People believed Earth was flat long after Pythagoras and Aristotle made the case for a spherical planet. How else to explain why a ship would disappear hull-to-topmast as it reached the horizon? Still, the flat-earthers, a little like today’s climate-change deniers, lingered until explorers including Columbus poured so much water on that fallacy that it dissolved.
Likewise, this is the year in which one of Wall Street’s most profitable tropes — that supersmart traders and mutual-fund managers enjoy special expertise to pick stocks — finally disappeared over the horizon of investing called index funds. The Wall Street Journal has even written their obituary and recently tallied up the score: Over the last ten years, “between 71 and 93 percent of U.S. stock mutual funds either closed or failed to beat their closest index funds.”
Jack Bogle has been saying as much for 40 years. And investors have finally gotten the message. “Vindicated is a funny word, but that’s probably good enough,” he told me recently. “I do feel vindicated.”
And Bogle should feel that way. Over the years, he’s made customers a ton of money and shown the Street for what it is: an expensive, fee-first, me-first way to invest. You can call Bogle one of the ancient Greeks of indexing. You can also call him ancient. He’s 87 now, and long-retired as the leader and head indexer at Vanguard. But in the more than four decades since Bogle started what eventually became the Vanguard Index 500, he has pulled on the oar of passive investing, patiently sticking to the same simple message through boom and bust: owning the whole market, such as the S&P, produces higher average returns, at lower cost, than trying to pick winners and losers. The company that Bogle launched to create the first index fund, Vanguard Group, is absorbing investor money at a record rate.
Vanguard collected $250.6 billion in assets in the ten months ending in October, about $204.5 billion of it ticketed to index funds — money that is largely coming out of competitors’ actively managed funds. And he’s not backing off any time soon. “I’m enjoying this moment, and I hope you are too,” he wrote in an August blog post.
Bogle wasn’t enjoying life so much in 1974, when the fund then-called First Index Investment Trust — and what the sharp pencils on the Street called “Bogle’s Folly” — launched with all of $11 million in underwriting, a tad short of the $150 million he was anticipating. The timing was brutal, in the middle of a bear market, and at a time when Bogle was fighting for his job following the bungled merger that had created Vanguard in the first place. “It was really a one-man thing,” he said. “The underwriting was a flop.”
Actually, it wasn’t. An index fund exists merely to share in the market’s profits (or losses) by essentially buying all the stocks or bonds in a given index on a weighted basis. Buy it and forget it and you’ll make money in the long run. Competitors had every reason to bad-mouth such an entity, because it represented a huge threat to their fat management fees. He recalls: “Ned Johnson at Fidelity said, ‘Our investors want above average returns. Who would settle for average?’ They didn’t. They got less.”
Today there’s no disputing that Jack Bogle has always been on the money, and we can see that conclusion in the marketplace. Like an outgoing tide, money has been flowing from actively managed funds into passively managed mutual funds and exchange-traded funds. Investors sluiced more than $300 billion out of active funds for passive funds in the last few years. Passive funds now account for $5 trillion of investors’ money. Vanguard itself has $2.3 trillion in assets invested in index funds. “In today’s world of creative destruction, we are the destroyers of a flawed investment system,” he said in a recent speech marking his 65th anniversary in the mutual-fund industry.
Particularly since the Great Recession, passive funds have handily beaten actively managed funds. And crushed hedge funds, leaving the likes of Bill Ackman, among others, having to make concessions to investors given his firm’s underperformance. Meanwhile, dozens of hedge funds have closed up shop, unable to defend their two-and-twenty compensation structure — that is, you pay them 2 percent of total assets and 20 percent of profits — when essentially doing nothing is a better strategy.
Indexing isn’t a marketing ploy. The notion first occurred to Bogle as a senior at Princeton. In a senior thesis that looked at the economic role of the investment company, he concluded: “Mutual funds can make no claim to superiority over the market averages.” That was in 1951. In creating the first index fund, he had analyzed the returns of all the stock mutual funds over 30 years and found they had underperformed by 1.6 percentage points. But an article by economist Paul Samuelson in the Journal of Portfolio Management in 1974 tipped the scale. Samuelson had done the same homework. “He said, ‘Would somebody please start an index fund?’” recalls Bogle. “He gave me the intellectual credibility; and I had the pragmatic credibility. That was all I needed.”
But the boom markets of the 1980s made the index funds’ superiority hard to see. Investors who were getting 10 percent returns didn’t think much about whether they could have been getting 12 percent or 14 percent returns from their expensively managed funds. By 1995, index funds could count just $50 billion in assets, a relatively paltry sum. But when the markets turned down, the heat was turned up on active managers. “It took a while for that to catch on,” says Bogle. “When it did, all of a sudden the warts on everybody else’s funds started to show.”
Bogle’s revolution was not just about indexing. It was also about attacking Wall Street’s very being. He organized Vanguard so that it would be owned by its investors. Vanguard would not be beholden to a corporate entity that needed a return on its investment. Instead, the mutual-fund investors themselves got the return. This organizational structure allowed Bogle to lower the cost of running a fund to under one percent in an era when many actively managed funds charged a 4 percent “load,” which to Bogle was a load of nonsense. It’s simple math: Companies earn money, create dividends, grow their stock price, and pass the wealth along to investors. The question is how much goes to Wall Street and how much goes to you. “Wall Street has been getting far too big a share and investors too small a share,” he says. Indexing redistributes the wealth more equitably. Vanguard’s expense ratio of assets under management is 0.12 percent — that’s forced the entire industry to gut its fee structure to remain competitive. The industry average now stands at 0.61 percent, or 0.77 percent absent Vanguard itself.
In today’s low-interest rate, low-return environment, the significance of lower cost has become much more apparent. In the boom market of the 1980s, investors were deluded into thinking that paying a couple of extra percentage points in fees didn’t matter if they were earning more than 10 percent on their investment. But in a world were every basis point now counts, fees matter even more. That’s been one of the driving forces behind the outflow of money to passive funds. “I probably sound like I’m self-satisfied and complacent, but I’m not,” Bogle says. “I think everybody wants to create something new. As you get older, you want to create something that helps people.”
Despite all the evidence, passive funds still account for less than one-third of the total market. Investors, it seems, still want to believe in magic. Which means Bogle’s job isn’t done. Fortunately, he’s still more than willing to call the Street out, as he did recently in a letter to The Wall Street Journal: “The fact is that, on balance, Wall Street hasn’t created value in the past and won’t create value in the future.”
You’ve got that right, Jack.