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Kenneth R. French is the Carl E. and Catherine M. Heidt Professor of Finance at the Tuck School of Business, Dartmouth College. He is the author of numerous articles on investing, finance, and economics. He is perhaps best known for his work on the Fama and French Three Factor Model, which in 1992 demonstrated that small capitalization and value stocks offered higher historical returns, and the difference is attributable to additional risk. He is a consultant to Dimensional Fund Advisors (DFA), a money management firm with close ties to the academic community. He is also on DFA’s board of directors and their Head of Investment  Policy.
His most recent study, The Cost of Active Investing, quantifies the cost of active investing, relative to passive/index investing, in the US equity markets.
We spoke with Ken French on May 29, 2008.
What is the main point of your study?
Basically, all I am trying to do is quantify an argument made by Burton Malkiel, William Sharpe, John Bogle, and many others. As they point out, if one investor chooses to hold a passive market portfolio, the aggregate of all other investors’ portfolios must be the market portfolio. Thus, before fees, expenses, trading costs, etc., both the passive individual’s portfolio and the aggregate of everyone else’s portfolios must deliver the market return. And as long as some investors in that aggregate portfolio pay the high fees and transaction costs of active investing (and we assume our passive investor does not suffer trading losses to the other investors), we can be sure the passive investor’s net return is always higher than the value-weight average of all other investors. I measure how much higher. How much does the average investor give up when he or she tries to beat the market?
You found that between 1980 and 2006, the average investor gives up 67 basis points a year by not investing passively and that this percentage was relatively stable through time. In dollar terms, the total cost of active management was $101.6 billion in 2006. Did you find either of the stability of the 67 basis points or the total cost in 2006 surprising?
The stability of the percentage is a surprising and interesting result. But it is also sensitive to a key assumption I made: the turnover in the passive portfolio is 10% a year. I think the 10% assumption is reasonable, but if I had assumed a turnover of 5%, the percentage cost of active management would have increased over time.
The estimate of $100 billion as the cost of active management is probably low, but I am trying to be conservative. I don’t want someone to say I overestimated some small cost, and use that as a reason to throw out my overall conclusion. So I tried to include only the most defensible costs. I have received four emails challenging my results and all were from people in the investment industry who complained that my estimates were too low. I am happy with that outcome.
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