David and Tom Gardner recently interviewed Vanguard Mutual Funds founder Jack Bogle on The Motley Fool Radio Show on NPR. Bogle, who is credited with popularizing the index fund, is currently the president of the Bogle Financial Markets Research Center. This is the second of four parts. Part 1 is linked to the right.
TMF: You mentioned some of the problems with marketing in the mutual fund industry. Talk generally about it and, if you would, provide a make-believe, specific example of marketing you see by a mutual fund company that just doesn't make sense to you.
Bogle: Sure. The problem with marketing is that you are always trying and what does marketing mean? It means giving the client or customer what he or she wants. In this business, we do it all the time.
We created 496 new technology funds, Internet funds, new economy funds, telecommunications funds, and aggressive growth funds investing in those stocks. When did we do it? Not when they were cheap in 1990; we did it in 1998, '99, and the early part of 2000 when they were very expensive. We sold them to investors by advertising staggeringly high returns that they had made previously and in come the sheep waiting to be sheared. Sheared they were.
We estimate that something like, in the last two or three years of the boom, $500 billion went into those overexposed, risky funds and something like $50 [billion] or $60 billion came out of value stocks. Value stocks were about to distinguish themselves in the market decline, and the new economy stocks were about to lead the market decline downward, just like the Nasdaq itself did.
TMF: Now, Jack, does that mean that you think a contrary investor has a chance at doing better than the market's average sustainability if they are not buying those telecom and high-tech funds at the wrong time -- if instead they are investing in things that are out of favor, things that are neglected?
Bogle: There is certainly a fair amount of evidence that says so, if you do the opposite of what everybody else is doing, buy the funds that are least popular, for example. You could make money on it. I remain very skeptical in part because investors are captives not only to the economics of investing, the fundamentals, the earnings and dividends, the long-term returns on stocks, but to the emotions in investing.
So, if someone goes into some group that is going down and is depressed -- let's say maybe energy stocks or something like that -- even though they are going to be right in the long run, if they are wrong for the first two years, they are going to throw up their hands and say, "I was wrong" and get out. Probably at exactly the wrong time.
My belief is own the entire stock market and hold every stock in it forever. That is the formula for success.
TMF: One of the charges leveled against Putnam Investments this week is that a Putnam manager made $1 million in a retirement account over a three-year period by market timing the Putnam International Voyager Fund. You have talked about it a little bit already, but I want to underline this. You have given a speech about it this week. How prevalent is market timing in the mutual fund industry as you know it and why is it wrong?
Bogle: The redemption rate in this industry last year was 42% of assets. That means that the average fund investor held his or her shares for an average of just two-and-a-half years. Now we are told by the industry that we shouldn't pay much attention to that number because most fund investors, they say 80% of the fund investors don't do anything during the year.
Well, if that is true, and I suppose it probably is, that means the other 20% have a redemption rate of around 400%. That means they are trading and holding shares for maybe 90 days. That is the average for that 20%. Something like that. So that is pretty darn prevalent.
We looked at one of the funds that had gotten in some trouble with all this trading and it was an amazing number. The fund had assets of $2 billion and it had redemptions for the year 2002 of $9 billion; $9 billion of redemptions in a $2 billion fund. That is 440% investment rate or redemption rate. There are a lot of timers in that baby, believe me.
TMF: Let's move from some theory here to some application of that theory. Let's take an average listener out there who is meeting with their financial advisor at some point in the next couple of weeks to talk about what mutual funds they own and what mutual funds they should be buying. What are one or two questions that every single individual investor should be asking their financial advisor or broker about a fund that they might buy?
Bogle: Well, I will give you a new term and then I will define it. I think that will be the best way to answer the question.
TMF: We like new terms on this show.
Bogle: I would measure each fund on its Stewardship Quotient.
TMF: The SQ.
Bogle: The SQ. No. 1 on the SQ is what does the fund cost? What do they charge per year? Low cost, high SQ; high cost, low SQ.
TMF: What does the high cost? What is a specific number that we should shoot for?
Bogle: A quarter of the funds in the industry have 2% or 2.5% fees or up. Probably a quarter have fees below three-quarters of 1%. I don't think people have much business in getting much above three-quarters of 1% for how much they pay.
TMF: Jack, do you know of any mutual fund that bears a load -- a front-end sales charge -- that you consider worthwhile?
Bogle: Well, generally speaking, I don't approve of loads because people trade their funds so much. There are some good funds out there. I happen to like the Capitol Group funds. You have front-end sales charges and fairly high 12b1 fees if you don't pay the sales charge at the outset. In general, they have been good managers and if you are going to hold the fund for 20 years and amortize those costs over that time period, it probably won't kill you.
On the other hand, I might go to Dodge and Cox, essentially the same quality of management, I would argue, and pay no load.
Tomorrow: the second part of the stewardship quotient.