The Cost Wedge: an American perspective
My professional body’s journal (Financial Analysts Journal) this month includes an article by John Bogle of the Vanguard mutual fund group in America. Bogle is unmatched in the UK. We have no top executive within financial services who has demonstrated over an entire career a dedication to the interests of the customer as the very basis of professional stewardship of money. A deeply old-fashioned philosophy, it has been repaid handsomely in Vanguard’s steady growth in market share for the past 30 years.
His theme in The relentless rules of humble arithmetic is what I call the Cost Wedge: the total cost of going through the industry to get your money to work in financial markets. The message is simple but needs to be better heeded in the UK. The simplest and most certain way to increase the output of your savings is not by trying harder or by taking more risk but working your way down the Cost Wedge.
The article is based on analysis of the last 20 years of data for actively managed equity funds investing in the US equity market. The benchmark is a low-cost S&P 500 index fund. The raw results indicate that the average active fund has reduced the compound growth rate of the index fund, which is 13%pa, by 2.8%. These are obviously nominal not real returns. The 2.8% wedge drives deeper into market returns when inflation is taken off: 2.8% out of 10.0%.
In America, realised gains in a mutual fund need to be distributed so active funds expose investors to taxes that are deferred in an index fund. This accounts for a further 2.2%. (In the UK too, active management increases the incidence of taxable gains at the investor level, because it requires investors to be active too, instead of buying and holding. The UK version of the tax wedge has been exacerbated by the replacement of indexation by taper relief.)
The US research picks up on another error that goes hand in hand with active management: chasing specialist funds that are flavour of the month. When average returns are recalculated using weightings based on fund flows, the Cost Wedge increases to a staggering 6.7% – half the nominal return.
The Cost Wedge works on wealth like compound interest in reverse. Bogle illustrates this using an example of a young worker with 45 years of pension accumulation to look forward and (on current mortality) 20 years of decumulation – potentially 65 years of negative compounding. Assuming the equity market as a whole provides a reasonable nominal return of 8% and the Cost Wedge is 2.5%, $1,000 invested in an index fund will compound to $148,800. In the average active fund the pull-through rate, after the wedge, is just $32,500. For passing through the industry to expose your money to the systematic market return for 65 years, it will take 78% of the growth.
Because of the growing importance of individual retirement provision, for many of the same reasons as here, Bogle argues that the nation’s interests are too important to let this market failure persist.
Not that he offers a solution for it. But Lord Turner, the author of the recent Pension Commission report, does. The market having failed to commoditise the investment function and bring economies of scale to bear, he suggests the solution is centralised gathering of contributions with management contracts put out to tender on very tight terms.
Whatever your free market instincts, it is very hard to argue against some such mix of public and private processes. It is the only true alternative to compulsion, which really does offend free market instincts.