The full transcript of John Bogle’s recent webinar examining exchange-traded funds and the outlook for America’s investors.
During the one-hour presentation, Mr. Bogle unveiled new research regarding how successful (or not) investors are when trading exchange-traded funds, and took a big picture look at the state of American finance.
Jim Wiandt, editor, Journal of Indexes (Wiandt): Good morning everyone, and welcome to a very special event that we have here today. We are actually at the NASDAQ market site and we have the Journal of Indexes editorial board meeting today.
We have a very special guest to present today at our webinar. John Bogle is a legend. He is an icon and is really the father of indexing and sensible asset allocation for average investors. We are delighted to have Mr. Bogle here today.
He is going to go through a series of slides, some of which are extremely interesting and very pertinent, which speak to the way the index industry has evolved in recent years.
The format for today will be first, Mr. Bogle will go through his slides, and then we are going to open things up for questions.
We have all of these slides posted to our Web site, IndexUniverse.com [available here]. Without any further ado, I will turn things over to Mr. Bogle. And, again, we are delighted to have you, Mr. Bogle, and look forward to the presentation.
[Editor’s Note: A replay of the webinar is available here.]
John Bogle, Bogle Financial Markets Center (Bogle): Thank you very much, Jim. And welcome, all you webinar listeners. I presume there are a few Bogle-heads there and I send a special welcome to them.
It’s fun to be with you this morning. I thought I would begin by giving you a report on the status of index funds in mid-2009. I guess the main point I would like to begin with is that we now know what we really suspected, or strongly believed, 25 or 35 years ago when I started the first index fund—that indexing would change the world of investing.
I believe it is now clear that indexing has changed the world of investing in some very remarkable ways. First and most notably, I think we’ve had an odd convergence of indexing in two different areas. Active fund management has become much more like passive fund management—for example, active managers are often quantitative, working off matching indexes or having enhanced index funds or closet index funds. Or when you look at brokerage recommendations, you see they overweight relative to the index or underweight rather than buy or sell. The way we look at investing has been changed by standard indexing.
But even as that has happened, passive indexing has gotten a lot more like active fund management. That is, we use index funds for rapid trading in some very remarkable ways, which I will discuss this morning.
We can go to the first slide there and just take a look at what I will call a triumph of indexing. You see the growth of indexing just in the last 15 years from $24 billion to $914 billion on the equity fund side. Throw in roughly $150 billion of bond fund indexing and you are over $1 trillion—about $1.60 trillion in index money in a long-term stock and bond mutual fund industry that has $6 trillion of assets. So indexing itself now accounts for one-sixth of all the mutual fund assets; quite a remarkable thing.
And so, it’s pretty nice to think that last year, 2008, is probably the best year indexing ever had in terms of performance. For the total stock market and the S&P 500—two good proxies for what is going on in the U.S. market—indexes of those two components put them in about the 65th percentile [of overall fund performance], outperforming about two-thirds of all mutual fund managers. Sure, the decline was about 37%, but the typical U.S. manager went down about 40%; the typical developed market fund went down about 45 to 50%; and the typical emerging market fund went down 55 to 60%. So on the stock fund side, it was quite a triumph for indexing.
On the bond index fund side, it was even more of a triumph. The total bond market index was up 5% last year, outperforming about 85% of comparable bond funds, thanks largely to a big drop, as most of you may know, in Treasury yield.
So we’ve got this wonderful growth rate. We’ve got a dominant industry position. And yet, some unusual things are happening. We will take a look at what is driving the growth of indexing by looking first at ETFs—exchange-traded index funds. And as the next chart shows, I describe them as a truly great business model. Hear carefully when I say “business model.” We will talk about other kinds of models later on.
You can see in the next chart that ETFs have come from almost nowhere—back in the early 1990s, when the first exchange-traded fund was started—to the fact that they are now actually just a hair behind in terms of equity fund assets the traditional index funds, the kind of funds that Vanguard pretty much runs: $457 billion compared to $460 billion, or $456 billion plus. So the ETFs have proved great competition for the classic index funds, basically what I thought about all those years ago.
I’m often asked, “Who is going to win the war: mutual funds or exchange-traded funds?” That is not a good question, because exchange-traded funds are mutual funds. They are just mutual funds you can trade all day long in real time. We will talk a little bit about that. So what we have is, what is growing is index funds for people who want to trade or who believe that the opportunity to trade or the ability to trade is important, intraday trading; and equity mutual funds, which are more designed for long-term investors.
But going over to the next chart, you will see pretty much what has driven the growth of index funds even more clearly than the previous chart. Exchange-traded funds were about 2% of the index fund business back in about 1997, 1998. By 2000, they got up to about 11%. In 2008-2009, they are 11% of equity fund assets, just exactly the same, almost exactly the same as the 11% in traditional index funds.
So we have had a huge growth rate for ETFs. And in terms of market share, stability in a lot of ways, and maybe disappointing stability in the market share of traditional, classic index funds—old, broad market index funds. But for quite a few years, the cash flow went very much in favor of … active funds over index funds for years and years.
But in 2007, as you can see in this chart, the index funds took in about twice as much in the way of assets as actively managed funds. Last year, index funds took in $200 billion in assets. Active funds lost $250 billion. And this year, index funds are taking in a little bit of money so far. These are annualized numbers for 2009. And the active funds are, again, losing so far, on an annualized basis, about $150 billion this year. So clearly, the trends are there. The trends are also there for traditional index funds versus exchange-traded funds.
You can see on this chart the dominance of exchange-traded funds has really been quite remarkable these last three or four years. Where the traditional index funds were taking $40 or $50 billion a year in net cash flow—a good measure of success in the marketplace—the exchange-traded funds were taking somewhere between $140 billion to $150 billion a year and three or four or five times as much. Whether this is a trend or not is much too early to say.
That has been somewhat reversed here in 2009 with, on an annualized basis, the traditional index funds actually adding about $40 billion, expected to add about $40 million in cash flow—where for the first time ever, exchange-traded funds are actually having cash outflow roughly in the amount of $30 billion annualized this year so far. Whether that is a turn in the tide, only time will tell.
Now, if exchange-traded funds are a brilliant business model, are they a good investment model or, as this next slide asks, are they a flawed investment model? And we know they are a good business model. We know they are great for fund marketers. We know they are great for brokers. We know they are great for investment advisers. We know they are great for institutional speculators. But the question is, what are ETFs doing for individual investors?
That is an interesting question and we have done some research on it, which we are going to unveil here in a little bit for the first time. I come back now to the difference between an exchange-traded fund and a traditional index fund. An exchange-traded fund, to use the quotation from the original ad for the SPDR [NYSE Arca: SPY]: “And now you can trade the market all day long in real time.” That is what the original SPDR was advertised as doing. I’m not exactly sure why anybody would want to trade the market all day long in real time, but that is their slogan.
In many respects, as this chart shows, that idea of using ETFs, exchange-traded funds, for speculation has come true, come more than true, come true in spades. You can look at it any way you want, but look at those turnover rates for share turnover in the SPDRs there. And they are in second: 10,105% turnover last year. Just think of that. There are about 711 million shares outstanding of the SPDRS and they have 8 billion shares traded last year?8 billion shares of SPDRS traded.
And that doesn’t seem to be particularly good, even for those investors. Because while the SPDR had a five-year return of -1.9% a year—it’s been a difficult market—the average investor in SPDRs had a return of -8.2% a year. So you tell me whether all that trading is good for investors or is not good for investors. You can see what you would expect.
On the other more speculative side of the markets, the ETFs trades very heavily. Real estate funds have huge ups and downs. The turnover of the iShares real estate ETF we looked at was 23,977%—to put precision on a number that doesn’t need to be precise.
Obviously, Financial SPDRS were attractive both to buyers and sellers last year, with 9,600% turnover. The NASDAQ QQQs? 8,700%. These are remarkable numbers, suggesting that a great deal of what’s going on in ETFs is a business of very rapid trading among large, institutional investors.
Now, when you look at more normal share turnover, over on the right side of the chart—we just took out of a group of about 38 or 40 funds, the lowest turnover funds. More than about half of them seemed to be Vanguard funds, which have turnover in the range of about 200% per year, far lower than those high percentages. So there is a use for ETFs that doesn’t require the trading that seems to show up in the less speculative part of the market.
How high is a 200% turnover rate? Well, the average mutual fund last year happened to have one of the highest turnover rates in a long time—a 33% redemption rate last year. That’s high, very high as far as I’m concerned. So you can imagine what I think of 200% turnover.
What we are seeing here is the use of funds, of ETFs, for speculation. For the bigger ones and for the more traditional ones, in some sense at least, we have much lower turnover, but still high compared to mutual fund turnover.
If we go to the next chart, we can try to answer the question on the next two charts. Okay, we know how ETFs do. But only in recent years have we found out how the investors in mutual funds do. You can actually calculate these returns, what we call the fund returns or the time-weighted return, or typical rate of return. Something starts at $10 and goes to $11?that’s 10%, not very complicated there. But then we do a dollar-weighted return, an asset-weighted return, to show how investor cash flows influence that return delivered by fund. The reality of life in this business is that it is very rare that investors do as well as the funds themselves.
And that is the point I’m making on this chart with the ETFs. These are all exchange-traded fund groups. You will be familiar with the groups: large-cap blend, large-cap growth and value, same in the mid-caps, European, emerging markets, and so on. And you will see that in general, investors lag those returns, just glancing at those numbers, by 5% or 6% a year of return. [That is, they earn] 5% or 6% less than the fund, than the ETF itself earns, showing that the trading is done in an unfortunate way in terms of timing.
The numbers shown over on the right side of this chart are unbelievably consistent. For example, on that page there are 46 ETFs, and in 40 cases out of 46, the investor returns lag the funds return. This is not an aberration. This is a very consistent return, which you will see again if we will flip over to the next chart, which just shows some additional subsectors of the market, in the ETF form, with the investor return and the investor lag.
You can see in some cases?the financial case, for example?the fund’s return trail the index return by almost 11% per year over the last five years. The investors had a negative return of almost 29% over the last five years, a lag in return of almost 18% a year. It is hard to believe. And there, 100% of the funds lag the index. So when you put those two charts together and add them up, out of 79 exchange-traded funds that we covered, 68 of them had investor returns that were either substantially, significantly, or moderately at least short of the returns earned by the funds themselves.
So if you want to take some kind of a simplified average and say that fund returns were generally negative to about 1% a year, and the investor returns on average were negative about 3.5% a year—I’m sorry. The fund returns happened to be positive, thanks to energy and utilities and emerging markets and such segments as that, just a simple average of positive 1%. You find the ETF returns averaged about 6% on these charts, accumulated over five years. But investor returns, if you take -3.5% with negative compounding over five years, investor returns were about -12%.
So when you put plus 6% for the five-year total return for the fund and -12% for the five-year total return for the investor, you are talking about 18% of investor capital that has been lost by all this trading. Now, you can ask, “Don’t regular mutual funds have this same problem of investor returns lagging the returns of the indexes or returns of the funds they own?” Of course they do, but it is not nearly as bad.
To show that, we will introduce one more chart, which I think will be the last chart I will use, so we can open it to your discussion. We happen to have Vanguard mutual funds that have ETFs, exchange-traded funds, in each of these categories. And we have compared the returns on the Vanguard mutual fund returns on this chart, beginning with large-cap blended funds, large-cap growth, large-cap value, mid-cap blended, small-cap blended, emerging markets and real estate investment trusts. We have a regular fund in those areas, Vanguard does: a regular mutual fund. Those returns are shown near the center section of the chart. And the investor returns on the exchange-traded funds are shown on the right side.
You will see that while the investor lag on the exchange-traded funds and side on the left have remarkably large and significant lags, the actual mutual funds themselves lag here and there, but in general, come very close to the returns earned by the market standard that they are in. So we have evidence, strong evidence, that exchange traded funds?because of the timing that goes on?are not acting in the best interest of investors, or investors are not acting in their own best interest, might be a fairer way to put it. While mutual fund investors have similar problems, they are nowhere near so serious. They are not even in the same league.
So the question I raise is?I suppose a broad, philosophical question?how long can a great business model last if it doesn’t deliver good returns to the investors who rely on it? And that is a question we might chat about. But first, before that, I would like to open the meeting and try to answer any questions any of you might have who were kind enough to attend this morning.
Wiandt: Thank you, Mr. Bogle. We have a lot of good questions. Why don’t we start out with one which talks about your methodology? There are a few questions in this area about how these returns are calculated. I guess the focus of these questions is, is most of this turnover retail turnover? Is it institutional? Is it both? And how did you come up with these calculations in terms of looking at the flows and calculating these returns?
Bogle: Well, first it is very hard to separate out institutional turnover, the huge turnover where people are speculating on, for example, the SPDRs. Investment adviser turnover, how big is that? How much is individual turnover by those who intend to invest and that other component of individual behavior, which is those that intend to speculate. I don't know anybody that has unscrambled that egg. I am not privy to Vanguard data on this point.
I think even more important would be the data that someone like Barclays could provide. They are, of course, the largest firm, the most dominant firm in this business with the broadest base of business. So we are just going to have to ask them how they would divide this up. I did have a conversation with a representative of Barclays three or four years ago, and I was making the same point I am making this morning. He said, “Well, that just is not right. Seventy percent of our investors are long-term investors.” And I said, “How do you define long-term?” And he said, “Six months to a year and a half.” Well, that is not my idea of a long-term investor. That is just another example of the difficulty of getting through. It is a matter of definition.
Now, as to the methodology, we don’t do these ourselves. These are Morningstar data. My understanding of how that data is compiled, and I take some comfort by the way, in its consistency from one group to the other—which suggests that there are not a lot of problems with the data. Although I’m the first one to state and underscore that all data has problems. When you see really consistent data like this, however, it’s an eye-opener. It may not be precise, but it’s got to be giving us an indication of what we know to be true.
One of my rules has always been, take a look at some numbers and if it flies in the face of your intuition, do the numbers over and over and over again. But if the numbers confirm your intuition?which is essentially that ETF shareholders and mutual fund shareholders generally look back at past performance and buy the funds that have done well?it is sort of performance-chasing…
We know that happens. We can’t measure it with precision.
Now when you get funds with a lot of daily cash flow in and out?I’m sure real estate REITs are a good example of that, and I’m sure the SPDR is a very, very good example of that?I don’t see how we can be precise in these returns. What you do is take monthly cash flows and compare them with the price of the fund, the average price of the fund during the month, then you figure out eventually how many investor dollars earn what returns over time. Is that way of aggregating the data precise? No, it is not.
But I’m persuaded in the absence of compelling evidence on the other side that these data are telling us something that is worth knowing. And it suggests that mutual fund trading is about as valuable as trading individual stocks, which is to say, not valuable at all, and harmful to your returns.
Wiandt: Every year we hear from active managers that “this is the year of active management.” Do you believe that there are environments that are more favorable to active management than passive management and index investing? And if so, what do those times look like?
Bogle: There is no way that active managers can possibly have an advantage no matter what the circumstances are. Just think about this: Almost 75% almost of all stocks are owned by institutional investors now, and they are basically, by and large, professional investors. They are pension fund investors. They are pension money managers, they are pension trustees I should say, pension money managers, mutual fund managers, which also manage pension funds and endowment funds. And that’s 75% of all stocks, and only 75% of all stocks. It is just not possible that they can be taking the individual investor on the other side— the remaining part of the market—to the cleaners with every trade. There is no evidence of that.
So what we find is that institutional investors and individual investors basically each capture the market return and they each capture the market—and together they each capture the total market return. That is inevitable. And that’s before cost. So when you take out costs, which are high, you end up explaining almost all the reasons that active managers cannot and do not beat the funds, beat the market itself. It is just statistically, mathematically, tautologically impossible.
Wiandt: How do you see the Barclays-Black Rock merger affecting the investment landscape? What do you view as the implications of that merger?
Bogle: Well, that’s a good question. I have a couple of observations. First, they paid a pretty good-sized price. I think since Barclays kept 20% of the company, the price comes out to be something like $17 billion or $18 billion. That’s a lot of money to pay for a fairly low-margin business. Second, ultimately, I think they are going to have to reduce the cost of the funds, which will make it less attractive as an investment—because they are just a very high-cost outfit, compared to the low-cost provider, which is always Vanguard.
iShares has an average expense ratio of 41 basis points. And those are the ETFs run by Barclays. Vanguard has an average expense ratio in its ETFs of 15 basis points. Eventually the low cost wins. That’s all there is to it. So they are going to have to worry about whether they can be able to be competitive with high prices—which can be providing them with a lot of revenues and maybe a lot of money to do marketing and a lot of money to create one new index-based ETF after another, which they seem to be doing.
I think it is going to be a hard business then to build market share. And since they are around a 50% market share now, in my experience, most firms, when they get to 50% market shares, find it much more likely for that market share to shrink than to grow.
There is also another kind of a subtle thing, and I don’t mean to be unkind at all to BlackRock, but they have a real problem with active management. There is no question they must be interested in index funds because they are indexed and not actively managed. We took a look at 100 funds. They have 100 closed-end bond funds and we took a look at them last year, and 99 of them—you know, the bond market went up 5%—99 of them had negative returns. Fifty-four of them had negative returns of over 20%, including 24 of the Black-Rock-managed bond funds that had negative returns of 30%–60% last year.
I mean you’ve got to be struggling with the business when active management is producing those kinds of returns on their bond funds, their area of expertise. So I wish them well. I don’t particularly want to be in a position of criticizing them. But with their record last year, I’m sure they are every bit as disappointed and surprised as I am. I would think, to them, indexing looks like a pretty darn good business.
Wiandt: What do you think the impact of all these leveraged ETFs and all the trading activity that you outlined is? Do you think that all that trading activity and the size of ETF trading—which some days is over 40% of trading in the market—is making for more volatile markets, is actually affecting what is going on in stock markets?
Bogle: Well, I struggle a little bit with that. I’m not sure enough of the data. For example, when we say that SPDR has 10,000% turnover, if you have a buy and a sell at the same time or almost at the same time of, say, 100,000 shares of the SPDR, that’s a volume number that is counted but doesn’t result in any stock changing hands. You are just offsetting the buyer against the seller. So I haven’t been able to cut through that fog. You know, the people that are running those businesses, I think, have some kind of an obligation to report exactly how much trading goes on. And, beyond my expertise, they may actually be doing that. I just don’t know that. It is certainly something we should know.
But in general, I looked at index fund trading, oh, a few years back before these ETFs got so big, maybe three or four years ago. And index fund trading counted for about 0.4% of all securities trading on the various companies—General Electric, Microsoft and companies like that. So 0.4% can’t be looked at as something that is driving the mare here. It’s got to be smaller. It is something that ought to be investigated. But the evidence I have so far is that you can’t really place the responsibility for market volatility on index funds. Although the growth of ETFs in the last few years may have changed that conclusion.
Wiandt: We have a couple of macroeconomic-focused questions. So I will ask those. The term “systematic risk” has become a scare tactic that the government uses to justify bailouts and defraud taxpayers. What is your view of systematic risk? What is your view of the bailout and how the government has reacted to the financial crisis?
Bogle: Well, I think it is a little over the top for me to say that the government is defrauding taxpayers. I don’t know quite the context to put that in. I would strike that from anything I could possibly respond to. I just don’t believe it is true. The more relevant question is, I suppose, that when we had this enormous risk to the financial sector of the economy, primarily—we will talk about that first.
The federal government had to do something. And I think what they have done is moving in the right direction, and that is, these banks were out of liquidity. They had created banks and investment banks together. And insurance companies we now know too were part of it, including AIG, American International Group, which was probably the worst of the bunch—doing all kinds of investment… engaging in all kinds of speculative activities that led to the market meltdown we had and where credit actually froze.
And all developed economies operate on free credit. When the credit markets close down, the government can’t just say, “Too bad.” Almost every small business, many individuals, we all depend on credit one way or the other for maybe just a short time, maybe a longer time. So the government had to take action. And I think they took the right action. I think they took the right action in approximately the right dimension.
Although it’s interesting that the actions they have taken have really … they said (a) and the actions turned out to be (b). So if we talk about the troubled asset repurchase program, so-called “TARP,” —I call it the toxic asset repurchase program—that was passed by the Congress under great, great pressure on October 15. It became a campaign issue, you may recall. And they still haven’t made their first purchase of a troubled asset all this time later. What they did, despite the obvious intent of Congress but maybe not the words, is funded the equity capital positions of banks rather than buying the troubled assets.
I’m not sure how easy it is going to be, even with this new public-private investment partnership—the PPIP—how easy it is going to be for us to do trading or have liquidity among these troubled assets. Because as I understand it, bank A is very reluctant to sell one of its toxic assets at, say, 25 cents on the dollar because they’ve got a whole portfolio of toxic assets. And they are scared to death they are going to have to mark them all to 25 cents.
My understanding of what’s going on in the financial economy out there is that 25 cents, give or take, may even be a little bit high. It is roughly what these toxic assets are going to prove to be worth, or at least most of them are going to prove to be worth. So it’s going to be very hard to get them paid off. It is going to take a lot of time. But, obviously, we eventually have to reverse this tremendous leveraging. We have to de-leverage our financial economy—to say nothing of our individuals who have heavy credit card debt, enormous mortgage debt. And there is a decent amount of corporate debt, although not nearly that excessive out there, too.
I mean, debt in our economy, I think, used to run around 60% of our gross domestic product. I believe it got up to around 135% or 140% of late. So we have to do the de-leveraging. The government had to play a role in maintaining liquidity in the system. So, while I can’t defend the exact way they did it—I don’t think anybody knows exactly how to do it—I would defend the policy that calls for government intervention.
Wiandt: We have a lot of questions about ETFs. There are a couple of lines of questions. One basic line is, are ETFs a good investment for a buy-and-hold investor? If someone buys an ETF and holds it for a long time, is it a good investment? Is it potentially a better investment than a traditional mutual fund structure?
Bogle: Well, the answer to that is yes. Unequivocally, it’s a better investment than a traditional mutual fund. Is it better than a classic mutual fund that is indexed? Or to put it another way, is the SPDR a better bet than the Vanguard 500 Index bought directly from Vanguard? That all depends, like everything else in this world—I don’t see that there is a particular, in the abstract, a particular advantage one way or the other. I don’t think the SPDR is necessarily better. Its cost might be a little bit lower than, say, a brokerage commission. The Vanguard 500 Index’s cost is a hair higher, but there is no commission.
I believe, by the way, that the tax efficiency of the SPDR, to the extent that it exists, is going to be indifferent from the standard S&P 500 Index Fund of Vanguard. We have been able to manage that fund with almost no realized gains. Particularly with the market of recent years, we’ve had plenty of high cost of stock in that index fund. Now, when you start to fine-tune it a little bit for an investor accumulating money, it’s absurd to buy the exchange-traded fund because you have to pay a commission every time you buy it—when you reinvest dividends, all those kinds of things—where that is done automatically for you at a known asset value in the 500 index fund.
So for the periodic investor or the retirement plan investor, it would seem to me, just on the mathematics involved, and assuming the performance of the two is the same … I’ll come back to that in a moment … but you don’t have to worry about tax efficiency for retirement plans. I’d say the 500 index is clearly?just because of the math?the superior choice. So you can flip a coin one way or the other.
But in general, long-term investing in the right kinds of index funds, by which I mean, broad market index funds—whether it is S&P 500, total U.S. stock market, possibly the emerging markets, certainly the developed international markets, the total international as we call it—I think they are pretty even competitors. And that is a perfectly good way to invest, and you almost certainly over time substantially outpace, no matter which way you go?ETF or standard index fund?the results of actively managed funds in the same area.
Did I cover all of that, Jim?
Wiandt: I think you did a pretty good job on that one. A follow-up question is, all this trading activity that you outlined for ETFs?does that damage the long-term buy-and-hold investor who is in ETFs?
Bogle: Well, the ETF returns?a little bit surprisingly to me?come pretty close to their category returns. It doesn’t seem to be damaging. And that said, if you are, in fact, are a long-term investor, it should matter very little. Because they seem to be able to produce the return of the index, or emulate it. For the short-term investor, there are often serious variations between the net asset value of the ETF and the market price at which it is trading, particularly in the less liquid market. So you are just flipping one more coin when you get into that game and, therefore, I wouldn’t recommend it.
Wiandt: Another question on ETFs: What are the safeguards and diligence that should be taken by an investor who is looking at ETFs? What sorts of ETFs should we be looking at, and what are the issues about structure or index that we should be looking at?
Bogle: Well, I’m someone who believes in simplicity rather than complexity. And buying the index funds in any of these broad categories is, by far, the simplest way to do it. You don’t have to worry about capital gains. And there are an awful lot of funny things going on in some of the wild ETFs and a great deal of tax inefficiency and large capital gains, things like that, that don’t seem to apply to the bigger indexes, like the bigger index funds, the bigger ETF funds.
But I just go the simple route, because it is clear and nothing can get in your way. You are not in business with all these speculators. And if that starts to make a difference, you won’t be influenced by it. So I would go to the standard index fund just on the basis of simplicity. If you’ve got a tenth of a point return less—and I can’t imagine it can be much different from that, 0.01% per year—I would say that is probably a price worth paying not to have the risk.
There are also quite a few variations on this. Some of these ETFs—I don’t want to speak too strongly about it, but they verge—their concepts verge on insanity: triple leverage, up markets, down markets, new ways to beat the market—how about exchange-traded notes, which are ETFs [or ETNs]? That is basically a call or a promise to pay you the index return by an outside financial organization. And some of them have gone bankrupt, so the exchange-traded notes became worthless. You just be very careful that you are not into the note business. You can’t be sure, ever, what will happen.
So I would say, opt for simplicity. Remember Ockham’s razor. Our friend, Sir William of Ockham, says, “You know, if there are multiple solutions to a problem, choose the simplest one.”
Wiandt: It looks like we have got an active investor here with a question. I think you may enjoy this one. He says, “Jack, you continue to encourage individual investors to buy and hold. However, I challenge you to name one goal-oriented endeavor besides investing where an intelligent individual would select a passive approach over an active one. Can you name even one?” he says.
Bogle: I’m sorry. You are just going to have to explain the question. Name even one investor?
Wiandt: Some activity that you would want to do in life where you would choose to be passive instead of active as a way of succeeding.
Bogle: Oh, that is such a great question! And, you know, there is an answer to it. And this is why we get so messed up in the financial business. Would you go to an average doctor? No. Why would anyone go to an active doctor, to a passive doctor or not the best doctor around? The problem is, in the financial markets, they are different from any other endeavor in American life. And that is, there is a market out there and it has a certain value. And all of us together own that market.
So literally the only way to capture the market return is to own the market without cost. That cannot be done. But you can do it with a cost of as little as 0.1%, and you will, by definition, beat all these other investors who do it at a cost of maybe 2%–2.5%. There is really not any mystery about this. It is all what I’ve been willing to call or have been able to call the “relentless rules of humble arithmetic.” Get the croupiers’ take out and you capture the market return; you as a group of investors. Lave the croupiers’ take in—pay the croupier … pay Wall Street … pay the money managers … pay the brokers … pay the investment bankers … pay the investment advisers … and you get what’s left.
You know, you are sitting---you individual investor who has asked the question—you, pal, are sitting at the bottom of the food chain of investing. You know, everybody gets paid before you do. Where else is that true in American business? I don't know if it is true anywhere else at all. So, yes, unequivocally, it is different and it has to be different. And our failure to acknowledge that difference is what gets us into so much behavioral problem.
Wiandt: Is there a role for financial advisers in helping individual investors? And if there is, what is a reasonable sort of cost for a financial adviser?
Bogle: Well, I happen to believe the financial adviser serves a very useful purpose for many, certainly not all, but for many, and perhaps even most, investors. We put the stock market and the bond market and financial planning in this aura of great mystery. And if you have been around long enough, and I think I have been around long enough, although I have to be around a little bit longer—if you have been around long enough, you realize that there is not that much mystery about it. The idea is to capture the returns of the bond market and the stock market, essentially.
And that is all there is to it: to capitalize on the miracle of compounding returns and avoid the penalty of the tyranny of compounding costs. Because in the long run, the tyranny of compounding costs overwhelms the magic of compounding returns. If investors understand that much and are broadly diversified, they can really operate on their own. Now, not everybody can do that. There are motions that they don’t understand the system to begin with. They probably think they are a lot smarter than the system. They barely know a stock from a bond and don’t know what managers to trust and what managers not to trust.
So I think the investment adviser can play a very useful role, particularly in fund selection and in asset allocation and, in general, trying to help investors avoid the penalties of the behavioral kind of investing; of doing dumb things at dumb times. We may even need a financial adviser to, at times of crisis, have the courage to say to his clients or her clients, “Don’t do something. Just stand there. Stay the course.” It is generally better than moving your money around at times of crisis.
What is a fair price to pay for that? Obviously, it varies greatly. By the way, I should say much more than parenthetically, I don’t think we should rely on financial advisers to pick the best funds for us. They can pick intelligent funds. They can pick broadly diversified funds. They can pick funds with low turnover and funds with low cost. But picking funds that win is pretty much hazardous duty that nobody, now matter what their knowledge is, has really the ability to do. We rely too much on fast returns.
I think the idea is to have the adviser help you capture as much of the market returns as you can do. What’s a fair price to pay for that? Well, we talked. And in this funny, funny industry which I’m part of, we always talk about percentage turnover. I think we ought to be thinking more about dollars. And 1% is certainly not an excessive fee in terms of revenues it generates for an adviser who has got to be interested in taking care of you.
If you have $10,000 or $50,000 or $100,000 to invest, I would argue 1% might even be too low. But if you take any more of that, it is too big a hit out of your long-term compounded return. But once you get to a larger investment, I think that 1% should be scaled down somewhat—so the adviser is treated reasonably well, but not a flat percentage all the way up in the millions of dollars. I happen to believe that is just too much money for too many assets.
So the adviser has to be worthy of his hire. And then you’ve got to figure out what that worth is. And something in the range of 1% scaled down as the account grows is a reasonable place to start. I don’t think it is easy to go beyond that except to say that at some point, I would think, maybe advisers will start to work on a fee basis, like a lawyer might work, like a doctor might work, something like that. The amount of attention he gives you—the investor—is what you are paying for: his time and effort rather than an asset-based fee. That may come to develop over time.
Wiandt: An asset allocation question: One of the main reasons we use asset allocation and diversification in our portfolio is to balance the risk. So if one thing is going up, another thing is coming down. If one thing is coming down, you’ve got something else coming up. The problem is—and if you look to October you can see this—when things go bad, it seems like everything goes down. And so what can you say to that? Is there anything that people should do in that environment or do you just ride it out?
Bogle: To me, first, in general, the question is correct insofar as it applies to equities. And it’s been long said—many, many years ago, and it’s proved so true in every crisis since then—international diversification lets us down just when we need it the most. And truer words than that were never spoken. On the other hand, the fact is that bonds produce a very good countercyclical return.
I don't know exactly what they did in September. But I mentioned at the beginning of my remarks that the bond index fund went up 5% last year. That really was counter in direction, if not in amount, to the 35%, 37% decline in the U.S. stock market. Now I look at bonds as being the ultimate diversifier. I don’t look at diversification in equities [in terms of] being in different equity styles as being particularly helpful in the long run.
Look, we all know there are times when growth is doing better than value and vice versa, that large-cap is doing better than small-cap and vice versa. But they seem to come back. They seem to revert to the mean over long, long periods of time. And it’s very hard. Individual stocks, individual styles, have a very similar correlation with a stock market as a whole, a very similar correlation with one another and with the stock market as a whole—even down to the individual stock level and the style level and the manager level. So I think if you are looking for safety, the best instrument for safety is a high-grade bond portfolio, including Treasuries and high-grade corporates.
Wiandt: What are Jack’s thoughts on using inverse ETFs for short-term tactical hedges for those individuals who can’t stomach some of the rides for true long-run buy-and-hold theory? In other words, what role do these products have, if any?
Bogle: None. Did I make my position clear? No, the problem is, it is wonderful to buy a leveraged short ETF just before the market goes way down. I think to put the question in that way is to answer it. Who knows when the market is going to go way down? The time you are most likely to buy that kind of a fund is when the market has gone down. It’s a kind of inverse performance-chasing. I don’t like tricks. They require timing. They require more courage than I have. And they require a belief that you know more than the market.
In my very first book, one of my rules at the end, my principles, my 12 pillars of wisdom, was, “Never think you know more than the market. Nobody does.” Investing is putting money to work where it earns an internal rate of return: interest rates, dividend yields, earnings growth. It is not guessing what prices are going to do next. You know, we all ought to know by now that the stock market is the way we buy the returns of American business over time, the way we participate in the returns of American business over time.
But it also turns out that on any short-term basis, the stock market is a giant distraction to the business of investment. Of course it is. An inverse ETF is a bet on the market taking a certain direction and a bet that you are smart enough to do it, so you better double your bet on the way down. I don’t mean to be too tough on these kinds of funds, but I think anyone that does that is crazy. But I wish them well. I always wish them well.
Wiandt: Here is a bit of a technical question. Professor Jeremy Siegel has challenged the method of calculating the S&P 500. He believes that the calculation should be earnings-weighted as opposed to cap-weighted, capitalization-weighted by market weight. What are your thoughts on that?
Bogle: It just isn’t true. Can I make it clearer? The fact of the matter is, this issue arose earlier in the year. And by the way, the Wall Street Journal had a very powerful and accurate response from Standard & Poor’s as to why it was statistically unsound. It is just not a good statistical technique.
[The S&P response took the example of] one little company that had a great big dollar amount of earnings loss. And to think about it this way, supposing that little company, just before it announced the loss, had been bought by, let’s say, Exxon; the company was bought by Exxon. The loss would be exactly the same. It would be carried over to their balance sheet but it would be in a big company.
The index is already weighted by market cap. It is clearly weighted by dividends; each company’s dividends and each company’s aggregate earnings. When there is an aberration, you just have to live with it. Call it an aberration. Call it anything you want but don’t change the weightings of earnings because it just doesn’t make statistical sense. I’ll bet Jeremy Siegel has had second thoughts about his position, by the way.
Wiandt: Jack, are you planning to write another book, perhaps an opus of your life?
Bogle: Well, that’s a good question. I think when my life’s work is done I’m going to write the book, but I don't know when that will be. But I’m not planning it right now. As the last paragraph in “Enough” says, “One must wait until the evening to enjoy the splendor of the day.”
Wiandt: Where do you see dividend yields going forward? Conventional experts see much lower returns. What are your thoughts on this? What are your thoughts on forward market returns?
Bogle: Well, my theory, or my mathematical construct—which I’ve been using for a long, long, long time now, certainly decades—is that in the long run, market returns are 100% composed of what I call investment returns, dividend yields at time of entry into the market and the earnings growth that follows. That’s not a very complicated way to look at it. But it turns out that it is totally accurate when you look at the returns of the market over the long run.
You have this element of what I call speculative returns, which is changes in valuation. If the price earnings multiple of stocks goes from 10 times earnings to 20 times earnings, that doubling over 10 years adds 7% a year to the returns on stocks. And we actually had that. That happened twice, in the ’80s and again in the ’90s.
But it can’t happen forever. In the long run, 100% of market returns or investment returns and speculative returns come and go. But in the long run they amount to nothing. So investment returns in the future will probably drive the market. I don’t look for speculative returns to drive it up or down a great deal, certainly not by 7% a year.
Right now the dividend yield looks to me to be about 3.25%. I had it at 4% earlier this year but we had a big drop in dividends, one of the biggest cuts in dividends—around a 22% drop is forecast for the S&P 500, and I don’t see that drop is going to be repeated in the kind of economy I see. I think most of the drop is behind us. So using the current dividend yield, down 20% from last year’s, would give us around a 3.25% yield.
From this level—well, let me first say, when one spends just a moment of time on the simplicity of it, we know a lot about earnings growth. And that’s the other component of the investment return. We know that from the beginning of time, practically, corporate earnings grow at the same rate of our economy over the long term. And so if our GDP has been growing at 5%, then corporate earnings should be growing at 5% nominally. and they do.
And what is interesting about that is that they are in a very narrow channel. If you are looking at them a little bit differently, corporate earning generally account, after taxes, for 4%–8% of our gross domestic product. That is a very narrow channel and they average about 6% of GDP. So let’s assume from these depressed earnings levels, that instead of growing at 5% as the economy may grow—it may grow a little slower than that—the corporate earnings can grow at 6% or 7% from here. It is conceivable.
It’s a probability, I think, but certainly not a certainty. So if you are going to use 6%, that is a 9.25% return on stocks. Let’s assume that maybe that valuation comes down and takes a point of that return. You ought to be looking at 8%, perhaps 7% return on stocks, which is pretty good, if not very good. Because when we do the same mathematics for the bond market at today’s interest rate on a portfolio of governments and corporates roughly equally weighted at today’s interest rates—it is going to be 4.75% or 5%. So let’s call it 5% for simplicity.
If you compound over the next decade at 8% instead of 5%, you ought to be a pretty happy investor. So I’m optimistic, although I want to underscore that in these economic conditions, one has to look at not only the possibilities of what the future returns will be in the rough dimensions that I described here—but the consequences to you if they are not. And if you are too exposed to equities and things go wrong—and they can always go wrong—the stock market is a bad place for hope. You want to be conservative, even though the odds favor the stocks doing significantly better than bonds in the coming decade.
Wiandt: We have time for a couple more questions. The federal government has made a massive infusion of money into the market. What does this portend to the value of the U.S. dollar going forward, and is there anything that investors should be doing about that to protect themselves?
Bogle: Well, it should portend a rapid drop in the dollar. But the dollar is, of course, affected not only by the financial side but by the expectations of investors. So I’m not sure it’s a lead-pipe cinch that the dollar will be hugely weak. It came out about $1.17 relative to the euro all those years ago and it’s not all that far from it now. I don't know the current rate. Say maybe $1.40. I haven’t looked recently. That is not a huge change for a decade against the euro.
So predicting the dollar is like any other prediction. You can be right and you can be wrong. And if the dollar is, in fact, weak, I think everybody understands that will be great for international U.S. corporations. So it should help equity prices. I don’t think one should base an investment strategy on the fact that one thinks one knows what the dollar is going to do in the years ahead. Although I would be inclined to agree with the thrust of the question and that is, it’s hard to think that we can have a stronger dollar over the next four or five years.
Wiandt: This is another asset allocation-focused question: Given the almost unprecedented experience of 10 years with bond and equity prices—where you saw bonds really outperform equities over a very long time horizon—should investors be looking at how they do asset allocation between fixed income and equities in a different way?
Bogle: Well, it’s funny that after the previous 20 years ended in 1999 with bonds doing so much worse than stocks—although if you start at the beginning with very high interest rate yields, bonds did actually pretty well—the average return on bonds running through those years was probably about 6% or 7%. And the return on stocks was about 17% over 20 years. And everybody was saying, “Shouldn’t we have more stocks?”
And the answer is “No. You shouldn’t have more stocks.” They are selling at very high valuations and there is a lot of reversion to the mean. You know, high stock returns tend to be followed by low stock returns. Great booms are followed by great busts. Prices revert to kind-of normal valuations over time. So at this time, I don’t think that one should pay a lot of attention to what happened in the last 10 years. I think what happened in the last 10 years—particularly to the stock market, or entirely to the stock market---is very much a reversion of the mean of the excess, greatly excess return that we had in the two previous decades.
Don’t forget, as 1999 ended and 2000 began, stocks were selling at almost 40 times earnings. That can’t stay at 40 times earnings; it has to come down. Now, in this muddy situation that we have, they are probably selling about 20 times these depressed earnings. It’s hard to get a handle on that. But half as highly valued and could come down a little bit. But bond returns … people should understand very importantly about bond returns that today’s yields are the best possible approximation of what bonds will deliver in the next 10 years. Let’s call that a 5% return.
There happens to be, over time, a 91% correlation between the interest rate in which you go into the bond market at and the return that the bond market provides over the next 10 years. So we have a pretty good idea that bond returns would be about 4%–6%. You take your chances on stock returns, and if you think they are going to be much lower than that guess I gave—I suppose if you are a market timer, you should reallocate to bonds if you think stocks are going to return less than 5%. But I don’t think we know enough to do that with much confidence.
I would further say, to me, now—and I’m very conservator investor, extraordinarily conservative—that I believe your bond position should equal your age. And my bond position does equal my age. So I really had a good year last year. Sometimes it’s a blessing to be old, but only rarely.
So, I think one should look at one’s asset allocation in a certain way. Let’s say you decide, for a whole bunch of reasons, that you want to be, say 70%—you’re a younger investor—70% in stocks and 30% in bonds. If you think you can do some forecasting about the direction of the bond or stock market, particularly the stock market, and you think it is going to be down, don’t get out of stocks at 70%, maybe go to 60%. Don’t go below 50%—call it 20 percentage points below your allocation—any more than you should never go above that.
I don’t think that is a good strategy. But it is a much better strategy than thinking, “I’m either in the market or I’m out of it.” Those wholesale changes in equity ratio I think are going to destroy the retirement funds of countless investors that follow it.
With that, I just really want to thank you, Mr. Bogle, for taking the time with all the investors here. I think it was outstanding. And I’m sure that all the Bogleheads out there really enjoyed it. And thanks to all of you for attending as well.
Bogle: Well, I enjoyed being with all of you. I hope you will forgive my bluntness, but any of you who know me realize it is probably a little late to give up on that. Have a great day everybody.