There are transaction costs in managing actual portfolios, but thereare no transaction costs attributed to the hypothetical portfolios repre sented by market indexes. This problem is a bit more difficult. Returns on actual portfolios should be calculated after deducting all transactioncosts, but comparisons with the indexes should be made only after crediting back to the actual portfolios unavoidable transaction costs.The portfolio manager cannot avoid the cost of investing new capitalor of disinvesting for the purpose of making payments to beneficiaries.On the other hand, transaction costs incurred in order to shift fundsamong particular assets in response to changing expectations couldbe avoided by a more passive policy. Returns on common stock portfolios should be judged with avoidable costs included and unavoidablecosts excluded.
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Management fees should not be considered in measuring rates ofreturn for diagnostic purposes. The purpose of the diagnosis is to evaluate the skill of the investor in judging the prospects for particularstocks, and the management fee is not relevant for that evaluation. Obviously, the size of the management fee will be taken into accountin judging the wisdom of continuing to retain an adviser or trustee,but the fee itself should not be allowed to cloud the evaluation ofperformance.
If the actual portfolio of common stocks is riskier than the marketas a whole, the bench mark is harder to define. Sharpe's capital market line provides the theoretical bench mark based on the linear extrapolation of the line between the risk-free asset and the portfolio of riskyassets. The linear extrapolation is based upon the assumption that investors can borrow at the same rate as the federal government and thatthe rate is independent of the amount borrowed. Neither of thoseassumptions is valid. The invalidity is not a serious deficiency ofSharpe's capital asset pricing model in its more general role of explaining the relationship between the risk of particular assets and theirrates of return, but it can be a significant blemish in defining a benchmark for the purpose of evaluating an investor's skill in selecting common stocks.
