From Chapters 9, 11 and 12

Research on Safe Withdrawal Rates

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JWR1945
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From Chapters 9, 11 and 12

Post by JWR1945 »

I find Chapters 9, 11 and 12 of our featured book, Common Sense on Mutual Funds, John Bogle has done an outstanding job of showing that index funds are the way to go if you are going to invest in a mutual fund. Yet, I found those chapters encouraging for those of us who invest in individual stocks.

Jumping directly to Chapter 12, which addresses effect of the size of a mutual fund, I see many reasons to believe that skill and discipline can contribute about 1% to one's overall return. The reason that mutual fund managers fail to show consistent success is that early success leads to too much fund growth, which limits a fund's upside potential.

John Bogle mentions several detrimental effects of having too much money in an active mutual fund. For example, funds limit their maximum percentage of shares of any company typically to 2% or 3% in order to maintain a broad base of diversification and they limit themselves to owning no more than 5% to 10% of any individual company in order to maintain liquidity. This combination limits the number of major portfolio positions available to a fund manager unless he invests in a very large number of smaller companies. Instead of coming up with a handful of outstanding ideas, he has to come up with dozens upon dozens of great ideas just to maintain his track record. The outstanding returns from his very best ideas are hopelessly diluted.

There are numerous hidden costs related to the size of a mutual fund. The short-term outlook and high turnover rates of most actively managed mutual funds make things even worse.

As to what should be the maximum size of a mutual fund, John Bogle mentioned what his own son did as an active manager: he closed two funds when their assets reached $100 million.

This takes me back to pages 252 and 253 in Chapter 11, where John Bogle discusses enhanced indexing. Enhanced indexing differs from closet indexing because it is openly disclosed as a fund objective and based upon market opportunities such as reflected in low price to earning ratios and low price to book ratios. I refer to such practices as price discipline. Early results are promising, producing a small but meaningful edge provided that expenses are kept very low.

[Typically, a person who invests in individual stocks can purchase stock when prices are in the lower third of their 52-week range and sell them when they are in the upper third of their 52-week range. The minimal holding period should be about a decade to keep transaction costs low. The ratio of highs and lows of the 52-week range is usually 1.5 to 2.0 or even more. Typically, this adds 1% or 2% to the return of a stock.]

I find such remarks very encouraging for the individual investor with less than $100 million to invest.

Going back to Chapter 9, which talks about selecting superior funds, I see more signs of encouragement for those of us who purchase individual stocks. The first thing is that I noticed was the use of a single yardstick that seldom applies to anyone. Funds are judged in terms of a single purchase at the beginning and a single sale at the end. Funds are not judged in terms of more realistic buying patterns such as a series of small purchases followed by a later series of withdrawals. Funds are not judged according to additional constraints such as the maximum decline that investors will tolerate as a function of time. Everything is rolled up into a single case (or a handful of limited conditions). There is only one criterion for success or possibly two: the buy and hold return of the fund possibly combined with a simple constraint on volatility.

I was also encouraged to know the limitations built into various studies. In terms of relative performance and time comparisons, the studies typically measure skill in terms of two years or less. [This is in sharp contrast to Mark Hulbert's recommendation to use the 9-year history of newsletter writers (and definitely not to use anything as short as Morningstar's 3-year metrics except to weed out consistent losers).]

I have come to believe that John Bogle is largely responsible for much of today's mindless nonsense about market timing. He uses the term much too loosely. He applies the failure of timing associated with frequent, short-term trading activity much too broadly. When neither Warren Buffett nor Sir John Templeton can find any stocks worth buying in the United States, I do not consider their recommendations to hold off buying as being market timing in the usual sense. Technically, it is timing because markets change and opportunities are likely to occur in the future. But I think that it should be recognized for what it is: just waiting for good prices.

Have fun.

John R.
peteyperson
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Re: From Chapters 9, 11 and 12

Post by peteyperson »

Hi John,

I find the comparisons between actively managed mutual funds and indexing to be too generalised. It also tends to highlight a lack of fundamental understanding on how one greats outperformance with investments in the first place. Active mutual fund managers are under constant pressure to deliver monthly and quarterly returns that aren't too much behind the index. This does not afford one the opportunity to hold the kind of concentrated positions in a well researched selection of outstanding businesses that is needed to deliver outperformance and give value to investors paying for more expensive active management.

The distinction between the styles of active management is also limited and confused. Many "value" fund managers will say that they invest in the value style or the Warren Buffett style of investing. Most however invest in the Ben Graham style of holding up to 100 stocks on a short-term basis, buying undervalued businesses and selling them again when they rise to near the analyst's assessment of fair value. This causes capital gains taxes. Warren Buffett's approach to investing is widely misunderstood and is very different from this. He aims to hold businesses that are undervalued wherever possible but more importantly, to buy a meaningful amount of stock in businesses that are expected to grow earnings by a superior rate over the next 5, 10, 15+ years, possibly with share buybacks to further increase the earnings per share. The return being the spread between the earnings upon purchase and the subsequent earnings upon sale, with an adjustment in annualised return up or down for changes in the PE multiple on the stock. Buffett benefited greatly from buying low PE stocks in the 70s. Many investors believe that is his sole investing motivation and fail to grasp that wherever possible he aims to get a double dip benefit from buying cheap and owning superior businesses with a consumer monopoly, pricing power & accelerated growth rates. He learned that long-term tax deferred returns are better than short-term returns even they are materially higher because of the tax bite. While one does have to keep an eye on the PE to ensure one doesn't buy too high (a big unexpected reduction expected future growth rates on earnings could result in a large loss of capital), the lack of a low PE should not be seen as a deterrant as few superior businesses are priced cheap. Especially now. Returns are likely to be lower from here because a sensible investor would have to factor in a lowering of the PE multiple from purchase to eventual sale to get realistic estimates.

Taking all of this together, an analysis by Bogle between active and indexed investing ignores what creates real opportunity to outperform the market and only uses as performance comparison the quarterly performance chasing results that by their own methodology are bound to fall short. Few mutual funds hold truly concentrated positions, wishing to limit the possible losses by holding 50+ positions at one time to avoid losing their job. The few concentrated actively managed funds, such as the Sequoia Fund, Clipper Fund and others which have delivered outperformance over decades are too few in number to affect the avg actively managed fund return used by Bogle in his comparisons. This makes a meaingful comparison impossible.

When one wishes to learn how to invest successfully from a business perspective, one has to look at which investors have done so successfully and have a long enough record to be able to remove luck as their primary source of outperformance. There are any number of investors who can provide useful study to this end.

Two year studies are meaningless. The market doesn't always readjust valutions that consistently, which means active fund managers are buying for price changes rather than earnings increases. A 10 year study is more useful, this shows up when you look at concentrated portfolio results on a rolling 10 year period vs market prices. This gives enough time for the company earnings to increase markedly and the stock price to be adjusted up even if the PE multiples haven't moved.

BTW, while Buffett did say that he could find almost nothing of interest in US equities (he's now buying cheaper international equities), it is worth remembering that his minimum investment is at least $500m and so the business needs to have a market cap of $5 Bn+. Individual investors have many more companies available for purchase than he does and so his comment might have been different if hasn't hamstrung by the capital he needs to deploy annually. This is similar to his comment 30 years ago that he was 90% Ben Graham, 10% Phil Fisher. Since the purchase of See's Candy in the 70s, his approach has changed but still people recite this quote and believe he's still using Ben Graham's 100 stock portfolio of cigar butt stocks.

Petey
JWR1945 wrote:I find Chapters 9, 11 and 12 of our featured book, Common Sense on Mutual Funds, John Bogle has done an outstanding job of showing that index funds are the way to go if you are going to invest in a mutual fund. Yet, I found those chapters encouraging for those of us who invest in individual stocks.

Jumping directly to Chapter 12, which addresses effect of the size of a mutual fund, I see many reasons to believe that skill and discipline can contribute about 1% to one's overall return. The reason that mutual fund managers fail to show consistent success is that early success leads to too much fund growth, which limits a fund's upside potential.

John Bogle mentions several detrimental effects of having too much money in an active mutual fund. For example, funds limit their maximum percentage of shares of any company typically to 2% or 3% in order to maintain a broad base of diversification and they limit themselves to owning no more than 5% to 10% of any individual company in order to maintain liquidity. This combination limits the number of major portfolio positions available to a fund manager unless he invests in a very large number of smaller companies. Instead of coming up with a handful of outstanding ideas, he has to come up with dozens upon dozens of great ideas just to maintain his track record. The outstanding returns from his very best ideas are hopelessly diluted.

There are numerous hidden costs related to the size of a mutual fund. The short-term outlook and high turnover rates of most actively managed mutual funds make things even worse.

As to what should be the maximum size of a mutual fund, John Bogle mentioned what his own son did as an active manager: he closed two funds when their assets reached $100 million.

This takes me back to pages 252 and 253 in Chapter 11, where John Bogle discusses enhanced indexing. Enhanced indexing differs from closet indexing because it is openly disclosed as a fund objective and based upon market opportunities such as reflected in low price to earning ratios and low price to book ratios. I refer to such practices as price discipline. Early results are promising, producing a small but meaningful edge provided that expenses are kept very low.

[Typically, a person who invests in individual stocks can purchase stock when prices are in the lower third of their 52-week range and sell them when they are in the upper third of their 52-week range. The minimal holding period should be about a decade to keep transaction costs low. The ratio of highs and lows of the 52-week range is usually 1.5 to 2.0 or even more. Typically, this adds 1% or 2% to the return of a stock.]

I find such remarks very encouraging for the individual investor with less than $100 million to invest.

Going back to Chapter 9, which talks about selecting superior funds, I see more signs of encouragement for those of us who purchase individual stocks. The first thing is that I noticed was the use of a single yardstick that seldom applies to anyone. Funds are judged in terms of a single purchase at the beginning and a single sale at the end. Funds are not judged in terms of more realistic buying patterns such as a series of small purchases followed by a later series of withdrawals. Funds are not judged according to additional constraints such as the maximum decline that investors will tolerate as a function of time. Everything is rolled up into a single case (or a handful of limited conditions). There is only one criterion for success or possibly two: the buy and hold return of the fund possibly combined with a simple constraint on volatility.

I was also encouraged to know the limitations built into various studies. In terms of relative performance and time comparisons, the studies typically measure skill in terms of two years or less. [This is in sharp contrast to Mark Hulbert's recommendation to use the 9-year history of newsletter writers (and definitely not to use anything as short as Morningstar's 3-year metrics except to weed out consistent losers).]

I have come to believe that John Bogle is largely responsible for much of today's mindless nonsense about market timing. He uses the term much too loosely. He applies the failure of timing associated with frequent, short-term trading activity much too broadly. When neither Warren Buffett nor Sir John Templeton can find any stocks worth buying in the United States, I do not consider their recommendations to hold off buying as being market timing in the usual sense. Technically, it is timing because markets change and opportunities are likely to occur in the future. But I think that it should be recognized for what it is: just waiting for good prices.

Have fun.

John R.
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