John C Bogle, concludes his speech at The Money Show in Las Vegas, Nevada on May 15, 2006 with a discussion on the selection criteria for mutual funds. Concluding that fund expenses, or the cost of ownership, matter.

The great irony of investing, then, is not only that you don’t get what you pay for. The reality is quite the opposite: You get precisely what you don’t pay for. So if you pay for nothing, you get everything.

Because the expected return of the average equity fun is completely unacceptable, Bogle outlines 4 possible investment strategies:

1. Select the funds with the best recent short-term records.
2. Select the funds with the best long-term records.
3. Select the funds with the lowest costs and lowest portfolio turnover.
4. Select an index fund that simply holds the stock market portfolio.

Selecting Short-Term Winners

Mutual fund investors really like to select funds that have the best recent returns.
How has that strategy worked?
According to Bogle, the top ten performers among the 851 equity funds in operation during the great market bubble of 1997-1999 generated an average return of 55 percent per year during the upswing, for a cumulative return of 272 percent for the full three years. Then, when the bubble burst, over the next three years (2000-2002 inclusive), all these funds dropped and not a single fund in the original top ten ranked higher than #790 out of the original 851 funds! So that the top ten funds found themselves in the bottom 5 percent. For the full six-year period the cumulative return averaged 7 percent, not too bad if you ignore the fact that the S&P 500’s cumulative gain over this same period was 30 percent. But for most shareholders of these funds, it was a real disaster. Most began investing after seeing the returns achieved in the first 3 years, and so totally missed the upside but then caught the full force of the downside. Their investments tumbled by an average of 34 percent per year over three years.
So they did not see a gain of 7 percent, but a loss of 57 percent for investors -— more than half of the capital they had invested. For Bogle the message is clear: avoid performance-chasing based on short-term returns.

Selecting Long-Term Winners

If Short-Term Winners are losers, how about investing in funds that have the best return over the long-term?
What at first glance might appear to be a good idea, doesn’t look so great after Bogle puts the numbers to it.

Of the 355 equity funds in existence 35 years ago in 1970, 223 -— almost two-thirds -— have gone out of business!
60 of those that remained had completely underperformed the returns of the S&P 500.
Another 48 funds provided returns within one percentage point, plus or minus, of the return of the S&P 500. Leaving just 24 ‘winners’. Meaning that only one fund of every 14 beat the market by more than one percent per year. 15 of those 24 funds beat the S&P 500 by less than 2 percent per year. So nine ‘real winners’, funds that out-paced the market by more that 2 percentage points over 35 years, remain.
Interestingly though, six of those nine winners achieved their gains over 10 years ago, after which their more recent records turned lackluster.
One of these six funds reached its peak way back in 1982, and two other in 1983, and the remaining three peaked in 1993 or earlier.

Only three funds, Davis New York Venture, Fidelity Contrafund, and Franklin Mutual Shares, 1 out of every 120 that started the race, have been able to maintain a record of sustained excellence.
But as Bogle warns, “before you rush out to invest in them, think about the odds that they will continue to outperform for the next 35 years, let alone the odds that they will even exist 35 years hence.”

Selecting Investments that Operate at Low Cost

Neither short-term performance nor long-term performance cannot help us select the right fund because performance comes and goes. But, according to Bogle, costs go on forever and are a factor that usually persists over sustained periods of time. Included in cost is not just the fund’s expense ratio but also the cost of its estimated portfolio turnover.
Portfolio turnover has to be included because transactions cost money and Bogle’s rule of thumb is that turnover cost is equal to 1 percent of turnover rate.

The combined costs range from 0.9 percent in the lowest cost quartile to 3.0 percent in the highest cost quartile.
That difference of 2.1 percentage points is a large portion of the 2.7 difference between the returns of the two groups over the past ten years. But there is more. The low-expense, low-turnover funds also assumed 34 percent less risk giving an annual risk-adjusted return of 3.8 percentage points. When these returns are compounded over time, the difference skyrockets.
According to Bogle, “fishing in the low-cost pond” should enhance your returns, as evidence that while the value of the high-cost funds did double over 10 years, the value of the low-cost funds tripled.
Yes, costs matter!

Selecting Index Funds that Own the Entire Stock Market

If low cost funds are good why not focus on the lowest-cost funds of all, index funds that own the entire stock market? Such funds often have expense ratios less than those for the low-cost quartile. Using a complex exercise called “Monte Carlo Simulation,” Bogle says we can project the odds that a passively-managed index fund will outpace an actively-managed equity fund over various time periods. The result: In any one year, about 29 percent of the active managers would, on average, be expected to outpace the index; over five years about 15 percent would be expected to win; over 10 years, 9 percent; over 25 years, 5 percent, and over 50 years just 2 percent of active managers would be expected to win.

Are you feeling lucky? Think you can pick that 1 out of 14 that will outperformed the S&P 500 by 1 percent or more per year over the next 35 years? Selecting that 1 fund is rather like looking for a needle in a haystack. If you want to invest, and not gamble, Bogle suggests investing in stock index funds (and bond index funds) which he says constitute the overriding portion of his own portfolio.

If, as I said at the outset, the road to investment success is hazardous, filled with dangerous turns and giant potholes, never forget that simple arithmetic can enable you to moderate those turns and avoid those potholes. So do your best to minimize your investment expenses and your own emotions, rely on your own common sense, be very careful, and then stay the course.