The Devil’s Invention

June 27, 2011

Once the fund was launched, there were a number of technical challenges to running it. Computing technology was primitive in the 1970s compared with today, and instead of PCs, the fund's first manager, Jan Twardowski, had to dial in to a mainframe from a terminal via a slow acoustic coupler modem. Mainframes were big expensive devices that were shared with multiple users. Twardowski wrote the program to build the S&P 500 Index portfolio using an antiquated computing language called APL. But at the time, the fund didn't have enough assets to buy all 500 stocks in the index, so Vanguard had to employ a sampling process of buying the larger stocks in the index and keeping sector weightings and other aspects of the fund similar to the index. Even though the turnover in a cap-weighted index is minimal, there were still significant challenges to buying and selling hundreds of stocks. Trading for most funds back then was usually in large blocks of single stocks, but the index fund needed to buy small blocks of hundreds of stocks. Vanguard had a special arrangement with an institutional broker to lower its transaction costs to a nickel a share, which, at the time, was a bargain.

Gradually, technology improved, transaction costs declined, and, most important, Vanguard began to win the ideological argument with investors and the rest of the fund industry about indexing. The traditional approach to equity portfolio management, and the one that remains the industry's modus operandi today, is to identify specific stocks that the fund manager believes will best achieve a fund's investment objectives and, most important, will perform better than "the market" itself. In this model, the advisor actively manages the portfolio by buying and selling stocks as perceived relative values change.

Vanguard's introduction of the First Index Investment Trust represented a complete reversal of this active management approach—that is, a passive management approach, under which the manager, in effect, buys stocks in percentages representing the particular market to be emulated, essentially holding the securities on a permanent basis and hoping to replicate the performance of either the overall market or a predetermined, discrete sector of the market. Under the passive approach to investing, an index fund should perform about as well as the market it tracks. Active investors as a group—fund managers, individuals, pension managers, and so on—should also match the performance of the market; indeed, as a group, they are the market. But active fund managers as a group end up underperforming the market for their shareholders, largely because of their funds' advisory fees, operating expenses and transaction costs, not to mention any sales loads paid by the investors who purchase the funds' shares.

Proponents of the passive school of investing argue that for the overwhelming majority of funds, active management works only in the short term, and then only for the gifted or the lucky. Ultimately, the returns on a mutual fund regress to the mean and then end up below the mean when expenses are taken into account. While this line of thinking had long been argued in academia, gradually the popular media began to take notice. In particular, the 1973 publication of Princeton professor Burton Malkiel's "A Random Walk Down Wall Street" marked a watershed moment in the history of finance; not because the ideas were new, but because the book explained the concept of efficient markets in lay terms and went on to be a best-seller, selling millions of copies. The book is currently in its ninth edition. Although he hadn't read the book prior to launching Vanguard's index fund, when he did, Bogle was amused by Malkiel's classic assertion that, "A blindfolded chimpanzee throwing darts at The Wall Street Journal can select a portfolio that can do just as well as the experts." Malkiel would go on to join Vanguard's board of directors, and he served from 1977 to 2005.

As it evolved, the efficient market hypothesis, or EMH, as it is sometimes called, splintered into three categories or "forms" of theory—weak, semistrong and strong. Weak-form EMH asserts that stock prices are random, and therefore most money managers cannot exploit the market to gain an edge. Although there is an acknowledgment that fundamental analysis might provide some excess return, whether or not money managers could exploit valuation inefficiencies in the market effectively over the long term is called into question. Semistrong-form efficiency takes the argument a step further, claiming that the markets adapt so quickly to all publicly available information that even fundamental analysis doesn't add any value. Strong-form efficiency arrogates that the market is so efficient that it already prices in all public and nonpublic information, and that even corporate insiders with private insights can't gain any legal advantage. According to both the semistrong and strong versions of the theory, the price of a company's share of stock immediately reflects all available information, as well as investor expectations, related to the company; in other words, the market is perfect and right all the time in its assessments of stocks' underlying intrinsic values.

Bogle never subscribed completely to the efficient market hypothesis, but rather to something he half-jokingly dubbed the "cost matters hypothesis." He examined the past performance records achieved by both the active and passive schools. He also examined the costs of each type of management. He concluded that a fund was far more likely to produce above-average returns under passive management than under active management. He based his conclusion on two factors:

  1. All investors collectively own all of the stock market. Because passive investors—those who hold all stocks in the stock market—will match the gross return (before expenses) of the stock market, it follows that active investors as a group can perform no better: They must also match the gross return of the stock market.
  2. The management fees and operating costs incurred by passive investors are substantially lower than the fees incurred by active investors. Additionally, actively managed funds have higher transaction costs because their managers' tactics drive them to buy and sell frequently, increasing portfolio turnover rates and therefore total costs. Since active as well as passive investors achieve equal gross returns, it follows that passive investors, whose costs are lower, must earn higher net returns.
 

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