We asked an investing legend if mutual funds are doomed, and his answer was just brutal

Vanguard founder John BogleVanguardVanguard founder John Bogle.

Active investment managers — investors that try to beat market indices — are in a tough spot.

There’s one man that could take most of the blame — Vanguard founder John C. Bogle, whose behemoth firm — now with $3.9 trillion under management — continues to attract assets, all while costing clients a tiny fraction of the cost of active management.

That’s great for Main Street investors, who can reap market gains on the cheap, but bad for Wall Street managers who need to be paid for their analysis and trading costs.

Last year, investors pulled $2oo billion from active US equity funds, the largest divestment from active management, while passive equity funds attracted $150 billion, according to JPMorgan data. A lot of that has to do with lousy performance.

In a recent extensive interview with Business Insider, Bogle laid out the bleak future for active managers — and where there still might be opportunities. Here’s an excerpt from the interview (emphasis added):

Levy: Vanguard’s CEO, Bill McNabb, recently said that active managers have a chance to survive and prosper, but with lower fees. Do you agree?

Bogle: I’m not about to disagree with the head of our company. The question that hangs out here is how much they have to cut their fees. The average fee is about 1%, give or take, and you can buy an S&P 500 index fund at Vanguard for five basis points [0.05%]. If you cut fees 50%, you’d still have fees 10 times as high as Vanguard. I’m not sure how much that would help you.

Levy:Are active-asset managers such as traditional mutual funds doomed then?

Bogle: The active managers have a philosophy they can win. They come into the office every day and say, “Boy, Mark, I’m going to beat the heck out of you today,” and they don’t. When they have a bad year, they say it’s that year; I’ll do it next year. It’s a hard business and it’s not the expense ratios that have to be cut, but also the trading. The transaction costs are very high — they’re hidden; they’re not going to tell you what they are — they are there and they are large.

The active managers have their work cut out for them. One thing they could do is put in an incentive fee. Get 10 basis points or five [0.10% or 0.05%], unless they beat the market. We’re paying people to beat the market when they aren’t doing it, and when you think about it, that doesn’t make sense.

They can put their expense ratio at 5 [basis points, 0.05%] and get another 1% if they beat the market by X. But they have to, under the SEC rules, be symmetrical. So if they lost to the market by 1%, they would be out of pocket. Managers, at least in this context, are not stupid. They know perfectly well they are going to lose that bet.

There’s some hope for active managers, but not much, according to Bogle. “If you’re very talented and keep winning, you’ll do just fine. It may take a while. But the talent is hard to identify and talent is hard to tell from luck,” he added. “There’s an awful lot of luck in this business.”

Here’s more from Bogle (emphasis added):

“I was just looking at a chart here we did for the Bogleheads. We took the top quintile of funds for the five years ending in 2010 and looked where they ranked over the next five years, 2010 to 2015.

Vanguard study on performanceVanguardOnly 16% of top-performing active funds remained top performers five years after 2010, according to a Vanguard study.

The highest quintile, 16% of the funds remained in the highest quintile, and 24% went to the lowest quintile.

If you look at the lowest quintile from 2010, 15% went to the highest quintile, and only 9% stayed in the lowest quintile.

It’s a very discouraging chart if you’re an active manager. It’s reversion to the mean, and it happens everywhere.”

Read the full Business Insider interview with Bogle here.

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