John Bogle on Investing by John C. Bogle

Author:John C. Bogle
Language: eng
Format: epub, pdf
ISBN: 9781119109587
Published: 2015-04-03T00:00:00+00:00

The Inevitable Failure to Earn the Cost of Capital

The best way to answer that question is to return to the issue of the creation of economic value with which I began these remarks. Whether or not the fund governance system works effectively depends upon the extent to which mutual funds earn the cost of capital for their shareholders. Doing so, of course, would require that funds earn for their shareholders at least what they could otherwise “be getting in price appreciation and dividends if they had invested instead in a portfolio about as risky,” using the words from Fortune that I cited at the outset.

A business corporation, as I have noted, calculates its cost of capital based on its debt-equity ratio, but since 100% of a given mutual fund corporation's capital is equity, its cost of capital is the return of the stock market (adjusted for the fund's relative risk). Given that standard, mutual funds as a group must fail to earn their cost of capital. The record is clear on that point. Measured over the past 50 years, the average equity mutual fund has carried a volatility risk quite similar to that of the market, but has lagged the market return by about 1½% annually over the long term, and about 2¼% over the past 15 years.

The reason that mutual funds as a group have earned only about 85% of their cost of capital is the heavy costs that they incur—not only operating expenses and advisory fees, but portfolio transaction costs. As a group, their professional managers, despite their expertise, have failed to outperform the market before the deduction of costs. So their costs doom them to below-market returns. And their costs have been rising, as advisory fees move ever upward, as new fees (such as 12b-1 marketing fees) are added, and as portfolio turnover escalates. The expense ratio for the average equity fund has risen from about 1.0% in the early 1960s to 1.6% now. During the same period, industry-wide portfolio turnover has risen from less than 20% to nearly 90%. The “double whammy” represented by this rise in total costs appears primarily responsible for the rise to more than 2% in the shortfall of annual fund returns relative to their cost of capital.

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