Common Sense on Mutual Funds

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This book was written in 1998 by John Bogle, the founder of Vanguard. It contains strong arguments and ample data to support a strategy of constructing a long-term portfolio from low-cost index funds. This book was written before ETFs became very popular so he doesn’t mention them. He believes that it is folly to attempt to pick actively managed mutual funds and expect their performance to beat a well run index fund over a long period of time.

Bogle argues for an approach to investing defined by simplicity and common sense. Below are his eight basic rules for investors:

  1. Select low-cost funds
  2. Consider carefully the added costs of advice
  3. Do not overrate past fund performance
  4. Use past performance to determine consistency and risk
  5. Beware of stars (as in, star mutual fund managers)
  6. Beware of asset size
  7. Don’t own too many funds
  8. Buy your fund portfolio – and hold it

Indexing

His arguments in favor of indexing are very persuasive. Plus, he presents historical return data to back up many of his points. He states that, in any given year, the S&P 500 index will often beat 70-80% of general equity funds. The index outperforms largely due to costs of equity funds. But there are other benefits to consider: tax efficiency mainly due to the low turnover of a well constructed index as well as survivorship bias existing in the return figures for the general equity funds. He also warns that not all indices are created equal – some indices have high turnover that can lead to greater tax liabilities and some index funds may have higher fees.

Taxes

Taxes are an important drag on performance to consider when constructing a portfolio. Over fifteen years to 1998, on a pre-tax basis the Vanguard S&P 500 index fund outperformed 94% of general equity mutual funds and 97% on a post-tax basis. The post-tax average difference in annual performance was 4.2%. That is a massive performance drag.

Another option that Bogle suggests to reduce tax liability is to invest in a tax-managed fund. Tax-managed funds use several techniques to reduce the taxes which will be incurred by their shareholders. The fund manager can follow an index but emphasize growth stocks with lower dividends. He can also realize losses on portfolio holdings that have declined then re-purchase the securities 30 days later. Additionally, the fund can limit its shareholder base to include only longer term investors by using a variety of penalties for rapid enter and exit into the fund. This is important because when shareholders leave the fund, capital gain distributions may need to be made to the full set of shareholders.

Selecting Superior Funds

While Bogle has established that the average mutual fund will never beat the index fund in the long term (largely due to cost and tax drags), you might be able to find a particular fund which will consistently beat the index through superior research and stock picking. However, it turns that there aren’t many funds that will actually outperform the index in the long run and it is exceptionally difficult to identify them. Bogle cites several academic studies which have attempted to identify persistently outperforming funds. These studies were unable to identify persistent winners. Bogle also demonstrates a few other attempts at identifying winning funds that have failed. Past performance is definitely not a good predictor of future success.

Reversion to the Mean

Bogle is a strong believer of the reversion to the mean of annual returns. By reversion to the mean, we mean that if a particular asset class has better than usual performance for some period of time, it is likely to have worse than usual performance in the future to bring its average return in line with the historical averages. One case that he points out is the differences in returns between value and growth stocks. He presents data which shows periods of better performance for growth stocks and other periods where value stocks performed better. He believes that there isn’t a fundamental difference in the long-term average returns for these two classes. We aren’t sure that mean reversion always holds since the long-term returns of some asset classes may change over time due to fundamental changes. But, it is not hard to pick data which supports mean reversion and Bogle has done it.

Global investing

He doesn’t see much advantage in holding international stocks. He doesn’t see the additional return to cover the currency risk plus he thinks that U.S. businesses have sufficient revenues derived from international markets to give you adequate exposure. The book was written before the strong international returns of 2003-2006.

Overall, this is an important book which espouses many of the ideas that are the core of Vanguard’s approach. Bogle is a legend in the industry and his ideas definitely deserve your consideration.