a Peter Bernstein died on June 5, 2009, at the age of 90. No individual made more influential and generous intellectual contributions to the field of economics and portfolio strategy.
b Methuselah, a biblical forebear of Noah, reputedly lived for 969 years—time enough, no doubt, to develop a unique perspective on the seasons and cycles of the economy and its financial markets.
c The data for the first period are somewhat anecdotal. For the second period, they are based on a 1938 study by the Cowles Commission, a respected independent study group. The third period covers the entire history of the highly respected Standard & Poor’s indexes.
d These data are based on 1871-1997 historical dividend yields and earnings growth. Only total return data—not its components—are available for the 1802- 1870 period. However, real stock returns of 7 percent prevailed during both eras, giving us two centuries of data that establish the consistency of real stock returns—surely a full test of time for us mere mortals with rather shorter expected lifetimes.
e If we look at all 61 rolling decades during the 1926-1997 period, the results are virtually identical.
f This tendency is referred to as reversion to the mean. I call it the law of gravity in the financial markets. It is discussed at length in Chapter 10.
g Given the wide range of professional opinion about the stock market outlook, I have added Appendix I, “Some Thoughts about the Current Stock Market as 1999 Begins.”
h The mutual fund shortfall would have been even more apparent if we had also adjusted for fund sales charges. For load funds (those charging sales commissions), sales charges would have consumed about 0.6 percent of total annual returns. For load and no-load funds combined, the reduction in return would have been about 0.4 percent.
i The Sharpe ratio, developed by Nobel laureate William F. Sharpe, is the customary basis for calculating risk-adjusted returns. The ratio is based on annual rate of return (in excess of the risk-free rate of return on U.S. Treasury bills) per unit of risk—more accurately, volatility, as measured by standard deviation.
j 100 basis points equals 1 percent.
k The rest of the market is measured by the Wilshire 4500 Equity Index, which includes all of the stocks in the all-market Wilshire 5000 Equity Index except those in the S&P 500.
l The respective percentage weightings among giant-cap, large-cap, mid-cap, and small-cap stocks are: Wilshire 5000 Index: 48, 28, 15, 9; large-cap mutual funds: 47, 35, 16, 2.
m This simple equation ignores the fund disadvantage engendered by holdings of cash reserves, which probably accounted for an annual handicap of about 0.6 percent during this bull market period. (Index funds, by definition, hold no cash.) On the other hand, survivor bias likely accounted for an advantage of at least a similar dimension, roughly offsetting this handicap for growth and value funds. So the comparison remains valid.
n In a later study, Professor Mark Carhart found that fully one-third of all stock funds disappeared between 1962 and 1993, and the Malkiel study showed that, even in as short a period as 1988 to 1992, 100 of the original 686 funds disappeared, a mortality rate of 15 percent. More recently, in 1993-1998, the halcyon period of mutual fund prosperity, about 600 equity funds vanished.
o Although duration is a complex mathematical concept, it measures an important factor: the sensitivity of a bond price to changes in the general level of interest rates. A short-term bond fund with a portfolio duration of, say, 2.0 would move up or down in price by 2 percent for each change of one percentage point in interest rates; a long-term bond fund with a portfolio duration of 12.0 would move up or down by fully 12 percent for each change of one percentage point in rates.
p R-squared is a measure of the mutual association between any two factors. In this example, the level of investment expenses explains, on average, 0.36, or 36 percent, of the level of bond fund returns. All other factors combined, such as risk, portfolio turnover, and management skill and luck, account for the remaining 0.64, or 64 percent.
q These problems are even more predictable and more evident in the money market fund category. However, they are completely ignored there as well.
r An international portfolio includes only foreign issues. A global portfolio includes both U.S. and foreign issues. These definitions are consistent with industry parlance.
s The gap of 2.4 percent (18.9 - 16.5) is somewhat larger than my earlier 2 percent estimate of fund costs, in part because of the drag created by the lower returns on the cash reserves typically held by actively managed funds.
t Beta is a measure of a fund’s volatility relative to a stock market index (usually the Standard & Poor’s 500 Index).
u A personal anecdote: When Robert Markman, an independent investment adviser who is a long-time foe of indexing, formed his own fund of funds early in 1995, I made so bold as to wager him $25 that an index fund modeled on the S&P 500 would prove a better investment than his MultiFund Moderate Growth Portfolio, the portfolio he identified as having a strategy that would outperform the S&P 500 over the following five years. With 3½ years having elapsed, the results so far: Vanguard 500 Index Fund +124 percent, MultiFund Moderate Growth Portfolio +58 percent. The bet isn’t due to be settled until April 1, 2000, so I’ m not yet banking the money. But if the S&P 500 Index generates, say, a 6 percent annualized return in the next 1½ years, the Markman Portfolio will have to rise at a 34 percent annual rate! That will be no mean challenge for this fund-of-funds portfolio.
v Before published industry norms for the two groups became available in 1968, I relied on a sample of funds whose objectives, portfolios, and annual returns made this distinction clear.
w For the record, Sir Isaac’s equation is: Gravitational force equals the gravitational constant times the relative masses of two objects divided by the distance between them squared.
x I must confess to being amused by the irony that the “bogle” was the earliest known goblin, already part of Scottish literature in 1500. Some years ago, I was called “Beta Bogle, the data devil.” Given my role in forming the first index mutual fund, it is entirely possible that active managers place me in the goblin category.
y An index fund has no particular size limitations, simply because its portfolio holds the same percentage of each corporation’s shares. It does no active trading of these stocks, merely buying or selling shares of each in proportion to the net cash flow from investors purchasing (or redeeming) the shares of the index fund.
z In fact, the tax never need be paid if the investment, at the investor’s death, is bequeathed to a beneficiary. Then, the original cost basis is stepped up to the market value at the time of death.
aa Currently, the maximum tax rate on long-term gains is 20 percent and the maximum tax rate on short-term gains (and ordinary income) is 40 percent.
ab Independent studies indicate that such alternative investments have provided returns in the range of 15 to 20 percent annually during 1992-1997. Compared with the 18 percent return on the S&P 500 Index during the same period, and taking into account the leverage in many alternative investments, such returns would not be considered very impressive.
ac Journalist Jason Zweig calls this effect “the black magic of de-compounding.”
ad I believe that my characterizations of the mutual fund industry in the aggregate here are fair, but it would be unfair not to acknowledge that some industry participants take a more enlightened view. They exist, though I am confident that they constitute a fairly small minority.
ae Unlike the conventional time-weighted total return, which simply measures the change in a fund share’s net asset value, with this figure adjusted for any dividends paid, a dollar-weighted total return relates the varying returns earned by a fund to the varying level of assets managed by the fund. The returns earned when a fund is managing a greater level of assets are accorded greater weight than those earned when the fund has a smaller level of assets. In effect, the dollar-weighted return reflects the experience of the average investor who owns the fund’s shares.
af Although the number of stock and bond funds currently exceeds 13,000, many of these funds represent different share classes of the same underlying portfolio. A single portfolio may feature as many as three or four different share classes—Class A, Class B, Class C, and so on—each with a different fee structure. If we count only the underlying portfolios, there are approximately 8,000 distinct stock, bond, and money market funds.
ag And three fine market years at that. In the tough climate of 1987, the redemption/ exchange rate took a quantum leap to an astonishing 62 percent of assets, a worrisome omen of what we might face in the next sharp market decline.
ah Depending on the particular circumstances of each case, this type of hitherto-untried litigation may or may not prove successful.
ai I first made this simple, bold statement in public in mid-1997, in a speech before an audience of 7,000 at the Los Angeles Times Investment Strategies Conference. It was presented again as the centerpiece of Chapter 4.
aj Perhaps these words should be taken with a grain of salt, since one cannot be certain of the motivations that underlie a note from a crewmember to his or her captain.
ak Ironically, I used this same formulation in my Princeton senior thesis in 1951: “Providing advantages to the mutual fund investor . . . is the function around which all others are satellite.” More recently, in Bogle on Mutual Funds, I noted how amazed Copernicus would have been to observe that, in the mutual fund industry, “the giant sun would revolve around its small satellite.”
al “Consequences must outweigh probabilities,” as Pascal warned us, a point I drive home in the conclusion of my Chapter 6.