Presidential Address: The Cost of Active Investing

I compare the fees, expenses, and trading costs society pays to invest in the U.S. stock market with an estimate of what would be paid if everyone invested passively. Averaging over 1980‐2006, I find investors spend 0.67% of the aggregate value of the market each year searching for superior returns. Society’s capitalized cost of price discovery is at least 10% of the current market cap. Under reasonable assumptions, the typical investor would increase his average annual return by 67 basis points over the 1980‐2006 period if he switched to a passive market portfolio. HOW MUCH DO INVESTORS SPEND TRYING to beat the market? To answer this question, I start by estimating the total amount society spends to invest. I measure four components: the fees and expenses investors pay for mutual funds, including open-end funds, closed-end funds, and exchange-traded funds; the investment management costs of institutional investors; the fees investors pay for hedge funds and funds of hedge funds; and the costs all investors pay to trade. I then compare these costs to what society would pay if all investors held a passive market portfolio. The difference is the cost of active investing. Consider a small but representative investor whose initial investment strategy is the value-weight combination of all investors’ strategies. Because the value-weight combination of all investors’ portfolios is the market portfolio, the representative investor’s initial return is the gross return on the market minus the value-weight average of all investors’ costs. How would his return be