By Paul B. Farrell, MarketWatch
SAN LUIS OBISPO, Calif. (MarketWatch) — Marquee performers, flashing neon lights. Cirque de Soliel 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.
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 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 favor 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.
How to beat a fund casino? Hint: it’s hidden in your after-tax returns
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 update daily on MarketWatch. See why Lazy Portfolios are five-year and ten-year pretax winners with no active trading.
Now listen closely as Jack Bogle, founder of the $1.7 trillion Vanguard Funds, explains why on an after-tax basis index funds are winners. Bogle warns, “just as gambling in a casino is a zero-sum game before the croupiers rake in their share and a loser’s game thereafter, so beating the stock and bond markets is a zero-sum game before the intermediation costs, and a loser’s game thereafter.”
Who loses? You and the other 95 million American investors are losers in this casino. Years ago Bogle figured out how to cut your loses. Here’s his secret: In the real world of games, indexing beats actively-managed funds
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 one’s that do rarely repeat. And yet their managers still make hundreds of thousands in annual compensation.
So investors are gambling, playing craps. Bogle’s remarks were underscored several years ago at some congressional hearings on fund reform, which was opposed by fund industry CEOs and killed. Then Illinois Sen. Peter Fitzgerald issued this indictment against their casino:
“The mutual fund industry is now the world’s largest skimming operation, a $7 trillion trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the nation’s household, college and retirement savings.”
I recently asked Bogle for an update. Looks worse today.
The house still wins, fund casinos can’t stop skimming investors
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 owing Vanguard’s S&P500 Index Fund VFINX -0.30% it took in about $180 million in operating expenses. And Vanguard’s 10.7% returns beat Fidelity Magellan’s FMAGX -0.38% 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.
Bogle says the fund casino skims a third off the top in expenses
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.
But fund casinos offer little entertainment. For most investors, you’re gambling your future, your retirement nest egg, with less left over. Fund casinos have mastered the opposite illusion; a fund casino makes you believe you’re winning even when you’re losing. Here’s how Bogle says the casinos run a “loser’s game” for investors:
“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.
Next, deduct “hidden portfolio transaction costs of at least 0.8%” from managed funds says Bogle. Yes, hidden, buried in the reported numbers, which are usually a few months to a year old. Then, you need to deduct the long-term costs of “sales commissions on load funds, another 0.7%.”
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.
Bogle warns that taxes make your losses much bigger
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.