Common Sense on Mutual Funds

“Common Sense” Defined

The Second Edition of the Oxford English Dictionary (OED II) captures the essence of these principles in its definition of common sense: “The endowment of natural intelligence possessed by rational beings . . . the plain wisdom which is every man’s inheritance . . . good sound practical sense.” Throughout this book, I try to honor these qualities, confident that plain-spoken reason makes not only a powerful case for common sense in mutual fund investing, but a persuasive argument for change in the mutual fund industry as well. The OED II also offers this fitting citation, published by The Times of London in 1888: “The general demand was for intelligence, sagacity, soundness of judgment, clearness of perception, and that sanity of thinking called common sense.” I believe that mutual fund investors will eventually make this same demand, and that it will become increasingly imperative as the ranks of fund shareholders, and the level of assets invested in mutual funds, continue to grow.

I chose the title Common Sense on Mutual Funds not only to emphasize the importance of common sense as it is defined by the foregoing words, but also because “Common Sense” is the title of a remarkable tract written in 1776. The author, Thomas Paine, a Philadelphian and one of the country’s Founding Fathers, was eager to end the governance of the American colonies by George III of Great Britain. Perhaps more than any other man, this author set the stage for the American Revolution. In the opening paragraph of the first of four pamphlets that were to constitute “Common Sense,” Thomas Paine acknowledged the challenge he was facing:

Perhaps the sentiments contained in the following pages are not yet sufficiently fashionable to procure them general favor; a long habit of not thinking a thing wrong, gives it a superficial appearance of being right, and raises at first a formidable outcry in defense of custom. But the tumult soon subsides. Time makes more converts than reason.

My sentiments about this industry, too, “are not yet sufficiently fashionable to procure them general favor.” Nonetheless, I believe that the formidable consensus that exists today in accepting without question the status quo of the mutual fund industry will soon subside. But I expect that it will take both time and reason to make converts, and that common sense will eventually prompt the conversion.

And so I ask you, dear reader, to bear with me as you explore new and important ways both of investing successfully in mutual funds and of thinking about the mutual fund industry. I offer these ideas in the same sense that Thomas Paine offered his ideas:

In the following pages, I offer nothing more than simple facts, plain arguments, and common sense; and have no other preliminaries to settle with the reader, than that he will divest himself of prejudice and pre-possession, and suffer his reason and his feelings to determine for themselves; that he will put on, or rather that he will not put off, the true character of a man, and generously enlarge his views beyond the present day.

A Five-Part Approach

The book is divided into five distinct parts. The first three are devoted to the examination of commonsense principles in the three prime areas that should most concern investors in the establishment of their mutual fund portfolios: investment strategy, investment selection, and investment performance. Part I, “On Investment Strategy,” emphasizes the need for a long-term focus, an understanding of the nature of the returns earned in the stock and bond markets, and the important role of asset allocation in investors’ portfolios. Each chapter in this section leads to the conclusion that common sense and simplicity are the keys to financial success. The same conclusion holds in Part II, “On Investment Choices,” in which I first cover index mutual funds and then describe choices among individual stock and bond funds and among various investment styles in each category. I also explore global investing in some depth, emphasizing the additional risks entailed in that strategy, but again finding that common sense carries the day. I reach the same finding when I discuss the search for the “holy grail”—mutual funds that provide predictably superior returns. Part III, “On Investment Performance,” includes some sobering reminders of challenging investment realities, including the profound—but rarely discussed—tendency of past fund returns and past financial market returns, whether high or low, to revert to long-term norms in the future. I also discuss the current, but dubious, focus on short-term relative (rather than long-term absolute) returns, the surprisingly negative implications of fund asset growth, and the extraordinary tax inefficiency of most mutual funds. Part III concludes with a study of the vital role played by time: It enhances returns, reduces risks, and magnifies the baneful impact of investment costs as well.

Many readers will find the content of the final two parts surprising in a book about successful investing in mutual funds. Were it not for the fact that the issues discussed in Part IV, “On Fund Management,” are a major cause of the generally inadequate fund returns discussed in earlier chapters, they would indeed be inappropriate here. But this industry has moved away from its traditional principles. Its focus today is on marketing rather than management, and it often uses today’s wondrous information technology in ways that are detrimental to investors. All told, the interests of fund shareholders are not being well served. The root of the problem, I suggest, lies with mutual fund governance and the industry’s peculiar operating structure, in which fund directors delegate all of a fund’s operations to an external management company. Again, I point to common sense and simplicity as the solutions to these problems; one option would be a restructuring of the industry so that it could far better serve mutual fund investors. Recognizing, however, that even the best corporate structures inevitably reflect the values of the individuals who constitute the corporation, in Part V, “On Spirit,” I take the liberty of discussing my personal experience in the entrepreneurship and leadership involved in the establishment of a major, but uniquely structured, mutual fund firm. I then conclude the book with a presentation of some reactions from some of those human beings who have served in that unique environment, and those who have been served by it.

Before we proceed further, a few words about this book. Although I have organized the chapters to be read consecutively, with the later material building on principles established earlier in the book, my goal has been to make each chapter a freestanding and independent essay on a particular issue. Thus, it was sometimes necessary to reiterate certain themes and statistics. This reinforcement, I hope, will be more than compensated for by the convenience of enabling the reader to focus on particular issues as interest and time dictate. Portions of these chapters may be familiar to some readers, for some of these themes, first tested in speeches or in journals or magazines, have been more fully developed here. However, much of the material appears here for the first time in any form.

Common Sense Redux

Despite the fact that the commonsense investment principles and the commonsense principles of industry structure that I express in the coming pages are, like the arguments expressed by Thomas Paine, “not yet sufficiently fashionable to procure them general favor,” I hope that readers will not fall back on a “formidable outcry in defense of custom.” Paine’s impassioned arguments—backed by little more than common sense—finally met with the favor of the citizens of the colonies, and the American Revolution ensued, even as I hope that my commonsense arguments will soon meet with the favor of mutual fund investors.

Common Sense on Mutual Funds will demonstrate that the ills and injustices suffered by mutual fund investors are not dissimilar to those our forebears suffered under English tyranny. The mutual fund industry is rife with “taxation without representation” in the form of the high fees charged by fund managers, facilitated by boards of directors that acquiesce to counterproductive management policies and excessive fees, with inadequate consideration of their powerful negative impact on the returns earned by fund shareholders. Fund shareholders, like the citizens of the American colonies, should be responsible for their own governance.

As Thomas Paine pointed out, “The king is not to be trusted without being looked after . . . a thirst for absolute power is the natural disease of monarchy.” Mutual fund management companies seem to have gained the power of kings in ruling the investments of the fund shareholders. If the English aristocracy in the eighteenth century was acceding to the king’s every whim, cannot the same be said of fund boards of directors? I have no quarrel with management companies’ focusing on their own profits. But the trade-off between the profits that accrue to fund shareholders and the profits that accrue to the fund management companies seems subject to no effective independent watchdog or balance wheel, despite the fact that the shareholders actually own the mutual funds. As in every other corporation in America, they ought to control them, too.

Principles and Practices

Mutual fund investors should return—and insist that the funds that they own return—to the sound investment principles and practices that are described in the first three parts of this book. And because the corporate structure of the industry has given rise to the abandonment of those investment principles and practices, fund investors should insist that mutual funds alter their organizational structures to mend the rift between ownership and control that exists today. In a commonsense manner, I have tried to reason through these issues with you, in the hope that the returns you earn on the assets you have entrusted to mutual funds will be meaningfully enhanced.

You haven’t quite heard the last word from Thomas Paine. As you reflect on the critical issues discussed in this book, without doubt you will think some of them strange to contemplate and difficult of accomplishment. So it was, too, in 1776, when Paine concluded the fourth pamphlet of “Common Sense” with these words:

These proceedings may at first appear strange and difficult; but, like all other steps which we have already passed over, will in a little time become familiar and agreeable; and, until an independence is declared, the Continent will feel itself like a man who continues putting off some unpleasant business from day to day, yet knows it must be done, hates to set about it, wishes it over, and is continually haunted with the thoughts of its necessity.

I am under no illusions. It won’t be easy, and surely won’t be fully accomplished in my lifetime. But I hardly need to remind you, using Thomas Paine’s most famous words, written one year before General George Washington’s battered army bivouacked in Valley Forge, enduring the bitter winter of 1777-1778: “These are the times that try men’s souls. . . . ’ Tis the business of little minds to shrink; but he whose heart is firm, and whose conscience approves his conduct, will pursue his principles unto death . . . . Tyranny, like hell, is not easily conquered, yet the harder the conflict, the more glorious the triumph.”

JOHN C. BOGLE

Valley Forge, Pennsylvania

February 1999