from active to passive over time.

IV. Hedge Fund Fees

Data on individual hedge funds is used to evaluate the fees clients pay to invest in U.S. equity-related funds. The average annual hedge fund fee for 1996–2007 is 4.26% of assets, and, because they pay two layers of fees, the average for clients who buy through funds of hedge funds is even higher, 6.52% per year.

VI. The Cost of Trying to Beat the Market

The author compare the resources investors actually spend in the U.S. market—the fees and expenses paid for mutual funds, the investment management costs paid by institutions, the fees paid to hedge funds and funds of funds, and the transaction costs paid by all traders—with what investors would spend if everyone followed a passive strategy. The difference between the actual and passive estimates is the cost of active investors’ search for superior returns.

VII. Summary and Conclusions

The author found the average of the annual estimates for 1980–2006 implying that the investors spend 0.67% of the value of all NYSE, Amex, and NASDAQ stocks each year trying to beat the market. Society’s capitalized cost of price discovery is at least 10% of the current value of the market. Thus, under the no-net-transfer assumption, an investor who holds a passive market portfolio outperforms the value-weight average of all active and passive investors by 67 basis points a year from 1980 to 2006.




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