A Different Drummer

Portfolio manager’s Letter August 2003

John Bogle the founder of Vanguard, wrote an op-ed piece in the Wall Street Journal today. In it he is compares the results of mutual funds their investors, and the market in general “Investors seem largely unaware of the substantial gap by which stock, bond and money market funds lag the returns of the markets in which they invest. While the Standard and Poor’s 500 Stock Index has risen at a 12.2% average annual rate since 1984, for example, the average equity fund has grown at a 9.3% rate, only three-quarters of the stock market’s return.”

The reason of course is frictional costs. Expense ratios average 1.6% of equity fund assets, and he estimates turn-over costs add another 0.8%, add in sale charges an other expenses and total costs come very close to 2.9% that the average fund has under performed the market “But that is only part of the mutual-fund problem. Originally rooted in a focus on stewardship, the fund industry has gradually come to focus instead on salesmanship.” The emergence of sector funds and the relentless pursuit of performance have left the average equity fund investor with performance that does not even come close to the performance of the average fund.

“This bewildering array of choices among nearly 5,000 equity funds has ill served investors. The returns incurred by the average equity fund investor since 1984 have averaged just 2.7% per year, a shocking shortfall to the 9.3% return earned by the average fund”.

2.7% per year!

Bogle says that during the greatest bull market in history the average equity fund investor has received just 2.7% per year. In other words after taxes and inflation the average Joe that had his money in mutual funds for the last eighteen years is probably in the hole. This is indeed something to ponder. At first it does not seem possible, but mindless pursuit of performance gets the crowd to always buy last years winners and we all know how that turns out. Bogle is calling for reform of the industry, more disclosure, and independent directors, he probably feels deep in his heart, that everyone should just buy and hold index funds.

But as a investment manager Bogle’s his statistics made me think about opportunity, how much value a good manager can add, and why value investing works. Bogle says that investing is a zero sum game, and of course it is. Fees remove value from the game and means that in the long run there is always going to be more losers than winners. But with the crowd and huge sums chasing the best performing sectors and funds; and losing big by doing this. The process must leave some winners. It should be possible for the manager running small sums, who only buys with a margin of safety. To beat the index fund?

If you really concentrate on value you will never buy into the hot sectors because the price will always be too high. Value means looking for what is not hot. And if the performance chasers are losing 10% a year to the market, is too much to expect to pick up a few points on the overall market. In a zero sum, if there are lots of big losers there must be some winners. It is the oldest lesson, see what the masses are doing and do the opposite. Is this rocket science? Of course not, does it require discipline, patience and thinking outside of the box? Yes it does.

The irony is that these problems that are causing so much grief for mutual fund investors provide an opportunity to those that are willing to follow a different drummer. Is unrealistic to expect to beat the market? I do not think so.