Wednesday, January 8, 2014

Common Sense on Mutual Funds

I wish I had read John Bogle’s book Common Sense on Mutual Funds when the first edition came out in 1999. I might have saved myself a lot of the time and money I wasted trying to beat the stock market. Instead I’ve read Bogle’s updated 10th anniversary edition long after I accepted the wisdom of trying to capture market returns at the lowest cost possible. If any readers are finding their commitment to indexing being poisoned by thoughts of purportedly market-beating strategies, this book is a great antidote.

Bogle amasses overwhelming evidence of the mutual fund industry’s failure to help investors capture anything close to the full returns of the market. He lays out so much statistical evidence to back up his case that the reader could benefit from notes at the bottom of pages such as “if you’re already convinced of the current point, skip ahead 10 pages.”

The book isn’t just a litany of complaints, though. Bogle lays out his ideas of how a fund company should be run. These aren’t just idle opinions. Bogle founded the Vanguard Group in 1974 and built it into a massive fund company run based on his ideals. By the standards of most mutual fund companies, Vanguard isn’t very successful at making its managers rich. But by Bogle’s standards of serving the interests of fund investors, Vanguard is wildly successful.

Prior to reading this book, I spent a lot of time agonizing over which index ETFs I should own. The conclusion I ultimately settled on in each case was one of Vanguard’s funds (some in Canada and some in the U.S.). Now I feel even better about these choices. My only lingering concern is that I don’t know if Vanguard Canada is run based on the same principles as Vanguard in the U.S.

For the rest of this book review, I’ll pick out a few parts of the book that I found particularly interesting.

Real Returns

“Nominal returns are unadjusted for inflation. Real returns are corrected for inflation and are thus a more accurate reflection of the growth in an investor’s purchasing power. Because the goal of investing is to accumulate real wealth—an enhanced ability to pay for goods and services—the ultimate focus of the long-term investor must be on real, not nominal, returns.”

Stocks vs. Bonds

“The data make clear that, if risk is the chance of failing to earn a real return over the long term, bonds have carried a higher risk than stocks.”

Mutual Fund Industry “Creativity”

“In this exceedingly creative industry, we will no doubt witness the development of countless new short-term strategies, each with an alluring but ultimately vacant promise that hyperactive short-term management of a long-term portfolio can generate getter results than a sensible buy-and-hold approach.”

Fund Selection

“The key to fund selection is to focus not on future return—which the investor cannot control—but on risk, cost, and time—all of which the investor can control.” Bogle quotes Nobel Laureate in Economics, William F. Sharpe as saying that when it comes to funds, “The first thing to look at is the expense ratio.”

Balanced Portfolios

The most widely accepted definition of a balanced portfolio is a 50/50 split between stocks and bonds. However, Bogle defines balanced as “two-thirds in stocks, one-third in bonds.”

Older Investor Asset Allocation

In the first edition of the book (in 1999 when stock markets were booming), Bogle recommended a 50/50 asset allocation for older investors living off their savings. In the 2010 update (just after stock markets had crashed), Bogle changed his mind to recommend “that an investor’s bond position should be equal to his or her age.” Imagine an investor who was 65 at the time of reading the book’s first edition. This investor’s stock allocation suffered through two massive declines, and then Bogle recommends that he or she should sell off some stocks in 2010. Could it be that even the great John Bogle isn’t immune to giving advice that amounts to buy high and sell low?

International Investing

“Foreign funds may reduce a portfolio’s volatility, but their economic and currency risks may reduce returns by a still larger amount.” Bogle recommends “limiting international investments to a maximum of 20 percent of a global equity portfolio.” Bogle wrote this for an American audience. It’s generally accepted that Canadians must diversify out of Canada. But the question is whether it is necessary to go beyond Canada and the U.S. My current allocation to stocks outside of Canada and the U.S. is about 27%, which is higher than Bogle’s recommended 20% maximum.

Indexing

Indexing is “the triumph of experience over hope.”

Mutual Fund Manager Market Timing

When it comes to mutual fund cash reserves, some argue that “smart managers, recognizing that a market decline lies in prospect, can reduce stock holdings.” Unfortunately, “quite the reverse is true. Funds tend to hold large amounts of cash at market lows and small amounts at market highs.”

Index Funds with High Expense Ratios

“When a representative of [an index fund charging 0.95%] was asked how such a confiscatory fee could be justified, he responded ‘It’s a cash cow.’”

Exchange-Traded Funds (ETFs)

Bogle says that ETFs have “ill served fund investors” because there are too many narrowly focused funds and are traded too much. When it comes to owning broad index ETFs for the long term, he does “endorse such a strategy.” But “buy-and-hold investors are conspicuous by their absence from the ETF scene.” Unfortunately, most Canadians can’t invest in U.S. mutual funds, so we have no choice but to use ETFs if we want to hold U.S. funds.

Disappearing Mutual Funds

“How investors can invest for the long term in an industry in which the majority of funds endure only for the short term is an interesting question.”

Reversion to the Mean

“Reversion toward the market mean is the dominant factor in long-term mutual-fund returns.” This is a big part of the reason why looking at past mutual fund returns is mostly futile.

Value Stocks

Over 60 years ending in 2008, growth and value funds had very close to the same average return. While value funds caught up significantly from 2001 to 2008, Bogle is not convinced that a value premium exists.

Dollar-Weighted Returns

When mutual funds report their returns, they use time-weighted returns, which are based on an investor who buys into a fund at the start of the reporting period and holds all the way through without buying more or selling. Dollar-weighted returns take into account the assets in the fund; they tell us what return the average dollar invested in the fund experienced. Unfortunately, when a mutual fund advertises good past returns, investors pile in and the fund usually subsequently cools off just when it has more assets under management. So, dollar-weighted returns tend to be lower than time-weighted returns.

To illustrate the difference in return calculations, Bogle gives an example that I can’t figure out: a “fund’s assets were $1 million at the start of the year, growing to $1.3 million by year-end, reflecting the 30 percent return. Then, on the last day of the year, investors suddenly recognized that its 30 percent gain was pretty remarkable, so they immediately invested $10 million in the fund. In this obviously extreme case, the dollar-weighted return is just 4.9 percent.”

In this example, the internal rate of return (IRR) is still 30%. Perhaps Bogle is using some measure other than IRR for the dollar-weighted return? Or perhaps the example is explained incorrectly? If the 30% return happened all in the first half of the year and the second half of the year had a 0% return, and if the $10 million was invested mid-year, the IRR works out to 5.05%, which isn’t too far from Bogle’s claimed 4.9%.

Fund Management

“No longer is the prudent, disciplined stewardship of fund portfolios the core function around which all others are satellite. Rather, the distribution of shares through aggressive advertising and selling techniques has become the industry’s core function.” I have tended to take for granted that a mutual fund’s main goal is to grow assets under management. However, the cost of this function actually harms the returns of existing investors.

“The mutual fund industry ... is now just another consumer products business. ... Investors are no longer fund owners; they have become mere fund customers.”

A quote from Goldman Sachs: “Managing money is not the true business of the money management industry. Rather, it is gathering and retaining assets.”

Hyperactive Trading

To combat “casino-like trading” Bogle advocates a “five-cent tax on each share of stock traded.” Such a tax would cost me less than 0.01% of my portfolio per year, but would make a huge difference for anyone trading frequently.

Compounding Fees

Bogle makes the point that even when fees sound like a small percentage, they compound over time to significant costs. Quoting Arthur Levitt: “a 1 percent fee will reduce an ending account balance by 17 percent over 10 years.” Bogle continues, “the 2-plus percent all-in cost for the average equity fund would reduce the amount of capital accumulated by about 24 percent over 10 years, and 39 percent over 25 years.” By my calculations, the three account balance reduction percentages should be 9.5%, 18.1%, and 39.3%, respectively. The only way I can make sense of this is if Levitt’s “1 percent” is actually 1.9%, and Bogle’s “2-plus percent” means 2.7%.

Vanguard’s Structure

With traditional mutual fund companies, shareholders own the mutual funds and have a board of directors who are supposed to appoint and control a management company to run the fund. Unfortunately, these boards of directors are usually ineffective and the management company tends to control everything, including their own pay. “A dollar in profits for the management company is a dollar less for mutual fund shareholders.” This makes it very clear that shareholders and managers have misaligned interests.

With Vanguard, shareholders own the mutual funds, and the funds own the management company. As a result, Vanguard “manages its own affairs on an at-cost basis.”

Vanguard employees are paid a percentage of the amount of money they save their shareholders compared to the fees charged by Vanguard’s largest competitors. “In 1998 alone, ... more than $3 billion of value was added to our clients’ returns.” The share of this that goes to Vanguard employees “can amount to as much as 30 percent” of their annual compensation.

Summary

Few investors will take the time to read the over 600 pages of this book, but the payoff for doing so is potentially huge. Investors give away a large percentage of their returns in fees and most don’t even realize it. Taking the time to understand Bogle’s teachings would more than double the investment retirement income for many Canadians.

3 comments:

  1. I've found the willingness to accept mutual fund creativity without questions very remarkable. It's one thing to have someone sell you a a fund that's focused on small-cap Chinese medical precious metals in hopes of getting a better return.

    But it's truly amazing when people believe that an income fund that distributes 10% or a PPN can give them something for nothing when in fact one is simply giving them back their money and the other is protecting them by taking away most of their returns. I'm not surprised that you can fool people with something this complex but I am surprised at how creatively it can be done.

    ReplyDelete
    Replies
    1. @Richard: I think it's easy to fool people when they want to believe it's true. It's easy to persuade people that coffee and red wine are healthy. Apparently it's also easy to convince people that you have a magic formula for earning a safe 10% each year.

      Delete
  2. This is a book I still have yet to read, but maybe I should.

    Thanks for the detailed review Michael.

    Mark

    ReplyDelete