Investors worldwide, particularly those in the United States, owe Jack Bogle a huge debt of gratitude. He founded the Vanguard group in 1975 and introduced the First Index Investment Trust (now the Vanguard 500 Index Trust) in 1976.
The trust’s assets under management have grown from $11 million in 1976 to more than $400 billion today. The Vanguard Group now manages $5.1 trillion in assets, with more than 70 percent of those assets in passive indexed products.
Index funds existed before the Vanguard Group. Wells Fargo’s famous (at least to quantitative finance geeks) Management Sciences department had created index funds for institutional clients as early as 1971.
What was unique about the Vanguard experiment is that it was aimed at retail investors and that the Vanguard Group was set up as a mutual company. That meant that the clients of Vanguard are also the owners.
Any profits earned in management fees are paid back to the investors, eliminating incentives to jack up fees and encouraging passing along savings from economies of scale.
This meant, for the first time in history, the U.S. retail investor had access to a well-diversified, low-cost, passively managed investment product. At today’s scale, Vanguard’s passive products save their clients roughly $24 billion in fees per year relative to active investing.
Index products represent approximately 20 percent of the retail market and 60 percent of the institutional market for U.S. equities. Jack Bogle and the Vanguard Group have had an immense impact on the U.S. mutual fund industry.
Bogle’s interest in mutual funds began with his senior thesis at Princeton University. Before December 1949, midway through his junior year, Bogle had no idea what a mutual fund was (at that time, more commonly called an investment company).
By May of 1951, he had written an extremely insightful thesis, “The Economic Role of the Investment Company.” One might think that the keys to the Vanguard experiment are all in the thesis. In one sense that is true, but had Bogle started his own company in 1951, it would not have looked like the Vanguard he founded 24 years later.
Bogle created Vanguard on the basis of one overriding principle: Mutual funds should be operated to serve the interest of their clients. That principle, and Bogle’s penchant for evidence-based decision-making, ultimately led to the features of Vanguard and its funds, well-diversified indexed products with low fees and a mutual organizational structure.
These later principals do not follow of necessity from the first. High fees can be warranted by high performance and active investing can be warranted by high returns. In fact, it is clear from Bogle’s thesis that he believed in active management and did not think highly of indexation, referring to it as a “fallacy.”
These beliefs are consistent with the fact that Bogle spent the first 23 years of his career at an active investment management firm. In the end, economic logic and, most importantly, the data won out.
Financial markets in developed economies are among the most competitive markets in the world. Economic logic implies that earning above-normal profits is extremely difficult in a competitive market.
Additionally, in financial markets, investors’ attempts to capitalize on superior insights move prices against them — pushing up prices when buying and pushing down prices when selling.
This process leads to prices that reflect (at least partially) the information from which the investor is attempting to benefit. Given this logic, market prices tend to be a good reflection of the collective information of market players.
A related argument, used by Bogle, is the mathematical fact that active management (when defined as a deviation from holding the indexed market) is a zero-sum game before fees and a negative-sum game after fees.
That is, if I take an active bet on overweight Apple stock in my portfolio, someone else must underweight Apple in theirs (because all of Apple’s outstanding shares are held by someone). The two of us can’t both be correct.
Similarly, if six poker players come to a table with $100 each, $600 will leave the table at the end of the night (less the fees of running the table). A good poker player can continue to win, night after night, as long as the bad players (the patsies) keep showing up.
The optimal strategy of a patsy is to not play the game, just as the optimal strategy for an investor who knows they are the pasty in the active management game, is to not play. Instead, they should index.
Bogle’s own analyses of the data (as well as others) was showing consistent results. The average active mutual fund manager did not earn high enough returns to cover his or her fees. Additionally, the signal-to-noise ratio in fund performance is so low that picking which managers will perform well in the future is extremely difficult.
To be sure, there are great active managers, such as Warren Buffett (Berkshire Hathaway), Jim Simons (Renaissance Technologies), Louis Simpson (Western Asset Management, GEICO, SQ Advisors) and Joel Tillinghast (Fidelity).
There are also less-efficient and less-liquid markets where active management makes sense. But Bogle’s analysis of the data led him to conclude that the typical retail investor is the patsy when trading against such great investors.
The optimal response for those investors with day jobs is to not play the game. When your one overriding principle is that mutual funds should be operated to serve the interest of their clients, Jack Bogle concluded that this translated into an index fund that gives the retail investor their share in the economy at the lowest cost possible.
When Vanguard was created, the concept was considered un-American since it guaranteed an average return. One can imagine Bogle wondering what could be more un-American than paying high fees for below-market performance with higher risk.
Thank you, Jack Bogle. I will toast you tonight with a glass of wine purchased with the fees I did not pay and the higher returns I received relative to investing in the average mutual fund.
Robert Korajczyk is the Harry G, Guthmann professor of finance at the Kellogg School of Management, Northwestern University.