Millionaire Teacher (8 page)

Global citizens and index funds

If you're British or Australian, you can follow the lead with Vanguard, which has already set up shop in your country. As a nonprofit group, it might be the world's cheapest financial service operator, and indexing is their specialty.

If you're from another country, or if you're a global citizen working overseas, there are indexing options available for you as well (which I will discuss in Chapter 6). As high as U.S. actively managed stock mutual fund costs can run, the average non-U.S. fund is even more expensive. In a study presented in 2008 by
Oxford University Press,
Ajay Khorana, Henri Servaes, and Peter Tufano compared international fund costs, including estimated sales fees. According to the study, the country with the most expensive stock market mutual funds is Canada. Fortunately, for Canadians, Vanguard is planning to extend its services to its long-suffering northern neighbors.

High global investment costs make it even more important for global citizens outside of the U.S. to buy indexes for their investment accounts, rather than pay the heavy fees associated with actively managed mutual funds.

Table 3.2
The World's Actively Managed Stock Market Mutual Fund Fees

Source:
“Mutual Fund Fees Around The World,”
Oxford University Press, 2008
31

Who's Arguing against Indexes?

There are three types of people who argue that a portfolio of actively managed funds has a better chance of keeping pace with a diversified portfolio of indexes after taxes and fees over the long term.

Introduced first, dancing across the stage of improbability is your friendly neighborhood financial adviser. Pulling all kinds of tricks out of his bag, he needs to convince you that the world is flat, that the sun revolves around the Earth, and that he is better at predicting the future than a gypsy at a carnival. Mentioning index funds to him is like somebody sneezing on his birthday cake. He wants to eat that cake, and he wants a chunk of your cake too.

He exits, stage left, and a bigger hotshot strolls in front of the captive audience. Wearing a professionally pressed suit, she works for a financial advisory public relations department. Part of her job is to compose confusing market-summary commentaries that often accompany mutual fund statements. They read something like this:

Stocks fell this month because retail sales were off 2.5 percent, creating a surplus of gold buyers over denim, which will likely raise Chinese futures on the backs of the growing federal deficit, which caused two Wall Street Bankers to streak through Central Park because of the narrowing bond yield curve.

Saying stock markets rose this year because more polar bears were able to find suitable mates before November has as much merit as the confusing economic drivel that financial planners write and distribute, assuming that nobody will read it anyway.

If you ask her, she will tell you that actively managed mutual funds are the way to go—but curiously doesn't mention she has killer mortgage payments on her $17 million, Hawaiian beachside summer home and you need to help her pay it.

Sadly, the third type of person who might tell you actively managed mutual funds have a better statistical long-term chance at profit (over indexes) are the prideful, or gullible folks who won't want to admit their advisers put their own financial interests above their clients.

Let's consider Peter Lynch, the man who was arguably one of history's greatest mutual fund managers. Before retiring at age 46, he managed the Fidelity Magellan fund <
http://fundresearch.fidelity.com/mutual-funds/summary/316184100
>, which captured public interest as it averaged 29 percent a year from 1977 to 1990.
32
More recently, however, Lynch's former fund has disappointed investors, earning a total of just 21 percent over the past decade, compared with 41 percent with the S&P 500 index.
33
Hammering the industry's faults, he says:

So it's getting worse, the deterioration by professionals is getting worse. The public would be better off in an index fund.
34

As the industry's idol from the 1980s, you might suggest that Lynch is a relic of a bygone era. Perhaps. But let's turn our attention to the present, and look at Bill Miller, the current actively managed fund manager of the Legg Mason Value Trust <
www.leggmason.com
> In 2006,
Fortune
magazine writer Andy Serwer called Miller “the greatest money manager of our time,”after Miller's fund had beaten the S&P 500 index for the fifteenth straight year.
35
Yet, when
Money
magazine's Jason Zweig interviewed Miller in July 2007, Miller recommended index funds:

[A] significant portion of one's assets in equities should be comprised of index funds . . . Unless you are lucky, or extremely skillful in the selection of managers, you're going to have a much better experience going with the index fund.
36

Miller's quote was timely. Since 2007, his fund's performance has dramatically underperformed the total U.S. stock market index. Some mutual fund managers, of course (these are people who actually run the funds) are required by their employers to buy shares in the funds they run. But in taxable accounts, if fund managers don't have to commit their own money, they generally won't. Ted Aronson actively manages more than $7 billion for retirement portfolios, endowments, and corporate pension fund accounts. He's one of the best in the business. But what does he do with his own taxable money? As he told Jason Zweig, who was writing for
CNN Money
in 1999, all of his taxable money is invested with Vanguard's index funds:

Once you throw in taxes, it just skewers the argument for active [mutual fund] management . . . indexing wins hands-down. After tax, active management just can't win.
37

Or, in the words of a real heavy hitter, Arthur Levitt, former chairman of the U.S. Securities and Exchange Commission:

The deadliest sin of all is the high cost of owning some mutual funds. What might seem to be low fees, expressed in tenths of one percent, can easily cost an investor tens of thousands of dollars over a lifetime.
38

You don't have to be disappointed with your investment results. With disciplined savings and a willingness to invest regularly in low-cost, tax-efficient index funds, you can feasibly invest half of what your neighbors invest—over your lifetime—while still ending up with more money.

You may not have learned these lessons in school, but they are vital to your financial well being:

Clearly avoiding the pitfall illustrated in
Figure 3.4
will precipitate a far more promising future.

Figure 3.4
A Financial Adviser's Conflict of Interest

Source:
Fang Yang

Notes

1.
W. Gregory Guedel. “Ali versus Wilt Chamberlain—The Fight That Almost Was,”
EastSideBoxing
, May 29, 2006, accessed October 20, 2010,
http://www.eastsideboxing.com/news.php?p=7095&more=1
.

2.
Linda Grant, “Striking Out at Wall Street,”
U.S. News & World Report,
June 20, 1994, 58.

3.
Mel Lindauer, Michael LeBoeuf, and Taylor Larimore,
The Bogleheads Guide to Investing
(Hoboken, New Jersey: John Wiley & Sons, 2007), 83.

4.
“Investors Can't Beat the Market, Scholar Says,”
Orange County Register
, January 2, 2002, accessed October 30, 2010,
http://www.ifa.com/Library/Support/Articles/Popular/KahnemanInvestorscantbeatmarket.htm
.

5.
Peter Tanous, “An Interview With Merton Miller,”
Index Fund Advisors
, February 1, 1997, accessed October 30, 2010,
http://www.ifa.com/Articles/An_Interview_with_Merton_Miller.aspx
.

6.
“Where Nobel Economists Put Their Money,” accessed October 30, 2010,
http://video.google.com/videoplay?docid=9128160907104616152#
.

7.
Ibid.

8.
“Arithmetic of Active Management,”
Financial Analysts' Journal
, 47, No. 1, January/February 1991, 7.

9.
Ibid.

10.
John C. Bogle,
The Little Book of Common Sense Investing
(Hoboken, New Jersey: John Wiley & Sons, 2007), xiv.

11.
David F. Swensen,
Unconventional Success, a Fundamental Approach to Personal Investment
(New York: Free Press, 2005), 217.

12.
Robert D. Arnott, Andrew L. Berkin, and Jia Ye, “How Well Have Taxable Investors Been Served in the 1980s and 1990s?”
The Journal of Portfolio Management, Summer
2000, Vol. 26, No.4, 86.

13.
Larry Swedroe,
The Quest For Alpha
(Hoboken, New Jersey: John Wiley & Sons, 2011), 13.

14.
Larry Swedroe,
The Quest For Alpha,
13–14.

15.
David F. Swensen,
Unconventional Success, a Fundamental Approach to Personal Investment,
217.

16.
Ibid., 266.

17.
Ibid.

18.
John C. Bogle,
Common Sense on Mutual Funds
(Hoboken, New Jersey: John Wiley & Sons, 2010), 376.

19.
Ibid., 384.

20.
John C. Bogle,
The Little Book of Common Sense Investing,
61.

21.
John C. Bogle,
Common Sense on Mutual Funds,
376.

22.
Ibid.

23.
Dilbert Comics, Reprinted with permission, Order Receipt #1591582.

24.
John C. Bogle,
The Little Book of Common Sense Investing,
90.

25.
John C. Bogle,
Don't Count On It!
(Hoboken, New Jersey: John Wiley & Sons, 2011), 382.

26.
Burton Malkiel,
The Random Walk Guide to Investing
(New York: Norton, 2003), 130.

27.
Ibid.

28.
Bruce Kelly, “Raymond James Unit Gives Bonuses to Big Producers,” I
nvestment News—The Leading Source for Financial Advisors,
June 18, 2007.

29.
Carole Gould, “Mutual Funds Report; A Seven-Year Lesson in Investing: Expect the Unexpected, and More,”
The
New York Times,
July 9, 2000, accessed April 15, 2011,
http://www.nytimes.com/2000/07/09/business/mutual-funds-report-seven-year-lesson-investing-expect-unexpected-more.html?
.

30.
Bert Whitehead,
Why Smart People Do Stupid Things With Money
(New York: Sterling Publishing, 2009), 205.