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Irrational exuberance

Created:
18 June 2008
Written by:
Alistair Blair

Regular readers will know that I am a fan of John Bogle. He founded the US Vanguard group of mutual funds (or as we call them, unit trusts) in 1975. Having always stuck resolutely to index funds, Vanguard has the lowest cost ratio in the business, at 0.2 per cent of funds under management (about one-tenth the level of the average mutual fund). It currently manages around one trillion dollars.

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Mr Bogle is now 79 and long-retired from Vanguard but he's a regular commentator. His latest speech, to the US's Financial Planning Association, was this week posted at johncbogle.com. I commend it to you. It contains little he hasn't said before, but what he says is so fundamental that it's worth hearing every time he says it.

On this occasion, Mr Bogle deconstructed expectations for the returns that will be earned over the coming decade from typical actively-managed US equity mutual funds. Apparently, a recent survey by Business Week revealed that US private investors expect their stock market to deliver headline returns of 11.8 per cent a year over the next 10 years. But small investors are almost always notoriously optimistic about prospective investment returns. Mr Bogle throws this estimate out in a trice. Referring to the average return over many decades and to hand-shows of the financial planners he is addressing, he suggests a fair estimate for the average annual equity market return over the coming decade will be around 7 per cent. This is made up from dividends of a little over 2 per cent, earnings growth approaching 6 per cent, and minus 1 per cent for a modest contraction in price earnings ratios from their current level of 18 (to 17 by 2018). But 7 per cent is what the S&P 500 will deliver… not what retail investors will earn. The average investor will suffer three expensive bites before he gets his share. The waterfall chart below shows these.

The first will be taken by inflation. This is a hot topic currently and the governor of the Bank of England suggests it could reach 4 per cent here before the year is out. Prospects for US inflation are hardly less troubling, but Mr Bogle is sanguine about the longer-term picture, drawing a figure of 2.5 per cent a year over the coming decade from expectations demonstrated by the US bond market.

Next, mutual fund expenses will take around 2 per cent on average from returns. Striking a familiar chord, Mr Bogle takes a swipe at portfolio turnover in these funds, observing that (in an "orgy of speculation") it has risen from 17 per cent in the 1960s to 215 per cent last year. If that acceleration continues, the expenses bite will be more than 2 per cent.

But investors do themselves ill on a similar scale to that inflicted by their fund managers. Do you remember that technology fund you bought so enthusiastically in 1999 when they seemed to be on a winning streak? Are you wading into natural resource investments at this very moment? And what were you doing in March 2003, when the recent bull leg got its clogs on after three years of woe? Very likely, you had a big pile of cash in your portfolio. In other words, how well have your sector and timing decisions served you over your investing career?

If your expertise in these aspects of investment matches that of the average mutual fund holder, you get in late and you get out late. Thus, although Mr Bogle anticipates that the average fund will earn 2.5 per cent a year over the next decade after inflation and expenses, he foresees that the average investor's decisions about when and which funds to buy and sell (encouraged by the cynical launch of new mutual funds to encourage investors into the whim of the moment) will cost him 2 per cent of that return.

So that should leave Joe Soap with a tidy half a per cent. A few gifted investors and quite a lot of lucky ones will do a lot better, of course. That's the law of averages. But Joe Soap would be much better served if he simply bought some low-cost exchange-traded funds or index funds, and forgot about them. That should improve his returns by 800 per cent (4.5 compared with 0.5) over 10 years.

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Read more of Alistair's columns at his IC home page.

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Alistair Blair is a past winner of the Business Writer of the Year Award, and has worked in investment banking and fund management.

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