by John C. Bogle, Founder , The Vanguard Group
President, Bogle Financial Markets Research Center
To the Bullseye 2000 Conference
In a sense, the year 2000 marks the
100th anniversary of the birth of the idea of market indexing. For
it was a century ago when a French academic named Louis Bachelier
published his dissertation, The Theory of Speculation. In
his seminal paper, Bachelier concluded that since "past, present,
and even discounted future events are reflected in market price
. . . it is impossible to aspire to mathematical predictions of
[price]." As a result, Bachelier concluded (and italicized): "The
mathematical expectation of the speculator is zero." We now
understand that to be one of the central facts of finance.
The Theory of Transaction Costs
In his 70-page dissertation, however, Bachelier
made no reference to the role costs play in shaping the returns
actually realized by the speculator. But today we understand that
the costs incurred by market participants matter . . . and matter
a great deal. So while Bachelier was right that the mathematical
expectation of the speculator—and, for that matter, of the long-term
investor—to outpace the returns earned in the financial markets
is zero, that expectation implicitly assumes that the costs of investing
too are zero. But after the costs of investing are taken
into account—after all of the fees, the transaction costs, and the
hidden costs of financial intermediation-the mathematical expectation
is for a loss … a loss that is precisely equal to the sum of those
So it is only to state the obvious when I say—as
I do, one way or another, in almost every speech that I deliver—the
financial markets are not for sale, except at a high price.
Yet when we present long-term returns in the stock market (whether
using the Standard & Poor's 500 Stock Index in the U.S. or the TSE
300 in Canada), we completely exclude investment costs and taxes.
As a result, we are in fact presenting only a theoretical construct
based on cost-free, tax-free investing. These market returns grossly
distort economic reality. Result: When we consider the inevitable
costs of investing, reality—a reality that is self-evident and inescapable—bites
theory: The net return of all investors as a group must fall short
of the gross return of the market by the amount of their costs.
Beating the market is a loser's game.
Now, 100 long years after Bachelier wrote his
paper, this reality has finally taken root, even among financial
market participants who are not among the lowest-cost players in
the game. Consider the recent paper prepared by Merrill Lynch
and BARRA Strategic Consulting Group entitled "Success in Investment
Management: Building the Complete Firm." Written by senior executives
of the two firms—after consultation with as distinguished a list
of money managers and powerful fund sponsors as one could possibly
imagine*—the study reaches this major, if obvious, conclusion: "Management
of Embedded Alpha, the frictional costs of running a portfolio,
will emerge as an essential contributor to investment manufacturing
quality and performance."
(*Among the firms named as providing assistance
and perspective for the study: Fidelity, Putnam, Mellon, State Street,
Oppenheimer, Citigroup, and Massachusetts Financial Services. I
hope that you will pardon me if I wonder how carefully they considered
its sweeping implications.)
The Merrill Lynch/BARRA Study
For me—and I think for you as financial service
professionals—the heart of the ML/BARRA study is not its
long series of speculations, however intelligent, about the future
development of investment management—the business itself, investment
manufacturing (their off-putting word); distribution; viable
business models; and optimal size. Rather, the heart of the study
is its clear articulation of what it calls Embedded Alpha,
the frictional costs that detract from the return that can be theoretically
produced by an investment portfolio in a frictionless securities
market. In a special appendix, firms are urged to "Manage Embedded
Alpha, Cut Those Hidden Costs." The costs are identified in these
direct quotations from the study:
- "Tangible Costs . . . management
fees and trading commissions. Each dollar given away for, say,
management fees is a dollar explicitly detracted from the portfolio
- "Managed Costs . . . unintended risk
exposures, tax costs, and Not-Equitized-Cash, an opportunity cost
for not keeping funds fully invested.
- "Invisible Cost . . . the adverse
market impact of trading and the opportunity cost of delaying
The study's conclusion: "Simply
put, every incremental basis point increase in rate of return translates
into competitive advantage (by which) a firm improves its absolute
performance and its ranking relative to its peers." Thus, what the
study calls the Complete Firm, the firm that "will lead the
way . . . will diligently seek to minimize these performance detractors."
Thus spaketh, I remind you, not Vanguard/BOGLE, with our 26-year
history of driving investment costs down, but Merrill Lynch/BARRA.
As the old saw goes, "there is no one more religious than a convert."
Here is their prescription
for curing the disease entitled, "Releasing Embedded Alpha."
- Take a Holistic View (whatever exactly
that is in this instance). Appoint a single Embedded Alpha
champion with the firm.
- Take an Alpha Inventory. Develop
a coherent policy, and review all work processes.
- Set Priorities. Widen managerial
bandwidth. (Again, I confess my ignorance of exactly what that
means in this context.)
- Develop a Strategic Agenda. Set goals
by which to measure success.
- Make It Real on the Shop Floor. Communicate
the agenda and align incentives accordingly.
- Tell the Market. Make the approach
to managing Embedded Alpha credible, then aggressively promote
it . . . This approach can improve the probability of superior
returns. (I'm not quite sure how aggressive promotion can relate
to superior returns.)
To my surprise, however, the
study presented no data whatsoever—none—on the dimension
of Embedded Alpha. "Purposely," we're told, "the paper does not
focus on data and statistics." But, the dimensions of cost are astonishingly
large, especially in mutual fund business. Based on my best estimates
of the costs currently incurred by investors in U.S. equity funds,
here is the picture:
|Average Equity Mutual
||% of Average Assets
| Advisory Fees
| Other Operating Expenses
|Total Expense Ratio(a)
| Transaction Costs(b)
| Opportunity Cost(c)
| Sales Charges(d)
a. Unweighted mutual fund ratio. The weighted
ratio is about 1.1%.
b. Most studies show far higher transaction costs. But since market
impact itself must be a net zero, (i.e., your aggressive
sale creates my bargain purchase), my low estimate reflects how
much "The Street" charges for its trading services.
c. Assuming 12% stock return; 6% cash return; 7% of assets in reserves.
d. 5% sales charge, amortized over ten-year holding period.
e. Assuming 10% fund after-cost return, 1% income, 9% capital;
50% of gains realized annually, two-thirds long-term, one-third
short-term; maximum tax bracket.
As it turns out, Embedded
Alpha is even higher in Canada. Consider these figures, for Canadian
|Average Canadian Equity
||% of Average Assets(a)
| Advisory Fees
| Other Operating Expenses
|Management Expense Ratio (MER)
| Transaction Costs
| Opportunity Cost
| Sales Charges (annualized)
a. The Power of Index Funds, by Ted cadsby. See
You don't need me to tell
you that the frictional drag from financial intermediation—330 basis
points (U.S.) or 470 basis points (Canada)—is a lot of Embedded
Alpha. And, if we include even modest estimates of taxes, it quickly
rises to 490 and 570 basis points, respectively.
Now let me show you how all
of this works out in practice. First, to be conservative, I'm going
to slash that 330 basis point charge by using a U.S. expense ratio
weighted by fund assets (a 50 basis point drop); and second, by
ignoring the 60 basis points for sales charges (since some funds
are available on a no-load basis). By so doing, I've reduced assumed
costs to 220 basis points. So let's use that conservative figure
as a benchmark for the Embedded Alpha of the average U.S. equity
Next, I'm going to assume
that funds earn average returns equal to those of the stock market
itself. My own data for the past 15 years suggest that, before
the deduction of all that Embedded Alpha, the average fund that
survived the period actually outpaced the stock market (Wilshire
5000 Total Market Index) by about 50 basis points per year. However,
only about one-third of all funds in business during that period
survived, and it seems reasonable to conclude that it was the poorer
performers that failed to stay the course. So an assumption that
the average fund provided a market-matching return seems not only
fair, but perhaps even generous.
Now let's look long-term.
Despite today's environment of frighteningly short-term investment
horizons, most new investors today, starting their programs with
their first $1,000 in a Canadian RRSP or a U.S. IRA or 401(k), will
still be investing 70 years hence. I'll use just 50 years as a long-term
horizon. What toll would a 220 basis point cost have taken on the
13.3% return that the Standard & Poor's 500 Stock Index earned over
the past 50 years? The fund would earn 11.1%, or 2.2% less. When
compounded, $1,000 in the S&P Index itself would grow to $514,000;
the fund, after costs, would grow to $193,000—a $321,000 loss to
the financial intermediaries. When we include taxes in the equation—I'll
be conservative again, and use 240 basis points, a tax rate of just
over 20%—the mutual fund annual pre-tax return of 11.1% drops to
8.7% after taxes. Then, the compounded value falls another
$128,000 to $65,000. Just $65,000.
But there's more trouble ahead.
Each year, investors pay their intermediation costs and their taxes
in current dollars. But they must measure their capital in
constant dollars. During the past half-century, the inflation
rate was 4.0%. Result: Real annual return for the investor,
4.7%. Another $55,000 reduction in final purchasing power
. . . to just $10,000. That real total is $504,000 less than
the theoretical total of $514,000 with which we began. Wow!
Put another way, the mutual
fund's real annual return before costs was not the 13.3%
nominal return earned by the S&P Index, but 9.3%. Result: The 2.2%
intermediation cost reduced each year's real return, not
by 16%, but by 24%. And that 2.4% tax cost further reduced
the fund's real annual return, not by 22%, but by 34%.
When we consider that annual
data through the remarkable magnifying glass we call compounding,
we can describe the investment returns earned by the fund—on cost
and tax assumptions that I think we can all agree are hardly excessive—as
shocking. The investor lost 63% of the market's cumulative return
to the intermediaries, 66% of that to taxes, and 85% of that
to inflation, ending up with just $10,000, or less than 2% of the
$514,000 compound market return. Yes, the U.S. mutual fund industry
is an expensive home for long-term investors.
Now, let's compare the fund
returns with those that would have been achieved by investing in
an index fund modeled on the Standard & Poor's 500 Index.
To be sure, such a fund would have fallen short of the Index itself,
for it must operate in the real world, paying operating costs and
being subject to taxes. But by holding those costs to the bare-bones
minimum, it would have performed quite a remarkable service relative
to the average mutual fund.
Assuming all-in costs of
20 basis points, the index fund would have provided a 13.1% annual
return, compounding to $471,000 vs. $193,000 for the active fund.
After a 120 basis point charge for taxes (index funds are typically
about twice as tax-efficient as ordinary funds), its net total value
would have been $276,000 vs. $65,000 in current dollars. In constant
dollars, the index fund final value would have been cut by inflation
to $45,000, vs. $10,000. The reality: The index fund would have
provided 2.4 times the after-cost value of the mutual fund,
4.2 times the fund's after-tax value, and 4.5 times the fund's
real terminal value. Yes, Embedded Alpha is a powerful destructive
What Can Active Managers
Learn From Indexing?
Paraphrasing the Greek philosopher
Horace, I fear that, like the mountains, the financial giants and
fund managers who developed the ML/BARRA study have "labored and
brought forth a mouse." Had they taken the trouble to make these
calculations of annual Embedded Alpha, and then compounded the resultant
return over the long-term, and then considered the reality that
costs and taxes are paid in current dollars but long-term
returns are received in real dollars, they would have realized
the truly confiscatory nature of intermediation costs and taxes.
Given the dramatic differences
of long-term returns I've just presented, my recommendations on
controlling costs, and my strategies for doing so, would be less
cliché-ridden, more blunt, and surely more difficult for managers
to swallow. (If you don't accept my thesis, of course, feel free
to ignore them.) So I urge investment professionals to accept these
- Accept the Mathematical Reality. Explicitly
recognize and acknowledge that investment success—not just in
the long-run, but every day—is defined by the apportionment of
market returns between investors on the one hand and financial
intermediaries on the other.
- Lower Expense Ratios.
Management expense ratios (MERs) on funds must be substantially
- Don't pay for past performance.
Reward future performance through incentive fee structures that
reward the successful manager—and penalize the unsuccessful manager.
(In the U.S., this structure must be symmetrical.)
- Be wary of costly marketing programs.
Advertising expenses (usually plumping high—and unsustainable—returns)
are ultimately paid by fund shareholders. Special note to the
U.S. mutual fund industry, where some firms' annual advertising
budgets exceed $50 million, and even $100 million: Those expenses
raise serious questions of fiduciary duty, questions about whether
the investment interests of fund clients are playing second
fiddle to the marketing interests of the adviser.
- Demand information on transaction costs.
Equally important, demand information about fund transactions.
Fund managers, fund intermediaries, and fund clients alike ought
to know whether transaction activity has enhanced or detracted
from the net returns a fund has realized for its shareholders.
- Get the facts about taxes. In this
great bull market, taxes have been the largest single component
of Embedded Alpha. Evaluate fund managers on after-tax returns,
and consider separate funds for taxable and tax-deferred accounts.
- Consider opportunity cost. Cash, to
be sure, is fine when it's raised just before a market decline.
But you know as well as I that there's simply no evidence that
funds have been successful at market timing. The return-enhancing
characteristics of cash in down markets is inevitably a small
fraction of its return-reducing characteristics in the
rising markets that are far more common.
In short, if actively-managed
funds are to meet the challenges posed by Embedded Alpha, they will
have to begin to adopt some of the characteristics that have given
passively-managed funds their remarkable advantage. If active managers
do not adapt to a world of smarter, better-informed, more cost-conscious,
and more tax-aware investors, the acceptance of index funds will
simply accelerate even more rapidly. Finally, the client will
The S&P 500 Index
You'll note that I've used
the S&P 500 Index as my market measure for the past 50 years. While
it was the only good standard available in 1950, it remains
the most widely accepted standard and, most importantly, continues
to provide an excellent long-term—if imperfect short-term—measure
of the entire stock market. Yet it's a peculiar index in some respects.
You may have heard-and even believed!—the apocryphal story about
the bumble bee: After carefully examining its aerodynamics, weight,
and size, an expert group of scientists proved beyond doubt that
the bumblebee can't fly. Yet fly it does. A similar fable
might be applicable to the Standard & Poor's 500 Stock Index: It
doesn't look like it should work, but it obviously does. One only
has to consider a few anecdotal examples to understand why it might
be a poor measure of market performance.
Consider first the S&P 500
fifty years ago, then as now an index of large-cap stocks in a large-cap
dominated market. (Well, not the S&P 500; it was the
S&P 90 from 1926 through 1957.) In 1950, it represented a highly
concentrated tribute to industrial America. Although I don't recall
anyone examining the composition of the Index with the kind of attention
lavished on it today, General Motors, its largest holding, represented
13.6% of its weight. Standard Oil of New Jersey (now ExxonMobil)
was next at 9.3%, and the top ten holdings accounted for 51.3% of
its weight, twice as concentrated as the 23% weight of the top ten
today. (IBM, which was to be the star performer of the subsequent
two decades, didn't join the Index until 1957.) Surprisingly, AT&T,
with a market capitalization larger than General Motors', was conspicuous
by its absence. Over the ensuing 50 years, two companies were dropped
from the Index, two others were merged, and the original 51.3% weight
falling by 92% to just 4.2% as the 1950 "Old Economy" base dwindled
in importance. Despite this remarkable handicap, the S&P Index dominated
the active fund managers during the era that followed.
90: Top Ten Stocks in 1950
1. General Motors
2. Standard Oil of N.J.
|3. Union Carbide
|4. Standard Oil of Calif.
|6. Texas Company
|7. U.S. Steel
|8. Kennecott Copper
|9. Eastman Kodak
Now advance the calendar to
1964. AT&T has now joined the Index, with a weight of 9.1%. Next
largest is General Motors at 7.3%, then Standard Oil of New Jersey
at 5.0%, and IBM at 3.7%. The "top ten" then accounted for 38.5%
of the index, again far higher than today's top ten weight of 23%.
Since then, the weight of these Old Economy leaders has tumbled
to barely 10% of the Index currently, but even their fall from grace
failed to diminish the sharp advantage of the 500 Index over the
average mutual fund during the 36 years that followed.
500: Top Ten Stocks in 1964
2. General Motors
|8. General Electric
|9. Gulf Oil
|10. Eastman Kodak
Just one more example. In
1980, with the quantum surge in oil prices and high expectations
for the petroleum industry, the energy sector's weight rose to an
all-time high of 32%. I suppose that it would have seemed foolish
to own such a single-industry-dependent index fund back then. And
in fact the index didn't, well, fly very impressively relative to
active funds during 1977-1983. Nonetheless, the splendid long-term
record of the S&P 500 during the years that followed, as we now
know, brooks no apologies. Like the bumble bee, the index can
fly. And on long flights, it soars.
Today, of course, the Index
has an equally heavy weighting in the "New Economy," including an
important dependence on technology stocks (34% at its high in March,
now 25%—a pretty good wallop!). I admit that even the current concentration
unnerves me a bit. But I'm such a believer in the magic of indexing
that I remain unshaken in my conviction that, no matter what the
short-term may hold, indexing continues to represent the best way
to invest for the long-term. Finally, broad diversification, low
cost, minimal portfolio turnover, and tax-efficiency conquer all.
| 7 %
A Moving Target
That is not to say the S&P
is an easy target for an investor—or even an average index fund
manager—to track. Change it does! Indeed in the past 20 years there
have been an astonishing 489 changes in the 500 Stock Index. These
are not trivial changes; on average during that period, each year
has resulted in the addition of stocks accounting for 2.8% of the
index's capitalization—an aggregate two-decade replacement equal
to 58% of its value. Typically, these changes are represented by
mergers; the few stocks deleted from the index for other reasons
typically have had very small market caps.
In essence, then, today's
S&P 500 Index is the result of a process in which old stocks have
been deleted from the Index at a rate of about three percent per
year, meaning that the weightings of each of the other holdings
is reduced by that same three percent per year. Had the 500 Index
remained unchanged over the past six years for example, Microsoft,
Cisco, and Intel would have represented, not the 4.9%, 2.8%, and
2.3% of the Index that they represented as 2000 began, but about
5.5%, 3.2%, and 2.5%. While these are not to be taken as hard numbers,
they do suggest that a strategy of gradually paring back
winners may have helped to marginally improve the performance of
the Index. Active managers may want to take note.
The S&P 500 = The U.S.
For all of its idiosyncrasies,
the fact is that the S&P 500 has been a virtually perfect representation
of the total U.S. stock market. The best long-term measure we have
for the stock market is the CRSP index, calculated by the Center
for Research in Security Prices at the University of Chicago. A
line chart comparing the cumulative returns of the S&P 500 Index
and the CRSP Index since 1926 presents two lines that are virtually
indistinguishable, with the S&P 500 having a compound annual return
of 11.3% and the CRSP Index a return of 11.0%. What is more, looking
at modern history—since 1953—both returns have averaged an identical
12.8%. The correlation coefficient (R2) between the two has been
a remarkable 0.975—about as close as the law allows.
To be sure, an index fund
covering the entire stock market has some important potential advantages.
It owns everything, including mid- and small-cap stocks,
and thus manifests more purely the theoretical justification of
indexing: Own the entire market, and by holding costs and taxes
to the bare bones minimum beat the lion's share of market participants.
There is even lower turnover, for stocks come into the index when
they are very small and there is no reason to sell them when they
reach an arbitrary size. They are held forever . . . or at
least until they are merged into another corporation. So while a
choice between an index fund based on the S&P 500 or one based on
the Wilshire 5000 Total Stock Market Index (more accessible than
the CRSP data, and with an historical R2 of 0.995) appears indifferent,
I continue to favor the total market index as the ideal form for
the U.S. stock index fund.
The TSE 300 has its idiosyncrasies
too. While it represents a larger proportion of the Canadian equity
market (85%) than the S&P 500 does in the U.S. (73%), it is considerably
more concentrated. Currently, 44% of the weight of the TSE 300 rests
in its largest ten stocks, versus 25% for the S&P 500. This concentration
is almost entirely the result of the remarkably-successful Nortel,
presently 19% of the TSE weight, with the next largest holding (BCE)
representing less than 4%. The other top-ten holdings roughly parallel
the 2% to 3% weights of their top-ten peers in the S&P 500.
Such a substantial weighting,
of course, presents a significant diversification issue, recently
manifested by the sharp 40% drop in Nortel's price from late September
through mid-November. Its weight in the TSE Index dropped from 28.5%
on September 30 to its recent 19% total. To be sure, investors as
a group holding the entire Canadian stock market suffered a similar
decline, and the central principle of indexing—"beat the market's
participants in the aggregate simply by owning the market itself
and minimizing costs"—remains intact. Yet, at some point, we ought
to consider developing indexes that meet certain pre-established
diversification standards (say, no more than 10%-15% of assets in
any one stock) irrespective of the weightings of the largest companies.
Surely Finland would be an interesting place to begin, with Nokia
currently representing 72% of the value of the Helsinki All-Shares
Index. But I believe such situations will prove rare and ephemeral,
and the present construction of the TSE Index should continue to
serve as an effective standard for long-term investing.
Annual Variation in Returns
While the S&P 500 is clearly
an excellent long-term proxy for the total U.S. stock market, there
will inevitably be individual years when it diverges. In 1991-1993,
it lagged the Wilshire 5000 Index by nearly three percentage
points per year. In 1996-1998, it led by three percentage
points annually. And so far this year it is ahead by about two points.
But what accounts for most of the periodic annual divergences in
the percentage of U.S. mutual funds outperformed by the S&P 500
is not how the Index differs from the stock market in total.
Rather, it is the peculiar characteristics of the mutual fund industry.
In terms of assets,
the large-cap stocks like those represented in S&P 500 represent
about 72% of the market's capitalization. Similarly, large-cap stocks
represent about 70% of the assets of the mutual fund industry.
But when counting—as we do—the number of individual funds,
some 57% are large-cap, 23% mid-cap are and 20% are small-cap, a
motley mix indeed. So, "percentage of funds outperformed" provides
but a crude measuring stick by which to judge the short-term success—or
failure—of the 500 Index.
As a result of these structural
differences, it's been a relatively common occurrence for the 500
Index to look better than it really is in some years
(the late 1990s, when it outperformed 85% of active funds on average)
and worse than it really is in others (the early 1990s, when it
outperformed less than 45% of funds). Indeed, in 1977-1980, the
first three full years in the life of Vanguard's pioneering 500
Index Fund, the Index outpaced only 22% of all equity funds. (It
wasn't much fun, but we kept the faith!) As this next chart shows,
there's a lot of reversion to the mean in the Index's returns relative
to the performance of U.S. equity funds. But the key to success
is basically the ability of the Index to stay out of the lower one-third
of funds—it appeared in that group in only four years out of 38,
or about one in ten. Who wouldn't be happy with any fund that
could do that! It will hardly surprise you to know that the
fact that the 500 Index is outpacing but about 38% of all U.S. mutual
funds so far in 2000 has not shaken a whit my confidence in the
merits of indexing.
Nonetheless, the S&P 500 (or
the CRSP, or the Wilshire 5000; it doesn't matter a great deal)
must remain the ultimate benchmark for all fund portfolios
no matter whether the market capitalization sizes—large, medium,
small—they represent, and no matter what investment style—growth,
value, blended—they emphasize. I can accept, if a bit grudgingly,
the current fashion of "benchmarking"—comparing the return of a
small-cap growth fund, for example, with the return of an index
of small-cap growth stocks-as a short-term tool for ascertaining
whether or not the manager is investing in accordance with his own
proscriptions (and, assumedly, those of his clients). But it seems
to me obvious that the fairest comparison of return over the
long-run is with an all-market index, not a style index.
It is difficult to imagine
that a client seeking a particular style—and a manager offering
that style as representative of his or her particular area of expertise
and comparative advantage—does not make that selection because it
is expected to enhance long-term returns. "What gaineth the client,"
one might say, "if he winneth the style derby, but loseth to the
whole stock market." So I think we in the investment world have
the duty, simply as a matter of fair and complete disclosure, to
present both sets of comparisons—the style benchmark and
the all-market benchmark—to clients. Let's let narrow style benchmarking
dictate neither our investment decision-making nor our standard
for appraising long-term accomplishment. In the long run, for better
or worse, investing is all about capturing as much of the market's
total return as we can.
Simplicity in an Era of
Today, changes are swirling
all around all of us in the investment community. Astride this great
bull market, the Information Revolution has presented us with more
facts and figures than we can possibly absorb, along with soaring
volumes, volatile markets, heightened public interest in financial
matters, and intense media coverage of almost every stock and every
mutual fund under the sun. Excessive and growing expenses and an
increasingly short-term focus, however, have combined to create
an insuperable Embedded Alpha in the mutual fund industry.
These trends have opened the
door to index funds—still the best way I know to capture substantially
all of the annual returns earned in the financial markets—although
index funds still represent barely 10% of U.S. equity fund assets.
But whether we subscribe to index dogma or not, we must remind ourselves
once again that the most productive investing is the most peaceable
investing, the lowest-cost investing, the most tax-efficient investing—investing
with the most consistent strategies, over the longest possible time
If you agree with these premises,
the opportunities for the sound management of individual investment
accounts through mutual funds hold great opportunity. But it's up
to true investment professionals to place far more emphasis on the
stewardship of the assets entrusted to them by their clients and
far less emphasis on responding to transitory stock market trends
and seemingly-compelling near-term marketing opportunities. There
is a line between the profession of investing other people's
money and the business of marketing financial products. That
it is an invisible, subtle line, however, doesn't mean it is non-existent.
And when we cross that line, we have a lot to answer for.
The best way for the true
professional to keep from crossing that line is to pay simple homage
to the timeless truth of the financial markets. Whether it is Bachelier
speaking, or Bogle, or the Embedded Alpha paper of Merrill Lynch/BARRA,
the mathematics of the markets are eternal. The investment
success of investors in the aggregate is defined—-not only over
the long-term, but every single day—by the extent to which market
returns are consumed by financial intermediaries. Index funds need
not be the only answer, for there is no reason that managed funds
that model their strategies, shape their portfolios, moderate their
transaction activity, and improve their pricing cannot take advantage
of the simple disciplines that have served index investors so well.
Such firms, I believe, will better serve their clients, and in the
long run better serve themselves. Even in this era of ever more
abundant information and ever growing complexity, the professional
firm that decides to emphasize simplicity and stewardship will soon
find that opportunity beckons!
Variations on Long-Term,
If the all-market index standard
should—finally, must—be the long-term standard for equity accounts
of all stripes, what use is served by the scores of index variations
on this basic theme over the past decade-plus? I confess that, with
the passage of time, I have become increasingly concerned about
the utility of these variations, and I owe this audience the professional
courtesy to tell you what bothers me and why it does so.
First, confession being good
for the soul, it was primarily because of my own drive and conviction
that Vanguard became the pioneer in index funds. We formed the first
S&P 500 Index fund in 1975, and then in 1987 pioneered the completion
("Extended Market") index fund, tracking the small- and mid-cap
stocks unrepresented in the S&P 500. In 1992 we created the all-in-one
Total (U.S.) Stock Market Index Fund. That same year, we also started
our Growth Index and Value Index Funds. Still earlier, in 1989,
we had converted a tiny actively-managed Vanguard small-cap fund
into a passive Russell 2000 Index fund, creating the industry's
first small-cap index fund. And in recent years we've added three
more index funds—mid-cap, small-cap growth, and a small-cap value
fund. That's a lot of market segment funds!
Over their histories, the
Vanguard segment funds have done quite respectably—and given the
survivor bias that significantly overstates the achievements
of actively-managed small-cap and mid-cap mutual funds, they are
doubtless far better than that—what's my concern? First, my instinctive
feeling is that the use of segment funds is unlikely to add long-run
value to the total market return. Second, I believe too many investors
are using these funds, not to fill gaps in their portfolio structure,
but to move assets around based on past performance, a formula apt
to result in failure.
What is more, these segment
funds carry far higher annual portfolio turnover-last year, 40%
to as high as 80%—many times the turnover of our S&P 500 Index Fund
(6%) and our Total Stock Market Fund (3%!). What a difference
a benchmark makes! While so far trading costs and tax impacts
have been nicely constrained, if our shareholders move their money
around rapidly in less generous markets than these, or heavily withdraw
substantial assets in a bear market, the roadblocks to maintaining
the tracking excellence we've demonstrated will be formidable.
Many of these problems could
be solved not by the creation of better funds, but by the
creation of better market-segment indexes—indexes with new
definitional concepts offering less sensitivity to stock substitutions,
and therefore lower portfolio turnover—and the imposition of redemption
fees to reduce short-term trading in these funds. For those investors
who cannot resist the urge—which they doubtless should resist!—to
overweight or underweight one market segment or another, such funds
may well provide the most sensible approach.
While indexing of all types
continues to grow, much of the recent growth has come, not through
conventional index funds, but through novel index funds known as
ETFs (exchange-traded funds). The assets of these funds totaled
$53 billion at mid-year, compared with $350 billion in standard
index mutual funds. But they are used primarily, not by long-term
investors, but by speculators. This year, the Spiders (SPDRS)
are being turned over at an annualized rate of 1415%, and the NASDAQ
100 Qubes at a rate of 5974%: Respective average holding
periods: 26 days, and six days. Why not? They are promoted
as short-term investments. A full-page advertisement for SPDRs recently
proclaimed: "Buy and sell the S&P 500 just as easily as you trade
a single stock . . . with real time pricing, you can trade your
position throughout the trading day." ETFs so far at least have
been developed as products for marketers and not for long-term investors.
So, lest we forget, I reiterate: There is a critical difference
between designing a product to sell to customers and creating
an investment to serve its owners.
to Speeches in the Bogle Research Center.