Legends Of Indexing: John Bogle

January 15, 2015

 

RiskBudgetIndexesLet’s face it: Without John Bogle, there would have been no Journal of Indexes. The launch of the Vanguard 500 Index Fund nearly 40 years ago spawned a revolution in the investing world. Today indexed assets continue to grow, steadily eroding the active management stronghold, and Bogle has been beatified by his most devoted followers as “Saint Jack.” But “complacent” was never a word used to describe him—he still thinks there’s a lot that investors need to watch out for.

You have been very clear that you think the ease of trading is one of the pitfalls of ETFs. Do you think if an investor uses ETFs within a disciplined or systematic rebalancing scheme, ETFs can work well in a portfolio?
Well, if you do buy and hold ETFs rather than trade them, it depends on how often you rebalance. I don’t know how many investors actually do that, but in that case, ETFs will probably not do any irreparable harm. I would give ETFs that. That might not be the greatest marketing tagline you’ve ever heard though: “It will not do you irreparable harm if you buy, hold and rebalance systematically, as long as you do not do so too often.”

One other thing that everybody should know is if you’re moving out of technology and into health care, to give you one example, somebody else is moving out of health care and into technology. It’s a zero-sum game—for every buyer, there must be a seller. You may be on the winning side or may be on the losing side, but for investors as a group, it’s zero sum, less the cost of investing, less the trading costs, management fees and those other things—expense ratios, taxes. You’d better be sure you’re right, but if you’re sure you’re right, you’re a damn fool. You may like to be right, you may hope to be right, but to be sure you’re right is the formula for investment failure.

I also worry about speculation in the SPDR S&P 500 ETF (SPY | A-98). That’s what ETFs seem to be all about—trading. Each day, The Wall Street Journal lists the 12 most widely traded stocks by number of shares. In dollar volume, every day, the SPDR is the most widely traded stock in the world. On a typical day, half or more of the 12 most active stocks are ETFs.

It is a whole new dimension of activity for the brokerage community, which thrives on trading by investors. And in fairness, a lot of what is happening in SPY and in all ETFs is a very heavy institutional participation. Something like 75 percent of the shares of SPY are held by institutional investors. Investors are making big bets on the market to go up or, if they’re short, on the market to go down. The shares may also be owned by an institution that fired a manager and wants some market exposure before hiring another manager. Why they would leave the index fund is not quite clear to me. The index fund would be the best place to stay, but they’re always looking for active managers with strong past performance, which simply doesn’t work.

But even individual investors are trading heavily. We don’t know exactly how heavily. SPY turns over at something like 5,500 percent a year, and that is just taking that annualized trading volume as a percentage of the fund’s assets. It did $28 billion in volume the other day, and the SPDR itself is around $195 billion. I should say in full disclosure, I think 3 or 4 percent turnover is pushing your luck, and 5,500 percent is simply not on my chart.

Now we have this great marketing device, the ETF. It’s in the news. It’s hot. It’s a way to bring people aboard the mutual fund train after it has left the station. As an industry, we have to know that all this trading does not help investors as a group, and yet we leap into this new business, because we have become a marketing business. I yearn for the day we get back to our roots—the asset management profession—and get out of the marketing business.

 

 

Where should investors be making active decisions or getting granular with their portfolio, in your opinion? There are certainly decisions to be made around international stocks and bonds, and around adjusting allocations to equities and fixed income over time.
I have been one that has—and I have been very clear on this—yet to see the magic of international investing. For probably 20 years, I have told investors that if you want to invest in international stocks, I am not going to stop you. But in the long run, the returns can’t be hugely different from the U.S. World equity markets move in basically the same direction, and it’s just a question of how much they move. But the idea of leaving the U.S. for a world portfolio, to move from a 100 percent U.S. portfolio and all of a sudden you’re down to about (in the present structure of the world’s markets) 42 percent U.S., is a bad idea for U.S. citizens. In fact, Warren Buffett recently described the investment strategy for the trust fund he plans to establish for his wife: 90 percent in the Vanguard 500 Index Fund, 10 percent in short-term U.S. Treasurys. I am compelled to point out that he has allocated 0 percent to international stocks.

The U.S. has the most diversified economy in the world. During the tremendous recession that began in 2007 and the subsequent rebound, the U.S. has had the best-performing economy in the world relative to any other major countries. We are the world leader in technology. We are the world leader in entrepreneurship, so much so that people are hacking U.S. businesses all day every day to steal our new ideas in the technology area. So I just don’t see the magic in international investing.

But I’m never certain that I’m right. How could I be sure of that? But I don’t invest internationally myself. And I would say if you’re going to abandon the U.S., you’ve got currency risk and you’ve got sovereign risk in the other countries. No country has the strength of our institutions, our government; no country has the solidity that we do. If you throw in technology leadership, entrepreneurial leadership, efficient production that gets better every day, I don’t see why you want to take a currency risk and a sovereign risk outside of your country.

But if you don’t agree with me—and I want to underscore I could easily be wrong in all this—I would not suggest you hold the world market weights; that is to say, 58 percent abroad. I would instead suggest you stick with maybe 20 percent international. That is not going to help you a huge amount, and it’s not going to hurt you a huge amount. But if you feel the urge, do it.

I’m just a simple guy. I started off with an idea that has been, for want of a better word, bastardized. Our S&P 500 index fund—the world’s first index mutual fund—simply allows investors to own the whole U.S. stock market and hold it forever, at very low cost. It works! Why do you think investors are knocking down our doors at Vanguard? (That’s not quite true in a literal sense.) We’re capturing about 60 percent of the industry’s net cash flow this year. No one has ever done that before. We’re at almost 20 percent of the industry’s long-term (stock and bond fund) assets. No firm has ever held anywhere near that dominant position before.

It’s not as if Vanguard had some huge marketing budget or that we’re trying to sell some hot fund. We’re not. We’re trying to give people their fair share of market returns. We’re trying to give them assurance that if they bring their money here they earn their fair share of the market’s return. That modest promise is essentially the Vanguard promise.

How do you think investors should go about adjusting their allocations between fixed income and equities then as they age? Is there a blueprint for that or should it be based on your risk tolerance?
If anybody were to give you a blueprint, I would say put your hand over your wallet. There are no blueprints. There is common sense, and the obvious principle here is to be more conservative and more protective when you’re older than when you’re younger. When you’re young, you have a small amount of capital, you can take more risk, you’ve got years to recoup, and you don’t care about income. When you’re older you want to protect what you have; if you’re wrong, you don’t have a lot of time to recoup, and on balance you want more income.

The rule of thumb I use is to think about having your bond position equal to your age, and think about it. Don’t do it, because first of all, you want to consider Social Security as part of your bond position. Ignoring Social Security is, I think, unless it’s fully explained, the major flaw in target-date funds. A typical Social Security recipient is not entirely a fair comparison, but it will do as a thinking comparison. The capitalized value of your future Social Security payments when you retire is somewhere between $250,000 and $400,000. So if you’re a maximum recipient, at $400,000, and you have $400,000 in your investment account, that is 100 percent in stocks—you’re 50/50.

 

 

Now, I wouldn’t take that too far, for Social Security is not actually a bond. Its value diminishes over time, and you can’t leave it to your heirs. But you ought to think about all sources of your retirement income. Having said that, when you own an equity portfolio, don’t get into it for market reasons, get into it for income reasons. Oversimplifying, what you want to do when you retire is walk out to the mailbox on Social Security day and on dividend payment day for the funds—assuming they’re the same day—and make sure you have two envelopes out there. One is your fund dividend and the other is your Social Security check. The Social Security will keep up with inflation year after year, and dividends are likely to increase year after year. They have been going up. Every once in a while there is an interruption, such as the Great Depression of the early 1930s. And many bank stocks eliminated their dividends in 2008, so there was obviously a drop. But it has long since recovered, and then some.

Bet on the dividends, and not on the market price. You’ve got those two envelopes and that’s your retirement. If you have a pension plan (one that is not likely to go bankrupt—and a lot of them are likely to) that is a third envelope. You want to be concerned about whether you have enough income to pay utility bills, pay for your food, pay your rent or your mortgage, whatever it might be, every month. You want income to help you pay those bills. And in the retirement stage, that’s what investing should be about—regular checks from dividends and/or from Social Security and/or from a pension account.

We have gotten so far away from that, but we have to keep thinking in those terms. Now, what makes life terribly difficult today is the staggering decline in interest rates. Around 1980, the interest rate on the intermediate-term Treasury got up to about 14.5 percent, while the dividend yield on stocks back then was probably 4 percent. That 14.5 percent is now 2.3 percent. The yield on stocks is now about 2 percent.

The problem the mutual fund industry faces is if you go into dividend-paying stocks at 3 percent—the yield for the total stock market is 2 percent, but dividend-paying stocks could produce 3 percent if you reach a little bit with good companies—on the typical fund, there’s an expense ratio of 1 percent, so it takes 33 percent of that dividend out of your pocket. The yield on a broad-market mutual fund is now 2 percent, so this marvelous industry is taking 50 percent of your dividend away from you.

But what about a cap-weighted index fund that only invests in dividend-paying stocks? Would that be an improvement over the broad market?
Well, it all depends. Sometimes yes, sometimes no. We go through long periods where value stocks, dividend stocks, or small-cap stocks do better than the total market, but within that, we know over the long term, going back to the 1920s, value stocks (including dividend-paying stocks) and small-cap stocks have provided higher returns than growth stocks and large-cap stocks. But there are periods that can be as long as 20 or 25 years when the opposite is true, so you just don’t know. Timing is everything, but I don’t like to rely on timing.

If you really need the dividend income, I see nothing wrong with overweighting high-dividend stocks, knowing you’re taking a small risk of falling significantly behind the total market. But you can own blue chip stocks, and you’re going to get a higher dividend, a situation I think would be attractive to an awful lot of investors. But once you depart from the market portfolio, you’re taking on extra risk. Any strategy may have done very well in the past, but in this business, the past is not prologue.

I happen to use Vanguard’s High Dividend Yield Index Fund in a small charitable foundation that I started. I love it because the foundation needs the income. There are good uses for it, but you could also make the same argument about using high dividends as using growth funds with low dividends, because there are periods in which they do much better. When you look at that crazy market we had up to 2000 before the crash, there the growth stocks did better than value stocks for about 10 years, and the large-cap stocks did much better than small cap for about for 15 years (in some earlier periods, those trends were even longer). Never let yourself be captive of recent trends in market sectors, would be my warning.

Do you believe in the French-Fama factors or do you think they are a distraction?
There is no question those factors, which are largely value and small-cap, have been the winning strategy over the entire period of the CRSP data, 1926-2014. For 90 years, they have been, on balance, the winning factors. There are extended periods when they didn’t win, but over the long term, they have won. But is that past prologue to the future?

My experience is to be very wary of thinking of the past as prologue in the world of investing. Think about it: If everybody agreed that value and small-cap were the sure path to excess returns, then investors would bid up the prices of value and small-cap stocks, sell their growth stocks and their large-cap stocks, and get with the trend. But that would drive the relative prices of large-cap stocks down and the price of value and small-cap stocks up.

I look at the market as being a great arbitrage medium, and I would make a small bet—$5 is a big bet for me—that over the next 20 years, large-cap and growth would do better than small-cap and value, because the market is such a great arbitrage mechanism between the past and the future.

 

You’ve said there will always be investors who are greedy, so the market will never be entirely indexed. Where do you think the percentage of indexed investors will top out?
Well, honestly, I’m not sure it will ever top out. It’s a trend that is justified by the numbers, by the gross return of the market less expenses, the net return. More investors learn that every day, and more journalists support that message. Morningstar has data to tell you pretty much the same thing; ditto for the academic community. There is no argument about that really. It’s a tautology. And as more investors and more business school professors and more articles in the Journal of Portfolio Management and Financial Analysts Journal drive home this truth, the index fund concept will grow.

I can see that growth is going to be slower going forward than it has been. However, when the Journal of Indexes started, index funds represented 9 percent of all mutual fund assets, and today that number is 32 percent, and we got here in 15 years. By 2030, it’s not going to grow as fast, just because of the law of large numbers—it’s not going to triple like it did. Maybe you could go to 40 percent, 45 percent. But I think incrementally it will continue to grow maybe by a point or a half a point a year and get you to the 50 percent range. At this rate, it would take until about 2030 for indexing to reach 40 percent of all equity assets; I can see it being in the 50 percent range by 2050, maybe 2040.

Incrementally then, it will slow down, but I don’t see it retreating. I can’t see what would cause a panic among investors about whether indexing works. It always works. And if you look at the largest funds this year, the S&P 500 has done so well it’s almost a joke. If you look at The New York Times [in late November], the S&P was up roughly 11 percent year-to-date, and the typical actively managed mutual fund was up 8 percent. That’s not going to happen time and time again. It’s just too good. So I hope investors will be honest enough to recognize it. Don’t expect such large excess returns for index funds year after year. Don’t expect more or less than the ability to capture your fair share of the market’s returns.

Do you think the 2008/2009 financial crisis helped or hurt indexing?
Well, it obviously helped. In 2007, index funds had a market share of 19 percent. That’s before the decline. And at 2010, we were at 25 percent. Actively managed funds dropped from 81 to 75 percent. I think one implicit reason for that is that when you buy an actively managed mutual fund, you think the manager will do something to anticipate market declines. There is no reason to expect that in an index fund. I have never said that index funds offer downside protection. My position is that index funds give you your fair share of market returns whether they’re good or they’re bad. I repeat it so often I’m almost saying it in my sleep. (My wife says, “What are you talking about?”)

Index funds make no claim to outperforming the market during downturns. But there is an implicit claim that the active manager will protect you in a downmarket, but the record shows that it does not happen. Unequivocally, it did not happen in the 2007-2009 crash.

You have been very consistent in your messages over the years, but is there anything that you believed about the markets back in 1976 when you launched that first index mutual fund that you have come to disagree with now, or believe the opposite?
No, there really isn’t. We started the fund in 1976 under a very peculiar set of circumstances, which nobody paid much attention to at the time. In 1970, the S&P 500 outperformed 89 percent of all large-cap blend managers, and about 75 percent of managers in 1973 and 1975. We all knew that wasn’t going to continue (although a lot of people thought it would). For the next two or three years, the index dropped down to beating only about 26 percent of active large-cap blend funds, a sort of reversion to the mean. The reality is that these figures aren’t very meaningful. Many of those funds that beat the index were small-cap funds, or value funds—funds that have a higher level of risk than the index.

What is your biggest concern right now for investors?
One of my biggest concerns is that the simple formula of indexing in a mutual fund structure—that is, low-cost—has taken Vanguard from nowhere to being the largest mutual fund complex in the world, with $3 trillion in assets under management. But I was never in this for the dollars and the size and the bragging rights. My focus—going back to my Princeton University senior thesis in 1951—was to try to serve investors a little bit better, with a company that had an internally managed structure. Despite our success, our mutual structure has never been copied by another fund company. Our structure is a fantastic innovation that was designed to serve investors first—and it does—but it has yet to be copied.

We’re certainly the leader, but we don’t have any followers. That’s a problem.

What I’m worried about more than anything else though, to be quite honest with you, is the world production economy and its growth, the world political system, the new power nations, religious fundamentalism and terrorism—all those things suggest to me this is an extremely risky time to invest. But you must invest. No one knows when to get out of the market; I don’t try to do it myself.

But I think investors should be aware of the global situation, whether you’re talking about economies, overextended and overleveraged financial systems, challenges from Russia on their own borders, or the ISIS revolution, which came out of nowhere. And I worry here at home about our fragile, stalemated political system. Have we lost the ability to govern ourselves?

These big global issues are challenges and risky for investors, but we really have no choice—I have no choice. I’m not heading for the hills. I have always been very conservative with my investments. Right now, counting all my different kinds of accounts, I am probably about 60 percent in stocks and 40 percent in bonds—Vanguard corporate bond funds in my tax-deferred retirement accounts and Vanguard municipal bond funds in my personal account.

I could scare myself into thinking I know what is going to happen and when it’s going to happen, but the reality is I don’t. But if I were an investor holding 100 percent of my assets in equities, I would probably do something to make my portfolio more conservative.

 

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