John Bogle is a venerable member of the investment establishment and has been a financial-market pioneer advocating the use of low-cost mutual funds, especially index funds, for investing. Common Sense on Mutual Funds, which was published in 1999, is Bogle’s most recent attempt to justify passive “index” investing over active strategies, which he critiques in a mere three paragraphs in the book. With the passive versus active debate continuing strong these days, I decided to take these paragraphs to task in order to show how many passive-only advisors misinform investors about the superiority of their strategies.
In the first paragraph of his critique, Bogle reiterates his complaint that actively managed portfolios aren’t worth the fees paid. Let’s first remember that Bogle created the Vanguard mutual fund company to offer mutual funds — both active and passive — at substantially lower fees than traditional mutual fund companies, so his research and analysis may not be totally impartial.
Nevertheless, to support his thesis that high-cost, actively-managed funds underperform, Bogle states the following:
The funds of funds [managed mutual funds that invest in other mutual funds] not only lag the market — we now know that five of every six funds have done that — but they seriously lag even the style categories of the funds in which they invest, in part because of the extra layer of costs they almost universally add. For example, in the year ended June 30, 1998, of the 14 funds of funds investing in large-blend (value and growth) funds, 4 ranked in the 96th to 100th percentiles (one was dead last) and 5 ranked in the 90th to 95th percentiles.
One problem with this analysis is the validity of the measurement period. There is virtually no performance measurement firm that would draw conclusions from a one-year period. Simply put, this is too short a time frame. So, to the extent that conclusions are drawn from this period, they are probably meaningless if not downright misleading. Bogle also recognizes this, but he does little to fix the bias:
Given the transitory nature of the one-year data, and the existence of a limited number of funds over the past ten years, perhaps the most relevant evidence is found in the three-year data.
So, for a three-year period (which is still too short), Bogle measures 35 funds of funds among a diversified list of styles, concluding that the average return of these funds ranked in the 66th percentile, thus making the case that funds of funds underperform in general.
One major problem in this analysis is that Bogle’s subjective measurement period only captures a raging bull market (the S&P 500 increased 30 percent per year during this timeframe). Either a longer time period or a defined market cycle should be the basis for such analysis.
Let’s look at a similar study I created using the Morningstar database for a five-year period ended in September 2005. The reason I selected this period is that it includes both falling and rising markets — a full market cycle. The annual return of the S&P 500 over this period was essentially unchanged at –1.49 percent, even though the market fluctuated widely during these five years.
For this period I created a universe of funds-of-funds portfolios arrayed by performance. I deleted funds that had an expense ratio of less than 25 basis points to ensure that index funds did not get into the screen. I also deleted funds closed to new investors, as well as those funds that required a minimum initial contribution of greater than $10,000.
For this data screen I identified a total of 118 funds that had at least five years of performance data in Morningstar. I then sorted this data for the five-year period using the percentile ranking by investment objective to get an accurate comparison of a fund’s performance within its stated objective. According to Morningstar, investment objective is “based on a fund’s objective on the wording in the prospectus sent by the mutual fund’s distributor or underwriter.”
The results of this analysis provide a different perspective on the performance of funds of funds. For the period, the median performance of these 118 funds was in the 41st percentile ranked by investment objective. Seventy-six of the 118 funds, or 65 percent, were in the top half of their universe. Only five funds out of 118 were in the bottom decile.
Recognizing that Morningstar rates funds from five stars (highest) to one star (lowest), I researched the star rating of these 118 funds. Three funds received a five-star rating, 32 a four-star rating, 57 a three-star rating, 24 a two-star rating, and only one fund had a one-star rating. In other words, 30 percent of all funds of funds were above average and 21 percent were below average over this five-year time period.
While Bogle looks at short-term returns as his only tool to measure portfolio performance, risk factors must also be taken into consideration when evaluating the return of a fund. Clearly, over one market cycle one would expect a lower rate of return for a lower level of risk.
In reviewing the three-year beta (a measure of risk, with 1 being equal to the risk of the S&P 500) of these 118 funds of funds, 12, or 10 percent, had a higher risk characteristic (beta) than the market. The highest beta of these funds was 1.09, slightly higher than the market. The median beta was 0.82, substantially less than the level of the market. Therefore, by and large, this universe of funds was substantially less risky than the S&P 500. This lower level of risk could account for the underperformance of the funds of funds during the time period that Bogle used.
Another measure of risk is standard deviation. The five-year standard deviation of the S&P 500 over this time period was 15.25 percent. In comparison to the index, 93 of the 118 funds of funds had a lower standard deviation than the S&P 500 (79%), indicating that the funds-of-funds universe was substantially less risky than the S&P 500.
Portfolio turnover was another important characteristic pointed out by Bogle:
To make matters even worse, managed funds-of-funds typically turn over their own fund portfolios at an average rate of about 80 percent per year, a short-term focus that inevitably impinges on the long-term returns that they earn.
In my research there were a few high-turnover funds among the 118 funds of funds, but the median fund turnover was only 26 percent per year, and there were only 15 funds with turnover above 80 percent.
Since there were a number of varying investment objectives in this universe, I drilled down and identified all those funds with equivalent style boxes of “large blend.” This universe consisted of 73 funds of funds. Looking at the ranking by five-year investment objective, the median fund was in the 41st percentile, the same as the entire universe of funds of funds.
The median performance of this large-blend universe was an annualized 2.4 percent versus the –1.49 percent for the benchmark S&P 500, an annual out-performance for the median fund of 3.9 percent. Looked at in another way, the –1.49 percent performance for the S&P 500 over this five-year time period indicates that, of the 73 funds in this large-blend universe, the S&P 500 index placed in the 70th position — or the 96th percentile!
Bogle concludes his brief analysis of funds-of-funds investing with the following:
It [the performance result] clearly reflects the powerful odds against successful fund selection for expensive funds-of-funds. It is a loser’s game.
Once more, Bogle’s analysis is flawed because he selects too short of a time period to measure investment performance. He also selects a three-year period that represents one of the great bull markets in history when the S&P gained 30 percent per year on average. He further neglects to introduce any measures of risk to evaluate how volatile these portfolios might have been. And by drawing conclusions using traditional performance measurement of a bull-market period, he penalizes the funds of funds that generally have much lower risk characteristics.
In contrast, the funds-of-funds universe that was bounded by five years of investment performance across a full market cycle indicated that the universe outperformed the median of all funds. Meanwhile, the risks associated with funds of funds was less than the risk of the S&P 500, whether measured by beta or standard deviation, and the turnover ratio of the funds-of-funds universe was well below the 80 percent level that Bogle indicates as being costly to the fund’s performance.
When a subset of the universe that is characterized by large-cap blend is selected, the average return outperforms the S&P 500 by 3.5 percent per year. Actually, the S&P 500, the preferred passive index-fund benchmark for many investors, placed in the 95th percentile during the five-year period when compared to similar large-blend funds of funds.
So, since the median funds of funds outperformed the S&P 500 by 3.9 percent per year after all fees, it would appear that, with some professional guidance, funds with above-median performance could post higher returns. In any case, the preponderance of evidence gleaned from my analysis indicates that investing in a funds-of-funds portfolio is a winner’s game. Bogle’s analysis, meanwhile, only serves to boggle the mind.
– Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and principal of Victoria Capital Management, Inc.