The Relentless Rules of Humble Arithmetic

The message of this article is simple, obvious, and almost invariably ignored by the investment community: Gross return in the financial markets minus the costs of financial intermediation equals the net return actually delivered to investors. This equation helps explain the failure of the mutual fund industry to deliver to shareholders their fair share of market returns, and it explains the enormous shortfall in the assets of the private and public retirement systems relative to their pension liabilities. It is high time for investment professionals to consider not only the “comparative advantage” of outmanaging their peers but also the “community advantage” that would result from a major reduction in the costs of our investment system. The overarching reality of our system of financial intermediation is both simple and obvious: Gross returns in the financial markets minus the costs of investing equal the net returns actually delivered to investors. Despite the importance of this reality to the collective wealth and security of our citizenry, the investment community has a vested interest in ignoring it. To explain the dire odds that investors face in their quest to beat the market, then, we don't need the efficient market hypothesis; we need only the “cost matters hypothesis” (CMH). Under the CMH, the returns earned by investors as a group must fall short of the market return by precisely the amount of the aggregate costs investors incur. By virtue of the “relentless rules of humble arithmetic,” all of us in the aggregate are average before costs and below average once our investment costs are deducted. America's investment system—our government retirement programs, private retirement programs, and all of the securities owned by stockowners as a group—is plagued by these relentless rules. Just as a gambler's winnings come only from what remains after the croupier's rake descends, so investors' winnings come only after intermediation costs. And these costs devastate long-term returns. This devastation is clearest in the mutual fund industry, the largest of all U.S. financial intermediaries. The enormous but often invisible costs of mutual fund investing and the counterproductive market timing and fund selection decisions made by mutual fund investors have caused the average investor to earn only about 25 percent of the market's cumulative nominal return over the past 20 years. Policymakers must enforce the fiduciary standard implicit in the Investment Company Act of 1940: Mutual funds must be organized, operated, and managed in the interests of their shareholders. The massive shift from defined-benefit to defined-contribution plans in the past 30 years has transferred much of the risk of retirement funding from Corporate America to Main Street America, and the results, thus far, are worrisome. Only 22 percent of U.S. workers save for retirement in a 401(k) thrift plan; a mere 10 percent save through an IRA. And the average balance in each—$33,600 and $26,900, respectively—is hardly the kind of capital necessary to provide a comfortable retirement. Corporate America also has come to ignore these relentless rules. The excessive returns corporations have projected for their pension funds have fostered a substantial underfunding of these plans. Projecting pension fund returns at the current 8.5 percent level allows a corporation to report higher earnings to its shareholders, but such a return has little basis in reality in today's environment. Today, the investment management profession is overwhelmingly focused on “comparative advantage”—providing superior returns to clients. We ignore the fact that in the essentially closed system in which financial markets operate, each dollar of advantage that one professional earns comes at the direct expense of another. As a group, we're average. After costs, we're all destined to fall short of the market return, victims of the relentless rules of humble arithmetic. It is time to expand our pursuit to “community advantage”—providing a higher share of market returns to our clients as a group. This achievement will be possible only by working to reduce system costs. If we do that, capitalism will work better for all stockowners as a group. Two powerful forces stand in the way of realizing this goal. The first is money: Financial intermediaries have become addicted to the stunning profits available in this industry. The second is the failure of financial agents to protect the interests of their principals. In addition to changing the structure, costs, and focus of our system of financial intermediation, we need to change the philosophy of our trustees. As the relentless rules of humble arithmetic and the increased awareness of fiduciary concepts begin to resonate with the investing public, as they inevitably will, we in the financial community, in our own enlightened self-interest, must live up to the responsibilities that we are duty bound to honor.