Bogleheads Have Strangled The Market

Any investor walking into a financial planning office in the last 6 years would have been told the same thing...

“Put your money in a mutual fund. Index mutual funds are best.”

“You can’t go wrong,” they say, economics professors have proved it.

But anyone who followed this advice in the last 6 years has lost money.

It all started with a good idea.

In 1975, John Bogle created the Wal-Mart of mutual funds. This fund would employ no MBA analysts or high-paid fund managers. Instead of trying to beat the market by picking stocks – a feat few managers can do - Bogle programmed a computer to mimic the return of the S&P 500.

In 1975, mutual funds charged 2% annual fees. His fund would charge less than 0.5%.

As it turns out, John Bogleunderestimated the impact of his innovation. As well as reducing the loads and charges paid by consumers, the passive trading strategy employed by index funds reduced portfolio churn, so commissions declined.

Bogle’s simple idea actually tacked on as much as 3.4% to annual stock market returns.

Returns that great were bound to change the industry. And they did, right to the core. Bogle would never have guessed it, but his innovation would cause a huge mess.

Bogle’s innovation gave mutual fund managers a strong incentive to become ‘closet’ indexers. If they couldn’t beat the market, they joined it... or risked losing their jobs...

Like the reflection of a mirror in a mirror, the idea was so influential, that the market almost became an index of itself.

The problem was, the market allocates capital through a continuous and massive game of trial and error. Opinions clash. An equilibrium price results. Winners emerge, losers fade away. It’s precisely this game that makes the market so efficient.

But when everyone started doing the same thing – investing in the indices – by the late 90s, the 3.5% annual edge had disappeared.

It always comes down to the same old problem: Fashionable ideas don’t make good investments: Indexing only returns superior profits when the majority is trying to pick stocks.

By 2000, Bogle’s Vanguard 500 Index fund was the largest mutual fund in the world, with over $100 billion in assets. Index-linked investments have gone nowhere in the last 5 years.

Bogle’s innovation had become too popular. But there’s a flip side to this trend: When everyone is indexing, stock pickers have the edge.

Since 2000, selected stock picking mutual funds have prospered in the time that indexing has failed. Is this just a coincidence? We think not. And could this be a force behind the explosion in hedge funds?

We think readers should avoid index funds in favor of active managers.

In Monday’s edition of DailyWealth, we’ll introduce you to some of the top stock pickers working for the main street investor... I call them “hedge funds with stock symbols.”

Good Investing,

Tom Dyson