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The Father Of Index Investing

By David and Tom Gardner
November 18, 2003

David and Tom Gardner recently interviewed Jack Bogle, the founder of US fund group Vanguard, on The Motley Fool Radio Show. Bogle, who is credited with popularizing the index fund, is currently the president of the Bogle Financial Markets Research Center. This edited version of their conversation is the first of two parts. Part two can be found here.

TMF: Jack, let's get right to it. In light of the ever-widening scandal, what is wrong with the mutual fund industry?

Bogle: It has a profound conflict of interest between the managers who run the funds and the shareholders who own them.

That is the nub of the late-trading and market-timing scandals. The managers have been doing things that are disgusting, for want of a better word. The late trading is simply illegal and unethical to boot. The International Time Zone trading where they allow certain investors, privileged investors, to time the markets when they know, as Attorney General [Eliot] Spitzer says, "which horse has won the race."

It has been known about for years, at least a decade. Articles have been in The Financial Analyst Journal about it. No surprise there. The general level of mutual fund timing is just plain too high. There is too much trading money sloshing around in this industry that was designed for long-term investors.

TMF: Let's talk about four of the major areas that you identify as good for mutual fund managers, but bad for the rest of us. Let's start with market timing.

Bogle: Well, I have touched on that a little bit. It is mainly the nibbling away of small amounts of money from long-term fund shareholders in favor of short-term traders. That is the number that I don't think is too large, but that doesn't mean it is ethical. I recently used the example of the young kid who goes to work in a one-man grocery store and he figures out by the second day that the owner wouldn't notice it if he took $5 out of the till every day. He did and the owner didn't. Does that make it right? I don't think so. It is theft.

TMF: How about management fees and what do you think a reasonable fee for a mutual fund is?

Bogle: Management fees in this industry run about 1.6% for the average equity fund. By the time you add in portfolio turnover costs, which nobody discloses, and you add the impact of sales charges and opportunity costs because funds aren't fully invested, and out-of-pocket fees, you are probably talking about another 1.4% of cost, bringing that 1.6% management fee or expense ratio up to 3% a year. That is an awful lot of money.

TMF: That is right. In a world where the market on average goes up 10% a year, to give away three percentage points of that gain is painful.

Bogle: It is very painful and if you compound that over time, what it means is that over 30 years a long-term investor in funds is going to get about half as much as an investor who doesn't have any cost at all. The dollar compounded at 10% is going to grow to about $18.50. A dollar compounded at even 7.5%, assuming a 2.5% cost, is going to grow to $9.25.

TMF: Huge difference.

Bogle: Huge difference. What you are seeing is, I am a mutual fund shareholder and I put up 100% of the capital, I take 100% of the risk and I get 50% of the return. The croupiers or the financial intermediaries put up 0% of the capital, take 0% of the risk, and also get 50% of the returns.

TMF: What about growth in a fund size? Why is that good for them, bad for me?

Bogle: What happens is that people I think very inadvisably often buy mutual funds when they are of moderate or small size and the manager has developed a very excellent record beating the market year after year. It is the nature of this business that people think the past is prologue; it is actually anti-prologue.

But people pour their money into that fund and it gets bigger and bigger and bigger. The management fees grow right up with the fund, but the fund stops doing well. Why? Because turnover costs are higher because opportunities to buy smaller stocks are limited. To have a fund where a stock makes an impact on the portfolio -- it's much more difficult on a $20 billion fund than on a $500 million fund. So it gets tougher and tougher for the fund to do well and it gets easier and easier for the manager to make a large profit.

TMF: What about the problems with marketing in the mutual fund industry?

Bogle: The problem with marketing is that you are always trying and what does marketing mean? It means giving the client or customer what he or she wants. In this business, we do it all the time.

We created 496 new technology funds, Internet funds, new economy funds, telecommunications funds, and aggressive growth funds investing in those stocks. When did we do it? Not when they were cheap in 1990; we did it in 1998, '99, and the early part of 2000 when they were very expensive. We sold them to investors by advertising staggeringly high returns that they had made previously and in come the sheep waiting to be sheared. Sheared they were.

We estimate that something like, in the last two or three years of the boom, $500 billion went into those overexposed, risky funds and something like $50 [billion] or $60 billion came out of value stocks. Value stocks were about to distinguish themselves in the market decline, and the new economy stocks were about to lead the market decline downward, just like the Nasdaq itself did.

TMF: Now, Jack, does that mean that you think a contrary investor has a chance at doing better than the market's average sustainability if they are not buying those telecom and high-tech funds at the wrong time -- if instead they are investing in things that are out of favor, things that are neglected?

Bogle: There is certainly a fair amount of evidence that says so, if you do the opposite of what everybody else is doing, buy the funds that are least popular, for example. You could make money on it. I remain very skeptical in part because investors are captives not only to the economics of investing, the fundamentals, the earnings and dividends, the long-term returns on stocks, but to the emotions in investing.

So, if someone goes into some group that is going down and is depressed -- let's say maybe energy stocks or something like that -- even though they are going to be right in the long run, if they are wrong for the first two years, they are going to throw up their hands and say, "I was wrong" and get out. Probably at exactly the wrong time.

My belief is own the entire stock market and hold every stock in it forever. That is the formula for success.

TMF: How prevalent is market timing in the mutual fund industry as you know it and why is it wrong?

Bogle: The redemption rate in this industry last year was 42% of assets. That means that the average fund investor held his or her shares for an average of just two-and-a-half years. Now we are told by the industry that we shouldn't pay much attention to that number because most fund investors, they say 80% of the fund investors don't do anything during the year.

Well, if that is true, and I suppose it probably is, that means the other 20% have a redemption rate of around 400%. That means they are trading and holding shares for maybe 90 days. That is the average for that 20%. Something like that. So that is pretty darn prevalent.

We looked at one of the funds that had gotten in some trouble with all this trading and it was an amazing number. The fund had assets of $2 billion and it had redemptions for the year 2002 of $9 billion; $9 billion of redemptions in a $2 billion fund. That is 440% investment rate or redemption rate. There are a lot of timers in that baby, believe me.

TMF: Let's take an average listener out there who is meeting with their financial advisor to talk about what mutual funds. What are one or two questions that every single individual investor should be asking their financial advisor about a fund that they might buy?

Bogle: Well, I will give you a new term. I would measure each fund on its Stewardship Quotient. The SQ. No. 1 on the SQ is what does the fund cost? What do they charge per year? Low cost, high SQ; high cost, low SQ.

TMF: What's a high cost? What is a specific number that we should shoot for?

Bogle: A quarter of the funds in the industry have 2% or 2.5% fees. Probably a quarter have fees below three-quarters of 1%. I don't think people have much business in getting much above three-quarters of 1% for how much they pay.

No. 2 on the SQ is portfolio turnover. Portfolio turnover is costly. It is directly related to the higher costs I discussed earlier so you want low turnover. If you can get a fund under 30% a year, I would say that was good. Probably above 70% is simply unacceptable.

TMF: According to a study you cite during the period 1984-2002, the U.S. stock market, as measured by the S&P 500 index, grew at a yearly rate of 12.2%. The average mutual fund, however, grew at a rate of 9.3% per year. So, the index fund outperformed the average mutual fund by nearly three percentage points per year. Why, specifically?

Bogle: When you add all the costs together, it comes to something like 3% a year, so it gives us a shortfall of 3%. That was all those brilliant mutual fund managers out there; professional and expert and well educated and trained, and most of them are. They have created such a perfect market that good results by one of them offsets bad results from the others. The average mutual fund manager is average.

TMF: So why does this industry exist outside of indexing? Let's say there is a select group that has proven if you take, for example, Jim Gibson at the Clipper Fund has outperformed the market consistently and has a theory that underlies his investment approach. Why do the rest of all these thousands of funds that consistently underperform the market, why do they exist?

Bogle: Well, they have a great sales force. Financial services in this country, since the beginning of time all over the world, have grown more by appealing to supply push. That is, go out and pay a lot of people a lot of money to sell your wares and by demand pull. That is to say, make it very attractive to the buyer and the buyers will beat a path to your door.

Part Two

The Stock Ideas series consists of articles originally published on our US site, Fool.com.