Editor's Note: The following is an excerpt from chapter nine of the book The Quest For Alpha: The Holy Grail of Investing by Larry E. Swedroe.

So far, we have been discussing gross returns. Investors don't earn gross returns; they earn returns net of expenses. To get to the net returns, we must subtract all costs, including trading costs. The most obvious cost is a fund's expense ratio. While the typical actively managed fund has an expense ratio of about 1.5 percent, the expense ratio of most index funds ranges from just 0.1 to 0.5 percent. Mutual funds also incur trading costs that are related to turnover.

Trading Costs
Trading costs are not limited to just commissions, but also include the difference between the bid and offer. When buying or selling large amounts of stock, funds can incur market impact costs. An estimate of the negative impact of the trading (turnover) of active managers is provided by a Morningstar study. Morningstar divided mutual funds into two categories: those with an average holding period greater than five years (less than 20 percent turnover) and those with an average holding period of less than one year (turnover greater than 100 percent). Over a 10-year period, Morningstar found that low-turnover funds returned an average of 12.87 percent per annum. On average, high-turnover funds gained only 11.29 percent per annum. Relative to low-turnover funds, trading costs (and perhaps higher operating expenses) reduced returns of the high-turnover funds by 1.58 percent per annum.

For taxable accounts, taxes are often the greatest expense of active management. The negative impact of the burden of taxes is a result of fund distributions. The incremental tax cost of active versus passive funds can easily exceed 1 percent per annum. For example, John Bogle studied the effect of taxes on returns and found:
For the 15-year period ending June 30, 1998, the Vanguard 500 Index Fund provided pretax returns of 16.9 percent per annum.
The fund lost 1.9 percent per annum to taxes. Its after-tax return of 15 percent per annum meant that the fund's tax efficiency was 89 percent.
The average actively managed fund provided pretax returns of 13.6 percent and after-tax returns of just 10.8 percent.
The fund lost 2.8 percent per annum to taxes, a tax efficiency of just 79 percent.

How great a hurdle is the burden of taxes? Consider the following:
Ted Aronson is the founder of Aronson + partners (now Aronson + Johnson + Ortiz), an institutional money manager with about $ 18 billion in assets under management. In an interview with Barron's, he admitted:
"I never forget that the devil sitting on my shoulder [is] low-cost passive funds. They win because they lose less. "
"That's why none of my 20 clients are taxable. Because, once you introduce taxesand it doesn't matter whether it ' s a 12-or 18-month holding period-active management probably has an insurmountable hurdle . We have been asked to run taxable money-and declined. The costs of our active strategies are high enough without paying Uncle Sam. " [Emphasis mine]
"Capital gains taxes, when combined with transactions costs and fees, make indexing profoundly advantaged, I'm sorry to say."
"All of the partners are in the same situation-our retirement dough is here. But not our taxable investments."
"If you crunch the numbers turnover has to come down, not to low, but to super-low, like 15 - 20 percent, or taxes kill you. That's the real dirty little secret in our business: Because mutual funds are bought and sold with virtually no attention attached to tax efficiency."
"My wife, three children and I have taxable money in eight of the Vanguard index funds."