Flogging a Live Horse

Yesterday, The Wall Street Journal printed six responses to Burton Malkiel's article, "Are You Paying Too Much for Your Investment Advice?" The letters stated that: "essentially all actively managed stock mutual funds, over the long term" trail index funds; Warren Buffett and George Soros don't come for free; active management is needed to create accurate stock prices; that managed funds can be good; that low-cost advice leads to failed expectations (hmmm); and that when the S&P 500 loses a lot of money, so do S&P index funds (hmmm again).

Missing from the letters was my argument: that Malkiel's point is moot because fund investors do not pay too much for investment advice. I'm going to beat that horse for a second time. Despite overwhelming evidence that fund investors are buying low-cost funds, and that fund investors are not squandering their collective monies on expensive purchases, this horse is very much alive. And still kicking.

In 1993, net cash flows into the very cheapest segment of United States diversified-stock funds, defined as those with annual expense ratios of less than 0.25%, were $4 billion. With total inflows into U.S. diversified-stock funds being $50 billion, this meant the lowest-cost funds accounted for 8% of the action. Last year, in contrast, the cheapest band was the only game in town. In 2012, U.S. diversified-stock funds with expense ratios from 0% to 0.25% attracted inflows of $29 billion. Every other price segment suffered outflows.

Note that this calculation is for mutual funds only. The effect would be more powerful were I to include exchange-traded funds, which barely existed 20 years ago.

For international-stock funds in 1993, funds with expense ratios of less than 0.25% represented 0.02% of net inflows. In 2012, the figure was 28%. With balanced funds, the cheapest group was less than 1% of 1993 inflows, but 38% of 2012 inflows.

I guess this is one of those things that I'll need to keep writing. The marketplace appears to have a powerful need to believe something other than reality.

Exaggerate Much?
I was struck by the first letter's comment that "essentially all" actively managed stock funds trail indexes over the long term. He proposes that actively managed funds be treated as if they were tobacco products, with a warning label that states: "Over a 16-20 year investment period, actively managed funds are commonly hazardous to your fiscal health."

"Essentially all" is a strong phrase. Treating a class of funds in a similar fashion as a cancer-causing subject is stronger yet. And this is an easy proposition to test.

Starting, again, from 1993, I looked at the next 20 years' worth of performance data from the 15 largest stock funds at that time. You can't ask for a fairer test than that. No cherry-picking, no hindsight bias. You could have bought the biggest and most popular funds or you could have purchased Vanguard 500 Index (VFINX).

The scorecard is below. "Trailed" means that the fund lagged Vanguard's index fund, and "Beat" means the opposite.

Is the index fund cause so just that it no longer needs truth at its side?

Caught in the Act
On Sunday morning, I was browsing AOL and Yahoo, when this headline caught my attention. (I don't recall which of the two services was the guilty party.) Do you see those parts that say "Humor" and "Satire"? Those weren't in Sunday morning's story. Yes, that's correct. Variety and the web aggregator initially took this article at face value and published it as news. I've been known to edit my columns after the fact. So perhaps I toss a stone. But ... come on.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.