Cost of Active Management - Bogle

John C. Bogle, Founder and Former Chairman, The Vanguard Group, believed and proved with actual data that, as a group, the passively managed funds always wins over the active managed. The question is how much the advantage is. Or how much of their return do investors relinquish to financial intermediaries? His answers:

As a group, active managers will fall short of the index return by the exact amount of the costs that they incur. The central fact of investing, then, is this simple proposition: Investment success is defined by the allocation of financial market returns—stocks, bonds, and money market instruments alike—between investors and financial intermediaries. Gross return minus cost equals net return. If the data we have available to us do not reflect that self-evident truth, well, the data are wrong.

I estimate that the total cost of investment advice, marketing, administration, brokerage, etc., in the U.S. currently comes to something like $300 billion per year. With the market capitalization of U.S. equities now at about $12 trillion, such an annual cost would represent about 2.5% of that total, or 25% of an assumed total return on equities of 10% per year.

His research also showed that only 11% of funds beat the market over the 30-year period. The odd of great "success", say, beating the market by 3% annually, is very slim: 0.6%! [Table reprinted from the original paper]

The Odds of Success: Mutual Fund Returns vs. S&P 500 1970-2001*
Odds of:	Number of Funds	All Funds
At Inception	355	100%
Surviving	158	44.5%
Beating the Market	39	11.0%
Beating the Market by more than 1%	23	6.5%
Beating the Market by more than 3%	2	0.6%

According to him, cost is the difference between success and failure for the long-term investor:

Consider the thirty-plus-year record I've presented, and compound an initial investment of $1,000,000 made back in 1970. At a return of 8.9%, the terminal value for the average managed fund came to $15.0 million. At a return of 11.8% for the Standard & Poor's 500 Index, the terminal value came to $34.6 million. Let's face it: Two-for-one is a staggering difference in capital, and $19,600,000 is serious money.

For taxable investors, the gap would be far wider, for with their high portfolio turnover—100% last year alone—mutual funds are notoriously tax-inefficient. They probably surrender another 1 ½ to 2 percentage points of [annual] return to tax-efficient passive strategies.

... Selecting a winning active manager is hard simply because successful investing in liquid, active, well-informed financial markets is itself hard. Brilliant, well-educated, serious professionals compete with one another, but with the knowledge certain that since investing is a zero sum game before costs and a loser's game after costs, only a tiny proportion of them can win the competition to beat the market in the long run. 100% of managers expect to win; in the long run, less than 5% succeed.