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John Bogle: There Is No Holy Grail

Why the search for winning mutual funds of the future, beyond low-cost index funds, is an exercise in futility

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Robert Abbott
Oct 25, 2018
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We all want to find the best mutual funds of the future, funds that will generate excellent returns to swell our capital. And, perhaps, the opportunity to claim some bragging rights, too!

In chapter nine of John Bogle’s book, “Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor,” the author tried to temper our expectations. He also repeated his message that low-cost mutual funds are the secret to long-term success.

He led off with the latter, noting that all investors seek to maximize their share of the market (or its various subsets). At the same time, and as he pointed out in chapter four, investors must recognize their portion will always be something less than 100%.

The reason for the shortfall is the fees that are paid, whether a couple of percentage points in actively managed funds or the fraction of a point in index funds. Within that framework, Bogle believed actively managed funds might provide about 85% of a market’s return, while a low-cost index fund should be able to get returns in the 98% or 99% level.

Bogle also believed the managers of actively managed funds recognized that truth and, as a result, “much of the industry is engaged in a hell-bent mission to take hold of the finest instrument ever created for long-term investing and transform it into a vehicle for intermediate-term—and even short-term—speculation.”

He explained, too, that the cumulative performance gap would grow beyond the nominal 12 points shown above. The reason? Compounding: In the short-term, the difference between a higher-cost fund and a lower-cost fund will minimal, but over the course of a decade that small difference will compound itself, leading to much higher returns in the future for the lower-cost funds.

According to the author, recognition of such divergences was what led him to create the first market index mutual fund, one based on the S&P 500. At the time of writing the first edition of this book, in 1999, his fund had been joined by some 140 other index funds, which Bogle considers further proof that low-cost index funds had been a real success. Not all of them concentrated on keeping costs down, though, and an “appalling” one-third of index funds charge sales loads or 12b-1 fees.

Given the headwinds facing higher-cost funds, Bogle alleges their managers decided to create a new holy grail: A short-term focus, lots of buying and selling and reading ads for fund managers who turned in the best performance in the last quarter. He sums up the message as “Switch and get rich.” The implication was that investors could do better than index funds; indeed, do better than 100% of the market return.

Bogle then went on to examine the possibility that investors could trade mutual funds like stocks and get rich doing so. He found evidence to refute that idea in (1) academic studies, (2) the record of funds that outpaced the market in the past, (3) the records of advisers who recommended fund portfolios and (4) the records of fund that invest in other funds (funds of funds).

One word keeps coming up in these investigations, “disappointment.” In none of the four areas he examined could he find evidence that active management could, on the whole, outperform the low-cost indexes.

Despite such findings, he said, “investors persist in believing that they can select, in advance, funds that will outperform the broad market indexes.” In part, that illusion is based on the record of some fund managers who have done well “over substantial periods of time.”

Yet even their superiority will not endure over the long term. He wrote,“By the time a long-term record of superiority has emerged, the outstanding mutual funds with outstanding records may already be colliding with an immutable principle of the financial markets: reversion to the mean.”

The odds, then, of identifying the future’s best funds are quite small, and even the workarounds are found wanting. Some investors will succeed in outperforming the market, and a smaller subset may even extend that success beyond the short term. Investors as a group, however, must underperform the market by the amount they have paid in fees and sales charges.

In summary, Bogle has made a case for believing that the holy grail of investing—sustainable, above-average returns without using low-cost index funds—is an illusion. A small minority of investors may find it, but investors as a group cannot.

To see a list of some investors who have found this holy grail, see the GuruFocus Scoreboard. Sort the list with the “10y” (10-year performance) button to bring the best performers to the top.

This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page. Note that chapter eight has not been included in this particular series because the contents seemed overly dated. 

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