Remarks by John C.
Founder and Former Chairman, The Vanguard Group
Washington State University
April 13, 2004
September 2005, a little more than a year
from now, will mark the thirtieth anniversary of the creation of the first
index mutual fund. That fund—originally, and proudly, named First Index Investment
Trust—is now, as Vanguard 500 Index Fund, the largest mutual fund in the world.
But that is only one indication of the success of index investing. For the
heresy that was indexing—passive portfolio management that invaded
a kingdom ruled, indeed populated solely by, active portfolio managers—has
now become dogma, part of the academic canon, taught almost universally
in college finance courses and in business schools, and part of the daily
discourse of investors.
The evidence on the triumph of indexing
is overwhelming. In the mutual fund industry, total assets of equity
index funds, barely $1 billion in 1990, now total over $550 billion,
one-sixth of all equity fund assets.
While that first index fund of 1975 wasn’t copied until 1984, nearly a decade
later, there are now 430 equity index funds, and even 30 bond index
funds. In the pension world, where the idea of indexing took hold
several years earlier than in the fund field, the indexed assets
of corporate and state and local retirement plans, $900 billion
in 1990, now total $3½ trillion.
Combined indexed assets—linked
to U.S. and international stock and bond indexes—of mutual funds
and retirement plans now exceed $4 trillion. Indeed, three of America’s
ten largest money managers (State Street Global Advisors, Barclays
Global Investors, and Vanguard, all overseeing from $700 billion
to $1 trillion in assets) have reached this pinnacle largely on
the basis of their emphasis on index strategies.
But the impact of indexing has gone far beyond the trillions
of dollars of assets that rely on pure index strategies. “Closet
index funds” that closely track the Standard and Poor’s 500 Index,
for example, are rife, seeking to add value by making relatively
modest variations in index stock weightings, all the while engaging
in tight “risk control” by maintaining a high correlation with the
movements in the market index itself. And rare is the active “buy-side”
institutional portfolio manager who, seeking to minimize what has
come to be called “benchmark risk,” fails to compare the weights
of his portfolio holdings with those in the index. The icing on
the cake of indexing: Wall Street’s “sell-side” analysts no longer
recommend “buy, sell, or hold.” Today, “over-weight, under-weight
and equal-weight” stocks relative to a firm’s share of the market’s
total capitalization have become the profession’s words of art,
itself a sort of closet indexing approach.
There can be no question that index-matching strategies—simple
and broadly diversified, heavily weighted by stocks with large capitalizations,
with low fees and low portfolio turnover—have changed the landscape
of our financial markets, and set a new standard in the way we both
measure and enjoy our investment returns. Yes, our focus has turned
away from absolute return and toward relative performance—beating
or falling short of the index benchmark. Of course, absolute performance
is what investors can actually spend, but, to state the obvious,
the fund that has the best relative performance is also the
The Intellectual Basis for Indexing
While the clear triumph of indexing can hardly have
surprised thoughtful observers of the financial scene, few commentators
have recognized that two separate and distinct intellectual ideas
form the foundation for passive investment strategies. Academics
and sophisticated students of the markets rely upon the EMH—the
Efficient Market Hypothesis—which suggests that by reflecting
the informed opinion of the mass of investors, stocks are continuously
valued at prices that accurately reflect the totality of investor
knowledge, and are thus fairly valued.
But we don’t need to accept the EMH to be index believers.
For there is a second reason for the triumph of indexing, and it
is not only more compelling but unarguably universal. I call it
the CMH—the Cost Matters Hypothesis—and not only is it all
that is needed to explain why indexing must and does work, but it
in fact enables us to quantify with some precision how well
it works. Whether or not the markets are efficient, the explanatory
power of the CMH holds.
More than a century has passed since Louis Bachelier,
in his Ph.D. thesis at the Sorbonne in 1900, wrote: “Past, present,
and even discounted future events are (all) reflected in market
price.” Nearly half a century later, when Nobel Laureate Paul Samuelson
discovered the long-forgotten thesis, he confessed that he “oscillated
. . . between regarding it as trivially obvious (and almost trivially
vacuous), and regarding it as remarkably sweeping.” In essence,
Bachelier was, as far as he went, right: “The mathematical
expectation of the speculator is zero.” By 1965, University of
Chicago Professor Eugene F. Fama had performed enough analysis of
the ever-increasing volume of stock price data to validate this
“random walk” hypothesis, rechristened as the efficient market hypothesis.
Today, the intellectual arguments against general thrust of the
EMH religion are few. While it would seem extreme to argue that
all stocks are efficiently priced all of the time,
it would seem equally extreme to deny that most stocks are
efficiently priced most of the time.
But whatever the consensus on the EMH, I know of no
serious academic, professional money manager, trained security analyst,
or intelligent individual investor who would disagree with the thrust
of EMH: The stock market itself is a demanding taskmaster.
It sets a high hurdle that few investors can leap. While the apostles
of the new so-called “behavioral” theory present ample evidence
of how often human beings make irrational financial decisions, it
remains to be seen whether these decisions lead to predictable errors
that create systematic mispricings upon which rational investors
can readily (and economically) capitalize.
But while the precise validity of the EMH may be debatable,
there can be no debate about the validity of the CMH. It
posits a conclusion that is also, using Dr. Samuelson’s formulation,
both “trivially obvious and remarkably sweeping” and it confirms
that Bachelier’s argument had to be taken one step further. The
mathematical expectation of the speculator is not zero; it
is a loss equal to the amount of transaction costs incurred.
So, too, the mathematical expectation of the long-term
investor also is a shortfall to whatever returns our financial markets
are generous enough to provide. Indeed the shortfall can be described
as precisely equal to the costs of our system of financial intermediation—the
sum total of all those advisory fees, marketing expenditures, sales
loads, brokerage commissions, transaction costs, custody and legal
fees, and securities processing expenses. Intermediation costs
in the U.S. equity market may well total as much as $250 billion
a year or more. If today’s $13 trillion stock market were to provide,
say, a 7% annual return ($910 billion), costs would consume more
than a quarter of it, leaving less than three-quarters of the return
for the investors—those who put up 100% of the capital. We don’t
need the EMH to explain the dire odds that investors face in their
quest to beat the stock market. We need only the CMH. Whether
markets are efficient or inefficient, investors as a group must
fall short of the market return by the amount of the costs they
Now for the really bad news. Investors pay their
investment costs each year in nominal current dollars, but
they measure their long run investment success in real dollars,
almost inevitably eroded in value by inflation. The nominal
long-term returns of about 10 percent on stocks that the financial
intermediation system waves before the eyes of the naive investing
public turn out to be about 6½ percent in real terms.
When we realize that in the mutual fund industry intermediation costs
total at least 2½ percentage points annually, they confiscate nearly
40% of the historical real rate of return on equities. And when
we subtract the cost of taxes (paid by taxable investors in current,
nominal dollars), the confiscation of real return rises to nearly
75%. In a coming era in which returns may well fall below historic
norms, we must look at potential investment accumulations in a new
and harsh light.
The academic and financial communities have dedicated
enormous intellectual and financial resources to studying past returns
on stocks, to regression analysis, to modern portfolio theory, to
behaviorism, and to the EMH. It’s high time we turn more of our
attention to the CMH. We need to know just how much our system
of financial intermediation has come to cost, to know the extent
to which high turnover may pay, and to understand the real
net returns that managers deliver to investors.
Two Schools of Indexing—Quantitative
All these years later, the distinctly different intellectual
approaches of the EMH and the CMH illuminate the history of indexing.
The Quantitative School, led by masters of mathematics
such as Harry Markowitz, William Fouse, John McQuown, Eugene Fama,
and William F. Sharpe did complex equations and conducted exhaustive
research on the financial markets to reach the conclusions that
led to the EMH. In essence, the “Modern Portfolio Theory” developed
by the Quantitative School showed that a fully-diversified, unmanaged
equity portfolio was the surest route to investment success, a conclusion
that lead to the formation of the first index pension account
(for the Samsonite Corporation), formed by Wells Fargo Bank in 1971.
That tiny $6 million account was invested in an equal-weighted index
of New York Stock Exchange equities. Alas, its implementation proved
to be a nightmare, and in 1976 it was replaced with the market-capitalization-weighted
Standard & Poor’s 500 Common Stock Price Index, which remains
the principal standard for pension fund indexing to this day.
While the Quantitative
School developed its profound theories, what I’ll call the Pragmatic
School simply looked at the evidence. In 1974, the Journal
of Portfolio Management published an article by Dr. Samuelson
entitled “Challenge to Judgment.” It noted
that academics had been unable to identify any consistently excellent
investment managers, challenged those who disagreed to produce “brute
evidence to the contrary,” and pleaded for someone, somewhere to
start an index fund. A year later, in an article entitled The
Loser’s Game, Charles D. Ellis argued that, because of fees
and transaction costs, 85% of pension accounts had underperformed
the stock market. “If you can’t beat the market, you should certainly
consider joining it,” Ellis concluded. “An index fund is one way.”¹,
In mid-1975, I was both blissfully unaware of the work
the quants were doing and profoundly inspired by the pragmatism
of Samuelson and Ellis. I had just started a tiny company called
Vanguard, and was determined to start the first index mutual
fund. It was then that I pulled out all of my annual Weisenberger
Investment Companies manuals, calculated by hand the average
annual returns earned by equity mutual funds over the previous 30
years, and compared them to the returns of the Standard & Poor’s
500 Stock Index: Result: annual returns, 1945-1975, S&P Index
10.1%; average equity fund, 8.7%.
As I mused about the reasons for the difference, the
obvious occurred to me. The index was cost-free, and its 1.4% annual
advantage in returns roughly approximated the total costs then incurred
by the average fund—the expense ratio plus the hidden costs of portfolio
turnover. To illustrate the enormous impact of that seemingly small
percentage difference, I calculated that a hypothetical initial
investment of $1,000,000 in 1945 would by 1975 have grown to $18,000,000
in the Index, vs. $12,000,000 in the average fund.
In September 1975, using those data and the Samuelson and Ellis articles,
I urged a dubious Vanguard board of directors to approve our creation
of the first index mutual fund. They agreed.
How Vanguard Came to Start the First Index Mutual
The idea of an index fund was hardly anathema to me.
Way back in 1951, the anecdotal evidence that I had assembled in
my Princeton University senior thesis on the then-miniscule mutual
fund industry led me to warn against the “expectations of miracles
from mutual fund management,” and shaped my conclusion that funds
“can make no claim to superiority to the market averages.” When
the newly-formed Vanguard began operations in May 1975, I had realized
my dream of establishing the first truly mutual mutual fund
complex, the idea of an index fund was at the top of my agenda.
Why? Because while the idea of an index fund would
have hardly appealed to a high-cost fund manager whose very business
depended on the conviction that, whatever his past record, he could
outpace the market in the future, indexing would be a natural for
us. We were organized as a shareholder-owned, truly mutual,
mutual fund group, with low costs as our mantra. So while our rivals
had the same opportunity to create the first index mutual fund,
only Vanguard, like the prime suspect in a criminal investigation,
had both the opportunity and the motive.
Our introduction of First Index Investment Trust was
greeted by the investment community with derision. It was dubbed
“Bogle’s folly,” and described as un-American, inspiring a widely-circulated
poster showing Uncle Sam calling on the world to “Help Stamp Out
Fidelity Chairman Edward C. Johnson led the skeptics, assuring the
world that Fidelity had no intention of following Vanguard’s lead:
“I can’t believe that the great mass of investors are going to be
satisfied with just receiving average returns. The name of the game
is to be the best.” (Fidelity now runs some $38 billion in indexed
The early enthusiasm of the investing public for the
novel idea of an unmanaged index fund designed to track the S&P
500 Index was as subdued as the admiration of our detractors. Its
initial public offering in the summer of 1976 raised a puny $11
million, and early growth was slow. Assets of First Index didn’t
top $100 million until six years later, and only because we merged
another Vanguard actively managed fund with it. But the coming
of the Great Bull Market that began in mid-1982 started the momentum,
and the fund’s assets crossed the $500 million mark in 1986.
From the outset, I realized that the 500 Index, by owning
large-cap stocks that represented 75% to 80% of the value of total
U.S. market, would closely parallel, but not precisely match, the
stock market’s return, since the Index excluded mid-cap and small-cap
stocks. So in 1987, we started a fund called the Extended Market
Fund, indexed to those smaller companies. If used in harness with
the 500 Fund, it would provide a total market exposure.
By year-end, combined assets of the two funds were nearly $1 billion.
In 1990, we added another “Institutional 500 Fund” designed for
pension plans, and in 1991, a Total Stock Market Index Fund, modeled
on the Wilshire Total (U.S.) Market Index, bringing total assets
of these essentially all-market index funds to $6 billion.
During 1994-1999, as the bull market continued, and
as our index funds continued to outpace the overwhelming majority—upwards
of 80%!—of actively-managed funds, asset growth accelerated—$16
billion in 1993, $60 billion in 1996, $227 billion in 1999.
Much of this success, as I warned our index shareowners, “should under
no circumstances be regarded either as repeatable or sustainable.”
It wasn’t. But even in the ensuing bear market, the index
funds outpaced more than 50% of their actively-managed peers, and
solid growth continued. Assets of our four “all-market” index funds
now total some $200 billion, with our other 33 index funds bringing
our total indexed assets to $300 billion today.²
So indexing has enjoyed a considerable commercial success,
drawing huge assets to Vanguard, and even larger amounts to other
managers and pension funds. It has enjoyed that success, not only
because of the sound and pragmatic foundation on which indexing
relies, but because it has, over three decades now, worked effectively
in providing superior returns. This is to say, indexing has not
been merely a commercial success. It has been an artistic
success. Indexing worked!
How well did it work? Thirty years ago in “Challenge
to Judgment,” Dr. Samuelson wrote: “When (respected) investigators
look to identify those minority groups endowed with superior investment
process, they are quite unable to find them . . . (Even) a loose
version of the ‘efficient market’ or ‘random walk’ hypothesis accords
with the facts of life . . . any jury that reviews the evidence
must at least come out with the Scottish verdict: Superior performance
is unproved.” And so he issued his challenge: “The ball is in
the court of those who doubt the random walk hypothesis. They can
dispose of that uncomfortable brute fact in the only way that any
fact is disposed of—by producing brute evidence to the contrary.”
So today, three decades later, let’s examine some brute
evidence. Let’s go back to the era in which the Samuelson article
was published, and see what lessons we can learn by examining the
evidence on the ability of mutual fund managers to provide market-beating
returns. In 1970, there were 355 equity mutual funds, and we have
now had more than three decades over which to measure their success.
We’re first confronted with an astonishing—and important—revelation:
Only 147 funds survived the period. Fully 208 of those funds
vanished from the scene, an astonishing 60% failure rate.
Now let’s look at the records of the survivors—doubtless
the superior funds of the initial group. Yet fully 104 of them fell
short of the 11.3% average annual return achieved by the unmanaged
S&P 500 Index. Just 43 funds that exceeded the index return.
If, reasonably enough, we describe a return that comes within plus
or minus a single percentage point of the market as statistical
noise, 52 of the surviving funds provided a return roughly equivalent
to that of the market. A total of 72 funds, then, were clear losers
(i.e., by more than a percentage point), with only 23 clear winners
above that threshold.
If we widen the “noise” threshold to plus or minus two
percentage points, we find that 43 of the 50 funds outside that
range were inferior and only seven superior—a tiny 2% of the 355
funds that began the period, and an astonishing piece of the brute
evidence that Dr. Samuelson demanded. The verdict, then, is here,
and it is clear. The jury has spoken. But its verdict is not “unproved.”
It is “guilty.” Fund managers are systematically guilty of the
failure to add shareholder value.
But I believe the evidence actually over-rates
the long-term achievements of the seven putatively successful funds.
Is the obvious creditability of those superior records in
fact credible? I’m not so sure. Those winning funds have
much in common. First, each was relatively unknown (and relatively
unowned by investors) at the start of the period. Their
assets were tiny, with the smallest at $1.9 million,
the median at $9.8 million, and the largest at $59 million.
Second, their best returns were achieved during their first decade,
and resulted in enormous asset growth, typically from those little
widows’ mites at the start of the period to $5 billion or so at
the peak, before performance started to deteriorate. (One fund
actually peaked at $105 billion!) Third, despite their glowing
early records, most have lagged the market fairly consistently during
the past decade, sometimes by a substantial amount.
The pattern for five of the seven funds is remarkably consistent:
A peak in relative return in the early 1990s, followed by annual
returns of the next decade that lagged the market’s return by about
three percentage points per year—roughly, S&P 500 +12%, mutual
In the field of fund management it seems apparent that
“nothing fails like success”—the reverse of the threadbare
convention that “nothing succeeds like success.” For the
vicious circle of investing—good past performance draws large dollars
of inflow, and having large dollars to manage crimps the very ingredients
that were largely responsible for the good performance—is almost
inevitable in any winning fund. So even if an investor was smart
enough or lucky enough to have selected one of the few winning funds
at the outset, selecting such funds by hindsight—after their early
success—was also largely a loser’s game. Whatever the case, the
brute evidence of the past three decades makes a powerful case against
the quest to find the needle in the haystack. Investors would
clearly be better served by simply owning, through an index fund,
the market haystack itself.
More Brute Facts
In the field of investment management, relying on past
performance simply has not worked. The past has not
been prologue, for there is little persistence in fund performance.
A recent study of equity mutual fund risk-adjusted returns during
1983-2003 reflected a randomness in performance that is virtually
perfect. A comparison of fund returns in the first half to the
second half of the first decade, in the first half to the
second half of the second decade, and in the first full decade
to the second full decade makes the point clear. Averaging the
three periods shows that 25% of the top quartile funds in the first
period found themselves in the top quartile in the second—precisely
what chance would dictate.
Almost the same number of top quartile funds—23%—tumbled
to the bottom quartile, again a close-to-random outcome. In the
bottom quartile, 28% of the funds mired there during the first half
remained there in the second, while slightly more—29%—had actually
jumped to the top quartile.
Perfect randomness would distribute the funds in each
performance quartile randomly in the succeeding period—sixteen blocks,
each with a 25% entry. As the matrix shows, the reality comes
close to perfection. In no case was there less than a 20% persistence
or more than a 29% persistence. Simply picking the top performing
funds of the past fails to be a winning strategy. What is more,
even when funds succeed in outpacing their peers, they still have
a way to go to match the return of the stock market index itself.
Yet both investors and their brokers and advisers
hold to the conviction that they can identify winning fund managers.
One popular way is through the Star system espoused by the
Morningstar rating service. Indeed, over the past decade, fully
98%(!) of all investment dollars flowing in equity mutual funds
in the nine Morningstar “style boxes” was invested in funds awarded
five stars or four stars, the firm’s two highest ratings. (The
ratings are heavily weighted by absolute fund performance, so we
can hardly blame—or even credit—Morningstar for primarily being
responsible for these huge capital inflows. Stars or not, high
returns attract large dollars.)
But as Morningstar is first to acknowledge, its star
ratings have little predictive value. The record bears out their
caution. Academic studies show that the positive risk-adjusted
returns (“Alpha”) that distinguish the four- and five-star funds
before they gain the ratings typically turn negative afterward,
and by a correlative amount. Data from Hulbert’s Financial Digest
confirm this conclusion. Following their selection, the
funds in the top-ranked Morningstar categories typically lag the
stock market return by a wide margin. Over the past decade, for
example, the average return of these “star” funds came to 6.9% per
year, fully 4.1 percentage points behind the 11.0% return on the
S&P 500 Index. What is more, that 37% shortfall in annual return
came hand in hand with a risk (standard deviation) that was 4% higher.
Even for the experts, picking winning mutual funds is hazardous
A Case Study
So the search for “long-term investment excellence”
is an elusive one. A fine new book (Capital, with the
foregoing words in its subtitle) by respected analyst Charles
D. Ellis drives this point home. Mr. Ellis describes a firm of
consummate professionals, serious about their trade, with an excellent
investment process. But for all that obvious excellence,
we also are given, perhaps inadvertently, an illustration of the
wide gap between manager achievement and shareholder achievement,
as well as a warning about casually accepting the assumption that
the past is prologue.
The Ellis book is a history of The Capital
Group Companies, a Los Angeles firm that may well be the most
widely-respected investment manager in America. Certainly the
accolades, from impartial observers and competitors alike, could
hardly be more glowing: “one of the most outstanding investment
firms ever created,” “one of the best firms in our business,”
“a premier investment firm,” and “people with a passion for long-term
investment success.” I would hardly disagree with these endorsements.
Indeed, I’ve been singing my own praises of Capital since the
early 1960s. (In my previous career at Wellington Management
Company, I even explored the possibility of a merger of our firms!)
Yet despite their organizational integrity and investment
focus, and despite the fact that the net returns they have delivered
to their fund shareholders are clearly superior to those of most
of their peers, the returns achieved by Capital can hardly be
said to have been extraordinary relative to the stock market itself.
The book documents the return of their flagship fund, the Investment
Company of America (ICA) during 1973-2003 at +13.2% per year,
or 1.8 percentage points over the 11.4% return on the S&P
500 Index. But, as nearly all fund comparisons do, it ignores
the impact of the initial 8½% sales charge paid by investors.
For a typical investor, such a cost would reduce that excess return
by about 0.8% to a single percentage point, although even that
small advantage is admirable in an industry that, as we now know,
struggles and, ultimately fails, to match the stock market’s return.
But of course, like
all comparisons, it is time-dependent. Other periods give
rise to different, and less compelling, results. For example,
during the past 25 years (1979-2003), ICA underperformed the market
in 16 years. While it outpaced the market by 0.7% (14.5% vs. 13.8%)
for the period, after adjusting for the sales charge, it fell
slightly behind, with a net annual return of 13.7%.
Indeed since 1983—two full decades—no matter
in which year we choose to begin the comparison, the results of
the ICA have pretty much paralleled those of the market itself,
with a correlation of a remarkable .95%. (To be fair, ICA is
less volatile, significantly lagging as the bull market bubble
inflated during 1998 to 1999, and then recouping the ground lost
during the ensuing bear market.)
But in an industry which ultimately fails
to match the market’s return, why not just salute ICA as equal
or even preferable to an index fund? First, because, despite
its long-term focus, it is relatively tax-inefficient. During
the past 25 years, for example, federal taxes consumed an estimated
2.5 percentage points of its annual return, reducing it from 13.7%
to 11.2% for taxable investors. While an S&P 500 index fund
is hardly exempt from taxes, its passive market-matching strategy
is highly tax-efficient. During the same period, taxes on an
index fund would have cost an estimated 0.9 percentage points,
reducing its 13.8% pre-tax return to 12.9%, a net after-tax
advantage over ICA of 1.7 percentage points per year. Not only
do taxable investors pay high costs in fund advisory fees, operating
expenses, and sales commissions when they buy active fund management,
they also pay a remarkably high tax cost.
A second reason for caution before we salute
is that, as our earlier evidence suggests, the past is rarely
prologue. And not just because of the “random walk” that characterizes
the returns typically achieved by active managers in highly efficient
markets. Success—even perceived success—in investment management
goes not unrecognized; indeed it is often hyped from the rooftops.
It draws money, creating that vicious circle we described earlier.
Warren Buffett warns us that “a fat wallet is the enemy of superior
returns,” and the record clearly confirms his wisdom.
Today ICA’s assets total $66 billion, an enormous
sum compared to assets of $1.3 billion 25 years ago. That exponential
growth hardly makes the job of active management any easier.
The number of investments large enough to make a meaningful impact
on the portfolio shrinks, even as the difficulty and cost of buying
and selling stocks escalates. What is more, the size of ICA is
only the tip of the iceberg, for the fund is part of a $500 billion
investment complex, and many of its largest holdings are also
held by Capital’s other funds and pension clients. The organization
currently holds, for example, some 11% of Target Corp. and GM,
and from 7% to 10% of Altria, FNMA, J.P. Morgan Chase, Eli Lilly,
Bristol-Myers, Dow Chemical, Tyco, Texas Instruments, and Fleet
Boston. Whether the massive growth in the assets Capital manages
will impede the firm’s ability to turn their past into prologue,
only time will tell.
What is the Intellectual Foundation for Active Management?
Let me summarize what I see as the intellectual basis
for indexing: Even if the EMH is weak, the CMH remains a tautology—all
the more important in the mutual fund arena where costs are so
confiscatory. The brute evidence on the rarity of superior management
goes far beyond the relatively few examples I’ve cited today.
And the vicious circle of superiority generating growth, generating
inferior returns—with few managers courageous and disciplined
enough to defy it—has become a truism. That the typical fund
portfolio manager holds his post for less than five years, furthermore,
means that a long-term investor has to identify not only a superior
manager, but bet on his longevity. And the astonishing fund failure
rate that, at current rates, implies a 50-50 survival rate over
the coming decade, is the icing on the cake of the case for indexing.
What, then, is the intellectual foundation
for active management? While I’ve seen some evidence that managers
have provided returns that are superior to the returns of the
stock market before costs, I’ve never seen it argued
that managers as a group can outperform the market after
the costs of their services are deducted, nor that any class
of manager (e.g., mutual fund managers) can do so. What do the
proponents of active management point to? . . . Themselves! “We
can do it better.” “We have done it better.” “Just buy the (inevitably
superior performing) funds we that we advertise.” It turns out,
then, that the big idea that defines active management is that
there is no big idea. Its proponents offer only a few
good anecdotes of the past and promises for the future.
Alas, it turns out that there is in fact one big
idea that can be generalized without contradiction. Cost
is the single statistical construct that is highly correlated
with future investment success. The higher the cost, the lower
the return. Equity fund expense ratios have a negative
correlation coefficient of –0.61 with equity fund returns. In
the fund business, you get what you don’t pay for. You get
what you don’t pay for!
If we simply aggregate
funds by quartile, this correlation jumps right out at us. During
the decade ended November 30, 2003, the lowest-cost quartile of
funds provided an average annual return of 10.7%; the second-lowest,
9.8%; the second-highest; 9.5%; and the highest quartile, 7.7%.
The difference of fully three percentage points
per year between the high and low quartiles, equal to a 30% increase
in annual return! The same pattern holds irrespective of the
time period, and essentially irrespective of manager style or
market capitalization. But of course, with index funds carrying
by far the lowest costs in the industry, there are few, if any,
promotions by active managers of the undeniable relationship between
cost and value.
Changing Times and Circumstances
So it is the crystal-clear record of the
past, an understanding of the present, and the realization that
even the future returns of today’s successful managers are unpredictable
that together seem to make the search for the Holy Grail of market-beating
returns a fruitless quest. It is the recognition of this reality
that has carried indexing to its remarkable eminence and growth.
But please don’t imagine that I am sitting back and reveling in
where indexing stands today. I press on in my mission as an apostle
of indexing, not only because complacency doesn’t seem a very
healthy attitude and resting on one’s laurels is too often the
precursor of failure, but for three other reasons: First, because
indexing has not yet adequately fulfilled its promise. Second,
because we have subverted the idea of indexing, adding to its
role as the consummate vehicle for long-term investing (“basic
indexing”) a new role as a vehicle for short-term speculation
(“peripheral indexing”). And third, because not nearly enough
individual investors have yet come to accept the extraordinary
value that indexing offers.
The initial promise of indexing was reflected in an
article that appeared in Fortune magazine in June 1976,
smack in the middle of the launch of our First Index Investment
Trust. Written by journalist A.F. Ehrbar, it was entitled, “Index
Funds—An Idea Whose Time is Coming,” and concluded that, “index
funds now threaten to reshape the entire world of money management.”
Yet nearly three decades later, while the influence of indexing
has clearly been powerful, it has failed to reshape that world.
This failure has been most abject in the mutual fund field, where
active managers have largely ignored the lessons they should have
learned from the success of indexing.
The reasons for that success are the
essence of simplicity: 1) The broadest possible diversification,
often subsuming the entire U.S. stock market; 2) a focus on the
long-term, with minimal, indeed nominal, portfolio turnover (say,
3% to 5% annually); and 3) rock-bottom cost, with neither advisory
fees nor sales loads, and minimal operating expenses. Rather than
being inspired to emulate these winning attributes, however, the
fund industry has largely turned its back on them.
Consider that only about 500 of the
3700 equity funds that exist today can be considered highly-diversified
and oriented to the broad market, bought to be held. The
remaining 3200 funds focus on relatively narrow styles, or specialized
market sectors, or international markets, or single countries,
all too likely bought to be sold on one future day. Portfolio
turnover, at what I thought was an astonishingly high 37% in 1975
when the first index fund was introduced, now runs in the range
of 100%, year after year.
While fund costs essentially represent the difference
between success and failure for investors who seek to accumulate
assets, they have gone up as index fees have come down.
The initial expense ratio of our 500 Index Funds was 0.43%, compared
to 1.40% for the average equity fund.
it is 0.18% or less, while the ratio for the average equity fund
has risen to 1.58%. Add in turnover costs and sales commissions
and the all-in cost of the average fund is at least 2.5%,
suggesting a future annual index fund advantage at least 2.3%
Pointedly, however, Vanguard’s actively managed funds
have learned from the success of our index funds. Indeed,
with low advisory fees paid to their external managers, relatively
low portfolio turnover, and our reasonable, if sometimes erratic,
success in selecting managers, these funds, according to a study
in a forthcoming issue of the Journal of Portfolio Management³,
have actually outpaced our index fund since its inception. (However,
if after-tax returns, had been considered, or if the base
date of the study had been 1989 rather than 1976, the index fund
would have had the superior record.) While I cannot agree with
the authors’ suggestion that I should take “more joy” in
our active funds than in our index funds, be assured that I take
great joy in the application of the principles that underlie the
success of our index funds and managed funds alike.
A Great Idea Gone Awry
My second concern is that the original idea of the
index fund—own the entire U.S. stock market, own it at low cost,
hang on to it forever—has been, to put it bluntly, bastardized.
The core idea of relying on the wisdom of long-term
investing is being eroded by the folly of short-term speculation.
And index funds are one of the principle instruments for this
erosion. Why? Because the term “index fund,” like the term “hedge
fund,” now means pretty much whatever we want it to mean.
In addition to 109 index funds now linked to
a relative handful of broad market indexes (S&P 500,
Wilshire Total Market, Russell 3000), there are 224 index funds
linked to narrow market indexes—small cap-growth stocks, technology
stocks, even South Korean stocks—funds that seem to be bought
to be sold. (I confess that, for better or worse, I did my share
in the creation of market segment index funds—growth, value, and
small-cap, for example. But today’s segmented index funds are
far narrower in scope.)
Much of the expansion of the index
fund marketplace has taken the form of “exchange-traded funds”
(ETFs), essentially mutual funds that are designed to be traded
in the stock market, often day after day, even minute-by-minute.
The assets of ETF index funds now total $150 billion, one-fourth
of the index mutual fund total of $550 billion. It seems logical,
as far as it goes, to actively trade specialty funds, and 118
of them have come in ETF form, with assets of some $60 billion.
But, to my amazement and disappointment, the dominant form of
ETF is not these narrow segment funds, but the broad market index
funds, including the S&P 500 “Spiders” and iShares, the NASDAQ
“Qubes,” and the Dow-Jones “Diamonds.” It is these ETFs that
dominate the field, representing some $90 billion of assets currently—index
funds originally bought to be held, now bought to be sold.
“Bought to be sold” is hardly hyperbole.
ETFs turn over at rates I could never have imagined. Each day,
about $8 billion(!) of Spiders and Qubes change hands, an annualized
portfolio turnover rate of 3000%, representing an average holding
period of just 12 days! (Turnover of regular mutual funds
by their shareholders now runs in the 40% range, itself an excessive
rate that smacks of speculation.) The extraordinary ETF turnover
should hardly be surprising, however. The sponsor of the Spiders
regularly advertises this product with these words: “Now, you
can trade the S&P 500 Index all day long, in real time.”
(To which I would ask, “What kind of a nut would do that?”)
So “What have they done to my song, Mom?” The simple
broad market index fund of yore, which I believe is the greatest
medium for long-term investing ever designed by the mind
of man, has now been engineered for use in short-term speculation.
What is more, it has also been joined by far less diversified
index funds clearly designed for rapid speculation. Please don’t
mistake me: the ETF is an efficient way to speculate,
trading opportunistically in the entire market or its segments,
and using them for such a purpose is surely more sensible (and
less risky) than short-term speculation in individual stocks.
But what’s the point of speculating—costly, tax-inefficient, and
counterproductive as it is—an almost certain loser’s game. Mark
me down as one whose absolute conviction is that long-term investing
is the consummate winning strategy.
What More Do We Need To Know?
My third concern is that, for all of the inroads
made by indexing, it has achieved only a small fraction of the
success that its clear investment merits deserve. If heresy
has turned to dogma, why hasn’t indexing become an even more important
part of the financial scene? Yes, the assets of index mutual
funds now total over $550 billion, representing nearly 15% of
equity fund assets. Yes, investors have invested $130 billion
in index funds over the past three years, some 35% of the total
cash flowing into equity funds.
But no, American families now hold $8.0 trillion
of equities, meaning that nearly $7.5 trillion is not
indexed. Indexing has achieved a far smaller share of individual
equity investments than in the pension field. And yet its cost
advantage is much larger in the highly-priced fund marketplace
than in the competitively-priced pension marketplace. If we as
a nation are going to rely even more heavily on individual retirement
and thrift plans than on corporate pension plans and Social Security,
the retirement savings of our citizens are going to be far less
robust. What more do we need to know in order to accept the
superiority of index funds so that they earn the acceptance they
I, for one, don’t think we need more information.
But the problem will not be easy to solve. The fund industry,
like the insurance industry, is a marketing business, and in both
cases the high costs of marketing represent a dead weight loss
on the net returns that investors receive. The problem faced
by low-cost, no-load index funds is that, as I have often observed,
“(almost) all the darn money goes to the investor!” The more
money that goes to the investor, of course, the less that goes
to the manager and marketers, the brokers and advertisers, the
marketing system that drives the world of financial intermediation.
So we need to work, day after day, to get across the message of
indexing to the “serious money” investors who, truth told, need
it the most.
There are lots of lessons to be learned from the issues
I’ve discussed today. Broadly, I’ve suggested that, while innovation
cannot be separated from luck, it can’t be separated from intellectual
discipline and determination either. I’ve also suggested that
simple ideas can hold their own—or more—with complex concepts.
When you get out in the business world, Occam’s Razor—“when
confronted with multiple solutions to a problem, choose the simplest
one”—is worth keeping in mind.
I hope you also take note that it is indeed possible
to gild to excess a sound innovation—in this case, the lovely
lily of all-market indexing—which needs no gilding—as well noting
the powerful forces that would like nothing better than to stop
indexing in its tracks before it strikes at their wallets. Their
only weapon is to use the records of their successful funds during
their flowering periods and imply that such success will persist—and
you now know how rarely that happens. Most of all, of course,
I hope I’ve explained not only the universal mathematical logic
of indexing—gross return minus intermediation costs equals
net return—but also presented an overwhelming array of brute
evidence that ought to persuade even the most skeptical among
you of its worth as an investment strategy.
Now think of this
in personal terms. What difference would an index fund make in
your own retirement plan over, say, 40 years? Well, let’s postulate
a future long-term annual return of 8% on stocks.
If we assume that mutual fund costs continue at
their present level of at least 2½% a year, an average mutual
fund might return 5½%. Extending this tax-deferred compounding
out in time on your investment of $3,000 each year over 40 years,
and investment in the stock market itself would grow to $840,000,
with the market index fund not far behind. Your actively managed
mutual fund would produce $430,000—only a little more than one-half
Looked at from a different perspective,
your retirement plan has earned a value of $840,000 before costs,
and donated $410,000 of that total to the mutual fund industry.
You have kept the remainder—$430,000. The financial system
has consumed 48% of the return, and you have achieved but 52%
of your earning potential. Yet it was you who provided 100%
of the initial capital; the industry provided none. Confronted
by the issue in this way, would an intelligent investor consider
this split to represent a fair shake? Merely to ask the question
is to answer it: “No.”
So when you begin your careers,
begin your own families and begin to save for their future security,
and consider the nest-egg you’ll need forty or fifty years from
now when you retire, I shamelessly commend to your using an all-market
index fund—the lower the cost, the better—as the centerpiece of
the savings you allocate to equities. If you do, as Dr. Samuelson
has written, you will become “the envy of your suburban neighbors,
while at the same time sleeping well in these eventful times.”
Finally, a word for those of you who will seek careers
in investment management. Please don’t be intimidated by the obvious
odds against beating the market. Rather, learn, as so few fund
managers seem to have done, from the reasons for the success of
the index fund. It is long-term focus, broad diversification,
and low cost that have been the keys to the kingdom in the past;
active managers who learn both from the disciples of EMH and the
apostles of CMH will have the best chance of winning the loser’s
game, or at least providing respectable long-term returns for
their clients in the future. So whatever you do in your investment
career—indeed whatever you do in any endeavor to which
you may be called—never fail to put your client first.
Placing service to others before service to self is not only an
essential part of whatever success may be, it is the golden rule
for a life well lived.
1. I should
note that one of the earliest calls for indexing came from a
book that I did not read until many years later: A Random
Walk Down Wall Street, by Princeton University Professor
Burton S. Malkiel (W.W. Norton, 1973). Dr. Malkiel suggested
“A New Investment Instrument: A no-load, minimum-management-fee
mutual fund that simply buys the hundreds of stocks making up
the market averages and does no trading (of securities) . .
. Fund spokesmen are quick to point out, ‘you can’t buy the
averages.’ It’s about time the public could.” He urged that
the New York Stock Exchange sponsor such a fund and run it on
a nonprofit basis, but if it “is willing to do it, I hope some
other institution will.” In 1977, four years after he wrote
those words, he joined the Board of Directors of First Index
Investment Trust and the other Vanguard funds, positions in
which he has served with distinction ever since.
2. This figure includes
our specialty index funds (small-cap, growth, value, Europe,
Pacific, etc.) as well as a series of bond index funds and enhanced
index funds. Their rationale and development, however, are
stories for another day. back
3. “Index Fundamentalism Revisited,”
by Kenneth S. Reinker and Edward Tower. Forthcoming in the Summer
2004 edition of the Journal of Portfolio Management. back
Note: The opinions expressed
in this speech do not necessarily represent the views of Vanguard’s
to Speeches in the Bogle Research Center
©2006 Bogle Financial Center. All Rights Reserved.