Two Investment Gurus: Index Funds are Path to a Winning Investment By Bonnie Bauman September 30 , 2005

Investors should steer clear of actively managed mutual funds, hedge funds and ETFs. The best path to take is the one that leads them to a globally diversified portfolio of index funds. So said Mark Hebner, author of Index Funds: the 12-Step Program for Active Investors and Vanguard founder and author of a number of books on index fund investing, John Bogle. (Bogle reiterated his views in a speech he delivered at the American Association of Individual Investors in May 2005.)

"The all-market index fund and the Standard & Poor's 500 Index Fund are far better ways to invest than searching through a seemingly-endless list of the products of the marketing-driven, asset-gathering machine that today's mutual fund industry has become," said Bogle.

Hebner, for his part, directs investors to a more globally diversified portfolio of index funds, including 15,000 stocks and a tilt toward small value stocks from 35 countries.

In his speech, Bogle laid out what he calls the central fact of investing: "As a group, investors never— never! —enjoy the gross return that the markets deliver." That's because at the end of the day, what investors walk away with are net returns after costs, he said.

“Thus, just as gambling in the casino is a zero-sum game before the croupiers rake in their share…and a loser's game thereafter, so beating the stock and bond markets is a zero-sum game before intermediation costs, and a loser's game thereafter,” Bogle said.

Bogle outlined the "huge sums" mutual fund advisors rake in: the annual costs incurred by investors in the average equity fund include: a management fee of 0.9%, plus other expenses 0.6%, for a total expense ratio of 1.5%; hidden portfolio transaction costs of at least 0.8%; and sales commissions on load funds, about 0.7% (a 5% commission, spread out over, say seven years). The total sum equals a whopping 3% per year!

"Most of you are familiar with the EMH— the Efficient Market Hypothesis —that suggests that most stocks are fairly valued, most of the time," Bogle said.

"But," he continued, "the relentless rules of humble arithmetic remind us of something both more certain and more profound than the EMH. I call it the CMH— the Cost Matters Hypothesis —the iron rule that investors as a group must always lose to the stock market by the amount of the costs they incur."

Meanwhile, Hebner points out in his book that the Fama/French Five Factor Model helps investors identify the stocks and bonds risk factors that best correlate to long-term historic returns, and therefore provide foundations for the best index funds. The application of these factors add about a 3% per year expected return at the same risk level as a U.S. total market index fund. This is after an investment advisor fee and an index fund fee. Taxes in such portfolios are also kept very low due to the use of tax managed index funds from Dimentional Fund Advisors.

In his speech, Bogle turned to "simple arithmetic" to prove the advantage of investing in passively managed index mutual funds versus actively managed mutual funds. For one thing, over the past 20 years, a simple, low-cost, no-load stock market index fund delivered an annual return of 12.8%, while the market's return was a close 13%. Meanwhile, the average equity mutual fund delivered a return of just 10%, less than 80% of the market's annual return. Hebner's book shows that a lower risk global portfolio returned 15.32% after fees.

Bogle indicated that "each $1 invested in the U.S. total market index fund grew to $10.12—the magic of compounding returns —while each $1 in the average fund grew to just $5.73, not 80% of the market's return, but a shriveled-up 57%—a victim of the tyranny of compounding costs . The magic, alas, is overwhelmed by the tyranny."

And that's all before taxes, pointed out Bogle. Due to the “astonishingly high” portfolio turnover of the average managed equity fund, another 2.2% is knocked off of the return—that equals only 41% of the market's annual return. For their part, index funds relinquished only 0.9% in taxes.

The "simple arithmetic" of hedge funds and ETFs is equally as bleak, Bogle said. In the case of hedge funds, Bogle pointed to a recent study that showed that the average hedge fund earned a return of about 9.3% per year in 1995 to 2003, slightly less than the stock market return of 9.4%.

Those who invest in ETFs, which Bogle described as "low-cost index funds that can be traded in the stock market just like regular stocks," don't fare much better. ETF investors for the most part are short-term investors. Said Bogle, "Only long-term holders are certain to benefit from the glitteringly low expenses of most ETFs."

In conclusion Bogle outlined four "Essential Rules" of Investing:

One, pare costs to the bone. "Realize that in investing you get what you don't pay for. Whatever future returns the stock and bond markets are generous enough to deliver, few investors will succeed in capturing 100% of those returns, simply because of the high costs of investing—all those commissions, management fees, investment expenses and taxes."

Two, diversify. Own American business and hold on to it. "Not one company of industry, but a broadly diversified portfolio of lots of companies and industries. Buy such a portfolio, never sell, and hold it forever. No one knows what stocks will do tomorrow, or even what they'll do over the next decade, but over the long pull the dividends and earnings growth of American business will be reflected in rising stock prices."

Three, don't forget to allocate your assets prudently between stocks and bonds. "As the years roll on, we have more wealth at stake, less time to recoup losses, and begin to rely on our investments to provide income. Each of these critical factors suggests that, as investors age, we should own even larger bond portions."

Four, don't do something, just stand there. Stay the course. "Once you get your costs down, your stocks and bonds diversified, and your stock/bond balance right. Not only expenses, but emotions, are the investor's greatest enemy." In his book, Hebner reminds investors that an investment advisor can help control these emotions that are so destructive of investor returns.

Hebner's book points out a fifth "essential rule" Bogle has left out. Investors who invest in index funds add substantial value to their investments by signing on with a registered investment advisor (RIA) that maintains the discipline of exclusively using index funds. RIAs are registered with the Securities and Exchange Commission and provide valuable ongoing advice and education.

Indeed, RIAs that specialize in indexing help investors to stay the course by encouraging long-term buy and hold and rebalancing strategies. On top of that, they advise prudent investing through ups and downs of the market. Furthermore, a few RIAs provide access to Dimensional Fund Advisor's low cost institutional-style index funds, which are based on the highly regarded Five Factor Model.

For example, Index Funds Advisors (IFA) works to make sure investors are matched with a risk appropriate portfolio of index funds by carefully qualifying and quantifying the investors risk capacity and matching it to a portfolio's risk exposure. This strategy ultimately results in higher gains for investors.

As is shown in the table below, from January 1986 to December 2005, IFA's Portfolio 100, pulled in an annualized return of 14.17%, whereas the S&P 500 trailed behind at 11.93%, the Russell 3000 Index was at 11.73%, and the CRSP Market 1-10 Index was at 11.70%.

It should be noted that the IFA index portfolio's annualized returns are calculated after the IFA and DFA fees are subtracted. By signing on with a fee-only investment advisor who sells only index funds, investors can be assured that the advisor does not receive compensation contingent on the purchase or sale of any investment products.

See the chart below to see how IFA's Portfolio 100 risk and return compared to three well-known indexes. At a lower risk and after DFA and IFA fees, it obtained about a 2% per year higher return over the 20 year period ending Dec. 2005.