"Many investors are under the mistaken impression that mutual funds are a secure and relatively matter-of-fact way to gain the benefits of diversification at low cost. In reality...mutual funds have a large incentive to benefit from the economics of their business, rather than look after their investors' long-term wealth. Thus we see some mutual funds not only charge outsized fees, but also practice portfolio management strategies which leave investors behind market index averages..."
- Arthur Levitt, the longest-serving SEC Chairman, in the foreword for 'The Clash of Cultures: Investment vs Speculation' (2012) by John Bogle
"If a statue is ever erected to honour the person who has done the most for American investors, the hands down choice should be Jack Bogle."
- Warren Buffett on John Bogle in Berkshire Hathaway's 2016 Annual Report
Bogle's journey from a Princeton University student to an investment legend
Born in 1929 in Montclair, New Jersey, to an American family hit hard by the Great Depression, John Clifton Bogle is arguably the most radically influential figure to emerge from the world of investing in the past hundred years. Having studied economics and investing at Princeton University and having written a 130-page thesis on the US mutual fund industry - titled 'The Economic Role of the Investment Company' - whilst at Princeton, Bogle was by his mid-20s one of the smartest thinkers in the American investment-management industry.
When Bogle launched Vanguard in 1975, the great and the good in America launched an attack on him. The chairman of Fidelity, Edward Johnson, led the sceptics assuring the world that Fidelity had no intention of following Vanguard's lead. "I can't believe that the great mass of investors are going to be satisfied with just receiving average returns. The name of the game is to be the best," said Mr Johnson (Fidelity now runs nearly $500 billion of indexed assets.) [Source: Gary Brinson Lecture delivered by Bogle at Washington State University on April 13, 2014.]
Never one to care too much about what the establishment was saying, Bogle drew inspiration from the pathbreaking research published by Nobel laureate Paul Samuelson of the University of Chicago. Samuelson was the foremost academic economist of the preceding century, not least because of his seminal textbook 'Economics: An Introductory Analysis', which was first published in 1948 and has acted as a primer on the subject for millions of youngsters across the world. Amongst Samuelson's several pathbreaking insights, the one which has had the greatest impact on financial markets is the 'efficient markets' theory, which says that asset prices fully reflect all available information. By implication, therefore, it is impossible to 'beat the market' consistently on a risk-adjusted basis since market prices should only react to new information.
Bogle took the efficient-markets theory to heart and was amongst the first executives in the mutual fund industry to fully understand its profound implication, namely, it makes little or no sense to pay juicy fees to a fund manager to manage your money, given that the fund manager has little or no chance of consistently beating the market. Thus was born Bogle's breakthrough idea - in 1975 Vanguard launched the world's first index mutual fund. Instead of beating the index and charging high fees, the index fund would mimic the index performance over the long run, thus achieving higher returns with lower costs than the costs associated with actively managed funds.
Take the following example. Suppose two people - Sarbani and Saurabh - graduate from university on the same day and get jobs with identical salaries. Assume further that throughout their 40-year long careers, they save identical amounts and invest with fund managers who generate identical returns of 12 per cent per annum (before fees). The only difference is that Sarbani uses an index fund which charges 0.1 per cent per annum and Saurabh uses an active fund which charges 2.5 per cent per annum. As a result, over her entire career, Sarbani generates 2.4 per cent per annum more than Saurabh and thus retires with a corpus 2.3 times as large as Saurabh's! This is because fees and expenses borne by customers of mutual funds have an exponential impact - the 2.4 per cent that Sarbani saves relative to Saurabh compounds over time to make her twice as rich as Saurabh.
In fact, Bogle's central insight - that actively managed mutual funds are not worth the fees they charge - has a deeper implication. Bogle figured out that even if the efficient-markets theory does not hold - and therefore even if markets were 'wildly inefficient' - by definition, around half of the fund managers would underperform the index BEFORE fees and expenses were taken into account. Therefore, once you subtract fees and expenses from fund performance you get:
Net returns to the investor = Gross returns from the fund - Fees and expenses of running the fund
On this basis, well over half the fund managers will underperform the market. In separate studies, Bogle, Morningstar and Rob Arnott (of Research Affiliates) have found that over the past three decades, between 80-90 per cent of US mutual funds underperform the index. In India, if we take the last three years' track record (until the end of 2018), the ratio of underperforming large-cap mutual funds is around 90 per cent, i.e., barely 10 per cent of large-cap mutual funds in India are able to justify their fees. (Source: SPIVA, <https://bit.ly/3atOGaS>)
Even more remarkably, as we highlight in the next section, it is impossible to predict on a forward-looking basis which large-cap mutual funds will outperform going forward, i.e., outperformance by such funds seems to be a random affair. Furthermore, in India, as in the US, most mutual funds which outperform are small (in terms of the assets under management). In particular, in India, I have noticed that once a large-cap fund exceeds Rs 10,000 crores ($1.4 billion) in AUM, outperformance ebbs away.
In 1975, Bogle took this simple insight with regards to the importance of costs and proceeded to build a firm which crushed the cost of money management in several ways, including:
Portfolio-turnover-related costs: In order to minimise the costs associated with brokerage, price impact and taxes, Bogle believed that portfolio turnover should be at most 3-5 per cent. In most large stock markets, most funds have portfolio turnover in excess of 30 per cent. Over a 10-year period in India, such a fund will end up giving away a quarter of the investor's wealth to stockbrokers (via commissions) and to the taxman (vis transaction taxes and capital gains taxes).
Advertising costs: In his book 'Clash of Cultures', Bogle wrote, "There is no evidence whatsoever that advertising benefits fund investors by bringing in an amount of new assets adequate to create economies of scale that offset the amount spent." As a result, for the first 30 years of its existence, Vanguard barely advertised. Over the past decade, it has stepped up its spend but even now: (a) it spends much less on advertising than its mainstream competitors; (b) almost all of its spend is on digital media (no mainstream newspaper or TV spend); and (c) every dollar spent on advertising is tracked carefully. (Source: AdAge, <https://bit.ly/3dkcy2D>)
Distribution costs: The world over, fund managers use distributors/brokers to sell their products to the ultimate investor. In return, the fund manager pays commissions to these intermediaries. In India these commissions can be as high as 70 per cent of the fees paid by the ultimate investor to the fund manager. When Vanguard was two years old, Bogle severed links with all the intermediaries who sold Vanguard's funds and moved the entire sales and marketing function in-house. Bogle thus gave the world its first fund with no distribution costs associated with it. In 2013, SEBI declared that all Indian mutual funds had to a have 'direct' option, i.e., an option wherein the investor can invest directly without having to go through a distributor.
As a result of Bogle's vision, the expense ratio of Vanguard's funds is 11 bps compared to the 64 bps for an average mutual fund in America. (Expense ratio is a mutual fund's annual operating expenses, expressed as a percentage of the fund's average net assets.) That 53 bps differential is huge. It almost ensures that Vanguard's funds will outperform the vast majority of actively managed funds on a consistent basis. As a result, Vanguard's clients would make much more money than the clients of most active managers. Such is the centrality of costs in the world of investing that Morningstar and Bogle have shown in separate number-crunching exercises that the most reliable predictor of a fund's future performance is its expense ratio.
In India, the cost differential between active vs passive investing is much bigger than it is in the US. Large-cap ETFs in India are now available with an expense ratio of 5 bps. In contrast, the expense ratio of large-cap mutual funds in India is in excess of 100 bps. Assuming an expense-ratio advantage of just 100 bps in favour of ETFs implies that Indian investors would save Rs 800 crore ($120 million) per annum if they invested in ETFs rather than large-cap funds. Given that less than 4 per cent of the Indian mutual fund industry's AUM is in passively managed assets, you can draw your conclusions regarding which direction, the share of index funds and ETFs will go in India. (Source: Livemint, <https://bit.ly/3jWdrzD>)
Saurabh Mukherjea is the author of 'The Unusual Billionaires' and 'Coffee Can Investing: The Low Risk Route to Stupendous Wealth'. He's the Founder of Marcellus Investment Managers.