The Costs Of Active Investing

All Arguments Have Two Sides: So Does Active InvestingLet's consider the impact of taxes on passive tax-deferred retirement savings accounts:1.Tax-deferred accounts can be actively-traded without adverse tax consequences (so why not trade them when appropriate?2.Your advice to invest passively in tax-deferred accounts causes your clients to pay your distribution or management fees on asset balances that ultimately belong to the government.3.Contributions to tax-deferred accounts will ultimately be taxed at full-bore ordinary tax rates while profits on the same money invested in a taxable account with a positive return may enjoy long-term capital gains tax-preference. In additions, short-term losses can be offset immediately against short-term gains. Those losses reduce the base for the management fees.4.Active trading within a mutual fund can realize the same benefits and also make the management fees charged by the funds tax-deductible (in the form of lower distributions).5.Since half of the money passively invested in tax-deferred retirement plans has been lost (mostly in the 2000-2003 50% bear market) you have to wonder about the value of passively managed assets. The losses were mostly from ill-considered investments in the stock of large-cap companies with many employees and no longer or barely still with us (Merrill Lynch, Wachovia, GM, Ford, Chrysler, and the 300 banks that have failed in the past two years and the disastrous ill-timed introduction of target maturity funds in 2007 (in the face of the 2008 credit crisis). The risk of huge losses never to be recovered in their lifetime in bond funds in coming years compounds the issue.6.Active management fees are, of course, justified only if an experienced active manager with a long-term track record of success can add value over and above passive returns. If you earned an average positive net annualized net return of 7-10% a year over the past decade and more than doubled your money, any fee you paid was worth it. If you avoided a 2.0% management fee and lost money, the fee was excessive.7.I am assuming the discussion of gross returns came up because separate account returns are reported that way by Morningstar and must be quoted to institutional clients in that matter to satisfy GPPS standards. Otherwise, returns are reported and quoted to clients net of average management fees to satisfy SEC standards. The standards are inconsistent and so any discussion of gross returns is irrelevant - no one earns them and they exist only to satisfy regulators.8.The cheap S&P 500 index funds barely earned a positive return this 21st century.9.Comparison of the 1980s and 1990s with the investment markets since then are irrelevant. When interest rates fell from 1982-1999, it only made sense that large-cap stocks (like the S&P 500) or "stocks masquerading as bonds" would rise. In the 1990s, Vanguard 500 out-performed 88% of all managed stock funds. Interest rate declines of that magnitude are behind us not ahead of us.10.Losing a dollar to save 25% in income taxes is tax-efficient and irresponsible.11.I feel sorry for Aronson's family if he "stayed the course" as so many investors did. It's time to put that wishful thinking investing behind us.12.It may surprise investors looking back at today from the perspective of ten to fifteen years from now that some of the least volatile but best buy-and-hold investments today might have turned out to be money funds (which take advantage of rising interest rates long-before stock and bond markets can absorb them) and stock funds of markets that long ago "emerged." (Taiwan, South Korea and Israel are three economies now regarded as developed countries, albeit with big bull's eyes on their backs.) The combination of economic growth and a falling dollar may be the most powerful combination over the next decade or so. However, it is wise to remember the lesson we learned this past decade, "the only thing that goes up in a down market is correlation."The tragedy is in the eyes of financial advisors who assumed that their clients earned the 10% a year average returns that they felt could be "expected" from stock funds only to discover that their clients can't afford to retire due to the losses they suffered in 2000-2003.Of course, advisors who objectively search for experienced and seasoned active managers have good reason to have loyal clients. Remember a 7.2% average annual return will double your money in a decade but it takes a low standard deviation (say under 8%) to keep the road from being too bumpy to live with. That may sound a simple goal but few if any mutual funds or passive advisors achieved that over the past decade.