The Bogle Blog

[Cool Dood]

No doubt many of you know John C. Bogle, of Vanguard -- now he has a blog:

http://johncbogle.com/wordpress/

If someone's already mentioned this, please delete my post.

[donheff]

Bogle's recent speech that he posted on the blog is interesting. He makes a good case (big surprise here) for low expense index funds as do most of the posters on this board. Being a recent member, I have never seen the previous threads people have referenced to the cost issue. So, I hope you will tolerate me bringing the issue up for another airing and give me the benefit of your research.

For now a BIG chunk of my wife's savings are in a group of 401k, IRA, and retirement funds setup by her firm. These funds are all highly rated by Morningstar and offer a good opportunity for diversification. But they are managed funds and have costs substantially higher than the .20 mentioned by Bogle or the .18 Firecalc default. But I am still unsure how to evaluate costs in these managed funds. When Morningstar reports fund performance as compared to various indexes they appear to be asserting that the funds' "costs" are already discounted from the reported returns. But Bogle seems to be saying otherwise -- and he has 55 years of experience.

So, once again for the dumb guys, how does this work?

[ats5g]

Quote:

Originally Posted by donheff Bogle's recent speech that he posted on the blog is interesting. He makes a good case (big surprise here) for low expense index funds as do most of the posters on this board. Being a recent member, I have never seen the previous threads people have referenced to the cost issue. So, I hope you will tolerate me bringing the issue up for another airing and give me the benefit of your research. For now a BIG chunk of my wife's savings are in a group of 401k, IRA, and retirement funds setup by her firm. These funds are all highly rated by Morningstar and offer a good opportunity for diversification. But they are managed funds and have costs substantially higher than the .20 mentioned by Bogle or the .18 Firecalc default. But I am still unsure how to evaluate costs in these managed funds. When Morningstar reports fund performance as compared to various indexes they appear to be asserting that the funds' "costs" are already discounted from the reported returns. But Bogle seems to be saying otherwise -- and he has 55 years of experience. So, once again for the dumb guys, how does this work?

All of Morningstar's performance numbers, as well as the performance numbers in a fund's prospectus are all after investing costs, with the exception of taxes and purchase costs. For example, if you pay $15 to buy a fund at a brokerage, that wouldn't be reflected in Morningstar's performance numbers.

So, Morningstar's numbers reflect the fund's performance after the expense ratio and transaction costs [buying and selling of the stocks]. In his speech, Bogle's Rule of thumb is: turnover costs equal 1 percent of turnover rate. So, "50 percent turnover would cost about 0.50 percent; and 10 percent turnover would cost about 0.10 percent, and so on."

that help any?

- Alec

[elroy]

Thanks. This is why I love this board. I did not know Bogle had a blog (Wasn't that a Dr. Zuess book). This is new to me and I will make it a routine stop.

[donheff]

Quote:

Originally Posted by ats5g So, Morningstar's numbers reflect the fund's performance after the expense ratio and transaction costs [buying and selling of the stocks]. In his speech, Bogle's Rule of thumb is: turnover costs equal 1 percent of turnover rate. So, "50 percent turnover would cost about 0.50 percent; and 10 percent turnover would cost about 0.10 percent, and so on."

So if the Morningstar rates of return are the "real" rates, then the turnover costs must be "impact" costs on the investor due to taxes, correct?

[ats5g]

Quote:

Originally Posted by donheff So if the Morningstar rates of return are the "real" rates, then the turnover costs must be "impact" costs on the investor due to taxes, correct?

There are two costs to turnover.

The first is that every time a fund buys and sells and security [stock, bond, etc] in the market, that fund has to pay a small cost for the execution of that trade [commissions, spread, etc.]. This is what Bogle is using his rule of thumb for.

The second cost is taxes. Every time a fund receives a dividend or realizes a capital gain [long term or short term by selling a security], that fund is required to distribute that dividend or gain to the fund's shareholders. Otherwise, the fund itself has to pay the taxes on that dividend or gain. For example, when Fidelity's Magellan fund reconfigured its holdings, it had to pay out a huge capital gain [see Fund Times: Magellan Makes Big Payout]. Higher turnover generally leads to more capital gains distributions, and more short term capital gains distributions [short term capital gains are taxed at your marginal tax rates, not the lower long term cap gains tax rates]. Lower turnover leads to capital gains tax deferral, allowing those gains to compound.

Some turnover is not that bad though. For example, funds that are specifically managed to minimize taxes, like Vanguard's Tax-Managed Small Cap whose turnover is 20%, will have more turnover because the fund is selling stocks at a loss, to generate capital losses, in order to offset the capital gains generated by having to sell stocks at a gain. This way, the fund can minimize its capital gains distributions to its shareholders. This is also done by funds like Bridgeway Ultra-Small Company Market.

- Alec

[donheff]

Quote:

Originally Posted by ats5g There are two costs to turnover. The first is that every time a fund buys and sells and security [stock, bond, etc] in the market, that fund has to pay a small cost for the execution of that trade [commissions, spread, etc.]. This is what Bogle is using his rule of thumb for.

Is this transaction cost not already accounted for in Morningstar's report return?

Quote:

Every time a fund receives a dividend or realizes a capital gain [long term or short term by selling a security], that fund is required to distribute that dividend or gain to the fund's shareholders. ... Lower turnover leads to capital gains tax deferral, allowing those gains to compound.

Here I am assuming that those distributions are included in Morningstar's total return rates. So the impact depends on the investor's tax situation.

What I am trying to figure out is how good or bad the given set of funds we have is relative to our specific tax situation. I want to be sure I understand what hidden costs I am missing in some managed funds vs. an index.

For example, how do you choose the "cost" factor to enter into Firecalc if the internal costs are already incorporated into the Morningstar figures.

[youbet]

Quote:

Originally Posted by donheff For example, how do you choose the "cost" factor to enter into Firecalc if the internal costs are already incorporated into the Morningstar figures.

The cost factor you enter into Firecalc is the* wieghted average of the expense ratios and any 12b-1 fees your funds charge.

Also, remember for the equity portion, Firecalc assumes the historical performance of the S&P 500, not the investment strategy of some managed fund you may own.* So, to the extent that your managed funds do not follow the S&P 500, Firecalcs historical testing of your situation will not be appropriate.

[SolidA]

It was good to see Bogle on the PBS Frontline show on retirement last night - he always has intelligent, relevant things to say. *Glad to see he has a blog.

[ats5g]

Quote:

Originally Posted by donheff Is this transaction cost not already accounted for in Morningstar's report return? Here I am assuming that those distributions are included in Morningstar's total return rates. So the impact depends on the investor's tax situation. What I am trying to figure out is how good or bad the given set of funds we have is relative to our specific tax situation. I want to be sure I understand what hidden costs I am missing in some managed funds vs. an index. For example, how do you choose the "cost" factor to enter into Firecalc if the internal costs are already incorporated into the Morningstar figures.

Yes, Morningstar's pre-tax returns account for the every cost of the fund [expense ratio, transaction costs] except for taxes.

- Alec

[donheff]

Quote:

Originally Posted by youbet The cost factor you enter into Firecalc is the wieghted average of the expense ratios and any 12b-1 fees your funds charge.

I guess I may be droning on with my questions but, what the hey, you folks are patient.

Based on what I am reading here, I would assume I should use Firecalc for what it does -- generate an estimate of how you would do in an index fund that continued to perform forever as it has in the past. Morningstar would describe that past performance as S&P - .18 (since the .18 would already be included in the Morningstar return). That is a very useful benchmark of how things may go.

Entering the average expenses of my current funds in Firecalc would make no sense unless I concluded those funds are likely to return approximately S&P minus current expenses.

[youbet]

Quote:

Originally Posted by donheff I guess I may be droning on with my questions but, what the hey, you folks are patient. Entering the* average expenses of my current funds in Firecalc would make no sense unless I concluded those funds are likely to return approximately S&P minus current expenses.

Correct. Or at least that's the way I understand it. Firecalc tests withdrawal rates, given specified asset allocations and expense ratios. Equity allocation is in S&P 500. Fixed you have a few choices. Firecalc doesn't answers questions such as "what if my portfolio was a string of apartment buildings on the south side of Minneapolis?" Or "what if I put all my money into GM preferred stock?"

[riskadverse]

Quote:

Originally Posted by ats5g There are two costs to turnover. ... The second cost is taxes. Every time a fund receives a dividend or realizes a capital gain [long term or short term by selling a security], that fund is required to distribute that dividend or gain to the fund's shareholders. Otherwise, the fund itself has to pay the taxes on that dividend or gain. For example, when Fidelity's Magellan fund reconfigured its holdings, it had to pay out a huge capital gain [see Fund Times: Magellan Makes Big Payout]. Higher turnover generally leads to more capital gains distributions, and more short term capital gains distributions [short term capital gains are taxed at your marginal tax rates, not the lower long term cap gains tax rates]. Lower turnover leads to capital gains tax deferral, allowing those gains to compound. ...- Alec

To give a real world example, without warning, my MIL just got $180K in distribution from her Fidelity Magellan investments.* *That's about 4 years worth of her expenses.* *I doubt if Fidelity, (or mutual funds) will ever see any reinvestment from her again.*