Bogle's Corner
By John Bogle

When we were an industry that sold what we made, the returns earned by shareholders closely paralleled the returns reported by the funds themselves. But when we became an industry that focused on making what would sell, those two returns sharply diverged. This departure began in the "go-go" era of the mid-1960s, when we created scores of risky funds, seeking high returns by rapid trading, investing in small and often risky companies, and following new "investment concepts."

Many of these funds reported past returns that were achieved by dubious means, including buying "letter stocks" from insiders at substantial price discounts and marking up their prices to the higher market price. The investment records of many of these "incubation funds" that were later taken public were little short of fraudulent. These funds were "hot." The money flowed in, and then they turned cold. Fund investors paid a high price for our folly.

In the recent era, while the conditions were different, the outcome was the same. In the late 1990s, fund investors again paid a high price for our focus on the promise of the technology-driven information age, and on the promised land of the great bull market. The price they paid can be measured by the errors that fund investors made in the timing of their fund purchases and the selection of the funds they chose.

The first two charts reflect those destructive patterns. The timing penalty (Figure 1) was evidenced by the fact that fund investors placed little money into equity funds during the cheap markets of the late-1980s and early-1990s (less than $10 billion per year), but invested more than $500 billion at the peak market levels of 1998–2000.



The selection penalty (Figure 2) made a bad situation worse. Investors poured the lion's share of that $500 billion into those "new economy" growth funds, technology funds, telecommunication funds and even Internet funds. It was these funds that led the market upward, and then led the market downward, with late-to-the-party fund investors paying an awful price. Ironically, at the height of the bubble, investors were actually liquidating their stodgy old value funds, which would provide excellent downside protection during the bear market that followed.



We are only now beginning to calculate the devastation that these two patterns dealt to the wealth of mutual fund investors. But the data showing investor returns—resisted by the industry ever since I first mentioned it in a speech to financial writers in Chicago 11 years ago—can no longer be hidden. We can now readily compare the returns earned by the fund itself—as reported in its shareholder reports and prospectus—to the returns actually earned by its investors. The technical distinction is between time-weighted and dollar-weighted (or asset-weighted) returns. The results are not pretty.

Begin with the fact that during the 25-year period 1980–2005, when the S&P 500 Index rose at a 12.3 percent annual rate, the return of the average fund averaged 10.0 percent annually, or 2.3 percentage points less. But the returns earned by fund investors fell far short of that 10.0 percent return. We can't be sure of exactly how far short, but an analysis of the past decade suggests that the gap was huge (Figure 3).



For example, the 200 funds with the largest cash inflows during the five-year period 1996–2000—essentially the duration of the late, great bull market—reported an average return of 8.9 percent for the 10 years from 1996 to 2005. But the dollar-weighted return of those 200 funds— the return actually earned by their shareholders—was just 2.4 percent, only 25 percent of the annual returns reported by the funds themselves.

The consistency of this pattern is remarkable. Among those 200 funds, the shareholders of 198 funds actually earned less money than the funds reported. In only two cases did the shareholders do better. In the best case, by just 0.5 percent per year; in the other case, by a minuscule 0.05 percent per year. When we compound these shortfalls, the results are little short of astounding (Figure 4). For fully 76 of the 200 funds, the cumulative shortfall ranged from minus 50 percent to minus 95 percent!



Unsurprisingly, given the marketing ethos of today's mutual fund business, the funds that reported the highest returns during the bull market experienced the largest gap between fund returns and shareholder returns, and vice versa. Figure 5, showing the relationship between the various quartiles of reported performance and the actual shareholder performance, makes it clear that the higher the performance quartile in the bull market, the lower the returns earned by investors. As it might be said in biblical terms, "and the first (in reported returns) shall be the last (in shareholder returns)."

The fund industry, naturally, argues that it bears little responsibility for this state of affairs. Rather, it is the foolishness of the investing public that is to blame for these disastrous results. But the industry surely bears a heavy responsibility—I would argue, the largest share—for the harm that has been done. Consider these facts:

• It was we in the fund industry who created those new funds that were to create such havoc for investors. As the market soared ever higher, we introduced those 494 brand-new "new economy" funds. Only a precious few of the major fund marketers had the courage to stand firm against the market madness, and forbear from creating and offering such funds.
• When we had funds whose performance turned "hot, we marketed them aggressively. Our public relations departments were willing co-conspirators with the press in establishing interviews with our "star" portfolio managers, many of whom, inevitably, turned out to be comets.
• The higher a fund's performance soared, the more we advertised our returns. Example: In March 2000, the month the market hit its high, there were 44 equity funds that advertised their performance in MONEY magazine. The average advertised annual return was +86 percent. Imagine! (During the next three years, these funds were to plummet by 39 percent.) Unsurprisingly, after the fall, in the October 2002 issue of Money, there were only four funds that advertised their performance.