According to the Investment Company Institute, the average expense ratio of actively managed stock mutual funds was .71% in 2020. The average expense ratio for index stock funds is .06%. Why are actively managed funds more expensive? Fees are higher in active funds to pay transaction costs, pay the salaries of the research team and in general more activity means more costs.
Why does this matter?
Assume you invested $100,000 in each of two funds, one passive and one active. The passive index fund has an annual fee of 0.06%, and the active one has an annual fee of 0.71%. If both returned 5% annually for 10 years, the lower-cost fund would be worth about $161,961, whereas the 0.71% fund would be worth about $152,204 or about $9,757 less. And the difference would compound over time, with the lower-cost fund worth about $30,653 more after 20 years.
I know, I know, I know. The theory of active management is it will beat passive investing and therefore assuming the same return for both types of management is implausible. However, as we will see in the next blog post, the theory does not hold up.