The Expected Return is the Market Return

One fairly straightforward, but important, point about investing is that the combined future return for all investors who purchase securities that are part of a given index must by definition equal the future return of that index before any fees. This is worth understanding when evaluating whether passive strategies are desirable.

Defining the Investor Base

For the sake of simplicity and familiarity, the S&P 500 index can be used to illustrate this point (although it is equally true of any other index as well). The S&P 500 index, a commonly referenced benchmark for stock investors, includes most of the best-known large companies in the United States.

There are a variety of different investor types who have exposure to S&P 500 companies. One of these is Indexers. Indexers own a pro-rata piece of every company in the S&P 500. As companies are added to or removed from the index, Indexers simply mimic those changes in their portfolios. They are strictly interested in matching the return of the S&P 500 as closely as possible.

By contrast, Active investors utilize the S&P 500 index as a performance benchmark but attempt to outperform it over time through active management. At any given point, these investors may own a different weighting in a particular stock or group of stocks (e.g. health care or financial stocks) than the index based on their predictions about future performance.

A final catch-all group (Group 3) owns exposures to S&P 500 companies but does not generally focus on the benchmark. Group 3 spans a wide range, from individuals who pick their own stocks in a brokerage account to hedge funds accumulating large positions in a company’s shares. It also includes employees who own stock in the company they work for, individuals who inherited stock from a relative and have simply continued to hold it, and many others. Some participants in this bucket may hold stocks for an extremely short time (e.g. professional trading or market making firms), while others may hold them for decades.

Total Individual Returns Must Equal the Market Return

When we aggregate all of the investments made by these three groups in S&P 500 companies, one thing is mathematically certain: the combined future return across all of those investors will by definition equal the index return before deducting any fees or other costs. Certainly, some of the invested dollars will earn a return in excess of the index average, but that excess return must be exactly offset by other dollars that earn a return below the index average.

In fact, the Indexers can essentially be removed from this equation. Since they are passively tracking the index performance, they know they will earn the S&P 500 return within a very small margin for error. That leaves the Active and Group 3 investors competing against each other in a zero-sum game. Another way to think about this is that the return of the Indexers will be equal to the combined return generated by everyone else, since the aggregate return for all participating investors must equal the index return before fees.

The Impact of Fees and Other Costs

However, investing is generally not a frictionless exercise. Investors who utilize advisors and/or access the market through mutual funds, exchange traded funds, or other professionally-managed vehicles incur management fees. Depending on the vehicle utilized, they may also incur sales loads, redemption fees or surrender charges, account maintenance charges, and other ancillary costs. All of these charges are taken off the top of the investment return. Ultimately what matters is how much money is left after accounting for all costs associated with the strategy.

Fees represent a permanent, recurring headwind that investors face. The size of the fee represents the degree of resistance. Indexers and Active investors all pay fees to some extent. Group 3 is less well-defined. There are some members of Group 3 that pay little or no expenses (e.g. a “do-it-yourself” investor who utilizes a discount brokerage to buy and hold individual stocks). There are also some members of Group 3, such as hedge fund investors, who likely pay substantially higher fees.

One reason people may elect to use index funds is that many index funds have low fees. Indexers who choose these low-cost vehicles willingly relinquish the potential for outperforming the index in order to lock in a known, but very small, level of underperformance. Active investors take the opposite tact and wager that they can generate enough extra return above the index to make up for any incremental fees.

For example, consider two hypothetical funds managed against the S&P 500. The first is an index fund with annual fees of 0.05%. The second is an actively-managed fund with annual fees of 0.75%. Assuming the portfolio manager executes the strategy correctly, the Indexers will receive, within a small margin for error, the S&P 500 return less the 0.05% fee.

Therefore, in order to merely stay even over multiple years, the actively-managed fund will need to beat the index return by an average of 0.70% annually¹. And importantly, because the Indexers have elected to lock in their portion of the overall return pie, that extra 0.70% has to come at the expense of other Active investors and members of Group 3. In any given year, there will be some portion of the Active and Group 3 capital that outperforms the index after fees, but it is essentially impossible for all of the capital in those groups to outperform.

Implications for Investors

One common criticism of Indexers is that they are almost certain to underperform the benchmark by a small amount each year because of fees, while a successful active strategy at least has a chance to outperform. Fair enough, but it is important to remember two things.

First, the desired active outperformance by definition has to come at the expense of sub-standard performance by other non-indexing investors. And the degree of outperformance must be large enough year after year to consistently overcome the headwind imposed by any additional fees incurred. While that kind of consistent success is not impossible, we have published other articles that delve into the difficulty active managers have had historically in achieving it.²

There are a multitude of factors that influence the performance of investments over time, most of which are beyond the direct control of any investor. We believe that one of the key drivers of long-term success is controlling the few factors that actually can be reliably controlled. Minimizing the headwind caused by fees is one such controllable factor.

1. Realistically, because the range of potential return outcomes for the actively-managed fund is much wider, Active investors should demand some additional outperformance beyond just the 0.70% fee differential as compensation for that uncertainty.
2. See "Active vs. Passive Investment Management" and "Active vs. Passive in Down Markets".