John C. (Jack) Bogle graduated from Princeton University in 1951 and founded The Vanguard Group, Inc. in 1974. In 1975, Vanguard introduced the first so-called “Index Fund” based on the Standard and Poor 500 (S&P500) stock index. The S&P500 is a market capitalization weighted average of 500 of the largest stocks that trade on the New York Stock Exchange or NASDAQ. Since the total market capitalization of these 500 stocks represents more than 95 percent of the entire market value of stocks traded on American exchanges, the index return is a good proxy for the overall “market” return. The purpose of the fund is to come as close as possible to emulating the return on the index. This is accomplished by purchasing and passively holding a portfolio of S&P500 stocks. Since there is no effort made to time the market or to pick winners and losers, there is no need to hire expensive economists or security analysts. The strategy can be deployed by a single manager equipped with a smart computer. Thus, the expenses of running the index fund are quite small. In fact, Vanguard’s annual fee today for running the fund is six basis points (that is, .06 percent) of fund assets. This compares to approximately 150 basis points for the average actively managed stock funds.

The rationale for creating the index fund was a growing suspicion or awareness that actively managed equity funds produce returns before fees that were no greater on average than market returns. Naturally, in this case the return after fees (the net return to the investor) would lag behind the market return (by, roughly, the amount of the fee). Thus, Bogle identified an opportunity to create a product that should be very appealing to the typical investor – getting market returns at very low expense.   Surely, this was an important financial innovation.

Less well known is Bogle’s innovation in corporate governance. Vanguard is the only mutual fund company that is truly “mutual” in that they are owned by the investors in the funds, rather than by a separate investment management company with its own shareholders. Thus, profits from management fees are used to further reduce fund expenses.

Bogle has been preaching the benefits of passive index fund investing, and the mutual form of governance for mutual funds, for more than forty years. He has produced dozens of books and articles on the subject. His argument rests both on the Efficient Market Hypothesis (EMH) that says that it is very difficult for active investors to beat the market, and the Cost Matters Hypothesis (CMH) that says that the net return on a fund is a negative function of the expense ratio of the fund. Bogle has conducted numerous studies of the variables that drive fund performance, and he finds that the single best predictor of return is the cost of running the fund (including the expense ratio mentioned above plus the sales load or commission, if any). Low cost funds do better than high cost funds.

In one sense he has been extremely successful; Vanguard is now the largest mutual fund company in the world with assets under management of nearly $3 trillion. The driving force behind this extraordinary growth is undoubtedly Vanguard’s success at producing market returns at extremely low cost.

Yet in another sense, based on actual realized returns of retail (non-professional) investors, he has been an abysmal failure. Most individual investors have remained oblivious to the Bogle message and Vanguard opportunity. Instead of matching the overall market, or lagging behind by a few basis points, the average realized returns of retail investors lag the overall market by literally hundreds of basis points. Obviously, most people are not taking advantage of Bogle’s brilliant innovation.

The reasons for the awful performance are many, including high expenses, excessive trading, and really poor timing. In one study, Bogle estimated the costs as follows: average expense ratio 150 basis points, average trading commissions 75 basis points, plus another 200 basis points of underperformance due to poor timing – selling low and buying high. This rough breakdown accumulates to 419 basis points of under-performance (150 plus 75 plus 200 minus index fund expenses of 6).

Returns: Historical and Expected

Four hundred and nineteen basis points per year is a gigantic reduction in potential return. The long-term historical return on the US stock market is approximately 10%. Thus, the typical retail investor suffers a forty percent reduction in annual return, and it gets a lot worse with compounding. Over a forty-year period, compounding at 10% takes $1 to $45, while compounding at 6% (10%-4%) takes $1 to $10. The average investor has given up almost 80% of the potential wealth gain.

Looking forward over the next ten or twenty years, many people argue that future returns will be lower than historical returns. This is due to lower expected economic growth, lower real rates of interest, and relatively elevated equity prices today. Suppose expected returns on the overall equity market are 6% looking forward, instead of the realized history of 10%. If the cost of mistakes remains the same at 400 basis points, this means fully two-thirds of the potential annual return is lost.

Recommendation

Bogle’s recommendation for the retail investor is very simple, even simpler than the Gone Fishing portfolio described last month. You only need to worry about two funds: an overall stock market index fund (Vanguard’s exchange traded fund VT (global stocks) or VTI (US stocks) would fit the bill) and an overall bond market index fund (like Vanguards exchange traded fund BND). The overall market value of stocks is about 150% of the value of bonds, so the market weighting between these two funds would be about 60% VTI and 40% BND. If you are more risk averse than the average investor, you should lower your target VTI allocation, and if you are less risk averse you should raise it. Finally, Bogle makes the argument that you should gradually reduce your stock allocation as you get older. Other than that, there is not much you have to do with your portfolio.

Bogle’s advice is consistent with the financial theory that was being created around the time frame that he started Vanguard. The key ideas in this theory are the value of diversification, the Capital Asset Pricing Model which says that you only get paid for taking on systematic risk and the primary (sole) source of systematic risk is volatility in the overall stock market, and the Efficient Market Hypothesis described above. Since the 1980s, however, further developments in financial theory challenge portions of this theory, particularly the notion that there is just one source of systematic risk. We will discuss this theory and the implications for portfolio management in the next posting.