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Bogle's Corner

Indexing has come a long way since that first index mutual fund was incorporated late in 1975. 'Index fund' has become part of the language of investors, has gained almost universal acceptance in the world of academe, and has established the standard by which the investment performance of active managers is measured. And it has worked , providing to investors in properly structured index funds exactly what they were promised: their fair share of financial market returns, no more, no less-not quite 100%, but almost.

The Paradigm of the Original Index Fund

What is it that has worked? For me, indexing still means today just what it meant all those yesterdays ago when that first fund was created, designed simply to track the returns and risks of the stock market itself, as measured by the Standard & Poor's 500 Stock Composite Price Index:
  1. The broadest possible diversification.
  2. Sustained over the longest possible time horizon.
  3. Operated at the lowest possible cost.
  4. With optimal tax efficiency.
  5. Thereby assuring the highest possible share of whatever investment returns our financial markets are generous enough to provide.

That definition has held up well, and has been almost entirely responsible for the growth of our original index mutual fund from its $11 million initial underwriting in August 1976 to its present total of almost $100 billion ($140 billion if we include its institutional counterpart), the largest mutual fund in the world. The total of all indexed assets at Vanguard now exceeds $300 billion, by far the dominant part of our industry's $620 billion index fund total. We have witnessed, I believe, the riumph of the index fund.

The First Paradox

Our industry's largest firm presents us with a truly classic case study in the growing importance of indexing and its implications for the future. So let's examine some of the actions and reactions of Fidelity Management and Research Corporation, which now manages an estimated $900 billion of assets, including equities valued at $620 billion, nearly 5% of all U.S. stocks.

When Vanguard's unique index mutual fund was introduced almost three decades ago, Edward C. Johnson III, Fidelity's chairman, publicly scorned the idea: 'I can't believe,' he told the press, '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.' In those ancient days, Fidelity was deemed to be a superior manager, though in retrospect much of its success had been achieved by the aggressive investment strategies it followed during the boom of the 'go-go' era during the mid-1960s. Even Mr. Johnson himself managed a hot fund (Fidelity Trend Fund) during that era. But the risks Fidelity's funds assumed came home to roost, as five of their eleven funds tumbled by 50% or more in 1973-1974, including Fidelity Trend Fund. (By 1965, Mr. Johnson had turned the portfolio over to the first of the six managers to follow him.)

But it is in Fidelity's Magellan Fund that we see the greatest example-indeed the virtual apotheosis-of how the fund industry has changed. Under the aegis of the legendary Peter Lynch, it had a truly sensational run from 1978 to 1983, outpacing the S&P 500 Index by an astonishing 26 percentage points . . . per year! ( Chart 8 ) With such success, the fund's assets burgeoned during that period from a mere $22 million to $1.6 billion. While its performance then reverted toward the mean, its excess return from 1984 through 1993 remained a healthy four percentage points per year. By then, its assets had grown to a staggering $31 billion.

In 1990, Mr. Lynch retired as portfolio manager, and Magellan's excess returns began to dwindle, losing to the S&P 500 in five of the next seven years. Nice gains came in the next two years, followed four of five losing years, including the current year-to-date. In all, since 1993, the fund has fallen an average of more than two percentage points per year behind the 500 Index-a far cry from the success of its earlier years. Yet, in a soaring stock market the growth of the fund's assets persisted, from $31 billion at year-end 1993, to $106 billion at the close of 1999, and even, after the crash, $62 billion today.

Reversion to the Mean

The larger the fund grew, of course, the more it came to resemble an index fund. Reversion to the market mean strikes again! In 1978-1982, the S&P return explained 82% of the return of Magellan, but in 2001-2004 fully 99%. I'm not arguing that is bad. (After all, I'm an indexer!) But I am arguing that cumulative management fees and operating expenses of $5 ½ billion (!) during a ten-plus-year period when the fund lagged the market by two percentage points per year (largely because of those costs) is, well, absurd-a waste of corporate assets. Absurd, I quickly add, when looked at from the vantage point of the investors who are paying them. From the standpoint of the management that is receiving them, they are the soul of rationality: 'We made the fund large, and we deserve to be paid for that accomplishment.' Make what you will of that argument.

Magellan Fund today is the prototypical closet index fund. But it is hardly Fidelity's only index-linked fund. Ten of its 15 largest equity funds have correlations with the market of between 0.92 and 100 (even excluding the aforementioned Fidelity Trend Fund, now itself with a eye-popping correlation of 0.99), only one of which succeeded in outpacing the index during the past decade. The reality is that such funds are virtually locked into closely approximating the returns delivered by the stock market itself. But only before the deduction of the substantial fees, operating expenses, and portfolio turnover costs they incur . It would take a Herculean leap of faith to believe that, after the deduction of such costs, they could match the returns of an index fund.

Thus, I was surprised to read in a recent Wall Street Journal article that, despite Magellan's lag to the S&P 500 since 1998 under his aegis, Robert Stansky, Magellan's portfolio manager, not only expects to beat the market, but 'to beat it over time by two to five percentage points annually.' With a 99% correlation with the market, and the two (or more) percentage point handicap of the fund's all-in costs, that would require a sustained three to seven point margin of advantage, something not a single mutual fund has attained over the past decade. But of course the past may not be prologue, and I wish Mr. Stansky well.

As funds reach box-car asset levels, of course, closet indexing is inevitable. After all, because of the high market impact costs of portfolio turnover that tie the funds of large organizations, Gulliver-like, to the market itself, the soaring size of Fidelity's equity position was inevitably accompanied by much more restricted investment decision-making. Fidelity's portfolio turnover has plummeted, from 100% in 1980 to 50% last year. The firm recently faced up to that reality, plunging aggressively into the growing index parade.

'If You Can't Beat 'Em, Join 'Em'

Following the ancient aphorism, 'if you can't beat 'em, join em,' the firm had started its first index fund, modeled on the S&P 500, out of commercial necessity in 1988. But their recent decision to slash, if only temporarily, the expense ratios of their index funds and launch an expensive advertising campaign to catch the public's eye clearly reflects a new strategic commitment to build their indexing business. (It is fair to speculate that both the 'loss leader' strategy and the advertising costs are, in effect, subsidized by the fees paid to Fidelity by its actively-managed and closet index funds.)

With the clear success of indexing, the debilitating costs of active management, and the straitjacket of massive size, it's hard to imagine they had any other choice. The firm's first move was to temporarily reduce the expense ratios of their index funds to an annualized rate of ten basis points (from the previous level of 25 basis points), blasting out the news in full-page newspaper broadsides. ^^^ ( Chart 9 ) As one commentator noted, this was a frontal assault on Vanguard's franchise as the low-cost provider of index funds; not 'a shot across the bow,' but 'a shot right at the mast.' A price war-uniquely, in my experience, a war to lower prices rather than to raise them-has broken out.

The Great Paradox

So now to the other half of the great paradox: As active fund management becomes more and more like passive management, so passive indexing is becoming more and more like active management . Nothing could better illustrate that paradox than the title of this conference-'The Art of Indexing'-and its agenda-'the rising tide of. . . new products that will benefit investors'; 'the expanding world of ETFs'; 'the increasing role of index derivatives'; and so on.

The original index fund, of course, required little, if any, 'art.' It's hardly an art to own the 500 stocks in the S&P 500 Index, own them at low cost, hold them forever, and let the chips fall where they may. But in today's sprawling index fund marketplace, 'art' may be a fair enough description, though I warn you that the word 'art' means not only 'the principles governing a craft,' but also 'trickery and cunning.'

The New Paradigm of Indexing

Consider how 'The Art of Indexing' compares with the original paradigm. If investing for the longest possible time horizon was the original paradigm, surely using index funds as trading vehicles can only be described as short-term speculation. If the broadest possible diversification was the original paradigm, surely holding discrete-even widely-diversified-sectors of the market offers far less diversification. If the original paradigm was minimal cost, it's clear that holding market sector index funds that are themselves low-cost obviates neither the brokerage commissions entailed in trading them nor the tax burdens entailed if one has the good fortune to do so successfully.

And as to the final, quintessential, aspect of the original paradigm-assuring, indeed virtually guaranteeing, the achievement of the stock market's return-the fact is that an investor who trades ETFs-after all the selection challenges, the timing risks, the extra costs, and the added taxes-has absolutely no idea of what relationship his or her investment return will have to the returns earned by the market itself. So the ETFs march to a different tune than the original, and I'm left to wonder, 'what have they done to my song, mom?'

 

 

Exchange Traded Funds

Broad Index

 

Basic Index Fund

Investing

Trading

Specialized Index

Broadest Possible Diversification

Yes

Yes

Yes

No

Longest Time Horizon

Yes

Yes

No

Rarely

Lowest Possible Cost

Yes

Yes

No*

No*

Greatest Possible Tax Efficiency

Yes

Yes

No

No

Highest Possible Share of Market Return

Yes

Yes

Unknown

Unknown

*Including trading costs.

The Exchange Traded Fund, the imaginative creation of Nate Most # more than a dozen years ago, has become, in recent years, a significant part of the $570 billion index fund asset base-a 28% share, up from just 9% at the close of 1999, albeit a growth in market penetration that has slowed considerably in recent years. ( Chart 10 ) Despite their stark contradiction of the five concepts underlying the original index fund, ETFs have become a force to be reckoned with in the indexing arena.

Assets and Cash Flows

When we look beyond the aggregates, it becomes clear how far ETFs have departed from the norm. As this table shows, the diversity of the investment choices available is remarkable:

Number of Funds

ETF Type

Examples

Total Assets

7

Total Stock Market

Spider/Viper

$64 billion

10

Other Broad Indexes

Qubes, Diamonds, EAFE Intl.

$40 billion

32

Market Styles

Growth, Small-Cap

$39 billion

61

Market Sectors

Tech, Telecom, Energy

$19 billion

25

Foreign Countries

Japan, Brazil

$12 billion

5

Bond

----

$6 billion

140

Total

 

$180 billion

 

While the assets of ETFs, dominated by the relatively broad market indexes, are small relative to traditional index mutual funds, they have grown at a more rapid rate. In terms of cash flow, ETFs have drawn $150 billion of net new money since 1999, even larger than the $114 billion flowing into their traditional cousins. What's more, the flow into style, sector, and foreign funds has overwhelmed the flow into the broad stock market index funds. While in the early ETF years, these broad funds accounted for 100% of the total inflow, during 1999-2003 they accounted for less than one-half, and so far this year their $3 billion of cash flow has represented only 12% of all ETF flow, with the less-diversified groups adding $22 billion. ( Chart 11 )

But those all-stock-market ETFs are, in my view, the only instance in which an ETF can replicate, and possibly even improve on, the five paradigms of the original index fund. But only when they are bought and held for the long-term . Their annual expense ratios are usually-but not always-slightly lower than their mutual fund counterparts, although commissions on purchases erode, and may even overwhelm, any advantage. While in theory their tax-efficiency should be higher, practice so far has failed to confirm that theory. But the fact is that their use by long-term investors is minimal. The Spiders are, in fact, marketed to day traders. As the advertisements say, ' Now you can trade the S&P 500 all day long, in real time. '

We know that ETFs are largely used by traders. The turnover of Spider shares is now running at about 2400% per year, compared to 20% for the shares of that original index fund. The turnover of the NASDAQ Qubes is even higher, at 3,700%(!) per year, and of course the turnover within the NASDAQ Index and the Dow Average are themselves substantial. It's only guess work, but perhaps 20% of the assets of these broadly diversified funds are held by long term investors, or about $12 billion. The remainder of the Spider-type holdings, I presume, represents the activities of arbitrageurs and market makers, making heavy use of short-selling and hedging strategies.
 
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