Ring In the New

January 2, 2014

To VANGUARD VETERANS AND PRINCIPALS:

“Ring In the New” follows the “Ring Out the Old” note that I sent you on December 31, 2013.  As 2014 begins, I’m pleased to send my first mailing of the new year, an essay entitled, The Arithmetic of “All-In” Fund Expenses. (Financial Analysts Journal, January/February 2014, ahead of print.) This Perspectives piece is my eighth article for this top professional journal, aimed importantly at CFA charterholders. (Congratulations to our 200 Vanguard crewmembers who have met these demanding standards!)

            My FAJ essay breaks new ground in its attempt to fill a huge gap in the analysis of the impact of mutual fund costs on shareholder returns. Up until now, consideration of fund costs has been almost universally limited to expense ratios, which currently average 1.12 percent for actively-managed equity funds. My piece notes that there are other, even higher costs that must be taken into consideration: fund portfolio turnover costs, cash drag, and sales loads and fees paid to brokers and financial advisers. By my calculation, those costs come to about 1.15 percent (a conservative estimate), bringing total costs of actively-managed equity funds to 2.27 percent annually.

            I go even further in my article, and consider the impact of taxes for investors in active funds—I estimate 0.75 percentage points—and the costs of investor behavior (buying funds after they hit the jackpot). Based on Morningstar data, I use an estimate of 1.20 percentage points. Now we’re up to a total of 4.22 percent in costs of actively-managed funds.

Now, let’s assume a stock market annual return over the coming decade at a reasonable 7 percent in nominal terms. With, say, 2 ½ percent inflation, that’s a 4 ½ percent real return. “All-in” fund costs would confiscate 94 percent of the stock market’s annual real return. In essence, that’s why “costs matter,” and why low-cost index funds are thriving.

            My article represents an extension of the data produced by Nobel Laureate William F. Sharpe in the FAJ of a year ago on the subject of expense ratios of active funds vs. index funds. He likes my broader approach, and has already endorsed my new article: “What a wonderful combination! . . . Your final sentence says it once again, concisely and powerfully.”

            Morningstar’s veteran analyst (and noted skeptic) John Rekenthaler has also endorsed my essay: “The best treatment yet of the subject.” As John approvingly comments on my cost estimates, “Better roughly right than precisely wrong.”

            I hope those of you concerned with these issues will give “The Arithmetic of ‘All-In’ Investment Expenses” the attention I believe it merits in making an even stronger case for index funds, well beyond the data that we conventionally rely upon. The final three paragraphs of my long paper provide the essential message, and I encourage all crew members to consider this vital addition to the full understanding of the “all-in” costs of active investing.

                        Jack                                    

P.S. As is my practice, I’m also posting this paper on my eblog, www.johncbogle.com, where it is available to all crew members and to the public.