For the average investor, investing in the stock market is pretty similar now to the 1950’s — it’s faster and cheaper, but not too different. But the first wave of truly new options is here…
For those of you who know what Mutual Funds and Active Management are, scroll to Section “4) Tell me about Vanguard Already!”
1) A Brief Explanation of a Mutual Fund
You have a friend who is great at making money on the stock market. They follow the latest market news, and always know which companies are undervalued by the market, but poised to have some good news come out.
You ask your friend to teach you, but you never quite get the hang of it. Maybe you don’t have the time or the passion, but you just can’t do as well as them — so you ask them to invest your money for you.
You trust your friend and all, but being a cautious person, you decide it is safer for everyone involved if you formalize the arrangement. You and your friend set up and put money into a company together, and you let your friend run it. You pay your friend a salary and a share of the profits, on top of what you and your friend will earn as shareholders. Congratulations — you just created a mutual fund. It’s a company like any other, but instead of taking the money to buy equipment or raw materials, you buy and sell stock to make money.
Years go by and your friend continues to excel. The whole country has gotten market fever, and your neighbor, tired of hearing how well your friend has done for you, wants in. You create and sell some new shares of your company to your neighbor. Now he is also a shareholder in your company, splitting the costs of paying your friend to invest for you all.
The year is 1924. You have created the world’s first open-end mutual fund — a company that can issue new shares to new investors (aka shareholders), giving the company more money to invest. Now a few great stock pickers (like your friend) can manage investments for the rest of us.
In summary, mutual funds enable:
- Great stock pickers to make a great living picking stock
- Investors to earn money in the stock market without working hard themselves
Everyone makes money and goes home happy and smiles like the people in a brokerage ad.
2) There’s just one problem…
Your friend is a freak — like athletic 7 foot tall men in the NBA, there are not enough good stock pickers to go around.
We’re going to come back to the word “Active” in the headline. If it confuses you, ignore it for now. (link)
In his seminal 1966 paper (ungated link), William Sharpe created an analytical framework for evaluating how well investment managers (like your friend above) perform, after taking the expenses (trading fees, salary, etc.) into account.
To prove to investors how well they are doing, mutual funds pick a benchmark for you to compare their performance to. A common benchmark is the S&P 500 — a measure of how well 500 large companies on the New York Stock Exchange are doing.
Sharpe found that adjusting risk and expenses, many mutual fund managers under-performed their benchmark. In the world research papers live in, you are better off buying those 500 stocks yourself than paying your friend to make picks that beat the S&P 500.
In the years since 1966, research continues to support this finding. Most mutual fund managers under-perform their benchmarks net of expenses, and journalists write shocked headlines about this year after year after year.
So as an investor in the real world, what can you do? In 1966, you could call a broker (on a landline phone!) and place 500 trades (at $100+ for each trade), and then adjust those trades quarterly as the benchmark changed (placing more $100+ trades). That would be both difficult and expensive. The real world is harder to live in than an academic research paper’s world.
You choose to find one of those elusive great stock pickers.
3) Finding a Diamond in the O.K. Corral — on marketing mutual funds.
It’s the 1960’s, and your neighbor finally feels like he has a good handle on this stock picking thing. He decides he wants to start his own mutual fund, and get investors to pay him for picking stocks. But he has no track record — who would trust him with money?
So he takes his money out of your fund, and starts a new fund. He manages it, and at the start, he is the only shareholder. He invests for a time, and he out-performs his benchmark! On a time horizon between 3 months and 5 years, he can show that he is one of the mutual fund managers worth paying for!
He prints up lots of prospectuses, and tells some financial advisors about how he is doing. The investment dollars start pouring in. Your neighbor gets paid more by each of those new shareholders in his mutual fund company.
But what if when your neighbor started his company, he didn’t do so well?
Mutual funds that don’t perform die — their managers move on to a start a new mutual fund, hoping to build a more attractive history.
The blue bars are baby mutual funds, sent out into a hostile world like sea turtles hatching on shore. The yellow are average performers, merged in with other average performers to lower costs (less managers to pay). The purple bars are funds that didn’t perform well enough in the first few years, so have no hope of being marketed successfully. These die a quiet, anonymous death. (link)
When you don’t have a good run of luck , you shut down or sell your fund (see the purple bars and yellow bars respectively). Then you open a fresh new mutual fund (the blue bars), and try again. Notice how many funds died in 2009. Those were funds with un-salvageable great recession performance records.
If your neighbor tries for long enough, he will eventually have a fund that happens to have a good record. Also, don’t forget that there are hundreds more people like your neighbor starting a new fund every year. Individually, they may not be very skilled or very lucky. But once the group hits a certain size, they are guaranteed to have someone get lucky, even if no one is very skilled.
If you open enough new mutual funds, you will eventually have one with a winning record by luck alone.
This is the Wyatt Earp Effect, after the Mid-Western gunslinger who survived a record number of duels. Maybe Wyatt was skilled at dueling. But maybe he was just lucky — there were enough gunslingers dueling enough times that someone beat the odds again and again and became a legend. For an example from the world of mutual fund managers, see Warren Buffet (another legend from the Wild Mid-West).
4) Tell me about Vanguard Already!
Enter the Rockstar of Retirement
It’s 1975, and investors still have two bad choices:
- Try to find one of those rare mutual fund managers who pick winners to manage your money, or
- Spend a lot of time and money copying the benchmark yourself.
Enter John C. Bogle. After studying the industry academically like William Sharpe, and working in it for years, he created a third option for investors.
Most managers under-perform their benchmarks after expenses. What if instead of trying to beat the market, you tried to keep expenses as low as possible?
Instead of paying one or more managers to make choices about what stocks will pay off, you just copy the benchmark. Those salary savings are passed on to the shareholders through lower expenses. Instead of each person making 500+ expensive trades, the fund can do it for them with less effort and at lower cost.
These new mutual funds, called index funds or passive funds (index is another term for benchmark), usually charge lower fees. To this day, the median fund with a person trying to beat the market — called active funds — charges 3 times more than the median index fund.
Bogle called his new company Vanguard. That first index fund started in 1975 with $11 million (after trying to raise 10 times that much). Today, Vanguard manages $3 trillion in 320 different mutual funds (though they also have active funds these days). That success is because, simply put:
Index funds are usually a better choice.
If numbers aren’t your thing, look at it another way: There are very few CEOs who inspire a cult of followers. Like Parrotheads and Deadheads, there are Bogleheads who believe in the gospel of copying benchmarks at low cost. They have even have a reddit. Mutual fund managers don’t usually have rabid fans.
5) Clouds in Index fundville, or A Wealthfront on the horizon
Some people say Margaritaville references and finance don’t mix. So let me make it blunt:
Index funds made copying benchmarks possible for the average investor. Before the rise of Vanguard, index investing was only practical as an academic exercise.
But since 1975 and the rise of the Internet, there are ways to take costs even lower.
Let’s look at our mutual fund again. You, your friend, and your neighbor are all in an index fund. You don’t pay anyone to make investment choices, but you do need to pay someone (significantly less) to:
- Place trades based on changes in the benchmark
- Sell new shares to new investors, and place trades with the new deposits to stay aligned with the benchmark
- Place trades when existing investors want to cash out, and pay those people back
These deposits and withdrawals make the fund a little less effective at copying the benchmark. Without going into too much detail:
- Some of the mutual funds money is in cash instead of in stock. New cash arrives to be invested, and cash needs to be on hand to pay out investors who leave.
- New cash has to be invested at current prices, which may be higher than when most of the shares bought, reducing the average gain for everyone.
- When that cash on hand falls too low or isn’t enough to pay out people who leave, you need to sell stock to create cash. This may mean selling at a bad time. Selling also usually has tax consequences. Those taxes consequences get passed on to all shareholders, not just the ones who left.
These problems are relatively small, and apply to all mutual funds. But the problem is worse than it looks, because your neighbor has an unfortunate habit.
Most people invest money when mutual funds do well, and withdraw money when they do poorly
From the ICI (link)
If you will forgive a cheesy metaphor, the markets are like an ocean of opportunity. Mutual funds are ships trying to navigate the ocean to get to a land of great profits. And your neighbor, like most mutual fund shareholders, likes to jump in the ship AFTER times are good, and jump out of the ship AFTER times are bad. Both of these decisions make mutual funds more inefficient in real life than in academic papers.
The direct costs of running the ship are still low, but indirect costs (like taxes passed on to be paid by shareholders, and missed opportunities to make gains from poorly timed buys and sells) add up for passengers. It’s not enough to stop investors from sailing, but it would be nice to avoid if possible.
Index funds offer cheap and efficiently operated ships, but they can’t save you from the bad choices of your fellow travelers. If only you could afford to build your own ship…
6) Wealthfront, a ship building machine
Investing in mutual funds is still easier than doing all those 500 trades yourself. Today, the cost of each trade has fallen to a few dollars each (the leading online brokers charge $7 or less a trade), but that’s still 500+ trades to make. It is still expensive and time consuming for a person make all those trades themselves or to hire someone to place trades on behalf of each investor.
But it’s 2016, and computers can place trades. Especially when computers are just copying a benchmark, they can make millions of trades very easily and efficiently. Enter Wealthfront’s catchy name for their custom boat building service — Tax Optimized Direct Indexing.
For investors with $100K to invest, Wealthfront will build you your own personal index fund. You only pay the costs of your own poor timing decisions, not your neighbors.
Wealthfront claims Direct Indexing adds 2% to returns every year —but it hasn’t operated for long yet. Only time will tell if that’s true.
They currently charge fees similar to Vanguard’s Index funds for the service. Overall, it is a new offering that hints at the future of investing and retirement. If you can afford it (median investable assets in America are <$70K, so most people can’t), this is could be an attractive new way to follow Bogle’s vision of low cost copying even further.*
_*_This is not investment advice. This is commentary excited about the cool new thing computers can do for investors. It may help the real world get closer to what the academic papers call perfect — or it may be a dead end.
7) Speaking of The Future
Throughout this article, I may have given the impression the index funds run the world.
40 years later, index funds’ share of total mutual fund assets is growing, but still a small piece of the industry
Percentage of Total Equity Mutual Fund Assets in Index Funds by year. (Link)
Both index funds and their robo competitors have a ton of room to grow. That leaves us with some questions:
- Do index funds continue to grow?
- Will services like Wealthfront* disrupt and overtake index funds?
*For example: Betterment, FutureAdvisor, SigFig. There are also offerings launched or launching from more established players, including Vanguard.
- Are robo-advisors peaking now, proving they are not quite ready for the mainstream investor?
- Will machine learning (or other technologies) swing the performance advantage back in favor of stock picking? If so, which investors will that benefit? How many investors can that benefit?
For more on the industry, see my take on the some of the new companies getting a lot of press:
Robin Hood and His Merry Robo-Advisors
_There are a lot of young brokerage and wealth management companies starting today with a modern technology twist. As a…_medium.com(https://medium.com/p/d47761112897)