This year’s Presidential Address to the American Finance Association (AFA), The Cost of Active Investing, concludes that investors spend 0.67% of the aggregate value of the market each year searching for superior returns.

active investingOn a capitalized basis, the cost to society of trying to beat the market is at least 10% of the current market cap.  In dollar terms, investors are spending $100 billion every year on excess fees and trading costs.  Capitalized at 10%, the spending has the cumulative effect of reducing investors’ wealth by over $1 trillion.

Where is the money going and how do investors avoid this wealth destruction trap?

Dartmouth Professor Kenneth French, president of the AFA, published the study in the August 2008 edition of the Journal of Finance.  French’s paper compares the fees, expenses and trading costs society pays to invest in the U.S. stock market with an estimate of what would be paid if everyone invested passively.  He looked at the years 1980 through 2006 and concludes that the typical investor would increase his average annual return by 67 basis points over the 1980 – 2006 period if he switched to a passive market portfolio.

Not surprisingly, French finds that excessive mutual fund fees are the biggest driver contributing 26 of the 67 basis points on a weighted average basis.  (See more on the high cost of mutual funds in Why Investors are Moving to ETFs).  Active trading costs and hedge fund fees also contribute to the waste.

Professor French didn’t include the cost of the capital gains distribution exposure that many mutual fund investors take on when investing.  Lipper analyst Tom Roseen found that the typical mutual fund investor loses nearly 200 basis points of return to taxes on distributions each year.

French concludes that a passive market portfolio, such as a portfolio of exchange traded funds, produces a higher return than the aggregate of all active portfolios.

For more on the French study, see the website for the Journal of Finance.  For more on Tom Roseen’s analysis, see Lipper’s website.