The Question to Outperform

by Stephen Kass on July 11, 2012

The debate over the efficiency of financial markets leaves investors – and those who advise them – to answer the question: Can active portfolio managers exploit market
inefficiencies enough to overcome the costs of their efforts? For those who answer no, the best option is to own passively managed funds.

Mutual funds incur five types of expenses: operating expenses and distribution fees, the cost of cash, trading expenses, market-impact costs and taxes. CPAs should be
aware that each of these categories creates a cost hurdle of 1% or more than active managers must surmount to outperform the less-expensive passive management strategy.

Operating expenses receive the most investor attention because they are the most visible. The average operating expense for an actively managed fund is 1.53%. For an
index or passive-asset-class fund, the expenses range is between 0.2% and 0.5%. Taxes on fund distributions are the biggest expense most investors face. One
study showed that taxes cut investor returns by 57.5%. To help combat this, CPAs can recommend a wide range of passively managed asset-class or index funds that are also
tax managed.

The best way to achieve the greatest percentage of available returns is to minimize all fund expenses. Index and passive-asset-class funds are a winning strategy because investors pay much lower fees.

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