Mutual funds: Stock fund returns aren't all so mutual

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Remember the "vanguard of the proletariat" - that Marxist/Leninist menace. It turns out that the vanguard part is alive, well and very successfully managing about $550 billion in mutual fund assets from a suburb of Philadelphia. The Vanguard Group is America's second largest mutual fund complex. Almost half of its assets are in various index funds.

John Bogle, Vanguard's retired, but not retiring, founder and chairman, is not shy about speaking his mind. The US mutual fund industry is fat, dumb and not particularly happy, to sum up his views.
The man has been a thorn in the industry's side for years. And that has made for some very savvy marketing - a word ironically that Bogle detests.The typical stock fund, says Bogle, paid investors 12% on average over the past 15 years, while the S&P 500 yielded about 18%. That's quite a gap, but Bogle thinks it's a big mistake to measure it only in percentages. "Follow the money," he urges.Investors were parking over $4 trillion in stock funds - the industry total was about $6.8 trillion for all types of funds - at the end of 1999, according to the Investment Company Institute. So, that 6% gap for stock funds adds up to $250 billion a year,Where did it go? The funds' reportable fees and expenses used up an average of about 1.6% last year. That's up from about 1.2% over the 15-year period. But they don't include sales charges to individual investors and the commissions that funds paid to brokers.Another reason why investors haven't kept up with the indexes is that their mutual funds needed to have some cash on hand in order to pay redemptions. That has held back performance in roaring bull markets.But there's a bigger culprit lurking behind the shortfall. "This is the most extraordinarily tax-inefficient industry ever devised by the mind of man," complains Bogle. Taxes on both short and long-term capital gains realized by fund managers take another 2.9% out of returns.That's why more and more Americans are putting stock funds into tax-advantaged retirement accounts, contrary to the standard advice before bull markets became a fixture on the scene.High-cost funds, such as international funds and small cap funds, have been proliferating. But Bogle thinks this is backward-looking innovation. "When technology stocks are hot, we start technology funds and when internet stocks are hot we start internet funds and so forth," he observes. "If this industry stopped innovating, we would start to move forward." Bogle, in fact, once banned use of the word "product" at Vanguard. "Mutual funds are either trusteeships or investment accounts, but not products," he says. "Products are things to be sold and I don't think that's what investment management is. "If we could just think about investments and focus not on what's good for the managers but, God forbid, on what's good for shareholders," he continues, "I think that would be the best of all possible innovations."Bogle complains that mutual funds, once long-term investors, have become short-term speculators. He reports that fund turnover normally was in the 15 to 20% range during the early days of his career. But it had risen to 90% last year. "There is no evidence whatsoever that all this flailing around enhances returns," he thunders. The industry's shift to a marketing mode, Bogle reckons, explains much of the higher turnover. "A few decades ago, investment committees managed mutual funds and focused on the long term," he observes. "Today, fund managers are in charge and they have become glamorous stars."And he laments that the industry has grown to depend on conflicts of interest. Little groups of insiders control the savings of great numbers of small and uninformed investors.Those who nominally serve as trustees are relieved, by legal devices, of the obligation to protect the interests of mutual fund shareholders. "I haven't heard the word stewardship in years," he complains. Index funds can go a long way toward solving these problems. And Bogle is credited with inventing the index-fund concept a quarter of a century ago. The Vanguard 500, the original no-load index fund, charges investors 0.18% per year for fees and expenses.And Bogle estimates that it could probably pay $15 billion in redemptions before it would need to pass along any tax hits for capital gains to investors.Of course, new exchange traded funds like SPDRs (Standard&Poor's Depository Receipts) and QUBES (shares that track the Nasdaq 100 index) are even cheaper. Their fees are about half the typical index mutual fund.But Bogle says that he would not invest in them. SPDRs turn over at the rate of 2,000% per year or once every eighteen days. And the average QUBE is held for only 2.8 days. "It's the casino writ large," he says. "I do not want to be the only long term investor in a fund whose shares are being traded every 2.8 days. I would feel very awkward."Vanguard also has a corporate structure that avoids many conflicts of interest. An external management company controls the individual funds in a typical US mutual fund complex. Somebody else owns the management company. But Vanguard is different."We have this funny company that's owned by Vanguard's mutual funds," says Bogle. "So, when I look at an issue I say how does it affect the shareholders."Bogle thinks that too many funds have been formed which often lack durable investment principles and are doomed to poor performance."They were simply born to die," he warns. "If the failure rate of the 1990s holds, more than 2,300 of today's 4,500 equity funds won't be around in 2010." And managers won't tend to hold onto their jobs for long.

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Mutual funds: Stock fund returns aren't all so mutual

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