The Case Again for Low Expense Index Funds

A new study by Mark Kritzman, president and CEO of Windham Capital Management, found that standard index funds - those with their lower fees and expenses (including transaction costs, taxes, management fees, and performance fees) - gave better returns than actively managed mutual funds and hedge funds (see New York Times article).

For his study, which is similar to past studies, Kritzman calculated the average return over a 20-year period, net of all expenses, of three types of investment, including a stock index fund with an annual return of 10 percent, an actively managed mutual fund with an annual return of 13.5 percent, and a hedge fund with an annual return of 19 percent. He used volatility, turnover rates, transaction fees, management fees, and performance fees that were based on industry averages.

His finding pointed to the problem with high expenses. The actively managed mutual fund and hedge fund each had total expenses of more than 3.5 and 9 percentage points a year, respectively. As a result, in order to break even with the index fund net of all expenses, the actively managed fund would have needed to outperform the index fund by 4.3 percentage points a year before expenses. For the hedge funds, it was even worse, with each fund needing to outperform index funds by 10 points a year. While similar studies have been done in the past, the current finding are just yet another reason that the 2-20 hedge fund model may see more resistance going forward. Managers will no doubt be asked more than ever to verify their ability to capture alpha.