The Vanguard Group
What Can Active Managers Learn from Index Funds?

Remarks by John C. Bogle, Founder , The Vanguard Group
President, Bogle Financial Markets Research Center
To the Bullseye 2000 Conference
Toronto, Canada
December 4
, 2000

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 costs.

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."

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:

  1. "Tangible Costs . . . management fees and trading commissions. Each dollar given away for, say, management fees is a dollar explicitly detracted from the portfolio net return.
  2. "Managed Costs . . . unintended risk exposures, tax costs, and Not-Equitized-Cash, an opportunity cost for not keeping funds fully invested.
  3. "Invisible Cost . . . the adverse market impact of trading and the opportunity cost of delaying trade execution."
  1. Take a Holistic View (whatever exactly that is in this instance). Appoint a single Embedded Alpha champion with the firm.
  2. Take an Alpha Inventory. Develop a coherent policy, and review all work processes.
  3. Set Priorities. Widen managerial bandwidth. (Again, I confess my ignorance of exactly what that means in this context.)
  4. Develop a Strategic Agenda. Set goals by which to measure success.
  5. Make It Real on the Shop Floor. Communicate the agenda and align incentives accordingly.
  6. 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.)
Average Equity Mutual Fund % of Average Assets
Advisory Fees 1.1%
Other Operating Expenses 0.5
Total Expense Ratio(a) 1.6%
Transaction Costs(b) 0.7
Opportunity Cost(c) 0.4
Sales Charges(d) 0.6
Total 3.3%
Taxes(e) 1.6
TOTAL 4.9%
Average Canadian Equity Mutual Fund % of Average Assets(a)
Advisory Fees NA
Other Operating Expenses NA
Management Expense Ratio (MER) 2.2%
Transaction Costs 1.3
Opportunity Cost 0.7
Sales Charges (annualized) 0.5
Total 4.7%
Taxes 1.0
TOTAL 5.7%
  1. 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.
  2. Lower Expense Ratios. Management expense ratios (MERs) on funds must be substantially reduced.
  3. 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.)
  4. 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.
  5. 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.
  6. 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.
  7. 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.
S&P 90: Top Ten Stocks in 1950
  1950 1960

1. General Motors

13.6% 0.2%

2. Standard Oil of N.J.

9.3 2.8
3. Union Carbide


4. Standard Oil of Calif. 4.4 0.5*
5. Sears 4.2 0.1
6. Texas Company 3.8 0.3*
7. U.S. Steel 3.7 0.1
8. Kennecott Copper 2.8 0
9. Eastman Kodak 2.2 0.1
10. Chrysler 2.0 0
51.3% 4.2%
S&P 500: Top Ten Stocks in 1964
  1964 2000

1. AT&T

9.1% 0.6%

2. General Motors

7.3 0.2
3. Exxon


4. IBM 3.7 1.5
5. Texaco 3.1 0.3*
6. DuPont 2.9 0.4
7. Sears 2.2 0.1
8. General Electric 2.2 4.1
9. Gulf Oil 1.6 0
10. Eastman Kodak 1.4 0.1
38.5% 10.1%
Index Sector Weightings
S&P 500
Wilshire 5000
12/1990 3/2000 11/2000 11/2000

Basic Materials

7 % 2 % 2 % 2 %

Capital Goods

10 8 9 8
Communication 9 8 6 6
Cons. Cyclicals 10 8 7 8
Cons. Staples 17 10 12 12
Energy 14 5 6 5
Financials 7 13 15 16
Health Care 11 9 13 13
Technology 9 34 25 25
Transportation 2 1 1 1
6 2 4 5

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