The Vanguard Group

An Index Fundamentalist Goes Back to the Drawing Board

by John C. Bogle
Founder and Former Chairman, The Vanguard Group
Journal of Portfolio Management
Spring 2002, Volume 28, Number 3

In 1997, I prepared a study1 of the returns for the mutual funds in each of the nine Morningstar "style boxes," a matrix with large-, mid-, and small-capitalization funds on one axis and value, blend, and growth funds on the other. The study, covering the five-year period 1992 through 1996, presented powerful evidence that the low-cost quartile of funds in each box had not only earned higher returns than those in the high-cost quartile, but returns that significantly exceeded the cost differential.

The results can be summarized as follows: Average return of low-cost funds, 14.9%; average return of high-cost funds, 12.3%. This difference of 2.6 percentage points was double the 1.3% expense ratio differential of the funds (annual expenses ratio of low-cost quartile, 0.7%; expense ratio of high-cost quartile, 2.0%). The differential increased slightly when risk-adjusted returns were substituted for total returns. As a result, I concluded: An investor who doesn't seriously consider limiting selections to funds in the low-expense group and eschewing funds in the high-expense group is someone who should take off the blinders—perhaps even a bit of a fool.

The Role of Costs

Emboldened by the magnitude and consistency across the nine style boxes, I then asked, in effect: Since the lowest-cost funds in the marketplace today are index funds, why not just buy index funds in each of the style boxes? I then tested that proposition, and I found the results equally compelling. In seven of the nine boxes, the comparable-style index produced higher returns, and in all nine boxes, the index funds assumed lower risks. In terms of risk-adjusted returns, the index fund's superiority was substantial in eight boxes, and marginally lower in but one (small-cap growth). Holding risk constant, the indexes delivered a return surplus of 3.6 percentage points per year (16.5% vs. 12.9%) in the large-cap group, 4.2 percentage points (18.0% vs. 13.8%) in the mid-cap group, and 4.4 percentage points (19.5% vs. 15.1%) in the small-cap group.

Armed with this data on the relationship between fund costs and fund performance, I concluded: "The magnitudes are so large and so consistent as to devastate the concept of high cost active management." Prudently, however, I added the obvious caveat: "We should go only so far with five-year numbers in a strong equity market . . . But a shorter period would be even less satisfactory, and a longer (ten-year) period would cut the number of funds we could observe by half, making for a less reliable sample. (But) the five-year data deserves testing in other periods and under a variety of market conditions."2 This paper will do exactly that, using the ten-year period ending June 30, 2001.

The Results

The decade-long period from June 30, 1991, to June 30, 2001, covered in the new study clearly included a variety of conditions—the quiet stock market of 1992-1994, the boom of 1995-1999, and the subsequent bust in 2000-2001. Interestingly, however, the annual return of the S&P 500 Stock Index was virtually the same during the past decade (15.1%) as during the earlier study (15.2%). However, the variation in actual returns between the best and worst style boxes was large in the prior study: 3.2 percentage points (15.1% to 11.9%). In the present study, the variation in average return between the extremes was only remarkably small: 1.3 percentage points (14.5% to 13.2%). This table presents the data:


Annual Rate of Return*
Ten-Years Ended June 30, 2001
Value Blend Growth
Large-Cap 13.6% 13.2% 13.4%
Mid-Cap 14.4 14.5 13.8
Small-Cap 14.5 14.3 14.4

The hypothesis that the funds in the low-cost quartile would outperform those listed in the high-cost quartile was again clearly validated during this period, as this table shows.


Annual Rate of Return
Ten-Years Ended June 30, 2001
Low-Cost Quartile High-Cost Quartile Low-Cost Advantage
Large-Cap Value 14.8% 12.8% 2.0%
Large-Cap Blend 14.7 10.9 3.8
Large-Cap Growth 14.2 11.2 3.0
Mid-Cap Value 15.3 12.5 2.8
Mid-Cap Blend 15.4 14.2 1.2
Mid-Cap Growth 14.7 12.5 2.2
Small-Cap Value 16.8 12.0 4.8
Small-Cap Blend 15.6 11.3 4.3
Small-Cap Growth 15.4 14.5 0.9
All Funds 14.5% 12.3% 2.2%


The expense ratio differential during this period was 1.2% (0.6% for the low-cost funds, 1.8% for the high-cost funds), a bit less than the 1.3% spread in the prior study (0.7% to 2.0%). But the performance differential was once again approximately double the cost differential, 2.2% and 2.6% respectively. Each $1.00 of extra cost, then, resulted in a loss of $1.83 of return in the ten-year period, as compared to $2.00 in the five-year period.

Unlike the previous period, in which the risk exposure of the high-cost funds (standard deviation, 12.2%) was only slightly higher than for the low-cost funds (11.8%), the risk exposure differential during the past ten years had increased sharply. The standard deviation of the low-cost funds averaged 17.4%, vs. 20.1% for the high cost funds, a 15% greater risk exposure. As a result, the risk-adjusted returns of the low-cost funds averaged 13.8%, versus 10.8% for the high-cost funds, raising the performance differential to 3.0% annually during the past decade. That is, each $1.00 of extra cost resulted in a loss of $2.50 in risk-adjusted return. It is not possible to understate the significance of these differences. Costs matter, and they matter even more now than the earlier study suggested.3

The consistency of the advantage in risk-adjusted return that low-cost funds have achieved over high-cost funds is remarkable, as this table shows.


Risk-Adjusted Returns 4
Ten-Years Ended June 30, 2001
Low-Cost Quartile High-Cost Quartile Low-Cost Advantage
Large-Cap Value 15.3% 13.4% 1.9%
Large-Cap Blend 14.6 11.0 3.6
Large-Cap Growth 13.3 10.2 3.1
Mid-Cap Value 15.8 11.5 4.3
Mid-Cap Blend 14.3 12.4 1.9
Mid-Cap Growth 13.7 11.6 2.1
Small-Cap Value 15.9 10.6 5.3
Small-Cap Blend 15.1 11.8 3.3
Small-Cap Growth 16.6 13.7 2.9
All Funds 13.8% 10.8% 3.0%

The Sharpe ratio provides another way of viewing risk-adjusted returns. In the previous study, the average Sharpe ratio for the low-cost funds was 1.13, or 35% higher than the 0.84 for the high-cost funds. But even that substantial difference widened in the ten-year study. The Sharpe ratio of 0.77 for the low-cost funds compared to 0.52 for the high-cost funds, an improvement of fully 48%.

This differential is even more consistent through the nine style boxes than was the case in the prior study, when eight of the nine style boxes fit the pattern. In the ten-year study the low-cost funds demonstrated substantial superiority in all nine of the style boxes.


Sharpe Ratios
Ten-Years Ended June 30, 2001
Low-Cost Quartile High-Cost Quartile Low-Cost Advantage 5-Years Ended Dec. 31, 1996
% Difference
Large-Cap Value 0.91 0.74 23% 60%
Large-Cap Blend 0.82 0.51 61 24
Large-Cap Growth 0.62 0.40 55 33
Mid-Cap Value 1.01 0.60 68 63
Mid-Cap Blend 0.81 0.66 23 56
Mid-Cap Growth 0.48 0.35 37 45
Small-Cap Value 1.04 0.57 82 9
Small-Cap Blend 0.74 0.46 61 (7)
Small-Cap Growth 0.60 0.43 40 8
All Funds 0.77 0.52 48% 35%


Index Funds

As a result of the powerful link between cost and return evidenced in my earlier article, I then asked the obvious question: If costs matter so much—as they obviously do—and if index funds are the lowest cost funds—why not just hold index funds that replicate each of the nine style boxes? That proved to be a profitable avenue of exploration. Taking all mutual funds as a group, and comparing them to a mix of comparable index funds, the earlier results showed the following:


Five-Years Ended December 31, 1996
Expense Ratio Annual Return Risk* Sharpe
All Funds 1.25% 13.7% 11.9% 0.99
High-Cost Quartile 2.03 12.3 12.2 0.84
Low-Cost Quartile 0.69 14.9 11.8 1.13
Index Funds 0.25 15.1 9.7 1.23

As the table shows, the Sharpe ratio of the index funds (1.23) exceed that of the average managed fund (0.99) by fully 24%; that of the high-cost funds (0.84) by 0.39, or 46%; and even that of the low-cost funds (1.13) by 0.10, or 9%. The consistency of this relationship between index funds and managed funds throughout the nine style boxes was remarkable. In eight of the nine boxes, the appropriate index fund Sharpe ratio exceeded that of the average managed fund by from 0.16 to 0.46. (In the four fund groups with the largest —and therefore more statistically significant populations—the range was narrower +0.16 to +0.31). Only in the small-cap growth fund segment did the small-cap growth index fund fall short, by 0.06. (More about that group later).

The new study clearly confirms the finding of the earlier study. During the ten-years ended June 30, 2001, the index fund advantage was again compelling:


Ten-Years Ended June 30, 2001
Expense Ratio Annual Return Risk* Sharpe
All Funds 1.16% 13.7% 18.7% 0.67
High-Cost Quartile 1.85 12.3 20.1 0.52
Low-Cost Quartile 0.64 14.5 17.4 0.77
Index Funds 0.20 14.4 16.2 0.79

The Index fund advantage over the average fund was slightly smaller than in the previous study—18% above the Sharpe ratio of the average fund (0.79 vs. 0.67), versus 24%. The advantage increased from 46% to 52% over that of the high-cost funds, (0.79 versus 0.52), but declined from 9% to 4% above that of the low-cost funds (0.79 versus 0.77).


Sharpe Ratio: Index Funds vs. Managed Funds
Ten-Years Ended June 30, 2001
Index Fund Managed Fund Index Advantage Index Advantage 5-Years Ended Dec. 31, 1996
Large-Cap Value 0.88 0.81 0.07 8% 25%
Large-Cap Blend 0.84 0.69 0.15 22 20
Large-Cap Growth 0.68 0.55 0.13 24 23
Mid-Cap Value 1.00 0.82 0.18 22 29
Mid-Cap Blend 0.87 0.74 0.13 17 30
Mid-Cap Growth 0.48 0.45 0.03 7 24
Small-Cap Value 1.06 0.84 0.22 26 40
Small-Cap Blend 0.73 0.67 0.06 9 20
Small-Cap Growth 0.38 0.48 (0.10) (21) (9)
All Funds 0.79 0.67 0.12 18% 24%


Once again, the index funds prevail over active managers, albeit at somewhat lower margins of advantage. The uniformity of advantage is striking, with the index funds providing higher risk-adjusted returns in eight of the nine style boxes, with the sole exception being the apparent superiority of active managers in the small-cap growth category, as evidenced in both the present and previous studies.

Summing up the Studies

It is highly significant that the ten-year study so powerfully echoes and reinforces the findings of the five-year study. Once again, low-cost funds outpace high-cost funds. Once again, costs matter even more than we expect (i.e., a 1% reduction in costs generates an increase in risk-adjusted return that is much larger than 1%). Once again, index funds—the fund category with the lowest costs—give an excellent account of themselves. The earlier study concluded: (1) higher returns are directly associated with lower costs; (2) the notion that indexing works only in large capitalization markets no longer has the ring of truth. Both conclusions are reinforced in the current study.

Mutual Fund Returns are Consistently Overstated

The consistency of the data in the two studies is impressive. But however one regards their validity, it must be recognized that the average returns of the actively managed mutual fund that I have presented are significantly overstated. First and foremost, they are survivor-biased. Only the funds that lived through the decade to report their performance at the close of the period are included in the sample. The 634 funds for which Morningstar reported ten-year records represent the survivors of an estimated 890 funds which began the decade. The records of the remaining 256 funds are lost in the dustbin of history. It is reasonable to postulate that the poorer performers dropped by the wayside, thereby biasing the study results in favor of the manager.

How much bias? We can't be sure. Independent studies confirm that survivor bias is substantial. In the Carhart and Malkiel studies5, survivor bias ranged from 1.5% to 3.1% per year. If we were to assume a bias of 2% during the ten-year period ended June 30, 2001 (larger for each of the small-cap groups, smaller for the large-cap groups), the annual risk-adjusted return of the average managed fund would drop to from 12.5% to 10.5%, a 3.9 percentage point shortfall to the 14.4% return of the total stock market, more than double the active fund shortfall of 1.9% suggested in these data. When they fail to acknowledge the role of survivor bias in the data, studies that purport to show that indexing doesn't work leave much to be desired.

Several years ago, in another study, Morningstar estimated the survivor bias for each of its style boxes over the five-year period 1992-1996. Even in that relatively short period, the bias was equal to almost 1% per year. Interestingly, in the light of my earlier finding that only small-cap growth funds had succeeded in outpacing their target index, the annual survivor bias in that style box was 1.7%. If we assume, for the purpose of argument, that the (necessarily larger) ten-year bias was 3.0% per year, the data showing a 1.7% percentage point annual advantage over the index for small-cap managers becomes a 1.3% disadvantage.

Some Fund Returns are Inflated

Second, even the records of those funds that do survive are to some degree suspect. It is hardly without precedent for small funds, often those run by large advisers, to inflate their records by purchasing IPOs, quickly "flipping" them and generating returns that do not recur when the fund gets large. Two managers have been fined by the SEC for this practice: One managed a fund which reported a 62% return for 1996, an excess return largely accounted for purchasing just 100 to 400 shares of 31 hot IPOs. The other rose 119% during the 18 months following its initial offering, 83 percentage points of which came from first-day gains realized on newly-public stocks. In yet another case, a fund advertised (in bold-face type) a 196.88% return in 1999, acknowledging (in small print) that a significant portion came from IPOs. Yet these records are included in the industry data as if they were the holy writ.

Third, actively-managed funds surrender a substantially larger portion of their pre-tax performance to taxes, in an amount that could have increased index fund superiority by as much as another 1.5% per year or more during the past decade. The 13.7% pre-tax annual return reported by the average mutual fund fell to an after-tax return of 11.1%, a loss of fully 2.6 percentage points to taxes. Since only one index fund has operated during the entire past decade, after-tax style-box returns for the indexes are not available. But the largest S&P 500 Index fund carried a tax burden of just 0.9%—far less than the tax burden for the average fund. Ignoring taxes represents one more overstatement of fund returns by most studies of manager performance.

Fourth, fund sales charges are ignored in most fund comparisons, including the data used in this study. Nonetheless, sales charges represent a hidden reduction in reported returns. If we assume that a decade ago three-quarters of all funds carried an average initial sales charge of 6%, the cost, amortized over the ten years, would reduce returns reported by funds by another 0.5% annually. The high turnover of fund shares by investors, however, indicates that the average holding period is no more than five years. Thus, the actual reduction in annual return engendered by sales charges would be significantly larger than 0.5%, another substantial reduction in the return of managed funds.

When we consider all of these factors, it must be clear that, whatever relationship exists between style-box returns in managed funds and index funds, the reported returns of managed funds are significantly overstated. Nonetheless, even accepting the overstated fund data as presented, mutual funds as a group, style-box by style-box, with only one exception, fall well short of their index fund benchmarks, largely as a result of the costs they incur. Index funds win.

The Data vs. the Facts

One might say: So what else is new? For it must be obvious that if we take all stocks as a group, or any discrete aggregation of stocks in a particular style, an index that owns all of those stocks and precisely measures their returns must, and will, outpace the return of the investors who own that same aggregation of stocks but incur management fees, administrative costs, trading costs, taxes, and sales charges. Active managers as a group will fall short of the index return by the exact amount of the costs the active managers incur. If the data we have available to us do not reflect that self-evident truth, well, the data are wrong.

There are infinite ways in which the data can mislead. We count each mutual fund as a unit in calculating average returns, while the industry's actual aggregate record is reflected only in an asset-weighted return. Funds rarely stay rigidly confined to their style boxes; a growth fund may own some value stocks; a small-cap fund may own mid-cap and large-cap stocks.

Of course, it is at least theoretically possible that mutual fund managers as a group may be smarter than other investors, and in fact consistently outpace the market by an amount sufficient to overcome their substantial costs. But let's think about that. Is it realistic to believe that fund managers who—including the pension accounts they manage—control the investment process applicable to upwards of 35% of the value of all U.S. equities, can outpace other managers, advisers, and individuals? For example, for fund managers to outpace the market by 1% annually after costs of, say, 2% (excluding taxes) would require an excess return of 3%. In that case, all other investors as a group would then lose to the market by about 2% per year, or by 4% after costs. In reasonably efficient markets such as those in the U.S., where prices are set largely by professional investors, such a gap would seem inconceivable. Further, the available data showing returns earned by individual investors give every indication that, like institutions, individuals match the market before costs and lose to the market after costs, a conclusion that would surprise no one who has ever examined performance data with care.

Important Success

Even someone who has never plied the fund performance seas must understand this central fact of investing: Investment success is defined by the allocation of financial market returns—stocks, bonds, and money market instruments alike —between investors and financial intermediaries. Despite the elementary, self-evident, and eternal nature of this capital market equation—gross return minus cost equals net return—the dialogue between advocates of indexing and advocates of active management continues unabated, for there is a lot of money at stake—certainly well over $100 billion per year. Mutual fund direct costs alone (excluding sales charges and transaction fees) account for some $70 billion; fund trading costs likely account for an additional $50 billion or more.

The reality is that the horses ridden by the mutual fund jockeys are handicapped with so much weight that the entire fund industry cannot possibly win the race for investment success. Given the limitations on the data available that I have noted above, of course, if one searches long enough and hard enough, one can possibly identify interim periods in which the equation will appear to be disproven. But the reality is what it is. While there can be debate over the figures, there can be no debate over the facts: For invesors in the aggregate, the capital market equation is unyielding. Yes, some managed funds can, and some do, outpace the indexes, but there is no sure way to identify them in advance.

Indexing and Market Efficiency

There is one more misconception that needs to be put to rest. It comes in this form: "If (Bogle) is right (about the role of cost and the superiority of indexing), he will be wrong; and if he is wrong, he will be right. The more people become convinced they can beat the market (i.e, Bogle is wrong) the more efficient the markets become as more intelligent and capable professionals enter the market. Ironically, it then becomes less likely they will outperform it. (But) if managers and investors come to believe active management is a waste of money (i.e., Bogle is right), money managers will be replaced by index funds. This will reduce the number of market participants, and hence worsen market efficiency. The remaining minority of active managers will then have a better chance of outperforming their respective markets."6

Alas, that allegation does not meet the test of simple logic. Whether the markets are efficient or not, as long as the index reflects the performance of the market (or any given segment of the market), it follows that the remaining participants (largely active managers) will also earn the market return (or market segment return) before their intermediation costs are deducted. Syllogism: (1) All investors as a group earn the market return. (2) Index funds earn the market return. Therefore: (3) All non-index investors earn the market return—but only before their costs are deducted. Result: The substantial costs of financial intermediaries doom active investors as a group to inferior returns.

Admittedly, if our markets turn inefficient—something that is hard to imagine in these days of infinite information—the "good" managers may be able to enlarge their edge over "bad" managers. But it must be self-evident, that in effect, each manger who succeeds in outpacing the stock market by, say, 4% per year before costs over a decade, must be balanced by another who falls short by 4%, again before costs. Efficient markets or inefficient, active managers—good and bad together—lose. Such is the nature of financial markets.

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