Why to avoid costs (and tracking error)

Actively managed stock funds charge yearly fees of 1-3%. Some take management fees north of 4%.

In addition to costs that are typically disclosed to investors (as "total expense ratio" or "management fees" or "entry/exit cost" etc.) there are other costs such as transaction costs that are not typically disclosed to investors.

All costs produce tracking difference.

We assume 0,48% as tracking difference for our "benchmark investment" (which simulates passive ETFs). Total cumulative gain of the benchmark investment (net of taxes) between 2009-2014 was 100,3%.

To illustrate how small differences in tracking difference turn into significant difference over the 6 year period, I recalculated the benchmark investment performance with tracking differences between 0,48% and 4%.

The result is that every 0,5% increase of tracking error makes the cumulative gain roughly 5-6% smaller. The relationship between increase of cost and decrease of cumulative gain isn't linear, but at least with such a short period of time (6 years), it is quite close to linear.

For example, 4% tracking difference drops the cumulative gains to just 60,30% (40% less than with 0,48% tracking difference). Even increasing tracking difference with just 0,52% (i.e. to 1%) drops cumulative gains significantly (to 93,90% - 6,4% less than with benchmark investment).

Many actively managed funds lose to their benchmark index even more than what their management fees etc. take away, which makes the situation even worse.

In long run, it's not the profits alone that matter - also cost of holding matters a great deal!