Has Vanguard Joined the Investment Porn Crowd?

(MoneyWatch) 

MoneyWatch columnist Jane Bryant Quinn once stated: "Americans are indulging themselves in investment porn. Shameless stories about performance tickle our prurient financial interest. ... Mainline magazines (like Money, Smart Money, and Worth) ... rarely descend to hard-core porn. That is what you get from the greedy gurus on cable TV, or the cruising shysters on the Internet. ... We in the quality-media crowd specialize in soft-core porn. ... The porn test isn't the headline, but whether the story is anchored in reality." While I generally regard Vanguard as one the good guys, unfortunately even it becomes purveyors of investment porn on occasion.

On the Boglehead Investment Forum, a poster used a Vanguard analysis tool and was told he just might have too much in index funds. Quoting Vanguard on the subject of investment manager risk: "Index funds make up the core of your portfolio, providing you the benefit of significant diversification within a market or market segment at low cost." So far so good. Unfortunately, it dove into the investment porn pool with this advice: "Index-oriented investors can add the potential for above-market returns by including one or more carefully chosen, low-cost, actively managed funds in their portfolio."

Index funds provide great advantages:

• Low costs
• High tax efficiency
• Eliminating the potential for style drift and allowing you to maintain control over your asset allocation

However, once you invest in an index fund you give up the potential for market-beating returns. That fact is what the investment porn crowd plays on. Listen to Edward C. Johnson III, chairman of Fidelity Advisors: "I can't believe that the great mass of investors are going to be satisfied with just receiving average returns. The name of the game is to be the best." This is what a typical stockbroker's pitch might be when confronted with an investor who asks about investing in index funds "If you index or passively invest, you will get average rates of return. You don't want to be average, do you? Don't you think you can do better than that?" Both stockbrokers and Edward Johnson are appealing to what seems to be the very human need to be "better than average." [Editor's note: Vanguard's response is comment no. 15 below.]

Obviously, adding actively managed funds to a portfolio of index funds adds the potential for above-market returns. So why do I call Vanguard's comment investment porn? Because the purveyors of investment porn fail to state that while active funds offer the potential for outperformance, the far greater likelihood is that they'll underperform, especially after taxes. Even worse is that not only are there far more losers than winners, but the average size of the underperformance is far greater than the size of the outperformance. In fact, one study, "How Well Have Taxable Investors Been Served in the 1980s and 1990s?" found that for the 10-year period 1982-91, the risk-adjusted odds of outperforming the S&P 500 Index on an after-tax basis was 38:1.

Wall Street and the financial media want you to make the mistake of confusing market returns with average returns. If you invest in index funds, you earn the market's rate of return for that asset class.

On Friday, we'll see evidence from Vanguard itself regarding the value of active management.

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