The American Enterprise Institute’s Peter Wallison offers his thoughts on the need for reform in the mutual fund industry, and touches upon Mr. Bogle’s comments at their May 9 conference.
The article is available here.
3 thoughts on “AEI Article on Mutual Fund Reform”
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Speaking of reforms, I think providing 401k investors with freedom of choice is badly needed.
What do I mean?
Of the $8.9 trillion in US mutual funds, $2.5 trillion is in 401k plans.
And these 401k plans often contain the high-fee, high-turnover funds that do a disservice to investors.
But 401k participants often have no choice but to invest in these undesirable funds because fund choices in a 401k plan are set by the company’s CFO or HR department.
Or worse still, some companies don’t offer employees a 401k plan at all.
The IRS should allow the freedom of choice for an employee to fund either their 401k or an IRA, up to the maximum contribution limit ($15k in 2006).
Contributions to an IRA would be deducted from gross income just like the 401k. Implementing this change would be easy – IRS form 5498 is already used for tracking individuals’ IRA contributions.
And participants would be free to choose any IRA option they want – and buy funds based on cost, turnover, and performance.
This newfound competition would likely drive fees lower both in existing 401k plans and across the industry as individuals seek out the best investments.
This solution would also allow workers not covered by a 401k plan a greater opportunity to save for retirement.
It could also potentially shield companies from future lawsuits related to ‘underperforming’ 401k plans.
And small companies or any company that finds 401k administration too costly would not be putting their workers at a disadvantage with respect to retirement saving.
Freedom of choice for 401k participants is badly needed and would provide numerous benefits.
The Case for an Investor Designed Fund Selection System
In February, 1994 a semi-retired, 67 year old mutual fund representative was unhappy about available fund selection resources for his own and family funds. With nothing more than a feeling that all was not quite right, armed with an MBA in mathematical programming/statistics, as a lark, embarked on an intellectual journey to investigate the fund selection process of a multi-trillion dollar industry.
With a clean slate, a personal computer, millions of bytes of raw performance data, no pre-conceived ideas, time, patience, curiosity and field experience, the work began – very slowly at first.
The objective was to come up with a system that serves solely investor needs without being constrained by the possible influence of “group thinkingâ€.
It became a labor of love with a dash of obsession thrown in for good measure. After many dead ends, frustrations and only small successes as an incentive, the dawn of 2002 (8 years later) saw the outline of an improved selection method emerging slowly but surely emerging.
The inquiry pointed to some startling conclusions. The first was the current system functions perfectly well for Investment Company’s (manufacturers) but not very well for investors (consumers). In fact, it is perfectly designed to deliver well below S&P 500 results 95% of the time.
The financial press and the pundits were right about the low probability of beating the S&P 500 but not because of the higher costs and expenses of managed funds so often mentioned. As counter intuitive as it seems, total returns trump higher costs and expenses. Basic research show focusing on these factors alone for fund selection will not improve investor outcomes.
What if the system was re-designed and re-engineered to break the S&P 500 Stock Index sound barrier 95% of the time? This is heresy in the face of conventional wisdom saying this it is not possible because of the “rock-bottom” costs and expenses of the S&P 500. The argument while powerful and compelling broke down under scrutiny. How could this be? He searched for answers. After consulting with several scientists and applied mathematicians, the answer was both obvious and obscure. It was also easily overlooked – exponential smoothing and other necessary metrics were conspicuously absent.
First of all, of the 100 or so journal articles on persistency in the last 50 or so years, the data chosen for research that had a low probability of uncovering “superior performing†funds. Also exponentially smoothing was not employed so that research results were not conclusive. It also explained why hundreds of thousands of our prospective fund observations, using properly smoothed data, repeatedly outperformed the current selection system using unsmoothed data by a factor of 2.0 – 2.4 over time.
Why is breaking the S&P 500 Stock Index sound barrier so important anyway?
Breaking the sound barrier opens up a dazzling array of performance not now available to investors currently enjoying only about two-thirds of S&P 500 returns over time. This level of performance has been rightly decried by Bogle by pointing to bloated costs and expense levels. However, research shows while these elements may be responsible for up to 3% of reduced outcomes 97% is due to total return of a malfunctioned selection system.
Mutual funds as a premier investment have not lived up to their potential. The reason is “mediocre performing†funds (about 75% of all funds) are mixed in with the “superior performing†funds (about 25% of all funds) – causing the smaller superior group to be drowned in a sea of numbers.
Many financial writers have said the best approach to mutual fund investing is index funds which mirror average market performance. “You will do better than about 75% of the actively managed fundsâ€, they say.
For many investors this strategy will work out just fine. As a practical matter, only a minority of investors have embraced this for: psychological, advertising …reasons prefer the more exciting managed funds though the probability of beating the market is only 5%.In the absence of a smarter system that beats the S&P 500 95% of the time; does the investor have any other choice?
What if you invested solely in the 25% “superior performing” group, the expected average outcome would be a healthy multiple not a dismal fraction of the S&P 500 Stock Index
The real potential of mutual funds is: an investment vehicle that has the potential of the solving the mediocre and uneven performance of public and corporate pension funds as well as 401K’s. This goal is only attainable with consistent access to “superior performing†funds that currently amount to USD 2.5 trillion.
The Case for a Separate,Independent Investor Fund Selection System
In February, 1994 a semi-retired, 67 year old mutual fund representative was unhappy about available fund selection resources for his own and family funds. With nothing more than a feeling that all was not quite right, armed with an MBA in mathematical programming/statistics embarked on an intellectual journey to investigate the fund selection process of a multi-trillion dollar industry.
With a clean slate, a personal computer, millions of bytes of raw performance data, no pre-conceived ideas, time, patience, curiosity and field experience, the work began – very slowly at first.
The objective was to come up with a system that serves solely investor needs without being constrained by the possible influence of “group thinkingâ€.
It became a labor of love with a dash of obsession thrown in for good measure. After many dead ends, frustrations and only small successes as an incentive, the dawn of 2002 (8 years later) saw the outline of an improved selection method emerging slowly but surely emerging.
The inquiry pointed to some startling conclusions. The first was the current system functions perfectly well for Investment Company’s (manufacturers) but not very well for investors (consumers). In fact, it is perfectly designed to deliver well below S&P 500 results 95% of the time.
The financial press and the pundits were right about the low probability of beating the S&P 500 but not because of the higher costs and expenses of managed funds so often mentioned. Total returns trump costs and expenses as counter intuitive as it seems. Basic research shows focusing on these factors alone will not improve investor outcomes.
What if the system was re-designed and re-engineered to break the S&P 500 Stock Index sound barrier 95% of the time? This seemed heresy in the face of conventional wisdom saying it is not possible because of the “rock-bottom†costs and expenses of the S&P 500. The argument while powerful and compelling broke down under scrutiny. How could this be? He searched for answers. After consulting with several scientists and applied mathematicians, the answer was both obvious and obscure. It was also easily overlooked – performance data exponential smoothed and other necessary metrics were conspicuously absent.
Of the 100 or so journal articles on persistency in the last 50 or so years, the data chosen for research had a low probability of uncovering “superior performing†funds. Also exponentially smoothing and other metrics were not employed so that research results were inconclusive. It also explained why hundreds of thousands of our prospective fund observations, using smoothed performance data, repeatedly outperformed the current selection system using unsmoothed data by a factor of 2.0 – 2.4 over time.
Why is breaking the S&P 500 Stock Index sound barrier so important anyway?
Breaking the sound barrier opens up a dazzling array of performance not now available to investors who currently enjoy about two-thirds of S&P 500 returns over time. This level of performance has been rightly decried by Bogle by pointing to bloated costs and expense levels. However, research shows while these elements may be responsible for up to 3% of reduced outcomes 97% is due to returns produced by the current selection system.
Mutual funds as a premier investment have not lived up to their potential. The reason is “mediocre performing†funds (about 75% of all funds) are mixed in with the “superior performing†funds (about 25% of all funds) – causing the smaller superior group to be drowned in a sea of numbers.
Many financial writers have said the best approach to mutual fund investing is index funds which mirror average market performance. “You will do better than about 75% of the actively managed fundsâ€.
For many investors this strategy will work out just fine. As a practical matter, only a minority of investors have not embraced this for and prefer the more exciting managed funds though the probability of beating the market is 5% of the time. In the absence of a smarter system that beats the S&P 500 95% of the investor has no other choice?
What if you invested solely in the 25% “superior performing†group, the expected average outcome would be a healthy multiple not a fraction of the S&P 500 Stock Index.
The real potential of mutual funds is an investment vehicle that has the potential of the solving the mediocre and uneven performance of public and corporate pension funds as well as 401K’s. This goal is only attainable with consistent access to “superior performing†funds that currently amount to USD 2.5-3.0 trillion.
Comments are welcomed and appreciated.
RegenAssociates@comcast.net
The opinions presented in http://www.johncbogle.com do not necessarily represent those of Vanguard’s current management.
© Copyright 2006 by John C. Bogle