The Devil’s Invention

June 27, 2011

thedevilsinventionIn "The House That Bogle Built," journalist Lewis Braham digs into the details of the life of the man known as the father of indexing and to many as "Saint Jack." The book follows Bogle from his tumultuous childhood through the founding of one of the world's best-known mutual fund companies to his ouster from his own company and rebirth as an investor advocate. What follows is an excerpted version of Chapter 11, which recounts the development and rise of Vanguard's indexing business and the advent of the ETF boom.

Vanguard launched the first index mutual fund, appropriately named First Index Investment Trust, in August 1976. Later, the name was changed to Vanguard 500 Index Fund. The company was not, however, the first money manager to track an index or even the S&P 500. But if you say to Jack Bogle that he created the first retail index fund, he'll holler, "No, no, no, no; don't use the word 'retail'! This is the first index mutual fund—period!" Although he readily admits that he wasn't the ur-indexer, he has, to put it mildly, a lot of pride in the invention, and certainly without him it's hard to imagine the index fund ever getting off the ground with the general public. The concept may have stayed within the rarefied field of academia or remained the exclusive province of institutional investors.

But the indexing idea had been kicked around for a long time before Vanguard launched its famous fund. Bogle himself had stated in his 1951 Princeton thesis that, "Funds can make no claim to superiority over the investment averages, which are in a sense investment trusts with fixed portfolios," although in the very same work he would go on to explain the benefits of actively managed funds. In fact, in 1960, when two University of Chicago finance wonks published an article titled "The Case for an Unmanaged Investment Company" in the Financial Analysts Journal, Bogle published a rebuttal titled "The Case for Mutual Fund Management" a few months later, using the pen name John B. Armstrong so as to avoid getting his employer, Wellington Management, in trouble with the SEC. In it he detailed how four unnamed funds—one of which was Wellington Fund—had beaten the Dow Jones industrial average for 30 years with less volatility than the market.1

The first indexed account was created by William Fouse and John McQuown at Wells Fargo Bank in 1971. Because at the time the Glass-Steagall Act prohibited banks from managing mutual funds, Wells Fargo could not launch an index fund for individual investors. So instead, Wells Fargo started to run institutional index money in a private $6 million account for Samsonite, the luggage manufacturer. Problems immediately resulted, though, because the benchmark Wells Fargo decided to track was the New York Stock Exchange, and McQuown and Fouse chose to equal-weight each of its 1,500 stocks. To maintain an equal position size in each stock required a great deal of turnover, and transaction costs consumed too much of the returns as a result. So in 1973, Wells Fargo switched to the S&P 500, a low-turnover market-cap-weighted index. Money manager Batterymarch Financial Management and the American National Bank in Chicago created similar indexed accounts for institutions at around the same time.

Although he always thought that most managers would lag the index, Bogle became a real convert in 1974 after reading an article titled "Challenge to Judgment" by famed economist Paul Samuelson in the Journal of Portfolio Management. In the article, Samuelson pleaded for someone to start an index fund for retail investors. Bogle then read Charles Ellis' article "The Loser's Game" the following year, which outlined the basic argument for indexing: Professional money managers now were the market in aggregate and would lag it after deducting their fees.2 Ellis would later join Vanguard's board of directors.

As it happened, the timing to create an index fund couldn't have been better for Bogle. He had just launched Vanguard in May 1975 and was looking to internalize the advisory function of the mutual funds as one of the steps in "cutting the Gordian knot" that tied Vanguard to Wellington Management. "The biggest problem was selling it to Vanguard's board of directors because we had agreed not to get into investment management," says Bogle. "So I said, 'This fund didn't have a manager.' The directors bought that. Of course, technically, it's true. The fund is unmanaged." Former and present Vanguard index fund managers Jan Twardowski, George "Gus" Sauter, and Michael Buek might beg to differ, and Bogle himself would later say of his unmanaged fund pitch, "It was one of the greatest disingenuous acts of opportunism known to man."3 Even index funds need a manager to make sure that the assets are invested appropriately.

Although he may have had some ulterior motives for starting the fund, certainly Bogle believed that indexing would produce the best results for investors. "We started operations in May 1975 and I had the proposal for the index fund on the directors' desk in June of 1975—the first thing we did," he says. "Then the idea had to be sold to the directors, sold with data." Bogle crunched the numbers himself, calculating returns for the average mutual fund for the past 30 years versus the S&P 500 and proving that the index had an edge of 1.6 percentage points a year. "That was the evidence I needed to persuade the directors," he says. "I didn't need any persuasion myself." In May 1976, Vanguard's board approved the filing of the First Index Investment Trust's prospectus.

But convincing the board was only the first step. Bogle also had to sell the index fund concept to investors and Wall Street itself. The reaction within the fund industry after the 1976 launch was decidedly negative: "the pursuit of mediocrity," one commentator called it; "un-American," said another; "the devil's invention," said a third; "a formula for a solid, consistent, long-term loser," said a fourth. Despite the naysayers, Bogle ultimately persuaded Dean Witter to lead an underwriting of the new fund. He'd hoped for $150 million, but it took three months to raise the $11 million that formed the initial base for the fund. By the end of 1976, the fund had grown to only $14 million. It was not going to be easy to convince investors to put their money into a fund that would merely match the market; investors wanted to beat the market.

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.

Putting numbers to this theory, the cost difference is dramatic. Vanguard was saving its index fund investors about 1.8 percent per year—the expense ratio of the Vanguard 500 portfolio was 0.2 percent versus 2.0 percent for the average equity fund (expenses plus transaction costs). To put that amount into perspective, in a market with a 10 percent annual return, an index fund might provide an annual return of 9.8 percent, while a managed fund might earn an annual return of 8.0 percent. If this happens, over 20 years, a $10,000 initial investment in an index fund would grow to $64,900, while an identical investment in a managed fund would grow to $46,600, a difference of more than $18,000 in the accumulated account value.

John BogleEven though he was deeply committed to indexing, Bogle was willing to admit that some active investment managers could add value to the fund management process. In most cases, he argued, these managers either were lucky or were among a tiny group of true investment geniuses—market wizards such as Warren Buffett, Peter Lynch, Michael Price and Vanguard's own John Neff. In general, though, Bogle maintained that trying to outperform the market was a futile exercise. "Index funds," he said, "are a result of skepticism that any given financial manager can outperform the market. How can anyone possibly pick which stock funds are going to excel over the next 10 years?" In this context, the best strategy is simply to try to match the market in gross return and count on indexing's low costs to earn a higher net return than most competitors.

All of this, of course, was heresy to traditional active fund managers, who argued that the only reason to invest in mutual funds in the first place was to try to maximize returns, not simply match the market on the way up and the way down. But eventually, despite the ridicule of active fund managers, indexing began to catch on. The Vanguard 500 Index enjoyed positive net cash flow in each year of its existence and had grown to $500 million by the end of 1986—a decade after its launch. That same year, the Colonial Group introduced an index fund, the industry's second. (It would be out of business by 1990, however, because it carried a punitive load and a high expense ratio, thus eliminating any ability to match the index.) By 1988, Fidelity and Dreyfus had followed suit with their own index fund offerings.

Initially, Bogle spoke of the index fund as "an artistic, if not a commercial, success," but that changed during the 1990s, when investors started to notice that the fund was beating most of its peers. From 1985 through the end of 1999, the Vanguard 500 earned a return of 1,204 percent, compared to the 886 percent average for the large-cap blend fund category, according to fund tracker Morningstar. Gradually, the fund's assets gathered steam, first topping the $1 billion mark in 1988 and beginning the 1990s with $1.8 billion. It then grew to $9.4 billion by 1995 and finally surged to $107 billion by the March 2000 peak, ultimately surpassing its archrival the Fidelity Magellan fund in the following month to become the largest mutual fund in the world.

Along the way, the technology for managing the "unmanaged" fund had improved dramatically. The fund's second manager, Gus Sauter, who today is Vanguard's CIO, took over the fund in 1987 and ran it through 2005. "When Gus first got here and looked at the software that was being used to manage the index funds, he said, 'You've got to be kidding me,'" says Vanguard CEO Bill McNabb. "The software was from the 1970s, a decade old. Gus came in, taught himself the old computer language, did diagnostics, and rewrote all the code in his spare time. You can see the difference in the index funds from the point Gus took over. There were two factors—one, he rewrote the software, and two, he figured out how to use [index] futures. You can look at the tracking error in the early 1980s, and when Gus came in 1987, and you see this tremendous change in how tightly the funds began to track their benchmarks."

For Bogle, an index fund modeled on the S&P 500 was only the beginning. As the Vanguard 500 fund grew in market acceptance and successfully operated at minimal cost, Bogle's confidence in the concept increased. The Standard & Poor's 500 represented roughly 70 percent of the market's capitalization. What about a portfolio that tracked the remaining 30 percent? Vanguard's Extended Market Index, formed in 1987, enabled investors to do exactly that, tracking the Wilshire 4500 Index.

Later, to simplify the process of holding both the S&P 500 Index and the Wilshire Extended Market Index, Vanguard offered the Total Stock Market Index, essentially owning the entire stock market by tracking the Wilshire 5000 Index, the most comprehensive market benchmark available. In 1989, the Small-Cap Index was introduced, using the Russell 2000 Index of small stocks, and a lower-cost 500 portfolio was designed for institutional investors with at least $10 million to invest. (Originally, most of the above index funds had slightly different names, often using the word "portfolio" instead of "index.") Today, assets in the Total Stock Market Index actually exceed those in the S&P 500 Index, and Bogle himself prefers it as the best proxy for the U.S. stock market.

In a speech before the Financial Analysts of Philadelphia in 1990, Bogle said, "The introduction of index funds focusing on growth stocks and value stocks awaits only the development of a growth index and a value index." Standard & Poor's introduced these two new indexes in May 1992, and just two months later, Vanguard launched portfolios with similar objectives. Bogle was confident that the principles of indexing would also work in world markets—perhaps work even better, since the expense ratios and port­folio transaction costs of international mutual funds were far higher than they were for U.S. funds. The Vanguard International Equity Index Fund was introduced in 1990, with European and Pacific Rim portfolios; an Emerging Markets index was added in mid-1994.

Nearly a decade after introducing the first equity index fund, Vanguard applied the indexing theory to the bond market, using the Lehman Aggregate Bond Index as a benchmark. (This index was renamed the Barclays Capital Aggregate Bond Index in 2008, after Lehman Brothers went bankrupt.) The Total Bond Market Index Fund, reflecting the market value of all taxable U.S. bonds, was founded in late 1986 to provide the same advantages of low-cost, high-quality and broad diversification to bond fund investors that the Vanguard 500 provided to equity fund investors. Early in 1994, without much enthusiasm from his associates, Bogle inaugurated three additional bond portfolios—short term, intermediate term and long term—based on the appropriate Lehman indexes. The three new portfolios, like the original all-market bond portfolio, met with modest early acceptance but gradually became increasingly popular. As of October 2010, the Total Bond Market Index Fund had $89 billion in it, making it one of Vanguard's most popular funds.

Although Fidelity and Dreyfus funds joined the indexing fray in the 1980s, more out of expediency than out of desire, Vanguard faced no real competition from them in this area because they weren't really interested in selling such low-margin products. But gradually some other players that initially had flown beneath the radar emerged as a genuine threat to Vanguard's index fund dominance.

Perhaps it should come as no surprise that some of the same academics involved with the foundations of efficient market theory helped create Vanguard's first real competitors. One of the earliest was Dimensional Fund Advisors (DFA), which is based in Austin, Texas. Its founders, University of Chicago MBA graduates David Booth and Rex Sinquefield, were indexing even before Vanguard, because Booth and Sinquefield worked, respectively, at Wells Fargo and American National Bank of Chicago on their institutional index accounts in the early 1970s. Together they launched DFA in 1981, providing indexlike offerings with low expenses not to individual investors, but to financial advisors and institutions. Other efficient market "luminaries" such as Eugene Fama and Kenneth French soon joined DFA's board of directors.

DFA's approach to indexing differed from Vanguard's in that DFA wasn't afraid to venture into lesser-known, riskier areas of the securities markets such as micro-cap stocks and Japanese small-cap stocks. Its oldest fund, DFA U.S. Micro Cap, was launched in 1981. The firm was also not such a purist when it came to indexing, since it would sometimes tweak published benchmarks to gain an edge, tilting them more toward a valuation-driven model. Or it would create its own in-house indexes that it saw as superior to published ones. It also developed a proprietary trading system to minimize transaction costs. Although the value ($8.3 billion) of its largest fund, DFA Emerging Markets, is dwarfed by Vanguard's heavy hitters, its low-cost index philosophy was inspired by the same spirit of modern portfolio theory as Vanguard's, and many of its funds have proven highly competitive with Vanguard's best.

A far more significant threat emerged from State Street Global Advisors and Barclays Global Investors in the form of exchange-traded funds (ETFs). These two money managers had already become fierce competitors in the institutional investor space for indexed assets in the 1980s and 1990s. For instance, total assets under management at State Street grew from $38 billion in 1988 to $142 billion by the end of 1993, and much of that institutional money was in passively managed indexed strategies. But then in 1993, State Street fired a broadside at Vanguard's retail business by launching the first ETF in the United States, the Standard & Poor's Depositary Receipt, or the SPDR S&P 500 ETF, as it came to be called. The ETF followed the same benchmark as the Vanguard 500 fund, but it was tradable all day long like a stock and therefore was easily accessible to individual investors. What's more, the management fees were competitive with Vanguard's. In fact, by March 2000, State Street had reduced the SPDR S&P 500's expense ratio to 0.12 percent, which was less than the Vanguard 500's 0.18 percent for individual investors at the time. By then the ETF had already attracted some $17.3 billion in assets.

It wasn't long before Barclays also entered the arena. The same division of wonky efficient market enthusiasts at Wells Fargo Bank that created the first institutional index account in 1971 was eventually acquired by Britain's Barclays Bank for $440 million in 1995 to become Barclays Global Investors. In the meantime, Barclays had already become an institutional indexing powerhouse. In 1996, it collaborated with Morgan Stanley to launch its World Equity Benchmark Shares, or WEBS, brand of index ETFs that tracked various international markets such as those of France, Italy and Japan. These were later rebranded as iShares in May 2000, which was about the same time that Barclays started to aggressively launch other ETFs that tracked U.S. benchmarks similar to Vanguard's. By the market's peak in 2000, Barclays was already managing $800 billion worldwide, primarily in institutional assets, but the storm clouds were brewing.

At the time, Vanguard officially claimed that it didn't see ETFs as much of a threat. "To me it's effectively a product extension like instant coffee," said Vanguard spokesman Brian Mattes in March 2000, just as Barclays was preparing for a major rollout of new ETFs. "When instant coffee debuted, did it really hurt the sales of brewed coffee? No. People still liked brewed coffee. But it put coffee in the hands of people who couldn't wait for it to percolate."4 But behind the scenes, the pressure was mounting. Indeed, although index funds had grown from 9 percent of total equity fund assets in 1999 to 17 percent by 2007, 7 percentage points of that number were from index ETFs. Without ETFs, the index mutual fund market share would have grown to only 10 percent.

Bogle, for his part, has always seemed ambivalent about ETFs. He thinks the low costs, broad diversification and tax efficiency of the more conventional S&P 500 type of ETFs have the same advantages as traditional index funds, but he frets that excess speculation in them will eat into investors' returns via high transaction costs and thus cause investors to buy and sell them at inopportune times. "The ETF is a little bit like the famed Purdey shotgun that you buy over in London," he says. "It's the greatest shotgun ever made. It's great for killing big game in Africa, but it's also great for suicide." Needless to say, Vanguard launched no ETFs under Bogle's watch as CEO or chairman. And yet once he stepped down as chairman in 1999, it wouldn't be long before Vanguard, too, felt the need to enter the fray. Perhaps, despite Bogle's best intentions, his beloved index fund was on its way to becoming the devil's invention.

This article was lightly edited to reflect the editorial conventions of the Journal of Indexes.

Copyright © 2011 by Lewis Braham.

Reprinted with permission of McGraw-Hill.

Endnotes

1 As described in Justin Fox, "The Myth of the Rational Market" (New York: HarperCollins, 2009), pp. 111-112.

2 Ibid., p. 130.

3 Ibid., p. 129.

4 Lewis Braham, "Vanguard's Arachnophobia," Fund Watch column, SmartMoney.com, March 23, 2000.

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