What is the cost matters hypothesis?
The cost matters hypothesis is a term referring to minimizing costs and fees in investment management in order to maximize the amount of returns for investors. The term is often associated with investorJohn Bogle, who popularized the index fund and argued that individual investors shouldn’t be burdened with high fees set by fund-management companies for investing their money in the financial markets via mutual funds.
In a 2005 article “The Relentless Rules of Humble Arithmetic” published in the Financial Analysts’ Journal by the CFA Institute, Bogle said that in an inefficient or efficient market, as outlined in the efficient market hypothesis, investors’ returns as a group should fall short of market returns by the aggregate costs entailed.
Bogle argued that “costs matter” and costs should be minimal for investors so that they can make the most of their investments and not be burdened by the management fees set by investment management firms. He wrote that “the investment community is ignoring the reality that the costs of financial intermediation are devastating the net return actually delivered to investors.”
Typically, management fees set by actively managed funds tend to be higher than those of passive funds that try to mimic the performance of the market by matching the composition of market indexes. The expense ratio—the ratio of management fees to assets under management—may be 0.1% for an index fund, for example, compared to 0.5% for an actively managed fund and 0.2% for an exchange-traded fund (ETF).
Active managers tend to justify their costs and the risk of investment by their funds’ performances exceeding the returns of their benchmarks. On the flip side, active funds that underperform or fail to match their benchmarks wouldn’t justify expenses being higher than the management costs for passive funds. Taking that into account, Bogle would argue that investors are at a disadvantage, and active funds’ underperformance ends up costing them more.
What is the formula for the cost matters hypothesis
Bogle expressed the cost matters hypothesis in this formula:
Gross returns in the financial markets – Costs of financial intermediation = Net returns delivered to investors
Who was John Bogle?
Bogle was a pioneer in the mutual fund industry for advocating passive investing and minimizing costs to investors. In 1974, after working for the Wellington Fund in investment management for more than two decades, he founded The Vanguard Group, which eventually became the biggest provider of mutual funds.
In 1976, Bogle introduced the first index mutual fund, the Vanguard 500 Index, to match the performance of the S&P 500 Index, but kept costs low for investors. This low-cost approach consequently changed the way that the fund investment community charged for managing money, since money managers had typically set the fees and investors had little negotiating power to change the rates.
Since the Vanguard 500 Index was introduced more than four decades ago, similar low-cost funds have proliferated, and Vanguard nowadays manages trillions of dollars in passively managed funds, namely index funds and ETFs. As index funds and ETFs gained popularity throughout the years, fund management firms stayed competitive by lowering their fees on actively managed funds.
Followers of Bogle’s investment mantra on low-cost management fees describe themselves as Bogleheads.
What are the limitations of the cost matters hypothesis?
Costs do matter for individual investors trying to make the most of their investments. But investors too focused on index funds might miss out on opportunities in actively managed funds or individual stocks that could have returns that exceed those of index funds over the long term.
Despite what the cost matters hypothesis attempts to achieve, and its advocation of passive index funds, some fund management companies charge the same fees on index funds as they do on ETFs and actively managed funds. As such, investing solely in index funds on the basis of cost may not be as rational as investing in other funds.
