In the aftermath of the great reversal in the equity market that began in the spring of 2000, advocates of “stock picking” put forth a peculiar argument. In a bear market, it was claimed, the ability to pick winners from among the rubble would be all the more important. Passive strategies, especially indexing strategies that attempt to garner the gains of the general market, were said to be doomed.

Not surprisingly, brokers and active mutual funds were the most vocal in proclaiming that they possessed the ability to identify the few stocks that would defy the odds. Most notably, they asserted that investors should not be afraid to pay up for this ability, in the form of higher expenses necessary for compensating fund managers blessed with this unique power to divine the winners.

Our view is quite different. Active managers have not put a scratch in the overwhelming empirical evidence that cites their failure to add value, whether in bull or bear markets. Moreover, in a bear market, where nominal returns can be negative or at best no better than the current annual rate of price inflation (2.2 percent), expense ratios of over one percent are simply exorbitant.

Our mantra remains unchanged. You should ignore overtures to find “winners” or to anticipate the market, and instead concentrate on factors within your control. Central among these is your ability to choose the most cost-effective means of capturing the returns associated with the asset class you seek. This month’s feature on mutual-fund expenses was adapted from an article published by our parent, the American Institute for Economic Research. Wise investors will read and heed:

During the 1990s, when an ebullient stock market provided a tailwind, most equity mutual funds delivered double-digit returns and few investors paid much attention to fund expenses.

After a long bear market, and with the prospect of a more subdued investment environment, mutual funds can no longer depend on phenomenal market returns to mask high expenses. Not surprisingly, fund expenses are receiving attention from both regulatory agencies and industry observers as a major factor in overall fund performance.

In testimony in March 2003 before the U.S. House of Representatives, John Bogle, founder and retired Chief Executive of The Vanguard Group, noted a clear and dramatic link between fund costs and investment returns. Among other things his testimony noted that:

• During the decade ended June 30, 2001, the lowest-cost quartile of funds earned an average net return of 14.5 percent a year, while the average high-cost fund earned an average 12.3 percent a year. The low-cost advantage prevailed regardless of the fund’s investment strategy or focus.

• The average equity mutual fund’s performance lagged the returns of the Standard & Poor’s 500 Stock Index by an average of 3.1 percent a year between 1982 and 2002. This lag corresponds almost exactly to the actual total costs fund investors incur annually.

(continued on page 52)

Also in This Issue:

Quarterly Review of Investment Policy
Mutual Fund Costs: As Important As Ever
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield