1. Mutual Funds Things we should know…

2. Mutual Fund Industry Total assets managed exceed $5.7 Trillion Y/E 1990 total was $1 trillion Source: Financial Resource Corp, 8/02 Over 9,000 mutual funds 50 million + individuals hold mutual fund shares Source: Common Sense on Mutual Funds, John C. Bogle, John Wiley & Sons, Inc; 1999

3. Trends that should worry us… High fees Boards of directors that don’t actively manage the shareholders’ interests Mediocre returns

4. Why the stock market? Average yearly stock market returns 1802-1997 Total nominal return 8.4%, total real return 7% 1926-1997 (Real=inflation adjusted) Total nominal return 10.6%, total real return 7.2% 1982-1997 Total nominal return 16.7%, total real return 12.8% Annual stock market volatility 1802-1997 St.Dev. Real annual return 18.1 1982-1997 St.Dev. Real annual return 13.2 Source: Stocks for the Long Run; Professor Jeremy J. Siegel, Wharton School, University of Pennsylvania

5. Bond Market Average yearly bond market returns 1802-1997 Total nominal return 4.8%, total real return 3.5% 1926-1997 Total nominal return 5.2%, total real return 2.0% 1982-1997 Total nominal return 13.4%, total real return 9.6% Annual bond market volatility 1802-1997 St.Dev. Real annual return 8.8 1982-1997 St.Dev. Real annual return 13.6 (Siegel)

6. Historical returns Stocks have historically earned higher returns than bonds. In 187 rolling 10 year periods since beginning of stock markets, bonds have higher returns 38 times (1 in 5) In 172 rolling 25 year periods over same time span, bonds outperform stocks only 8 times (1 in every 21) (Siegel)

7. Mutual fund returns 30 year period (1967-1997) Average General U.S. Equity Fund Return of 10.8% (annualy) S&P500 Index over the same period Return of 12.5% (this is the Index itself, NOT an index fund…) (Bogle)

8. Mutual Funds vs. the Index The S&P 500 Index beats 80% of the mutual funds in an average year. Statistically, this should be 50%… How about the Broader Market? Wilshire 5000 Index has had the same return (13.7%) as S&P500 since 1970. (Bogle)

9. Index returns vs. Growth/Value (Large funds) Over the last 15 years: Wilshire 5000 Index returned 16.0% Average growth / value fund = 14.1% 33 of the 200 growth and value funds that SURVIVED the period beat the Wilshire 5000. Odds: 1 in 6 (Siegel)

10. Index vs active returns (cont. from previous slide..) Odds of beating the Wilshire 5000 by 3% points over the same period: 1 in 200 BY DEFINITION: Mutual funds as a group MUST provide GROSS returns equal to the Market Last 15 years: Wilshire 5000=16.0%, Average of all funds gross return = 16.0%

11. Distribution of Returns GROSS mutual fund returns fit a normal distribution that one would expect to see when results were truly random (coin flipping) Relative gross returns of mutual funds statistically have followed a random pattern: Skill of managers appears to be a matter of luck Managers have the additional handicap of COSTS to overcome

12. Survivor Bias in Reporting Returns Same 15 year period: 20% of all funds FAILED to survive the period Their returns (or lack of) are NOT reported at the end of the period (and thus are not counted against the aggregate)

13. Survivor Bias 10 Year period (1982-1991) 18% of funds disappeared. Survivors reported aggregate returns of 17.1% If you count ALL funds, the more accurate return was 15.7% The Survivor Bias artificially enhanced the reported returns by 1.4% Source: A Random Walk Down Wall Street, Burton Malkiel, Princeton University 15 year period ending in 1991 Survivor bias added a phantom 4.2% to the annual gains (Siegel)

14. Survivor Bias Additional data shows that from 1962-1993, fully ONE-THIRD of all stock funds disappeared. Source: Mark Carhart From 1988-1992 (very short period) 100 of the original 686 funds disappeared Malkiel From 1993-1998 (Boom years for funds) 600 FUNDS disappeared Bogle

15. Tax Efficiency Average fund turnover (assets) = 80% Bogle During 15 years ended 1998, Vanguard’s Index fund beat 94% of all funds on a PRE-TAX basis, but beat 97% of all funds on an AFTER-TAX basis, due to lower asset turnover and higher tax efficiency Vanguard, Inc.

16. Tax Efficiency Inefficiency leads to reduced overall returns for most actively managed funds

17. How About Risk Management? Active fund managers claim to provide added value because they can actively move money to cash to protect assets from market downturns. Ideally, we would observe low cash positions as markets surged and high cash positions during declines. Statistically, the exact opposite is true…

18. Risk / Cash management Last three market declines: Active funds held very low cash positions (4%) Last three market advances: Active funds had very high cash positions. (11%) As measured by standard deviation, Mutual funds (14.8%) are actually riskier than both S&P500 (14.3%) or Wilshire 5000 (14.0%) Index Funds… Bogle The Truth?…Managers are statistically no better at guessing than you are…

19. Impact of fees on return Average fund fees 1.4% Average Index fund fees 0.2%

20. Gross market return – Cost = Net market return All investors own the entire stock market. Active + Passive investors total return must = the gross return of the market. Fees / Costs by active investors are higher than those of passive investors. Therefore, because they earn equal gross returns, passive investors must earn the higher NET return.

21. Add up the shortfall… Statistically speaking, active mutual funds must earn gross returns EQUAL to the market index. Subtract for Costs, Survivor Bias, Taxes, and Higher Risk The result is a HISTORICAL SHORTFALL of around 4% (depending on how one measures the impact of Survivor Bias).

22. The ugly truth… On a BEFORE TAX, BEFORE COST basis, actively managed funds have returns that are virtually equal to the indices. AFTER TAX and other COSTS, Actively managed funds fall short on AVERAGE by 4.2% AFTER TAX and other COSTS, Index funds fall short by 0.2%

23. All Index Funds are Not Created Equal Some have statistical returns that more closely match the index Some have lower fees. Shop around. Vanguard is king of low costs…

24. Indexing has grown in Acceptance As results have stacked up over the past three decades, Investors have begun to accept Indexing as a legitimate strategy Prominent professionals now concede that many ‘average’ individual investors would be best off buying and holding index funds…