The Vanguard Group
Whether Markets are More Efficient or
Less Efficient, Costs Matter

By John C. Bogle
Founder and former CEO
The Vanguard Group

From the Nov-Dec 2003 issue of CFA Magazine

More than a century has passed since Louis Bachelier, in his Ph.D. thesis at the Sorbonne in 1900, wrote: “Past, present, and even discounted future events are (all) reflected in market price.” Nearly half a century later, when Nobel Laureate Paul Samuelson discovered the long-forgotten thesis, he confessed that he “oscillated . . . between regarding it as trivially obvious (and almost trivially vacuous), and regarding it as remarkably sweeping.”

Bachelier, of course, was right. By 1965, University of Chicago Professor Eugene F. Fama had performed enough analysis of the ever-increasing volume of stock price data to validate this “random walk” hypothesis, rechristened as the efficient market hypothesis (EMH). Today, the intellectual arguments against the EMH religion are few. The church, however, has three different dogmas. Princeton Professor Burton Malkiel describes them: the weak form (stock price changes over time are statistically independent); the semi-strong form (prices quickly reflect new value-changing information); and the strong form (professional managers are unable to accurately forecast the future prices of individual stocks).

Whatever the form of the EMH, I know of no serious academic, professional money manager, trained security analyst, or intelligent individual investor who would disagree with the thrust of EMH: The stock market itself is a demanding taskmaster. It sets a high hurdle that few investors can leap. While the apostles of the new so-called “behavioral” theory present ample evidence of how often human beings make irrational financial decisions, it remains to be seen whether these decisions lead to predictable errors that create systematic mispricings upon which more rational investors can readily capitalize.

In the summer of 1951, not long after I came into this business, I first heard that era’s pungent description of behavioral theory: “The crowd is always wrong.” (While I’m inclined to agree with that formulation, I’d substitute usually for always.) But I remain mystified about just how it is that “the crowd” can be wrong when, in the (essentially) closed system that is our stock market, every seller must be met by a buyer, and vice versa. Such a match, of course, is not necessary in each subset of the system. Indeed, in the mutual fund subset the crowd is almost always wrong. Investors are legendarily indifferent to buying equity funds until a bull market is well underway, but pour staggering amounts of capital into them as the subsequent and inevitable bear market approaches. To make matters worse, the objects of investor affection are usually the funds with the highest past performance, which of course are about to suffer the largest declines.

But the EMH may well prove less important in investment theory than a new wisdom that is beginning to emerge. I call it the CMH: The Cost Matters Hypothesis. Like the EMH before it, the CMH posits a conclusion that is both trivially obvious and remarkably sweeping: The mathematical expectation of the speculator is a loss equal to the amount of transaction costs incurred. When he concluded otherwise, that “the mathematical expectation of the speculator is zero,” Bachelier was wrong.

So, too, the mathematical expectation of the long-term investor is a shortfall to the stock market’s return, a shortfall that is precisely equal to the costs of our system of financial intermediation—the sum total of all those advisory fees, marketing expenditures, sales loads, brokerage commissions, transaction costs, custody and legal fees, and securities processing expenses. Intermediation costs in the U.S. equity market may well total as much as $300 billion a year, nearly 3% of the value of that $12 trillion market.

We don’t need the EMH to explain the dire odds that investors face in their quest to beat the stock market. We need only the CMH. Whether markets are efficient or inefficient, investors as a group must fall short of the market return by the amount of the costs they incur. And since the cost of our intermediation system is relatively stationary over short periods, the impact of that cost is inversely correlated with the returns on stock prices (i.e., a 3% annual cost would consume one-fifth of a 15% market return, but fully one-half of a 6% return.) Even for investors who incur more modest costs (say, 1% per year), the odds are that 95% of them will fail—often by huge amounts—to earn the stock market’s return over an investment lifetime.

It is often alleged that in “less efficient” markets, investment managers can provide investors with superior returns. But the CMH shows not only why that can’t be so, but why the reverse is true. Consider the logic: Mutual fund expense ratios and portfolio transaction costs are lower in the most efficient segments of the market, and higher in its least efficient segments. Therefore in the efficient large-cap sector, if the smartest (or luckiest) investor can beat that market segment by two percentage points annually, then the dumbest (or unluckiest) must lose by two percentage points. If the costs of large-cap funds average 1 ½ percentage points per year, then the winner wins by ½ percentage points net and the loser loses by 3 ½ percentage points net.

Now let’s assume that in the less efficient small cap sector the winner can win by twice as much, say, four percentage points, with the loser inevitably losing by the same amount. But with fund costs of, say, 3 percentage points in this segment, the winner tops the segment return by just 1 percentage point and the loser falls fully 7 percentage points behind. Inefficient markets, may create the opportunity to win by a larger margin, but they are inevitably accompanied by the equal opportunity to lose by a larger margin as well. The higher costs incurred in such markets increase disproportionately the penalties of failure.

Now for the really bad news. Investors pay their investment costs each year in nominal current dollars, but they measure their long run investment success in real dollars, almost inevitably eroded in value by inflation. The nominal long-term returns of about 10 percentage points on stocks that the financial intermediation system waves before the eyes of the naive investing public turn out to be about 6 ½ percentage points in real terms. When we realize that in the mutual fund industry intermediation costs total as much as three percentage points annually, they confiscate nearly one-half of the historical real rate of return on equities. And when we subtract the cost of taxes (paid by taxable investors in current, nominal dollars), and contemplate an era in which returns may well fall below historic norms, we look at potential investment accumulations in a new and harsh light.

The academic and financial communities have dedicated enormous intellectual and financial resources to studying past returns on stocks, to regression analysis, to modern portfolio theory, to behaviorism, and to the EMH. It’s high time we turn more of our attention to the CMH. We need to know just how much our system of financial intermediation has come to cost, to know whether high turnover pays, to know the real net returns that managers deliver to investors, and to evaluate the perverse impact on investors of the irrational investment choices offered by the mutual fund industry.

Investment professionals need not—indeed since time is money to our clients, must not—wait to act until those studies confirm much of what our intuition tells us already—things that are, well, “both trivially obvious and remarkably sweeping.” We must be figuring out how to take a major chunk of costs out of our system of financial intermediation—eliminating excess capacity, as the economists would say—so as to reduce the burden of costs and taxes on our clients. And it’s high time we become more serious about accepting the merits of passive all-stock-market investing as a separate and distinct asset class. It is never too late to begin to build a better world for the investors of tomorrow.



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