Beyond Bogle?

John (Jack) Bogle founded the Vanguard Group, and pioneered index funds. He has had a profound influence on the world of investing.

If a statue is ever erected to honor the person who has done the most for American investors, the hands down choice should be Jack Bogle.

Warren Buffet

Bogle’s work has also inspired legions of fans. BogleHeads try to adhere to Bogle’s investment philosophy, yet sometimes misunderstand or misapply his teachings.

Index Funds

An index fund is a collection of investments designed to track a particular index. When you buy an index fund, you’re essentially buying every stock in the index in the proportion (generally weighted by market cap) of that stock in the index. Index funds are considered to be passively managed, because the investment managers are not making active decisions about what they are purchasing or how much of it they purchase. Index funds generally have very low costs associated with them.

Bogle launched the first index fund, the First Index Investment Trust (later renamed to the Vanguard 500 Index Fund) in 1976, with an expense ratio of 0.46%. Prior to this, all funds were actively managed. Fund managers were responsible for researching, analyzing, buying and selling individual stocks for their funds. In the days before software-aided research and analysis, and electronic trading, this was often quite expensive. Some funds charged annual fees as high as 3%. Bogle observed that since active managers were effectively trading against each other, the average manager would do well to match the return of the S&P 500 index. A 3% expense ratio might not seem like a lot, but thanks to the effect of compounding, it can place a real drag on the value of an investor’s portfolio.

The above chart compares the value of a portfolio with $10,000 invested in the S&P 500 with an expense ratio of 0.46%, to a portfolio with an identical initial investment in a fund that matched the performance of the S&P 500, but charged a 3% management fee, over the 20 years before 1976. $10,000 in the S&P 500 would have grown to over $60,000, while the same $10,000 in the mutual fund would have grown to just over $35,000. While the returns in the mutual fund are healthy, thanks to the strong performance of the stock market overall, they are dwarfed by the returns that would have been realized by simply investing in the market as a whole.

For an actively managed fund charging a 3% fee to match the return an investor could have realized by investing in the stock market as a whole, it would have needed to outperform the overall market by quite a bit. The vast majority of mutual funds weren’t able to do that, and were, in effect, losing their clients’ money.

Bogle’s efforts were initially derided by Wall Street, and dubbed, “Bogle’s Folly”. The first index fund was slow to gain traction. Outflows frequently exceeded inflows in the early years. Over time, however, index funds have won out. Bogle’s Vanguard is now the largest investment company in the world, managing over $8 trillion in assets, the vast majority of them in index funds. Most large fund managers, Fidelity, Schwab, Blackrock, etc. also offer highly competitive and nearly identical index fund products. 

Bogle’s Philosophy, and how it’s Commonly Misunderstood

Bogle’s investment philosophy was based on a few key insights:

1. Diversification: Rather than trying to pick the specific stocks that might outperform the market, investors would be better off buying a large part, or all, of the market. That way they can benefit from the success of the market as a whole.

2. Management Costs: Management costs can greatly dampen the growth of a portfolio by depleting its value on a regular basis. Investors would do well to minimize these.

3. Trading Costs: Trading costs from frequent trading can also put a damper on the value of a portfolio. Investors would do well to keep these costs low.

4. Taxes: Active trading can result in frequent tax bills due to realized capital gains. Paying these taxes can also damp the value of ones portfolio. To this end, investors should avoid realizing capital gains on an ongoing basis.

Bogle recommended buying and holding index mutual funds in order to achieve broad diversification with minimal management, trading and tax expenses.

The Efficient Markets Hypothesis

The Efficient Markets Hypothesis (EMH) is an investing theory that maintains that all known information about an asset is already factored into its price. Therefore, there’s no such thing as an underpriced or overpriced asset. Ergo, the smart move is simply to buy the entire market as a whole, by buying an index fund.

It’s commonly believed that Bogle advocated for, and was inspired by, the EMH. Bogle did not. In fact, he hadn’t even heard of the theory when he created his first index fund. Bubbles, crashes, and hype cycles prove that the markets aren’t always right. Individual assets are also frequently over- or under-priced.

Bogle coined the term Cost Matters Hypothesis, to better capture his philosophy. He promoted index funds because they were the best way to reduce costs, not because he believed that the market was always efficient.

High Cost Index Funds

Bogle’s investment philosophy is sometimes mistranslated as “Just buy an index fund”. Some actors have exploited this misunderstanding and created index funds with very high expense ratios. Unsuspecting investors, who might think they are following Bogle’s philosophy by buying into a diversified index fund, will find that their portfolios are growing a lot slower than they would have otherwise.

What Has Changed?

Bogle’s investment philosophy was crafted in the days before software analysis and electronic trading. A lot has changed since then.

Lower Trading Costs

In 1976, if you wanted to trade a stock, you would have to send someone to physically stand on the floor of an Exchange on your behalf, shout out your desires, and hope to find someone who represented someone who wanted to make the opposite trade as you. As you might guess, it was very expensive to trade stocks. A large part of the costs of active funds was trading fees.

Trading has gotten a lot cheaper since then, and many brokerages even offer free trades today.

Electronic Research and Analysis

In 1976, it was expensive to research and analyze the data needed to make investment decisions. Active funds needed to hire and retain multiple very smart people to perform this research and analysis. These costs were a large part of the management costs associated with active funds.

Cost Matters – To a Point

Bogle advocated for reducing investment costs. Vanguard’s mutual ownership structure has allowed the company to continue to focus on reducing costs in service of its owners, who are also its investors. 

Vanguard’s first index fund had an expense ratio of 0.46%. This was dramatically lower than the then prevalent rate of almost 3%. Vanguard has continued to reduce costs, and some of its index funds have fees as low as 0.03%. Bogle was correct to focus on costs when creating his investment philosophy. However, costs only matter up to a point.

The above chart shows the performance of $10,000 invested in the S&P 500 at an expense ratio of 0.46% v/s the same $10,000 invested in the S&P 500 at an expense ratio of 0.03%. The difference between the two portfolios is a lot smaller than the earlier chart.

ETFs and SMAs

When Bogle crafted his philosophy, buying into a Mutual Fund was the only practical way for an investor to build a diversified portfolio without doing a lot of work themselves. Exchange Traded Funds (ETFs) were introduced in the 1990s, and provided significant benefits over Mutual Funds, particularly in taxable accounts. Bogle, somewhat stubbornly, resisted the use of ETFs because he felt that the ease of trading would encourage more investors to actively trade them. However, those fears have proven unfounded.

More recently, thanks to lower trading fees, Separately Managed Accounts (SMAs), have become more accessible to investors, providing tax benefits to higher net worth individuals. SMAs also allow investors to apply their own values to their investing.

I will cover the differences between ETFs, Mutual Funds, and SMAs (or Direct Indexing) further in an article in the near future.

Concentration

Markets, as a whole, have become increasingly concentrated over the years. Today, buying an S&P 500 fund means putting 13% of your investment into just two stocks (AAPL and MSFT). This goes against the principle of broad diversification.

What should I do today?

The introduction of low-cost index funds sounded the death-knell for many active managed funds and their managers. It was almost impossible for them to compete with the net returns offered by passive index funds.

Bogle’s core insights around broad diversification and keeping costs low have stood the test of time. Index funds are also still the best strategy for the do-it-yourself investor, who would do well to grab a model index fund from Vanguard (or a Target Date Fund), and keep putting money into it over a long period of time. It’s not the most exciting thing to talk about at cocktail parties, but they would almost certainly crush the long term total returns of most investors, and certainly anyone bragging about their day trading or their latest options play.

Beyond Indexing

Modern innovations have allowed a form of active investment to make a comeback. Quantitative funds, or quant funds for short, are a type of investment fund that uses mathematical models and algorithms to make investment decisions. Quant funds use a variety of quantitative methods and data to analyze securities and identify investment opportunities, with the goal of generating positive returns for investors. The use of modern technology allows quant funds to keep their expenses very low (as low as 0.14% with some funds). At the same time, they are able to identify and exploit inefficiencies in the market pricing of assets to generate returns that beat the corresponding index funds. All this while adhering to Bogle’s core insights around diversification and keeping costs low.

At Prospero Wealth, we spend a lot of our time thinking about how we can maximize client returns over long periods of time, and we continuously improve the technology and processes  that we use to build bespoke portfolios at scale. If this sounds compelling to you, or your personal situations have outstripped your ability to understand or plan for it appropriately, we’d love to talk to you about it.

Questions? Comments? Feel free to reach out to me at suhas@prosperowealth.com if you would like to discuss this, or your personal situation, further.