Tuesday, August 22, 2006

Thoughts on Bernstein's The Four Pillars of Investing - Chapter 3

Chapter 3 discusses the history and superiority of indexed investing versus active management. Most of the discussion here is well known regarding the superior performance of index funds over actively managed index funds. Bernstein does a great job and the history is very helpful, as well.

One interesting discussion is the true nature of expense and cost involved in actively managed funds. In addition to the expense ration, which is well publicized, additional expenses exist: Commissions, Bid/Ask Spread and Market Impact Costs.

These additional expenses are not clearly documented, but reduce fund performance as compared to a relevant index.

Commissions are transactional expenses, the bid/ask spread is the fee paid to market makers who provide the liquidity necessary to facilitate purchase and sale of stock on exchanges (they help guarantee that stock will be availalable to buy and sell). The spread is smaller (o.4%) for the largest mostly highly traded companies, larger for foreign stocks (1-4%) and largest for small, thinly traded stocks (up to 10%). Impact costs derive from the size of a mutual fund and the expenses related to trading in such very high volumes (a good example is the reduced return of Fidelity's Magellan fund as it grew in size. Bernstein uses the bid ask spread as an estimate for impact costs.

The end result are addition layers of expenses that mutual funds (and therefore investors) must pay before they enjoy investment returns. These additional expenses can push large cap expenses up 70% beyond the expense ratio and for higher expense funds, such as emerging markets up 350%.

My past readings had only marginal discussions of expense ratios at 12b1 fees. The additional expenses were quite eye opening.

Key points are that over time it is impossible to time the market and that even the best stock picker's performance is more random than consistent.

Ultimately, a mutual fund's long term returns are the market's returns - the aforementioned expenses - failures in the fund manager's strategy.

Have a wonderful day,

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