What Las Vegas can teach us about mutual-fund investing
When you go to Las Vegas, one of the important things to know is what the "vig" is for whatever game you choose to play.
The vig, or "vigorish," is the amount the house takes out of the pot.
Play where the vig is high, and it is likely you will lose your money quickly. Play where the vig is low, and you've got a shot at staying in the game longer.
Why am I telling you this?
Because there is a vig in mutual-fund investing, too. It's called the expense ratio.
If you bought shares in a low-vig fund such as the Vanguard 500 Index Fund 15 years ago, you earned an annualized 5.57 percent over the period after annual expenses of 0.17 percent. It was not a wonderful period for the index because it provided only a better performance than 60 percent of its surviving higher-vig managed competitors. (Over the three-, five-, 10- and 15-year periods, it did better, on average, than 70 percent of its competitors.)
Just 40 percent of funds in what Morningstar calls the "large-blend" domestic equity category provided higher returns than the index fund.
They averaged an annualized return of 6.82 percent and averaged expense ratios of 1.17 percent. In other words, if you took a chance and paid a higher vig, you had a chance of increasing your return.
But was it worth it? If you committed to paying a full 1 percentage point more in expenses, you had a chance of increasing your annualized return by an average of 1.25 percent.
Unfortunately, you had only a 40 percent chance of gaining that 1.25 percent, taking its real value down to 0.5 percent. So you were certain to pay 1 percentage point more each year to get a return that would likely be only 0.5 percentage point higher.
A bet on a managed fund was about as bad as buying a state lottery ticket — the intrinsic value of the managed fund "ticket" was worth only half the gain. (It isn't quite that bad because stocks tend to have positive returns, so they are a positive-sum game. Gambling is always a zero-sum game in which a fixed pot of money is redistributed.)
This is not a stacked-deck example. Focus on fixed-income investing and the house vig is just crazy.
In one of the largest fixed-income categories, intermediate bonds, there was virtually no chance of beating the Vanguard Intermediate Term Bond Index Fund over 15 years.
The index fund was in the top 5 percent, earned 7.08 percent a year and cost 0.22 percent, while the average managed fund cost 0.89 percent but earned only 5.79 percent.
Funds that did better than the index averaged a 7.58 return, only 0.5 percent more than the index fund. In effect, managed fixed-income fund investors were paying 0.67 percent a year more for the privilege of having a 5 percent chance of gaining an average increase in return of 0.5 percent. What a deal!
Is all this new to you? Well, don't feel bad. It's new to most people, whether they are playing on Wall Street or in Las Vegas.
But in both places, you've got better odds if you play where the vig is low.