For me, simplicity has always been the key to successful investing, and the time-honored wisdom of Occam's razor, set forth by the fourteenth-century philosopher and friar William of Occam, has stood me in good stead: When confronted with multiple solutions to a problem, choose the simplest one.[10] My career has been a monument, not to brilliance or complexity, but to common sense and simplicity, "the uncanny ability," as one observer has said of me, "to recognize the obvious." (I'm not sure it was meant as a compliment!) So let's recognize some of the simple and obvious facts of our highly complex financial and investing life today, beginning with the role of innovation.
It is hard to argue against the value of innovation in general. Our laptop computers probably have enough calculating power to send a man to the moon. With tiny pocket versions, we can connect to Wi-Fi all over the world; keep in touch with our kids; and take, send, and store photographs. The Internet provides an infinite store of information available on demand. E-tailing has given consumers the benefit of previously unimaginable price competition. Medical technology (like my heart transplant) has enhanced and lengthened our life and its quality.
But in the financial sector innovation is different. Why? Because here there exists a sharp dichotomy between the value of innovation to the financial institution itself and the value of innovation to its clients. Financial institutions operate by a kind of reverse Occam's razor. They have a large incentive to favor the complex and costly over the simple and cheap, quite the opposite of what most investors need and ought to want.
Innovation in finance is designed largely to benefit those who create the complex new products, rather than those who own them. Consider, for example, the revenue production (and cost bloating) that occurs along the food chain of the creation of collateralized debt obligations (CDOs) backed by mortgages. The mortgage broker brings in the borrower and takes a commission from the bank. The bank takes a commission when it secures the mortgage; the rating agency takes a fee (estimated at $400,000 a throw) for each security it rates (usually, of course, in return for the coveted AAA rating, without which it can't be sold). The stockbroker takes a commission when he sells the security to customers. These costs—however deeply hidden—end up being paid by some combination of the person who borrows the money to buy a home and the end-user investor who purchases the CDO for a portfolio. The multiple croupiers—all those middlemen—reap the rewards.
With the unfathomable complexity of these and other financial innovations and the endorsement—and, I would argue, the complicity—of our rating agencies, this financial legerdemain creates a modern version of alchemy. It begins with the lead, as it were—a package of, say, 5,000 B- or BB-rated mortgages, with maybe even a few A's thrown in. They are then miraculously turned into the gold, as it were, of a $500 million CDO with (in one typical case) 75 percent of its bonds rated AAA, 12 percent rated AA, 4 percent rated A, and only 9 percent rated BBB or below. (Hint: We now know that, despite the risk-reducing character of such broad diversification, lead is still lead.)[11]
For banks, the lure of CDOs is elementary: They like getting paid large fees for lending money, and when they can quickly get the loans off their own books and into public hands (so-called securitization), it can hardly be surprising that they aren't much concerned about the creditworthiness of those families for whose homes they have provided mortgages.
As rightly newsworthy as they have been, these complex CDOs and structured investment vehicles (SIVs) (essentially money market funds that borrow short and lend long, therefore lacking the security of true money market funds) are only the bleeding edge of an enormous growth in these complex financial instruments that has overwhelmed our financial markets and superseded the capitalization and trading volume of the investments themselves.
At the same time, the markets have been flooded by so-called derivatives, that is, instruments whose values are derived from yet other financial instruments. (Recall our earlier discussion of the futures and options on the S&P 500 index.) Through interest rate swaps and credit default swaps (don't ask)—traded back and forth around the globe in nanoseconds—these derivatives are used to assume risk, to magnify risk, and (paradoxically) to hedge risk. Their trading volumes are staggering (though rarely disclosed), and their dimension is grotesquely disproportionate to the instruments from which their value is derived. (The credit obligations subject to default swaps are valued at $2 trillion; the swaps themselves total $62 trillion.) The notional principal value of all derivatives is almost beyond imagination—some $600 trillion, nearly 10 times the $66 trillion gross domestic product (GDP) of the entire world.
The innovation of derivatives has enriched the financial sector (and the rating agencies) with their enormous fees, even as the overrated, as it were, CDOs have wreaked havoc on the balance sheets of those who purchased them and have now been left holding the bag, surprisingly including the banks and brokers that created and sold them. Since virtually all of the main mutual fund managers also run pension money, their broad embrace of CDOs has in addition eroded the retirement plans of tens of millions of citizens.
Not to be outdone, SIVs have also created havoc. For it turns out that in order to sell these instruments to their customers, banks increasingly issued so-called liquidity puts to buyers, effectively guaranteeing to repurchase the SIVs on demand at face value. Citigroup, it turns out, was holding not only $55 billion of CDOs on its books, but also some $25 billion of SIV assets that could be (and later were) "put" back to the bank, a risk not publicly disclosed by Citigroup until November 4, 2007.
Astonishingly, Robert Rubin, chairman of Citigroup's executive committee (and a man, one might say, of not inconsiderable financial acumen), has stated that until the summer of 2007, he had never even heard of a liquidity put. That admission is not quite as embarrassing as former chairman Charles Prince's comment as the storm of the financial crisis was about to break: "As long as the music is playing, you have to keep dancing. We're still dancing." One can only wonder just when senior bankers stopped looking at their balance sheets.
In the months following the deterioration of the credit standing of our largest banks and investment banks (and many smaller banks), the crisis spread to two of our government-sponsored enterprises (GSEs), known as Fannie Mae and Freddie Mac. Together, they have provided some $5 trillion of mortgage loans to American families, an essential part of the nation's policy of encouraging home ownership. While their mortgage portfolios are of far higher quality than those alchemistic CDOs, these highly leveraged (say, $40 of borrowed money for each $1 of assets) shareholder-owned firms depend on regular borrowing in the money market.
Fears about their solvency (despite the implicit support of the federal government) have led to a collapse of about 80 percent in their stock prices. Faced with a credit crisis engendered in part by heavy mortgage foreclosures around the country, the U.S. Treasury had no choice but to formally affirm its backing for these GSEs.[12] This issue goes far beyond credit, however. It raises the profound policy question of whether it is sensible or desirable—or ultimately even possible—to privatize the substantial rewards earned in mortgage lending (their shareholders made billions; their executives received fortunes in compensation), at the same time as we socialize the risks (the taxpayers pick up the tab). More broadly, why should our government use taxpayer dollars to lift inefficient, indifferently managed firms to safety? Surely that is a long way from the kind of capitalism envisioned by the economist Joseph Schumpeter.
Since there's money to be made—lots of it—in the creation and marketing of inevitably complex innovations, the disease is contagious. CDOs and their by-now hundreds of innovative kith and kin in banking are echoed in the flood of innovations among stock and bond mutual funds. Of late, these fund innovations that belie simplicity seem designed to respond more generally to the expectation that the returns on stock and bond funds over the coming decade will lag behind historic norms—and far behind the halcyon norms of the 1980s and 1990s, when annual stock returns averaged 17 percent and bond returns averaged 9 percent.
Who wouldn't want to recapture such days? We truly never had it so good before or since that time! But we know (within a reasonably narrow tolerance) what returns to expect from simple, broadly diversified portfolios of stocks and bonds over the next decade (likely 7 and 5 percent, respectively). So we have no choice but to rely on reasonable expectations, formed on the basis of the known sources of stock returns (the initial dividend yield plus the subsequent rate of earnings growth) and bond returns (the initial interest rate). What then explains our expectations (or our hopes) that we can outguess the markets and add additional returns by selecting complex strategies or managers that hold optimal subsets of the market portfolio? Dr. Samuel Johnson would answer: "It was the triumph of hope over experience."
Yet what comes from all this churn of fund innovation, other than a plethora of management and advisory and transaction fees? Inevitably, we are left with a certain melancholy about the objectives of those who provide these intermediation services. They must be well aware that most investors have been ill-served by innovation, and would be best served by the kind of simple, straightforward all-market index strategy that was pioneered at Vanguard. Indeed, as he relinquished the reins of the Magellan Fund in 1990, even Fidelity's remarkable Peter Lynch declared, "Most investors would be better off in an index fund." He was right!
But in finance, we have businesses to run. However unfortunately for our investors, there is great pressure both to shape and to respond to the short-term perceptions of our clients—a fact of life that, for better or worse, rules at least as strongly in the marketing of financial products as it does in consumer products such as automobiles, perfume, toothpaste, and jewelry. But of necessity, all of this shuffling of financial paper entails a cost that ill serves investors.
As Benjamin Graham pointed out way back in September 1976—coincidentally, only moments after the first index fund was launched—"the stock market resembles a huge laundry in which investors take in large blocks of each other's washing, nowadays to the tune of 30 million shares a day." (He could not have imagined today's speculation: more than three billion shares a day.) That's a lot of washing, a reflection of Wall Street's perennial advice to its clients: "Don't just stand there. Do something!"
Alas, the reverse proposition, "Don't do something. Just stand there,"while the inevitable strategy of all investors as a group—think about that, please—not only is counterintuitive to the emotions that play on the minds of virtually all us individual investors, but also would be counterproductive to the wealth of those who market securities and who manage securities portfolios. While the industry, disingenuously, argues that investors should ignore indexing in favor of funds designed to serve their individual objectives and requirements, Ben Graham had an opinion on that, too: "only a convenient cliché or alibi to justify the mediocre record of the past."
Sometimes the public interest demands introspection, so later I'll explore at greater length how the industry in which I have spent my life has failed in some of its most basic stewardship obligations—to its shareholders, to its owners, to itself, and to its own history—and how it can find the right path again. For now, let me just say that the industry has run its own mad rush to innovation—everything from the short-term global income funds and adjustable-rate mortgage funds of the 1980s to the "ultra short-term" high-yield bond funds of 2007 (which in the 2008 crisis became another one of the industry's abject failures).
Our creation of literally hundreds of technology funds, telecommunications funds, Internet funds, and the like to capitalize on the Information Age during the New Economy craze of 1998–2000 is but one more example of complex innovation run amok. As the market soared, fund investors poured hundreds of billions of dollars into these highly promoted funds, only to take a huge hit in the subsequent crash.
We actually can measure how much that wholesale embrace of fund innovation cost our investors. Let's compare the returns reported by the funds themselves (time-weighted returns) to the returns actually earned by fund investors (dollar-weighted returns) during the 25 years ended 2005. The average equity fund reported an annual rate of return of 10 percent for the period—trailing the 12.3 percent return on an S&P 500 Index fund. But the return actually earned by the investors in these funds was 7.3 percent, a lag of 2.7 percentage points per year below the return the funds themselves reported.
Cumulatively, then, fund investors on average experienced but a 482 percent increase in their capital over the period. Yet, simply by buying and holding the market portfolio through an index fund, they would have earned an increase in capital of 1718 percent, nearly four times as large! Thanks to the innovation and creativity of fund sponsors—and surely the greed (or perceived need) of fund investors—the return that mutual fund investors received on their hard-earned capital was less than a third of the return offered by the stock market itself. For the mainstream funds, the losses were much smaller; for their New Economy cousins, the losses were staggering. So much for the well-being of the investor!
As to the well-being of managers, we can conservatively estimate that the fees and sales loads paid to fund managers and distributors during this period totaled in the range of $500 billion. So yes, someone is earning enormous profits by jumping on the bandwagon of innovation, but unless you are a fund manager or distributor, that someone is not likely to be you.
Amidst this wave of complexity, have we forgotten the fact that the most productive investing is the simplest investing, the most peaceable investing, the lowest-cost investing, the most tax-efficient investing—investing with the most consistent strategies and over the longest time horizon? Apparently so. And I'm afraid that the new jazzed-up iterations (largely exchange-traded funds) of the simple index fund that I spawned all those years ago are helping to lead the way. No wonder I wake up some mornings feeling like Dr. Frankenstein. What have I created!?
Let me be clear: I favor innovation when it serves fund investors. And I'm pleased that I've been lucky enough to have played a key role in a number of such innovations in the past: the stock index fund, the bond index fund, the defined-maturity bond fund, the tax-managed fund, and even the first fund of funds (and Vanguard is the only firm, I believe, that has never levied an additional layer of expense ratios on such funds).
In recent years, there have been other investor-friendly innovations, including target retirement funds and life strategy funds. Properly used (and properly costed!), these funds can easily serve as an investor's complete investment program for the long run. But in today's wave of fund innovation, I see little else that seems likely to serve investors effectively. Let me give a brief thumbnail sketch of the "products" (by my standards, the wrong way to think about mutual funds) that have been created of late, and offer my own perspectives.
Exchange-traded funds (ETFs) are clearly the most widely accepted innovation of this era. Of course I admire their endorsement of the index fund concept—and (more often than not) their low costs. And how could I not admire the use of broad market index ETFs that are held for the long term, and even broad market segment ETFs that are used in limited amounts to accomplish specific goals? But I have serious questions about the rampant trading of most ETFs, and the negative impact of those layers of brokerage commissions.
Further, I wonder why only 21 among today's 817 ETFs meet the classic requirement of the broadest possible diversification in U.S. or global stocks, with 739 of the remaining ETFs investing in equity market sectors that range from the reasonable to the absurd. (The remaining 57 are ETFs based on various bond indexes.) In this latter category I'd include sectors as narrow as "Emerging Cancer" and leveraged funds that promise to double the market's returns in either up or down markets. Not to be outdone, a few ETFs now offer the opportunity to triple those swings. Could quadruple be next?
Put another way, ETFs used for investment are perfectly sound, but using them for speculation is apt to end badly for investors. Back in 2005, in his 91st year, the Nobel laureate economist Paul Samuelson called the first index mutual fund the equivalent of the invention of the wheel and the alphabet. (Perhaps he was prejudiced: His holdings in that fund, the Vanguard 500 Index Fund, helped pay for the educations of Dr. Samuelson's six children and his 15 grandchildren.) He has never said anything comparable about ETFs, nor, I suspect, will anyone of equal stature do so.
While this so-called index method of value investing has been presented as some sort of Copernican revolution, the idea behind the methodology is many decades old. But offering such funds in ETF form suggests that they are useful for short-term trading—a dubious proposition on the face of it. And bringing them out only after the sharp upsurge in value-fund relative returns during the 2000–2002 stock market collapse suggests the marketing motivation that sponsors are so good at, even though it almost invariably leads to performance chasing that ill serves investors.
Of course, we've been assured by the sponsors of these dubiously dubbed index funds that "value investing wins" (not "has won in the past"), especially in troubled markets. But in the sharp market tumble of mid-2007 to mid-2008, the two leading fundamental index funds were down nearly 20 percent, a loss nearly half again larger than the 13 percent decline in a standard S&P 500 index fund. As for the financial entrepreneurs who believe in weighting portfolios on the basis of book values, revenues, and earnings, and those who believe in weighting portfolios by dividends, I'm interested to read that they're now arguing with each other about which is the correct strategy, creating even more confusion for investors.
Given the truly remarkable successes of some of the nation's largest college endowment funds and some of our most speculative hedge funds, small wonder that fund sponsors are falling all over themselves to create fresh-faced new funds using purportedly similar strategies: hedging (funds that are long 130 percent in stocks and short 30 percent), market neutral (funds with no net equity exposure), commodities, purported private equity/venture capital equivalents, and so forth. Here are two pieces of advice: One, look before you leap. Two, don't leap until the fund has produced an actual 10-year track record. Above all, remember (again, courtesy of Warren Buffett), "What the wise man does in the beginning, the fool does in the end." Or, as the Oracle of Omaha sometimes expresses it, "There are three i's in every cycle: first the innovator, then the imitator, and finally the idiot." No matter what fund managers may offer you, don't you be the idiot.
First principles: Commodities have no internal rate of return. Their prices are based entirely on supply and demand. That is why they are considered speculations, and rank speculations at that. Contrarily, the prices of stocks and bonds are ultimately justified only by their internal rate of return—composed, respectively, of dividends and earnings growth and by interest coupons. That is why stocks and bonds are considered investments. I freely concede that the growing worldwide demand that has helped drive the huge rise in the prices of most commodities in recent years may well continue. But it may not. I'm not at all sure that speculation on future price increases will be rewarded.[13]
The fund industry apparently only recently discovered that millions of investors are moving from the accumulation phase of investing to the distribution phase (even though that demographic handwriting has been on the wall for decades). So we have new funds that, in effect, guarantee the exhaustion of your assets in whatever time period you choose (something that has always been all too easy to accomplish!). We also have funds designed to distribute 3 percent, 5 percent, or 7 percent of your assets without necessarily invading principal. Only time will tell if that will happen, but what seems to have been ignored by the fund industry, for obvious reasons, is the alternative: serving retired investors by increasing fund investment income, the forgotten man of the fund industry. But the only sound way to provide more income per unit of risk is to slash fund expenses, so such client-focused innovation is unlikely to happen.
No doubt about it. With returns in Brazil, Russia, India, and China soaring in recent years, fund sponsors were quick to market them. My long experience warns that it's all too counterproductive for investors to jump on the bandwagon of superior past performance. Of course, the sharp declines (30 to 50 percent in the first half of 2008) that at least India and China have suffered will squash investor appetites for them.
History tells us that when U.S. stock returns lead the world, equity fund capital flows into international markets decline; and then they soar when non-U.S. issues lead. It's hardly surprising, then, that only 20 percent of equity fund cash flows were directed into non-U.S. funds in 1990–2000, when U.S. stocks vastly outpaced for eign issues. Nor is it surprising that since then, with foreign stocks outpacing U.S. issues, the tables have been turned. (Fully $220 billion flowed into foreign funds in 2007, and only about $11 billion into domestic equity funds. Now there's a red flag!) But in the hottest sectors of the international markets, risk is high, so be careful. (Also note that since 1990, the returns of non-U.S. stocks—even including their recent boom—have been dwarfed by the returns on U.S. equities: 6 percent annually versus 10 percent.)
No objective industry veteran can look at this blunderbuss of innovation with other than a jaundiced eye. The problem is not only that future returns earned on untried and often costly strategies are unpredictable and rarely live up to their hyperbolic promises. The problem is that such a proliferation of idiosyncratic funds that ignore the value of simplicity inevitably results in a fund failure rate that, however rarely publicized, is little short of astonishing. In an earlier book, I wrote that of 355 funds that existed in 1970, only 132 made it through the next 35 years.
In the recent era, of the 6,126 mutual funds that existed at the start of 2001, 3,165 had already been consigned to the dustbin of history by mid-2008. Small wonder that even the portfolio managers who run the funds don't "eat their own cooking." Among 4,356 equity funds, 2,314 managers own no shares—none—in the funds they manage. How, I ask, can a less-informed member of the investing public successfully implement a long-term strategy involving mutual funds if only half of all funds can even make it through a period as short as seven years? And how can fund investors muster any faith whatsoever in the funds that now exist when more than half of their managers won't put their own money on the line?
In fact, it is clear that fund investors no longer muster much faith in their mutual funds. A survey of fund investors conducted for one prominent fund manager (not Vanguard) found that 71 percent of investors don't trust the fund industry. Some 66 percent said fund firms don't take responsibility for protecting their shareholders' well-being. And even in the deeply troubled financial sector, mutual funds are at the bottom of the list of trusted service providers.
So mark me down as a believer in innovation that is based on clarity, consistency, predictability relative to the market, and low cost; innovation that will serve investors over the long term; innovation that provides an optimal opportunity that it will work tomorrow rather than innovation based on what worked yesterday; innovation that not only minimizes the risks of ownership but clearly explains the nature and extent of those risks.
Mark me down, too, as an adversary of complexity, complexity that obfuscates and confuses, complexity that comes hand in hand with costs that serve its creators and marketers even as those costs thwart the remote possibility that a rare sound idea will serve those investors who own it.
If it sounds like I'm reaffirming my belief in the index fund—in both its stock form and its bond form—and in ideas like tax-managed funds, defined-maturity bond funds, and target-date funds (all of which, at their best, have index funds at their core), well, you read me loud and clear. Like William of Occam, I believe that the simple way is the best way—almost always the shortest route to long-term investment success.
Mark me down, too, as an index fundamentalist (though not a fundamental index fundamentalist!), a passionate believer that the simplicity of the original index fund design—highly diversified portfolios of stocks weighted by their market capitalizations—continues to represent the gold standard for investors. If that is indeed true, then other complex fad products are debased by all that alchemy. As we have seen earlier, many have tried, but no one has yet made lead out of gold. Indeed, all these years later, I still struggle to develop any methodology (other than relative costs) for identifying winning strategies or winning funds in advance, and for successfully predicting how long those winning strategies will persist or how long those portfolio managers will continue to manage the funds that have delivered those superior returns in the past.
By now, I suppose, I've pretty much painted myself into a corner as an aging mutual fund Luddite who finds himself uninspired—and unimpressed—by the rise of complexity (and excess cost) at the expense of simplicity (and minimum cost). But it's a great corner!
Happily for my peace of mind, and my conscience, I find that nearly all of the positions I've set forth in this chapter have been endorsed by some of the most informed and respected academics of our time—among them, Nobel laureates William Sharpe and Paul Samuelson (soon to have 95 years of wisdom under his belt)—and by the most successful investors of the modern era, beginning with Warren Buffett himself. I'm happy to let David Swensen, the brilliant chief investment officer of the Yale University Endowment, a man with an impeccable character and a peerless reputation for intellectual integrity, speak for these deservedly lauded intellects, and for me as well:
The fundamental market failure in the mutual-fund industry involves the interaction between sophisticated, profit-seeking providers of financial services and na~ive, return-seeking consumers of investment products. The drive for profits by Wall Street and the mutual-fund industry overwhelms the concept of fiduciary responsibility, leading to an all too predictable outcome . . . The mutual fund industry consistently fails to meet the basic active management goal of providing market-beating returns . . . A well-constructed academic study conservatively puts the pre-tax failure rate at 78 to 95 percent for periods ranging from ten to twenty years [as measured against the Vanguard S&P 500 Index Fund]. . . .
Investors fare best with funds managed by not-for-profit organizations because the management firm focuses exclusively on serving investor interests. No profit motive conflicts with the manager's fiduciary responsibility. No profit margin interferes with investor returns. No outside corporate interest clashes with portfolio management choices. Not-for-profit firms place investor interest front and center. Ultimately, a passive index fund managed by a not-for-profit investment management organization represents the combination most likely to satisfy investor aspirations . . . Out of the enormous breadth and complexity of the mutual-fund world, the preferred solution for investors stands alone in stark simplicity.
In a word, amen.
Swensen's apt tribute to an uncluttered, client-focused strategy combined with a simple client-focused structure serves as profound reaffirmation of the fact that our financial system today has quite enough complexity and innovation—with their grossly excessive costs—and not nearly enough simplicity, with its minimal dilution of investor earnings.
[10] Occam expressed the razor (or rule) in various ways in his writings. The most common version translates from the Latin as "Plurality ought never be posited without necessity."
[11] In mid-2008 Grant's Interest Rate Observer examined one such CDO. Its original principal value was $2 billion. Every series of bonds had been downgraded, with the AAA bonds now rated B1 ("speculative, high credit risk"). The estimated value of the entire portfolio had plummeted by more than 80 percent, to $362 million.
[12] Even this backing proved insufficient to relieve the great financial pressure on these two enterprises. So, in September 2008 the U.S. Treasury Department placed them in a federal conservatorship.
[13] An interesting fact: From the time of the Great Fire in London in 1666 to the end of World War I in 1918, commodity prices in England were unchanged on balance. That's two and one-half centuries!