Excerpted from Common Sense on Mutual Funds by John C. Bogle, pages 127-128
To illustrate that the benefits of a passively managed index fund (compared to an actively managed mutual fund) derive largely from the costs incurred by the traditional fund, I have based the above illustration on the results of a cost-free market index. An actual operating index fund, though it obviously need pay no advisory fees, must incur real-world operational expenses. In fact, the lowest-cost publicly available index funds operate at annual expense ratios of less than 20/100 of 1 percent. Returns (at least for those that are operating most efficiently) should run about 0.20 percent per year behind those of the target index. These efficiently managed funds have, in fact, trailed the index by some 0.20 percent annually, implying that very low portfolio turnover, combined with minimal brokerage commissions, has held transaction costs to nominal levels. To account for costs, we would reduce the 16.0 percent return presented over the past 15 years by the Wilshire 5000 Index to 15.8 percent for a Wilshire 5000 Index fund. The net return would exceed the 14.1 percent return achieved by the average managed fund by 1.7 percentage points.
Even that comparison gives managed mutual funds the benefit of a huge doubt, and, as a result, hardly gives index funds the credit they deserve. The comparison suffers from at least three distinct advantages: (1) it ignores fund sales charges; (2) it is biased in favor of funds that survive the entire period over which the comparison is made; and (3) it is not adjusted for taxes on income dividends and capital gains distributions.
Virtually all presentations of industrywide mutual fund returns suffer from their failure to take into account the initial (front end) sales charges, which are incurred on about 75 percent of purchases of all mutual funds, and any redemption (back end) charges paid by investors who redeem their shares after relatively short-term holding periods. (About 15 percent of funds subject investors to these penalty fees; the number of inventors who redeem shares early and are subject to these fees is not possible to determine.) If investors pay a 5 percent initial sales charge and hold their fund shares for 5 years, their return would be penalized by about 1 percent per year; if they hold the shares for 10 years, the penalty is about one-half of 1 percent per year (these amounts rise if fund returns are positive; they decline if returns are negative). Many funds are sold without sales loads, so the effective industrywide penalty on performance probably reduced fund returns from 14.1 percent to 13.6 percent, or by at least 0.50 percent annually over the past 15 years.
