Excerpted from Common Sense on Mutual Funds by John C. Bogle, pages133-136
In this analysis of market indexes and index mutual funds, I have had to rely largely on the records of the original two index funds simply because, as the pioneers in the field, they are the funds with the longest records (23 years for the Vanguard 500 Index Fund, and seven years for the Total Stock Market Index Fund). But a caution is necessary: Both of these index funds are large; both are free of sales loads; both have operated at rock-bottom cost; both have maintained low portfolio turnover; and both have been administered with extraordinary efficiency, enabling them to track their target indexes with considerable precision.
The same cannot be said about all of the index funds that are now available in the marketplace. Of some 140 index funds, about 55 are modeled on the S&P 500 Index; four on the Wilshire 5000 Index; 46 on sub-sets of the overall U.S. stock market (large-cap growth and value, small-cap growth and value, and so on); 18 on international markets; and just 20 on the U.S. bond market. Instead of blindly choosing an index fund, investors must be careful to determine that the fund they select is indexed to the market segment they wish to emulate.
Surprisingly, one-third of all index funds carry either front-end or asset-based sales charges. Why an investor would opt to pay a commission on an index fund when a substantially identical fund is available without a commission remains a mystery. The investor who does so starts out on day one by falling as much as 5 percent or more behind the target index - behind the eight-ball, as it were - and falls further behind each year, as fund expenses take their toll. Suffice it to say that it would be silly for an intelligent investor to select an index fund that carries a commission.
It is equally nonsensical to select a fund that carries a high operating cost. Annual expense ratios of index mutual funds run from as low as a nominal 0.02 percent for funds available to very large institutional investors and 0.18 percent for publicly available funds, to as high as 0.95 percent, the rate charged by at least one established fund. That is simply too much to pay. (When a representative of that fund was asked how such a confiscatory fee could be justified, he responded, It's a cash cow - for the manager. Indeed it is. But a cash cow for the investor is a better option.)
Further, beware of the many funds that attest that their expense ratios are low, stating only in the fine print that fees are being waived for a temporary period or until a specific future date. What, really, is the point in your paying an artificially low expense ratio of, say, 0.19 percent for a few years, after which a much higher 0.50 percent fee may be assessed? It is at least possible that, by that time, your investment will have appreciated in value, and you will be subject to capital gains taxes that outweigh the obvious advantage of shifting to a truly low-cost fund. Be sure to read all the fine print about costs in the advertisements, and pay careful heed to the details in the fund's prospectus.
Next, there is the question of portfolio turnover. One of the great advantages of index funds is their tax efficiency. But some index funds, either because of constant heavy investor activity, or because of portfolio strategies based on the aggressive use of index futures, generate high portfolio turnover - sometimes as much as 100 percent or more - and consequently realize and distribute substantial capital gains. When tax-efficient index funds abound, there is simply no reason for taxable investors to select index funds that are tax-inefficient.
Further, all index funds are not created equal in operating efficiency. Some index fund managers, whether by virtue of skill, experience, or dedication, simply do a better job than others in the execution of portfolio transactions. Taking 1996 through 1998 as an example, the best managers of the Standard & Poor's 500 Index funds were actually able to outpace the returns of the index itself by as much as 1/10 of 1 percent annually before the deductions of operating costs; the least successful managers fell 3/10 of 1 percent (or more) behind. This difference in ability to match the index is pretty much ignored by the marketplace. But is should not be. Of what value is a manager, for example, who brags about an expense ratio (often temporary) of 0.18 percent and loses 0.30 percent in operating margin, resulting in a net shortfall of 0.48 percent to the index? Compare those results to the performance of a manager who charges 0.28 percent and exactly matches the index return, for a net shortfall of 0.20 percent. Investors should carefully examine the aspects of each manager's implementation of strategy for any index fund that is being considered.
Finally, index funds vary in the amount of unrealized capital gains in their portfolios. In the abstract, those with modest appreciation (or even losses) on their books might be favored over those with very large appreciation. But this factor should be weighed only in light of the countervailing advantages the funds may offer, as well as their susceptibility to heavy redemptions, their election of redemption-in-kind policies (thus obviating the need to liquidate portfolio securities), and their tax management strategies.
YAHOO! FINANCE TIP
Yahoo! Finance reports a mutual fund's cost, turnover and capital gains data on its profile page. For an example, see VFINX's profile page.
None of these little percentages may seem like much, but they can represent the difference between day and night for the long-term index fund investor. Even tiny differences in returns truly matter in a lifetime investment program. Consider the different approaches to index fund selection, given in Table 5.3. After a decade, $10,000 in the no-load, low-cost, efficient index fund would have grown to $30,500; in the worst outcome, the load, high-cost, inefficient fund would have grown to $26,500.
Such a hypothetical example is hardly absurd. It is real. Over the past decade $10,000 invested in one efficient, low-cost, no-load S&P 500 Index fund would have grown to $54,000. Another putatively identical, but less efficient, higher-cost index fund carrying a 4.5 percent load, would have grown to only $47,000 - truly a staggering gap between two S&P Index funds with the same portfolios. (This fund, as it happens, was the cash cow described earlier.) All index funds are not created equal.
VANGUARD INDEX TRUST 500 INDEX Delayed quote data /
Net Asset Value: / 114.53
Trade Time: / Sep 16
Change: / 0.95 (0.84%)
Prev Close: / 113.58
YTD Return*: / 1.87%
Net Assets*: / 74.41B
Yield*: / 1.85%
* As of 31-Aug-05 /
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FUND BASICS / 31-Aug-05
Morningstar Overall Rating: /
Total Assets: / 74.41B
Category: / Large Blend
Total Expense Ratio: / 0.18%
Fund Profile - Holdings
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PERFORMANCE & RISK / 31-Aug-05
YTD Return: / 1.87%
5y Avg Return: / -2.82%
Rank in Category (ytd): / 906
% Rank in Category (ytd): / 56.98%
Beta (3y): / 1.00
Morningstar Risk Rating: / Average
Performance Details - Risk Details
FUND SUMMARY
Vanguard 500 Index Fund seeks investment results that correspond with the price and yield performance of the S&P 500 Index. The fund employs a passive management strategy designed to track the performance of the S&P 500 Index, which is dominated by the stocks of large U.S. companies. It attempts to replicate the target index by investing all or substantially all of its assets in the stocks that make up the index.
VANGUARD INDEX TRUST TOTAL STOC Delayed quote data /
Net Asset Value: / 29.80
Trade Time: / Sep 16
Change: / 0.23 (0.78%)
Prev Close: / 29.57
YTD Return*: / 2.88%
Net Assets*: / 30.49B
Yield*: / 1.58%
* As of 31-Aug-05 /
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FUND BASICS / 31-Aug-05
Morningstar Overall Rating: /
Total Assets: / 30.49B
Category: / Large Blend
Total Expense Ratio: / 0.19%
Fund Profile - Holdings
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PERFORMANCE & RISK / 31-Aug-05
YTD Return: / 2.88%
5y Avg Return: / -1.73%
Rank in Category (ytd): / 651
% Rank in Category (ytd): / 40.94%
Beta (3y): / 0.99
Morningstar Risk Rating: / Above average
Performance Details - Risk Details
FUND SUMMARY
Vanguard Total Stock Market Index Fund seeks to replicate the aggregate price and yield of the Wilshire 5000 Total Market Index. The fund employs a passive management strategy designed to track the performance of the Wilshire 5000 Index, which consists of all the U.S. common stocks traded regularly on the NYSE, AMEX, or OTC markets. It typically invests substantially all of its assets in the 1,300 largest stocks in its target index, thus covering nearly 95% of the Index's total market capitalization while maintaining a representative sample of the remainder.
Selecting Funds Based on Past Performance Is Risky
Excerpted from Common Sense on Mutual Funds by John C. Bogle, pages211-212
Mark Carhart, of the University of Southern California, is another respected scholar who tackled the issue of persistence in fund performance. He evaluated 1,892 diversified equity funds over 16,109 fund years (amazing!) from 1962 to 1993. First, he found that "common factors in stock returns [value vs. growth, large cap vs. small cap, high beta vs. low beta] and investment expenses almost completely explain persistence in equity fund returns." Properly adjusting for the customary failure to consider the effect of the subaverage returns of funds that have gone out of existence, Carhart confirmed Professor Burton Malkiel's conclusion, described in Chapter 5, that survivor bias has enhanced past annual returns reported for funds over the 1982-1991 decade by about 1.4 percent per year. Dr. Malkiel also found some limited evidence of persistence during the 1970s, but none during the 1980s.
Looking at past one-year returns relative to those of the subsequent year, Carhart concluded, among other things, that relatively few funds stay in their initial decile ranking, although funds in the top and bottom deciles maintain their rankings more frequently than the 10 percent that mere chance would suggest. The 17 percent of funds repeating in decile one seems less than compelling. The 46 percent of funds repeating in decile ten, on the other hand, is quite imposing, a performance that seems largely explained by the fact that many low-decile funds tend to be trapped there by their high costs. In his conclusion, Carhart warns: "While the popular press will no doubt continue to glamorize the best-performing mutual fund managers, the mundane explanations of strategy and investment cost account for almost all of the important predictability of mutual fund returns." [Italics added] Translation: Relying on past records to select funds that will provide superior performance in the future is a challenging task.
Professional Management with Mutual Funds
Excerpted from Bogle on Mutual Funds by John C. Bogle, page 53
The second principle of mutual fund investing is professional management. Managing an investment portfolio entails selecting and supervising the fund's holdings. The investment professionals who manage the fund must do so strictly in accordance with the fund's basic investment objectives and policies. For instance, if you invest in a particular balanced fund, you may be promised that a highly diversified list of blue chip stocks will comprise 60% to 70% of total net assets and a diversified list of high-grade bonds will comprise the remainder. The professional manager has an obligation to meet these standards under all circumstances.
Put Your Funds in the Right Accounts
As an investor, you probably know about asset allocation -- the mix of stocks, bonds, and cash you hold. But have you ever considered asset location?
To minimize taxes on dividends and interest, consider placing the most tax-inefficient investments in your tax-deferred accounts and the most tax-efficient investments in your taxable accounts.
Generally, the mutual funds that trigger the highest current taxes tend to be taxable money market and bond funds. That's because most of their total return comes from taxable interest income, which is taxed as ordinary income at the investor's marginal tax rate. Stock funds -- particularly index funds, growth-oriented funds, and, of course, tax-managed funds -- tend to trigger lower taxes because these types of funds generate more of their total return from capital gains. Long-term capital gains generally are taxed at a lower rate than ordinary income. As you might expect, balanced funds -- those funds that hold a mixture of stocks and bonds -- fall somewhere between the most and least tax-efficient funds.
So you should put taxable bond and money market funds in your tax-deferred accounts and your stock funds in taxable accounts, right? Generally, but not all funds fall neatly under those overall guidelines. That's why you have to examine each fund closely to understand its potential tax efficiency. An investment in a money market mutual fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market mutual fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in these funds.
Tax-deferred accounts
Consider your most tax-inefficient funds as potential candidates for your tax-deferred accounts, such as employer retirement plans and traditional IRAs. When you hold these types of funds in a tax-deferred account, you don't pay taxes until you withdraw from the account -- usually in retirement when you're likely to be in a lower tax bracket. Your taxable money market funds and bond funds clearly fit into this category -- at least the portion you don't need ready access to. Among your stock funds, value funds may be good candidates for your tax-deferred accounts because they generally invest in stocks that offer higher dividend yields than growth stocks.
Taxable accounts
Of the stock funds you own, those that generate the highest proportion of capital gains to dividends can be particularly well-suited for your taxable accounts. Growth funds, index funds, and tax-managed funds generally fit into this category. Why do these funds generate more capital gains? Instead of paying dividends to shareholders, growth companies typically reinvest a large percentage of profits in equipment, buildings, and other resources. As the companies grow, the value of their stock typically grows, and funds that eventually sell those stocks realize capital gains. For the bond or money market funds you need to hold at-the-ready in taxable accounts, you can use the Cut Taxes on Your Taxable Accounts strategies to shield income dividends from taxes.
Making a final determination
There are no hard-and-fast rules to determine which investments should go in which kind of accounts because the tax efficiency of any particular fund can be more or less than you might expect. Some value funds -- which you'd expect to be tax-inefficient -- are managed to operate tax-efficiently, perhaps by following a buy-and-hold strategy, making them appropriate for a taxable account. Some growth funds -- which you'd expect to be relatively tax-efficient -- are surprisingly tax-inefficient, perhaps because frequent trading by the fund's adviser is generating short-term capital gains, which are taxed as ordinary income. Factors such as investment methodology, cash flows into or out of the fund, and trading frequency may outweigh growth versus value in determining a fund's tax efficiency. As a final check on whether a fund is best held in a taxable or tax-deferred account, look at its after tax returns (that is, how much of a fund's pretax return you get to keep after paying taxes). The larger the difference between a fund's pretax and after-tax return, the less tax-efficient the fund -- and if you want to own it, the greater the likelihood you'd want to hold it in a tax-deferred account.
Mutual Fund Top Performers
Overall Top Performers
U.S. Stock Funds- Bear-Market
- Conservative Allocation
- Large Blend
- Large Growth
- Large Value
- Mid-Cap Blend
- Mid-Cap Growth
- Mid-Cap Value
- Moderate Allocation
- Small Blend
- Small Growth
- Small Value
- Specialty - Communications
- Specialty - Financial
- Specialty - Health
- Specialty - Natural Resources
- Specialty - Precious Metals
- Specialty - Real Estate
- Specialty - Technology
- Specialty - Utilities
/ Bond Funds
- Bank Loan
- High Yield Muni
- High Yield Bond
- Interm-Term Bond
- Intermediate Government
- World Bond
- Emerging Markets Bond
- Long Government
- Long-Term Bond
- Multisector Bond
- Muni National Interm
- Muni National Long
- Muni National Short
- Muni Single State Interm/Short
- Muni Single State Long
- Muni California Long
- Muni California Interm/Short
- Muni Florida
- Muni Minnesota
- Muni New Jersey
- Muni New York Long
- Muni New York Interm/Short
- Muni Ohio
- Muni Pennsylvania
- Short Government
- Short-Term Bond
- Ultrashort Bond
- Convertibles
International Stock Funds
- Diversified Emerging Markets
- Diversified Pacific Stock
- Europe Stock
- Foreign Stock
- Japan Stock
- Latin America Stock
- Pacific ex-Japan Stock
- World Stock
/ Hybrid Funds
- World Allocation
Mutual Fund Top Performers - Overall / As of 10-Sep-05
Select a symbol for a detailed quote and links to additional information.