Fund Industry Principles: What Investors Need to Know and Aren't Told

Common Sense on Mutual Funds | John C. Bogle | ISBN: 9780470597484

← Previous: Time as the Fourth Dimension | Next: The Mutual Fund Marketing Machine →

Part IV of the book shifts from investing to the industry itself. Chapter 15 is Bogle at his most frustrated. He’s watching the mutual fund business abandon its founding principles, and he’s writing a manifesto for investors to fight back.

Lincoln said important principles must be inflexible. Bogle says the fund industry made its core principle way too flexible. Management used to be everything. Now distribution is everything.

Three founding principles, all dying

The industry was built on management, diversification, and service. Management meant:

Trusteeship. Shareholders come first. Reasonable fees. Now it’s asset gathering at any cost.

Professional competence. Analyze companies. Hold for the long term. Now it’s 85% portfolio turnover and gunslinger managers chasing hot sectors.

Long-term focus. Mutual funds were built for patient investors. Now shareholders switch funds every 3 years and use them for market timing.

Keynes warned that when capital development becomes a by-product of casino activity, the job gets done poorly. Bogle says that’s exactly where the fund industry went.

Distribution replaced management

Bogle’s 1951 Princeton thesis (written when the industry had $2 billion total) already said funds should cut fees and not claim superiority over market averages. The focus should be serving shareholders, with portfolio management as the core function.

Fifty years later, the head of the largest fund complex compared the business to movie distribution: “It’s better to be in the distribution business.” The fund supermarket model encourages buying any hot fund, switching often, and letting long-term shareholders pay the trading costs.

Expense ratios rose 50% from 1981 to 1997 even as assets exploded 70-fold. Annual costs paid by equity fund investors went from $320 million to $34 billion. If ratios had stayed flat, investors would save $7 billion a year. If economies of scale had been shared, even more.

The irony: shareholders pay higher fees for worse results. Bigger funds don’t perform better. They perform worse (see Chapter 12). But advisers earn more because fees scale with assets.

Six things investors should demand

Bogle lists six areas where better information would change behavior:

1. Cost information

Prospectuses now show costs on a $10,000 investment over 1, 3, 5, and 10 years. Bogle pushed for this. Good step. But portfolio transaction costs (from turnover) still aren’t disclosed. They can rival the expense ratio. Funds should estimate and report them.

Also missing: how costs eat fund income. Average equity fund gross income is 1.9%. After expenses, net income is under 0.5%. Costs consume 75% of income. That’s never highlighted.

2. Fee waiver information

Money market funds use temporary fee waivers to advertise artificially high yields. One fund grew from $100,000 to $9 billion in under two years with waived fees, then reinstated full fees without telling shareholders. Teaser rates aren’t real yields. Waivers should be guaranteed for at least 3 years or banned from advertising.

3. Performance information

Time-weighted returns (what the fund reports) often differ wildly from dollar-weighted returns (what investors actually earn). Bogle’s example: a fund with +20% annual time-weighted returns had -4% dollar-weighted returns over a decade. Investors piled in at the top.

Morningstar now reports both (Bogle’s 2009 update notes this win). But individual funds still don’t disclose it.

Also watch for fake outperformance. Ten top funds in 1995 returned 67% with tiny assets and three-month holding periods. In 1996-1997, they returned 5-6% and fell 25% behind the market over three years.

4. Proxy voting information

Read your proxy statements. Bogle’s example: fees up 50%, adviser sold for $1 billion seven months later, then another 0.25% 12b-1 fee requested. Shareholders approved both. Annual fees: $45 million to $100 million. Directors called it “no unfair burden.” Advisers should disclose revenues, expenses, and profits per fund.

5. Alternative strategies

Index funds exist. Individual stocks for taxable accounts exist. Holding 15-20 blue chips directly can beat fund returns after taxes. Investors should know they have options beyond traditional active funds.

40 index funds charge sales loads. 25 have expense ratios above 1%. Bogle says forget those.

6. Investment guidance accountability

Magazines publish “best fund” lists but rarely follow up. One magazine’s honor roll funds returned 12.5% annually since 1973 vs. 14.7% for the Wilshire 5000. The index beat the honor roll in 14 of 15 years. Another magazine’s picks returned 14.7% over two years vs. 20.1% for the index. They called it “reasonably content.”

Publications should report how their recommendations performed after publication.

My take

This chapter is consumer protection, not investing strategy. Bogle is saying you’re being sold a product by people who don’t have your interests at heart.

The proxy voting story made my blood boil. Fee increases, a billion-dollar sale, more fee increases. Shareholders approved because they didn’t read the proxy.

The dollar-weighted vs. time-weighted return gap is the most important number in fund investing. A fund reporting 10% while investors earn 6% is a wealth destruction machine in disguise.

Some progress since 1999: Morningstar reports investor returns, SEC improved cost disclosure, index funds doubled market share. But the industry still markets harder than it manages.

Read your prospectus. Read your proxy. Check costs against peers. Vote with your feet.