IFA's Quote of the Week - 34 (Michael C. Keenan)

by Mark Hebner / Mary Brunson - Friday, 12 September, 2008

When it comes to implicit or hidden costs associated with 401(k)’s, Keenan asserts that transaction expenses associated with actively managed funds are roughly equal to their also high expense ratios. Using research from a 2007 report provided by Investment Technology Group, Inc. (ITG) that studied data collected from its clients, which include “the vast majority of large fund managers in the U.S. and Europe”, Keenan determined that if an actively managed fund has 100% annual turnover, it incurs nearly 1% in transaction costs. When this occurs year after year, as is the case with active management, turnover expense is devastating to long-term portfolio growth.

Keenan states, “Index funds incur about 80% less in transaction costs than actively managed funds”. According to that assumption, index funds carry just 0.18% in annual transaction expenses.

The table on the right shows the turnover ratios of various funds for the one-year period for 2006. As you can see, passively managed index funds have far less annual turnover than actively managed funds. For example, the Dimensional Large Cap Value Fund had 9% annual turnover and the Dimensional Small Cap Value Fund had 27%--a sharp contrast to the Rock Canyon Top Flight Fund with turnover of more than 1600%. If we extrapolate from the ITG data, that fund’s turnover would have generated a whopping 15% in transaction expenses! What were they thinking?

The general excuse given by active fund managers is that they find opportunities to beat their index, and therefore their higher fees and transaction costs are worthwhile. The evidence, however, is to the contrary. The charts below show how rare it is that active beats passive.

Many investors know that excessive turnover triggers unpleasant tax consequences, but it significantly hampers returns for tax-advantaged accounts, as well. Plan participants suffer under the weight of these excessive and unreported fees.

A movement is under way to clear away the smoke and mirrors associated with retirement investing. There is an acute hunger for clarity and useful information pertaining to the intrinsic relationship between active management and excessive returns, expenses and returns, risk and time, and risk capacity and risk exposure. The proposed solutions, while long overdue, will take time to resolve, implement, and will be met with the usual politicking that will erode precious time. But, investors need answers now. You can obtain a world-class investing lesson at ifa.com. Hundreds of peer-reviewed academic studies, charts, graphs, benchmarking tools, portfolio simulators, calculators and a risk capacity survey will help you learn and invest according to the Science of Investing.

Index Funds Advisors matches individuals and institutions, including corporations, foundations, endowments and perpetual care entities, with risk-appropriate blends of indexes that have shown to deliver risk-optimized returns over time.  To learn how you can implement a low-cost, risk-appropriate, passive rebalancing indexing strategy, click here.