Bogle's Corner

November 01, 2005

Excerpted from remarks by John C. Bog l e to the Am e ri can As s ociation of Individual Investors, Philadelphia Chapter, on May 24, 2005 .

In the long run, what drives the returns on financial investments are the relentless rules of humble arithmetic. For stocks, the investment return is driven by a simple combination of the initial dividend yield plus the rate of future earnings growth. These fundamental factors have accounted for 10 percentage points-5 percent dividends and 5 percent earnings growth-of the 10.2 percent long run return on stocks.

Unfortunately, those 10 percent returns may be difficult to achieve in the future. Today's stock market yields just 2 percent. If we assume that stocks will maintain their historical 5 percent earnings growth rate, we are looking at future annual stock returns of only about 7 percent-more than 3 percent less than the historical average.

The Simple Arithmetic Of Hedge Funds

With the outlook for returns so low, it's especially tempting to reach for higher returns by seeking out other kinds of investments. Yet looking for "something better" than stocks and bonds implies that there is something better. Is there?

Today's "big new idea" for gaining extra returns is "alternative investments," although, in fact, these alternatives are just stocks and bonds of a different character and mix, boxed in a different and more expensive package. I wonder if their popularity isn't simply the inevitable reaction of investors (and brokers) who, after one of history's great bear markets, want to buy (or sell!) something new.

Hedge funds, of course, are the talk of the town. But please don't forget that many individual hedge funds are taking risks, often hidden, that would send chills up and down one's spine. (Think of the failure of Long-Term Capital Management; think of the 700 hedge funds that reportedly folded last year.) Furthe r, when hundreds of billions of dollars flow into hedge funds, their managers chase an increasingly limited supply of market inefficiencies, and the value to be added by hedging strategies is apt to get arbitraged away. As yesterd a y's successful managers are flooded with money, their growth virtually precludes their repeating past achievements in the future. What is more, those past achievements have been overrated. A recent study showed that the average hedge fund earned a return of about 9.3 percent per year in 1995-2003, slightly less than the stock market return of 9.4 percent, and more relevantly, less than the 10.1 percent return on a conservative stock/bond balanced fund (which happened to be slightly less volatile as well).

As to the future, simple arithmetic can help us in evaluating potential hedge fund returns. If the stock market were to deliver a 7 percent return in the future, the investor in a low expense, tax-efficient index fund would likely realize a net after-tax return of about 6.2 percent. Even if we grudgingly assume that a hedge fund were to earn 10 percent- no mean task in the tough environment ahead-it would deliver only 4.8 percent to investors, only two-thirds of the net return on the simple index fund. Why? Because the managers would take 2.8 percent (1 percent plus 20 percent of the total return), and taxes (for an investor in the 33 percent tax bracket) could come to an additional 2.4 percent age points, a total reduction of 5.2 percentage points from the 10 percent gross return.

The risk of selecting the right hedge fund is huge, and while the popular hedge-fund-of-hedge-funds diversify that risk, they are even more costly. The simple arithmetic of hedge funds-even if you are lucky enough to pick a winner-suggests that their high costs and high taxes will result in inadequate net returns to their investors. My conclusion: Nearly all individual investors should join me in resisting the siren song of these overrated hedge fund temptresses.

The Simple Arithmetic Of Exchange-Traded Funds

There's another investment product that has recently caught the eye of the fanciful investing public: the exchange -traded fund, or ETF. These funds are generally low-cost index funds that can be traded in the stock market just like regular stocks. As one advertisement for the Standard and Poor's 500 ETF (the "Spider," in the lingo of the financial community) says, "Nowyou can trade the S&P 500 all day long, in re a l time." Leaving totally aside for the moment the question of why anyone in his right mind would want to do that, the simple arithmetic of investing suggests that most investors should ignore this so-called opportunity.

As you must know, I love index funds that track the S&P 500 and the total stock market. But I don't love them as trading vehicles; I love them as vehicles for owning the stock market at low cost and with high tax efficiency, and for holding it, well, forever. Most investors in ETFs, however, seem not to be following my advice, but the advice in the Spider ad. The share turnover of Spiders during the past year came to a cool 4,536 percent, meaning that the average share was apparently held for a period of less than one day! What's strange about this is that, as suitable as ETFs may be for long-term investors, they are totally unsuitable for rapid fire traders. Why? Because of costs.

Let's take a look at the simple arithmetic of ETFs. Consider the following situation, whereby: 1) an investor buys, and later sells, 100 shares of the Spider (approximately $12,000 of the fund, with its bargain basement expense ratio of 0.11 percent-other ETFs can be three or four times as costly to operate); and 2) he pays a minimum commission of $35 for each transaction (lower if done electronically, higher if done over the phone). Now consider three scenarios, in which our trader moves in and out of the Spider (a) twice a year (turnover 200 percent), (b) five times a year (500 percent) or (c) once a month (1200 percent-a lot, but still a far cry from the 4,000-plus percent average turnover). The investor's total annual costs, respectively, would then take 1.3 percent, 3.0 percent and 7.1 percent from his annual return. Repeated over time, that's a large dent!

If the investor can successfully time these trades, he may be able to make up these deficits; if not, which is much more like l y, he will lose even more than those costs. Only long-term holders are certain to benefit from the glitteringly low expenses of most ETFs. The traders that ETF sponsors appeal to in their ads are destined to play a loser's game, all because of the relentless rules of the humble arithmetic of the markets.

Cost Matters

What's an investor to do in this low- return environment , if hedge funds and ETFs are n't the answer? Focus on the one thing you can control: costs.

With the arithmetic of investing suggesting lower returns in the years ahead, the ability to capture the fair share (up to almost 100 percent) that you deserve will be more important than ever. Low cost funds-and of course index funds-are the best way to get your fair share. But don't take my word for it. Ask Wa r ren Buffett. Ask his mentor, Benjamin Graham. Ask Jack Meyer, the re m a r kably successful wizard who tripled the Harv a rd Endowment Fund from $8 billion to $27 billion. H e re's what Mr. Meyer had to say:

"Most people think they can find managers who can outperform, but most people are wrong. 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value. The investment business is a giant scam."

When asked, "Can private investors draw any lessons fro m what Harv a rd does?" Mr. Meyer answered: "Yes." He then recounted the lessons. "First, get diversified. Come up with a portfolio that covers a lot of asset classes. Second, you want to keep your fees low. That means avoiding the most hyped but expensive funds, in favor of low-cost index funds. No doubt about it. And finally, invest for the long term."

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