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It is hard to imagine that even a single one of the large-cap core eq- uity funds has a similar record of consistency. Consistency matters. A fund that is good or very good in the vast majority of years produces a far larger long- term return than a fund that is superb in half the years and a disaster in the remaining half.
In the next chapter, the impact of that long-term consistency is catalogued over the past 25 years. These annual data are what we call survivor-biased; they exclude the records of the inevitably poorer perform- ing funds that regularly go out of business. As a result of this noise in the data, the chart further understates the success of the market-owning index strategy.
While the criticism is valid, the excellent long-term record of the flawed Index belies the existence of a sig- nificant problem. In fact, since the market peaked early in as shown in Exhibit 3. I imagine that the vast majority of money managers would have been ec- static with such an outcome. Equally important, it is consistent with the age-old principle expressed by Sir William of Occam: instead of joining the crowd of investors who dabble in complex machinations to pick stocks and try to outguess the stock market two inevitably fruitless tasks for investors in the aggregate , choose the simplest of all solutions—buy and hold the market portfolio.
Of the equity mutual funds then in exis- tence, only remain. The 96 percent of funds that fail to meet or beat the Vanguard Index Fund lose by a wealth-destroying margin of 4. Indexing is also the predominant strategy for the largest of them all, the retirement plan for federal government employees, the Federal Thrift Savings Plan TSP.
All contributions and earnings are tax-deferred until withdrawal, much like the corpo- rate k thrift plans. Overcoming what must have been some serious reservations, even the Bush administration determined to follow the TSP model in its plan for Personal Savings Accounts as an op- tional alternative to our Social Security program. Since , the Vanguard index fund has produced a compound annual return of 12 percent, better than three- quarters of its peer group.
Yet even 30 years on, ig- norance and professional omerta still stand in the way of more investors enjoying the fruits of this un- sung hero of the investment world. To understand why they do not, we need only to recognize the simple mathematics of investing: All investors as a group must necessarily earn precisely the market return, but only before the costs o f investing are deducted. In a market that returns 10 per- cent, we investors together earn a gross return of 10 per- cent.
But after we pay our financial intermediaries, we pocket only what remains. And we pay them whether our returns are positive or negative! The returns earned by investors in the aggregate inevitably fall well short of the returns that are realized in our financial markets. How much do those costs come to?
For individual investors holding stocks directly, trading costs average about 1. That cost is lower about 1 percent for those who trade infrequently, and much higher for in- vestors who trade frequently for example, 3 percent for investors who turn their portfolios over at a rate above percent per year.
In equity mutual funds, management fees and operat- ing expenses—combined, called the expense ratio—aver- age about 1. If the shares are held for five years, the cost would be twice that figure—1 percent per year. But then add a giant additional cost, all the more per- nicious by being invisible. I am referring to the hidden cost of portfolio turnover, estimated at a full 1 percent per year.
At that rate, brokerage commissions, bid-ask spreads, and market impact costs add a major layer of additional costs. So if we pay nothing, we get everything. Most equity funds hold about 5 percent in cash reserves. If stocks earn a 10 percent return and these reserves earn 4 percent, that cost would add another 0. Brandeis first published in , I came across a wonderful passage that illustrates this sim- ple lesson.
Brandeis, later to become one of the most in- fluential jurists in the history of the U. Supreme Court, railed against the oligarchs who a century ago controlled investment America and corporate America alike. Because the relentless rules of the arith- metic of investing are so obvious.
Indeed, the self-interest of the leaders of our financial system almost compels them to ignore these relentless rules. Their self-interest will not soon change. But as an investor, you must look after your self- interest. Only by facing the obvious realities of investing can the intelligent investor succeed. How much do the costs of financial intermediation matter?
When you think about it, how could it be otherwise? By and large, these managers are smart, well-educated, experienced, knowledgeable, and honest. But they are competing with each other. When one buys a stock, another sells it. There is no net gain to fund shareholders as a group.
In fact, they incur a loss equal to the transaction costs they pay to those Helpers that Warren Buffett warned us about in Chapter 1. Investors pay far too little attention to the costs of in- vesting. Perhaps an example will help. Result: a net annual return of just 5. In the early years, the line showing the growth at a 5. But ever so slowly, the lines begin to diverge, finally at a truly dramatic rate.
It makes them worse. Where returns are concerned, time is your friend. And by the end of the invest- ment period, costs have consumed nearly 70 percent of the potential accumulation available simply by holding the market portfolio. Add that mathematical certainty to the relentless rules of hum- ble arithmetic described earlier. But enough of theory and hypothetical examples. The return on the average mu- tual fund averaged just That 2. Never forget: Market return, minus cost, equals investor return.
Fund investors, inevitably at the bot- tom of the food chain, have been left with too small a share. Investors need not have incurred that loss. Such a fund actually returned That is an annual margin of superiority of 2. On first impression, that annual gap may not look large. But when compounded over 25 years, it reaches staggering proportions. Both of these accumulations are overstated because they are based on dollars, which have less than half the spending power they enjoyed in During this period, inflation eroded the real buying power of these returns at an average rate of 3.
Now, the average fund produced barely one-half ac- tually 53 percent of the profit earned by the stock market through the simple index fund—a return that was there for the taking. It is in the nature of arithmetic that de- ducting the same inflation rate from both figures further increases the comparative advantage of the investment with the higher return, in this case the index fund.
Yes, costs matter! Indeed, costs make the difference between investment success and investment failure. You can add and subtract for yourself. It equals you guessed it only 6. Do your own arithmetic. Realize that you are not consigned to playing the hyperac- tive management game that is played by the overwhelming majority of individual investors and mutual fund owners alike.
The index fund is there to guarantee that you will earn your fair share of whatever returns our businesses earn and our stock market delivers. That is a four-bagger. The general equity funds are up percent. The public would be better off in an index fund. Even hyperactive investors seem to believe in in- dexing strategies. It is what we should all own in theory and it has delivered low-cost eq- uity returns to a great mass of investors.
But the idea that fund investors themselves actually earn those returns proves to be a grand illusion. Not only an illu- sion, but a generous one. The reality is considerably worse. During the year period examined in Chapter 4, the returns we presented were based on the traditional time-weighted returns reported by the funds—the change in the asset value of each fund share, adjusted to reflect the reinvestment of all income dividends and capital gains distributions.
But that fund return does not tell us what return was earned by the average fund investor. And that return turns out to be far lower. To ascertain the return earned by the average fund in- vestor, we must consider the dollar-weighted return, which accounts for the impact of capital flows from in- vestors, into and out of the fund.
In fairness, the index fund investor, too, was enticed by the rising market, and earned a return of Yes, during the past 25 years, while the stock market index fund was providing an annual return of Compounded over the full period, as we saw in Chapter 4, the 2. But the dual penalties of faulty tim- ing and adverse selection were even larger. Exhibit 5. And once again, the value of all those dollars tumbles because we must take inflation into account. The index fund real return drops to 9.
While the data clearly indicate that fund investor returns fell well short of fund returns, there is no way to be precise about the exact shortfall. Whatever the precise data, the evidence is compelling that equity fund returns lag the stock market by a substantial amount, largely accounted for by their costs, and that fund investor returns lag fund returns by an even larger amount.
What explains this shocking lag? Simply put, counter- productive market timing and fund selection. First, share- holders investing in equity funds paid a heavy timing penalty. They invested too little of their savings in equity funds during the s and early s when stocks repre- sented good values.
Then, inflamed by the heady optimism and greed of the era and enticed by the wiles of mutual fund marketers as the bull market neared its peak, they poured too much of their savings into equity funds. Sec- ond, they paid a selection penalty, pouring their money into the market not only at the wrong time but into the wrong funds.
In both failures, investors simply failed to practice what common sense would have told them. This lag effect was amazingly pervasive. Then, the fund industry or- ganized more and more funds, usually funds that carried considerably higher risk than the stock market itself, and magnified the problem by heavily advertising the eye- catching past returns earned by its hottest funds.
As the market soared, investors poured ever larger sums of money into equity funds. While only 20 percent of their money went into risky ag- gressive growth funds in , they poured fully 95 per- cent into such funds when they peaked during and early They also pulled their money out of growth funds and turned, too late, to value funds.
During those five years, these aggressive funds pro- vided spectacular records—annual returns averaging 21 percent per year, well above even the outstanding return of But during the five years that followed, in through , retribution followed. While the index fund eked out a small gain less than 1 percent per year , the returns of these aggressive, risk-laden funds tumbled into negative territory.
For the full 10 years, taking into account both their rise and their fall, the returns reported by these aggressive funds were actually quite acceptable—an average of 7. But woe to the shareholder who chose them. For while the fund returns were acceptable, the re- turns of their shareholders were, well, terrible. Their average return came to minus 0. For the record, the annual return of the index fund share- holder, at 7.
When the annual returns of these aggressive funds are compounded over the full period, the deterioration is stunning: a cumulative fund return averaging more than percent; a cumulative shareholder return averaging negative 4. This astonishing penalty, then, makes clear the perils of fund selection and timing.
It also illus- trates the value of indexing and the necessity of setting a sound course and then sticking to it, come what may. Fund investors have been chasing past performance since time eternal, allow- ing their emotions—perhaps even their greed—to over- whelm their reason. But the fund industry itself has played on these emotions, bringing out new funds to meet the fads and fashions of the day, often supercharged and spec- ulative, and then aggressively advertising and marketing them.
It is fair to say that when ever-counterproductive in- vestor emotions are played on by ever-counterproductive fund industry promotions, little good is apt to result. The fund industry will not soon give up its promo- tions. But the intelligent investor will be well advised to heed not only the message in Chapter 4 about minimizing expenses, but the message in this chapter about getting emotions out of the equation. The beauty of the index fund, then, lies not only in its low expenses, but in its elimination of all those tempting fund choices that prom- ise so much and deliver so little.
Unlike the hot funds of the day, the index fund can be held through thick and thin for an investment lifetime, and emotions need never enter the equation. The winning formula for success in invest- ing is owning the entire stock market through an index fund, and then doing nothing.
Just stay the course. The predictability is so high. Why would you screw it up? As described in Chapter 4, the index fund has provided excellent protection from the penalty of these costs. While its real returns also were hurt by inflation, the cumulative impact was far less than on the actively managed equity funds. The fact is that most managed mutual funds are astonishingly tax-inefficient, a result of the short- term focus of their portfolio managers, usually frenetic traders of the stocks in the portfolios they supervise.
The turnover of the average equity fund now comes to about percent per year. In fairness, based on total assets rather than number of funds, the turnover rate of actively managed funds is 61 percent. Industrywide, the average stock is held by the average fund for an average of just 12 months.
Based on equity fund total assets, only 20 months. Hard as it is to imagine, from to , the turnover rate averaged just 16 percent per year, an av- erage holding period of six years for the average stock in a fund portfolio. This huge increase in turnover and its attendant transaction costs have ill-served fund investors. The other half are held in tax- deferred accounts such as individual retirement accounts IRAs and corporate savings, thrift, and profit-sharing plans.
If your fund holdings are solely in the latter category, you need not be concerned with the discussion in this chapter. But the index fund follows pre- cisely the opposite policy—buying and holding forever, and incurring transaction costs that are somewhere be- tween infinitesimal and zero. With the high portfolio turnover of actively managed funds, their taxable investors were subject to an estimated effective annual federal tax of 1. Despite the higher returns that they earned, in- vestors in the index fund were actually subjected to lower taxes—in fact, at 0.
When we calculate the accumulated wealth in terms of real dollars with buying power, investor wealth again contracts dramati- cally. The annual real return of the average equity fund now drops to 4. Even with the more subdued returns earned in the postbubble era, actively managed funds persist in foisting this extraordinarily costly tax inefficiency on their share- holders. While the net annual return of the average equity fund was 8. But surely the final straws include 1 high costs, 2 the adverse investor selections and counterproductive market timing described in Chapter 5, and 3 taxes.
But the very last straw, it turns out, is inflation. It is truly remarkable—and hardly praise- worthy—that this devastation is virtually ignored in the in- formation that fund managers provide to fund investors. A paradox: While the index fund is remarkably tax- e fficient in managing capital gains, it turns out to be rela- tively tax-inefficient in distributing dividend income. Here is the unsurprising and ever relentless arith- metic: the annual gross dividend yield earned by the typi- cal active equity fund before deducting fund expenses is about the same as the dividend yield of the low-cost index fund—1.
But after deducting the 1. Fund operating costs and fees confiscate fully 80 percent of its dividend income, a sad reaffirmation of the eternal position of fund investors at the bottom of the mu- tual fund food chain. The result: a net yield of 1.
For taxable shareholders, that larger dividend is subject to the current 15 percent federal tax on dividend income, consuming about 0. Para- doxically, the active fund, with an effective tax rate of just 0. But the reality is that the tax imposed by the active managers in the form of the fees it deducts before paying those dividends has already consumed 80 percent of the yield.
If the Vanguard Index Fund could have de- ferred all of its realized capital gains, it would have ended up in the To the extent that the long-run uptrend in stock prices continues, switching from security to security involves realizing capital gains that are subject to tax. Taxes are a crucially important financial consideration be- cause the earlier realization of capital gains will substantially reduce net returns.
Index funds do not trade from security to security and, thus, they tend to avoid capital gains taxes. How- ever, I must warn you that during the past 25 years—the period examined in the three preceding chapters—the A mere 0. A dividend yield averaging 3. But, illustrat- ing the difficulty of forecasting changes in the amount that investors are willing to pay for each dollar of corporate earnings, the speculative return was anything but normal.
Thus we can expect a dead-weight loss of 2. If it re- mains at that level a decade hence, speculative return would neither add to nor detract from that possible 8 percent investment return. If you think it will leap to 25 times, add 3 percentage points, bringing the total re- turn on stocks to 11 percent. Now assume that 7 percent is a rational expectation for future stock market returns. To calculate the return for the average actively managed equity mutual fund in such an en- vironment, simply remember the humble arithmetic of fund investing: nominal market return, minus investment costs, minus taxes reduced to reflect lower capital gains realiza- tion , minus an assumed inflation rate of 2.
It may seem absurd to project such a low return for the typical equity fund investor. But the numbers are there. Again, feel free to disagree and to project the future using your own rational expectations. In summary, the future outlook for stock returns is far below the long-term real return on U.
My projection of a future real return of 4. The real long-term rate of per share earnings growth of U. As suggested earlier, some experts put the figure at only 1 percent on an earn- ings per share basis.
The fact is that lower returns harshly magnify the relentless arithmetic of excessive mutual fund costs, even ignoring all those unnecessary taxes. While costs of 2. The 1. What can equity fund investors do to avoid being trapped by these relentless rules of arithmetic, so devastating when applied to future returns that are likely to be well below long-term norms?
There are at least five options for improving on it: 1 Select winning funds on the basis of their long-term past records. Or 5 Select a low-cost index fund that simply holds the stock market portfolio. In the latter part of , in a speech before these professionals at their Chicago conven- tion, I polled the audience. The clear consensus: stock returns of 6. When Henry McVey, market strategist for Morgan Stan- ley, polled the chief financial officers of the largest corporations in the United States, they ex- pected a future return on stocks of 6.
Other highly regarded investment strategists also share my general view that we are facing a new era of subdued investment returns. Gary P. With an inflation assumption of 2. What can- not be explained is why people are willing to pay the considerable fees involved. Perhaps they are paying for historical returns, for hope, or out of desperation Aggregate fees for the active managers should thus be, at most, the fees associated with- passive management.
Yet, these fees are several times larger than fees that would be associated with passive management. This illogical conun- drum will ultimately have to end. Yet, we live with a legacy of that era: histori- cally high fee structures brought on by trillions upon trillions of dollars seeking growth during the boom and shelter in its aftermath. Second, facing the dual challenge of market efficiency and high costs, investors will continue to shift assets from active to passive management.
Impetus for this move will be the growing realization that high fees sap the performance poten- tial of even skillful managers. Sure, there are always some winners that survive over the years. And if we pore over records of past performance, it is easy to find them.
The mutual funds we hear the most about are those that have lit up the skies with their glow of past success. And when they falter, they often go out of business, consigned to the dustbin of mu- tual fund history. Exhibit 8. The first and most obvious surprise awaits you: fully of those funds—almost two- thirds—have gone out of business.
You can safely assume it was not the best performers that have gone to their well-earned demise; it was the lag- gards that disappeared. The average fund portfolio manager, in fact, lasts just five years. There are many reasons that funds disappear, few of them good. Even funds with solid long-term records go out of business. The funds have simply outlived their usefulness. In other cases, a few years of faltering performance does the job. Sadly, the second oldest fund in the entire mutual fund industry was a recent victim of these attitudes, put out of business by a new owner of its management company.
After surviving all the tempestuous markets of the past 80 years: State Street Investment Trust, —, R. In any event, of the equity funds of are gone, mostly the poor performers. Together, then, funds—nearly 80 percent of the funds among those origi- nal —have, one way or another, failed to distinguish themselves. That leaves just 24 mutual funds—only one out of e very 14—that outpaced the market by more than one percentage point per year. That still leaves us with nine solid long-term winners.
It is a tremendous accomplishment to outpace the market by 2 percentage points or more of annual return over 35 years. Make no mistake about that. But, here a curious— perhaps almost obvious—fact emerges Exhibit 8. Six of those nine winners achieved their superiority many years ago, often when they were of small size. As they grew, the records of six of them turned lackluster.
One fund reached its performance peak way back in , 24 long years ago. On balance, it has lagged ever since. Two others peaked in The remaining three peaked no more recently than , more than a decade ago. That leaves just three funds. Identified in Exhibit 8. Hail to the victors!
Significantly, while the portfolio managers for these three funds have changed over the years, the changes have been infrequent. Succeeding his father Shelby C. Will Danoff has been the lead manager of Fidelity Contrafund since , and Michael Price managed Franklin until , followed by a successor who ran the fund until But before you rush out to invest in these three funds with such truly remarkable long-term records, think about the next 35 years.
Think about the odds that they will con- tinue to outperform. Think about their present size. Think about the fact that within that time frame they are all virtually certain to have at least several new managers. It is a changing and competitive world out there in mutual fund land, and no one knows what the fu- ture holds.
But I wish these managers and the sharehold- ers of the funds they run the very best of luck. Conspicuous by its absence from this list of winning funds is Legg Mason Value Trust, managed since its inception by legendary investment professional supreme, Bill Miller. Since the fund did not begin operations until , it is not on my list. But it provides several lessons about fund performance. But by , the gap had shrunk to 1.
Unsurprisingly, the major inflows of investor capital did not begin until , the seventh year of the streak. Will the fund be afflicted with the same malaise that attacked six of those nine long-term winners just discussed? Or is it merely a brief interval of bad luck. Who can know? Whatever the case, the odds in favor of owning a con- sistently successful equity fund are less than one out of a hundred.
However one slices and dices the data, there can be no question that funds with long-serving portfolio man- agers and records of consistent excellence are the excep- tion rather than the rule in the mutual fund industry. Just buy the hays tack! The haystack, of course, is the entire stock market portfolio, readily available through a low-cost index fund.
The return of such a fund would have roughly matched or exceeded the returns of of the funds that began the year competition described earlier in this chapter. And I see no reason that the same fund cannot achieve a roughly commensurate achievement in the years to come—not through any legerdemain, but merely through the relentless rules of arithmetic that you now must know so well. In fund performance, the past is rarely prologue. With his customary wisdom, Paul Samuelson sums up the difficulty of selecting superior managers in this parable.
A tad delusional? I think so. With all their buying and selling, active investors ensure the market is reason- ably efficient. That makes it possible for the rest of us to do the sensible thing, which is to index. Want to join me in this parasitic behavior? To build a well-diversified portfolio, you might stash 70 per- cent of your stock portfolio into a Dow Jones Wilshire index fund and the remaining 30 percent in an international-index fund.
Every single firm in the fund industry acknowledges my conclusion that past fund performance is of no help in projecting the future returns of mutual funds. Exhibits 5. Studies show that 95 percent of all investor dollars flow to funds rated four or five stars by Morningstar, the statistical service most broadly used by investors in evaluating fund returns.
How successful are fund choices based on the num- ber of stars awarded for such short-term achievements? Not very! Sadly, the orientation of fund investors toward recent short-term returns works worst in strong bull markets. Exhibit 9. The relative performance of the four- and five-star funds has improved since then. Rydex OTC RS Emerging Growth MorganStanley Capital Op Janus Olympus Janus Twenty Managers Capital Appreciation Janus Mercury Fidelity Aggressive Growth Van Wagoner Emerging Growth WM Growth Focused on Internet, telecom, and technology stocks, these funds generated an average return of 55 per- cent per year during the upswing—a cumulative return of percent for the full three years.
Well, you can guess what came next. Fund 9 on the upside actually was last— on the downside. Fund 1 dropped in rank to ; fund 2 dropped to , and fund 3 tumbled to On aver- age, the one-time 10 top funds in the bull market were out- performed by 95 percent of their peers in the bear market that followed.
For investors who believed that the past would be prologue, it was not a pretty result. More like 2 percent. Do the arithmetic. And with 3 years of average annual gains of 55 percent on the upside and annual losses averaging 34 percent on the downside Exhibit 9. Yet while that return was not particularly satisfactory in terms of the traditional returns reported by the average equity fund, it was hardly a disaster.
But for the shareholders of the funds, it was a disas- ter. By investing after seeing those mouth-watering cumu- lative returns that had averaged almost percent, achieved in a soaring bull market, nearly all the buyers of these funds had missed the upside. Then, not a moment too soon, they caught the full force of the downside.
Result: While the funds themselves achieved a net gain of 13 percent, the in- vestors in these funds incurred a loss of 57 percent. By in- vesting in these once high-flying funds, more than half of the capital that investors had placed in these hot funds had gone up in smoke. The message is clear: avoid per- formance chasing based on short-term returns, especially during great bull markets.
As it hap- pened, the top 20 funds of that ranked number one in each year had a subsequent average ranking of among the list EXHIBIT 9. During that period, the highest achievement on the fund list was turned in by the number one funds, which averaged a rank of in the subsequent year. The clear reversion to the mean suggested by that single test represented powerful evidence that winning performance by a mutual fund is unlikely to be repeated.
But there was no reason except common sense to as- sume that the to experience would recur. So, just for fun, I repeated the test in , beginning with the top-performing 20 funds in and the top 20 funds in each of the nine subsequent years. I then checked the rank of each fund in the following year, just as before. In general, the results were remarkably similar. The average subsequent rank of the top 20 funds from through was , outpacing 57 percent of their peers and barely above the average fund among the 1, fund total—just as in the prior test.
In an interesting rever- sal of fortune, however, the number one funds of that era turned out to have, not the highest subsequent ranking, but the lowest ranking among the top These champi- ons subsequently earned an average ranking of among the 1,fund total, outpacing only 34 percent of their peers. The message is clear: reversion to the mean RTM —in this case, the tendency of funds whose records substantially exceed industry norms to return to average or below—is alive and well in the mutual fund industry.
So please remem- ber that the stars produced in the mutual fund field are rarely stars; all too often they are comets, lighting up the firmament for a brief moment in time and then flaming out, their ashes floating gently to earth. With each passing year, the reality is increasingly clear.
Fund returns seem to be random. And by then, you might ask yourself questions like these: 1 How long will that manager, with that staff and with that strategy, remain on the job? In short, selecting mutual funds on the basis of short-term performance is all too likely to be hazardous duty, and it is almost always destined to produce returns that fall far short of those achieved by the stock market, itself so easily achievable through an index fund.
We run [the contest] for the first year [for 10, managers]. Now we run the game a second year. Again, we can expect 2, managers to be up two years in a row; another year, 1,; a fourth one, ; a fifth, We have now, simply in a fair game, managers who made money for five years in a row. The number of managers with great track records in a given market depends far more on the number of people who started in the investment business in place of going to dental school , rather than on their ability to produce profits.
What do you mean? Under normal circumstances, it takes between 20 and years [of monitoring performance] to statistically prove that a money manager is skillful, not lucky. Investors need to know how the money management business really works.
The game is unfair. Where do you invest? In Vanguard index funds. Once you throw in taxes, it just skewers the argument for active management. Personally, I think indexing wins hands-down. Professional investment advisers provide many other services including asset allocation, information on tax considerations, and advice on how to save while you work and on how to spend when you retire; and they are always there to con- sult with you about the financial markets.
Experienced advisers can also help you avoid the potholes along the investment highway. Put more grossly, they may help you avoid making such dumb mistakes as chasing past performance or trying to time the market. At their best, these impor- tant services can enhance the implementation of your investment program. The remaining 40 million families rely on profes- sional helpers.
That is, their advice on equity fund selection produces re- turns for their clients that are probably not measurably different from those of the average fund, some 2. And if professional investment consultants are wise enough—or lucky enough—to keep their clients from jump- ing on the latest and hottest bandwagon for example, the new economy craze of the late s, reflected in the mania for funds investing in technology, telecommunica- tions, and Internet stocks , their clients could earn returns that easily surpass the disappointing returns achieved by fund investors as a group.
Remember the additional short- fall of 2. To remind you, the nominal return of fund investors came to just 7. Alas from the standpoint of the advisers , there is sim- ply no evidence that the fund selection advice they provide has produced any better returns than those achieved by fund investors on average. In fact, the evidence goes the other way.
For equity funds purchased directly: 6. Specifically, the study found that adviser asset alloca- tions were no better, that they chased market trends, and that those they advised paid higher upfront charges. The other groups in- cluded funds operated by privately owned managers, by publicly-owned managers, by managers owned by finan- cial conglomerates, and by bank managers. The Merrill Lynch funds were 18 percentage points below the fund industry average; the Goldman Sachs and Morgan Stanley funds were 9 percentage points below av- erage; and both the Wells Fargo and Smith Barney funds were 8 percentage points behind.
Part of the reason for this disturbing performance may arise from the nature of the job. When the firm introduces a new fund, the brokers have to sell it to someone. Imagine a day when nobody sold anything, and the stock market lay fallow, silent all day long. A Merrill Lynch example illustrates the destructive challenges that are often faced by investors who rely on stockbrokers.
The subsequent returns of the funds, however, were an incredible failure. Internet Strategies tanked almost immedi- ately. Its asset value dropped 61 percent during the re- mainder of and another 62 percent by October The total loss was a cool 86 percent as most of its investors cashed out their shares at staggering losses. Keeping a record like that alive would have been a continuing embarrassment to the firm. For what it is worth, the losses in Focus Twenty were less severe.
Its asset value declined 28 percent in the remain- der of , another 70 percent in , and another 39 percent in , before finally posting positive returns in the three years that followed. But, unlike its Internet Strategies cousin, Focus Twenty soldiers on. The comparative standard would be the returns earned by Vanguard Index Fund. Each quarter, the Times faithfully published the records of the index fund and the advisers, tracking their initial portfolios and the subsequent changes they made.
By , seven years later, the Times reported their ac- complishments Exhibit That is, the average ad- viser produced a paper profit on his portfolio of recommended funds that was about 40 percent less than the profit on the index fund. In mid, the Times abruptly terminated the con- test without notice.
But the fact is that the Times terminated it at the very peak of the bull mar- ket, and at the moment of triumph for the index fund. Since then, the index fund, like the market itself, has barely held its own. Two advisers did considerably better than the index fund during that subsequent period; one was worse, and one about the same. Here is a final piece of compelling evidence to sup- port that thesis.
Mark Hulbert, editor of the Hulbert Fi- nancial Digest, has been monitoring the real-time records of financial advisers who report their recommendations in newsletters subscribed to by investors. Only three outper- formed the market over the subsequent 26 years.
These examples surely reinforce the thesis that index funds endure, while most advisers and funds do not; that index fund returns strongly exceed the returns earned even by those advisers and funds that do survive; that the odds against successful fund selection by advisers are large, and that compounding these rather consistent differentials in rates of annual return mount up to truly staggering differ- ences in wealth accumulation over the long term.
If you consider the selection of an adviser, please take heed of these findings. If you decide to go ahead, make sure you are paying a fair fee which results in a deduction from whatever rate of return your fund portfolio earns. Since most investment advisory fees tend to begin in the range of 1 percent per year, be sure to balance the worth of the peripheral services that advisers provide against the re- duction in your returns that those fees are likely to repre- sent over time.
Finally—and this will hardly surprise you—look with particular favor on advisers who recom- mend stock and bond index funds in their model portfolios. The warning signs here are recommendations of load funds, insurance products, limited partner- ships, or separate accounts. It is simply not worth paying anybody more than 1 percent to manage your money. If he tells you that he is able to find managers who can beat the indexes, he is fooling both you and himself. Relying on even the best-intentioned financial advice seems to work only spasmodically.
How can suc- cessful fund selection prove so difficult? Because of some- thing that, deep down, our common sense tells us: Performance comes and goes. That factor is the costs of owning mutual funds. Costs go on foreve r. While some funds scale down their fee rates as assets grow, the reductions are usually suf- ficiently modest that high-cost funds tend to remain high- cost; lower-cost funds tend to remain lower-cost, and the few very low-cost funds tend to remain very low-cost.
The average-cost funds, too, tend to persist in that category. Another large cost of equity fund ownership is the sales charge paid on each purchase of shares. It, too, tends to persist. Load funds rarely become no-load funds, and vice versa. I can recall no large fund organization making the immediate conversion from a load to a no- load distribution system since Vanguard took that drastic and unprecedented step 30 years ago.
Transactions cost money, and we estimate that turnover costs are roughly 0. Similarly, 50 per- cent turnover would cost about 0. Rule of thumb: turnover costs equal 1 percent of the turnover rate. Most comparisons of fund costs rely solely on re- ported expense ratios, and uniformly find that higher costs are associated with lower returns.
This pattern holds not only for equity funds as a group, but in each of the nine Morningstar style boxes large-, mid-, and small- cap funds, each sorted into fund groups with growth, value, and blended objectives. While few independent comparisons take into account the additional cost of fund portfolio turnover, a similar relationship exists. Funds in the low-turnover quartile have consistently outperformed those in the high-turnover quartile for all equity funds as a group, and in each of the nine style boxes.
Tak- ing into account both costs, we find that the all-in annual costs range from 0. This exercise ignores sales charges and, therefore overstates the net returns earned by the funds in each quartile. Costs matter! Net annual return of low-cost funds, Pre-cost returns fall into a narrow range: a high of Costs account for most of the difference in the annual net returns earned by the funds.
And there is another significant difference. Those highest-expense, highest- turnover-cost funds assumed fully 34 percent more risk than their lowest-cost cousins. When we compound those annual returns over time, the cumulative difference reaches staggering proportions. Total compound gain for the period: percent for the low-cost funds, percent for the high-cost funds, a near doubling of profit arising almost entirely from the cost differential.
Talk about the relentless rules of humble arithmetic! In other words, the final value of the low-cost funds more than tripled over the decade, whereas the value of the high-cost funds barely doubled. Again, yes, costs matter!
But if you are seeking the lowest-cost funds, why limit the search to actively managed funds? The classic index fund had the lowest costs of all: an expense ratio averaging 0. With no measura- ble turnover costs, its total all-in costs were but 0. The gross return of the Index Fund was Carrying a lower risk than any of the four cost quartiles annual price volatility averaging If investors could rely on only a single factor to select future superior performers and to avoid future inferior performers, it would be fund costs.
The record could hardly be clearer: the more the managers and brokers take, the less the investors make. So why not own an index fund with no active manager and no management fee, and with virtually no trading of stocks through those Helpers mentioned in Chapter 1? Why not, indeed? Chapter 12 explores this idea further. And for much of that time, mil- lions of fund investors not to mention dozens of fi- nancial journalists including this one basically ignored him.
Sure, we recognized the intrinsic mer- its of index funds such as low annual expenses and because the funds keep turnover to a minimum, tiny transaction costs. Moreover, because index fund managers convert paper profits into realized gains less frequently than do the skippers of actively man- aged funds, shareholders pay less tax each year to Uncle Sam. To be sure, those three advantages form a trio as impressive as Domingo, Pavarotti, and Carreras. You win. In fact, more often than not, aiming for bench- mark-matching returns through index funds assures shareholders of a better-than-average chance of out- performing the typical managed stock or bond port- folio.
You have a right to call it, as you recently did in a booklet you wrote, The Triumph of Indexing. Several index funds carry expense ra- tios as low as 0. And it works. The case for the success of indexing in the past is compelling and unarguable. And with the outlook for subdued returns on stocks during the decade ahead, I am concluding my anecdotal stroll through the relentless rules of humble arithmetic with a final statis- tical example that suggests what the future may hold.
We can, in fact, use statistics designed to project the odds that a passively managed index fund will outpace an actively managed equity fund over various time periods. The particular example presented here assumes that index fund costs will run to 0.
Result: Over one year, about 29 percent of active managers on average, would be expected to outpace the index; over five years about 15 percent would be expected to win; over 10 years, 9 percent; over 25 years, 5 percent; and over 50 years just 2 percent of active managers would be expected to win Exhibit How will the future actually play out? So it looks as if our statistical odds are in the right ballpark.
This arithmetic suggests—even demands— that index funds deserve an important place in your portfolio, even as they constitute the overriding portion of my own. Whatever the case, in the era of subdued stock and bond market returns that most likely lies in prospect, fund costs will become more important than ever.
Even more so when we move from the illusion that mutual funds as a group can capture whatever returns our finan- cial markets provide to the even greater illusion that most mutual fund investors can capture even those depleted re- turns in their own fund portfolios.
My conclusions about the market returns we can expect in the years ahead, as well as my conclusions about the share of those returns that funds will capture, and the share of those returns that we investors will actually enjoy, have one thing in com- mon: They rely, not on opinion, but largely on mathe- matical facts—the relentless rules of humble arithmetic that make selecting winning funds rather like looking for a needle in a haystack.
You ignore these rules at your peril. If the road to investment success is filled with dan- gerous turns and giant potholes, never forget that sim- ple arithmetic can enable you to moderate those turns and avoid those potholes. So do your best to diversify to the nth degree; minimize your investment expenses; and focus your emotions where they cannot wreak the kind of havoc that most other people experience in their investment programs. Rely on your own common sense.
Emphasize all-stock-market index funds. Care- fully consider your risk tolerance and the portion of your investments you allocate to equities. Then stay the course. I should add, importantly, that all index funds are not created equal. While their index-based portfolios are sub- stantially identical, their costs are anything but identical.
Some have miniscule expense ratios; others have expense ratios that surpass the bounds of reason. Some are no-load funds, but nearly a third, as it turns out, have substantial front-end loads, often with an option to pay those loads over a period of usually five years; others entail the pay- ment of a standard brokerage commission. Exhibit The wise investor will select only those index funds that are avail- able without sales loads, and those operating with the lowest costs.
These costs—no surprise here! Fidelity Spartana 0. Vanguard Admiral a 0. Vanguard Regular 0. USAA 0. Rowe Price 0. UBS 0. Morgan Stanley 0. Wells Fargo 0. Evergreen 0. Morgan 0. I assume, however, that these variations will be lower in the future, and have therefore ignored them as an element in the cost-value equation. Funds tracking a par- ticular index are—or should be—commodities in terms of their portfolios and the returns they provide.
While cost differentials may look trivial when expressed on an annual basis, com- pounded over the years they make the difference between investment success and failure. Its subsequent return can be compared with that of the original Van- guard Index Fund over the same period. The sales commission on the Vanguard Index Fund was eliminated within months of its initial offering, and it has operated with an expense ratio averaging 0.
By , the ratio had decreased to 0. In con- trast, the Wells Fargo fund carried an initial sales charge of 5. These seemingly small differences added up to a 23 percent enhancement in value for the Vanguard fund. All index funds are not created equal. Intelligent investors will select the lowest cost index funds that are available from reputable fund organizations. It should be your own cash cow. Some years ago, a Wells Fargo representative was asked how the firm could justify such high charges.
Investors face a mind-boggling set of confus- ing choices—large cap, mid-cap, small-cap, industry sec- tors, international, single country, and so on. To make it more confusing, indexing works like a charm in every one of these areas. A well-administered index fund is in- evitably destined to surpass the returns earned by the other investors in the market segment tracked by its index.
Even though we never have complete information about the precise returns earned by investors as a group in each segment, given the relentless rules of humble arithmetic, it must work that way. Remarkable but unsurpris- ing. While these comparisons, sorted by number of funds rather than by fund assets, have the flaws noted earlier, the message could hardly be clearer: indexing is the winning strategy.
During the past five years alone, an astonishing 28 percent of all general eq- uity funds have gone out of business. But common sense tells us that for each big success, there must also be a big failure. As it must. For, whether markets are efficient or inefficient, as a group all investors in that segment earn the return of that segment. In inefficient markets, the most successful managers may achieve unusually large returns.
But never forget that, as a group, all investors in any discrete seg- ment of the stock market must be, and are, average. Common sense tells us that for each big success, there must also be a big failure. But after all those deductions of even larger management fees that funds incur in less efficient markets, and the damaging impact of their even larger turnover costs, the aggregate lag is even wider.
So even in inefficient market segments, index funds, with their tiny costs, win again. International funds are also subject to the same allega- tion that it is easier for managers to win in supposedly less-efficient markets. But also to no avail. With indexing so successful in both more ef- ficient and less efficient markets alike, and in U. But while investing in particular market sectors is done most efficiently through index funds, betting on the winning sectors is exactly that: betting.
Largely because emotions are almost certain to have a powerful negative impact on the returns that investors achieve. Add a library card to your account to borrow titles, place holds, and add titles to your wish list. Have a card? Add it now to start borrowing from the collection. The library card you previously added can't be used to complete this action.
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Most advisors, however, are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship. Investing is all about common sense. Owning a diversified portfolio of stocks and holding it for the long term is a winner's game.
Trying to beat the stock market is theoretically a zero-sum game for every winner, there must be a loser , but after the substantial costs of investing are deducted, it becomes a loser's game. Common sense tells usand history confirmsthat the simplest and most efficient investment strategy is to buy and hold all of the nation's publicly held businesses at very low cost.
The classic index fund that owns this market portfolio is the only investment that guarantees you with your fair share of stock market returns. To learn how to make index investing work for you, there's no better mentor than legendary mutual fund industry veteran John C. Over the course of his long career, Boglefounder of the Vanguard Group and creator of the world's first index mutual fundhas relied primarily on index investing to help Vanguard's clients build substantial wealth.
This tenth anniversary edition includes updated data and new information but maintains the same long-term perspective as in its predecessor. Bogle has also added two new chapters designed to provide further guidance to investors: one on asset allocation, the other on retirement investing. A portfolio focused on index funds is the only investment that effectively guarantees your fair share of stock market returns.
For decades, Jack has urged investors to invest in ultra-low-cost index funds. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned.
He is a hero to them and to me. This new edition of The Little Book of Common Sense Investing offers you the same solid strategy as its predecessor for building your financial future. Build a broadly diversified, low-cost portfolio without the risks of individual stocks, manager selection, or sector rotation.
Forget the fads and marketing hype, and focus on what works in the real world.