John Bogle

IFA's Quote of the Week - 14 (John C. Bogle)

John Bogle


"Surprise! The returns reported by mutual funds aren't actually earned by mutual fund investors."


John C. Bogle,
The Little Book of Common Sense Investing, 2007




In the June 2002 issue of Money Magazine, Jason Zweig gets to the bottom of what mutual fund investors really earn. He describes the difference between the returns that mutual funds report and the actual returns of the average investor in those funds. Active investors chase hot funds. As a consequence, they end up with less than one fifth the funds' annual returns. When inflation and our estimate of taxes are deducted, it is not a pretty picture for active investors. See below.

The table below illustrates some of the details of this unique study. The large gap between the funds' and shareholders' returns was a shock to even the researchers.

The reason for this gap is attributed to active investors who followed the destructive behavioral patterns that Dalbar Research had been describing since 1994. These patterns include waiting for funds to have a good year or two followed by pouring in a flood of cash just before the fund reaches its peak. Then they ride the fund to near bottom and sell.

One encouraging exception was the Dimensional Fund Advisors (DFA) institutional index funds. Because the shareholders of these funds buy and hold diversified portfolios at all times, they ride out the market gyrations and end up obtaining market rates of returns. The table below shows the worst big funds ranked by how investors performed relative to the funds and five DFA funds listed in the article.

In one example from the study, the Firsthand Technology Value fund racked up an impressive annualized return of 16% from 1998 to 2001. However, the investor return over this period was a devastating 31.6% loss. In total it was estimated that investors lost $1.9 Billion in this fund over this period, while the fund reported time-weighted returns of 16%. The head of fund marketing for Firsthand stated, "... people lost a lot of money because they took oversized bets in technology at the wrong time." A careful analysis of the chart below will reveal the tragedy of active investors behavior.

A study released by Dalbar in 2006 came up with similar results, but over a much longer period. The study indicated that during the 20 years from 1986 to 2005, the average stock fund investor earned returns of only 3.9% per year, while the S&P 500 returned 11.93%. On an inflation adjustedReturn, the average equity fund investor earned $19,625 on a $100,000 investment made in 1986, while the inflation adjusted return of the S&P 500 would have been $400,938 or 20 times greater, as shown in Figure 1-2 and Figure 1-3.

Dalbar previously conducted similar studies in 1994 and 1998. The 1998 study found that the return of the S&P 500 was five and a half times greater than what the average investor earned. All three studies showed that the average fund investor earned much lower returns than the S&P 500 or the average mutual fund. Clearly, investor behavior can have a far more negative impact on investment performance than investors realize.

Some investors can benefit from enlisting an investment educator or mentor who will focus on changing their investing behavior, encourage long-term investing, and discourage the gambling practices of trying to beat a market

Figure 1-2

Figure 1-3
Dalbar, Inc. Investor Behavior Studies 2001 - 2003 - 2004 - 2007

The fund tracking service Morningstar started disclosing these "investor returns" in 2006. On the Data Definition page of their web site, they state that "Morningstar investor returns (also known as dollar-weighted returns) measure how the typical investor in that fund fared over time, incorporating the impact of cash inflows and outflows from purchases and sales. In contrast to total returns, investor returns account for all cash flows into and out of the fund to measure how the average investor performed over time. Investor return is calculated in a similar manner as internal rate of return. Investor return measures the compound growth rate in the value of all dollars invested in the fund over the evaluation period. Investor return is the growth rate that will link the beginning total net assets plus all intermediate cash flows to the ending total net assets."

Now that Morningstar is tracking such data, investors bad behavior is finally quantified, as well the advantages of using a passive advisor who helps reduce investor error. In the Morningstar Indexes Yearbook: 2005, they analyzed how the average index investor did on their own versus those that are guided by an advisor using asset class index-type funds from DFA. Here is what they had to say:

"Consider the success Dimensional Fund Advisors (DFA) has had in selling its funds through advisors who undergo training on the merits of passive investing and in portfolio construction theory. Consider that over the past decade the dollar-weighted return of all index funds was just 82% of the time-weighted return investors could have gotten with those funds. Yet, the figures for DFA are much better. In fact, the dollar-weighted returns of DFA funds over the past 10 years are actually higher than their time-weighted returns [see Table 1-3]. Suggesting advisors who use DFA encourage very smart behavior among their clients, even buying more out-of-favor segments of the market and riding them up, rather than buying at the peak and riding the trend down, which is usually the case with fund investors."

Table 1-3

The emotions of active investors go up and down like a roller coaster, leading them to negative returns on average, after expenses and taxes are deducted. Results of studies like those presented herein should enable investors to resist the behaviors that have caused them such despair and poor results in the past.