Investment Relativism: Why Fund Returns Lie to You (Chapter 11)

Book: Common Sense on Mutual Funds: Fully Updated 10th Anniversary Edition by John C. Bogle ISBN: 978-0-470-59748-4

Bogle calls this chapter “Happiness or Misery?” and borrows from Charles Dickens to make his point. Specifically, he pulls out Mr. Micawber’s famous formula from David Copperfield. Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

Bogle applies this to investing. Market returns 17.8%, your fund returns 18.3%? Happiness. Your fund returns 13.2%? Misery.

Welcome to the Age of Investment Relativism. Where everything gets measured against the S&P 500, and almost everyone comes up short.

The Benchmark Problem

At some point in the 1990s, everyone started comparing their fund returns to the S&P 500. It became the universal yardstick. Your 401(k) report shows it. Financial news anchors talk about it. Your uncle at Thanksgiving brings it up.

And here’s the problem. Over the 15-year period ending in 1998, the average equity mutual fund trailed the S&P 500 by about 4.6% per year. Per year. That’s not a small number. Over 15 years, that gap turns into a massive difference in your actual wealth.

So most fund investors were living in Micawber’s misery. Their funds were making money in absolute terms, sure. But relative to what they could have earned by just buying the whole market? They were falling behind every single year.

Closet Indexing: The Worst of Both Worlds

This benchmarking obsession created a weird side effect. Fund managers started getting scared of looking too different from the S&P 500. If you deviate from the index and it works, you’re a hero. But if you deviate and it doesn’t work, you get fired.

So what did many managers do? They started building portfolios that basically looked like the index. Same stocks, similar weights. Just different enough to technically be “active management.” But not different enough to actually produce different results.

Bogle calls this closet indexing. And it’s genuinely the worst of both worlds. You get index-like returns, minus the high fees of active management. You’re paying active management prices for a product that’s basically an expensive index fund.

This is still a massive problem today. Studies have found that a huge percentage of actively managed funds are essentially closet indexers. You’re paying 1% or more for something you could get for 0.03% with an actual index fund.

The Big Lie: Time-Weighted vs Dollar-Weighted Returns

OK. This is the part of the chapter that honestly made me a little angry. Because it reveals something that the fund industry really doesn’t want you to think about.

When a fund reports its returns, it uses something called time-weighted returns. This measures how the fund itself performed. If you put in $10,000 at the start of the year and it grew to $11,000, that’s a 10% time-weighted return. Simple enough.

But that’s not what most investors actually earn. Because most investors don’t put in their money at the start and leave it alone. They add money after the fund has already gone up (because they heard it’s doing well). They pull money out after it drops (because they’re scared). They buy high and sell low, basically.

The return investors actually earn based on the timing and amount of their cash flows is called the dollar-weighted return. And it’s almost always lower than the time-weighted return.

Sometimes dramatically lower.

The Timing Gap Is Enormous

Bogle dug into the numbers and found that the gap between what funds reported and what investors actually earned was staggering. In some cases, 5 to 10 percentage points.

Let me say that again. A fund could report 15% annual returns over a decade, and its average investor might have actually earned 5% or even less. Because the investors who piled in money did so after the big gains had already happened. And the investors who pulled out did so right before the recovery.

This is human nature at work. We see a fund going up and we want in. We see a fund going down and we want out. It feels like the smart thing to do. But it’s exactly backwards. You’re systematically buying high and selling low.

And here’s what makes this extra frustrating. The fund industry has zero incentive to fix this. They report time-weighted returns because those numbers look better. They advertise their best performing periods. They know that this attracts money from investors who will then earn less than the reported returns. But more money flowing in means more fee revenue. So everyone’s happy except the investors.

The Industry Looks Fine on Paper

This is Bogle’s real insight in this chapter. If you look at the mutual fund industry’s reported numbers, things look OK. Not great, but OK. Most funds trail the index, but plenty of them still make money for investors in absolute terms.

But once you switch from reported returns to actual investor returns, the picture gets much darker. The actual money that actual people earned is far less than what the brochures say. The performance gap from fees is bad enough. But the behavior gap from bad timing makes it so much worse.

And nobody in the industry talks about this. Because why would they?

If You Can’t Beat ‘Em, Join ‘Em

Bogle’s conclusion is pretty straightforward. If most active funds trail the index, and investors in those funds do even worse than the funds themselves, then the answer is obvious. Just buy the index.

An index fund solves both problems at once. It matches the market return (minus tiny fees), which already puts you ahead of most active funds. And because there’s nothing to chase, no hot manager, no exciting strategy, investors in index funds tend to have a smaller behavior gap. There’s less temptation to jump in and out because the fund is never going to be the “hottest fund of the year.”

It’s boring. But boring is the point. Boring means you actually keep your money invested. Boring means you don’t mess things up by chasing performance. Boring means you earn something close to the market’s actual return.

This Problem Has Gotten Worse

Since Bogle wrote this, the behavior gap has probably gotten wider. Social media, real-time portfolio tracking, financial influencers showing off their returns. All of it creates more temptation to chase whatever’s working and abandon whatever’s not.

Every few years there’s a new hot thing. Crypto in 2021. AI stocks in 2024. Whatever comes next. And every time, people pour money in after the big gains and get crushed when things cool off.

The data keeps confirming Bogle’s point. Dalbar’s annual studies consistently show that the average equity fund investor earns far less than the funds they invest in. The gap between fund returns and investor returns hasn’t closed. If anything, it’s widened.

So the next time you see a fund advertising amazing returns, ask yourself: is that what the fund earned, or what the investors earned? Because those are two very different numbers.

Previous: Reversion to the Mean (Chapter 10) Next: Asset Size (Chapter 12)