Bogle: Diving Deeper to Learn More from the Legend

As study after study shows that over 80% of large cap Indian mutual funds underperform their benchmark, the intellectual legacy that John Bogle left behind becomes ever more relevant for Indian investors. Beyond the idea of index funds, Bogle identified several deeper truths about our profession – the importance of minimising costs, of being sceptical of auditors & brokers, and of giving our clients a stake in our success – which are very relevant in India today.

“Many investors are under the mistaken impression that mutual funds are a secure and relatively matter-of-fact what to gain the benefits of diversification at low cost. In reality…mutual funds have a large incentive to benefit from the economics of their business, rather than look after their investors’ long-term wealth. Thus we see some mutual funds not only charge outsized fees, but also practice portfolio management strategies which leave investors behind market index averages…” – Arthur Levitt, the longest serving SEC Chairman, in the Foreword for ‘The Clash of Cultures: Investment vs Speculation’ (2012) by John Bogle

“If a statue is ever erected to honour the person who has done the most for American investors, the hands down choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultra-low-cost index funds. In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers who have promised their investors large rewards while delivering them nothing – or, as in our bet, less than nothing – of added value. In his early years, Jack was frequently mocked by the investment-management industry. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned.” – Warren Buffett on John Bogle in Berkshire Hathaway’s 2016 Annual Report

Bogle’s journey from Princeton University student to investment legend
Born in 1929 in Montclair, New Jersey, to an American family hit hard by the Great Depression, John Clifton Bogle, is arguably the most radically influential figure to emerge from the world of investing in the past hundred years. Having studied economics and investing at Princeton University and having written a 130 page thesis on the US mutual fund industry – titled ‘The Economic Role of the Investment Company’ – whilst at Princeton, Bogle was by his mid-20s one of the smartest thinkers in the American investment management industry.

His industry knowledge and work ethic ensured a rapid ascent at Wellington Fund and in 1970, aged 41, he was named as the Chairman of this pioneering mutual fund house. Four years later, an unwise merger approved by Bogle led to his downfall and he was “fired with enthusiasm”, amidst much acrimony, by the Board of Wellington. In one of the most celebrated comebacks in American business, Bogle not only bounced back to found Vanguard Company in 1974 but also by pioneering a new style of investing which has become over the last 20 years the default method for investing in developed markets like the United States.

When Bogle launched Vanguard, the great and the good in America launched an attack on him. The Chairman of Fidelity, Edward Johnson, led the sceptics assuring the world that Fidelity had no intention of following Vanguard’s lead. “I can’t believe that the great mass of investors are going to be satisfied with just receiving average returns. The name of the game is to be the best” said Mr Johnson (Fidelity now runs nearly $500 billion of indexed assets.) [Source: Gary Brinson Lecture delivered by Bogle at Washington State University on 13 April 20014.]

Never one to care too much about what the establishment was saying, Bogle drew inspiration from the pathbreaking research published by Nobel laureate, Paul Samuelson of the University of Chicago. Samuelson is the foremost academic economist of the preceding century not least because of his seminal textbook ‘Economics: An Introductory Analysis’ which was first published in 1948 and has acted as a primer on the subject for millions of youngsters across the world. Amongst Samuelson’s several pathbreaking insights, the one which has had the greatest impact on financial markets is the “Efficient Markets” theory which says that asset prices fully reflect all available information. By implication therefore it is impossible to “beat the market” consistently on a risk-adjusted basis since market prices should only react to new information.

Bogle took the Efficient Markets theory to heart and was the amongst the first executives in the mutual fund industry to fully understand its profound implication, namely, it makes little or no sense to pay juicy fees to a fund manager to manage your money given that the fund manager has little or no chance of consistently beating the market. Thus was born Bogle’s breakthrough idea – in 1975 Vanguard launched the world  first index mutual fund. Instead of beating the index and charging high fees, the index fund would mimic the index performance over the long run—thus achieving higher returns with lower costs than the costs associated with actively managed funds.

Take the following example – suppose two people – Sarbani and Saurabh – graduate from university on the same day and get jobs with identical salaries. Assume further that throughout their 40-year long careers, they save identical amounts and invest with fund managers who generate identical returns of 12% per annum (before fees). The only difference is that Sarbani uses an index fund which charges 0.1% per annum and Saurabh uses and active fund manager which charges 2.5% per annum. As a result, over her entire career, Sarbani generates 2.4% per annum more than Saurabh and thus retires with a corpus 2.3x as large as Saurabh’s! This is because fees and expenses borne by customers of mutual funds have an exponential impact – the 2.4% that Sarbani saves relative to Saurabh compounds over time to make her twice as rich as Saurabh.

In fact, Bogle’s central insight – that actively managed mutual funds are not worth the fees they charge – has a deeper implication. Bogle figured out that even if the Efficient Markets theory does not hold – and therefore even if markets were “wildly inefficient” – by definition, around half of the fund managers would underperform the index BEFORE fees & expenses were taken into account. Therefore, once you subtract fees & expenses from fund performance you get:
Net returns to the investor = Gross returns from the fund – Fees & expenses of running the fund.
On this basis, well over half the fund managers will underperform the market. In separate studies, Bogle, Morningstar and Rob Arnott (of Research Affiliates) have found that over the past three decades, between 80-90% of US mutual funds underperform the index. In India, if we take the last three years’ track record (upto the end of 2018), the ratio for underperforming large cap mutual funds is around 90% i.e. barely 10% of large cap mutual funds in India are able to justify their fees. (Source: https://us.spindices.com/documents/spiva/spiva-india-year-end-2018.pdf)

Even more remarkably, as we highlight in the next section, it is impossible to predict on a forward looking basis which large cap mutual funds will outperform going forward i.e. outperformance by such funds seems to be a random affair. Furthermore, in India as in the US, most mutual funds which outperform are small (in terms of the assets under management). In particular, in India we have noticed that once a large cap fund exceeds Rs 10,000 crores (US$ 1.4 billion) in AUM, outperformance ebbs away.

In 1975, Bogle took this simple insight with regards to the importance of costs and proceeded to build a firm which crushed the cost of money management in several ways including:

• Portfolio turnover related costs: In order to minimise the costs associated with brokerage, price impact and taxes, Bogle believed that portfolio turnover should be at most 3-5%. In most large stockmarkets, most funds have portfolio turnover in excess of 30%. Over a ten year period in India, such a fund will end up giving away a quarter of the investor’s wealth to stockbrokers (via commissions) and to the taxman (vis transaction taxes and capital gains taxes).
• Advertising costs: In his book ‘Clash of Cultures’, Bogle wrote that “There is no evidence whatsoever that advertising benefits fund investors by bringing in an amount of new assets adequate to create economies of scale that offset the amount spent.” As a result, for the first 30 years of its existence Vanguard barely advertised. Over the past decade it has stepped up its spend but even now: (a) its spends much less on advertising than it mainstream competitors; (b) almost all of its spend is on digital media (no mainstream newspaper or TV spend); and (c) every dollar spent on advertising is tracked carefully. (Source: https://adage.com/article/special-report-marketer-alist-2012/vanguard-proves-pays-advertise/238421/)
• Distribution costs: The world over fund managers use distributors/brokers to sell their products to the ultimate investor. In return, the fund manager pays commissions to these intermediaries. In India these commissions can be as high as 70% of the fees paid by the ultimate investor to the fund manager. When Vanguard was two years old, Bogle severed links with all the intermediaries who sold Vanguard’s funds and moved the entire sales & marketing function in-house. Bogle thus gave the world its first fund with no distribution costs associated with it. In 2013, SEBI declared that all Indian mutual funds had to a have ‘direct’ option i.e. an option wherein the investor can invest directly without having to go through a distributor.

As a result of Bogle’s vision, the expense ratio for Vanguard’s funds is 11bps compared to the 64bps for an average mutual fund in America. (Expense ratio is a mutual fund’s annual operating expenses, expressed as a percentage of the fund’s average net assets.) That 53bps differential is huge. It almost ensures that Vanguard’s funds will outperform the vast majority of actively managed funds on a consistent basis.. As a result, Vanguard’s clients would make much more money than the clients of most active managers. Such is the centrality of costs in the world of investing that Morningstar and Bogle have shown in separate number crunching exercises that the most reliable predictor of a fund’s future performance is its expense ratio.

In India, the cost differential between active vs passive investing is much bigger than it is in the US. Large cap ETFs in India are now available with an expense ratio of 5bps. In contrast, the expense ratio of large cap mutual funds in Indian is in excess of 100bps. Assuming an expense ratio advantage of just 100bps in favour of ETFs implies that Indian investors would save Rs 800 crores (US$120 million) per annum if they invested in ETFs rather than large cap mutual funds. Given that less than 4% of the Indian mutual fund industry’s AUM is in passively managed assets, you can draw your conclusions regarding which direction, the share of index funds and ETFs will go in India. (Source: https://www.livemint.com/Money/5uy7XNtE6cEXxoa5UfCiPL/Passive-investing-rises-as-largecap-funds-underperform.html)

But there is much more to Bogle’s legacy than low cost index mutual funds. He realised that there is a two tier principal-agent problems in the fund management industry: the first between the fund manager and his client (this is the problem which the index fund addresses) and the second between the fund manager and the owners/shareholders of the fund management house (the standard principal-agent problem in any business).

To address the latter issue, Bogle came up with an utterly novel construct: Vanguard would be owned by its clients! This solution actually addresses both the principal-agent problems: if the clients control the fund manager, not only does that compel the fund manager to keep his costs – including compensation costs – low, it also forces him to be responsibly build a long term franchise which is in the best interests of the shareholders who also happen to be the clients. The fund manager is therefore answerable to only one master – the client – not two (as is the case in most privately owned companies).

Thirdly, Bogle figured out that beyond greedy fund managers, the investor is surrounded by other agents – promoters/CEOs, auditors, investment bankers, sell-side analysts, lawyers – who collude with the promoter to gouge the investor. He called this the “double agency society” problem: “The nature of this largely tacit conspiracy is not complex, and its web is wide. It includes the managers of our giant corporations – their CEOs and CFOs, directors, auditors, and lawyers – and Wall Street – investment bankers, sell-side analysts, buy-side research departments, and the managers of giant investment institutions. Their shared goal: to increase the price of a firm’s stock…to raise the value of its currency for acquisitions, to enhance the profits executives realise when they exercise their stock options…
How to accomplish this objective? Project high long-term earnings growth, offer regular guidance to the financial community as to your short-term progress and, whether by fair means or foul, never fall short of the expectations you’ve established. Ultimately, these ambitions goals are doomed to fail for corporations as a group.” (Source: ‘The Clash of Cultures: Investment vs Speculation’ (2012) by John Bogle; emphasis in bold is from Bogle)

Whilst Bogle worked in the US, much of what he says is equally applicable to India. By implication, the Indian investor is not only battling against the high fees charged by Indian fund managers but also against a system loaded in favour of promoters. By design, this system loots the Indian investor with metronomic regularity through a variety of asset classes & a variety of investment vehicles. At Marcellus, we are seeking to break free of this construct by: (a) using our in-house forensic accounting models rather than believing the audited financial statements published by companies; and (b) conducting in-depth research in-house rather than using sell-side research.

Investment implications
Nearly two-thirds of the Rs720,000 crores (around US$100 billion) equity assets managed by Indian mutual funds are invested in large & midcap cap stocks (defined by the Indian regulator as the top 250 companies by market cap) [Source: https://www.sebi.gov.in/statistics/mutual-fund/mf-investment-objectives.html].

As mentioned earlier, credible studies of Indian mutual funds now show that over 80-90% of large cap mutual funds fail to beat the relevant benchmark. Such sustained underperformance actually masks even deeper challenges for these funds. In our bestselling book ‘Coffee Can Investing: the Low Risk Route to Stupendous Wealth’ (2018), we have shown:

• Of the 30-40 cap leading mutual fund schemes in India which managed to generate top quartile performance in a given three year period, around 45% of these funds deliver sub-par returns (i.e. returns in the bottom two quartiles) in the subsequent three year period (see page 85 of the book).
• This reversion to mean implies that over the past decade, there are only 3 leading mutual mutual funds in India which have managed to consistently stay in the top quartile. The remaining 97 have either been outside the top quartile for the entire decade or have sporadically entered the top quartile suggesting that luck, as much as skill, is responsible for their performance.
• The two preceding bullets are flattered by ‘survivorship bias’ because the mutual fund industry’s trade body, AMFI, reports all fund performance data after deleting the results of the funds which have been shut down. Since nearly 20% of Indian large cap mutual fund schemes have been wound up over the past five years, excluding these dead schemes obviously flatters the industry’s performance (on the reasonable presumption that the funds which have been shut down were the worst performing funds). [Source: https://www.moneylife.in/article/nearly-20-percentage-of-equity-mutual-funds-merged-or-discontinued-in-past-five-years/42003.html]

In light of the above, it is not surprising that Indian equity investors are migrating away from large cap funds either towards the alternative asset management industry. Even though the alternatives industry India is not exactly populated by saints, assets under management for it have rocketed from negligible levels a decade ago to Rs 250,000 crores now (US$35 billion) now [Rs 110K cr for AIF + Rs 140K cr for PMS: Source: CAIA and SEBI). As one would expect, wealthier and better informed Indian investors are at the forefront of this shift from mutual funds to alternative assets but if the American experience is anything to go by, less affluent investors are unlikely to be far behind. All they need is an Indian John Bogle. Until he/she arrives, you can see how we at Marcellus are doing in terms of return generation:
To read our other published material, please visit https://marcellus.in/newsletter/the-lenders-in-our-portfolio-will-gain-from-the-ongoing-crisis/
Saurabh Mukherjea is the author of “The Unusual Billionaires” and “Coffee Can Investing: the Low Risk Route to Stupendous Wealth”.