People are mostly insane.

For evidence, look no further than sales of bottled water in the first world. Our ancestors spent hundreds of billions of dollars developing the infrastructure to deliver potable water to every home, yet we spend billions each year to purchase bottled versions of what we can get for free almost anywhere. Boom – I just blew up the very foundation of economics.

Takeaways:

1. Investors pay too much for traditional active management

2. The market itself does most of the heavy lifting for most mutual funds and ‘smart \beta’ products

3. Where mutual funds do add value in excess of market returns, most of this value is consumed in fees and costs

4. Many GTAA strategies produce returns with low systematic market exposure

5. These strategies produce a much higher proportion of active value.

This irrational behaviour also extends to how we pay for financial products. Consider that most financial products are benchmarked to an index that one can easily track with ultra-cheap ETFs or index funds. Want exposure to U.S. equities? Vanguard’s VTI ETF provides exposure to every U.S. listed stock for just 0.05% per year. That’s basically free. Want international bond exposure? Vanguard’s BNDX gives you diversified international bond exposure for just 0.15%. Again – free.

Yet according to a recent Blackrock report, active mutual funds still dominate about 2/3 of investors’ allocations. And according to the Investment Company Institute, the average cost of active mutual funds is currently about 0.70% on an asset-weighted basis, and 1.33% on an equal-weighted basis. Different fund mandates have different expense ratios, per Figure 1.

Figure 1.

Source: Investment Funds Institute

Presumably, advisors recommend active funds because they expect outperformance relative to an index fund alternative. Let’s set aside for a moment the fact that this outperformance has not materialized for active funds in well over a decade (see SPIVA report here). Instead, let’s play along with the illusion of outperformance and assume an active equity fund delivered a 1% return premium after fees and costs, while an equity index fund produced a 9% return in the same period. Further, assume that the fund has a beta of 1 to the market (this will be explained below).