Investors Wasted Half a Trillion Dollars Trying to Beat the Market
Earlier this year, Warren Buffett caused a stir when he estimated that investors had wasted $100 billion on fees for underperforming hedge funds in the last decade. Even for one of the world’s richest men, that is a staggering sum of money. If there is any good news in this, it’s that these wasted fees were mostly incurred by the relatively small group of investors that have access to hedge funds.
How much money would investors have saved, over the past decade, if they had indexed their underperforming mutual funds?
Given that mutual fund managers oversee more than $16 trillion, and study after study has highlighted their weak overall performance, we suspected that the “unrewarded expenses” of mutual funds were even bigger than those of hedge funds. Inspired by Buffett’s analysis, we set out to quantify the amount of money wasted by America’s nearly 100 million mutual fund investors. We wanted to know specifically, “How much money would investors have saved, over the past decade, if they had indexed their underperforming mutual funds?”
Sadly, our estimate of unrewarded mutual fund expenses was even larger than we assumed.
We estimate that unrewarded fund expenses top $500 billion over the past decade.
According to our rough analysis, over the past decade, mutual fund investors wasted about half a trillion dollars on unrewarded active management expenses. To provide some context, the $500 billion wasted on active management is more than the US government’s combined annual spending on education, transportation, food, energy, and housing. It’s also enough money to buy every house in Houston, all the outstanding shares of Buffett’s beloved Berkshire Hathaway, or every single item imported from China last year.
In other words, it’s a huge pile of money that could have been spent far more productively.
This is not to say that all expenses are bad. Mutual fund costs wouldn’t be an issue if the fund managers delivered what they promised – excess returns relative to a benchmark index. Unfortunately, the vast majority of actively managed mutual funds underperform their benchmark. This means that millions of investors are wasting billions of dollars betting on a losing proposition.
Does this imply that investors should always pick the lowest cost index fund?
In our view, the solution is not that simple. We don’t believe that the cheapest answer is always the best answer. Rather, our goal is to find the most cost-effective way to achieve the exposure we are targeting. For broad market exposure, that solution could be a low-cost ETF. In other cases, like when we are targeting specific factor exposures, the best option may be a more sophisticated fund with a slightly higher expense ratio.
Ultimately, we seek to ensure that our clients only incur expenses that have a high probability of providing demonstrable value. And the evidence is clear, that value is not likely to be found with traditional active managers.
Explanation of our Analysis:
To arrive at our admittedly rough estimate, we took the following steps:
Step 1: Approximated the total expenses incurred by mutual fund investors from 2007 – 2016, using annual AUM and expense ratio figures from the 2017 ICI Fact Book. (~$780 billion)
Step 2: Estimated the percentage of funds that underperformed their benchmarks over 3 years, by category, using data from the 2016 SPIVA Scorecard. [Three-year returns were used because the average mutual fund holding period is approximately 3 years.] Based on this metric, roughly 80% of equity, 50% of bond, and 85% of hybrid fund managers underperformed their benchmarks.
Step 3: Multiplied the total mutual fund expenses incurred (Step 1) by the percentage of funds that underperformed (Step 2) to approximate the amount investors spent with underperforming managers. (~$600 billion)
Step 4: Estimated what annual expenses would have been if the assets from underperforming funds (Step 2) had instead been invested at index fund expense ratios. Index fund expense ratios were taken from the 2017 ICI Fact Book. (~$100 billion)
Step 5: Estimated “unrewarded expenses” by subtracting hypothetical index fees (Step 4) from estimated active management fees (Step 3). This resulted in an estimate of ~$500 billion in “unrewarded expenses.”
