Why Index: Active versus Passive Fund Expenses

The main argument in favor of index funds over actively managed mutual funds goes like this:


  1. You can't find an active manager who will beat the market ...

  2. But you'll have to pay them a high expense ratio to try ...

  3. And their efforts will result in portfolio churning, which will hurt you through transaction costs and more frequent payments of capital gains taxes.


Point number 1 has been established through numerous studies. The more of these you see, the more overwhelming the evidence looks that no manager can beat the market in the long run. In the short run a few of them will do it through sheer luck, and a few lucky investors will have chosen the lucky managers ... But now we're talking "luck squared" - and face it, you aren't that lucky.

Once you accept point 1, you can measure the effects of points 2 and 3 with a simple calculator:


Investing   $   for   years;
Market's expected Annual Rate of Return is %
  Index Fund Active Fund
1. Market-Beating Skill: 0 % 0 %
2. Expense Ratio: % %
3. Transaction Costs: % %
Tax Inefficiency: % %

Cost-Adjusted Return Rate: % %
Final Balance: $   $  
Disadvantage: $  


Notes and Refinements

Transaction costs are an expense (usually not well publicized) above and beyond the fund's expense ratio. They are paid to the fund's brokers for buying and selling securities, meaning that they increase as a function of the portfolio turnover rate. You can estimate them with this calculator:

Annual Turnover Rate: %
Estimated Transaction Costs:     %
Find Turnover Rate

Tax inefficiency also generally increases with turnover, but not in a way that can be reliably estimated, so you'll have to use the Morningstar box at right to look up the tax hit a fund's return rate has taken in the past. (It's the difference between the long term Pretax Return and Tax-adjusted Return.)      
Find Tax Inefficiency

People have identified still other costs associated with high turnover; see chapter 3 of The Four Pillars of Investing, and the section called "Fees Not Covered by the Prospectus" in chapter 9 of The Bogleheads' Guide to Investing.

Also see the Bogleheads Wiki articles on Mutual Funds and Fees and Principles of Tax-Efficient Fund Placement.


Do Your Homework

Not all index funds are low cost. Use Morningstar to do your research. You're looking for a low expense ratio and no sales fees.


Article Contents
Why Index? Intro
Fund Expenses
Style Drift
Stock Trading

Article Contents
Index Funds Article


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