Disagreement With A Legend

Jack Bogle may have contributed more to the investment management industry than any other human in history.  Mr. Bogle is the founder of Vanguard, the largest mutual fund company in the world, and innovator who came up with the idea of the shareholders owning the funds they invest in.  Because of this structure (no shareholders who are demanding profits), they are able to keep their fees exceptionally low, which is one of the reason we use them for our clients.  They are also the fund company that popularized index funds, espousing the idea that owning the entire market passively is a much better bet than trying to pick winning stocks.  Low fees, broad diversification…what's not to like?

In listening to a recent interview with Mr. Bogle, I found myself agreeing with almost everything he said.  Almost everything.  When the interviewer asked Bogle about investing outside the US he argued against it, claiming excessive risk and lack of returns.  Here are his comments when asked about investing in an international index fund (that his company provides!):

"So if people knew they were putting 45% of their so-called international, non-US, money in Great Britain, France and Japan — I mean every one of those three countries has real problems," Bogle said.

"The French don’t work very hard, The Japanese have a structured and deeply aging economy overburdened by future retirement claims… Britain doesn’t know what’s going to happen if they do the exit from the European community, nor do they know what’s going to happen if they stay in."

Seems like a logical argument.  The heaviest weightings in the international index have real problems.  Why would you want to invest in them?

Here is the issue.  It flies in the face of the very theory he is promoting at Vanguard!  When you invest in index funds you are taking the stance that markets are efficient so it is pointless to try to outguess it by picking stocks.  The data totally backs up Vanguard's claim on the merits of index funds, by the way.  So when Bogle states all the reasons why international stocks won't perform as well as US stocks, he is basically saying that the market is inefficient.  You see, he is probably right when he states all the problems with France, Japan and Great Britain, but what he doesn't seem to understand is that the market knows exactly what he knows (probably more).  If that is the case, the market should be pricing in that lower growth in the form of cheaper stock prices.  In fact, the market is doing exactly that.  According to Henderson Global Investors, the Price-to-Earnings Ratio (which is a measure of how expensive a stock is) in 2016 for the US is 17 while in Japan and Europe it is 14. 

Let me even do a little thought experiment using Japan.  Let's say tomorrow morning you wake up to the headline that Japan has had a massive census error and instead of their population being older than every other developed nation, that it is in fact the opposite.  There is a huge generation of working aged Japanese that were unaccounted for.  In addition, their massive debt has really been an accounting error.  In fact, they have been in the black for years and in fact have surpluses (I know it seems crazy, but bear with me).  What do you think would happen to their stock market when it opened for trading?  My guess is that it would go up…probably a lot.  Why?  Because the market would adjust to the new reality that Japan is not as bad as originally thought.  If you believe that statement, then you also have inadvertently believed that the market is efficient.  It is pricing Japanese stocks today at a level much lower than it otherwise would, to account for all the problems in the Japanese economy.

This explains the simple truth that "the stock market is not the economy" (it is actually very funny to look at the chart on this post since it comes from Vanguard!).  Trying to claim, like Bogle, that the stock market's performance will be the same as the country's performance is just not backed by any evidence. The US economy could do significantly better than Japan over the next 10 years and their stock markets could do the exact opposite.  All that matters with the stock market is expectations.  If Japan beats very low expectations, they could easily do better than the US (who has very high expectations).

So to circle back on the original question- Greenspring respectfully disagrees with Mr. Bogle.  We believe that investors should have an allocation of their portfolio to foreign stocks.  We have found they add diversification value (as evidenced here, here and here) which for many investors is key to smooth out their returns.

More Conflicts At Big Brokerage Firms

Did you ever wonder how a financial advisor makes their investment recommendations?  There are thousands of mutual funds on the market today.  How does he/she pick one over the other?  If your advisor works for a big brokerage firm like Morgan Stanley or Merrill Lynch, some of the decision making is taken out of his/her hands.  There is a little known practice that happens in which funds pay for "shelf space".  In order for a fund to be offered on a large brokerage firm's platform, they must pay hefty fees.  Some fund companies are happy to do this in order to gain distribution, while others refuse.  Here is Jason Zweig of the WSJ discussing some of the nuances:

The financial industry calls these fees “payment for shelf space,” and they can add up. At Edward Jones, revenue-sharing fees from fund companies topped $153 million in 2014, or just under 20% of the the St. Louis-based brokerage and advisory firm’s total net income that year.

At Merrill Lynch, fund companies pay up to 0.25% of sales and 0.10% of assets annually for “marketing services and support,” according to a 2015 disclosure. Morgan Stanley collects $750,000 per year from each of 28 fund companies it has designated “global partners” and $350,000 annually from each of another 11 “emerging partners,” according to the firm’s latest available disclosure.

The disclosure statements warn that revenue sharing can be an ethical minefield. Edward Jones says the payments create “an additional financial incentive and financial benefit” to the firm and its advisers. Merrill Lynch points out that funds that don’t enter into such arrangements “are generally not offered to clients.” Morgan Stanley says the firm may “promote and recommend” funds that pay higher revenue sharing.

Do you think there is a conflict here?  You bet.  Let me give you a real life example.  Before I founded Greenspring, I was employed by one of these large institutions.  After doing some of my own research I found a fantastic real estate fund that I thought would make sense to own in client portfolios.  But since this fund company was not willing to pay a portion of their revenue to my firm I was not able to offer it to clients.  As an advisor, when you can't recommend products that are in your client's best interest, there is a conflict.  One other thing you have to realize…the only way for the economics on this type of arrangement to work is by using high fee funds.  If you are offering your products on Merrill Lynch's platform, you can't pay Merrill Lynch 0.35% in the first year if your expense ratio is 0.2%.  Why do you think you can't buy a Vanguard mutual fund at these firms (which by the way is probably one of the best fund companies on the planet)?  Because Vanguard only charges 0.1%-0.2% for many of their fund expenses.  They don't charge enough to share fees.

Many investors think that a fee-based relationship is the same whether it is at Merrill Lynch, Morgan Stanley or an independent firm.  It's not.  While you may be paying similar fees to your advisor in each of these scenarios, what you don't see is that independent firms don't charge for shelf space, and therefore are free to recommend any product they think is best for their client.  The big firms only recommend funds that have paid them for shelf space.  This can have a major impact on fund selection and portfolio performance.

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.