The damning money-weighted rates of return analysis carried out by Simon Lack in his book The Hedge Fund Mirage has prompted a useful debate about the true returns recorded by hedge funds. Industry lobbyists have not had much luck in undermining his critique, which is hardly surprising as the data, interpreted correctly, is essentially unanswerable (the conclusions you draw from the data is another matter).
One defence that hedge funds could reasonably make however is that the same kind of analysis is also unflattering to mutual funds and ETFs. For evidence you need look no further than the latest book by Jack Bogle, the seemingly indestructible founder of Vanguard, a man whose tenacity with a bone of contention knows no limit. In his retirement, and with a newly repaired heart, he has lost none of his zeal for flailing at the shortcomings of mutual fund companies (including on occasions the one he founded).
Using updated figures, the new book reiterates his longstanding beef that mutual funds, just like hedge funds, trade too much and charge too high fees, being run essentially for the benefit of their management companies first and investors some way back in second place. Using money-weighted rates of returns underlines how consistently and persistently the returns obtained by investors in mutual funds (and more recently ETFs) have in practice lagged the time-weighted returns on which most fund marketing is based.
With large cap mutual funds in the United States, for example, Mr Bogle calculates, the performance gap between fund and fund investor since the mid-1990s averages out at 2.2% per annum. This adds up to a cumulative loss of more than 60% if you compound the shortfall over a period of 15 years. Large cap US mutual funds in turn on average lag the S&P 500 index by around 1.3% per annum, largely thanks to fees and trading costs.
Since the 1950s, he notes, the average holding period of mutual funds has fallen from six years to one year. The volatility of fund returns has shot up too: more than 38% of equity mutual funds today are 10% more volatile than the market. Unsurprisingly, the funds with the highest volatility are also the ones that in aggregate leave their fund investors furthest behind.
The data for ETFs, a much newer phenomenon, is the real surprise however. The average annual turnover rate of investors who own ETFs, Mr Bogle notes, is a staggering 1400 per cent, or 140 times the annual redemption rate of traditional index funds. In 2011 the dollar value of trading in US ETFs alone came to $18 trillion dollars. The more narrow or specialist the ETF, the more dramatic the rate at which their investors turned over their holdings.
The results of this feverish activity are all too predictable to anyone who follows mutual fund and hedge fund experience. According to Mr Bogle’s calculations, the time-weighed annual return of ETFs tracking broad market indices in the five years to November 2011was minus 1.0% (it was not one of the greatest periods for market returns). The return achieved by the average investor in those mainstream ETFs was a loss of 2.3% per annum.
The shortfall, around 1.3% per annum, or a cumulative 6.0% over five years, is slightly less than that experienced by active mutual fund investors. With narrow focus or exotic ETFs, however, including those that are leveraged to boost potential returns, the gap between time and money weighted returns has been 3.8% per annum, or a cumulative 20.5% over five years. That puts the expected returns from these new racier breed of ETFs on a par with roulette (which is no doubt one reason why so many providers have swarmed into the market, swamping it with overcapacity).
The fact that ETFs have grown in size so rapidly that they have now overtaken traditional index funds in terms of assets under management is testament to what Mr Bogle deplores as modern investors’ increasing taste for speculation rather than investment. This in turn may have broader consequences in heightening market instability. He cites an academic study which argues that with ETFs now accounting for 35% of Wall Street turnover, they may have added materially to systematic risk in the stock market. An estimated 75% of ETF trades are carried out by institutional investors.
To be fair, I don’t think we need to be quite as censorious as Mr Bogle is in denouncing all these modern trends, alarming though they are. A fair number of ETF trades, for example, will be for hedging purposes, rather than speculation. And, as with other types of fund, it is futile to blame fund managers entirely for the stupid and unproductive uses to which in practice their funds are frequently put. With ETFs in particular, unlike most actively managed funds, the culprit behind the overtrading is clearly the investor rather than the fund manager.
Fund managers of all types are responsible however for the expectations which they spend heavily to engender. It is dishonest is to argue that all funds can in practice consistently deliver the returns that most fund providers, either implicitly or explicitly, promise and which even sophisticated institutional investors seem only too ready to believe, despite the impressive evidence to the contrary.
That does not make funds bad potential investments per se. But current mandated disclosure does not go far enough – why not tell it how it is? – and better disclosure, including the empirical evidence on money-weighted returns, would at least draw less fire from the combative Mr Bogle and his many admirers.
Jonathan Davis 