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Busted: The Failure of Mutual Funds and Birth of ETFs

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Not only can ETFs give you access to investments that mutual funds can’t, but they can be solid, long-term investment vehicles—if you follow the iMoney strategy.
  • ETFTrends.com reader Layne Prebor is quitting his last mutual fund and has decided to take matters into his own hands: “[I] have assumed complete responsibility for my investment decisions.”

One day, John Wasik had the honor of playing audiovisual geek for John C. “Jack” Bogle. John remembers ....

I had booked him to keynote a business journalist’s conference (the Society of American Business Editors and Writers) in Denver, and his PowerPoint presentation didn’t make it to the hotel, so he punted with some old transparencies and an overhead projector. It was Stone Age compared to today’s slick presentations, but Bogle delivered it effortlessly in his dead-on, humorous style.

For those of you who don’t know Jack Bogle and his amazing career, you’re in for a treat. Among other things, Bogle is the Thomas Edison of the stock-index mutual fund. More than 30 years ago, Bogle had this idea that instead of guessing which stocks would do well, he would package them all in one fund: the Vanguard 500. As the chairman of the Valley Forge, Pennsylvania–based fund giant (the only one mutually owned by its customer-investors), he saw that a number of roadblocks got in the way of investors earning market-based returns. Managers consistently made bad decisions in buying and selling stocks. They bought and sold at the wrong times. They passed their trading costs along to shareholders. Most of them couldn’t beat the market averages over time. Even if they had a great year, they were probably lucky and were unlikely to do it again. This was the core of Bogle’s research, and his inspired mental lightbulb led to the index fund.

So when Jack finished his incredibly precise and typically devastating critique of actively managed funds, he told John to keep his transparencies. “I felt like Moses had descended from the mountain and he handed me the tablets,” John says. “It’s been nearly half a decade since Bogle gave his presentation, but I still have his transparencies and a clear memory of what he said.”

The title of Bogle’s talk was “It’s an Ill Wind That Blows No Good: How the Mutual Fund Scandals Will Serve Fund Owners.” At the time, the acrid smell of the mutual fund late-trading scandals was a lingering stench over some major mutual fund companies (not Vanguard, though). Managers from older, established complexes such as Putnam Investments, which offered the very first mutual fund, allowed hedge fund operators to trade against their portfolios when the market closed. This was a fraud against hapless fund investors who trusted the mutual fund companies to protect and invest their money.

Bogle noted this precipitous fall from grace in his speech and added a few pointed barbs of his own. In many ways, he presaged the rise of ETFs. The trust vacuum needed to be filled. Smart investors were tired of half-truths and portfolios they couldn’t see into; they’d had enough. ETFs gathered steam in the wake of the scandals and haven’t looked back. Once again, Bogle laid the groundwork:

  • Cost matters! Bogle studied the relationship between high-cost actively managed stock and index funds. The difference in returns over the 18-year period he studied (1984–2002) was remarkable. The costliest funds posted a 6.8 percent actual return—6.5 percent when you adjust for risk and a paltry 4.3 percent when you subtract taxes. In the same period, low-cost funds turned in a 10.2 percent actual return—10.3 percent risk adjusted and 8.3 percent after taxes. That last number is critical: You could nearly double your return by staying in an index fund that didn’t trade. That’s the foundation for index ETFs: Eliminate the management and trading costs and errors, and you boost your total return.

  • Timing and selection cream investors over time. As if the cost argument weren’t enough, Bogle found that you paid dearly for managers consistently guessing wrong on which stocks to buy and how they timed their purchases. He looked at one of the greatest periods of stock market growth and discovered that investors were getting nowhere near market returns. In fact, they were getting fleeced. In that period, stocks rose 12.2 percent. When you subtract management costs and the expenses due to bad timing (most investors guess wrong on when to buy and sell), active fund investors received a pathetic 2.6 percent return.

  • Buy high, sell low? Most investors dive into the market near the top and sell near the bottom. Many active managers do the same. It’s a strategy guaranteed to lose money. Bogle’s graph showed that $1.5 trillion flowed into stock mutual funds in the first quarter of 2000, which was when the market peaked before it headed south. Was this unusual? No. The mutual fund and brokerage industry relentlessly advertised returns during the dot.com bubble, performance that was unlikely to be repeated and certainly destined to go the other way. Open-ended funds are also cursed by their organizational structure. When fundholders are selling their shares, managers must sell off positions to meet cash redemptions. That means, they, too, are forced to sell at the worst time.

Brain Freeze: We Listen to Bad Vibes

Although Bogle didn’t discuss this at the time, we’re hardwired to consistently do the wrong thing in investing. Our brains are programmed to be optimistic, misinterpret short-term trends as long-term realities, and see patterns where there’s only random noise. We love trends. We love winning when everything seems to be coming up roses. We hate losing and have a hard time owning up to it. Denial then becomes our best friend. These components of our genome consign us to be consistent losers at investing—unless we listen to the rational voices in our brains. As investors, we can do much better. As Jason Zweig says in his book Your Money and Your Brain, if you’ve never yelled, “How could I have been such an idiot?”, you’re not an investor. There is almost nothing, Zweig says, that makes smart people feel as stupid as investing does.

It’s possible to ignore Wall Street and the fund industry as they vie for our hearts, minds, and money every day of the year. What’s important is to recognize that there’s another way of thinking about investing. Instead of timing the market, forget about timing. Got your eye on a hot new search engine company? Forget about it. Most new businesses go out of business. Think passive. ETFs were born to the role, but their birth came after some rough years in the mutual fund business. Despite this investment wisdom, mutual fund companies barrage us with yesterday’s returns, luring in billions when we’re most vulnerable to believe the good times will last. (They never do.)

How could you have predicted when these funds would have had their hot years or their failure to repeat those stellar numbers? You couldn’t. But you can see how the index investors fared. Although they didn’t catch those incredibly stratospheric returns, the downside was mild—they were three times less volatile! Unfortunately, most investors would have been lured in by the returns of the 1998–1999 period, only to be burned in 2000–2001.

Table 1.1. Yesterday’s Winners, Tomorrow’s Losers: Active Funds’ Declines

1998–1999

2000–2001

Fund

Rank

Return

Rank

Return

Van Wagoner: Emerging Growth

1

105.52

1106

–43.54

Rydex OTC: Investor Shares

2

93.43

1103

–36.31

TCW Galileo: Aggressive Growth

3

92.78

1098

–34.00

RS Investor Shares: Emerging Growth

4

90.19

1055

–26.17

PBHG: Selected Equity

5

84.56

1078

–29.03

Average Fund Return

76.72

–31.52

S&P 500 Return

24.75

–10.50

Source: Bogle Financial Research Center

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