One finance professor has figured out how much investors pay in commissions, fees, and other investing costs -- and the number will shock you.
A recent New York Times article discussed a working paper by Dartmouth professor Kenneth French. In "The Cost of Active Investing," French calculates how much U.S. investors spend to invest their money. When he added up ETF and mutual fund fees, stock and bond commissions, and the costs of institutional money management through hedge funds and other investment vehicles, the tab came to roughly $100 billion -- annually.
If you're wondering how that money affects Wall Street, just look at investment banks' recent earnings. You'd think that when you divide that nine-figure sum among the major financial firms, none of them would need the Federal Reserve's help to bail each other out. Perhaps JPMorgan Chase (NYSE: JPM ) and Bear Stearns (NYSE: BSC ) should add Ben Bernanke to their thank-you list, too.
A hefty burden
Even on Wall Street, $100 billion is a lot of money. When you compare that figure to the overall size of the stock market, however, the result looks much more innocuous -- 0.67% of the total market capitalization of domestic markets gets spent on fees and transaction costs.
Still, that's a lot more than you have to pay. As the article points out, you can buy into a simple index fund and pay around 0.15% in fees. And while saving half a percent may not seem like much, the difference between earning 9.5% and 10% on your money adds up over time. For instance, if you have $100,000 invested today, that fee savings will create almost $230,000 in extra cash for your nest egg 30 years from now.
Is active management ever worth the cost?
The debate over active versus index investing isn't likely to resolve itself soon. It's well-known that most mutual funds don't beat the market. Yet over time, some fund managers have consistently delivered market-beating returns. All their funds share at least one trait: low expenses.
But it's a tough fight. Even winning managers make mistakes. Bill Miller, manager of Legg Mason Value Trust and former holder of a 15-year winning streak against the S&P 500, has lost big so far this year on picks like Google (Nasdaq: GOOG ) , Expedia (Nasdaq: EXPE ) , and Aetna (NYSE: AET ) . Another longtime outperformer, American Funds' Growth Fund of America, has suffered losses in Fannie Mae (NYSE: FNM ) and AIG (NYSE: AIG ) , despite delivering returns at the top of its peer group.
Even though good managers go through bad periods, don't assume it's impossible to find consistent winners over the long haul. You simply need to force active managers to prove themselves to you -- and hold them responsible for unnecessarily high fees until they show you that they're worth the cost.
On the other hand, if you're content with average returns, index funds aren't a bad way to go. Wall Street won't thank you -- but your checkbook will.
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