Bogle: On Equity Styles

Chapter 6 of "Common Sense on Mutual Funds" is a discussion of investment style, returns, and relative index fund performance.

Over the last 30 years, academic research into the US stock market has shown that the whole US stock (equity) market can be dissected into various sectors that have there own risk and return characteristics. Below is a short excerpt from www.Investopedia.com that explains the most common style box:

The domestic equity style box, designed to assist in the evaluation of securities, is the best-known and most popular type of style box. Morningstar's domestic equity style box, shown below, provides a simple equity classification system.
The vertical axis of the style box is divided into three categories, which are based on market cap. For mutual fund evaluations, Morningstar's proprietary market cap evaluation methodology is used to rank the underlying stocks in each mutual fund in order to determine the fund's market cap. Of the 5,000 stocks in Morningstar's domestic equity database, the top 5% are categorized as large cap. The next 15% are classified as medium cap and the remaining stocks are classified as small cap.

The horizontal axis is also divided into three categories, based on valuation. Once again, the underlying stocks in each mutual fund portfolio are reviewed. The price-to-earnings (P/E) andprice-to-book (P/B) ratios are used as the basis of a mathematical calculation that results in the classification of each stock as growth, blend or value. "Blend" is used to describe stocks that exhibit both growth and value characteristics.

Analysis of the style boxes will show an investor that the smaller the sector the higher the return. Likewise, value funds outperform growth funds. In addition, as style drifts towards smaller and value, risk increases.

Understanding this breakdown is important for a couple of reasons;

1. It allows an investor to understand why and how their mutual fund performance is behaving in a certain manner. For example, over time, a small value fund should outperform a large growth fund - because it is riskier.

2. It helps explain manager performance. For many years, a mutual fund (or portfolio manager) was evaluated on pure returns. Now funds are reviewed through the risk and style box lens. A fund manager who focuses on small value and outperforms the total market will be evaluated against other small value measures not the whole market. So managers can no longer outperform by taking higher risks.and be perceived as being smarter than the market.

Next post I will explore how index funds compare against active managers in each style box.

Indexing: The Triumph of Experience over Hope

Warren Buffet in 1996:

"Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals."

In chapter 5 of John Bogles's Common Sense on Mutual Funds, he makes his case for index funds.

What is an index fund? It is simply a mutual fund that holds a basket of stocks that meet a specific definition. They are not chosen by a single person, or by an investment committee, or by some formula.

The Dow Jones, S&P 500, and NASDAQ are index's. The Dow is 30 large US stocks, the S&P 500 is the largest 500 stocks in the US, and the NASDAQ is the market of technology stocks. An index fund is a mutual fund that replicates a particular index.

If you own the S&P 500 index fund, you own the 500 largest stocks in the US. Nobody picked those stocks in that fund, they are there because they meet the definition of 1 of the 500 largest stocks in US.

There are now hundreds of index funds available to investors. Including everything from a total US market fund to small cap value funds to international funds to specific industry funds, ie health care.

What studies have shown is that over time index funds perform better than funds that are managed by investment professionals.

Bogle shows that over the last 40 years the S&P 500 index earned 9% while the average actively managed equity fund earned 7.6%

To clarify:

The S&P is a good index to represent the total US market. By definition it is the average of all the investors investing in the market. And therefore, by definition, roughly half the investors will be better and half will be worse. Then, when you factor in expenses, it is nearly impossible to consistently outperform an index net of fees. A look at the above numbers demonstrates this. The average fund fees for mutual funds are approximately 1.3% to 1.5%. So if the average mutual fund earns the market average (since all equity mutual funds are essentially the market) of 9% then subtract the fees., the net return is the 7.6% . A mutual fund would have to earn better than 10% to beat the index net of fees.

It is primarily due to the fee issue that index funds outperform over time. This exists over all types of index funds. It mathematically has to: actively managed funds have higher expenses and if the index in every category is the average, the net active return has to be lower than the average (net of fees). This last argument is not mine it is William Sharpe's - 1990 Nobel prize winner in Economics.

Stock market value and the economy

A recent blog by Larry Swedroe - who is always worth the time.

He gives a brief but excellent explanation of stock market value relative to the overall economy.

http://moneywatch.bnet.com/investing/blog/wise-investing/the-economy-isnt-the-same-as-the-market/1732/

On Asset Allocation - The average investors most important decision

In Chapter 3 of Common Sense on Mutual Funds, John Bogle emphasizes the importance of getting your personal asset allocation correct.

Asset allocation means your stock to bond mix. Bogle emphasizes that bonds should be used as a moderator to your risky stocks. Not as another risky investment alternative. He says this because there are bonds that are very risky such as low grade and junk bonds. So by mix he means stable investments (short term high grade bonds) relative to risky, volatile investments (stocks).

He sites the famous 1986 study in the Financial Analysis Journal by Brinson, Hood, and Beebower that over 90% of the variation in pension plan returns studied were due to the stock bond mix. Not the particular stocks or bonds chosen.

Bogle clarifies the meaning behind the study's outcome: "Long-term fund investors might profit by concentrating more on the allocation of investments between stock and bond funds, and less on the question of what particular stock or bond fund to hold"

He goes on to emphasize that an investor needs to understand their time horizon, ability to stomach volatility, and whether the savings is for accumulating wealth or the distribution of wealth. Longer time horizons and investors in the savings stage can invest in a greater percentage of stocks. Versus an investor who is in the distribution phase of their investment cycle who should have a lower percentage of stocks. All investors should work with a trusted, competent advisor in order to develop the allocation mix that is best for them.

Bogle goes on to demonstrate that once the allocation mix is defined. The second most important thing an investor should do is fill the portfolio with low cost, preferably index, funds. Study after study show that when comparing similar funds, low cost is the best determinant of long term performance (see blog post 8/27/10).

The advice is straight forward: Determine the percentage of stocks you should own, then fund your portfolio with low cost index funds.

In future posts we will discuss what makes up the stock and bond portions. But you cant get to this question until you have determined the allocation.

SIMPLE 401K investing. Spend 5 minutes and potentially improve your wealth.

Most people get little advice an how to invest in their 401K plan. This is a SIMPLE approach. Spend 5 minutes reading the link below - simple investing advice on how you could invest in your 401K.

Remember that the more you allocate to stocks in your portfolio the greater the downs you will experience.

http://online.wsj.com/article/SB10001424052748704407804575425851977494576.html?mod=ITP_thejournalreport_0

Combine the above with this golden nugget of wisdom from John Bogle, summarizing a recent Morningstar study in the August 26, 2010 Wall Street Journal:

"A mutual fund's past returns are no guarantee of its future. Even the most sophisticated rating systems are erratic at best in forecasting a fund's performance in the years ahead. But for decades, academic experts and analysts have proven that fund costs are a powerful predictor of relative performance. Returns come and go, as it were, but costs go on forever.

A recent study by the Morningstar fund evaluation service came to this very same conclusion. In an admirable report that was the opposite of self-serving, Morningstar found that using fund-expenses ratios as a factor in choosing mutual funds was even more helpful than relying on its own carefully constructed "star ratings." Specifically, focusing on funds with the lowest expense ratio was more helpful in fully 58% of the time periods studied.

"In every asset class (U.S. stock funds, international stock funds, balanced funds, taxable bonds, and municipal bonds) over every time period," Morningstar wrote, "the cheapest quintile produced higher net returns than the most expensive quintile." Among domestic equity funds, the returns of the lower-cost funds outpaced the returns of the higher-cost funds by about 1.3 percentage points annually. That proves to be a compelling edge. Over a 50-year investment lifetime, for example, a return at the 8.1% historical average for stocks would produce nearly 50% more capital than a return of 6.8%.

These calculations actually understate the success of low-cost funds. "Survivor bias"—only the more successful funds survive to make it into the database—permeates the equity-fund data. According to Morningstar, in the highest-cost quintile only 57% of equity funds survived over the past five years. Even in the lowest-cost quintile, only 81% survived. So much for relying on most mutual funds as long-term investments.

The idea that costs matter is not new. In a 1966 article in the Journal of Management, economist William F. Sharpe concluded, "all other things being equal, the smaller a fund's expense ratio, the better results obtained by its stock holders."

Bogle on fees in todays Wall Street Journal

http://online.wsj.com/article/SB10001424052748703846604575447531979322798.html?mod=ITP_opinion_0

Occum's Razor and Stock Market Returns

In chapter 2 of John Bogle's Common Sense on Mutual Funds, he introduces Occums postulate that states: the simpler the explanation then the more likely it is to be correct.

Bogle has applied Occum's razor to all the noise that surrounds stock returns and has found that if you accept that the performance of individual securities and portfolios are unpredictable on a short term basis, one can arrive at three factors that determine long term stock performance. Those three factors are:

1. Dividend yield at time of initial investment

2. Subsequent rate of growth in earnings

3. The change in the price-earnings ratio during the period of investment.

Bogle then states that since 1926 that less than 20% of the markets return has been due to speculation. The majority of return is due to the two other factors: dividends and earnings growth.

He states that speculation is almost a neutral factor in the nature of long run returns.

This is important. It means that even if you had a speculative edge, over the long run, your advantage is not that great. Not to mention that the transaction costs involved may eliminate any edge you may have.

Occum's razor applied to the stock market: returns over the long run will equal dividend yields + long term economic growth. everything else is noise.