Bogle Didn’t Hate Active Management

​Bloomberg’s Senior ETF Analyst Eric Balchunas has written a book focused on the man who was the driving force behind the rise of index investing. “The Bogle Effect: How John Bogle and Vanguard Turned Wall Street Inside Out and Saved Investors Trillions” hit bookstore shelves this week. It looks to capture the scope of the icon’s impact from the financial industry to ordinary investors. The conclusions drawn by the author offer a unique perspective on a financial industry titan. This article is the second of a two-part interview; it has been edited for brevity and clarity. 

ETF.com: Vanguard offers more actively managed funds than it does index funds. How do you see Bogle's relationship with active management? 

Eric Balchunas: Bogle had no problems with active, in a way. He definitely loved index funds, and he tended to use them and sell them in contrast to active.  

But if you read his books, he's most proud when he talks about the active funds, especially the Wellington Fund. There's a whole chapter dedicated to it in his last book, and he also loved the Vanguard PRIMECAP fund. [But] what he loved about these funds was how cheap he made them.  

I call it Boglemetrics. You know Sabermetrics, from “Moneyball” by Michael Lewis, where that one baseball guy started looking at other stats besides batting average and home runs, which are what most people focus on? He looked at things like on-base percentage and slugging percentage.  

Boglemetrics is about just looking at the expense ratio and the turnover. And by focusing on those costs and keeping those as low as possible, you start your active fund with a lead [on performance].  

He wasn't anti-active; what he was really about was stewardship—whether you're active, passive or whatever. I think he thought—and I agree with this—active tends to be where stewardship runs dry.  

ETF.com: Would you talk a little more about that? 

Balchunas: If you look at the active mutual funds that blew up in the ’80s and ’90s, in terms of getting way bigger, they didn't really share a lot of economies of scale.  

The dollar fees some of these funds earned were enormous, and the operating margins were enormous. They could have shared a little of that with investors or lowered the fee a little, and that would have been maybe the stewardship or the fiduciary move that [Bogle] thought was lacking.  

That's also why they were so disruptable, because by the time the world heard [about index funds] and wanted cheap [exposure, active funds] were so far behind—they just really didn't see this coming. I don't think Bogle was anti-active at all, as much as just [against]- not being a true fiduciary and treating your investors and your clients really well.  

But Vanguard has $1.3 trillion in active assets, which is fascinating to me. They're the third-largest active fund manager, and that’s with [Bogle] pushing index funds only.  

Imagine if index funds hadn't been invented, and the Vanguard mutual ownership structure launched only active mutual funds. In my opinion, they would be the biggest active mutual fund manager six times over easily, because, again, they bring a gun to a knife fight, whether it's bond or stock investing. The cheaper you are, the further of a lead you start with.  

Morningstar has great numbers, which I put forth in the book, and the beat rates for the lower-cost active funds go up dramatically. There's a clear correlation between expense ratio and the percent of funds that outperform the benchmark.  

If these big mutual fund companies in the ’80s and ’90s—when they were flush with cash—had shared some of the economies of scale and the fees went lower, their beat rates would have gone up.  

The metaphor I use in the book is the music industry. Over time, the cost to make a CD went down and down until it was under $1. But the price they sold the CDs for remained at $16-17. And they didn't share any of that.  

Then the mp3 comes along, and Napster, and people have no loyalty. [The music industry’s] revenue was cut in half in a couple of years. There are business lessons in here with economies of scale. I call it the Steve Jobs rule. He said you have to cannibalize yourself before somebody else does.  

ETF.com: After having lived in Bogle World for so long while researching your book, what keeps active management afloat, despite the evidence that it doesn't outperform that much? 

Balchunas: Right now, traditional active [management] is being kept afloat by the market just going up and up and up. We call it the bull market subsidies—totally overwhelmed the outflows.  

But this year it looks like it might be ending, so all you're left with is flows. Now the market goes down, [and] it's a bear-market tax on your assets, plus you see outflows, plus there was a lot of money probably in those funds that didn't leave, because it would have to take a capital gains tax hit, and now it can leave.  

I’d think we're going to see a couple trillion dollars just wiped out of active pretty quickly in the next year or two. I have a whole chapter on this: They're going to start to reinvent themselves with ESG, or thematic ETFs or direct indexing. There are multiple ways in which active is changing forms. And I think it's OK.  

A lot of active in the future is going to be stuff that can complement a low-cost index fund. The cheaper index funds take over the core of portfolios, the more people can look for something completely different to complement it with. And that's why you haven’t seen a ton of outflows from ARK. That’s why you’ve seen thematic ETFs, which seem ridiculous, take in a ton of money. That's why you see crypto, defying the odds and showing massive resiliency, despite most people being confused as to its true purpose.  

The problem is it’s boring, as Barry Ritholtz said. It's like watching a tree grow. For some people, it's wonderful: “You've given me the freedom of time. Thank you!” But there are a lot of investors who like the markets, they like watching them. [Those investors are] going to try to put some lottery tickets on top of that, to make sure they don't miss out on any huge trends. 

ETF.com: Where do you think Bogle was wrong about financial markets, or investors? 

Balchunas: There are three places where I disagree with Bogle, and most people—even his closest friends—probably have a different view [from him]. One of those is international markets. He just didn't think that was necessary.  

Another one was ETFs. Had Vanguard not gotten into ETFs, fewer investors would be served with the beauty of a low-cost portfolio because ETFs get out to more people. Whereas [with the company’s other products], you have to come to them. I feel he was probably wrong there.  

The third one is he thinks that, in the future, there's going to be a massive neutralization of all the asset managers—or at least the [very] big ones—because they're going to be so overrun and so desperate that they can't even consolidate and there's going to be no answers for them. Their only option is going to be to neutralize and turn to Vanguard’s structure. I just I don't see that happening.  

Those were three areas where I really couldn't find anybody to agree with him, even people really close to him like Burt Malkiel and Rick Ferri. These are people who tended to say, “Well, I totally agree with Jack on that.”  

I think even though Bogle launched and democratized and really put forth so many different things, he sort of, over time, thought it was all unnecessary. He basically locked in this idea that really, you just need a total market index fund, and you hold it for 50 years. And anything outside of that is just a distraction, and you don't need it.  

I don't know if I'm that pure. I don't know if anybody is that pure. I think there's more going on in humans, and maybe he didn't acknowledge that as much.  

This guy was right about a lot, so here's his view. And there are some people who have another view, and you can walk away with what you think. 

Contact Heather Bell at [email protected]