We’ve all heard it. We’ve all read it. Most managers fail to match, let alone beat, the market. Actually, it makes sense! And, there’s a very simple reason for this, which comes in two parts.
First, if you believe – probably rightly so – that institutional managers of giant pension plans, mutual funds, etc., actually comprise most of the trading volume, then you begin to realize the managers ARE the market.
So, if they ARE the market, why is it half of them don’t perform above the average and half below? That brings us to the second reason: Expenses.
Indexes don’t have expenses. You can’t even buy an index. You can buy An index mutual fund or exchange-traded fund (ETF) that replicates an index, but not the index.\
Managers, however, are judged on portfolio net-asset-value (NAV) – the value after expenses.
Let’s use an example you experience every day: Your house.
Suppose you bought a house for $250,000 and it appreciated in value right along with the overall housing market at 5% per year for 13 years. Did you tie the market?
Now, let’s use some assumptions you would have to take into account to report YOUR performance:
- Property taxes are and remain at 1% per year
- Insurance is only 0.5% of value each year
- Maintenance is less than 1% and rises at 3% per year
- Final selling costs are only 3%
- Moving costs, loan interest expenses, and cash flow loss is ignored.
What does your performance look like?
| Year | $250,000 | Prop Txs | Ins. Exp. | Maint. | Sell | Value |
| 1 | $262,500 | $2,500 | $1,313 | $2,400 | $256,288 | |
| 2 | $275,625 | $2,500 | $1,378 | $2,472 | $269,275 | |
| 3 | $289,406 | $2,500 | $1,447 | $2,546 | $282,913 | |
| 4 | $303,877 | $2,500 | $1,519 | $2,623 | $297,235 | |
| 5 | $319,070 | $2,500 | $1,595 | $2,701 | $312,274 | |
| 6 | $335,024 | $2,500 | $1,675 | $2,782 | $328,067 | |
| 7 | $351,775 | $2,500 | $1,759 | $2,866 | $344,651 | |
| 8 | $369,364 | $2,500 | $1,847 | $2,952 | $362,065 | |
| 9 | $387,832 | $2,500 | $1,939 | $3,040 | $380,353 | |
| 10 | $407,224 | $2,500 | $2,036 | $3,131 | $399,556 | |
| 11 | $427,585 | $2,500 | $2,138 | $3,225 | $419,722 | |
| 12 | $448,964 | $2,500 | $2,245 | $3,322 | $440,897 | |
| 13 | $471,412 | $2,500 | $2,357 | $3,422 | $14,142 | $448,991 |
The market did 5% per year; but YOUR record was 4.6% per year.
Your record looks like it’s 0.4% below market, right? It’s actually 8% below the market performance (5% – 8% of 5% = 4.6%).
Your house tied – you didn’t.
Now you know why my most managers don’t outperform the index. Collectively, they are the index; but they have expenses, too.
Jim
