In a 2003 contribution to CFA Magazine, Vanguard founder and former CEO Jack Bogle introduced the cost matters hypothesis, or CMH. Bogle presented his theory as a substitute for the efficient-market hypothesis as a means of framing the task facing investors aspiring to beat the market:
“We don’t need the EMH to explain the dire odds that investors face in their quest to beat the stock market. We need only the CMH. Whether markets are efficient or inefficient, investors as a group must fall short of the market return by the amount of the costs they incur.”
This same harsh math was elegantly laid out by William Sharpe in his seminal 1991 piece “The Arithmetic of Active Management”:
“If ‘active’ and ‘passive’ management styles are defined in sensible ways, it must be the case that
- before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar;
- after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.
“These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.”
Not a Hypothesis, a Fact\
Fact: Costs matter. While markets’ efficiency will be forever questioned, there is no question that the costs we incur in investing deduct directly from our returns—it’s simple subtraction. Fees are the clearest hurdle facing portfolio managers. The more they charge for their services, the harder they will have to work to earn back and ultimately justify their fee. As such, there is, on average, an inverse relationship between fees and managers’ success. This is difficult for many investors to grasp as they assume that “you get what you pay for,” but as Bogle has said, in investing, you get what you don’t pay for. Paying Ferrari prices will likely land you behind the wheel of a lemon. Meanwhile, paying lemon prices will probably put you in control of a Honda—efficient, reliable, safe, an all-around good value, though not something you’ll be bragging about at a barbecue.
We recently documented this relationship in our Active/Passive Barometer report. In this report, we measured actively managed funds’ performance against a blended benchmark composed of their passively managed Morningstar Category peers (including exchange-traded funds and index mutual funds). Those active funds that survived the period (that is, they weren’t closed or merged away) and generated performance that exceeded that of their average passive peer were deemed to have succeeded.
The second column in Exhibit 1 shows active funds’ success rates over the 10-year period ending Dec. 31, 2014. As you can see, the majority of active managers across all but one category failed to best their passive counterparts.
Of course, no one sets out to pick an average manager. So how might investors improve their odds of picking a winner? Sorting by fees is as good a first step as any. In the third and fourth columns of Exhibit 1 you’ll see the success rates for the lowest- and highest cost quartile of funds across each category. In all but one case, the lowest-cost funds in a category had above-average success rates and far greater chances of beating their average passive peer than the highest-cost funds in the category. Fees matter.
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In part 2 of this article, we will look at the other aspects of cost.
