The recent resolution of a simple five-year-old bet shows why fund investors often have such a hard time deciding the “right” thing to do when it comes to choosing funds.
In 1995, Vanguard Group founder Jack Bogle and Bob Markman, head of the Markman MultiFunds, made the classic passive versus active management wager. They bet $25 that their chosen fund — the Vanguard Index 500 or the Markman Moderate Allocation fund — would come out ahead in five years, winner take all.
Bogle won, but Markman’s payoff started a public exchange of letters between the two, and it soon became obvious that even the most simple fund issues are easily blurred. That’s why it’s hard to pick a fund on which to bet your hard-earned savings.
Here’s the skinny on the bet and the spin from both sides.
As of mid-April, when Markman sent Bogle the payoff, the Vanguard Index 500 was up 26.7 percent annualized over the five-year study period, compared to a 20.7 percent annual gain for Markman Moderate, which like all Markman funds invests in other mutual funds instead of stocks.
But Markman noted he had fallen for a sucker’s bet because Markman Moderate kept roughly 25 percent of its assets in bonds and cash, while the Index 500 was entirely in stocks.
And while it wasn’t part of the bet, he took solace in the fact that his fully invested Markman Aggressive Allocation fund topped the index fund with a 27.7 percent annualized gain.
Bogle, however, wasn’t offering solace.
In his response to Markman, he wrote that the index fund’s victory over Markman Moderate “validates the principle that brought me to offer the original bet: The odds in favor of a stock market index fund over any managed fund are powerful, and they get better as the managed fund’s expense ratio rises.”
What’s more, he noted that the Index 500’s victory was much greater after taxes were factored in, because nearly 30 percent of Markman’s profits would have gone to Uncle Sam, compared to just a fraction of the index fund’s gains. (On an after-tax basis, Markman Aggressive also lagged the index fund.)
The verbal sparring then delved into more arcane subjects. The exchange of letters (you can read it on the funds page at www.morningstar.com) was not the most sportsmanlike show from these spirited, intelligent and likable men.
What’s worse is that the bet really didn’t settle anything, particularly not what it set out to, which was whether active or passive management would deliver superior performance.
In reality, the market over the last five years ruined the academic value of this bet. That’s because index funds tend to win out when large-company stocks are in favor, while active managers look better when small- and mid-cap stocks heat up.
The five years ending in 1999 represent the best five-year run for large-cap stocks in 75 years. Any fund that was not fully invested was almost certain to lose to the index.
What’s more, the real benefit to indexing is not so much performance as it is capturing and compounding the small, incremental benefits of having lower costs. Those small bits can produce a big edge when compounded over time, while the burden of active management, particularly the double layer of expenses Bogle criticizes in most fund-of-funds, impedes growth.
“Saving that expense ratio and getting it to compound in your favor is a big issue,” says Roger Gibson of the Center for Fiduciary Studies in Pittsburgh. Bogle and Markman have agreed to renew their bet for the next five years; to truly reflect the bet’s original intent, they should keep the starting point as 1995, rather than beginning anew (as they plan to).
Cloudy images are presented almost every time a fund ad shows performance and investors try to decide which funds to bet on with their own money. Every winning bet seems to have its exceptions, codicils and woulda-coulda-shouldas.
Ultimately, Bogleheads (as Bogle’s index-investing fans are called) believe they are right and have great returns to prove it. So do Markman’s supporters. So long as the investors are happy with the results, the style that achieved them is relatively unimportant.
Fund investing is not a bet in which you win by making others lose. As a result, search more for an investment strategy you can believe in than one that others think is “right.”
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Charles A. Jaffe is mutual funds columnist at The Boston Globe. He can be reached by e-mail at jaffe@globe.com or at The Boston Globe, Box 2378, Boston, Mass. 02107-2378.
