........................................................................................................................
Three
Challenges of Investing:Active Management, Market Efficiency,
and Selecting Managers
Remarks by
John C. Bogle Founder and Former Chairman, The Vanguard
Group A Dialogue
with Barr Rosenberg Chairman, AXA Rosenberg GroupClient Conference,
Boston, MassachusettsOctober 21, 20011.
Passive
vs. Active Management-What's There to Debate About?
Back in 1992, the organizer of an investment conference telephoned
legendary portfolio manager (and my good friend) John Neff and
invited him to debate with me the issue of passive vs. active
management. John, his candor springing eternal, fired back: Jack's
going to say 'most managers can't beat the index' and that's true.
I'm going to say 'some managers can,' and that's true too. "What's
there to debate about?" He was right, but he was also wrong. There
is an issue worthy of debate: "How large is the margin by which
the market index beats the managers?"
No Debate:
Passive Wins
Conceptually, there's no reason to debate whether or not passive
management beats active management. Passive must win. Why? Because
if we take all stocks as a group, or any discrete aggregation
of stocks in a particular style, an index that holds all of those
stocks at their market capitalization weights will precisely track
their return. Therefore the index must, and will, outpace the
return of the totality of investors who own that same aggregation
of stocks, but incur management fees, administrative costs, trading
costs, taxes, and sales charges. As a group, active managers will
fall short of the index return by the exact amount of the costs
that they incur. The central fact of investing, then, is this
simple proposition: Investment success is defined by the allocation
of financial market returns-stocks, bonds, and money market instruments
alike-between investors and financial intermediaries. Gross return
minus cost equals net return. If the data we have available to
us do not reflect that self-evident truth, well, the data are
wrong. There are infinite ways in which the available data can
mislead. Consider mutual fund returns: We count each mutual fund
as a single unit in calculating average returns, while the industry's
actual aggregate record is better reflected in an asset-weighted
return. Funds rarely stay rigidly confined to their style boxes;
a growth fund may own some value stocks; a small-cap fund may
own mid-cap and large-cap stocks. Some fund records are hyped
when they are small and will never again recur. Few funds are
ever fully invested in stocks, and cash is a drag in up markets
and a benefit in market declines. Of course, it is at least theoretically
possible that mutual fund managers as a group may be smarter than
other investors, and in fact consistently outpace the market by
an amount sufficient to overcome their substantial costs. But
let's think about that. It seems highly unrealistic to believe
that fund managers, who-including the pension accounts they manage-control
the investment process applicable to upwards of 35% of the value
of all U.S. equities, can outpace other managers, advisers, and
individuals. For example, for fund managers to outpace the market
by 1% annually after costs of, say, 2% (excluding taxes) would
require an excess return of 3%. In that case, the individuals
who hold the remaining 65% of equities would, as a group, lose
to the market by about 2% per year, or by 4% after costs. Not
only does that seem improbable on the face of it, but, there is
no evidence that individuals fall short of the market. The limited
data we have available suggest that amateurs match the market
before costs and lose after costs. By definition, then, their
professional cousins must do the same.
Worth
Debating: By How Much?
But there is something to debate, and it is important: How big
is the gap between the market's returns and the returns earned
by investors as a group? Put another way, how much of their return
do investors relinquish to financial intermediaries? I estimate
that the total cost of investment advice, marketing, administration,
brokerage, etc., in the U.S. currently comes to something like
$300 billion per year. With the market capitalization of U.S.
equities now at about $12 trillion, such an annual cost would
represent about 2.5% of that total, or 25% of an assumed total
return on equities of 10% per year. I don't believe that cost
figure is far-fetched. Mutual funds alone carry management fees
and expenses of some $65 billion, and incur portfolio transaction
costs estimated at another $40 billion. Even the Investment Company
Institute, a vigorous industry advocate, places the total direct
shareholder costs of publicly-available managed equity mutual
funds, weighted by sales volume, at 1.6% per year. (The unweighted
average is considerably higher, about 2.0%.) Add to that about
0.8% in unseen, but nonetheless real, cost of portfolio transactions,
and we're at 2.4% (unweighted, 2.8%). Add in opportunity cost
(equity funds are rarely fully-invested) and out-of-pocket fees
and the like, and 2.5% seems more akin to an informed but conservative
estimate than a crude guess. At those levels, obviously, cost
matters.
-------------------------------------------------------------------------------
| Mutual Fund Costs |
| |
Sales
Weighted |
Average
Fund |
| Direct
Costs* |
1.6% |
2.0% |
| Transaction
Costs (est.) |
0.8 |
0.8 |
| Sub-Tota |
l 2.4% |
2.8% |
| Other
Costs (est.) |
0.4 |
0.4 |
| Total |
2.8% |
3.2% |
* Expense
ratio plus amortized sales charges.
The Proof
of the Pudding
Unless fund managers have superior stock-picking ability, then,
it follows that they, like all investors, will lag the market
by the amount of their costs. How much is that lag? Well, I've
produced the data literally hundreds of times for thousands of
funds over a whole variety of time periods going all the way back
to 1940. It all shows essentially the same thing: The gap between
stock market returns and fund net returns is roughly equal to
the costs the funds incur. Practice confirms theory. Let me present
to you just one of those studies, for the period from the start
of 1970 through September 30, 2001. The results: 355 funds began
the race; 197 (more than half, surely the poorer performers) dropped
out; only 158 survived the competition. Average annual return
of the survivors, 10.4%; S&P 500 return, 11.8%. Gap 1.4%. If we
assume, conservatively, an annual survivor bias of just 1.5%1
, the fund return would be 8.9%, and the index advantage would
be increased to 2.9% per year. Since the volatility of the Index
during that period was lower than that of the funds, that remarkable
2.9% annual advantage for passive investing was achieved without
the assumption of additional risk.
| The
Odds of Success:
Returns of Surviving Mutual Funds vs. S&P 5001970-2001*
|
| Number
of Equity Funds |
Average
Annual Return |
| 1970: |
355 |
S&P
500: |
11.8% |
| 2001: |
158 |
Avg.
Fund: |
10.4% |
| Non-Survivors: |
197 |
Index
Advantage: |
1.4%
|
* Through 9/30/2001
Over that
32-year period, 39 of the surviving funds outpaced the Index and
119 failed to do so-apparent odds of about three to one against
the investor. They jump to almost ten to one if we take into account
the number of funds that began the period, which is, after all,
the universe from which the investor would have made his initial
selection. But the odds against winning meaningfully are in fact
far larger. Half of the winners-16 of the 39-won by less than
a single percentage point, a market-equivalent return. Thus only
23 funds-one in fifteen-won by a significant margin. And a mere
two out of the 355 funds-less than 1%-won by three or more percentage
points. Those odds are not good.
For taxable
investors, the gap would be far wider, for with their high portfolio
turnover-100% last year alone-mutual funds are notoriously tax-inefficient.
They probably surrender another 1 ½ to 2 percentage points of
return to tax-efficient passive strategies. By merely guaranteeing
investors of their fair share of the returns earned in the stock
market, passive investing deserves a major place in the portfolio
of individuals and institutions alike.
2. The
Stock Market: More Efficient or Less?
The digital computer has enabled us to catalog a vast and readily
accessible library of financial information on virtually every
publicly-held common stock listed on the U.S. market. Public policy
and the democratization of the stock market have caused corporations
to become more open and forthcoming about their financial results.
The great bull market has helped to fund an enormous community
of investment professionals-buy-side and sell-side alike-to analyze
and evaluate that information. And the rise of the Internet has
facilitated the spread of that information into the marketplace
with lighting speed. Taken together, these developments would
suggest that the stock market is more efficient today than ever
before. And so we have a better case than ever for the strong
form of the efficient market (or random-walk) hypothesis: That
absolutely nothing that is already known or knowable about a company
will benefit the fundamental analyst. Why? Because all of this
information is reflected in the price of its stock. Result, according
to the theory: Fundamental analysis cannot produce investment
recommendations that will enable an investor consistently to outperform
a buy-and-hold strategy in managing a portfolio. Yet years before
the information revolution and the great bull market, the growth
of the professional investment community, the entry of stock prices
into the daily consciousness of others of millions of investors,
and the omnipresence of CNBC, CNN, Fox, and Bloomberg on our television
screens, a grizzled veteran of the stock market wars came to the
same conclusion: In general, no. I am no longer an advocate of
elaborate techniques of security analysis in order to find superior
value opportunities. This was a rewarding activity, say, 40 years
ago, when our textbook "Graham and Dodd" was first published;
but the situation has changed a great deal since then. In the
old days any well-trained security analyst could do a professional
job of selecting undervalued issues through detailed studies;
but in the light of the enormous amount of research now being
carried on, I doubt whether in most cases such extensive efforts
will generate sufficiently superior selections to justify their
cost. To that very limited extent I'm on the side of the "efficient
market" school of thought now generally accepted by the professors.
The year was 1976. The grizzled veteran was Benjamin Graham, Warren
Buffett's mentor and one of the great investment minds of the
20th century. As far as the theory goes, I agree with the efficient
market school: Picking stocks is a zero sum game. How could it
be otherwise? Benjamin Graham agreed. Here's how he answered the
question, "Can the average manager win?:" No. That would mean
that the stock market experts as a whole could beat themselves-a
logical contradiction. But I do not buy the efficient market theory
in its entirety. Why? Because markets are themselves inefficient.
In the very long run stock prices are clearly driven by investment
fundamentals. It is the earnings and dividends generated by America's
corporations that without a doubt govern the markets total returns.
Since 1872, the cumulative annual return of the U.S. stock market
has averaged 9.0%, and dividend yields and earnings growth combined
have produced the lion's share-8.8 percentage points-of that total.
And it is the investment fundamentals-the evaluation of a corporation's
balance sheet, cash flows, earnings, and future prospects-that
are the focus of professional investors and the foundation of
the efficient market theory.
----------------------------------------
But in the
shorter-run, stock returns are driven not only by those investment
fundamentals, but by speculation: The change in the prices that
investors are willing to pay for each dollar of earnings (the
P/E ratio). If stocks yield 2% at the start of a year and earnings
grow by 8%, the investment return will be 10%. If the opening
P/E ratio of 20 times rises to 22 times, add a speculative return
of 10%, for a total return of 20% for the market. If the P/E drops
to 18 times, deduct 10%. Market return: Zero. What a difference!
It is investor emotions, often inexplicable for individual stocks
and for the market alike, that drive the market in the short run,
and sometimes for remarkably extended periods. But not forever.
Consider the period 1980 through 1999. The initial annual dividend
yield on the S&P 500 Stock Index was 5.7%; the annual earnings
growth rate of those stocks was 6.1%. Total investment return
on the Index: 11.8%. Its price-earnings ratio at the outset was
9 times; at the end 30 times. That 233% increase, spread over
20 years, added a speculative return of 6.2% a year to the investment
total, including a total stock market return of 18.0% for the
period: 66% investment, 34% speculation. (The actual return on
the Index was 17.8%.) Unsurprisingly, the chickens soon came home
to roost, and the retribution for that explosion of speculative
enthusiasm was swift. The initial dividend yield at the end of
1999 was down to 1%, and earnings growth through September 2001
was zero. Result: An investment return of only 1%. But the 30%
tumble in the P/E-from 30 times to 21 times-took an annualized
19 percentage points from that return, for an annualized market
return of -18%. Such a swing in the market pendulum from optimism
to pessimism-perhaps from greed to fear would be more accurate-is
just the kind of emotional swing that has generated short-term
market movements since time immemorial, shifting the focus of
the market away from the generally high efficiency of investment
fundamentals.
| Components
of Stock Market Return |
| |
1980-1999 |
1999-2001 |
1980-2001 |
| Initial
Dividend Yield |
+5.7% |
+1.2% |
+5.7% |
| Earnings
Growth |
+6.1
|
0.0
|
+5.5
|
| Investment
Return |
+11.8% |
+1.2% |
+11.2% |
| Speculative
Return* |
+6.2% |
-19.4% |
+3.9% |
| Calculated
Market Return |
+18.0% |
-18.2% |
+15.1% |
| |
|
|
|
| Initial
Earnings |
$14.82 |
$48.17 |
$14.82 |
| Initial
P/E Ratio |
9.2x |
30.5x |
9.2x |
| Final
Earnings |
$48.17 |
$48.00 |
$48.00 |
| Final
P/E Ratio |
30.5x |
21.0x |
21.0x |
* Impact of P/E Change
How might
we go about determining whether or not the stock market has become
more efficient? One might suppose that in more efficient markets
the difference between returns earned by the best-performing and
the worst-performing funds would decline, so I studied that issue.
To avoid distortions caused by large variations in annual returns
offered by different styles (i.e., large-cap vs. small-cap, growth
vs. value), I focused on the largest, most homogenous, and most
centrist group of funds: Large-Cap Core funds (funds that hold
both growth and value stocks), a large group, now 607 funds in
number, that is generally comparable to the S&P 500 Index in composition.
The study showed little pattern of change in the standard deviation
of fund annual returns over the past 20 years. While the highest
standard deviation was in 1982 (11.6%), all other years ranged
between 8 ½% (in 1981, 1984, 1991, 1998 and 1999) and 4 ½% (1994).
Examining the standard deviation of five-year returns showed,
if possible, even less change. It was 15.0% in the earliest period,
15.4% in the latest, and 15.1% in 1991-95. The 13.2% figure for
1986-90 looks like an unusual aberration. In all, there is nothing
in the record of these standard deviations to conclude that the
efficiency of the market has changed very much. You can look at
the chart for yourselves and decide whether you can see any pattern.
------------------------------------------------------------
I must add
that, whether the stock market is growing more or less efficient
is irrelevant to the basic mathematics of passive investing. Yes,
theory suggests that in inefficient markets the winners will win
bigger-and the loser's will lose bigger-but winners are never
easy to identify in advance. And in efficient and inefficient
markets alike, all investors as a group share the markets returns
before costs, and lose to the market in the exact amount of those
costs. 3. Selecting An Active Manager: Damn Hard? Damn Right!
In his book Damn Right!, Charlie Munger, Warren Buffett's partner
at Berkshire-Hathaway, says, "if in your thinking you rely on
others, often through purchase of professional advice, you will
suffer much calamity . . . not from malfeasance, but because (the
professional adviser) has a subconscious bias (arising from) financial
incentives different from yours." He continues, "How to select
a manager who almost surely will invest money better than average
. . . is one of those questions that make life interesting." It's
not only interesting, but hard. Selecting a winning active manager
is hard simply because successful investing in liquid, active,
well-informed financial markets is itself hard. Brilliant, well-educated,
serious professionals compete with one another, but with the knowledge
certain that since investing is a zero sum game before costs and
a loser's game after costs, only a tiny proportion of them can
win the competition to beat the market in the long run. 100% of
managers expect to win; in the long run, less than 5% succeed.
How do we pick winning managers? Why, we analyze their past performance,
and far more often than not, invest with those who have performed
best in past. How often do past winners repeat their winning ways
in the future? Do Winners Repeat? Not very often! Let's look at
the record. In my first book, Bogle on Mutual Funds, I tested
the top 20 equity funds during the 1972-82 decade against their
returns during the next decade. Result: Their average rank in
the next decade was #142 among 309 funds (par would be #155)-a
tiny margin of advantage. But the range of their ranking went
from #2 to #245-a huge premium for making the right selection,
and a big risk in making the wrong one. But the average return
of the winning funds was 14.3%, a nice premium of 1.2% above the
average fund
| Ten-Year
Rank of Top 20 Equity Funds |
| 1972-1982
Rank |
1982-1992
Rank |
|
| 1 |
769 |
|
| 2 |
183 |
|
| 3 |
823 |
|
| 4 |
560 |
|
| 5 |
614 |
|
| 6 |
64 |
|
| 7 |
735 |
|
| 8 |
95 |
|
| 9 |
245 |
Number
of funds:841 |
| 10 |
264 |
|
| 11 |
369
|
Avg.
follow up rank: 350 |
| 12 |
176 |
|
| 13 |
400 |
|
| 14 |
80 |
|
| 15 |
14 |
|
| 16 |
51 |
|
| 17 |
48 |
|
| 18 |
316 |
|
| 19 |
693 |
|
| 20 |
501 |
|
Of course,
the winning margins of the top 20 funds dwindle sharply from the
first period to the second. In the first study, from 8.3% above
the average fund in 1972-82 to 1.2% in the next decade. In the
second study, from 4.9% above the average fund in 1982-92 to 0.9%
in 1992-2001. This reversion to the mean is hardly surprising,
but buying the winners might nonetheless seem like a reasonable
strategy. But given the wide range of future returns, only if
the investor is willing to buy at least 20 funds. And only if
sales charges and taxes are ignored, which the statistics do,
but the investor cannot. Why risk that strategy when in both subsequent
periods the S&P 500 Index outpaced the repeating winners? The
Index provided an annual return of 16.1% vs. 14.3% for the winning
funds in 1982-92, and 12.6% vs. 11.1% in 1992-2001. Simply put:
While on average winners seem to generate momentum, outpacing
their peers by a marginal account, the passive strategy trumps
the winner strategy, and without all of those added sales charges
and taxes.
| Follow
up Performance:
Top 20 Equity Funds vs. the S&P 500 |
| |
1982-1992
Return |
| S&P
500: |
16.1% |
| Top
Funds, 1972-1982: |
14.3% |
| Index
Advantage: |
1.8% |
| |
|
| |
1992-2001
Return |
| S&P
500: |
12.6% |
| Top
Funds, 1982-1992: |
11.1% |
| Index
Advantage: |
1.5% |
I've also looked at performance momentum on a one-year basis going
back to 1982. Through 1998 the results confirm the 10-year findings.
Buying the winning 20 funds each year produces an excess return
of 1.1% over the average fund in the subsequent year, but a deficit
of 2.0% to the S&P 500 Index. In the NASDAQ boom of 1999, however,
the average return of the top 20 funds was a cool +204.9%, a huge
victory over the Index, followed by a relatively modest loss of
21.8% in 2000. These are odd data, for the top 20 funds of 1999
tumbled to an average rank of 3622 out of 4407 funds in 2000,
with 15 of the original top 20 holding rankings below #3881, and
three holding ranks of 4403, 4404, and 4405. But if this data
on buying past winners impresses you, be my guest!
| One-Year Rank of Top
20 Equity Funds |
| 1999 Rank |
2000 Rank |
|
| 1 |
3,962 |
|
| 2 |
4,028 |
|
| 3 |
4,166 |
|
| 4 |
4,246 |
|
| 5 |
4,303 |
|
| 6 |
4,405 |
|
| 7 |
2,670 |
|
| 8 |
4,403 |
|
| 9 |
3,885 |
Number
of funds:4,407 |
| 10 |
2,425 |
|
| 11 |
4,299 |
Avg.
follow up rank: 3,622 |
| 12 |
4,404 |
|
| 13 |
4,167 |
|
| 14 |
4,324 |
|
| 15 |
4,155 |
|
| 16 |
4,169 |
|
| 17 |
4,227 |
|
| 18 |
2,619 |
|
| 19 |
1,975 |
|
| 20 |
3,881 |
|
There Is
An Answer Don't lose heart, however. I've studied fund data for
decades, and I have found what appears to be a sure way to pick
winning equity funds in advance. And when Mr. Munger talked about
the advisers' financial incentives, he hit the nail on the head.
For it turns out that investment costs-advisory fees, administrative
and marketing costs, portfolio brokerage costs-provide an astonishingly
universal guideline for manager selection. For there is a direct,
seemingly causal relationship between low costs and high returns,
and between high costs and low returns. The obvious conclusion:
Do your fishing in the low-cost pond. The evidence is compelling.
During the decade ended June 30, 2001, the equity mutual funds
in the lowest cost quartile turned in a market-risk-adjusted return
of 13.8%, compared to 10.8% for the funds in the highest cost
quartile-a return advantage of an astonishing three full percentage
points per year. That relationship persists with remarkable consistency
irrespective of investment style: Using the nine Morningstar style
boxes (sorting funds into large-, medium-, and small-cap on one
axis; and value, blend, and growth on the other axis), the low-cost
funds win in all nine style boxes, and by significant and roughly
comparable magnitudes. In six of the nine boxes, the low-cost
fund performance advantage ranges between 1.9 percentage points
and 5.2 percentage points per year. Here are the data: It may
seem intuitively obvious that funds with expense ratios of more
than, say, 2% per year are apt to fall behind funds with ratios
of less than 1%. What is truly remarkable, as I noted earlier,
is that the cost advantage of 1.2% held by the low cost quartile
(expense ratio 0.6%) over the higher-cost quartile (expense ratio
1.8%) is associated with, not a 1.2% advantage in return, but
a 3.0% advantage. While it's not clear why this leverage exists,
some of the difference appears to be accounted for by higher portfolio
turnover. The high cost group, almost systematically, turns its
portfolios over at a higher rate than the low cost group-on average
98% versus 63%-thus incurring a higher level of transaction costs,
but the source of the remaining gap must, at least for now, remain
a mystery. But the fact is that owning lower cost funds provides
a measurable, and to an important degree predictable, advantage
to investors.In all, we can fairly draw three conclusions about
using past data to help us select winning managers: 1) Funds with
superior longer-term past performance have, on average, provided
a marginal advantage over the average fund. 2) Choosing passive
strategies reflected in index funds has provided an even larger
advantage. 3) Selecting low-cost funds has proven to be a major
indicator of future superiority. Generally, index funds are the
lowest-cost among all funds, so these conclusions are mutually
reinforcing. Given the wide spread in future returns generated
by past winners, the safest way to assure a market return, and
to eliminate the risk of materially under-performing the market,
passive investing seems the obvious answer.
* * *
Ten days ago, the Nobel Prize for Economics was awarded to three
Americans who challenged the notion of efficient markets. Rather
than operating on homogeneous information, they postulated, many
markets were inefficient, operating with asymmetric information
in which buyers know something sellers do not, or vice versa.
It seems clear, however, that the U.S. stock market and the mutual
fund market largely fall, not into the asymmetric category, but
into the homogeneous category. As I've noted earlier, a huge volume
of financial information flows freely among market participants,
suggesting that the stock market is highly efficient in its appraisal
of fundamental corporate values. The consistency in variations
among mutual fund returns over the years often provides credible
evidence to reinforce that case. And while far too few investors
are apparently aware of the considerable weight that fund costs
must be given in assessing the prospects for future returns, the
principal costs of mutual funds-expense ratios and sales charges-are
readily ascertainable. The industry knows the facts about costs
and is required to disclose them. But the overwhelming majority
of fund firms is unwilling to express these facts, to highlight
them, to acknowledge their importance, or even to face them. As
Upton Sinclair wrote in his introduction to Main Street, "it is
difficult to get a man to understand something when his salary
depends on his not understanding it."1. Studies by Princeton's
Burton G. Malkiel and University of Southern California's Mark
Carhart place survivor bias from 1.5% to 3.1% per year. BackNote:
Unless stated otherwise, all return data are through 9/30/2001
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