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Rekenthaler Report

Jack Bogle’s Latest: Basic Math

The smartest people don’t necessarily run the best funds.

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Our Friend the Beaver
In one of the older Doonesbury strips, B.D. (wearing his football helmet, as always) asks Mike the subject of his biology paper. Mike responds, “Juxtabranchial organ secretions in the higher mollusks.” Mike reciprocates the question. B.D.’s answer: “Our friend the beaver.”

Mike will surely receive the higher of the two grades. In college biology courses, a paper that uses the word “juxtrabranchial” will almost always impress a professor more than a paper that can be readily understood by third graders. Would that B.D. were a mutual fund investor rather than a college student! In that case, he rather than Mike might be the victor.

The reason is explained by Jack Bogle, in a recent speech given to The Institute for Quantitative Finance (The “Q” Group). As evidenced by his title, “David and Goliath: Who Wins the Quantitative Battle?,” Bogle uses a different metaphor than I do. (SAT question: Jack Bogle is to the Old Testament as your author is to: A) Homer, B) Milton, C) Shakespeare, D) a comic strip.) In either case, though, the claim is simplicity.

Two Math Paths
As Bogle points out, there are two flavors of quantitative investors.

The organization before which Bogle spoke consists of “algorithmic quants.” They are “Goliaths of academia and quantitative investing,” who speak “the language of science and technology, of engineering and mathematics, developed with computers processing Big Data, and trading stocks at the speed of light.” Many have doctorates, and most invest through a “complex quantitative approach that ... dazzles even the vast corps of the financial engineers of our universities who emulate them.”

Opposing them are “arithmetic quants"--David with his slingshot, B.D. with his single-syllable vocabulary, and Bogle, who “would have been way over [his] head” had he attempted to follow his day’s leading academic theorists. However, he did not. Indeed, reports Bogle, when he founded the first index mutual fund, in 1975,  not only was he unaware of future Nobel Laureate Eugene Fama’s existence but also had not heard of the term "Efficient Markets Hypothesis," or EMH.

What the arithmetic quant lacks in sophistication, he compensates for with simplicity. Bogle calls the arithmetic quant’s mathematics the “Cost Matters Hypothesis," or CMH. It is the simple yet unarguable fact that “investors as a group earn the stock market’s return less the frictional costs of investing.” From that comes the corollary that if a fund can earn the stock market’s return while keeping its frictional costs below most others’, that fund must be above average.

The Professors Prove Useful
Although Bogle’s CMH does not require the support of the EMH, it is greatly strengthened by it. The CMH guarantees that a cheap fund that emulates the overall market will beat the norm. What it does not speak to, however, is the possibility that an identifiable subgroup of active investors will also be able to manage that feat, and by a larger margin. If that is the case, why index? Buy the winning active funds instead.

That does indeed seem to be the sensible route--and the history of the mutual fund industry, until very recently, is the history of investors doing just that. The problem, of course, is that although the EMH is not quite as neat and tidy as its founders once believed, being pockmarked with various “anomalies” and, on occasion, cratered by mass panics (nobody has satisfactorily explained the U.S. stock market’s 22% one-day loss on Black Monday, 1987), it suffices as a first approximation of the truth. Most markets, at most times, are efficient enough to limit the outperformance of even their most-astute participants.

And those people often have high cost barriers to overcome. Actively managed mutual funds have trouble enough, carrying annual expense ratios that are 75 to 100 basis points above the cheapest index funds, in addition to their higher trading costs. But hedge funds, wherein most algorithmic quants can be found, have expense problems that active mutual funds can only nightmare about. Hedge funds run at least 3% per year, on average, estimates Bogle. Fancy math comes attached to an even fancier price tag.

Report Cards
Which returns us to the tale of Mike and B.D., interpreted from the fund investors’ perspective.

Mike’s paper was thoroughly researched. Should you wish to know about organ secretions in higher mollusks (although not the lower variety), and be willing to limit yourself to the juxtabranchial versions, then Mike’s paper should have delighted you. The problem is, as Mike labored through his task, perspiration from his brow dripped over the paper, blotting out random words. And he worked very hard, 300-basis-points worth of hard. Every point extracted another drop. When Mike finished, his paper was a blur. Some parts were excellent--but overall, the professor found that the confusion outweighed the insights.

In contrast, although there wasn’t much to B.D.’s argument, he barely sweated while working it up. His paper was nearly flawless. Only one word per page was missing, so that readers could easily determine its meaning through context. (Also, it’s not as if B.D.’s intent was particularly difficult to figure out.) The professor had rather hoped to learn more about our friend the beaver. However, he appreciated B.D.'s clarity.

The final grades: Mike got a C+, while B.D. received a B. This placed B.D. in very good stead indeed. In mutual fund investing, unlike with scholarship, churning out B's year after year can make for a Phi Beta Kappa.

Energy, Taxes, and High-Frequency Traders
Belated news: I made a trade! That doesn’t often happen; my last transaction was in 2013. But after writing earlier this year that downtrodden energy stocks looked to be good long-term bets, I did just that by exchanging  Morningstar (MORN) stock that was worth 5% of my portfolio for 2.5% positions in each of two energy-pipeline funds:  Alerian MLP ETF (AMLP) and  ClearBridge Energy MLP Opportunity (EMO). The former is an exchange-traded fund, and the latter is a closed-end fund.

As befitting this column’s subject, the reasoning for the move was simple. Oil prices are depressed, thereby taking down energy stocks with them, including pipelines. However, as pipelines move product regardless of spot prices, it’s possibly that they have been unduly punished by the oil-price decline. Also, they should survive if prices fall even further. That was it, really. It was neither a comment on the fortunes of Morningstar (company stock remains my largest position), nor on the particular merits of those two funds. They are general plays; they will rise and fall as their sector performs.

One thing struck me while looking through my statement, though. The U.S. government will claim about $10 for each share of Morningstar stock that I sold, through its 2016 federal taxes. High-frequency traders capture less than a penny per share. I understand why people dislike the principle of HFTs. It feels like Wall Street preying on Main Street. But the practical implications for a retail investor with a taxable account? Pffft. The smallest change in the federal tax is far more important than if HFTs live or die.

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: MORN, EMO, AMLP. Find out about Morningstar’s editorial policies.