Swedroe: Indexing No Average Experience

January 17, 2014

Larry Swedroe reminds us just how far indexing has come in the public imagination.

The 1973 publication of Burton Malkiel’s “A Random Walk Down Wall Street” set off a revolution. Malkiel presented the findings from academic research on the failure of actively managed funds to beat the market. The standard response at the time was “so what, you can’t buy an index fund.” That was true until John Bogle came along.

Bogle graduated from Princeton in 1951. His senior thesis was titled: “Mutual Funds can make no claims to superiority over the Market Averages.” Bogle wrote that his inspiration for starting an index fund came from three sources, all of which confirmed his 1951 research: Paul Samuelson’s 1974 paper, “Challenge to Judgment,” Charles Ellis’ 1975 study, “The Loser’s Game,” and Al Ehrbar’s 1975 Fortune magazine article on indexing.

Bogle, who founded The Vanguard Group in 1974 (now the largest mutual fund company in the United States), started the First Index Investment Trust on Dec. 31, 1975, later renamed the Vanguard 500 Index Fund. The following June, a very prescient story appeared in Fortune: “Index Funds: An Idea Whose Time is Coming.” It concluded: “Index funds now threaten to reshape the entire world of money management.”

Paraphrasing philosopher Arthur Schopenhauer: “All great ideas go through three stages. In the first stage they are ridiculed. In the second stage, they are strongly opposed. In the third stage they are considered to be self-evident.” This was certainly the case for Bogle’s experiment.

When it was launched, it was heavily derided by the mutual fund industry. The fund was even described as “un-American,” and it inspired a widely circulated poster showing Uncle Sam calling on the world to “Help Stamp Out Index Funds.” The fund was lampooned as “Bogle’s Folly.” An executive of fund manager National Securities and Research Corporation categorically rejected the idea of settling for average. “Who wants to be operated on by an average surgeon?”

Echoing that comment, Fidelity’s chairman, Edward Johnson, stated: “I can’t believe that the great mass of investors are going to be satisfied with just receiving average returns.”

And that refrain became one of the big lies that Wall Street tells: Indexing (and passive investments in general) gets you average returns.

The table below presents the Morningstar percentile rankings for the 10- and 15-year periods ending Dec. 24, 2013, for the funds of the two leading providers of passively managed funds, Vanguard and Dimensional Fund Advisors (DFA). (Full disclosure: My firm, Buckingham, recommends Dimensional Funds in constructing client portfolios.)

Vanguard is the leading provider of index funds. While DFA’s funds are passively managed, with the exception of their U.S. Large Fund, they are not index funds. When reviewing the rankings, keep in mind that the rankings contain survivorship bias—funds that have done poorly often disappear either because investors fled and the fund was closed, or the fund family merged the poorly performing fund into a better-performing fund.

Those poorly returning funds disappear from the rankings. Thus, the actual performance ranking of surviving funds is significantly understated. And the longer the period, the worse the survivorship bias becomes.

Morningstar Percentile Ranking (as of Dec. 24, 2013)

Fund 10 years 15 years
Domestic
Vanguard 500 Index (VFINX) 34 51
DFA U.S. Large (DFUSX) 31 n/a
Vanguard Value Index (VIVAX) 41 60
DFA U.S. Large Value III (DFUVX) 7 4
Vanguard Small Cap Index (NAESX) 21 63
DFA U.S. Small (DFSTX) 22 33
DFA U.S, Micro Cap (DFSCX) 35 18
Vanguard Small Cap Value Index (VISVX) 42 70
DFA U.S. Small Value (DFSVX) 30 24
Vanguard REIT Index 39 41
DFA Real Estate (DFREX) 43 30
International
Vanguard Developed Markets Index (VDMIX) 51 n/a
DFA International Large (DFALX) 48 53
DFA International Value III (DFVIX) 15 22
DFA International Small (DFISX) 29 15
DFA International Small Value (DISVX) 12 1
Vanguard Emerging Markets Index (VEIEX) 44 50
DFA Emerging Markets II (DFEMX) 16 27
DFA Emerging Markets Value (DFEVX) 10 9
DFA Emerging Markets Small (DEMSX) 9 8
Average Vanguard Ranking 39 56
Average DFA Ranking 24 20

For the seven index funds of Vanguard, the average 10- and 15-year rankings were 39 and 56 percent, respectively—keep in mind the caution about the impact of survivorship bias on the long-term rankings. If survivorship bias were accounted for, it’s highly likely that the 15-year ranking for Vanguard’s funds would be well below 50 percent. Turning to the DFA funds, the 10- and 15-year rankings of their 13 passively managed funds were 24 and 20 percent, respectively. Outperforming 76 percent and 80 percent of the surviving funds is hardly an average performance.

And if Morningstar accounted for survivorship bias, the rankings would be considerably higher. And what’s also of interest is that their highest rankings were in the very asset classes that active management proponents say are the most inefficient: international small and small value stocks and emerging market stocks, with DISVX, the DFA International Small Value, achieving a first-percentile ranking.

Given the evidence, it’s pretty clear that passively managed funds don’t get you average returns. They provide investors with market returns of the asset classes they invest in and, by doing so, they produce above-average returns for their investors.


Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.

 

 

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