While reading The Little Book of Common Sense Investing by Vanguard founder Jack Bogle, I found one of the chapters on predicting future stock returns especially interesting. Here’s my attempt at summarizing it.

What are we buying when we buy a share of a company? Essentially, we are buying a stream of future money. That money is returned to us the form of earnings growth (which increases the share price) and dividends (which goes straight to us as cash).

As an example, let’s take a fictional company and call it Bob’s Taco Shack. The taco stand has earnings of $20,000 a year. It has 1,000 shares, so it’s earning $20 per share (EPS). Bob gives out $10 of that $20 as a dividend to shareholders, and reinvests the remaining $10 back into the company. Currently, the share price is $200, which gives us a price/earnings ratio of 10 and a dividend yield of 5%. Now, let me pose some statements, which I hope make sense.

1. If earnings stay constant, then one would expect the share price to stay constant as well. The stream of money coming is the same, so the price should be the same.
2. If earnings stay constant, and dividends are 5% year, then your return should be just that 5% a year. From the example, you just get that $10 in dividends (5% of $200).
3. If earnings grow by 5% a year, and there are no dividends, then your return would again be 5% a year. You are paying 10 times earnings. If the earnings go up by 5% to $21 per share, then the share price should go up to $210. You earned the same amount as the earnings grew.

This leads to the formula for what Bogle terms the “fundamental” return:

Now, if Bob announces that he plans to expand into fancy shrimp tacos and fish tacos, then maybe people will expect higher future profits and be willing to pay more per share, raising the P/E ratio. But this is based on speculation. Bob hasn’t actually done anything yet. So now we have speculative return:

Over long periods of time, if you take the entire stock market, you would expect the speculative return to be very negligible. This makes a lot of sense, right? In the end, you’ve got to show me the money! And history agrees. Over the last 100 years, the total annualized return for the total U.S. market was 9.6%, and all but 0.1% of that was explained by earning growth and dividends. (See graph below.)

What about the future?
Great, right? As long as corporate earnings growth keeps chugging along and we keep getting some dividends, we should be good to go. Over the past 25 years, the U.S. stock market has had earnings growth of 6.4% and an overall dividend yield of 3.4%. Nice! But wait – there was also a speculative return of 2.7% due to the overall P/E ratio expanding from about 9 to 18!

As you can see below, that gave us really strong annual returns of 12.5% since ~1980. The problem is, this isn’t likely to continue. For one, dividend yields continue to drop, and are now about 2%. As Bogle states, even if you assume a continued corporate earnings growth rate of 6%, now you have a total of 2 + 6 = 8%. But the P/E ratio is not likely to get any bigger. If anything, history says it should shrink back a bit. If it goes back to 16, that alone will subtract 1% from expected returns.

Data taken from Little Book of Common Sense Investing, Exhibit 7.1

(If you don’t agree with the 7% number, make up your own based on your expected dividend rate, earnings growth, and future P/E expansions or shrinkage.)

As you can see, this shows that it is unlikely that in the next 25 years we will earn much more than 8% annually from stocks alone, and chances are it will be more in the range of 7%. Add in those bonds as you get older, and that return decreases even further. Food for thought…

My comment was – Will earnings growth rates increase, as companies are presumably re-investing money not paid as dividends in themselves? I sure hope so, but it seems like a lot to ask.

Even though the expense ratio for an ETF may be slightly lower than a mutual fund, that doesn’t necessarily completely explain the cost differential between them. In addition to any commission costs, there are also the issues of bid/ask spreads and deviation from NAV. These are explained briefly below along with some useful tools to evaluate their impact.

Historical Bid/Ask Spread Values
Since ETFs are by definition traded on an open exchange, there can be differences between what people are currently willing to pay (the “bid” price), and what people are willing to sell at (the “ask” price). Even if you assume the ETF is priced correctly at it’s inherent value, this bid/ask spread means you will be overpaying a bit when you buy, and losing a bit when you sell. It can be thought of as slight purchase fee and redemption fee. (This also holds true when you trade individual stocks!) Mutual funds, on the other and, always trade at net asset value.

Some people try to avoid getting a “bad fill” for their trade by doing a limit order between the bid and ask instead of a market order, but limit orders carry the risk of non-execution. If the share price goes up, you’ve missed out and must submit another order anyways.

Many of the low-cost ETFs I am interested in are from Vanguard, and thankfully they have compiled a list of the average bid/ask spreads over the last 30 days for their entire ETF line-up. Here’s a sampling:

[Read more…]

Now that Vanguard allows us to waive all their $10 low-balance fees, I need to reconsider my choice in bond funds. But which one? Here’s a my brief and very generalized understanding of bonds, based on my own readings. Please use this only as a starting point for your own research.

Quick Bonds Primer
Bonds are essentially loans, either from government or private companies. In portfolios, they are usually used to reduce the overall volatility because of their low correlation with stocks. When stocks go one way, bonds tend more to go the other (thought not always). This can allow you to lower risk without significantly lowering returns. See this Vanguard illustration.

While there are many different types of bonds – corporate, mortgage-backed, U.S. Government Treasuries, municipal, to name a few – you can break them down into two ways:

Maturity Risk
The longer the loan length, or time until maturity, the more sensitive bond prices are to interest rate fluctuations. Bonds are often grouped into short-term, intermediate-term, and long-term categories. The lender (us) is usually compensated for this extra volatility with higher returns. Another way to measure sensitivity of a bond fund is by looking at the duration. For example, if a bond has a duration of two years, its price would fall about 2% when interest rates rose one percentage point. On the other hand, the bond’s price would rise by about 2% when interest rates fell by one percentage point.

Credit Risk
Just like with consumer loans, the worry is about defaults. The riskier the borrower is, the higher interest they must pay. Given the same maturity length, a junk bond with a low credit rating will pay a higher return than a government-backed Treasury bond. Foreign bonds aren’t very popular, due to the added currency risk and also higher expenses.

Where’s the best risk/reward combination?
Just because as risk goes up, return goes up, doesn’t mean that there is a linear relationship between the two. You want to find the best combination for your portfolio needs.
[Read more…]

Here’s a nice Reuturs article interviewing Warren Buffett and Charlie Munger shortly after the recent Berkshire Hathaway shareholder meeting.

On index funds and beating the market:

Warren Buffett said on Sunday most investors are better off putting their money in low-cost index funds, though he believes he can still outperform major market indexes.

“A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money,” Buffett said at a press conference, a day after the annual shareholder meeting for his Berkshire Hathaway Inc.

As for Berkshire, which ended March with nearly $90 billion of stock and fixed-income investments, Buffett said “we think we can do better than the S&P. I would be disappointed if our portfolio didn’t do a couple of percentage points better. I would be amazed if it did (much) better.”

I’m not sure if this is Buffett being humble, or he is admitting that beating the S&P by a large margin is getting harder and harder.

On performance chasing:

Charlie Munger, Berkshire’s vice chairman, said at the press conference that many investors actually fare worse in actively managed funds. He said many funds perform well when they’re small, but struggle to keep up when investors chase that early performance, and pour in cash.

“Successful funds attract a massive amount of money, and the later performance typically gets mediocre,” he said. “Then they keep publishing returns for the whole period for someone who started 20 years ago…. The reporting has falsehood and folly in it.”

If I believed in the “Buffett way”, which on some days I do, I would simply buy BRK directly rather than try to replicate or beat his results by trading on my own as a mere mortal.

I recently received an e-mail that went like this:

“It’s not expenses that matter, it’s total return after expenses. You could charge 1% but if I make you 30% who cares? Why don’t people understand this? I offer my clients superior performance for my fees.”

This irked me. I thought about sending him a few articles about why there’s no proof that any consistent market-beating performance by money managers exists. But instead, I said okay, fine. Here’s an open invitation. I give you my money to manage. You can choose whatever investments you like – mutual funds, individual stocks, whatever.

Instead of a flat fee, you choose the investments, and you get to keep 80% of how much you beat a benchmark portfolio where I try to match your level of risk using index funds. If you fail to beat my portfolio, you must pay me back the difference. So let’s say an advisor would charge 1% of assets. All they would have to do is beat the market consistently by 1.25%, and they’ve got that made already. If they kick butt and beat the market by 5%, they get 4% of assets!

Yes, all the risk here is held by the manager. So what? If you’re so confident you can do better than my portfolio of index funds, put your money where your mouth is. It’s like working for straight commission. You make me more money than my no-brainer portfolio, I make you money. I feel this is much more fair than the current setup, where we pay a relatively fat fee regardless of ensuing performance.

You might be thinking: “But no manager would have enough money to guarantee against that kind of potential loss”

Again, very true. I’d need some collateral to make sure he wouldn’t cut and run. The risk could be mitigated if you could buy some sort of insurance policy to hedge against catastrophic losses. Now, it would probably be expensive, as going back to my original point, as historical statistics show that market-beating performance is unlikely to happen. Maybe Lloyd’s of London is balking, and that’s why I haven’t heard back from him yet…

A more reasonable option?
Although I still wouldn’t buy such a mutual fund, here’s a more reasonable option for actively managed mutual funds. If you fail to beat the relevant index, your expense ratio should be 0%. No need to make people “whole”, but you have to refund all fees taken from the last year. Otherwise, you can earn a pro-rated amount of any market-beating gains with a cap of say, 2%. I know some mutual funds vary their expense ratios slightly based on performance, but none as harshly as this.

Ever wonder why this isn’t how mutual funds are set up?

A mere two days after I ranted about Zecco’s slow opening procedure in the second part of my Zecco Free Trades Brokerage Review, reader Richard alerts me that they have removed the mail-in paperwork requirement for many new applicants. After applying, you now see this:

If you applied for an Individual or Joint account on or after Thursday, May 10th, and you have a US Social Security Number, you?re all set.

However, if you either:
– applied prior to Thursday, May 10th for any account
– applied on or after May 10th, but you were asked to mail your documents
– applied for an IRA account
– do not have a US Social Security number:

please provide your required paperwork.

Hmm… This is either coincidence, or maybe I have some influence after all. 😀 Somebody also said that Zecco was swamped with IRA applications near the April 15th deadline, which further slowed things down. Either way, I hope this indicates better things to come!

Continuing on the line of thinking started by my post on What if my bank fails?, the next question might be what if my mutual fund company went bankrupt? I mean, I have a lot of money in Vanguard and Fidelity right now. What happens if one of them “pulls an Enron” or simply runs out of money?

One source of information is this 2004 Money magazine article written shortly after previous mutual fund scandals:

What happens if my fund company fails?
Your money is safe. Under the Investment Company Act of 1940, which governs the industry, each fund is set up as an individual corporate entity, with its own board of directors. Essentially, your fund hires the fund company to manage its assets. If the company were to file for bankruptcy, its creditors would not be able to touch the funds’s assets. And the fund’s directors could immediately hire a new manager, pending shareholder approval.

The way I read this, mutual fund managers are interchangeable. If the fund company goes bankrupt, the assets would remains the same, one would just have to hire a new company to manage it. In addition, one of the features specific to Vanguard is that it is set up as client-owned. How this works is that each of us might own a share of a mutual fund like VFINX. In turn, that mutual fund is a separate entity that contributes money to fund Vanguard’s operations, instead of the other way around. Here is an excerpt from Mel Lindauer of the Diehards forum, which explains this setup well:

First, The Vanguard Group Inc. (VGI) is actually a subsidiary of the various mutual funds, each of which is a separate legal entity. The best way to describe Vanguard’s unique structure would be to think of General Motors turned upside down, with Chevrolet, Cadillac, Oldsmobile, Pontiac, etc. as the corporate parents, and General Motors as a subsidiary. If you think of Chevrolet, Cadillac, Oldsmobile, Pontiac, and the other GM divisions as mutual funds, and General Motors (the subsidiary, in this situation) as Vanguard Group Inc., you’ll get the picture.

Since VGI is actually owned and funded by the various mutual funds, it technically couldn’t go bankrupt unless all of the various mutual funds that support it went bankrupt. The only way that could happen would be for the value of all of the stocks and/or bonds held by each and every individual Vanguard mutual fund to go to zero. So, forget about Vanguard going bankrupt — it just isn’t going to happen.

Some have expressed concerns about putting “all their eggs in one basket” by consolidating their investments at Vanguard. There’s simply no need to worry about that. Each fund is a separate investment company (and part owner of the Vanguard Group, rather than the other way around). Thus, having all of your investments in several Vanguard funds is tantamount to having your investments spread among a variety of baskets, each independent of the other. So, put your fears to rest; your investments are safe at Vanguard.

The Real Question – Ethics and Management
In the end, the real fear that one should have is that their mutual fund management will simply make poor or reckless investment decisions and lose your money perfectly legally. Also, in previous ethics scandals, managers also performed illegal trading or other activities specifically forbidden in their prospectuses. This is why ethics and consistency of management should be a component of why you choose to invest in a mutual fund, and why I feel very comfortable with the majority of my assets in Vanguard index funds.

I have never heard of a mutual fund company going out of business. But I’ve read about a lot of bad mutual funds with horrible performance. And this drop usually happens after a period of great performance and the heavy advertising and money inflows that ensues. Something to think about.

A reader e-mailed me an interesting article about index funds from today’s Wall Street Journal entitled A Close Race, a Surprising Finish. It’s only available for 7 days, after that a subscription is required.

The basic idea was to try and compare after-tax returns of index mutual funds and index ETFs, due to the often-touted tax-advantages of ETFs. The article summarized these theoretical benefits well:

The tax-related advantages of ETFs stem from their unique structure. ETFs are created when securities brokerages or specialists assemble baskets of stocks that match an ETF’s underlying index and exchange them with the fund for ETF shares that the brokerages can either hold or sell to small investors. These ETF shares can be bought and sold any number of times without the underlying stocks they represent being touched. When the brokerages opt to take ETF shares off the market, the fund hands over stock, rather than cash. This allows the ETFs to avoid selling their underlying stocks to accommodate investor traffic.

(This explains why many mutual funds have purchase or redemption fees to discourage active trading, while ETFs can be bought and sold all day long.)

For this study, commission costs for both were assumed to be zero. So who won?

Big, low-cost index funds from Boston-based Fidelity Investments and Vanguard Group Inc., Malvern, Pa., outperformed the ETFs in most of the comparisons we set up. For the 40 time periods studied, the mutual funds prevailed in 34 — including a sweep of the one-, three-, and 10-year after-tax categories.

Why is this?

The lesson for small investors: Whatever structural differences ETFs may have in the way of tax advantages, other factors — such as a fund’s expense ratio and management philosophy — can be equally important in determining performance in the competitive index-tracking business.

ETF tax advantages pertain, by and large, to capital gains, not dividend distributions. And, as noted, ETFs almost never sell their funds’ underlying securities, so capital-gains taxes are rare… But S&P-500 index mutual funds are pretty efficient, too. They don’t trade holdings as often as mutual funds run by stock pickers, so they rarely distribute capital gains either.

The lack of significant tax advantages for index ETFs is especially true in the case of Vanguard ETFs and mutual fund equivalents, as they are just different share classes of the same investment holding. I believe Vanguard does this so they can use the ETF “side” to keep their taxable events to a minimum, benefiting the mutual fund costumers as well. Here, the only difference in raw performance should be due to the different expense ratios.

Added
Management philosophy? Why does this matter in an index fund? Well, this is another area that may surprise some – it takes skill to manage an index fund!! A good index fund manager can eek out a few more basis points of return. From the article:

In addition, tactical moves by index-fund managers can boost results. While an index fund should, in theory, trail its benchmark by at least the amount of its expense ratio, fund managers can reduce at least some of the cost through techniques such as lending out the fund’s underlying stocks for payments, and buying stocks ahead of anticipated additions to their index.

From Vanguard:

Not all index fund managers have equal skill in tracking target benchmarks. Skilled managers may, for example, be able to minimize the transaction costs associated with managing the portfolio.

Vanguard and Fidelity both seem to be adept managing index funds well. Here is an article from Efficient Frontier (see, I told you it has some good stuff.) that discusses this further, calling it transactional skill, as opposed to stock selection skill.

Summary
This article is intended for people who have already decided that index funds are best for them, and they are just wondering how to best implement it. As the title says, it was a close race and there was no runaway winner. This is important! It’s unlikely you’ll end up in the poor house due to picking over the other.

Now, if you do want to optimize, the article indicates that while low expense ratios, structural tax advantages, and good management are all important, any one by itself won’t guarantee the absolute best performance. You have to find the best combination of all three, as well as consider things like fees, commissions, and minimum balance requirements.

Want more to read about investing? Here are two sites that have supplied me with a lot of good food for thought. I find these intriguing because while both are written by men well known for their financial acumen, they often sway far from those topics and can touch on politics, family life, and the pursuit of happiness in general.

Warren Buffett – Berkshire Hathaway Shareholder Letters
Every year, Mr. Buffett writes a letter to shareholders that discusses his company’s successes, mistakes, future moves, and a bit of everything else. Although I don’t view him as a deity like many others do, and have no plans to buy any BRK stock, I do find his writing to be easy to follow and often offers fascinating insights to a successful investor’s thought process.

However, I think one thing that people overlook is that Warren Buffett gets very intimate with many of the companies that he invests in, either with close relationships with the management or even by becoming the management for a while. He knows these companies inside and out, and can affect change within them. That’s something the common investor can’t easily emulate.

William Bernstein – EfficientFrontier.com Articles
In addition to being a practicing neurologist, starting a portfolio management company, and writing one of my favorite books on investing – The Four Pillars of Investing, Mr. Bernstein also writes a quarterly article on his website EfficientFrontier.com. It mainly discusses asset allocation, such as his thoughts on commodities, but has also wandered into areas like the housing market and estate taxes.

Here’s an excerpt from this most recent article:

If you want to pick your own stocks and bonds, be my guest. Just don?t imagine that making your decisions on the basis of publicly available information and analysis will lead you anywhere but to the poor house. You?re going to have to look at the primary data and analyze it entirely by yourself. And you?d better be good at it.