Hi Guys,
In
1946, Henry Hazlitt wrote a short book that would become a best selling classic: “Economics in One Lesson”. The book collected a huge readership, and has been reissued numerous times. The “One Lesson” is fully explained in Chapter
1; it is 4 pages of text in its entirety. Here is a Link to the entire book so it takes a little time to download:
http://fee.org/resources/detail/economics-in-one-lesson-2?gclid=CMet8uqeg8UCFREoaQodXCkA_g#calibre_link-34His summary of that One Lesson follows:
“The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”
You might want to sample a practical application of the One Lesson. Chapter by chapter, Hazitt provides many examples. His “Broken Window” (chapter 2) is brilliant. Continue reading as much as you like from the Link above.
So, in Hazlitt’s headlights, economics is a two dimensional problem with time being one parameter, and the integration of all impacts a second parameter. It’s a simple 2 X 2 matrix.
Numerous independent mutual fund studies have similarly concluded that only 2 factors are primary determinants of fund performance: (
1) time in game and (2) costs. Hence, a 2 X 2 matrix can be constructed.
In my modeling of this uncomplicated matrix, time is characterized as either short-term or long-term, while costs form the other axis.
Short-term can be viewed as a single year’s return while long-term can be visualized as a
10 to 30 year performance period (you choose your own long-term time measurement depending on your goals). The most straightforward way to model the cost axis is to segregate high cost (active funds) and low cost (Index funds) options.
Likely more than any other non-academic researcher, John Bogle has explored these issues for decades. I’ve used his analyses to fill-out the matrix with approximate numbers. Here is the Link to Bogle’s “The Arithmetic of “All-In” Investment Expenses” that I reference:
http://www.cfapubs.org/doi/pdf/10.2469/faj.v70.n1.1A primary output from Bogle’s work is to scope the total extra costs associated with active fund management beyond Expense Ratio. He identifies and typifies these costs that incrementally add to the conventional Expense Ratio. The extra costs are: (
1) transaction costs, (2) cash drag, (3) sales loads when applicable, and (4) excess taxes. Please access his paper for details.
Bogle’s work is approximate and imperfect because some data are unavailable and estimates are required. Depending on how the numbers are generated, and the conservatism buried within each estimate, the extra costs hover both slightly South or slightly North of 2% annually.
Over a short period that 2% increment might not be overwhelming, but when integrated over extended timeframes (like
10, 20, or 30 years), those extra fees are brutal to a portfolio’s end value. Bogle’s illustrative Table Two shows double digit active fund penalties that multiply as the time horizon expands. His Table Three and Figure
1 add further injury when tax considerations are appended.
Separately, very carefully executed Monte Carlo studies demonstrate just how difficult it is to overcome a 2% extra fee handicap. The simulations show how rare it is to overcome a 2% cost differential. In practice, some do it, but many fail. And active manager’s inconsistent persistency over a long-term time horizon is yet another uncertainty that tarnishes their records.
Both Hazlitt and Bogle share a noteworthy common trait. They have the insight and the skill to simplify complex problems without losing the basic message. I admire both gentlemen. Please visit the Links provided.
Please consult the referenced Links for much needed detail. My story is incomplete.
Sorry for my over exuberant title.
Best Regards.
