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Keynote Speech by John C. Bogle, Founder and Senior Chairman, The Vanguard Group The Fourth Annual Superbowl of Indexing December 5, 1999 Just a year hence, the world's first index mutual fund, proudly named "First Index Investment Trust" at its incorporation on December 31, 1975, will celebrate the 25th anniversary of its birth. What is now Vanguard 500 Index Fund began with assets of just $11 million; on November 16, 1999, assets crossed the $100 billion milestone for the first time, a remarkable compound growth rate of nearly 50% per year. At the outset, the fund was both excoriated and denigrated—"un-American" was the least of it—so, while I'm rarely one who thinks asset totals are very important as such, perhaps that date may serve as a useful landmark of the moment that heresy finally turned to dogma. What is more, it now seems certain that Vanguard 500 Index Fund will become the largest mutual fund in the world by the end of the century, fulfilling the prediction I made publicly nearly eight years ago, in January 1992. Yes, our single rival to the asset crown—if such it be—remains about $1 billion ahead, but Vanguard 500 still has 13 months in which to pass it. Oh, yes … a technical note: Despite the fact that almost everyone will be celebrating the millennium when 1999 rolls into 2000, I'm confident the indexers in this audience—dedicated as you are to statistical precision—will not do your celebrating until the clock ticks away the real millennium, when year 2000 ends and 2001 begins. The Pioneers While Vanguard 500 was the first index mutual fund, I hasten to add, the pioneers of indexing theory were William E. Fouse, John ("Mac") McQuown, James Vertin, and their associates at Wells Fargo Bank, who did a wealth of remarkable statistical work during the early 1970s. Their first trial—based on an unweighted index of New York Stock Exchange equities—ended in failure, but their second trial, using the capitalization-weighted Standard & Poor's® 500 Stock Index as the standard, worked perfectly. (Trial and error is what pioneering is all about!) When I was poring over old statistical manuals to calculate the annual returns of the average equity fund, my first project after Vanguard's founding on September 24, 1974, however, I was completely oblivious to their work. Nor, to my later embarrassment, had I read A Random Walk Down Wall Street—now a classic in the field—which was published in 1973. It contained author Burton G. Malkiel's plaintive plea that some institution, somewhere, sponsor an index fund. A spiritual leader of the crusade ever since, Dr. Malkiel became part of its substance in 1977, when he joined Vanguard's Board of Directors, on which he has served with distinction ever since. Rather, my inspiration came from three other sources, each of which reaffirmed the conclusion I'd reached during the course of my research for my 1951 senior thesis at Princeton University: "Mutual funds can make no claim to superiority over the market averages." That conclusion was bolstered by Dr. Paul Samuelson's Journal of Portfolio Management paper titled "Challenge to Judgment" in 1974, and by Charles Ellis' study ("The Loser's Game") in the Financial Analysts Journal and Al Ehrbar's indexing story in Fortune, both in mid-1975. As 1975 drew to a close and we started our fund, I had no doubt that indexing was an idea whose time had come. As I reflect on how we, rather than anyone else, happened to pioneer the index mutual fund, it now seems almost preordained. After all, anyone who ever considered the proposition would have quickly figured out—without, I hasten to add, having to understand the complicated formulas and conceptions of the then rapidly evolving Modern Portfolio Theory—that all investors as a group must fall short of the market's return by the precise amount of the aggregate costs they incur. And anyone who took the trouble to evaluate the performance data available in 1974 would have learned, as I quickly did, that neither mutual fund managers nor institutional managers of pension funds were providing returns that suggested an ability to outpace managers in other endeavors, such as bank trust departments and stock brokerage firms. (In those days, there were few "do-it-yourself" individual investors.) But the Vanguard organization, as we structured it at its very inception, was a provider of mutual fund services, not a manager of money. Our charter was to serve, not the fund adviser, but the fund shareholder. (We recognized, if you will, that "no man can serve two masters.") Our mission was to be the lowest-cost provider of financial services in the world. So even if 100 mutual fund firms had grasped the opportunity of a lifetime that indexing presented at the same instant we did, 99 would have prayed that the cup of indexing pass quickly from their hands. But as fate would have it, one firm had just been formed that—like the suspect in a good murder mystery—had both the opportunity and the motive to seize the day, and take the first step that would one day relandscape the financial firmament. After recognizing our opportunity, only force of will, persistence, determination, patience, and missionary zeal were required. Perhaps some of those characteristics will be evident in my remarks this evening. (Well, at my age, maybe my patience is flagging.) Spawning a New Industry It occurs to me that most, perhaps all, of the index pioneers would be surprised—at least I am—that their idea has spawned a whole new subset of the financial services industry. Assets of equity index funds now total $300 billion, nearly 10% of equity mutual fund assets. There are 334 index mutual funds, 139 modeled on the Standard & Poor's 500 Index, and 195 in other categories, some of which make considerable sense, and some of which do not. Among those that do not are 69 funds which carry sales loads; the reason for their existence totally escapes me. Among those that do are international index funds and fixed-income index funds. Because of the extra costs of managed international funds—higher fees and expense ratios, higher portfolio turnover, and higher transaction costs—the advantages of low-cost index funds are proportionately even larger than in the domestic arena. Although so far only a single mutual fund firm has made a serious commitment to bond indexing, that arena too makes consummate good sense. Given the smaller margins of potential performance superiority that are possible among fixed-income funds, together with the truly outrageous fees charged by most bond funds, this area holds great potential. But the new index industry includes far more than scores of index managers (some managing their funds at low costs—at least for a while—and some at costs that are confiscatory). It also includes large numbers of creative marketers engaged in proving that the number of indexes that can be used to create new "products" is virtually limitless; and numerous purveyors of methods to beat the indexes, or reshape them, by one obscure statistical technique or another—from computer-assisted mathematical models to portfolios composed solely of mortgage-backed bonds and S&P 500 futures—and hundreds of providers of legal, financial, technological, and communications services to all of those countless souls who are engaged in the creation, management, and marketing of index funds. Indexing has also spawned a new magazine—a Dow Jones publication called Indexes, of all things—and, to state the obvious, the annual Superbowl of Indexing itself, now meeting for the fourth year, with 97 speakers and 300 participants. Our initial 500 Fund, a quiet firstborn, was an only child for nearly a full decade. It was not until 1984 that the second index fund was born, and it proved to be a pale imitation of its older sibling. Its high costs, predictably, have utterly destroyed the fund's ability to do what its sponsors implicitly promised: To match the return of the S&P 500 Index. While this fund, which is managed by one of the largest and most respected banks in America, has persevered to this day, its shareholders have been ill-served. A $10,000 investment when the fund began, hit at the outset by a 4.5% sales charge, and then by operating costs of some 1% each year, would have been worth just $116,000 as 1999 drew to a close. The same investment at the same time in the first index fund, the fund that the copier was emulating, was worth $143,000—a gap of a mere $27,000. (When asked by the press how the fund could justify its lofty costs, a spokesman answered: "It's our cash cow." And of course it is.) "All Index Funds Are Not Created Equal" Yes, as a clever advertising headline for one S&P 500 index fund recently declared, "All Index Funds Are Not Created Equal." The transmitter of this message—a large and respected name in the fund field—was bragging about its index fund's ostensibly low costs, without acknowledging that its expense ratio of 0.50% was fully 180%(!) above its lower-cost peers. And, as it turns out, 50 basis points is not so bad. Yet another large and respected investment banking and research firm offers its index fund at 150 basis points. (Just what is it about "large and respected"?) And what does the prospectus say? "The objective of the fund is to track the return of the Standard & Poor's 500 Stock Composite Index, before expenses." And that's all it says. But surely more is required. Perhaps something like this: "Investors should understand that, as a result of the fund's high expenses, their returns will be substantially less than the returns earned by the index." Lest there be any doubt that, as the self-serving advertisement said, "all index funds are not created equal," all index funds should be required to provide tables in their prospectuses that compare their potential capital accumulation—after costs—with the accumulation in the index itself. Assuming a 10% market return, such a table would show that the fund manager with a 50 basis point cost who told the world that all index funds are not created equal would cost a naive investor 11% of the cumulative value of the S&P Index itself over 25 years. And the investment banker's fund would cost an even more naive investor some 27% of the final stake. Yes, "not all index funds are created equal." A Better Standard? With the passage of time, I have become convinced that the most intelligent index fund strategy is modeled on the Wilshire 5000® Equity Index. (It recently became the "Wilshire 5000 Total Stock Market Index," from my perspective a change long overdue.) Later on, I'll discuss the merits of the total stock market index as a performance standard against which active managers of funds should be measured, but for now let me say that owning an index fund based on the total U. S. stock market virtually guarantees that investors will capture 98% to 99% of the stock market's annual return. By way of contrast, active investors as a group are virtually guaranteed to capture but 75% to 85%, simply because of the costs of investing. The search to identify, in advance, the few winning funds is like looking for a needle in the total market haystack. Why bother looking for the needle when you can own the haystack? Owning an all-market index fund, simply put, means buying businesses—in essence, every publicly held business in America—and holding them for Warren Buffett's favorite holding period: Forever. Owning the average actively managed mutual fund, on the other hand, means trading pieces of paper, holding each sheet for this industry's favorite holding period: 406 days. (Fund turnover now averages 90% per year.) Believe me, there is a difference between these two strategies—in the complex and speculative task of mutual fund selection, in the certainty of future relative returns, in management fees and expense ratios, in portfolio turnover costs, and in sales loads too. And, lest we forget, in tax-efficiency. (The grotesque tax-inefficiency of most active mutual funds, while assuring irreparable harm to taxable fund investors, has provided no demonstrable advantage to tax-deferred fund investors in IRAs and retirement plans.) Too Many Index Funds? The selection of the large-cap S&P 500 as the appropriate benchmark at the outset of indexing has earned a lot of money for index fund shareholders. But I don't believe that it should remain the standard in the years ahead. (Though I wouldn't dream of encouraging satisfied investors in the S&P 500 Index funds to make the switch. After all, those 500 stocks represent 75% of the weight of the all-market index.) The consummate simplicity and comprehensiveness of the all-market index fund has me questioning, more than ever before, the wisdom of other, narrower index strategies.* Here, to be forthright, I am questioning no judgment other than my own, for we started the first small-cap index fund just over a decade ago, and the first growth index and value index funds in 1992—just as soon as the corresponding Standard & Poor's/BARRA growth and value indexes made their debut. The problem with small-cap index funds—and, lest I paint with too narrow a brush, small-cap funds in general—is that by maintaining what is called "style purity" (i.e., never having the temerity to jump out of the small-cap style box), such a fund must sell its winners and begin all over again. Such a move not only defeats the long-term nature of investment strategy, but has powerfully negative tax consequences. We all ought to be reconsidering this strategy to make it work more effectively. The growth and value index strategies, too, ought to be reexamined. By definition, each accounts for 50% of the capitalization of the Standard & Poor's 500 Stock Index. But with the soaring market value of the technology stocks, the number of growth stocks comprising that 50% has dropped from 232 companies a decade ago to 128 today. The 1,060% appreciation in Microsoft stock alone since 1994—increasing its weight from less than 1% of the index to nearly 4%—has taken as many as 25 former growth stocks and transmogrified them into 25 new value stocks, making the value index "growthier" than ever before. Furthermore, as companies are elbowed out of the Growth Index into the Value Index, there are potential adverse tax consequences to taxable investors in a growth index fund. Again, as "style" index strategies are tested by time, we owe them some reconsideration. In any event, it is high time for better disclosure of the implications and consequences of "style purity," in index funds and active funds alike. Today is no time for dogmatism. *Index funds following narrower styles, however, remain an intelligent medium for investors who own particular actively managed funds and wish to gain total market exposure. The Newest Fad But if these modest—and well-intentioned—departures from the majesty of broad stock market indexing should be carefully reconsidered, what can one say about the latest fad in indexing? Exchange-traded funds, already acronymically known as ETFs (which, I confess, I still confuse with the completely unrelated "electronic funds transfer") are the hot item of the day. They've taken indexing far beyond what any of us present at the creation a quarter-century ago could have imagined. Fair enough. But what is wrong is that this new breed of index funds, by accident or design, seems to be frustrating the original purpose of the index strategy—efficient long-term investing in a diversified portfolio of businesses—giving us instead a vehicle for short-term speculation in the stock market. This is not to knock, in any way, the Spiders (SPDRs, modeled on the Standard & Poor's 500 Index). I've acknowledged for years my respect for the creativity that went into their design, their low operating costs and fine tracking of the index, and their tax-efficiency, in which the investor, in substance, is solely responsible for his own taxes. I happen to believe, however, that the services, conveniences, and low costs offered by the best S&P 500 Index funds, along with the absence of brokerage commissions, make them the superior vehicle for long-term investors. Of course, the tax issue (for taxable investors) remains, and it may well be that some long-term investors may prefer to own conventional index funds through a newly created Spider-like series by today's conventional index funds. Such an eventuality should neither surprise nor concern investors. In any event, I expect no interruption in the robust growth of index mutual funds, which now account for nearly 40% of equity fund cash flow. The real-time pricing of Spiders, on the other hand, makes them by far the superior vehicle for short-term speculators, doubtless well worth the brokerage commissions involved. The marketplace supports that judgment: While our index fund investors turn their holdings over at a rate of just 10%, the annual turnover of Spider shares is running at an annual rate of 1,800% in 1999, about 22 times the 80% turnover rate of the average share of stock on the New York Stock Exchange. In the stock market today, the average share is held for about 456 days (itself a period that is hardly a monument to long-term investing), while the average Spider is held for just 20 days. Not even three weeks! And relative to the burgeoning ETF universe, Spider investors are models of decorum. Their counterparts, who trade the even-gamier Nasdaq 100, are turning over their "QQQs" at an annual rate of 7,800%, an average holding period of just over four days! Long-term investors might consider extreme caution before investing in a program—however inexpensive, whatever its tracking success, and irrespective of its potential long-term tax efficiency—in which most investors are, well, four-day wonders. Of course, ETFs have been carried far beyond Spiders and QQQs. There are now 17 WEBS (with much higher expense ratios—in the plus 1% range) based on global indexes, soon to be joined by 51 new ETFs called iShares (cost not yet disclosed), presenting an even wider selection of domestic and foreign markets. But these new ETFs have been designed with a purpose diametrically opposed to the purpose of that pioneering index mutual fund of 1975. Our purpose was to create an investment that would serve long-term shareholders, to be bought and held, to be the hedgehog who knows one great thing, rather than the fox who knows so many things, bringing simplicity rather than complexity to the world of investing. The purpose of the ETFs seems to be to create a product that will sell, a product that, if all goes well, will serve speculators efficiently, but will serve its sponsors whether things go well or not. Indeed, an executive of a major ETF sponsor recently said, "Brands have always existed in consumer products. We see investors buying (our) brand just like they buy a brand of toothpaste. "But believe me: There is a difference between designing a product that sells, and creating an investment that serves." Active Managers and Indexes Last January, when I offered up "When Active Managers Win, Who Loses" as the title of these remarks, I assumed that this would be a year in which the average mutual fund, after five consecutive years in the doghouse, would finally beat the S&P 500 Index. During the 1994–1998 period, the average fund lagged the 500 by an astonishing 75 percentage points (+119% vs. +194%). What is more, as a dyed-in-the-wool believer in reversion to the mean in the financial markets, I suspected that the time for the smaller stocks to rise again was at hand. I was well aware that while the 500 Index is invested 100% in large-cap stocks, about one-half of the industry's general purpose stock funds are large-cap funds (and with a slightly smaller average cap size at that) and one-half are mid- and small-cap funds. This distribution almost assures superiority for the average fund when non-S&P stocks outperform. As the year draws to a close, my guess is looking pretty good. The non-S&P stocks are up 22.0%, while the S&P 500 is up 16.0%. And the average fund has produced a gain of +18.0%—two percentage points better. The 500 triumphed in the first quarter, but the average fund led the second quarter lap, as Indexes magazine headlined, "Man Bites Dog! Pros Beat Indexes." And the average fund led again in the third quarter lap, which The New York Times (somewhat more temperately) headlined, "A Small Victory for Stock Picking." If the year ends with the S&P Index still lagging, we can expect to see more dramatic headlines as year 2000 begins. So, at least for the moment the tables have turned ever so slightly toward the active fund managers, and we indexers must be ready with a rational response. So let's begin with the basics: The fact is that indexers always win. That is, in any financial market—and any segment of any financial market—indexers owning all of the securities in that market at low cost must provide better returns than the other investors in the market in the aggregate, simply because the costs incurred by active investors—commissions, fees, taxes—are substantially higher. Costs matter. Costs always matter. And that is why active managers as a group can never win. So the answer to the question "When active managers win, who loses?" is: other active managers. Perhaps hyperactive managers, or inactive managers, or managers not included in the database. Nonetheless, simple data being simple data, there will be years when it looks as if active managers win. Mutual fund history, indeed, shows that the average fund beat the S&P 500 in 1991–1993, in 1977–1982 (right after our index fund began), and in 1965–1968 (the Go-Go era). But there is much more to the data than meets the eye—especially over the long run. Let me give you just a few examples:
**For the tax-deferred investor, the relative returns are: active fund, +12.9% annually and +517% cumulative; index fund, +16.7% annually and +914% cumulative. A Retrospective So, fellow indexers, be of stout heart: Active managers as a group never win. As we begin to commemorate the 25th anniversary year of the birth of the index mutual fund, amid the surfeit of data available today, let's never lose sight of that immutable fact—time-honored to a fault. As Peter Bernstein tells us in his remarkable book Capital Ideas, it was way back in 1908 that the French economist Louis Bachelier spelled out the unequivocal brute fact in his thesis: "The mathematical expectation of the speculator is zero." However, he ignored the costs of investing, the proceeds raked off by the numerous croupiers at work in the marketplace. After these costs, as I expressed it most recently in a New York Times op-ed piece last summer: "In the stock market casino, it is the croupiers who win." Paraphrasing the title of a book of the 1940s, I asked "Where are the customers' private jets?" Where, indeed. Nobel Laureate Paul Samuelson has said that his view of indexing theory, "oscillated from regarding it as trivially obvious (and almost trivially vacuous) and regarding it as remarkably sweeping." Of course, it is both, giving further testimony to the ancient wisdom of Sir William of Occam. In 1621, he formulated a rule that came to be known as "Occam's Razor," essentially that, "when confronted with multiple solutions to a complex problem, choose the simplest one." Yes, the secret of success in investing is the obvious one: The haystack trumps the needle, almost every time. No matter what the data that compare active managers with market indexes appear to show, we'd best never ignore that immutable fact. As Oliver Wendell Holmes reminded us, "we need education in the obvious more than investigation of the obscure." I hope my message tonight has reinforced that wisdom. The information provided on our website may be used in conjunction with the offering of Vanguard fund shares only if preceded or accompanied by a prospectus. You can download a prospectus or request one by mail in the Prospectuses and Reports area of Vanguard.com's Funds Directory, or by calling Vanguard at 1-800-871-3879. Return to Speeches in the Bogle Research Center. |
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