Socially conscious investing & a talk by Vanguard's Jack Bogle on the rationale for index investing
Scott MacLeod
Ben Lomond lead to a lot of connecting in beneficial ways. Thanks.
Drawing on Quaker thinking and Jack Bogle's arguments for index
investing (of Vanguard Mutual Funds) as the most rational approach
over the long run, here are some perspectives on socially conscious
investing, with mutual funds
(http://scott-macleod.blogspot.com/2008/12/american-dipper-nontheist-friends.html).
This blog post below includes a talk by Jack Bogle on the rationale
for index investing. I hope this will complement the ideas which
Connie Brookes, Friends' Fiduciary and others shared over last
weekend.
And here, again, the new Ben Lomond Rightly Ordered Finances Google
Group to extend the connecting through time -
http://groups.google.com/group/quaker-ben-lomond-rightly-ordered-finances.
It's also listed on the Facebook page of Western Friend Magazine
(thanks, again, Kathy and Ben Lomond!!). Please join simply to stay in
touch through this group, and occasionally exchange Friendly ideas.
Friendly regards,
Scott
Blog post:
American Dipper: Nontheist Friends, Socially Conscious Index Mutual
Funds, Index Investing
Hi,
For a long time I've appreciated Quaker engagement with the
relationship between principle (e.g. anti-war thinking) and money.
Friends' long history with war tax resistance is one example. I've
also appreciated Quaker approaches to socially conscious investing.
"Friends Fiduciary" is an example here - friendsfiduciary.org. "Domini
Social Investments" (domini.com) and Vanguard Mutual Funds'
(https://personal.vanguard.com/us/home) "Vanguard FTSE Social Index
Fund Investor Shares"
(https://personal.vanguard.com/us/JSP/Funds/Profile/VGIFundProfile0213Content.jsf?tab=0&FundId=0213&FundIntExt=INT#hist::tab=0),
both of which are index mutual funds, take related approaches. And
TIAA-CREF's "Cref Social Choice Equity"
(tiaa-cref.org/performance/mutual_funds/profiles/0059.html) also uses
a related approach. They use social criteria to identify which stocks
to buy and hold in their portfolios. In significant ways, socially
responsible investing and index funds increased in number vis-a-vis
counterculture and the 1960s.
Vis-a-vis the stock market today (December 2008), the indexing
approach again has great merit, as a starting point for thinking about
investing. Buying the index and holding it for the long term (10 years
plus) has proven to increase your chances for the best returns of
almost any investment. Although the US stock market is down about 40%
year-to-date, it rose around an astounding 18% annually from
1982-1999). An index approach (such as buying Vanguard's S&P 500 index
mutual fund or Vanguard's Total Stock Market index mutual fund, or one
of the similar index funds above) to investing is still the most
sensible, rational approach I know. Over the long run (say, 10 years
plus), stock index funds have beaten about 8 out of 10 actively
managed stock mutual funds, primarily because all investors 'are' the
stock market, and therefore we all can't beat it, and due to low
costs. Asset diversification still matters, too, to weather this kind
of volatility, - something like 90-10% stocks-to-other-asset-classes
(bonds, real estate, cash) for a 30 year old, and 60-40
stocks-to-other-asset-classes for a 60 year old. "Morningstar's Guide
to Mutual Funds," available in the US in most main libraries, and
often in a limited version through these libraries online, is a very
useful related reference for United States mutual funds
(morningstar.com).
Indexing is probably the best approach to investing, offering the best
chances for long term returns I know of. And social indexing has added
benefits socially, - relating to nontheistically friendly (and
Quaker-) ways of thinking. And thanks significantly to the power of
compounding returns year after year, stock investing has been proven
to be the best way to generate wealth.
So, stock market returns are down a lot now, and this significantly
affects people's retirement income, but riding out the risks (such
downturns) of the stock market, by dollar cost averaging into the
stock market (investing regularly through a pension fund in an index
mutual fund, potentially a socially conscious one, is very sensible.
And the stock market will (probably) go up again. Historically, the
U.S. stock market has returned on average about 7% annually (10%
average annual return a year less 3% fo inflation) over the past 75
years with lots of ups and downs (risk or volatility - which is why it
only makes sense to think of investing in stocks for the long term),
beating every other investment class.
Here's Vanguard's rationale for index investing from John Bogle, the
founder of Vanguard Mutual Funds' approach to indexing:
http://www.vanguard.com/bogle_site/sp20040413.html (which I've posted
below because it seems to be a little hard to find online) and a
related view from Vanguard Australia:
(http://www.vanguard.com.au/personal_investors/knowledge-centre/indexing/plain-talk-guides/understanding-indexing.cfm).
And here's Jack Bogle in a video interview with Steve Forbes of Forbes
Magazine - http://www.forbes.com/2009/01/09/intelligentinvestingbogle.html
where he shares rationales for the benefits of index investing.
Through sensible investing, nontheist friends may be able to support
friendly causes most effectively, and bring about some of the
nontheistically friendly changes we might seek.
Scott
As The Index Fund Moves from Heresy to Dogma . . . What More Do We Need To Know?
Remarks by John C. Bogle
vanguard.com/bogle_site/sp20040413.html
September 2005, a little more than a year from now, will mark the
thirtieth anniversary of the creation of the first index mutual fund.
That fund—originally, and proudly, named First Index Investment
Trust—is now, as Vanguard 500 Index Fund, the largest mutual fund in
the world. But that is only one indication of the success of index
investing. For the heresy that was indexing—passive portfolio
management that invaded a kingdom ruled, indeed populated solely by,
active portfolio managers—has now become dogma, part of the academic
canon, taught almost universally in college finance courses and in
business schools, and part of the daily discourse of investors.
The evidence on the triumph of indexing is overwhelming. In the mutual
fund industry, total assets of equity index funds, barely $1 billion
in 1990, now total over $550 billion, one-sixth of all equity fund
assets.
While that first index fund of 1975 wasn’t copied until 1984, nearly a
decade later, there are now 430 equity index funds, and even 30 bond
index funds. In the pension world, where the idea of indexing took
hold several years earlier than in the fund field, the indexed assets
of corporate and state and local retirement plans, $900 billion in
1990, now total $3½ trillion.
Combined indexed assets—linked to U.S. and international stock and
bond indexes—of mutual funds and retirement plans now exceed $4
trillion. Indeed, three of America’s ten largest money managers (State
Street Global Advisors, Barclays Global Investors, and Vanguard, all
overseeing from $700 billion to $1 trillion in assets) have reached
this pinnacle largely on the basis of their emphasis on index
strategies.
But the impact of indexing has gone far beyond the trillions of
dollars of assets that rely on pure index strategies. “Closet index
funds” that closely track the Standard and Poor’s 500 Index, for
example, are rife, seeking to add value by making relatively modest
variations in index stock weightings, all the while engaging in tight
“risk control” by maintaining a high correlation with the movements in
the market index itself. And rare is the active “buy-side”
institutional portfolio manager who, seeking to minimize what has come
to be called “benchmark risk,” fails to compare the weights of his
portfolio holdings with those in the index. The icing on the cake of
indexing: Wall Street’s “sell-side” analysts no longer recommend “buy,
sell, or hold.” Today, “over-weight, under-weight and equal-weight”
stocks relative to a firm’s share of the market’s total capitalization
have become the profession’s words of art, itself a sort of closet
indexing approach.
There can be no question that index-matching strategies—simple and
broadly diversified, heavily weighted by stocks with large
capitalizations, with low fees and low portfolio turnover—have changed
the landscape of our financial markets, and set a new standard in the
way we both measure and enjoy our investment returns. Yes, our focus
has turned away from absolute return and toward relative
performance—beating or falling short of the index benchmark. Of
course, absolute performance is what investors can actually spend,
but, to state the obvious, the fund that has the best relative
performance is also the absolute champion.
The Intellectual Basis for Indexing
While the clear triumph of indexing can hardly have surprised
thoughtful observers of the financial scene, few commentators have
recognized that two separate and distinct intellectual ideas form the
foundation for passive investment strategies. Academics and
sophisticated students of the markets rely upon the EMH—the Efficient
Market Hypothesis—which suggests that by reflecting the informed
opinion of the mass of investors, stocks are continuously valued at
prices that accurately reflect the totality of investor knowledge, and
are thus fairly valued.
But we don’t need to accept the EMH to be index believers. For there
is a second reason for the triumph of indexing, and it is not only
more compelling but unarguably universal. I call it the CMH—the Cost
Matters Hypothesis—and not only is it all that is needed to explain
why indexing must and does work, but it in fact enables us to quantify
with some precision how well it works. Whether or not the markets are
efficient, the explanatory power of the CMH holds.
More than a century has passed since Louis Bachelier, in his Ph.D.
thesis at the Sorbonne in 1900, wrote: “Past, present, and even
discounted future events are (all) reflected in market price.” Nearly
half a century later, when Nobel Laureate Paul Samuelson discovered
the long-forgotten thesis, he confessed that he “oscillated . . .
between regarding it as trivially obvious (and almost trivially
vacuous), and regarding it as remarkably sweeping.” In essence,
Bachelier was, as far as he went, right: “The mathematical expectation
of the speculator is zero.” By 1965, University of Chicago Professor
Eugene F. Fama had performed enough analysis of the ever-increasing
volume of stock price data to validate this “random walk” hypothesis,
rechristened as the efficient market hypothesis. Today, the
intellectual arguments against general thrust of the EMH religion are
few. While it would seem extreme to argue that all stocks are
efficiently priced all of the time, it would seem equally extreme to
deny that most stocks are efficiently priced most of the time.
But whatever the consensus on the EMH, I know of no serious academic,
professional money manager, trained security analyst, or intelligent
individual investor who would disagree with the thrust of EMH: The
stock market itself is a demanding taskmaster. It sets a high hurdle
that few investors can leap. While the apostles of the new so-called
“behavioral” theory present ample evidence of how often human beings
make irrational financial decisions, it remains to be seen whether
these decisions lead to predictable errors that create systematic
mispricings upon which rational investors can readily (and
economically) capitalize.
But while the precise validity of the EMH may be debatable, there can
be no debate about the validity of the CMH. It posits a conclusion
that is also, using Dr. Samuelson’s formulation, both “trivially
obvious and remarkably sweeping” and it confirms that Bachelier’s
argument had to be taken one step further. The mathematical
expectation of the speculator is not zero; it is a loss equal to the
amount of transaction costs incurred.
So, too, the mathematical expectation of the long-term investor also
is a shortfall to whatever returns our financial markets are generous
enough to provide. Indeed the shortfall can be described as precisely
equal to the costs of our system of financial intermediation—the sum
total of all those advisory fees, marketing expenditures, sales loads,
brokerage commissions, transaction costs, custody and legal fees, and
securities processing expenses. Intermediation costs in the U.S.
equity market may well total as much as $250 billion a year or more.
If today’s $13 trillion stock market were to provide, say, a 7% annual
return ($910 billion), costs would consume more than a quarter of it,
leaving less than three-quarters of the return for the investors—those
who put up 100% of the capital. We don’t need the EMH to explain the
dire odds that investors face in their quest to beat the stock market.
We need only the CMH. Whether markets are efficient or inefficient,
investors as a group must fall short of the market return by the
amount of the costs they incur.
Now for the really bad news. Investors pay their investment costs each
year in nominal current dollars, but they measure their long run
investment success in real dollars, almost inevitably eroded in value
by inflation. The nominal long-term returns of about 10 percent on
stocks that the financial intermediation system waves before the eyes
of the naive investing public turn out to be about 6½ percent in real
terms.
When we realize that in the mutual fund industry intermediation costs
total at least 2½ percentage points annually, they confiscate nearly
40% of the historical real rate of return on equities. And when we
subtract the cost of taxes (paid by taxable investors in current,
nominal dollars), the confiscation of real return rises to nearly 75%.
In a coming era in which returns may well fall below historic norms,
we must look at potential investment accumulations in a new and harsh
light.
The academic and financial communities have dedicated enormous
intellectual and financial resources to studying past returns on
stocks, to regression analysis, to modern portfolio theory, to
behaviorism, and to the EMH. It’s high time we turn more of our
attention to the CMH. We need to know just how much our system of
financial intermediation has come to cost, to know the extent to which
high turnover may pay, and to understand the real net returns that
managers deliver to investors.
Two Schools of Indexing—Quantitative and Pragmatic
All these years later, the distinctly different intellectual
approaches of the EMH and the CMH illuminate the history of indexing.
The Quantitative School, led by masters of mathematics such as Harry
Markowitz, William Fouse, John McQuown, Eugene Fama, and William F.
Sharpe did complex equations and conducted exhaustive research on the
financial markets to reach the conclusions that led to the EMH. In
essence, the “Modern Portfolio Theory” developed by the Quantitative
School showed that a fully-diversified, unmanaged equity portfolio was
the surest route to investment success, a conclusion that lead to the
formation of the first index pension account (for the Samsonite
Corporation), formed by Wells Fargo Bank in 1971. That tiny $6 million
account was invested in an equal-weighted index of New York Stock
Exchange equities. Alas, its implementation proved to be a nightmare,
and in 1976 it was replaced with the market-capitalization-weighted
Standard & Poor’s 500 Common Stock Price Index, which remains the
principal standard for pension fund indexing to this day.
While the Quantitative School developed its profound theories, what
I’ll call the Pragmatic School simply looked at the evidence. In 1974,
the Journal of Portfolio Management published an article by Dr.
Samuelson entitled “Challenge to Judgment.” It noted that academics
had been unable to identify any consistently excellent investment
managers, challenged those who disagreed to produce “brute evidence to
the contrary,” and pleaded for someone, somewhere to start an index
fund. A year later, in an article entitled The Loser’s Game, Charles
D. Ellis argued that, because of fees and transaction costs, 85% of
pension accounts had underperformed the stock market. “If you can’t
beat the market, you should certainly consider joining it,” Ellis
concluded. “An index fund is one way.”¹,
In mid-1975, I was both blissfully unaware of the work the quants were
doing and profoundly inspired by the pragmatism of Samuelson and
Ellis. I had just started a tiny company called Vanguard, and was
determined to start the first index mutual fund. It was then that I
pulled out all of my annual Weisenberger Investment Companies manuals,
calculated by hand the average annual returns earned by equity mutual
funds over the previous 30 years, and compared them to the returns of
the Standard & Poor’s 500 Stock Index: Result: annual returns,
1945-1975, S&P Index 10.1%; average equity fund, 8.7%.
As I mused about the reasons for the difference, the obvious occurred
to me. The index was cost-free, and its 1.4% annual advantage in
returns roughly approximated the total costs then incurred by the
average fund—the expense ratio plus the hidden costs of portfolio
turnover. To illustrate the enormous impact of that seemingly small
percentage difference, I calculated that a hypothetical initial
investment of $1,000,000 in 1945 would by 1975 have grown to
$18,000,000 in the Index, vs. $12,000,000 in the average fund.
In September 1975, using those data and the Samuelson and Ellis
articles, I urged a dubious Vanguard board of directors to approve our
creation of the first index mutual fund. They agreed.
How Vanguard Came to Start the First Index Mutual Fund
The idea of an index fund was hardly anathema to me. Way back in 1951,
the anecdotal evidence that I had assembled in my Princeton University
senior thesis on the then-miniscule mutual fund industry led me to
warn against the “expectations of miracles from mutual fund
management,” and shaped my conclusion that funds “can make no claim to
superiority to the market averages.” When the newly-formed Vanguard
began operations in May 1975, I had realized my dream of establishing
the first truly mutual mutual fund complex, the idea of an index fund
was at the top of my agenda.
Why? Because while the idea of an index fund would have hardly
appealed to a high-cost fund manager whose very business depended on
the conviction that, whatever his past record, he could outpace the
market in the future, indexing would be a natural for us. We were
organized as a shareholder-owned, truly mutual, mutual fund group,
with low costs as our mantra. So while our rivals had the same
opportunity to create the first index mutual fund, only Vanguard, like
the prime suspect in a criminal investigation, had both the
opportunity and the motive.
Our introduction of First Index Investment Trust was greeted by the
investment community with derision. It was dubbed “Bogle’s folly,” and
described as un-American, inspiring a widely-circulated poster showing
Uncle Sam calling on the world to “Help Stamp Out Index Funds.”
Fidelity Chairman Edward C. Johnson led the skeptics, assuring the
world that Fidelity had no intention of following Vanguard’s lead: “I
can’t believe that the great mass of investors are going to be
satisfied with just receiving average returns. The name of the game is
to be the best.” (Fidelity now runs some $38 billion in indexed
assets.)
The early enthusiasm of the investing public for the novel idea of an
unmanaged index fund designed to track the S&P 500 Index was as
subdued as the admiration of our detractors. Its initial public
offering in the summer of 1976 raised a puny $11 million, and early
growth was slow. Assets of First Index didn’t top $100 million until
six years later, and only because we merged another Vanguard actively
managed fund with it. But the coming of the Great Bull Market that
began in mid-1982 started the momentum, and the fund’s assets crossed
the $500 million mark in 1986.
From the outset, I realized that the 500 Index, by owning large-cap
stocks that represented 75% to 80% of the value of total U.S. market,
would closely parallel, but not precisely match, the stock market’s
return, since the Index excluded mid-cap and small-cap stocks. So in
1987, we started a fund called the Extended Market Fund, indexed to
those smaller companies. If used in harness with the 500 Fund, it
would provide a total market exposure. By year-end, combined assets of
the two funds were nearly $1 billion. In 1990, we added another
“Institutional 500 Fund” designed for pension plans, and in 1991, a
Total Stock Market Index Fund, modeled on the Wilshire Total (U.S.)
Market Index, bringing total assets of these essentially all-market
index funds to $6 billion.
During 1994-1999, as the bull market continued, and as our index funds
continued to outpace the overwhelming majority—upwards of 80%!—of
actively-managed funds, asset growth accelerated—$16 billion in 1993,
$60 billion in 1996, $227 billion in 1999.
Much of this success, as I warned our index shareowners, “should under
no circumstances be regarded either as repeatable or sustainable.” It
wasn’t. But even in the ensuing bear market, the index funds outpaced
more than 50% of their actively-managed peers, and solid growth
continued. Assets of our four “all-market” index funds now total some
$200 billion, with our other 33 index funds bringing our total indexed
assets to $300 billion today.²
So indexing has enjoyed a considerable commercial success, drawing
huge assets to Vanguard, and even larger amounts to other managers and
pension funds. It has enjoyed that success, not only because of the
sound and pragmatic foundation on which indexing relies, but because
it has, over three decades now, worked effectively in providing
superior returns. This is to say, indexing has not been merely a
commercial success. It has been an artistic success. Indexing worked!
Brute Facts
How well did it work? Thirty years ago in “Challenge to Judgment,” Dr.
Samuelson wrote: “When (respected) investigators look to identify
those minority groups endowed with superior investment process, they
are quite unable to find them . . . (Even) a loose version of the
‘efficient market’ or ‘random walk’ hypothesis accords with the facts
of life . . . any jury that reviews the evidence must at least come
out with the Scottish verdict: Superior performance is unproved.” And
so he issued his challenge: “The ball is in the court of those who
doubt the random walk hypothesis. They can dispose of that
uncomfortable brute fact in the only way that any fact is disposed
of—by producing brute evidence to the contrary.”
So today, three decades later, let’s examine some brute evidence.
Let’s go back to the era in which the Samuelson article was published,
and see what lessons we can learn by examining the evidence on the
ability of mutual fund managers to provide market-beating returns. In
1970, there were 355 equity mutual funds, and we have now had more
than three decades over which to measure their success. We’re first
confronted with an astonishing—and important—revelation: Only 147
funds survived the period. Fully 208 of those funds vanished from the
scene, an astonishing 60% failure rate.
Now let’s look at the records of the survivors—doubtless the superior
funds of the initial group. Yet fully 104 of them fell short of the
11.3% average annual return achieved by the unmanaged S&P 500 Index.
Just 43 funds that exceeded the index return. If, reasonably enough,
we describe a return that comes within plus or minus a single
percentage point of the market as statistical noise, 52 of the
surviving funds provided a return roughly equivalent to that of the
market. A total of 72 funds, then, were clear losers (i.e., by more
than a percentage point), with only 23 clear winners above that
threshold.
If we widen the “noise” threshold to plus or minus two percentage
points, we find that 43 of the 50 funds outside that range were
inferior and only seven superior—a tiny 2% of the 355 funds that began
the period, and an astonishing piece of the brute evidence that Dr.
Samuelson demanded. The verdict, then, is here, and it is clear. The
jury has spoken. But its verdict is not “unproved.” It is “guilty.”
Fund managers are systematically guilty of the failure to add
shareholder value.
But I believe the evidence actually over-rates the long-term
achievements of the seven putatively successful funds. Is the obvious
creditability of those superior records in fact credible? I’m not so
sure. Those winning funds have much in common. First, each was
relatively unknown (and relatively unowned by investors) at the start
of the period. Their assets were tiny, with the smallest at $1.9
million, the median at $9.8 million, and the largest at $59 million.
Second, their best returns were achieved during their first decade,
and resulted in enormous asset growth, typically from those little
widows’ mites at the start of the period to $5 billion or so at the
peak, before performance started to deteriorate. (One fund actually
peaked at $105 billion!) Third, despite their glowing early records,
most have lagged the market fairly consistently during the past
decade, sometimes by a substantial amount.
The pattern for five of the seven funds is remarkably consistent: A
peak in relative return in the early 1990s, followed by annual returns
of the next decade that lagged the market’s return by about three
percentage points per year—roughly, S&P 500 +12%, mutual fund +9%.
In the field of fund management it seems apparent that “nothing fails
like success”—the reverse of the threadbare convention that “nothing
succeeds like success.” For the vicious circle of investing—good past
performance draws large dollars of inflow, and having large dollars to
manage crimps the very ingredients that were largely responsible for
the good performance—is almost inevitable in any winning fund. So even
if an investor was smart enough or lucky enough to have selected one
of the few winning funds at the outset, selecting such funds by
hindsight—after their early success—was also largely a loser’s game.
Whatever the case, the brute evidence of the past three decades makes
a powerful case against the quest to find the needle in the haystack.
Investors would clearly be better served by simply owning, through an
index fund, the market haystack itself.
More Brute Facts
In the field of investment management, relying on past performance
simply has not worked. The past has not been prologue, for there is
little persistence in fund performance. A recent study of equity
mutual fund risk-adjusted returns during 1983-2003 reflected a
randomness in performance that is virtually perfect. A comparison of
fund returns in the first half to the second half of the first decade,
in the first half to the second half of the second decade, and in the
first full decade to the second full decade makes the point clear.
Averaging the three periods shows that 25% of the top quartile funds
in the first period found themselves in the top quartile in the
second—precisely what chance would dictate.
Almost the same number of top quartile funds—23%—tumbled to the bottom
quartile, again a close-to-random outcome. In the bottom quartile, 28%
of the funds mired there during the first half remained there in the
second, while slightly more—29%—had actually jumped to the top
quartile.
Perfect randomness would distribute the funds in each performance
quartile randomly in the succeeding period—sixteen blocks, each with a
25% entry. As the matrix shows, the reality comes close to perfection.
In no case was there less than a 20% persistence or more than a 29%
persistence. Simply picking the top performing funds of the past fails
to be a winning strategy. What is more, even when funds succeed in
outpacing their peers, they still have a way to go to match the return
of the stock market index itself.
Yet both investors and their brokers and advisers hold to the
conviction that they can identify winning fund managers. One popular
way is through the Star system espoused by the Morningstar rating
service. Indeed, over the past decade, fully 98%(!) of all investment
dollars flowing in equity mutual funds in the nine Morningstar “style
boxes” was invested in funds awarded five stars or four stars, the
firm’s two highest ratings. (The ratings are heavily weighted by
absolute fund performance, so we can hardly blame—or even
credit—Morningstar for primarily being responsible for these huge
capital inflows. Stars or not, high returns attract large dollars.)
But as Morningstar is first to acknowledge, its star ratings have
little predictive value. The record bears out their caution. Academic
studies show that the positive risk-adjusted returns (“Alpha”) that
distinguish the four- and five-star funds before they gain the ratings
typically turn negative afterward, and by a correlative amount. Data
from Hulbert’s Financial Digest confirm this conclusion. Following
their selection, the funds in the top-ranked Morningstar categories
typically lag the stock market return by a wide margin. Over the past
decade, for example, the average return of these “star” funds came to
6.9% per year, fully 4.1 percentage points behind the 11.0% return on
the S&P 500 Index. What is more, that 37% shortfall in annual return
came hand in hand with a risk (standard deviation) that was 4% higher.
Even for the experts, picking winning mutual funds is hazardous duty.
A Case Study
So the search for “long-term investment excellence” is an elusive one.
A fine new book (Capital, with the foregoing words in its subtitle) by
respected analyst Charles D. Ellis drives this point home. Mr. Ellis
describes a firm of consummate professionals, serious about their
trade, with an excellent investment process. But for all that obvious
excellence, we also are given, perhaps inadvertently, an illustration
of the wide gap between manager achievement and shareholder
achievement, as well as a warning about casually accepting the
assumption that the past is prologue.
The Ellis book is a history of The Capital Group Companies, a Los
Angeles firm that may well be the most widely-respected investment
manager in America. Certainly the accolades, from impartial observers
and competitors alike, could hardly be more glowing: “one of the most
outstanding investment firms ever created,” “one of the best firms in
our business,” “a premier investment firm,” and “people with a passion
for long-term investment success.” I would hardly disagree with these
endorsements. Indeed, I’ve been singing my own praises of Capital
since the early 1960s. (In my previous career at Wellington Management
Company, I even explored the possibility of a merger of our firms!)
Yet despite their organizational integrity and investment focus, and
despite the fact that the net returns they have delivered to their
fund shareholders are clearly superior to those of most of their
peers, the returns achieved by Capital can hardly be said to have been
extraordinary relative to the stock market itself. The book documents
the return of their flagship fund, the Investment Company of America
(ICA) during 1973-2003 at +13.2% per year, or 1.8 percentage points
over the 11.4% return on the S&P 500 Index. But, as nearly all fund
comparisons do, it ignores the impact of the initial 8½% sales charge
paid by investors. For a typical investor, such a cost would reduce
that excess return by about 0.8% to a single percentage point,
although even that small advantage is admirable in an industry that,
as we now know, struggles and, ultimately fails, to match the stock
market’s return.
But of course, like all comparisons, it is time-dependent. Other
periods give rise to different, and less compelling, results. For
example, during the past 25 years (1979-2003), ICA underperformed the
market in 16 years. While it outpaced the market by 0.7% (14.5% vs.
13.8%) for the period, after adjusting for the sales charge, it fell
slightly behind, with a net annual return of 13.7%.
Indeed since 1983—two full decades—no matter in which year we choose
to begin the comparison, the results of the ICA have pretty much
paralleled those of the market itself, with a correlation of a
remarkable .95%. (To be fair, ICA is less volatile, significantly
lagging as the bull market bubble inflated during 1998 to 1999, and
then recouping the ground lost during the ensuing bear market.)
But in an industry which ultimately fails to match the market’s
return, why not just salute ICA as equal or even preferable to an
index fund? First, because, despite its long-term focus, it is
relatively tax-inefficient. During the past 25 years, for example,
federal taxes consumed an estimated 2.5 percentage points of its
annual return, reducing it from 13.7% to 11.2% for taxable investors.
While an S&P 500 index fund is hardly exempt from taxes, its passive
market-matching strategy is highly tax-efficient. During the same
period, taxes on an index fund would have cost an estimated 0.9
percentage points, reducing its 13.8% pre-tax return to 12.9%, a net
after-tax advantage over ICA of 1.7 percentage points per year. Not
only do taxable investors pay high costs in fund advisory fees,
operating expenses, and sales commissions when they buy active fund
management, they also pay a remarkably high tax cost.
A second reason for caution before we salute is that, as our earlier
evidence suggests, the past is rarely prologue. And not just because
of the “random walk” that characterizes the returns typically achieved
by active managers in highly efficient markets. Success—even perceived
success—in investment management goes not unrecognized; indeed it is
often hyped from the rooftops. It draws money, creating that vicious
circle we described earlier. Warren Buffett warns us that “a fat
wallet is the enemy of superior returns,” and the record clearly
confirms his wisdom.
Today ICA’s assets total $66 billion, an enormous sum compared to
assets of $1.3 billion 25 years ago. That exponential growth hardly
makes the job of active management any easier. The number of
investments large enough to make a meaningful impact on the portfolio
shrinks, even as the difficulty and cost of buying and selling stocks
escalates. What is more, the size of ICA is only the tip of the
iceberg, for the fund is part of a $500 billion investment complex,
and many of its largest holdings are also held by Capital’s other
funds and pension clients. The organization currently holds, for
example, some 11% of Target Corp. and GM, and from 7% to 10% of
Altria, FNMA, J.P. Morgan Chase, Eli Lilly, Bristol-Myers, Dow
Chemical, Tyco, Texas Instruments, and Fleet Boston. Whether the
massive growth in the assets Capital manages will impede the firm’s
ability to turn their past into prologue, only time will tell.
What is the Intellectual Foundation for Active Management?
Let me summarize what I see as the intellectual basis for indexing:
Even if the EMH is weak, the CMH remains a tautology—all the more
important in the mutual fund arena where costs are so confiscatory.
The brute evidence on the rarity of superior management goes far
beyond the relatively few examples I’ve cited today. And the vicious
circle of superiority generating growth, generating inferior
returns—with few managers courageous and disciplined enough to defy
it—has become a truism. That the typical fund portfolio manager holds
his post for less than five years, furthermore, means that a long-term
investor has to identify not only a superior manager, but bet on his
longevity. And the astonishing fund failure rate that, at current
rates, implies a 50-50 survival rate over the coming decade, is the
icing on the cake of the case for indexing.
What, then, is the intellectual foundation for active management?
While I’ve seen some evidence that managers have provided returns that
are superior to the returns of the stock market before costs, I’ve
never seen it argued that managers as a group can outperform the
market after the costs of their services are deducted, nor that any
class of manager (e.g., mutual fund managers) can do so. What do the
proponents of active management point to? . . . Themselves! “We can do
it better.” “We have done it better.” “Just buy the (inevitably
superior performing) funds we that we advertise.” It turns out, then,
that the big idea that defines active management is that there is no
big idea. Its proponents offer only a few good anecdotes of the past
and promises for the future.
Alas, it turns out that there is in fact one big idea that can be
generalized without contradiction. Cost is the single statistical
construct that is highly correlated with future investment success.
The higher the cost, the lower the return. Equity fund expense ratios
have a negative correlation coefficient of –0.61 with equity fund
returns. In the fund business, you get what you don’t pay for. You get
what you don’t pay for!
If we simply aggregate funds by quartile, this correlation jumps right
out at us. During the decade ended November 30, 2003, the lowest-cost
quartile of funds provided an average annual return of 10.7%; the
second-lowest, 9.8%; the second-highest; 9.5%; and the highest
quartile, 7.7%.
The difference of fully three percentage points per year between the
high and low quartiles, equal to a 30% increase in annual return! The
same pattern holds irrespective of the time period, and essentially
irrespective of manager style or market capitalization. But of course,
with index funds carrying by far the lowest costs in the industry,
there are few, if any, promotions by active managers of the undeniable
relationship between cost and value.
Changing Times and Circumstances
So it is the crystal-clear record of the past, an understanding of the
present, and the realization that even the future returns of today’s
successful managers are unpredictable that together seem to make the
search for the Holy Grail of market-beating returns a fruitless quest.
It is the recognition of this reality that has carried indexing to its
remarkable eminence and growth. But please don’t imagine that I am
sitting back and reveling in where indexing stands today. I press on
in my mission as an apostle of indexing, not only because complacency
doesn’t seem a very healthy attitude and resting on one’s laurels is
too often the precursor of failure, but for three other reasons:
First, because indexing has not yet adequately fulfilled its promise.
Second, because we have subverted the idea of indexing, adding to its
role as the consummate vehicle for long-term investing (“basic
indexing”) a new role as a vehicle for short-term speculation
(“peripheral indexing”). And third, because not nearly enough
individual investors have yet come to accept the extraordinary value
that indexing offers.
The initial promise of indexing was reflected in an article that
appeared in Fortune magazine in June 1976, smack in the middle of the
launch of our First Index Investment Trust. Written by journalist A.F.
Ehrbar, it was entitled, “Index Funds—An Idea Whose Time is Coming,”
and concluded that, “index funds now threaten to reshape the entire
world of money management.” Yet nearly three decades later, while the
influence of indexing has clearly been powerful, it has failed to
reshape that world. This failure has been most abject in the mutual
fund field, where active managers have largely ignored the lessons
they should have learned from the success of indexing.
The reasons for that success are the essence of simplicity: 1) The
broadest possible diversification, often subsuming the entire U.S.
stock market; 2) a focus on the long-term, with minimal, indeed
nominal, portfolio turnover (say, 3% to 5% annually); and 3)
rock-bottom cost, with neither advisory fees nor sales loads, and
minimal operating expenses. Rather than being inspired to emulate
these winning attributes, however, the fund industry has largely
turned its back on them.
Consider that only about 500 of the 3700 equity funds that exist today
can be considered highly-diversified and oriented to the broad market,
bought to be held. The remaining 3200 funds focus on relatively narrow
styles, or specialized market sectors, or international markets, or
single countries, all too likely bought to be sold on one future day.
Portfolio turnover, at what I thought was an astonishingly high 37% in
1975 when the first index fund was introduced, now runs in the range
of 100%, year after year.
While fund costs essentially represent the difference between success
and failure for investors who seek to accumulate assets, they have
gone up as index fees have come down. The initial expense ratio of our
500 Index Funds was 0.43%, compared to 1.40% for the average equity
fund.
Today, it is 0.18% or less, while the ratio for the average equity
fund has risen to 1.58%. Add in turnover costs and sales commissions
and the all-in cost of the average fund is at least 2.5%, suggesting a
future annual index fund advantage at least 2.3% per year.
Pointedly, however, Vanguard’s actively managed funds have learned
from the success of our index funds. Indeed, with low advisory fees
paid to their external managers, relatively low portfolio turnover,
and our reasonable, if sometimes erratic, success in selecting
managers, these funds, according to a study in a forthcoming issue of
the Journal of Portfolio Management³, have actually outpaced our index
fund since its inception. (However, if after-tax returns, had been
considered, or if the base date of the study had been 1989 rather than
1976, the index fund would have had the superior record.) While I
cannot agree with the authors’ suggestion that I should take “more
joy” in our active funds than in our index funds, be assured that I
take great joy in the application of the principles that underlie the
success of our index funds and managed funds alike.
A Great Idea Gone Awry
My second concern is that the original idea of the index fund—own the
entire U.S. stock market, own it at low cost, hang on to it
forever—has been, to put it bluntly, bastardized.
The core idea of relying on the wisdom of long-term investing is being
eroded by the folly of short-term speculation. And index funds are one
of the principle instruments for this erosion. Why? Because the term
“index fund,” like the term “hedge fund,” now means pretty much
whatever we want it to mean.
In addition to 109 index funds now linked to a relative handful of
broad market indexes (S&P 500, Wilshire Total Market, Russell 3000),
there are 224 index funds linked to narrow market indexes—small
cap-growth stocks, technology stocks, even South Korean stocks—funds
that seem to be bought to be sold. (I confess that, for better or
worse, I did my share in the creation of market segment index
funds—growth, value, and small-cap, for example. But today’s segmented
index funds are far narrower in scope.)
Much of the expansion of the index fund marketplace has taken the form
of “exchange-traded funds” (ETFs), essentially mutual funds that are
designed to be traded in the stock market, often day after day, even
minute-by-minute. The assets of ETF index funds now total $150
billion, one-fourth of the index mutual fund total of $550 billion. It
seems logical, as far as it goes, to actively trade specialty funds,
and 118 of them have come in ETF form, with assets of some $60
billion. But, to my amazement and disappointment, the dominant form of
ETF is not these narrow segment funds, but the broad market index
funds, including the S&P 500 “Spiders” and iShares, the NASDAQ
“Qubes,” and the Dow-Jones “Diamonds.” It is these ETFs that dominate
the field, representing some $90 billion of assets currently—index
funds originally bought to be held, now bought to be sold.
“Bought to be sold” is hardly hyperbole. ETFs turn over at rates I
could never have imagined. Each day, about $8 billion(!) of Spiders
and Qubes change hands, an annualized portfolio turnover rate of
3000%, representing an average holding period of just 12 days!
(Turnover of regular mutual funds by their shareholders now runs in
the 40% range, itself an excessive rate that smacks of speculation.)
The extraordinary ETF turnover should hardly be surprising, however.
The sponsor of the Spiders regularly advertises this product with
these words: “Now, you can trade the S&P 500 Index all day long, in
real time.” (To which I would ask, “What kind of a nut would do
that?”)
So “What have they done to my song, Mom?” The simple broad market
index fund of yore, which I believe is the greatest medium for
long-term investing ever designed by the mind of man, has now been
engineered for use in short-term speculation. What is more, it has
also been joined by far less diversified index funds clearly designed
for rapid speculation. Please don’t mistake me: the ETF is an
efficient way to speculate, trading opportunistically in the entire
market or its segments, and using them for such a purpose is surely
more sensible (and less risky) than short-term speculation in
individual stocks. But what’s the point of speculating—costly,
tax-inefficient, and counterproductive as it is—an almost certain
loser’s game. Mark me down as one whose absolute conviction is that
long-term investing is the consummate winning strategy.
What More Do We Need To Know?
My third concern is that, for all of the inroads made by indexing, it
has achieved only a small fraction of the success that its clear
investment merits deserve. If heresy has turned to dogma, why hasn’t
indexing become an even more important part of the financial scene?
Yes, the assets of index mutual funds now total over $550 billion,
representing nearly 15% of equity fund assets. Yes, investors have
invested $130 billion in index funds over the past three years, some
35% of the total cash flowing into equity funds.
But no, American families now hold $8.0 trillion of equities, meaning
that nearly $7.5 trillion is not indexed. Indexing has achieved a far
smaller share of individual equity investments than in the pension
field. And yet its cost advantage is much larger in the highly-priced
fund marketplace than in the competitively-priced pension marketplace.
If we as a nation are going to rely even more heavily on individual
retirement and thrift plans than on corporate pension plans and Social
Security, the retirement savings of our citizens are going to be far
less robust. What more do we need to know in order to accept the
superiority of index funds so that they earn the acceptance they
clearly deserve?
I, for one, don’t think we need more information. But the problem will
not be easy to solve. The fund industry, like the insurance industry,
is a marketing business, and in both cases the high costs of marketing
represent a dead weight loss on the net returns that investors
receive. The problem faced by low-cost, no-load index funds is that,
as I have often observed, “(almost) all the darn money goes to the
investor!” The more money that goes to the investor, of course, the
less that goes to the manager and marketers, the brokers and
advertisers, the marketing system that drives the world of financial
intermediation. So we need to work, day after day, to get across the
message of indexing to the “serious money” investors who, truth told,
need it the most.
Conclusion
There are lots of lessons to be learned from the issues I’ve discussed
today. Broadly, I’ve suggested that, while innovation cannot be
separated from luck, it can’t be separated from intellectual
discipline and determination either. I’ve also suggested that simple
ideas can hold their own—or more—with complex concepts. When you get
out in the business world, Occam’s Razor—“when confronted with
multiple solutions to a problem, choose the simplest one”—is worth
keeping in mind.
I hope you also take note that it is indeed possible to gild to excess
a sound innovation—in this case, the lovely lily of all-market
indexing—which needs no gilding—as well noting the powerful forces
that would like nothing better than to stop indexing in its tracks
before it strikes at their wallets. Their only weapon is to use the
records of their successful funds during their flowering periods and
imply that such success will persist—and you now know how rarely that
happens. Most of all, of course, I hope I’ve explained not only the
universal mathematical logic of indexing—gross return minus
intermediation costs equals net return—but also presented an
overwhelming array of brute evidence that ought to persuade even the
most skeptical among you of its worth as an investment strategy.
Now think of this in personal terms. What difference would an index
fund make in your own retirement plan over, say, 40 years? Well, let’s
postulate a future long-term annual return of 8% on stocks.
If we assume that mutual fund costs continue at their present level of
at least 2½% a year, an average mutual fund might return 5½%.
Extending this tax-deferred compounding out in time on your investment
of $3,000 each year over 40 years, and investment in the stock market
itself would grow to $840,000, with the market index fund not far
behind. Your actively managed mutual fund would produce $430,000—only
a little more than one-half as much.
Looked at from a different perspective, your retirement plan has
earned a value of $840,000 before costs, and donated $410,000 of that
total to the mutual fund industry. You have kept the
remainder—$430,000. The financial system has consumed 48% of the
return, and you have achieved but 52% of your earning potential. Yet
it was you who provided 100% of the initial capital; the industry
provided none. Confronted by the issue in this way, would an
intelligent investor consider this split to represent a fair shake?
Merely to ask the question is to answer it: “No.”
So when you begin your careers, begin your own families and begin to
save for their future security, and consider the nest-egg you’ll need
forty or fifty years from now when you retire, I shamelessly commend
to your using an all-market index fund—the lower the cost, the
better—as the centerpiece of the savings you allocate to equities. If
you do, as Dr. Samuelson has written, you will become “the envy of
your suburban neighbors, while at the same time sleeping well in these
eventful times.”
Finally, a word for those of you who will seek careers in investment
management. Please don’t be intimidated by the obvious odds against
beating the market. Rather, learn, as so few fund managers seem to
have done, from the reasons for the success of the index fund. It is
long-term focus, broad diversification, and low cost that have been
the keys to the kingdom in the past; active managers who learn both
from the disciples of EMH and the apostles of CMH will have the best
chance of winning the loser’s game, or at least providing respectable
long-term returns for their clients in the future. So whatever you do
in your investment career—indeed whatever you do in any endeavor to
which you may be called—never fail to put your client first. Placing
service to others before service to self is not only an essential part
of whatever success may be, it is the golden rule for a life well
lived.
1. I should note that one of the earliest calls for indexing came from
a book that I did not read until many years later: A Random Walk Down
Wall Street, by Princeton University Professor Burton S. Malkiel (W.W.
Norton, 1973). Dr. Malkiel suggested “A New Investment Instrument: A
no-load, minimum-management-fee mutual fund that simply buys the
hundreds of stocks making up the market averages and does no trading
(of securities) . . . Fund spokesmen are quick to point out, ‘you
can’t buy the averages.’ It’s about time the public could.” He urged
that the New York Stock Exchange sponsor such a fund and run it on a
nonprofit basis, but if it “is willing to do it, I hope some other
institution will.” In 1977, four years after he wrote those words, he
joined the Board of Directors of First Index Investment Trust and the
other Vanguard funds, positions in which he has served with
distinction ever since. back
2. This figure includes our specialty index funds (small-cap, growth,
value, Europe, Pacific, etc.) as well as a series of bond index funds
and enhanced index funds. Their rationale and development, however,
are stories for another day. back
3. “Index Fundamentalism Revisited,” by Kenneth S. Reinker and Edward
Tower. Forthcoming in the Summer 2004 edition of the Journal of
Portfolio Management. back
Note: The opinions expressed in this speech do not necessarily
represent the views of Vanguard’s present management.
Return to Speeches in the Bogle Research Center
©2006 Bogle Financial Center. All Rights Reserved.
Remarks by John C. Bogle
Founder and Former Chairman, The Vanguard Group
to the Washington State University
Pullman, Washington
April 13, 2004
(http://scott-macleod.blogspot.com/2008/12/american-dipper-nontheist-friends.html
- December 6, 2008)
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