In short: A panel of experts brought in by Google to advise their employees pre-IPO recommended buying index funds, not actively managed mutual funds. Their reasoning? The statistical improbability of outperforming the market is less than 100:1, and the amount you beat the market by gets eroded anyways by the higher fees you’ll be paying for the service of having a human fund manager.
An added gem: There’s a great link in the article to a Mutual Fund/ETF Expense Analyzer, which lets you compare up to 3 funds for their performance upon an amount and term length you enter.
As Google’s historic August 2004 IPO approached, the company’s senior vice president, Jonathan Rosenberg, realized he was about to spawn hundreds of impetuous young multimillionaires. They would, he feared, become the prey of Wall Street brokers, financial advisers, and wealth managers, all offering their own get-even-richer investment schemes. Scores of them from firms like J.P. Morgan Chase, UBS, Morgan Stanley, and Presidio Financial Partners were already circling company headquarters in Mountain View with hopes of presenting their wares to some soon-to-be-very-wealthy new clients.
One by one, some of the most revered names in investment theory were brought in to school a class of brilliant engineers, programmers, and cybergeeks on the fine art of personal investing, something few of them had thought much about. First to arrive was Stanford University’s William (Bill) Sharpe, 1990 Nobel Laureate economist and professor emeritus of finance at the Graduate School of Business. Sharpe drew a large and enthusiastic audience, which he could have wowed with a PowerPoint presentation on his â€œgradient method for asset allocation optimizationâ€ or his â€œreturns-based style analysis for evaluating the performance of investment funds.â€
But he spared the young geniuses all that complexity and offered a simple formula instead. â€œDon’t try to beat the market,â€ he said. Put your savings into some indexed mutual funds, which will make you just as much money (if not more) at much less cost by following the market’s natural ebb and flow, and get on with building Google.
The following week it was Burton Malkiel, formerly dean of the Yale School of Management and now a professor of economics at Princeton and author of the classic A Random Walk Down Wall Street. The book, which you’d be unlikely to find on any broker’s bookshelf, suggests that a â€œblindfolded monkeyâ€ will, in the long run, have as much luck picking a winning investment portfolio as a professional money manager. Malkiel’s advice to the Google folks was in lockstep with Sharpe’s. Don’t try to beat the market, he said, and don’t believe anyone who tells you they canâ€”not a stock broker, a friend with a hot stock tip, or a financial magazine article touting the latest mutual fund.Seasoned investment professionals have been hearing this anti-industry advice, and the praises of indexing, for years. But to a class of 20-something quants who’d grown up listening to stories of tech stocks going through the roof and were eager to test their own ability to outpace the averages, the discouraging message came as a surprise. Still, they listened and pondered as they waited for the following week’s lesson from John Bogle.
â€œSaint Jackâ€ is the living scourge of Wall Street. Though a self-described archcapitalist and lifelong Republican, on the subject of brokers and financial advisers he sounds more like a seasoned Marxist. â€œThe modern American financial system,â€ Bogle says in his book The Battle for the Soul of Capitalism, â€œis undermining our highest social ideals, damaging investors’ trust in the markets, and robbing them of trillions.â€ But most of his animus in Mountain View was reserved for mutual funds, his own field of business, which he described as an industry organized around â€œsalesmanship rather than stewardship,â€ which â€œplaces the interests of managers ahead of the interests of shareholders,â€ and is â€œthe consummate example of capitalism gone awry.â€
Bogle’s closing advice was as simple and direct as that of his predecessors: those brokers and financial advisers hovering at the door are there for one reason and one reason onlyâ€”to take your money through exorbitant fees and transaction costs, many of which will be hidden from your view. They are, as New York attorney general Eliot Spitzer described them, nothing more than â€œa giant fleecing machine.â€ Ignore them all and invest in an index fund. And it doesn’t have to be the Vanguard 500 Index, the indexed mutual fund that Bogle himself built into the largest in the world. Any passively managed index fund will do, because they’re all basically the same.
Financial management firm Aperio Group partner Solli took one look at my unkempt collection of mutual funds and said, â€œYou’re being robbed here.â€ He pointed to funds I had purchased from or through Putnam, Merrill Lynch, Dreyfus, andâ€”yesâ€”Charles Schwab (which referred me to Aperio) and asked, â€œDo you know that you’re paying these guys to do essentially nothing?â€ He carefully explained the many ingenious ways fund managers, brokers, and advisers had found to chip away at investors’ returns.
Turns out that I, like more than 90 million other suckers who have put close to $9 trillion into mutual funds, was paying annual fees, commissions, and transaction costs well in excess of 2 percent a year on most of my mutual funds (see â€œWhat Are the Fees?â€ page 75). â€œDo you know what that adds up to?â€ Solli asked. â€œAt the end of every 36 years, you will only have made half of what you could have, through no fault of your own. And these are fees you needn’t pay, and won’t, if you switch to index funds.â€
All indexing calls for, Solli explains, is the selection of a particular stock market indexâ€”the Dow Jones Industrial Average, Standard and Poor’s (S&P) 500, the Russell 1000, or the broader Wilshire 5000â€”and the purchase of all its stocks and bonds in the exact proportions in which they exist in that index. In an actively managed fund, managers pick stocks they think will outperform a particular index. But the premise of indexing is that stock prices are generally an accurate reflection of a company’s worth at any given time, so there’s no point in trying to beat that price. The worth of a client’s investment goes up or down with the ebb and flow of the market, but the idea is that the market naturally tends to increase over time.
Moreover, even if an index fund performed only as well as the expensively managed Merrill Lynch Large Cap mutual fund that was in my portfolio, I would earn more because of the lower fees. Stewarding this kind of investment does not require a staff of securities analysts working under a fund manager who makes $20 million a year. In fact, a desktop computer can do it while they sleep.
There are always exceptions, of course, Solli says, â€œa few funds that at any given moment outperform the indexes.â€ But over the years, he explains, their performances invariably decline, and their highly paid cover-boy managers slide into early obscurity, to be replaced by a new hotshot managing a different fund.
If a mutual-fund investor is able to stay abreast of such changes, move their money around from fund to fund, and stay ahead of the averages (factoring in higher commissions and management fees) it will be by sheer luck, says Solli, who then offers me pretty much the same advice John Bogle and his colleagues offered Google. Sell the hyped but fee-laden funds in my portfolio and replace them with boring, low-cost funds like those offered by Bogle’s Vanguard.
What are the fees?
Every fee that a mutual fund charges should be outlined somewhere in its prospectus. But many people don’t even think to look for it, and you can’t necessarily trust your broker to bring it up. â€œThe first step is simply getting people to pay attention to fees,â€ says Patrick Geddes, chief investment officer of Aperio Group, in Sausalito. Hang tough in asking your broker for the full breakdown of what those fees will cost you each year.
If you need help, the National Association of Securities Dealers has a useful tool for computing fees, called the Mutual Fund Expense Analyzer, on its website. You put in the name of the fund, the amount invested, the rate of return, and the length of time you’ve had the fund, and it tells you exactly how much you’ve been charged.
You can also compare past fees for different funds before you invest. For example, if you had put $100,000 into Putnam’s Small Cap Growth Fund Class B Shares and held it for the past five years, you would find that Putnam would have charged you $13,809 in fees during that time. Vanguard’s Total Stock Market Index Fund, on the other hand, would have charged only $1,165 for the exact same investment.