7. Because mutual fund companies have “owners” who seek profits for their fund company, there are aggressive sales campaigns and incentives paid to salespeople (advisers) to recommend their funds for clients. Investors pay for these. 7. Salespeople rarely tout indexes because they are less profitable for financial service companies to sell.
8. Actively managed fund companies pay annual “trailer fees” to advisers, rewarding them for selling their funds to investors—who end up paying for these. 8. Index funds rarely pay trailer fees to advisers.
9. Most US fund companies charge sales or redemption fees—which go directly to the broker/adviser who sold you the fund. The investor pays for these. 9. Most index funds do not charge sales or redemption fees.
10. Actively managed mutual fund companies are extremely well liked by advisers and brokers. 10. Index funds are not well liked by most advisers and brokers.
Captain America Calls for Government Action
David Swensen is one of America’s most famous investors. He runs Yale University’s endowment fund. Like the marvel comic hero Captain America, he fights for justice. In this case, he rallies against high mutual fund fees. In his book, Unconventional Success, he wrote, “The fund industry’s systemic exploitation of individual investors requires government action.”40
As high as US actively managed stock mutual fund costs can run, the average non-US fund is even more expensive. In a study presented in 2008 by Oxford University Press, Ajay Khorana, Henri Servaes, and Peter Tufano compared international fund costs, including estimated sales fees. According to the study, the country with the most expensive stock market mutual funds is Canada.41
High global investment costs make it even more important for global citizens outside of the United States to buy indexes for their investment accounts rather than pay the heavy fees associated with actively managed mutual funds.
In June 2015, Morningstar published its Global Fund Investor Experience Study. Country cost rankings hadn’t changed much since the 2008 study, “Mutual Fund Fees Around the World.”
Investors who buy actively managed funds in Canada and India end up the biggest losers. Not including the damages of sales commissions (which were included in the Oxford University Press study in Table 3.2), Canadian and Indian investors are still paying more than 2 percent per year in mutual fund fees.42
Table 3.2 The World’s Actively Managed Stock Market Mutual Fund Fees
Country Total Estimated Expenses, Including Sales Costs
Ranking of Least Expensive to Most Expensive Actively Managed Funds
Netherlands 0.82%
#1
Australia 1.41%
#2
Sweden 1.51%
#3
United States 1.53%
#4
Belgium 1.76%
#5
Denmark 1.85%
#6
France 1.88%
#7
Finland 1.91%
#8
Germany 1.97%
#9
Switzerland 2.03%
#10
Austria 2.26%
#11
United Kingdom 2.28%
#12
Ireland (Dublin) 2.40%
#13
Norway 2.43%
#14
Italy 2.44%
#15
Luxembourg 2.63%
#16
Spain 2.70%
#17
Canada 3.00%
#18
Source: “Mutual Fund Fees Around the World,” Oxford University Press, 2008
Sadly, actively managed mutual fund investors from Belgium, China, Denmark, Finland, France, Germany, Hong Kong, Italy, Korea, Norway, Singapore, South Africa, Spain, Sweden, Taiwan, Thailand, and the United Kingdom aren’t far behind. Not including sales commissions, the Morningstar study pegs their actively managed mutual fund costs at 1.75 to 2.0 percent per year.43 After accounting for sales commissions, most of them pay much more.
Why Donald Trump Should Have Bought Index Funds
In 1982, the first year Forbes published its list of the wealthiest Americans, the magazine calculated Donald Trump’s net worth at $200 million. He inherited most of the money from his father. By 2014, Forbes said his wealth had jumped to $4.1 billion. That’s a compounding annual return of 9.9 percent. But Trump cries foul.
He complains that Forbes downplays his wealth. According to Business Insider, he recently said his net worth is $8.7 billion. In 1999, Forbes said, “We love Donald. He returns our calls. He usually pays for lunch. He even estimates his own net worth. But no matter how hard we try, we just can’t prove it.”
Let’s assume that Forbes is wrong—and that Trump has the money he says he does. According to Timothy L. O’Brien’s book TrumpNation: The Art of Being The Donald, Mr. Trump said he was worth $500 million in 1982, not the $200 million reported by Forbes. If we ignore Forbes’ data and base Trump’s wealth on his own figure ($8.7 billion) we find that his net worth has increased by an average compounding rate of 9.05 percent per year.
If Trump had invested that initial $500 million in Vanguard’s S&P 500 index fund, he would have compounded his money by 11.3 percent annually over 33 years. His $500 million would have grown to $17.11 billion. That’s $8.41 billion more than Trump says he has.
Between 1982 and 2014, he could have sat on his butt, spent a few million dollars every year, and ended up a lot wealthier than he is right now.
Who’s Arguing against Indexes?
There are three types of people who argue that a portfolio of actively managed funds has a better chance of keeping pace with a diversified portfolio of indexes after taxes and fees over the long term.
Introduced first, dancing across the stage of improbability is your friendly neighborhood financial adviser. Pulling all kinds of tricks out of his bag, he needs to convince you that the world is flat, that the sun revolves around the Earth, and that he is better at predicting the future than a gypsy at a carnival. Mentioning index funds to him is like somebody sneezing on his birthday cake. He wants to eat that cake, and he wants a chunk of your cake, too.
He exits, stage left, and a bigger hotshot strolls in front of the captive audience. Wearing a professionally pressed suit, she works for a financial advisory public relations department. Part of her job is to compose confusing market-summary commentaries that often accompany mutual fund statements. They read something like this:
Stocks fell this month because retail sales were off 2.5 percent, creating a surplus of gold buyers over denim, which will likely raise Chinese futures on the backs of the growing federal deficit, which caused two Wall Street Bankers to streak through Central Park because of the narrowing bond yield curve.
Saying stock markets rose this year because more polar bears were able to find suitable mates before November has as much merit as the confusing economic drivel that these representatives write and distribute.
If you ask her, she will tell you that actively managed mutual funds are the way to go. But she won’t mention the killer mortgage payments on her $17 million Hawaiian beachside summer home. You need to help her pay it.
Sadly, the third type of person who might tell you actively managed mutual funds have a better statistical long-term chance at profit (over indexes) are the prideful, or gullible, folks who won’t want to admit their advisers put their own financial interests above their clients.
Let’s consider Peter Lynch, the man who was arguably one of history’s greatest mutual fund managers. Before retiring at age 46, he managed the Fidelity Magellan fund, which captured public interest as it averaged 29 percent a year from 1977 to 1990.44 Since then, however, Lynch’s former fund has disappointed investors. If $10,000 were invested in the fund in January 1990, it would have grown to $83,640 by May 16, 2016.45 The same $10,000 invested in Vanguard’s S&P 500 Index Fund would have grown to $99,760. Hammering the industry’s faults, Peter Lynch says:
So it’s getting worse, the deterioration by
professionals is getting worse. The public would be better off in an index fund.46
As the industry’s idol from the 1980s, you might suggest that Lynch is a relic of a bygone era. Perhaps. But let’s turn our attention forward and look at Bill Miller. He was the fund manager of Legg Mason Value Trust. In 2006, Fortune magazine writer Andy Serwer called Miller “the greatest money manager of our time,” after Miller’s fund had beaten the S&P 500 index for the fifteenth straight year.47 Yet, when Money magazine’s Jason Zweig interviewed Miller in July 2007, Miller recommended index funds:
[A] significant portion of one’s assets in equities should be comprised of index funds. . . . Unless you are lucky, or extremely skillful in the selection of managers, you’re going to have a much better experience going with the index fund.48
Miller’s quote was timely. Since 2007, his fund has performed horribly. Between January 2007 and May 17, 2016 (the time of this writing), it gained a total of 2.6 percent. During the same time period, Vanguard’s S&P 500 index gained 78.2 percent.49
Poor performing funds often change their names. Such was the case with Bill Miller’s Legg Mason Value Trust. Miller was once considered “the greatest money manager of our time.” But today, the fund’s name brings nothing but pain. In 2011, Miller stepped down.50 The fund is now called ClearBridge Value Trust.51
Some mutual fund managers, of course (these are people who actually run the funds), are required by their employers to buy shares in the funds they run. But in taxable accounts—if fund managers don’t have to commit their own money, they generally won’t. Ted Aronson actively manages more than $7 billion for retirement portfolios, endowments, and corporate pension fund accounts. He’s one of the best in the business. But what does he do with his own taxable money? As he told Jason Zweig, who was writing for CNN Money in 1999, all of his taxable money is invested with Vanguard’s index funds:
Once you throw in taxes, it just skewers the argument for active [mutual fund] management . . . indexing wins hands-down. After tax, active management just can’t win.52
Or, in the words of a real heavy hitter, Arthur Levitt, former chairman of the US Securities and Exchange Commission:
The deadliest sin of all is the high cost of owning some mutual funds. What might seem to be low fees, expressed in tenths of 1 percent, can easily cost an investor tens of thousands of dollars over a lifetime.53
You don’t have to be disappointed with your investment results. With disciplined savings and a willingness to invest regularly in low-cost, tax-efficient index funds, you can feasibly invest half of what your neighbors invest—over your lifetime—while still ending up with more money.
You may not have learned these lessons in school. But you can learn them now.
Index fund investing will provide the highest statistical chance of success, compared with actively managed mutual fund investing.
Nobody yet has devised a system of choosing which actively managed mutual funds will consistently beat stock market indexes. Ignore people who suggest otherwise.
Don’t be impressed by the historical returns of any actively managed mutual fund. Choosing to invest in a fund based on its past performance is one of the silliest things an investor can do.
Index funds extend their superiority over actively managed funds when the invested money is in a taxable account.
Remember the conflict of interest that most advisers face. They don’t want you to buy index funds because they (the brokers) make far more money in commissions and trailer fees when they convince you to buy actively managed funds.
Notes
1Fred Schwed, Where Are the Customers’ Yachts?, Or, A Good Hard Look at Wall Street (New York: John Wiley & Sons, 1995), 1.
2W. Gregory Guedel, “Ali versus Wilt Chamberlain—The Fight That Almost Was,” EastSideBoxing, May 29, 2006, www.boxing247.com/weblog/archives/109022.
3Linda Grant, “Striking Out at Wall Street,” US News & World Report, June 20, 1994, 58.
4Warren Buffett, Berkshire Hathaway 2014 Annual Report, accessed May 18, 2016, www.berkshirehathaway.com/ 2014ar/2014ar.pdf.
5Mel Lindauer, Michael LeBoeuf, and Taylor Larimore, The Bogleheads Guide to Investing (Hoboken, NJ: John Wiley & Sons, 2007), 83.
6“Investors Can’t Beat the Market, Scholar Says,” Orange County Register, January 2, 2002, www.ifa.com/articles/ investors_cant_beat_market_scholar_ says_hope_yen/.
7Peter Tanous, “An Interview with Merton Miller,” Index Fund Advisors, February 1, 1997, www.ifa.com/Articles/An_Interview_with_Merton_Miller.aspx.
8“Where Nobel Economists Put Their Money,” accessed October 30, 2010, www.youtube.com/watch?v=#x002D;HrTD5J2qP0.
9Ibid.
10“Arithmetic of Active Management,” Financial Analysts’ Journal 47, no. 1 (January/February 1991): 7.
11Ibid.
12Ibid.
13David F. Swensen, Unconventional Success, a Fundamental Approach to Personal Investment (New York: Free Press, 2005), 217.
14Robert D. Arnott, Andrew L. Berkin, and Jia Ye, “How Well Have Taxable Investors Been Served in the 1980s and 1990s?” The Journal of Portfolio Management 26, no. 4 (Summer 2000): 86.
15Larry Swedroe, The Quest For Alpha (Hoboken, NJ: John Wiley & Sons, 2011), 13.
16Larry Swedroe, The Quest For Alpha, 13–14.
17Mark Hulbert, “Index Funds Win Again,” February 21, 2009, The New York Times, www.nytimes.com/2009/02/22/your-money/stocks-and-bonds/22stra.html?_r=0.
18David F. Swensen, Unconventional Success, a Fundamental Approach to Personal Investment, 266.
19Ibid.
20John C. Bogle, Common Sense on Mutual Funds (Hoboken, NJ: John Wiley & Sons, 2010), 376.
21Ibid., 384.
22John C. Bogle, The Little Book of Common Sense Investing, 61.
23John C. Bogle, Common Sense on Mutual Funds, 376.
24Ibid.
25Morningstar.com, accessed May 16, 2016.
26John C. Bogle, The Little Book of Common Sense Investing, 90.
27John C. Bogle, Don’t Count On It! (Hoboken, NJ: John Wiley & Sons, 2011), 382.
28Burton Malkiel, The Random Walk Guide to Investing (New York: Norton, 2003), 130.
29Ibid.
30“Does Past Performance Matter,” S&P Dow Jones Indices, January 2016, us.spindices.com/documents/spiva/persistence-scorecard-january-2016.pdf.
31Larry Swedroe, “You Make More Money Selling Advice Than Following It,” CBS MarketWatch, May 21, 2010, www.cbsnews.com/news/you-make-more-money-selling-advice- than-following-it/.
32Nick Levis, “7 Top Mutual Funds with Long Term Track Records,” Business Insider, July 20, 2011, 2016, www.businessinsider.com/mutual-funds-with-solid-long-term-track-records-2011–7.
33“Interview with Russel Kinnel,” interview by author, September 10, 2015.
34Morningstar.com, accessed November 13, 2015.
35“Confessions of a Former Mutual Funds Reporter,” Fortune magazine archives, April 26, 1999, archive.fortune.com/magazines/fortune/fortune_archive/1999/04/26/258745/index.htm.
36“The 100 Best Mutual Funds for the Long Term,” US News & World Report, May 19, 2010, http://money.usnews.com/money/personal-finance/mutual-funds/articles/2010/05/19/the-100-best-mutual-funds-for-the-long-term.
37Jason Zweig, Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich (New York: Simon & Schuster, 2007).
38Bruce Kelly, “Raymond James Unit Gives Bonuses to Big Producers,” Investment News—The Leading Source for Financial Advisors, June 18, 2007.
39Carole Gould, “Mutual Funds Report; A Seven-Year Lesson in Investing: Expect the Unexpected, and More,” The New York Times, July 9, 2000, www.nytimes.com/2000/07/09/business/mutual-funds-report-seven-year-lesson-investing-expect-unexpected-more.html?.
40David F. Swensen, Unconventional Success, A Fundamental Approach to Personal Investment (New York: Free Press, 2005), 1.
41Ajay Khorana, Henri Servaes, and Peter Tufano, “M
utual Fund Fees Around the World,” The Review of Financial Studies 22, no. 3 (2008), Oxford University Press, faculty.london.edu/hservaes/rfs2009.pdf.
42“Global Fund Investor Experience Study,” Morningstar, June 2015, corporate.morningstar.com/us/documents/2015%20Global%20Fund%20Investor%20Experience.pdf.
43Ibid.
44“The Greatest Investors: Peter Lynch,” Investopedia, accessed April 15, 2011, www.investopedia.com/university/greatest/peterlynch.asp.
45Morningstar.com, accessed May 16, 2016.
46John C. Bogle, The Little Book of Common Sense Investing, 47–48.
47Andy Serwer, “The Greatest Money Manager of Our Time,” Fortune, November 15, 2006, money.cnn.com/2006/11/14/magazines/fortune/Bill_miller.fortune/index.htm.
48Jason Zweig, “What’s Luck Got to Do with It?” Money, July 18, 2007, money.cnn.com/2007/07/17/pf/miller_interview_full.moneymag/.
49Morningstar.com, accessed May 16, 2016.
50Joe Light and Tom Lauricella, “A Star Exits after Value Falls,” The Wall Street Journal, November 11, 2011, www.wsj.com/articles/SB10001424052970203611404577043910758867408.
51Morningstar.com, accessed May 16, 2016, www.morningstar.com/funds/XNAS/LMVTX/quote.html.
52Paul B. Farrell, “‘Laziest Portfolio’ 2004 Winner Ted Aronson Scores Repeat Win with 15 Percent Returns,” CBS Marketwatch.com, January 11, 2005, www.tsptalk.com/mb/longer-term-strategies/1047-laziest-portfolio-2004-winner-print.html?imz_s=llndr74at79s89u1mjuje7p321.
53Mel Lindauer, Michael LeBoeuf, and Taylor Larimore, The Bogleheads Guide to Investing, 118.
RULE 4
Conquer the Enemy in the Mirror
Millionaire Teacher Page 9
