Common Sense on Mutual Funds

"Yes. It’s a wonderful book. Of course, as people say on Wall Street, Mr Bogle is talking his own book, i.e. he’s pitching his own speciality. But as long as you bear that in mind, you can get an enormous education from this book. It’s a wonderful, comprehensive introduction to how the financial markets work. It shows who has your interests at heart, and what the various self-interests are, of all the people you are likely to encounter when you invest. Every step of the way, somebody is going to be dipping into your wallet and pulling money out – often without fully informing you. When you read this book, you’ll have a much better sense of who is taking the money, where it goes, and whether you should be willing to permit it. “Every step of the way, somebody is going to be dipping into your wallet and pulling money out – often without fully informing you.” My own view is a little different from Mr Bogle’s. I wouldn’t go so far as to say that you should never buy a fund that isn’t an index fund. But if you do, you need to have compelling reasons why you are departing from that strategy, because indexing really works. That’s not because professional money managers are stupid or dishonest. It works because indexing is very, very, very cheap. It’s an incredibly low cost way to manage money. And it’s very hard for any other strategy to overcome that disadvantage. Exactly. And it happens at several levels. The first level is because he or she has all this brainpower, you have to pay for that. It’s expensive to research individual stocks, and to have a team of analysts doing it. All of that costs substantial amounts of money – often, for a large fund, well into the millions of dollars a year. The second cost is that someone who is attempting to buy the best stocks, and avoid the worst ones, has to do a fair amount of trading. That fund manager will be buying and selling pretty frequently. Each time he or she trades, that triggers trading costs. An index fund, on the other hand, is pretty much a pure buy-and-hold vehicle. It buys all the stocks in a market index and just holds them, until, for some reason, they’re no longer in the index – and that can be many, many, years. Typically, the average fund that is run by an active portfolio manager will hold a stock for about 11 months at a time. For an index fund, it’s often more like 10-20 years at a time. That’s at least a 10-fold difference in the frequency with which the stocks are traded. Each time, brokerage charges are incurred, which come out of your pocket and add up over time. For many funds, the costs of trading can equal or exceed the costs of management. But at index funds, trading costs are tiny. The third factor is taxes. Index funds tend to generate lower tax bills for people who hold them over time, which can be a very valuable advantage. There are also two philosophical questions that investors might want to ask themselves. One problem is, if I’m buying into this fund because I believe the people running it are extremely smart, then presumably I want to own it as long as they run it. You wouldn’t want to buy a fund run by somebody who is likely to leave before you’re ready to sell, because you don’t know who is going to take over to replace that person. But life is very unpredictable, and at any given moment the genius who is the reason you bought the fund may decide to leave, may get fired, may get hit by a bus, and you suddenly find yourself owning a fund run by someone you’ve never heard of. At which point, you may say, “Wait a minute! I don’t want to own this fund anymore.” Then, if you decide you want to sell it, you may have to pay a tax bill to get out of a fund you don’t even want to own anymore. The second problem is this remarkable paradox: Investors are charged very substantial fees for all this research on stocks that the average fund manager doesn’t even bother hanging on to for more than 11 months. It’s as if the manager spends months and months on research, learns everything there is to know about the company, puts the company into the portfolio, and then as soon as it goes in, it’s time to take it out. That should lead people to question the value of this research process. If, after all that work, the fund manager changes his mind 11 months later, how much could he have learned in the first place? Why was it worth paying him all that money? Those are questions that aren’t easy to answer, even for people who do it for a living. I’ve never actually heard a good answer to that from a fund manager. In the US, at the retail level, yes, Vanguard is the largest provider of index funds to individual investors, and anyone reading the book should bear Mr Bogle’s perspective in mind. Chances are that if he had run a fund company that specialised in something other than index funds, he wouldn’t have written the same book. We all have our biases. But some biases are good for people. Mr Bogle’s is obvious, he doesn’t try to disguise it or excuse it away, and it so happens that his advice is so beneficial for people that I think the bias is entirely appropriate."