Secrets Of Success: Remember, the tortoise usually beats the hare

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An interesting pile of material lands on my desk from the good folk at Vanguard, the American mutual fund company whose organisation remains a model most fund management companies over here could study with profit.

Vanguard is the only large mutual fund company in the US directly owned by its fundholders. So it has a more powerful incentive than most to minimise the great chunk of costs the fund management company takes out of its funds' investment returns before they actually reach the investor. In most fund management companies, there is an inherent and ongoing conflict between the desire of the fund management company to maximise its profitability and the investment results its clients can achieve.

The other day, I stumbled across this splendid quote from Professor Paul Samuelson, the American economist among the first to advocate the use of index funds as a safer savings for ordinary investors. In 1967, Professor Samuelson told why he bought shares in an investment management company. "There was only one place to make money in the mutual fund business, as there is only one place for a temperate man to be in a saloon", which is "behind the bar and not in front of it".

That remains a sound piece of cautionary advice, though it is not as frightening as the statistics which Jack Bogle, the founder of Vanguard, claims to have unearthed about the investment returns American mutual fund investors achieved in the 20 years to 2002. He says that while the S&P 500 index had an average annual return over the 20 years of 13 per cent per annum, the average equity mutual fund returned just 10 per cent per annum, the difference of 3 per cent being almost entirely explained by the higher costs of actively managed funds.

More startling, the average mutual fund investor achieved an annual return over this period - the longest and biggest bull market in US history - of no more than 2 per cent per annum. I have mentioned similar calculations of this nature before, but this is the lowest such figure I have come across, and it seems hard to accept. The figures are difficult to calculate, so it is at best a rough estimate, not something that can ever be established with complete precision.

But if Mr Bogle is right , you do not need to look far to discover why it should be so. It comes back to our old friend, past performance. This remains the basis on which most funds in practice are still sold, despite the evidence that past returns contain little of predictive value you can act on with confidence. The important thing to grasp is that it is by no means mathematically impossible for the average fund to make 10 per cent a year after costs, while the average fund investor, which is not the same thing, earns a return of 2 per cent per annum.

To see why, suppose you live in a world where there are only three funds, each of which earns a compound return of 8 per cent per annum over five years. But imagine that one of those funds makes a return of 80 per cent in its first year and then records four straight years when its return is minus 5 per cent. The two other funds churn out returns of 8 per cent per annum, year in, year out.

It will take four years before the cumulative return on the first fund, the number that will no doubt be trumpeted in the advertisements, falls below that of the other two. After three years, for example, the data will show that anyone who invested £100 at the outset in Fund A would have made £162 from Fund A and a mere £122 from the other two.

If you assume next that all the new money fund investors have to commit to the market at the end of each year goes into the fund with the highest cumulative return at that date, the first fund will grow much more rapidly. In fact, by the end of the five years, it will have two and a half times more money than the other two combined.

Yet if you think about it, you will realise the majority of the investors in that fund will have done nothing but lose money. They missed out on the spectacular first year and their average return at the end of the period will not only be substantially below that of the three funds taken together, but also below the average return achieved by the fund itself. There is no place to show the workings of this highly simplified example (readers can e-mail me for the data), but it is easy to show that on these assumptions nine out of 10 investors in Fund A will lose money. Just as strikingly, no fewer than two-thirds of all investors will also end up losing money, although all three funds have five-year records showing 8 per cent per annum annual returns. Something like this process is what happened to mutual fund investors in the US over the 20-year period highlighted by Mr Bogle.

Most investors in a fund which records a spectacular first year never get to see any part of that return in later years, despite this headline figure often being the basis on which they originally chose it. It underlines yet again why anyone buying a fund should always look at the year-by-year record of returns, not the cumulative three-, five- or 10-year figures. The latter can be cruelly deceptive, and dangerous if you base your decisions on them in isolation. The case for index funds, of course, is that they will never feature at the top of the cumulative league tables, but they will continue to bore away, racking up something close to the overall market return each year.

Mr Bogle's genius was to understand this, and to go on to build what is now among the largest and most trusted mutual fund businesses in the US around that simple idea. For the first five years of its existence, Vanguard's pioneering index fund took in no net new money, and, curiously, no other fund company has chosen to copy its business model. It pays to remember the parable of the tortoise and the hare.

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