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SJun 8, 2012

What Las Vegas Can Teach Us About Mutual Fund Investing

Scott Burns
What Las Vegas Can Teach Us About Mutual Fund Investing

When you go to Las Vegas one of the important things to know is what the “vig” is for whatever game you choose to play. The vig, or “vigorish,” is the amount the house takes out of the pot. Play where the vig is high and it is likely you will lose your money quickly.  Play where the vig is low and you’ve got a shot at staying in the game longer. Whether the vig is high or low, someone may leave with more money but most will leave with less.

Play the slot machines and, according to professional gambler John Patrick, the vig is about 13 percent. This means the house takes about 13 cents from each dollar played and redistributes 87 cents to the players. In essence, each dollar played is immediately worth only 87 cents.

Tempted to complain about being ripped off? Don’t. If you’ve ever bought a state lottery ticket, you’ve played a game where the house vig is 50 percent and the intrinsic value of a $1 lottery ticket is, you guessed it, 50 cents.

Want a low-vig casino game? Try blackjack. Pay close attention to what’s called basic strategy and the vig can be as low as 1.5 percent. You may not win at slots or blackjack, but the low vig in blackjack means you can stay in the game longer. Get a good run of cards and you might even go home with some money in your pocket.

Why am I telling you this?

Because there is a vig in mutual fund investing, too. It’s called the expense ratio. If you bought shares in a low vig fund such as the Vanguard 500 Index Fund 15 years ago, you earned an annualized 5.57 percent over the period after annual expenses of 0.17 percent. It was not a wonderful period for the Index because it only provided a better performance than 60 percent of its surviving higher vig managed competitors. (Over the 3, 5, 10 and 15 year periods it did better, on average, than 70 percent of its competitors.)

Just 40 percent of funds in what Morningstar calls the “large blend” domestic equity category provided higher returns than the index fund. They averaged an annualized return of 6.82 percent and averaged expense ratios of 1.17 percent. In other words, if you took a chance and paid a higher vig, you had a chance of increasing your return.

But was it worth it?

If you committed to paying a full 1 percentage point more in expenses, you had a chance of increasing your annualized return by an average of 1.25 percent. Unfortunately, you only had a 40 percent chance of gaining that 1.25 percent, taking its real value down to 0.5 percent. So you were certain to pay 1 percentage point more each year to get a return that would likely be only 0.5 percentage point higher.

A bet on a managed fund was about as bad as buying a state lottery ticket— the intrinsic value of the managed fund “ticket” was worth only half the gain. (It isn’t quite that bad because stocks tend to have positive returns, so they are a positive-sum game. Gambling is always a sum-zero game in which a fixed pot of money is redistributed.)

This is not a stacked-deck example. Focus on fixed income investing and, as I suggested in a recent column, the house vig is just crazy. In one of the largest fixed income categories, intermediate bonds, there was virtually no chance of beating the Vanguard Intermediate Term Bond index fund over 15 years. The index fund was in the top 5 percent, earned 7.08 percent a year and cost 0.22 percent while the average managed fund cost 0.89 percent but earned only 5.79 percent. Funds that did better than the index averaged a 7.58 percent return, only 0.5 percent more than the index fund.  In effect, managed fixed-income fund investors were paying 0.67 percent a year more for the privilege of having a 5 percent chance of gaining an average increase in return of 0.5 percent. What a deal!

Is all this new to you? Well, don’t feel badly. It’s new to most people, whether they are playing on Wall Street or in Las Vegas. But in both places, you’ve got better odds if you play where the vig is low.

Filed Under: Mutual Fund Investing