John Bogle on Opportunity Cost

1. Tangible Costs . . . management fees and trading commissions. Each dollar given away for, say, management fees is a dollar explicitly detracted from the portfolio net return. 2. Managed Costs . . . unintended risk exposures, tax costs, and Not-Equitized- Cash, an opportunity cost for not keeping funds fully invested. 3. Invisible Cost . . . the adverse market impact of trading and the opportunity cost of delaying trade execution. Result: “Simply put, every incremental basis point increase in rate of return translates into competitive advantage (by which) a firm improves its absolute performance and its ranking relative to its peers.” Thus, what the study calls the Complete Firm, the firm that “will lead the way . . . will diligently seek to minimize these performance detractors.” Thus spaketh, I remind you, not Vanguard/BOGLE, but Merrill Lynch/BARRA. Here is their prescription for curing the disease: “Releasing Embedded Alpha.” 1. Take a Holistic View (whatever exactly that is in this instance). Appoint a single Embedded Alpha champion with the firm. 2. Take an Alpha Inventory. Develop a coherent policy, and review all work processes. 3. Set Priorities. Widen managerial bandwidth. (Again, I confess my ignorance of the term in this context.) 4. Develop a Strategic Agenda that sets goals by which to measure success. 5. Make It Real on the Shop Floor, communicating the agenda and aligning incentives accordingly. 6. Tell the Market.

Mutual Fund Costs Are Declining ICI Position: Ownership cost of equity funds down 40%. • 1980 231 bps; 1998 135 bps (Load 200 bps, no-load 83 bps). Specific Flaws: 1. Weighted by sales volume. Unweighted expense ratio up 64% — 96 to 158 bps. 2. Lowest cost decile up 28% from 71 bps to 90 bps (1997). 3. Ignores hidden cost of portfolio turnover (50 to 125 bps). 4. Ignores opportunity cost (60 bps). 5. Ignores fees on “wrap accounts.” 6. Amortization of sales loads based on 25 year-old data. If updated, 1998 cost up by 50 bps, to 185 bps (estimated). Fundamental Flaw: Price competition is (correctly) defined by the actions of producers, not the actions of consumers. Thus price competition is not “intense” in fund industry; it is barely alive. Myth #4: 1 1 0 1 2 0 1 4 1 1 5 2 9 6 1 5 8 1 3 9 9 0 1 0 0 1 1 0 1 2 0 1 3 0 1 4 0 1 5 0 1 6 0 1 7 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 Average Equity Fund Expense Ratio (basis points) Mutual Fund Costs Are Declining ICI Shareholder Costs - 1998: Average 193 bps Avg. Sales-Weighted: 135 bps Avg. Asset-Weighted: 132 bps 1998 Total Cost: $ 44.0 B 1980 Total Cost: $ 0.8 B Myth #4: 1999

Carefully and regularly evaluate whether your transaction activity has enhanced or detracted from the returns you have realized for your clients. 6. Taxes are the largest single detractor from Embedded Alpha. If your clients are taxable, evaluate your managers on after-tax returns and use after-tax returns as the basis for incentives. If you have both taxable and tax-deferred accounts, offer separate funds for each. 7. Eliminate opportunity cost. Cash, to be sure, is fine when raised just before a market decline. But you know as well as I that there’s simply no evidence of firms that have been successful at market timing. Thus, the return-enhancing characteristic of cash in down markets is inevitably a small fraction of its return- reducing characteristic in the rising markets that are far more common. 8. (For mutual funds only.) Get rid of 12b-1 fees, those sales commissions that are built into expense ratios. They make your reported returns look terrible; they usually entail heavier costs to the investors you serve; and simply, by being hidden, they raise serious questions about your candor and integrity. While together these steps will change the nature of institutional investing, given the influence of Embedded Alpha on long-term returns, I believe it is only a matter of time before clients will demand change. Forewarned is forearmed.

Those frictional costs, the study suggests, constitute a dead-weight burden that detracts from the return that can be theoretically produced by an investment portfolio in a frictionless securities market. So firms are urged to “cut those hidden costs,” including: 1. “Tangible Costs . . . management fees and trading commissions. Each dollar given away for, say, management fees is a dollar explicitly detracted from the portfolio net return. 2. “Managed Costs . . . unintended risk exposures, tax costs, and Not-Equitized-Cash, an opportunity cost for not keeping funds fully invested. 3. “Invisible Cost . . . the adverse market impact of trading and the opportunity cost of delaying trade execution.” Result: “Simply put, every incremental basis point increase in rate of return translates into competitive advantage (by which) a firm improves its absolute performance and its ranking relative to its peers.” In the study’s words, the firm that “will lead the way . . .minimize

these performance detractors.” Thus spaketh, I remind you, not Vanguard/BOGLE, but Merrill Lynch/BARRA. Perhaps surprisingly, the study presents no data whatsoever on the dimension of Embedded Alpha. So it won’t astonish you to learn that I’ve taken it upon myself to do exactly that, examining the mutual fund business and the costs that fund investors incur. The pictures: Average Equity Mutual Fund % of Average Assets 1. Advisory Fees 0.8% 2. Other Operating Expenses 0.5 Total Expense Ratio1 1.3% 3. Transaction Costs 0.7 4. Opportunity Cost 0.4 Total 2.4% You don’t need me to tell you that 240 basis points is a lot of Embedded Alpha. And I haven’t even taken into account the impact of fund sales charges and the heavy cost of taxes for non-retirement plan investors! Embedded alpha is admittedly lower for pension funds—its estimated at 1.3%—but it nonetheless takes a powerful toll there as well. Indeed, a recent study by a major pension consultant projected that even costs at the 1.3% level reduce the probability that a given active manager can beat the market over the long term at 5%—just one chance in twenty. The Long-Term Toll of Costs Now let’s look long-term. Despite today’s environment of frighteningly short-term investment horizons, most pension funds have seemingly perpetual lifetimes. And most individual investors now start their programs in an IRA or 401(k) at a young age, and will still be investing, not only 50, but even 70, years from now.

So the trend that this tortuous methodology measures is hardly evidence of what is described as “vigorous price competition” in the fund industry. Indeed, since few, if any, fund groups have slashed their fees to take on the low-cost funds in the marketplace, price competition is hardly intense; it is barely alive. And the study has still more weaknesses. It completely ignores a huge cost of fund ownership, fund portfolio turnover. That would add 0.50% to 1.00%-plus to the putative 1.35% total. It amortizes sales loads based on 25-year old data, ignoring today’s infinitely shorter (and therefore far costlier) holding period. It ignores the opportunity cost that funds incur by their failure to be fully invested in stocks—another 0.60% cost. And it no longer even reports the fact, buried deep in the first of its two studies, that the average expense ratio of the lowest cost decile of funds has actually risen by 27% since 1980—from 0.71% to 0.90% in 1997—perhaps up 35- 40% if Vanguard were excluded. Even the lowest cost funds will not be denied their fee increases.two