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Rekenthaler Report

Jack Bogle's Great Insight

The quiet virtue of relative predictability.

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Promises Made, Promises Kept
"What's this?" Bogle will roar. "Only one great insight?" All right, fine. I will reword. Jack Bogle's least-appreciated great insight. 

Conventional risk statistics measure absolute predictability. Cash is regarded as the riskless investment because its price is completely predictable from one day to the next. One dollar today sells for one dollar tomorrow. (It could scarcely be otherwise.) In contrast, the price of a bond that fluctuates with changes in interest rates cannot be known in advance, and that of a stock that fluctuates widely is more uncertain yet. Stocks are absolutely less predictable than bonds, which are absolutely less predictable than cash. That is how risk is described.

Relative predictability--a phrase that Bogle mentioned in passing to me, in a conversation last week--is something altogether different. The relatively predictable asset is the asset that behaves as expected, given the performance of the financial markets. Relative predictability has nothing to do with the usual statistics that measure absolute levels of risk. It cannot be measured by standard deviation. Relative predictability is unrelated to volatility. In its realm, cash can be highly risky and stocks can be fully safe.

Consider the Reserve Primary Fund. On Sept. 16, 2008, that money market fund cut its net asset value from $1.00 to $0.97, as it got caught holding Lehman paper when that bank was seized by the government. By absolute measures, that 3% daily decline was nothing much. By relative measures, of course, the loss was enormous. Nobody expected a cash fund to break the buck; the fund immediately was swamped with redemption requests, such that the fund (and sponsoring firm) was eventually liquidated.

Meanwhile, the  Vanguard Total Stock Market Index Fund dropped a cool 37% in 2008, but steadily gained new assets. Each and every month of 2008, including October when it lost 17.6%, Vanguard Total Stock Market Index sold more new shares than it paid out in redemptions. The reason was relative predictability. The fund's absolute returns were anything but predictable--or desired--but its relative performance was as reliable as clockwork. Whatever the Wilshire 5000 did, the fund did. It gave shareholders exactly what they had purchased.

If those examples haven't convinced you that a fund investor's risk meter ticks to something other than absolute results, then consider  PIMCO Total Return. Once the world's largest mutual fund, PIMCO Total Return has shed $180 billion in assets during the past 24 months, even as it has posted steadily positive returns. Press reports about a corporate power struggle and performance that slightly lagged the category average were all it took to dethrone the king. The coup came from the loss of trust rather than of principal.

By now, you might be muttering, "Has this guy never heard of tracking error?" Well yes, I have. Tracking error, which measures how far a fund's performance deviates from that of its benchmark, assesses one aspect of relative predictability. But there's much more to the concept than that. Critically, realized tracking error does not incorporate expectations--the beliefs and hopes that investors place in their funds. Tracking error doesn't explain why PIMCO Total Return became shunned, nor why American Funds suffered huge redemptions after the 2008 crash (most of the company's largest funds tracked the market indexes quite closely that year).

Relative predictability, not tracking error, fully explains how Vanguard was constructed. Offering index funds obviously improves relative predictability. (Morningstar's Don Phillips comments, "The genius is in defining failure as not getting the market return and then offering a product that can't lose by that definition. The magic is step one, not step two.")

But so do many other Vanguard policies. Using multiple managers rather than a single manager improves relative predictability. Running plain-vanilla bond funds that eschew exotic bonds and complex strategies improves relative predictability. Creating funds with tightly defined mandates improves relative predictability. Temporarily closing popular funds that are attracting hot money makes for a savvier investor base, which improves relative predictability.

In short, Vanguard was built to deliver relative predictability. It does that task better than any other fund company. As a result, it has become the world's largest fund company, in a runaway. Has Vanguard's cost advantage helped it to the pole position? Without a doubt. Would Vanguard be the market leader if it offered similarly cheap funds that were relatively unpredictable? No chance.

The rest of the industry is gradually catching on. The other major fund providers increasingly are offering index funds; replacing their star managers with management teams; and reducing their funds' idiosyncrasies through strict internal risk controls. Citing the value of independent thinking by promoting the virtues of a high Active Share may be all the rage in fund marketing, but when it comes to running the actual money, the industry has never been more cautious. Better to deliver no surprise at all than to deliver two good surprises, followed by a bad one.

The same may also be said for the trend in financial advice. During the past 30 years, leading advisors have moved from being stock (and bond) pickers to fund selectors to portfolio builders. The first approach promised high advisor skill in identifying market outperformers, the second implied moderate skill, and the third often promises no skill whatsoever. The result is improved relative predictability from financial advisors. After all, if the client does not believe that the advisor can beat the market, the client will not be disappointed if the portfolio fails to do so.

As I've written elsewhere, textbook definitions of investment risk are woefully inadequate. No greater example exists than the lack of discussion about relative predictability. Quite literally, there are more direct matches for a Google search of Justin + Bieber + Mars (per rumors, he is considering an interstellar concert) than of relative + predictability + investing. Perhaps this column will raise the tally to even.

RIP, 130/30 Funds
Per a recent article, there are no longer any funds with "130/30" in their name. (There are still a couple of funds left that follow that strategy, but they've changed their names and gone into hiding.) Only a few short years ago, 130/30 funds were all the rage. But they failed, miserably, at the task of relative predictability.

The expected performance for these funds was clear: Being 130% long in stocks and 30% short, and therefore 100% long as a net position, they would on average perform as the overall stock market, minus their (usually high) expenses. But that wasn't how they were marketed. They were sold as "alternative" funds that would behave unlike traditional stock funds. Indeed, Morningstar was lobbied to create a new 130/30 fund category to accommodate the group.

Bowing to the inevitability of investment mathematics, 130/30 funds behaved as if they were 100% net in stocks (imagine that!), thereby disappointing their shareholders, thereby leading to bad feelings, redemptions, and, before long, mass extinction. Once again, neither standard deviations nor tracking error tell the tale. These dinosaurs expired because they were relatively unpredictable.

(Russ Kinnel called this category's demise, or at least failure to ever become meaningful, way back in 2008.)

Another lesson: On occasion, being "behind the times" in not creating a new category for funds means being ahead of the times. This principle, however, is generally unappreciated by fund marketers.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for 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.

John Rekenthaler has a position in the following securities mentioned above: VITSX. Find out about Morningstar’s editorial policies.