Remarks by John C. Bogle, Chairman and Founder
The Vanguard Group
Before The Washington (D.C.) Society of Investment
December 16, 1997
Today, more than any time in the history of the financial markets, the
quest for investment success is focused on relative performance over the short-term.
We have entered what I call "The Age of Investment Relativism," as all eyes
seem focused on a comparison that has become as much a part of our lives as
the daily fluctuations in the stock market: How did the equity portfolio we
manage perform relative to the Standard & Poor's 500 Composite Stock Price
Index? Whether we experience happiness or misery seems to depend on how we
answer that question.
The impecunious and mercurial Mr. Micawber (in Charles Dickens' David Copperfield) set the stage for my theme some
150 years ago, bestowing happiness and misery according to the following formula: "Annual income, twenty pounds, annual expenditures nineteen six, result happiness.
Annual income, twenty pounds, annual expenditures twenty pounds six, result
Similarly, as investment managers today, we work in a system that seems
to operate according to this updated formula: "market return, eighteen point
six; my return nineteen point one; result happiness. Market return, eighteen
point six, my return fifteen point seven; result misery."
That latter comparison, in fact, expresses the shortfall of the average
domestic equity mutual fund to the stock market (as measured by the S&P
500 Index) over the past 15 years18.6% vs. 15.7%. Surely it suggests
why most managers of equity funds are feeling considerable professional miseryif
hardly financial miserytoday.
The more things change, it seems, the more they remain the same.
If the issue were simply "did the adviser outpace the market?" over
the decade, the answer is clear. Most advisers did not. Indeed, as a matter
of simple mathematics and elementary logic, most advisers cannot outpace the
market. And it is only fair that advisers should fully disclose not only the
absolute rates of return they have achievedin interim periods and over
the long termbut how those returns have compared to the returns that
would have been achieved by an appropriate
benchmark standard accepted by manager and client alike as a prime measure
of success over the long pull.
But we have long since passed that basic point of departure. Now we
see a powerful focus on quarterly relative performance. And the
performance is invariably related to a single, omnipresent "bogey" (a Scottish
word meaning "goblin," and few advisers regard it in kinder terms), the redoubtable
S&P 500 Stock Index.* What is more, we often see weekly comparisons, and
even daily comparisonsafter a significant market drop but,
curiously, rarely after a sharp rally. "Having gone up less for all those
years," the client asks his fund manager, "did you go down less when the market
dropped 554 points a few Mondays ago?" The oddly and narrowly constructed
Dow Jones Industrial Average, of course, remains our basic measure of daily
market swings, though the market-value-weighted S&P 500 is equally invariably
used when the time comes to make relative return comparisons over longer periods.
Today, just as institutional pension officers scowl over their bifocals
as they review the quarterly performance comparisons in regular meetings with
their investment advisers, so individual investors receive the data each quarter,
either in real time on their computers, or as late (shocking!) as the next
morning's newspaper. It seems dubious in the extreme that such short-term
focus can be other than counterproductive.
I should point out that these rat-a-tat volleys of comparative information
are of relatively recent vintage. Indeed, mutual fund sponsors were prohibited
by the Statement of Policy of the NASD from publishing "total returns"even without making comparisonsfrom 1950 through
1965. But, by the early 1970s, the total-return teetotaler of the old days
had become a social drinker. It may not be stretching things to say that by
the early 1990s he was on the verge of becoming an alcoholiccomparisonwise,
to be sure.
It doesn't really matter whether today's omnipresent S&P comparison
has been fomented by the information overload in this miraculous age of communications
technology. Or by the self-styled sophistication of the institutional client,
who seems to have a vested interest in frequently changing advisers. Or by
the appetite of the burgeoning mutual fund industrywith its daily asset
valuationsas funds have become the investment of choice among American
families. Or by the overly aggressive marketing of funds. (Have any of the funds you see advertised ever fallen short of the S&P 500?) Relative investment performance"investment
relativism" if you willis the order of the day.
The problem with all of this is not that managers should not be held
to a performance standardof course they shouldbut that they
are held to a single standard irrespective of client objectives, and that
the measurements take place during extremely short periods. We might well
ask: "To what avail?"
*In fact, I must confess to being amused by the irony that the "bogle"
is in fact the earliest-known goblin, already part of Scottish literature
in 1500. (Some years ago, I was called "Beta Bogle, the data devil.") Given
my role in forming the first index mutual fund in 1975, it is not without
possibility that active managers place me in the goblin category.
Enter "Closet Indexing"
Surely it is no service to our clients that many fund managers, caught
up in the perception that beating the market each quarter is happiness and
losing is misery, seem to use the 500 Index as the mandatory measuring stick
for their own portfoliosi.e., "S&P technology stocks, 14% of the
value of the index, 21% of my portfolio; GE, 3.0% of the S&P, 1.2% of
my portfolio," and so on. All with this implicit question: "Is my 'bet' (as
it is usually described) the right one? Or should I align my portfolio more
closely to the index?" There's a lot of casino capitalism by managers and
clients alike going on in investing today, and I suppose "betting"even
betting not to loseis as good as
any word to characterize this over-reliance on the composition of an unmanaged
and relatively unchanging market index.
In recent years, it seems to me, this strategy has become almost tacitly
accepted. Indeed, there is considerable anecdotal evidence that we have gone
beyond mere measurement to action, as in "I think Coca-Cola is grotesquely
overvalued. But, in case it keeps going up, I'm going to buy a 1.5% portfolio
position for protection. Since that's less than Coca-Cola's 2.0% weight in
the S&P 500 Index, I'll have a good defensive position versus the Index
when it takes the tumble it so richly deserves." Whatever the case, isn't
that philosophy the antithesis of professional investment management? Hasn't
it become the formula followed by a nervous portfolio manager anxious to hold
his or her job? Isn't it the result of the marketing department's holding
sway over the investment department? In each case my finding would be: "Guilty
Such a "closet indexing" strategy is, in my view, more pervasive than
most investors recognize (or have been led to recognize). But, whether it
takes place at the margin of a portfolio or permeates it, I've never seen
it disclosed in a fund's prospectus. (A cynic might wonder whether fund independent
directors and trustees have been fully informed on the subject.) To be sure,
so far it largely applies, when it does, to the large-cap managers. Closet
indexing is a relatively simple process when the ten largest stocks in the
S&P 500 Index represent nearly 20% of the Index, the largest 50 stocks,
50%. Even if it creeps into the small cap side of the business, it seems unlikely
to permeate it, since the largest ten stocks comprise just 1.7% of the Russell
2500 Small Cap Index, the largest 50 stocks just 8.2%. That said, the fact
is that large-cap strategies dominate the financial markets. Large-cap stocks
account for roughly two-thirds of the assets of all equity mutual funds, and
an even higher proportion of institutional assets.
And closet indexing may well be having an impact on stock returns. While
I'd never ascribe causality to any of the myriad factors that affect the price
of a stock, it seems more than coincidence that so far in 1997 the largest
gains among the blue chip stocks whose capitalizations dominate the market
have come to those stocks in which mutual funds have the smallest relative
positions. Yet the five largest stocks in the 500 Index most underowned by
mutual funds are up almost 50% so far this year, compared to an average gain
of roughly 30% for the remaining 495 stocks.
Put another way, could it be that active managers, in their passion
to compete with the passive Index, are primarily responsible for driving up
the price of the underowned large stocks in the Index, giving it, over the
past three years, the most formidable record of outpacing active fund managers
in the history of the Index, surpassing 90% of equity funds? Are managers
forcing their portfolios to become more Index-like, so as to avoid serious
shortfalls in the quarterly comparison "sweepstakes" (another word from the
world of gambling)? And, if so, are managers sowing the seeds of their own
performance inferiority today? Stranger things have happened.
Well, these trends suggest why I describe the present era as the Age
of Investment Relativism, in which the overarching goal is to avoid inferior
short-term returns relative to the S&P 500, rather than to achieve superior
absolute long-term returns. Since quantitative science entered the business
of mutual fund performance in the mid-1980s, relativism has become the basis
of a comprehensive performance measurement system. Beta (risk,
measured by the fund's price volatility relative to the 500 Index), and Alpha (the fund's rate of relative return adjusted
for risk) have entered our lexicon. We also have the Sharpe Ratio, measuring
a fund's excess return over the Treasury bill relative to its risk (standard
deviation), not to be confused with the information ratio (Selection Sharpe
Ratio), which measures excess return over a benchmark standardusually,
of course, our devilish friend, the S&P 500. I do not believe that this
focus on simplistic mathematical precision is an entirely healthy state of
being for managers or for their clients, nor for the market itself. Yet there
is, as yet, no end in sightno Omega on
The Real Villain: The Index Fund
Surely the most important reason by far for the defensive reaction of
managers to index comparisons is the index fund itself. The index is
a mean adversary, but the index fund is
the real villain of the piece. Once upon a time, managers could (and did)
use the argument, "yeah, but who can buy the market?" And later, "yeah, but
the index is theoretical, and it would cost a lot to buy, be expensive to
operate, and you wouldn't be able to nearly match the index." The low-cost
index fund has given the lie to these foolish make-weight arguments. But even
though Vanguard founded the first index mutual fund began in 1975, fully 22
years ago (perhaps the bogle goblin really was the
data devil), it was not until the mid-1990s that index funds began to catch
the fancy of investors and become a formidable competitor for their assets.
And tough competition they are. As recently as 1994, index funds accounted
for only 3% of equity fund flow ($4 billion). In 1997, index fund inflow should
reach a 15% share ($30 billion). What is more, tough in the marketplace they
should be. For they have been tough in the market. As I noted at the outset, the total return on the original S&P 500 index
fund (net of costs) over the past 15 years was 18.2% annually, compared to
15.7% for the average U.S. equity fund. While this period was an especially
fine one for the large cap stocks in the S&P, even atotal stock market index fundthe Wilshire 5000 Equity Index,
adjusted to account for estimated costswould have returned 17.7%, only
0.5 percentage points shy of the 500 and still an advantage of two full percentage
points in annual return. (And that's even before fund sales charges are taken
The fact is that, at least in my judgment, the index fund should be the investment of choice. It is the odds-on
(pardon another expression from the world of gambling) favorite to win the
race (another!) against three of every four managers. We know that, for the
market as a totality, low-cost investingwhich is really all that an
index fund is aboutineluctably beats high-cost investing over the long
run. And while I happen to prefer the all-market index because of its complete
diversification and nominal portfolio turnover, I can't imagine that the long-term
return of the S&P 500 Index, comprising as it does 70% of the market,
will vary significantly from the return of the total market. In any event,
the marketplace, now dominated by S&P 500 indexing, is increasingly moving
in the direction of all-market indexing. I fully expect that over the next
few years this broader strategy will become the principal choice for institutional
indexers and fund indexers alike.
I also strongly favor the use of indexes from market segments as the
standards for funds with particular investment styles (i.e., large-cap value,
small-cap growth, etc.). However managers should be warned that, taking into
account relative return (generally solid for the segment indexes across the
board) as well as relative risk (generally significantly lower for the indexes, a point almost universally ignored), the advantages
of an index strategy are equally apparent at all market cap levels and in
all investment styles and venues. So, market segment index funds seem certain
to take their proper place in the marketplace, and all forms of indexingnow
about 15% of institutionally-managed equity assets, will continue to grow,
perhaps to as much as 25% to 30% a decade hence.
The Rise of Quantitative Investing
And the bad news for traditional managers continues. Another form of
index-like competition is emerging, and I'm confident it too will take its
place in the field. I refer to what are called "quantitative" investment strategies,
which I define to be computer-driven strategies that rely rigidly and exclusively
on mathematical formulas to manage investment portfolios. I differentiate
the use of quantitative techniques as the foundation of portfolio strategy
and selection from the clearly pervasive use of computers to screen and value
individual stocks and stock groups as part of the traditional security-analyst-based
management process. ("We're all quants now.") Today, industry estimates place
the assets managed by quants at $100 billion, and the growth rate is strong.
Some of these quantitative strategies might fairly be described as the
ultimate form of investment relativism. But they must not be confused with
closet indexing. With fully disclosed policies and strategies, they are hardly
hidden in the closet; their strategies are rigorous and controlled, not random
and intuitive; and their costs are often well below conventional norms. (It's
far less costly to run a computer program than to employ a large portfolio
research and management staff.)
Typically known as enhanced index funds, these funds seek to outpace
a market index. The first mutual fund in this category began in 1986, and
has slightly bettered the index itself, by enough to give it a significant
edge over an index fund. The overall evidence of success in such "disciplined"
and/or "sector neutral" strategies, as they are known, is quite mixed, but
my guess is that they'll prove attractive to investors who realize the value
of indexing, but can't quite abandon all hope that they can identify in advance
active managers who will outperform.
Other strategiessometimes known as "Positive Alpha" or "market
neutral"are based on achieving, not a rate of relative return, but
an absolute rate of return. These strategies may gain an advantage by their
ability to use specialized investment techniques (including short-selling,
hedging, etc.) and often rely on strict quantitative discipline. These managers
may gain an advantage by capitalizing on the fund industry's Achilles' heel:
asset size. When assets under management are limited, the drag of transaction
costs is held within tolerable levels that do not themselves frustrate the
implementation of aggressive investment policies. Both of these developing
quantitative approachesEnhanced Indexing and Positive Alpharepresent
important challenges to the status quo.
The Changing Role of the Traditional Active Manager
Faced with this competition, how should the traditional manager respond?
If closet indexing is the wrong response, indeed a counterproductive oneas
I believe it iswhat is the right one? First, a given: today and for
as far ahead as the eye can see, each adviser should freely acknowledge that
he or she should be expected to outpace an agreed-upon market performance
standard over the long run, and strive to do just that. What else is an adviser supposed to do? How else can we measure whether any
economic value being created is sufficient to justify the cost of retaining
the adviser in the first place? Of course, the standard need not necessarily
be the S&P 500 Index (though it would be appropriate for large cap funds
with a blendedgrowth stocks and value
stocksstyle). Broader all-market indexes will also become part of the
world of investing.
And other styles may also be considered as standards. Indexes measuring
returns for style/market cap "boxes" (nine, under the Morningstar
system) will also become part of our world. It is simply unrealistic for small-cap
managers, or mid-cap managers (or for that matter high-cost large-cap managers,
though they have the best chance) to duplicate
the long-term record of an all-market index. They should be measured against
the market segment (or segments) in which they choose to participate. Weighted
indexes combining appropriate levels of large cap and small cap, value and
growth, and international surely make sense. That said, however, blame the client if he selects a small-cap strategy and the
adviser outperforms the small-cap universe yet fails to outpace the total
market over the long term. But blame the adviser
if he overweights small-cap in the hope of beating the total market over the
long term but fails to do so.
Further, consider the role of bonds and cash reserves in the asset mix
of the target index. Stock indexes (and index funds), to state the obvious,
hold neither. A balanced fund should be measured against a balanced mix of
stocks, bonds, and reserves. And it would not necessarily be foolish for an
adviser to an equity fund which holds a fairly consistent 5% to 15% position
in cash reserves to use a similarly adjusted stock/reserve benchmark. Such
a policy would dampen the fund's volatility during those inevitable times
when stock prices tumble. But "slightly lower" must be what the client is
given to expect. In any event, it is important that the client understand
that it is next to impossible to "market-time" a changing cash position. And
most important of all, the client must understand that, in a positive stock
market over time, he will pay a commensurate price in relative rate of return.
Put simply, he should understand that, over the long-run, a
percentage point increase in volatility is meaningless; a percentage point
increase in return is priceless. That powerful, and, I think virtually
unarguable syllogism, should give both adviser and client ample food for thought.
Confronting the Index Challenge
In this age of investment relativism, I'm convinced thatfaced
with the competition of index investing and quantitative investingtoo
many managers today are responding in the most ineffective manner possible,
by "closet indexing." But shaping an inchoate and
undisclosed policy around the structure of an index is, finally, managerial
suicide. It is the ultimate concession to the unarguable economic
value of the low-cost, passively managed index fund over the high-cost, actively
managed traditional fund. The managed fund then provides an ever more index-like
portfolio, until it becomes a virtual index fundbut without the added
value provided by low operating and advisory expenses, microscopic portfolio
turnover and commensurately lower taxes, and a fully invested participation
in equities. In short, today's chance of
victory, as small as it demonstrably is, will become tomorrow's certainty of defeat if managers offer tacit index
funds with high fees, high portfolio turnover, and a significant position
in cash reserves. And it is the mutual fund shareholder who will pay the price.
Relativism suggests that managers are becoming more similar to
the enemy"if you can't beat 'em, join 'em." But in the long-term, it
is being different that gives an individual
manager at least a fighting chance to win the battle for extra market return.
Surely holding to a clearly differentiated strategyand, for mercy's
sake, keeping a tight lid on fees and other coststo cope with the realities
of index competition is better than just standing there and hoping, again
in Mr. Micawber's words, that "something will turn up."
I acknowledge that not all fund managers subscribe to the new relativism.
Indeed, some of the better managers in the field find it repugnant. A recent
article in MONEY magazine suggests that
it is caused by "aggressive marketing executives who see short-term numbers
as the best way to attract new shareholders." One top strategist says, "that's
the marketing side of the business talking, not someone with a fiduciary duty."
Another asserts, "relative investing is ridiculous." Still another routinely
consults what he describes as his 11th Commandment: "Thou shalt not do relative
investing." Warns another, "relativity worked well for Einstein but has no
place in investing."
Such mutual fund managers who elect to be differentand I wish
that there were more of themneed to make it absolutely clear to shareholders
that their returns will not closely track the quarterly returns, nor even
the annual returns, of a market index, even as the managers should make it
equally clear that their expectation is to outpace the market over the long
run. The short-term nature of today's pervasive environment of comparisons
is merely noise, a discordant element that ill-serves managers and financial
markets alike. In this context, I reiterate a thought, courtesy of William
Shakespeare, contained in my book. I describe the short-term noise in the
market as "a tale told by an idiot, full of sound and fury, and signifying
In short, relativism is the triumph of process over judgment. I believe
that it is possible for some managers to apply judgment borne of wisdom and
experience to outpace the market over time, without assuming undue risk. The
characteristics of those who do so will be individuality, training, experience,
savvy, determination, contrarianism (or sheer iconoclasm), and hard work.
The Puritan Ethic is not all bad! Importantly, they will limit the assets
of the funds they manage relative to the market cap of the asset class in
which they utilize their expertise, and relative to their proclivity to actively
trade the portfolio rather than analyze, buy, and hold.
Some successful managers, rather than being concerned with short-term
relative risks, will run fully invested equity positions to capitalize on
the fundamental long-term opportunities of equity investing. Others will succeed
simply by investing with the courage of their convictions, rather than slavishly
relying on short-term standards, and holding cash reserves when they judge
market risk as excessive. Both groups will manage their funds at reasonable
costs, allocating their fee revenues toward human talent and investment productivity,
rather than engaging in marketing profligacy designed not to improve investment
returns for fund shareholders, but solely to advance the manager's own profitability.
In short, to be successful in a world in which indexing and quantitative
strategies will become increasingly pervasiveand fully competitivethe
successful traditional investment manager must serve the client's interest
. . . first, last, solely.
To conclude, I rely again on Charles Dickens, this time in A Tale of Two Cities: "It was the best of times.
It was the worst of times." It has been the best of times for the stock market,
a 15-year bull market of unprecedented magnitude, creating happiness beyond
measure. But it also has been the worst of times (though it is hardly perceived
as that . . . yet), creating misery for the average mutual fund manager, who
has lagged the S&P 500 Index by an unprecedented annual margin of nearly
three percentage pointssurely less than a ringing tribute to professional
management. Looking ahead to a new century, the mutual fund industry must
be challenged to serve its clients much more effectively.
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in the Bogle Research Center
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