This theory states that, at any given time, the market consists of all the holdings of all investors, and that the total market return is equal to the asset-weighted return of all investors.
As a result, for every invested pound that outperforms the total market over a given period, there must by definition be another pound that underperforms.
The zero-sum game discussed here describes a theoretical cost-free market.
Costs in the mix
Imagine the total of all investors’ returns forming a bell curve, with the market return as the average. In reality, however, investors are subject to costs. The impact of these costs shifts the return distribution to the left.
A high-cost investment moves the return curve much farther to the left than a low-cost investment, making outperformance compared to both the market and the low-cost investment much less likely.
In other words, after accounting for costs, the total performance of investors is less than zero sum.
As costs increase, the performance deficit becomes larger, and the likelihood of underperformance increases until significant underperformance becomes as likely, or more likely, than even minor outperformance.
To quantify the impact of costs on net returns, we charted managers’ excess returns as a function of their expense ratios across various categories of funds over a 10-year period. Figure 1 shows that higher expense ratios are generally associated with lower excess returns. The red line in each category in the figure represents the simple regression line and signifies the trend across all funds for each category. For investors, the clear implication is that by focusing on low-cost funds (both active and passive), the probability of outperforming higher-cost portfolios increases.
Low costs can support higher returns
Costs play a crucial role in investor success. Whether invested in an actively managed fund or an index fund, each basis point an investor pays in costs is a basis point less that the investor receives in returns. Since excess returns are a zero-sum game, as cost drag increases, the likelihood that the manager will be able to overcome this drag diminishes.
As such, most investors’ best chance at maximising net returns over the long term lies in minimising costs. In most markets, index funds have a significant cost advantage over actively managed funds. Therefore, we believe that most investors are best served by investing in low-cost index funds over their higher-priced, actively managed counterparts. We expect the case for low-cost index fund investing to hold over the long term. Like any investment strategy, however, the real-world application of index investing can be more complex than the theory would suggest.
This is especially true when trying to measure indexing’s track record versus that of active management. Various circumstances, including survivorship bias, can result in data that at times show active management outperforming indexing while, at other times, show indexing outperforming active management by more than would be expected.
Survivorship bias is introduced when funds are merged into other funds or liquidated, and so are not represented throughout the full time period examined. Because such funds tend to be underperformers, this skews the average results upward for the surviving funds, causing them to appear to perform better relative to a benchmark.
However, the average experience of investors – some of whom invested in the underperforming fund before it was liquidated or merged – may be much different. The majority of active funds underperformed in most of the asset classes we examined, and this underperformance became more pronounced as the time period lengthened and survivorship bias was accounted for.
Thus, it is important to take survivorship bias into account when comparing the performance of active funds to their benchmarks, especially over longer time periods.
The zero-sum game, combined with the drag of costs on performance and the lack of persistent outperformance, creates a high hurdle for active managers in their attempts to outperform the market. This hurdle grows over time and can become insurmountable for the vast majority of active managers.
A red line does not necessarily exist between actively managed funds and index funds.
For investors who wish to use active management, either because of a desire to outperform or because of a lack of low-cost index funds in their market, many of the benefits of low-cost indexing can be achieved by selecting low-cost, broadly diversified active managers.
However, the difficult task of finding a manager who consistently outperforms, combined with the uncertainty that active management can introduce into the portfolio, means that, for most investors, we believe the best chance of successfully investing over the long term lies in low-cost, broadly diversified index funds.
Peter Westaway is chief economist and head of investment strategy at Vanguard