SAN LUIS OBISPO, Calif. (MarketWatch) — Marquee performers, flashing neon lights. Cirque du Soleil and Celine. David Copperfield’s magic. Elvis and the Jersey Boys. Mirage and Circus-Circus. Cha-ching, cha-ching. Welcome to the world’s biggest casino!
Vegas? No, the mutual fund industry.
The world’s biggest casino? Not Las Vegas, but mutual funds.
Still, the Vegas imagery captures my imagination every time, reminding me of Vanguard founder Jack Bogle’s analysis of America’s mutual fund industry, repeated often in so many memorable talks, in InvestmentNews and others since the 1970s. So let’s update Bogle’s fabulous “croupier” analogy of the fund industry; it makes us feel the red hot excitement of Vegas casinos! Cha-ching, cha-ching!!
Bogle begins by hammering home a key fact: “Investors earn a net return, after all of the costs of our system of financial intermediation.” Forget the published statistics that have historically favored industry insiders, not investors. In fact, the fund industry is allowed to skim lots off the top, says Bogle, leaving investors with a lot less than the government-sanctioned numbers barely reveal.
Why is this so crucial? Because this is Bogle’s secret system for beating the mutual fund casino. We first covered the Lazy Portfolios 10 years ago in early 2002. Bogle was the inspiration. That led to our “Lazy Person’s Guide to Investing” and ultimately became the 8 Lazy Portfolios that are now updated daily on MarketWatch. See why Lazy Portfolios are five-year and ten-year pretax winners with no active trading.
Yes, buying any mutual fund other than index funds is pure gambling. Research proves Bogle’s point. Every year roughly 70%-80% of funds fail to beat their benchmark, and the ones that do rarely repeat. And yet their managers still make hundreds of thousands in annual compensation.
I recently asked Bogle for an update. Looks worse today.
Bogle’s reputation was built on low-cost index funds. His first was back in 1976 and it’s still popular, managing $26 billion in assets. Active fund managers hate index funds because there’s not enough for their croupiers to skim off with index funds.
For example, when we first compared the cost of owning Vanguard’s S&P500 Index Fund VFINX, +0.16% it took in about $180 million in operating expenses. And Vanguard’s 10.7% returns beat Fidelity Magellan’s FMAGX, +0.48% 7.5% returns that year while Magellan paid itself over twice as much in fees, roughly $400 million in fees on less than half the assets. Why? Because of all the extra expenses, index funds are able to pass on to their investors a much bigger share of the total returns.
Things aren’t much better today: Magellan’s total expense ratio is 0.54% with an average annual five-year return of minus 3.6% versus expenses of just 0.17% for Vanguard’s index fund, which has had positive annual return averaging 0.48% the past five years.
Why? Another big part of the reason is that active managers are “churning” their portfolios, adding trading costs. For example, Magellan turns over the portfolio 99% annually versus a mere 4% at Vanguard. The two have similar portfolios of big-ticket blue chips.
People go to Vegas for the entertainment, expecting to lose. You’ve got to have some fun in that world of magic, color, fun, bright light — even love — hearing the cha-ching, cha-ching of money going into the casinos’ coffers.
“The mutual fund croupiers rake huge sums off the stock market table,” says Bogle. Here’s his current estimate: Management fees average 0.8%. Other expenses are 0.6%. So the average expense ratio for the industry is well over 1%, often five to seven times the ratio for comparable index funds.
As a result, the total costs for you, if you’re an investor in an actively managed fund, is 3%, leaving you with just 4% on a 7% return. Yes, the casino’s operators are skimming off almost a third of your mutual fund to pay themselves some handsome salaries.
But it’s even worse on an after-tax basis: “Because of the shocking tax inefficiency” the fund casino’s average turnover is often greater than 100% for an actively managed stock fund portfolio. So you deduct another 2%, says Bogle. When you compare index funds with managed funds “the real annual return drops to 8.9% for the index fund and to 5.1% for the equity fund,” almost half as much. Cha-ching, cha-ching!!
Bogle went even further in his research, comparing the results of compounding the two alternatives over a 20-year period: “The cumulative profit of each $1 initially invested in the managed fund came to just $1.70 in real terms, after taxes and costs, only 38% of the real profit of $4.50 in the index fund.” In short, indexing is substantially more profitable.
But few fund casino insiders will admit any of this openly. Why? Because for decades the fund casino has heavily financed a special interest lobby that’s protected by Congress and the SEC, both of whom let the fund casinos hide behind the false front of misleading pretax returns in their ads and sales pitches.
Of course most investors fail to analyze real after-tax returns and just stick with highly publicized actively managed mutual funds in spite of the higher costs and lower average returns. As a result, they are losing money year after year.
Bottom line: Stop betting in the fund casino’s “loser’s game.” Check out the Lazy Portfolios, see how in the longer run, over five and 10 years, indexing wins.