Newly published research shows that US investors are losing $235 billion a year by using actively managed funds. But the true figure is probably higher.
It’s well documented that the vast majority of actively managed funds underperform the market, net of costs, over the long term. Yet, even now, active investing remains far more popular than the simpler and cheaper passive alternative.
So how much are investors paying for their predilection for active funds when you add the amount they’re losing by lagging the index to the substantial additional costs entailed in using active managers?
Moshe Levy, Professor of Finance at the Jerusalem School of Business Administration, set out to answer that question in a study published in the July 2023 edition of The Journal of Investing.
Professor Levy evaluated the performance of US active equity funds from December 1991 to March 2021, based on their Sharpe ratios — in other words, the returns they achieved when properly adjusted for risk.
He found that the vast majority of funds — 92.1% of them — underperformed the relevant benchmark index.
An eye-watering loss
Levy then compared the returns the funds delivered with those of a low-cost S&P 500 index tracker. Relative to what they would have achieved with an index fund, he found that the aggregate annual loss investors in US active equity funds incur is a staggering $235 billion.
Of that loss, $186 billion is accounted for by underperformance — in other words, inefficient portfolio allocation — and the remaining $49 billion by the additional fees investors had to pay to have their money actively managed.
“The $49 billion figure is a direct transfer from investors to funds via fees,” Professor Levy explained in a recent interview. “But most of the loss is due to the fact that most funds underperform the index even before fees. In other words, even if all funds would have charged zero fees, investors would still suffer an aggregate loss of $189 billion relative to the alternative of investing in the market index.”
Of course, investors who were fortunate enough to have invested from the outset in one of the 7.9% of funds did fare better. But again, Levy’s findings suggest that identifying an outperforming fund ex ante was extremely difficult. For example, there wasn’t a strong association between a fund’s performance and its size and popularity. “When choosing their funds,” he concluded, “investors apparently attach too much weight to historical returns.”
The actual figure is probably higher
By any reckoning, $235 billion is an enormous sum of money for investors to be losing on an annual basis — and remember, these are just US investors. In fact, the real figure could be larger still. “Levy’s estimate, if anything, is too low,” says the investment author and analyst Larry Swedroe. “It does not account for the incremental burden of higher taxes incurred by active investors with taxable holdings.”
Professor Levy agrees that the loss is actually higher than $235 billion when you consider the loss to the wider economy, and not just to investors. “Most individuals in the active equity mutual fund industry,” he writes, “do not seem to be creating economic value, and the wealth transfer component actually reflects an opportunity cost for the economy — these individuals’ talents could be more productive elsewhere.”
All around the world, the fund management industry continues to attract the brightest graduates. New research by the CFA Institute shows that, in the UK, finance has now overtaken medicine as the most popular sector for university leavers to work in, and that high salaries are the primary factor. The question needs to be asked: Would it be better for all of us if our brightest young people were encouraged to deploy their talents in sectors of the economy where they really can add value?
Consistent with other studies
The truth is that, sobering though they are, the findings of Moshe Levy’s study were depressingly predictable. They are more or less consistent with those of Kenneth French in a 2008 study called The Cost of Active Investing.
In his conclusion to that paper, Professor French suggested several reasons why so many people continue to invest in actively managed funds. “Perhaps the dominant reason is a general misperception about investment opportunities,” he wrote. “Many are unaware that the average active investor would increase his return if he switched to a passive strategy… Overconfidence is probably the other major reason.”
For his part, Professor Levy believes the main reason why active funds remain so popular is that investors are human and are prone to a variety of cognitive biases. In that same interview referred to earlier, he also said that the fund industry is good at exploiting those biases in the way it markets its products.
“For example, they tend to advertise their performance only when it was good,” he said, “which may lead to the wrong impression that funds are much better than they actually are. Another approach is the ‘incubation strategy’: privately starting several new funds and after a few years making public only those who did well. This presents investors with a very biased track record.”
Whatever their reasons, investors are paying a heavy price for using active managers. If you’re one of them, for how much longer can you afford to carry on doing it?
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