Michelle Singletary

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Color of Money
Mutual Funds
with Michelle Singletary
Post Business columnist
Tuesday, April 10, 2001; 1 p.m. EDT

Today, Post Business columnist Michelle Singletary hosts John C. Bogle, founder of The Vanguard Group Inc. and president of the Bogle Financial Markets Research Center, to talk about the growth of mutual funds -- what fees are too high and what investors might look out for in this bear market.

John Bogle

Bogle founded Vanguard in 1974 and served as chairman and senior chairman through 1999. The Vanguard Group, which has its headquarters in Pennsylvania, is one of the two largest mutual fund organizations. Vanguard holds more than 100 mutual funds with assets totaling more than $550 billion. In 1975, Bogle founded Vanguard 500 Index Fund, the first index mutual fund. Bogle has also written several books including "John Bogle on Investing: The First 50 Years" (McGraw-Hill 2000) and "Bogle on Mutual Funds: New Perspectives for the Intelligent Investor."

The transcript follows.

Editor's Note: Washingtonpost.com moderators retain editorial control over Live Online discussions and choose the most relevant questions for guests and hosts; guests and hosts can decline to answer questions.

Fairfax, Va.: Dear Mr. Va.:

How do you "buy at sound prices" in this market? In your recent National Press Club speech, I believe you said something like "Investing depends on accumulating money at sound prices and not at inflated prices like we have..."

Even with the recent market pull-back, the dividend yield of the S&P 500 isn't much more than 1%.

For long-term investors, would it make sense to re-evaluate one's portfolio to increase the overall dividend yield? Perhaps by adding a fund with a higher yield (say an equity-income fund, or a balanced fund), or by increasing the percentage of bonds and/or money market funds in the portfolio?

The more I read on this subject, the more I keep coming back to the idea that -- if you think the FUTURE returns of the equity market might fall in the 5-8% range, then you might be well served to have a simple 50/50 portfolio, half equity, half cash and bonds.

I'm 52, so my age colors my views, but I'd welcome your take.

Thank you, Bill L.

John Bogle: The art of buying stocks at sound prices is an extremely difficult art to master. Indeed, I don't think anyone can master it. The closest you can come to buying at sound prices, is to buy over time. Even if you are not a regular investor, (with a lump sum) that too should be spread over time to gain the benefits of dollar averaging. If the investors ought to be thinking less about changing their strategies these days but thinking more about whether their strategies were right in the first place. We are now being tested by a tough bear market and periods of market duress are generally bad times to make substantial changes in asset allocation. That said, yes, investors who require income should definitely be thinking of equity income funds and value funds, to say nothing of bond funds.

Sadly, the time to have thought about that is a year ago. One more evidence, our emotions are a very unreliable way to make investment decisions.

Michelle Singletary: Hi. Thanks for joining me today. We are ready to take your questions about the mutual fund industry.

Laurel, Md.: Mr. Bogle, what do you see as the advantages of Vanguard's Gold fund, and its recent nondiversification?

John Bogle: The Vanguard Gold fund is only appropriate for a fairly limited group of Vanguard investors who believe we are facing a major upsurge in inflation. I believe for those who use the fund, it should be limited to no more than 5% of their equity holdings. The change in the status of the fund to undiversified has no significant impact on its investment program.

Laurel, Md.: Every time I look at bond fund ratings, I expect to see Vanguard at or near the top, figuring their superiority at cost containment should be even more prominent for less volatile bond returns. But that doesn't seem to happen. Why is that? Does Vanguard take fewer risks than many others?

John Bogle: There are several thousands of bond funds out there. And there are always going to be a few that take extreme positions than Vanguard, perhaps taking more risk or perhaps taking less risk. It is usually the "outliers" that find their way both to the top -- and the bottom -- of their performance charts. But if you've examined the Vanguard's funds through Morning Star's star ratings (which are very accurate for bond funds), virtually all of them have four or five stars. It is our low cost that are primarily responsible for those ratings, and our professional investment staff has provided exceptional management oversight. In an area where portfolios are extremely homogeneous -- GNNA funds -- Vanguard is virtually always at the top of the list.

Alexandria, Va.: What type of IRA mutual fund would you recommend given the market downturn? I have a high level of risk tolerance and am investing for at least 20 years out but already have several aggressive growth investments. Recently I have seen a lot of conflicting advice. Thank you.

John Bogle: I believe that IRA investor with 20 year time horizon is best advised to own either S&P 500 index fund or a total stock market index fund. This will assure enjoying whatever returns the stock market earns. Growth stocks will come and go; value stocks will come and go; in the long run I believe they will provide identical returns. So investors can spare themselves guessing which will do best and equally importantly trying to "time" allocations to growth and to value.

Laurel, Md.: Have you heard any scuttlebutt about what form, if any, of Social Security privatization will occur? What investment vehicles do you think the public would have? Would Vanguard attempt to be part of it?

John Bogle: I think that both the administration and Congress are completely at sea in deciding where to go with Social Security. Contributions to the overall social security system cannot be reduced without endangering future retirement payments. I think the existing system should be left alone. I do believe a system of voluntary contributions to a social-security-like program might be provided by the federal government, but I believe the investment should be made not in mutual funds, but in an all market index fund administered at minimal cost by what I would describe as an independent Social Security Investment Board.

Laurel, Md.: I have holdings in your Small Cap Index fund. Its inception date is reported to be 1960. But you founded Vanguard in 1974. Where was the fund before then?

John Bogle: The Small Cap Index fund was an existing managed active fund run by Vanguard's predecessor company and was converted to an index strategy in September of 1989. Thus, the pre-1989 record is irrelevant.

Annapolis, Md.: I've never gotten a reasonable answer to this question. Why do you suppose focused funds, those with fewer than 30 stocks, tend to have relatively high costs? For example, one of my favorite funds (Oakmark Select) not only has fewer than 20 stocks, but only has to do thorough research on the several hundred stocks on the "approved" list of Harris Associates, and yet the annual cost is around 1.3%. This seems to be the case with most other focused funds...

John Bogle: Mutual funds typically charge "what traffic will bear." Focus funds have been relatively popular. Therefore managers feel they can charge relatively high amounts. I believe investors are better off being much more diversified which persuades me that in the long run, index funds will out-perform most focus funds.

Silver Spring, Md.: Could you please comment on socially-responsible investing? Do you think socially responsible mutual funds will play a bigger role in investors' portfolios in the future?

John Bogle: I believe that as a general principle any limitation on investment choices is more likely to impede returns than to enhance returns. But I doubt that the impact either way would be substantial where the socially responsible fund very broadly diversified. In the long run, it is an individual decision for the investor to make: whether to seek investment return through a very diversified portfolio that may include some stocks of companies whose social responsibilities don't meet common standards, but I think the answer lies more in the investor's values than in the funds' characteristics. Furthermore, I think each person defines what is a socially responsible company very differently, so the water is rather muddy.

Michelle Singletary: I often hear financial planners and investment advisors criticize investors for "settling" for returns when investing in an index fund. Are index fund investors settling? And, what about the argument that managed funds outperform index funds?

John Bogle: The record is crystal clear that over the long run, index funds have outperformed the vast majority of actively managed funds. That means, simply put, that the odds are against the investor who picks an actively managed fund. The past returns earn by a mutual fund are a very poor -- often a reverse -- indicator of future performance. The simple fact of the matter is that all investors share in the market's return (say 10%) and the index fund does the same -- but only before costs. Given the heavy cost of mutual funds, it follows necessarily the mutual fund investors as a group will fall short of a low cost all-market index fund. Furthermore, the record is clear that index funds are substantially more tax efficient. And taxes have cost mutual fund investors even more than the mutual funds management fees and operating cost and sales charges.

Anchorage, Alaska: I am 55 years old. My 401 k plan offers investment in an S&P 500 index fund, a Bond Fund, a money market fund, and in May or June a small cap index and an international index fund. I expect to retire in 5-7 years. What would be the most optimal allocation of resources amongst my 401 k choices.

John Bogle: For me, I would gradually work towards about a 60% investment in the stock index fund and a 40% allocation to the bond index fund. It's simple and straight forward and provides a reasonable balance of risk and return, considering the short term time arise.

Lincoln, N.E.: Mr. Bogle: Isn't it true that to a large degree there is an element of "momentum" investing in index funds? For example, the tech. sector portion of VFINX rose over approximately one year to as high as 30%. Monthly investors were buying those rising shares at rising prices. Isn't that the hallmark of "momentum" investing? If so, doesn't index investing boil down to low-cost growth investing in a widely diversified portfolio?

Also, is it true that with index investing, because it is share weighted, the return basically corresponds to the return of the top quintile of a fund's holdings?

John Bogle: As to the first question, the increase of tech stocks in the 500 index portfolio came only because their prices had risen; the cash flow into the fund is invested each day into the entire portfolio and not nearly in the tech stock portion. So, I don't sense any momentum on that score.

As to the weight to the top quintile. The top 20% weight of the fund will contribute essentially 20% of the fund's return over time. The idea of weighting in the investments of the portfolio where large holdings may account for 2-4% of the portfolio is typical of all market index funds and actively managed funds, but of the stock market itself.

Rockville, Md.: One of my major concerns these days is about fees that may be charged on 401(k) accounts. No one has given me a straight answer on who is monitoring this, although I did determine that the Labor Dept. is responsible in some form. Employees are given no info on what costs might be associated with transferring balances from one fund to another, what fees are charged by the particular funds they invest in, and any management fees that their employer or the 401(k) management company may be charging. I've come to realize that some of these fees can be fairly significant and yet they are invisible to the employees. It almost makes you want to invest solely in money market funds.

John Bogle: First of all if you invest in money market funds in your 401K you will have the same fees and charges that you just outlined. Although money market fund expenses are usually somewhat lower than equity fund expenses but the cost of the fund maintenance and cost that the employer may incur are the same in both cases. I believe that the investor is entitled to knowing the cost and fees both by the fund company and by the plan itself. If you are not informed about those costs, I would plan to write to your employer and the Dept. of Labor.

San Francisco, Calif.: For an American investor, you do not think it is necessary to have international stocks to have a diversified portfolio.

Would you say the same for an investor in a smaller country like Australia. Should an Australian have all of his or her stocks in Australian companies, and should that investor goes outside to the "international" market? How should currency risk be managed (if at all)?

John Bogle: The U.S. economy is, in my judgement, the strongest and most diversified in the world. So rules that fit the U.S. investor don't necessarily fit investors in other nations. Taking the Australia example, I think an internationally diversified portfolio would make a good supplement to an Australian investment. I believe that investors should accept currency risk simply because in the long run, currencies tend to be neutral in impact but also because the cost of hedging currency is quite heavy.

Albuquerque, N.M.: Mr. Bogle -

Do you see any merit in the "slice and dice" version of index investing?

So far I have not found any better approach to investing than to accept that I don't know the future, and to save 50% of my income, in 50% bonds and 50% market-weighted equity funds.

As I understand it, to slice-and-dice, one stakes out a few different subclasses of equities and gets a sort of free lunch or reduced risk by rebalancing between them as they fluctuate. However, there is no promised certainty to this method, or there would be no risk and therefore no reward. Yet in a sense, the extra risk is supposed to "promise" an extra reward -- seems contradictory to me. <

P.S. For what it's worth, I agree with your position on international funds as a sort of fad and an unnecessary risk for no particular reward.

John Bogle: I agree with you that "slice and dice" is both complicated and unlikely to enhance return. A 50/50 stock index/bond index strategy may not be the perfect strategy, but the number of strategies that are worse is infinite. I wrote those words in my first book nearly a decade ago and I wouldn't change them today.

Odenton, Md.: Is Vanguard going to offer a 529 College Savings plan in the very near future?

John Bogle: We are working on a 529 plan but have yet announced its timing.

Miami, Fla.: Mr. Bogle,

You have referred several times to the recent speculative bubble, which is now in correction. Do you believe that there is also a credit bubble in the US which will unwind and cause further correction to the market over the next few years?
Thanks
Mark

John Bogle: The credit expansion has been large. I'm not sure, however I would characterize it as a "bubble." But I do believe that our economy in terms of capital spending, consumer spending and credit has significant consolidation before it. And that seems to be happening today, it's anyone's guess whether these consolidations reflect today's stock prices but I'd guess that some of it --perhaps even most of it-- in the market.

Quantico, Va.: Do you recommend no-load OR load funds? Both have pros/cons, but for systematic investing, please advise. Also, given the downward spiral of the market, should I wait it out or buy "bargain" stocks now? Finally, what is a conservative view of the type of return I should expect in the stock market?

Michelle Singletary: Just to piggy back on this question. Is there ever a reason to pay a load going into a fund?

John Bogle: As to sales loads, in general it is extremely difficult or almost impossible for load funds to outperform no load funds because of the substantial impact of the sales charge --particularly over short term holding periods. However, to select proven well managed funds and hold them to the long term, paying a sales charge at the outset is not an unreasonable strategy provided that the broker focuses on the long term and high quality. Many investors need investment advice. If they do, paying a sales charge is a way to compensate for the advice. If they don't, well chosen no load funds should be preferred.

First, I wouldn't buy individual stock. That's just not my style. As for buying the stock market or index fund or diversified funds now, now is always the time to invest simply because our timing instincts always lead us in the wrong way. However, if a person were to inherit a $100,000 today and ultimately wanted to own 50% stocks and 50% bonds, I would invest one fifth of the stock position (i.e. 10,000 of the 100,000) today and gradually accumulate the remaining $40,00 over the next several years. Dollar averaging is valuable because it takes the emotions out of investing. And the emotions, almost always, are counter-productive.

As to future returns, a year ago, I predicted that the returns over the coming decade might average only about 5% with the decline in the market, the decade begins today could yield a slightly higher return perhaps 7-8%. Nobody knows what those returns would be, but I believe those are reasonable expectations. The important point is that I simply do not believe that we are entering a decade today where returns will even approach the 17% annual return provided by stocks during the 1990's. In short, I believe "the party's over." But that doesn't mean that investors should head for the cellars. Only that they should be cautious in their allocations to their equities.

Albuquerque, N.M.: How do investors determine the least amount of risk needed to take to meet our financial goals?

That's the basic question. Here are related ones behind it:

Many of us have learned recently that even when we accept the concepts of asset allocation and a balanced portfolio, we are likely to overestimate our risk tolerance in good market times, and underestimate it in poorer market times.

Is it possible to assess one's risk tolerance objectively, and arrive at an allocation that will be appropriate, or close enough, for all types of markets? If so, how? Is portfolio standard deviation a good measure of risk? How do you work in the fact that you must take some risk to meet your goals?

Thanks

John Bogle: To begin with there is no objective way to determine risk tolerance because risk tolerance is so subjective. As a rule, I suggest beginning with an idea of 50% bonds/ 50% stocks and then raising or lowering the equity position depending on factors like these:
1. The amount of wealth at stake.
2. The number of years remaining to accumulate assets
3. The investor's income requirent (and I'm speaking here pure income not capital gains)
4. The investor's courage to stay the course in good and bad times alike.

Carmel, Calif.: Dear Mr. Bogle,

I don't have a question, just comments.

Thank you for sharing your wisdom with us through your books, and speeches. If I hadn't read your books, I might be worried,during this bear market, instead of secure in the fact that I have a comfortable
asset allocation. Like you always say,"Buy Right, Hold Tight", and "Stay the Course". Thank you for giving the "small investor", like myself the tools to make informed investment decisions.

Sincerely, Kathleen

Michelle Singletary: I totally agree with Kathleen. It's important that we little investors have someone so prominent give a voice to our concerns.

John Bogle: Thank YOU. You made my day!

Arlington, Va.: Why do Mutual Fund managers sell off assets at the end of each year and how can I predict how much Capital Gains I will realize at these times?

John Bogle: Most of the mutual fund managers are doing their selling throughout the year. And any fund worth its salt will be pleased to tell you how many capital gains have been realized during the course of the year. Unfortunately for investors, and managers pay virtually no attention to taxes, meaning that most mutual funds are not very good investments for taxable investors.

Sebring, Fla.: With all the different formulas (p/e ratio, beta, r-squared) for evaluating a fund, which do you find important.

John Bogle: Well, the best indication of risk for me is the standard deviation of the portfolio which must be related to the standard deviation of the stock market itself. Beta is adequate and is usually fairly stationary over time but alpha is totally unpredictable. R-square is a good measure of diversification, and I believe most investors should emphasize carefully chosen funds with r-squares of 90 or more.

Arlington Va.: When is it reasonable to transfer mutual funds holdings within a 401k? Are there tax consequences to selling a position at a loss within the 401k?

John Bogle: There are no tax consequences when mutual funds held in the 401K plans are redeemed. But, if I understand the question, there is no way to transfer mutual fund shares into a 401K plan for a regular account.

Rockville, Md.: Assuming you have made the maximum contributions to 401(k)plans, IRA's, etc., how do you feel about the use of variable annuities given their increased costs? What types of funds would you put in a variable annuity?

John Bogle: Most variable annuities are so highly priced that they basically destroy the long term tax advantages that variable annuities offer. I would strongly recommend that investors buy very low cost funds ---esp. index funds-- in their varied annuities.

Miami, Fla.: Dear Mr. Bogle:

What is the biggest mistake most investors make?

I would like to take this opportunity to express the gratitude of millions of investors -- because you are "The conscience of the industry". <

John Bogle: Investors make so many mistakes, it's hard to begin! Let me try:
1. Chasing past performance.
2. Buying funds as if they were individual stocks.
3. Ignoring costs.
4. Giving inadequate attention to taxes.
5. Owning too many funds.
6. Not adequately considering bond funds.

Lincoln, Neb.: Would you help those of us with little experience in the bond market understand what impact there will be in performance of bond funds as new treasury security offerings dwindle and even end and the number of AAA rated corporations also is declining. Should income investors be thinking of money market funds and/or jumbo CDs?

John Bogle: I believe that there will be as far ahead as we can see an adequate supply of high quality U.S. funds. I believe the math strongly favors a short term bond fund over a money market fund or a CD. Although there is a greater amount of short term risk. I would also suggest that money market funds and CDs, while they have a stable principal value, have a variable income, which as it happens is now falling. To obtain more durable income, longer term bonds are required although their principal value will fluctuate much more significantly. The question the investor must answer is which is more important to me: stable principal? or stable income?

Mount Airy, Md. My wife currently has her Roth IRA invested fully in the Vanguard 500 Index Fund. I'll be opening a Roth later this year with Vanguard as well and am trying to decide which fund to use. I'm a definite indexer (though I have about 15% of my 401k in Janus Worldwide and 5% in company stock (small cap), and the rest in Vanguard Growth and Income). I'm only 28 so I'm trying to keep my money pretty much fully in stocks. As you can see I'm basically invested in large caps. Is there really a downside to me staying this way (invest my Roth in Vanguard's Total Stock Market Index - a little more exposure to mid and small caps) or go all out and hop on the midcap index fund for all some definite diversification? I'd REALLY like to put that money in your health care fund, but that $25,000 initial deposit is a bit stiff for me! Thanks for the input.

John Bogle: I continue believe that even under the circumstances you set forth, the all market index fund is the best choice. It provides some mid-cap and small-cap participation. In the long run, I don't believe there is an inherit bias either for or against large cap stocks or small cap stocks, or for that matter gross stocks or value stocks. And when we decide to go to a narrower side of the market, we're constantly thinking about when should I change my strategy and that is not very easy to do successfully.

Michelle Singletary: You beat the drum quite a bit about the cost of mutual funds. And yet the industry has been pretty scandal free. And many surveys show fees are coming down. So is the industry getting a bum rap on fees? Industry people say they are giving investors their money's worth by paying for the best managers. Do you agree? Why does cost matter?

John Bogle: The stock market has provided a return of 15% in the last 20 years. That means that each $1000 has grown to $16,000. After cost and taxes, the average mutual fund has delivered 9%, meaning that each $1,000 has grown to $5,600. Even taking into account that an index fund would incur some modest cost and some low taxes, that gap speaks for itself. Of course there is no scandal in this industry but I would raise the question as to whether delivering investors that small share of the stock markets return is not itself a scandal. I believe that this industry focuses to much on marketing and not enough on management. Too much on bringing money in and not enough on the stewardship of the money that is already here.

General advice to someone who has never invested before:
Start by investing regularly, modest amounts in an all market index fund. You're guaranteed to get the market return minus a few costs and will learn a lot what it's like when the market fluctuates --the thrill of profits and the agony of losses. Test yourself. Keep investing. Look at your portfolio as infrequently as you dare. 25 years from now, take a careful look, I'd bet almost anything that you'll be delighted.

Michelle Singletary:

That was our last question today. Thanks to John Bogle, and to everyone who joined us.