Loss Calc

How Negative is the Negative-Sum Game of Investing?

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Loss Calc

In theory, investing is a zero-sum game and in practice it is a negative-sum game. Everyday, millions of individuals transact with one another based on their estimates or perception of where value currently exists in the market. Through this repeated process of voluntary transactions, the almost vast and what seems like chaotic fury of economic activity is effectively transmitted into a single piece of information: the price.

As investors, we get to decide how we would like to take advantage of this information aggregating mechanism. Historically, this process has produced approximately $0.10 on every $1 every year1. Regardless of how we decide to gain access to this $0.10, it will always come with a cost. Even for the camp that believes in following a buy-and-hold passive strategy to investing (i.e. we accept the price as being fair for risk taken), we must pay something in order to get access to this $0.10.

This is why investing, as a whole, is considered a negative-sum game. For every winner in every transaction, there must be a loser. The guy who was right in holding a lot of Apple stock (AAPL) was only able to by other investors willing to sell it to him and miss out on the future profits. But how negative is this negative-sum game? What are all of the costs associated with trying to capture the $0.10 on every $1? Would understanding these numbers possibly entice us to consider alternative ways to invest?

Let’s start with a baseline case. For somebody who knows absolutely nothing about the wide world of investing, they would be best served by buying and holding the entire universe of publicly available companies across the entire world through a passively managed index fund. You can buy the Vanguard Total World Stock Index (VTWSX) for 0.27% per year. Thus, the negative-sum for this investor is quite small.  

On the other end of the spectrum, you have professional money managers who not only have access to the best and brightest talent in the industry, but they also have global access to all investable marketplaces. These people have unlimited information and an entire payroll of analysts to turn that information into portfolio action items. These managers attempt to find value by consistently outsmarting their peers and their unlimited information and entire payroll of analysts. In essence, it is a battle of intelligence and process. Who is better at analyzing the information or can get access to that information quicker? What does the negative-sum look like for these folks?

We recently came across a study conducted by Navigate Fund Solutions2 that attempted to quantify the structural costs associated with actively managed mutual funds. These costs included 12b-1 fees, transfer agency fees, trading costs associated with fund inflows and outflows as well as cash drag. The authors of the study looked at the 7-year period ending 2013 and focused solely on the share classes that most retail investors take advantage of. In other words, institutional share classes, which usually have a minimum investment amount over $1 million, were excluded from the study. The entire sample size was just shy of 5,000 different funds and fund share classes, which covered approximately $3.1 trillion in assets. Numbers are reported in terms of both “equal-weighted (EW),” which should be thought of as the cost one could expect to incur by investing in an active mutual fund as well as “asset-weighted (AW),” which should be thought of as the cost experienced by all active investors in aggregate.  Table 1 below shows the results.

Structural Costs of Open-End Actively Managed Mutual Funds
7 Years (1/1/2007 - 12/31/2013)
Cost Component Equal Weighted Asset Weighted
12b-1 Fees 0.40% 0.15%
Transfer Agent Fees 0.17% 0.14%
Trading Costs from IF and OF 0.26% 0.20%
Cash Drag 0.22% 0.26%
Total Cost 1.05% 0.75%

As you can see, depending on which measure you look at (EW or AW), investors experienced somewhere in between 0.75% and 1.05% on average just in structural related costs. This of course does not take into account the expense ratio of the actively managed mutual fund, which as of the end of 2013 averaged around 1.25% for U.S. funds as reported by Morningstar. That puts the overall cost of active investing around the 2% range. So historically we have earned $0.10 for every $1 invested and we would need to give up $0.02 for every dollar in fees if we decide to take an active approach to investing.

While at first glance, 2% might not seem like a substantial number, the power of compounding takes what may seem like a blip and turns it into a complete financial nightmare. Just to give a simple example, a $100,000 initial portfolio value compounded at 8% over 30 years would equal just over $1,000,000 in today’s dollars. Now, if that portfolio had grown at the 10% return that we have seen historically, the ending balance would have been approximately $1,750,000 in 30 years. That is a $750,000 difference just from the costs associated with investing.

Now, the active management industry may have a leg to stand on if they could prove that there is a consistent subset of managers who could cover their average 2% negative sum in extra performance above their benchmark, but as decades of research has suggested, this doesn’t seem to be the case. In fact, the number of active managers that have been able to consistently outperform the market is less than what we would expect by random chance alone.

The take-home for investors is to understand that there is $0.10 per dollar invested that is there for the taking. It doesn’t come without stressful periods of market volatility and heightened degrees of uncertainty, but it is nonetheless there. This is the baseline. The next question is how much of a negative sum game do you want to turn this into? Do not assume that you can consistently find more value out there in the marketplace. Many professionals have tried and vast majority have failed. While our industry has tried to turn investing into a game of additional value, it really is a game of subtraction.


1. Morningstar long-term average return for S&P 500 since 1928 rounded for illustrative purposes

2. Navigate Fund Solutions Study: Avoidable Structural Costs of Actively Managed Mutual Funds (November 2014)