Bogle on the Cost Matters Hypothesis

John Bogle gave a speech in February entitled "The Relentless Rules of Humble Arithmetic", about how costs in the financial industry are severely impacting investor returns. He suggesting that we don't need EMH to explain why the financial industry sucks, but merely the CMH:


EMH CMH
Efficient Markets Hypothesis Cost Matters Hypothesis
  • Strong Evidence
  • Sound Explanation
  • Mostly True
  • Overwhelming Evidence
  • Obvious Explanation
  • Tautologically True

The CMH is quite simple: it states that investor returns are equal to the average market return minus fees and costs. The title of the speech is from a statement by Louis Brandeis (later a Supreme Court justice), made during the roaring pre-Depression era, explaining why the speculation of the period was not sustainable. Bogle, whose detractors say that all he has is "an uncanny ability to recognize the obvious", states the obvious:

Since the returns investors receive come only after the deduction of the costs of our system of financial intermediation—even as a gambler's winnings come only from what remains after the croupier's rake descends—the relentless rules of that humble arithmetic devastate the long-term returns of investors. Using Brandeis's formulation, we seem obsessed with the delusion that a seven percent market return, minus three percent for costs, still equals a seven percent investor return; i.e., that costs are too trivial to be considered.

The difference between a 7% and a 4% long-term return are gigantic, a fact that becomes especially pressing if equity returns are going to be lower this century. When fees and taxes are combined, those who want decent returns can no longer afford to play Wall Street's shell game:

index fund vs. managed fund returns

And as Bogle points out, things get even worse when you add in the bite of inflation, which as a constant cost increases the relative difference between these returns (ie 9% vs. 5%, with 3% inflation, becomes 6% vs 2%). And the mathematics of compounding means that over time, the differences in return get magnified. Having half the rate of return does not mean you get half the return - when you double, the other guy has quadrupled, but by the time you quadruple, he has 16-upled!

It gets still worse. The table above uses the return of an average fund. But hot, popular funds that are ballooning into size tend to lag the market even more. So if you look at asset weighted returns of managed mutual funds, they do even worse. That is, the average dollar earns even less than the average fund.

To add some support for my "sports-picking scam" thesis, there is a signicant negative correlation between how many funds a firm operates and its return. Bogle calls them marketing firms (rather than management firms), I call them corporate scam artists, and by either formulation they are preying on the human intuition that past results predict future performance. An intuition which generally serves us well, but does not match the evidence in this case.

There is one error in Bogle's analysis, and that is his assumption towards the end that the market is a zero-sum game, and that its returns are an external given. Increasing market liquidity and efficiency provide real benefits to the world, and market returns depend, of course, on how efficiently capital is allocated. Bogle states, quite foolishly, that a winning fund (one which beats the market) is merely diverting fees to it rather than its rivals. False though this is, lets not forget that the core of the argument is not about winning funds, but about their conspicuous absence.

Bogle's final argument however, is much more in line with classic economic thinking. He mentions Keith Ambachtsheer's essay "Beyond Portfolio Theory: The Next Frontier", which consider where investing should go next. Keith suggests what we ought to think more about the costs of investing and acquiring information, and about moral agency, specifically the conflicting economic interests of managers and investors.

If I might be permitted to stretch a metaphor a little bit, I see some commonality between the moral agency problems of money managers and of governments. In both cases, while we might benefit from giving experts control if they somehow acted in our interests, the reality is that they act in their own interest. And given that, the passive approach of index funds or minimal government, while not as good as the imagined utopia of selfless stewardship, is the best we can do with the humans we have.

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This EMH nonsense reminds me

This EMH nonsense reminds me more and more of socialism as time goes by! They both share the ugly traits of being both wrong and deceitful and, worse yet, they just seem to keep resurfacing, sort of like bad foot warts.

:grin:BRAVO Mr Friedman!!!!

:grin:BRAVO Mr Friedman!!!! I've been telling anyone who'd listen this is the case for years, and now that they've lost tons of thier money in mutual funds, they're ready to do it again in real estate , for a whole bunch of different, but similiar types of reasons. I'm going to forward your post to associates and let them try to chew on it for awhile, even though its closing the barn door after the horse left.

There is one error in

There is one error in Bogle’s analysis, and that is his assumption towards the end that the market is a zero-sum game, and that its returns are an external given. Increasing market liquidity and efficiency provide real benefits to the world, and market returns depend, of course, on how efficiently capital is allocated. Bogle states, quite foolishly, that a winning fund (one which beats the market) is merely diverting fees to it rather than its rivals. False though this is, lets not forget that the core of the argument is not about winning funds, but about their conspicuous absence.

Could it be that the conspicuous absence of winning funds is in fact due to the success of fund managers? The market can be efficient only to the extent that investors allocate their funds wisely. Conversely, it's poor choices by other investors that create the opportunity for some people to beat the market. So if it's really hard to beat the market, doesn't that mean that the fund managers and other major investors are doing their jobs pretty well?

When I graduated college, I

When I graduated college, I immediately spent some time over at The Motley Fool. One of the things I quickly realized was that most (85%) actively managed mutual funds don't beat the S&P 500 index over any real time period. That, coupled with the fact that your return is dropping by about 2% to fees was enough for me.

I'm a firm believer in index funds. With expense ratios of 0.2% compared to 2%, I'd consider it a much better option. And since I don't have the time or inclination to try to pick that 15% that beats the market (at least with my retirement funds), it seems like a logical place to park my money.

Yeah, I meant a positive

Yeah, I meant a positive feedback loop in the negative direction. It's right if you parse it as (negative (feedback loop)) but as you pointed out, wrong if you parse it as ((negative feedback) loop), which is the more natural interpretation.

So there is the potential

So there is the potential for a negative feedback loop to continue, where the dollar loses value, so people switch to something else (the Euro being the prime candidate) as their default “universal currency", so the dollar becomes less valuable, etc.

I'm pretty sure you mean positive feedback. Negative feedback dampens the disturbance. Positive feedback amplifies it.

It’s value is high partly

It’s value is high partly because its the world’s reserve currency of choice, that is the demand for dollars is higher than the demand for other currencies not just because people really want our goods and services, but because they use the dollar for other purposes.

But A is simply an extension of B. If no one wanted to trade with us or invest in our borders, then the dollar would not be the world's reserve currency of choice. As long as our growth is stronger than the EU area's growth, then the dollar should be able to gain ground on Euro based on the first condition.

A sinking currency is not a very good store of value, hence less useful as a reserve. So there is the potential for a negative feedback loop to continue, where the dollar loses value, so people switch to something else (the Euro being the prime candidate) as their default “universal currency", so the dollar becomes less valuable, etc.

To a certain degree. This release of dollars would undoubtedly make US goods cheaper and increase demand for the dollar based on its internal purchasing power. So as long as our economy is stronger than other industrial nation's economies, the feedback loop has a check.

Patri, ...I think there is a

Patri,

...I think there is a potential negative feedback issue with the dollar. It’s value is high partly because its the world’s reserve currency of choice, that is the demand for dollars is higher than the demand for other currencies not just because people really want our goods and services, but because they use the dollar for other purposes. A sinking currency is not a very good store of value, hence less useful as a reserve. So there is the potential for a negative feedback loop to continue, where the dollar loses value, so people switch to something else (the Euro being the prime candidate) as their default “universal currency", so the dollar becomes less valuable, etc.

Foreign central banks have less interest in the value per se of the dollars they have in their reserves than they do in the relative exchange value of their domestic currency and the dollar. As long as the US is a significant export market for a given country, that country will have a greater interest in maintaining the relative value of the dollar than the US itself does.

Regards, Don

David - I think there is a

David - I think there is a potential negative feedback issue with the dollar. It's value is high partly because its the world's reserve currency of choice, that is the demand for dollars is higher than the demand for other currencies not just because people really want our goods and services, but because they use the dollar for other purposes. A sinking currency is not a very good store of value, hence less useful as a reserve. So there is the potential for a negative feedback loop to continue, where the dollar loses value, so people switch to something else (the Euro being the prime candidate) as their default "universal currency", so the dollar becomes less valuable, etc.

Now, there is a "floor" to this process because eventually the dollar gets down to where its worth is based on people wanting to buy our stuff. But we aren't there yet.

The next fantasy mental

The next fantasy mental construct to have the shit kicked out of it is the US dollar.

Ya really think it's gonna sink further? I don't think so. I think the reason it has sunk was mainly because people have become comfortable with the Euro (and maybe a little too comfortable). As long as US growth remains higher than in Europe, the Dollar will gain ground to the Euro.

I believe the Austrian

I believe the Austrian Business Cycle is compatable with the EMH to allow bubbles.

How about THC? :)

How about THC? :)

In fact that's the nub of

In fact that's the nub of the difference between the "strong" and "weak" forms of the EMH, right? The strong form says there will be no bubbles; the weak form says there may be, but you will not in general be able to reliably tell when they're happening or predict when they'll burst.

I've heard a theory very

I've heard a theory very similar to the CMH before: the large mutual funds (Fidelity, Vanguard, etc) are the market, or at least the bulk of it. Thus, their returns are the index return minus the fees they charge.

Both this theory and the CMH as outlined above make more sense to me than the EMH, or at least the "strong" form of it.

Yes, bubbles are somewhat of

Yes, bubbles are somewhat of an argument against the EMH. OTOH, if you could predict and time bubbles, you could easily beat the market. Yet mutual funds are not successfully doing so.

Do you have an actual

Do you have an actual arguments against the EMH?

I'm not terribly familiar with the different forms of the EMH, but isn't the existence of bubbles a strike against at least some of them?

Stephan, This EMH nonsense

Stephan,

This EMH nonsense reminds me more and more of socialism as time goes by! They both share the ugly traits of being both wrong and deceitful and, worse yet, they just seem to keep resurfacing, sort of like bad foot warts.

Do you have an actual arguments against the EMH? Patri laid out some evidence of what a tough time nearly all mutual funds have compared with the Index over the long term. That certainly is congruent with some forms of the EMH.

That entire industry(mutual

That entire industry(mutual funds) is quickly approaching the moral status of used car sales and politics. Its taken awhile but the facts are slowly dawning on people. The next fantasy mental construct to have the shit kicked out of it is the US dollar.:lol:

And how about a little thing

And how about a little thing called deferred taxes payable on retirement type accounts. that ought to take the wind right out of anyones sails.

This reminds me of a

This reminds me of a splendid quote from the Economist recently:

a hedge fund is “a compensation scheme masquerading as an asset class"

The same can probably be said of mutual funds. If you have a subscription to the Economist, the article can be read at http://www.economist.com/displaystory.cfm?story_id=3666459.

They also make the point that Mutual funds have stopped trying to be creative because the career down-side for the fund manager is bigger than in a hedge fund setting. This probably explains why there are few if any "stars" that beat the index.

One concept I never see

One concept I never see discussed in the indexing vs. actively managed debate is the concept of risk. If EMH is valid, one of the reasons that actively managed funds lag the indices could be that they are taking on less risk (in some cases) than that of the indices. There is value in a manager who can provide a superior risk-adjusted return. That value could (but may not) exceed the difference in the fees paid on the actively managed fund. There is value in outperforming the index in a down year, and its quite possible that beating the index by 1600 basis points in such a year could outweigh the burden of several years of higher fees.

True, too many funds are basically high-cost clones of the S&P 500. However, very well may be funds that provide a superior risk-adjusted return, even accounting for the additional expenses of active management.

Slowjoe, Hedge funds are

Slowjoe,

Hedge funds are quite different than mutual funds and while the compensation can be high (Soros made $750M last year in compensation), there is more motivation for the hedge fund manager to make clients money. Yes, both charge earn a fee based on assets - 1% for hedge funds, 1-5% for mutual funds.

The big difference is that a hedge fund manager can earn 20% of gross profits if he has gone over their high water mark (some agreed upon performance index, like Fed Funds + 100). The flip side is that if he loses money, he will earn the asset fee but has to dig out from the negative and then go above the same water mark before earning the 20% incentive fee. The mutual fund manager actually does not have an incentive to make money for clients but does have the incentive to beat whatever index he is using as a performance metric - "Sure, I was down 24%, but the S&P was down 40%. I outperformed it by 1600 bps!"

Since all hedge fund managers use their own money to start them, their downside is much bigger. However, that has not stopped a ton of people starting them. Most media incorrectly report the number of hedge funds at 8,000 but the real number is more like 4,000 because they include fund of funds. Nevertheless, 80% are in equity and 80% of those employ a long/short strategy. In other words 64% of all hedge funds are roughly doing the same strategy. There will be a bloodbath in the coming years within that 64% as they squeeze out arbitrage and revert to the mean. Until then, you will just have to sit on your hands with that hedge fund rage.

Costs DO Matter Catallarchy:

Costs DO Matter
Catallarchy: Bogle on the Cost Matters HypothesisSome while ago, the fishwrat Investor's Business Daily put out a list of the biggest myths related to investin--one of which, shockingly, was

John Bogle on Costs Costs

John Bogle on Costs
Costs matter no matter what. The financial advisor who tells you that costs don't matter is not acting in your best interest.