Bogle views stock market speculation as debilitating for investors and the economy as a whole. Unnecessary short-term trading does nothing for the value of the market except to siphon off transaction costs to the financial intermediaries. As in a casino, there are winners and losers, but the house always gets its share.
While technology and competition have forced down individual transaction costs, the response has been to encourage more trading in order to keep the dollars flowing in.
Wall Street has a function to perform in allocating capital to those who need it, and in providing liquidity, but those roles have been overwhelmed by speculation.
Transaction costs can be enormous, and their effect is often unrecognized by most investors who place their money in the hands of mutual funds. This source provides a good summary of the cost structure.
"Currently the typical expense ratio for an actively managed mutual fund is about 1.5%, and that number has been going up lately. With an expense ratio of 1.5%, a mutual fund is cutting itself in on 1.5% of the total money in the fund every year."
The expense ratio has the following components:
"Administrative costs are the costs of record keeping, mailings, maintaining a customer service line, etc. These are all necessary costs, though they vary in size from fund to fund. The thriftiest funds can keep these costs below 0.20% of fund assets, while the ones who use engraved paper, colorful graphics, and phone answers with highfalutin' accents might fail to keep administrative costs below 0.40% of fund assets."
"Surely the fee that you as a mutual fund investor should be most outraged by is the 12b-1 distribution fee. This fee ranges from 0.25% of a fund's assets all the way up to 1.0% of the fund's assets. This fee is used for marketing, advertising, and distribution services. Yup, that's right. If you're in a fund with a 12b-1 fee, you're paying every year for the fund to run commercials and try to sell itself."
Bogle reminds us that while earnings compound, so do costs. Let’s look at a simple example to see how this works. Say your favorite aunt died when you were young and left you $10,000. You wisely invested it in a well-regarded equity fund and left it there for 40 years so that it would be available to you in your retirement. Say you chose well and your investment earned 7 percent annually over the 40 years. You could then expect to have about $150,000 dollars available. However, you hadn’t reckoned on the fund fees. Say your fund took out the typical 1.5 percent each year; that would mean the actual rate of return was 5.5 percent annually. A return of 5.5 percent over 40 years means you would only have about $85,000. That seemingly small fee took away over 40 percent of your earnings and cost you about $65,000. And remember, 1.5 percent is the typical fee, yours could be higher.
Bogle believes it is absurd to pay these fees, and he thought that many years ago. His recognition that a speculatively traded fund, with its fees, cannot match the market as a whole in the long run, led him to create the index fund. Vogel is most famous for founding the Vanguard 500 Fund. Tying a portfolio to an index that tracks the market as a whole limits the need for transactions and minimizes costs. And it guarantees that you will do as well as the market—at least to the degree that the market is represented by the chosen index.
Our source on fund expense ratios provides this information:
Returning to our example, if one had invested in a fund with an expense ratio of 0.18 percent, and had realized the same 7 percent annual gain, the amount available after 40 years would have been about $140,000 rather than $85,000.
Recent studies have indicated that most people who invest in a 401K are not even aware that there are costs associated with their plan. Estimates indicate that for the average investor, about a third of the potential value of a 401K account is consumed by fees levied by fund managers. There are new regulations forcing plans and managers to be explicit about what fees are in place. Hopefully, this will instill some shame and some competition and drive the fees down. It really does make a big difference.
Finally, Bogle provides us with this perspective: