Bogle Says: All Costs Matter

For a guy with a second hand heart, he sure likes to get in the ring.

I am speaking, of course, about Vanguard founder and chairman John C. Bogle. Although he slowed briefly for a heart transplant a few years ago, Mr. Bogle still comes out of his corner punching. Speaking to the annual Morningstar Mutual Funds meeting in June he demonstrated that cost not only mattered in the big picture, it mattered in all nine of the new “style boxes” that have become the shorthand descriptions for funds since the Chicago mutual fund research and publishing firm introduced them.

And now he’s at it again.

Speaking to the Family Financial Forum, an event sponsored by Northern Trust Bank, Mr. Bogle warned that mutual fund investors might be receiving a $10 billion tax bill for payment by April 15, lowering their investment returns. Rendered every year, he calculated that capital gains taxes, alone, reduced fund returns by 1.4 percent a year over the last 15 years of bull market.

Add the 1.5 percent expenses of the average equity fund and the less visible cost of high portfolio turnover— which he estimated at 0.4 percent a year— and the total cost drag on a mutual fund portfolio could approach 3.5 percent a year.

The result?

Before taxes, the average equity manager failed to beat the index that accounts for 70 percent of all market value in America, the Standard and Poors’ 500 Index. When taxes were considered, they did even worse. A comparison is shown below.

The Index, The Index Fund, and It’s Managed Rivals, 1981-1996

Source: J. Bogle, Vanguard Group

For many investors, mutual fund turnover and taxes are a non-issue: with huge flows of new money going into tax deferred 401k plans, many investors can afford to be sublimely indifferent to Mr. Bogles’ concerns. Others are ill inclined to look their mutual fund gift horse in the mouth: with the average fund still far ahead of long term averages even if it trails the index, why bother?

Because it is important. Very important. The blunt fact is that costs— expenses, turnover, and taxes— make an enormous difference to the investor over a long period of time. To illustrate, Mr. Bogle compares the returns of two hypothetical investments:

• A managed fund that has an gross return of 10 percent a year, a pre-tax net of 8.0 percent a year, and an after tax net of 6.5 percent a year. A $100,000 investment in this fund would grow to $483,000 after 25 years.
• An index fund that has a gross return of 10 percent a year, a pre-tax net of 9.8 percent a year, and an after-tax net of 9.0 percent a year. The same $100,000 investment would grow to $862,000— nearly double the managed fund.
  

  What can you and I do?

It all depends. While costs always matter, the combined total costs of ordinary managed mutual funds are clearly enough to make taxable investors seriously consider two alternatives to typical mutual funds:

• We can commit a major portion of our investments to index funds or, better still, to tax managed index funds. One of Mr. Bogles, Vanguard Index 500, is now the second largest mutual fund, closing fast on Fidelity Magellan.
• We can invest in a portfolio of individual stocks, owning enough to be diversified. In the process, we will avoid management expenses and have control of turnover related expenses. With luck, we’ll have minimal tax expenses.

Always ready with a challenging suggestion, Mr. Bogle offers a simple solution to the problem of a portfolio of individual stocks— a new mutual fund of the largest 50 stocks, held forever. Since the stocks would account for 30 percent of all stock market values, it would be highly improbable that the fund would under perform the market by the 3 percent annual cost difference.

I bet we see a number of funds like that, soon.

This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Photo by Karolina Grabowska

(c)  A.M. Universal, 1997