Tuesday, September 13, 2005

Happy Anniversary, You’re Perfect, Now Change—Part I

My apologies to the popular Broadway musical for usurping a name similar to, but not exactly the same as the above headline. While the original title of the show, I Love You, You’re Perfect, Now Change, would also be most appropriate to this article, the timing was such that the headline wording is more relevant since it was exactly 30 years ago, in September of 1975, that a courageous, brilliant, and most prescient individual had the foresight to establish the first index mutual fund. So, Happy Anniversary to the Vanguard 500 Index Fund, whose concept and creation not only produced an investment strategy that has captured the attention of millions of investors and spawned the largest single mutual fund in existence, but also forced a dramatic transformation in the way financial institutions and individual investors considered the then rather abstract notion of passive investing. Yet, some predict the great success that has resulted from that invention 30 years ago, might also contain the seeds of its destruction, or at the very least, in a change implied by the headline.

The Origin and the Bogle Legend

The story behind the birth of the first index fund is not only interesting, it is also instructive since the original rationale for its creation is as valid today as it was 30 years ago. It also provides a commentary on the genius and perseverance of its creator, John Bogle, the legendary former chairman and CEO of the Vanguard Group.

From previous articles, you might recall that Mr. Bogle (or Saint Jack as he is also known) is one of my investment heroes, and the word legendary hardly does him justice. One biographic description of his accomplishments states, “His influence on the world of finance has not gone unnoticed. Among other awards, in 2004, Time magazine named Mr. Bogle as one of the world’s 100 most powerful and influential people.” It continues, “In 1999 Fortune magazine designated him as one of the investment industry’s four ‘Giants of the 20th Century.’”

John Bogle was not the first to recognize the merits of indexing. The concept was pioneered by Wells Fargo Bank in 1971 when it developed an account for the pension fund of Samsonite Corp. It was based on a strategy of using an equal weighted index (an equal number of shares) of all equities listed on the New York Stock Exchange. By 1974, a few other financial institutions offered index funds to institutional investors.

In 1974, Nobel Laureate Paul Samuelson (now a professor of economics at MIT) wrote an article for the Journal of Portfolio Management titled, “Challenge to Judgment.” Mr. Bogle relates, “It noted that academics had been unable to identify any consistently excellent institutional mangers, challenged those who disagreed to produce ‘brute evidence’ to the contrary, and pleaded for someone, somewhere, to start an index fund.” A year later, in a seminal article titled, “The Loser’s Game,” Charles D. Ellis (more on him later) argued that because of fees and transaction costs, 85 percent of institutional investors had underperformed the stock market. He suggested, “If you can’t beat the stock market, you should certainly join it.” Ellis concluded, “An index fund is one way.”

Inspired by Samuelson and Ellis, Bogle did his own calculations verifying that from 1945-1975, the average annual return earned by the Standard & Poor 500 Stock Index was 10.1%. Over that same period, the average equity fund earned 1.4% less at 8.7%. Bogle concluded, “As I mused about the reasons for the difference, the obvious occurred to me. The index was cost free and its 1.4 % annual advantage in return roughly approximated the total costs then incurred by the average fund—the expense ratio plus the hidden costs of portfolio turnover. To illustrate the enormous impact of that seemingly small percentage difference, I calculated that a hypothetical initial investment of $1,000,000 in 1945 would by 1975 have grown to $18,000,000 in the Index vs. $12,000,000 in the average fund.”

Bogle goes on to describe how, “In September 1975, using those data and the Samuelson and Ellis articles, I urged a dubious Vanguard board of directors to approve our creation of an index mutual fund. They agreed. The original fund was appropriately titled ‘First Index Investment Trust.’ [Its name was changed to Vanguard Index Trust 500 in 1980.] Our introduction was greeted by the investment community with derision. It was dubbed ‘Bogle’s Folly,’ and described as un-American, inspiring a widely circulated poster showing Uncle Sam calling on the world to ‘Help Stamp Out Index funds.’” In a speech given in April 2004, Bogle pointed out that “Fidelity Chairman, Edward C. Johnson, led the skeptics, assuring the world that Fidelity had no intention of following Vanguard’s lead. ‘I can’t believe that the great mass of investors is going to be satisfied with receiving average returns. The name of the game is to be the best.’ [Ironically], Fidelity now runs some $38 billion in indexed assets.” In that same speech, Bogle pointed out that Vanguard’s total indexed assets have recently increased to $300 billion.

Fund Survivors Are Few

Examining the actual performance more than three decades later, led to what Bogle calls “an astonishing—and important revelation.” In 1970 there were 355 equity mutual funds. Of that number, because of inferior performance, 208 have closed or were absorbed into other funds leaving only 147 survivors. The failure rate of 60% is indeed astounding. Of the survivors, 104 fell short of the 11.3 % average annual return achieved by the unmanaged (passively managed) S & P 500 Index, with just 43 exceeding the return of the index, or just 12% of the original total. Of the 43, only seven (2%) exceeded the returns of the Index by 2% or more, and according to Bogle, most have lagged the market fairly consistently during the past decade, sometimes by a substantial amount. Any gambler will tell you; those odds are not very favorable.

Bogle relates how public acceptance of the index fund and the passive investing concept “came with a speed that was truly glacial.” Assets did not reach $100 million until 1982 and it was 1987 before the $500 million mark was attained. However, as the public became more knowledgeable about the advantages of indexing, by April of 2000, the Vanguard S&P 500 Index Fund topped $100 billion, becoming the largest single mutual fund in the industry, and it still is today. Equity index fund assets currently total $570 billion, nearly one sixth of all equity mutual fund assets. The recent growth in index fund assets now far surpasses the growth of the fund industry itself with Vanguard garnering a dominant 66% share.

Costs Do Matter

From a pure dollar and cents perspective, the advantages of index investing are overwhelming. As described by Bogle, over a 20 year period ending in May of this year, “a simple, low cost no-load stock market index fund delivered an annual return of 12.8 percent—just a hair short of the 13.0 percent return of the market itself. During the same period, the average equity mutual fund delivered a return of just 10.0 percent, less than 80 percent of the market’s annual return.” It is no accident that this shortfall of 2.8 percentage points a year agrees largely with Bogle’s estimate of annual costs of 3.0 percent incurred by actively managed funds. Obviously, costs do matter.

So Do Taxes

While 2.8 percent may not seem like much over a 20 year period, here is how that number impacts your cumulative dollar return: At 10.0 percent, a $10,000 investment in the average actively managed fund would have produced a cumulative return of $67,300. A comparable investment in the index fund would have returned $110,800, a $43,500 advantage. However, that’s not the end of the story—the above is all before taxes. Primarily as a result of an outrageously high turnover rate (over 100%), the average managed equity fund cost those investors with taxable portfolios an additional 2.2 percentage points in taxes. This provided the index fund with an even higher 4.1 percent advantage, dropping the cumulative total return to some $45,000 for the actively managed fund, less that half that of the index fund investment.

Considering there are some 8,000 mutual funds and who knows how many managers, the probability of an investor choosing either a fund or a manager who can overcome this fundamental arithmetic advantage over the long term is remote—in fact it is probably zero.

David F. Swenson—A Name to Remember

At the outset, I mentioned the name Charles D. Ellis. He is the founder of Greenwich associates, a well known financial consulting firm. He was also the Chairman of the Yale University Endowment fund, the most successful endowment in the business. Mr. Ellis did not manage the fund, although I gather he was instrumental in hiring David F. Swenson as chief investment officer. As a consequence of the endowment’s amazing performance, Mr. Swenson has become an investment legend. Serendipitously, while I was in the middle of writing this article, Joseph Nocera, in a story in The New York Times, reviewed Mr. Swenson’s brand new book Unconventional Success: A Fundamental Approach to Personal Investing. Swenson had previously written a highly regarded book strictly for institutional managers. The new one is for the individual investor. Nocera describes how, at the age of 31, Swenson began the project of “turning Yale’s Endowment Fund into the best-run, most influential institutional fund in the country—the fund that every other institution wants to emulate.” He goes on to say, “His track record is astounding.” Over the last two decades, Yale has generated average annual returns of 16.1 percent. The fund has grown in that time to over $15 billion from $1.3 billion even though it now spends over $500 million a year to help cover Yale’s operating budget.

Much of the book is a polemic aimed at the mutual fund industry. He offers incontrovertible evidence that the for-profit mutual fund industry consistently fails the average investor. He rails against excessive management fees; the frequent churning of portfolios; believes it is criminal to allow popular funds to balloon in size; cites the hidden schemes that reduce returns, including pay-for-play product placement fees, stale-price trading scams, soft-dollar kickbacks and 12b-1 distribution charges. According to Nocera, Swenson “absolutely skewers Morningstar;” the company that has built its reputation rating mutual funds but is of no help in evening the odds.

The book’s title provides a clue to Mr. Swenson’s advice for the individual investor. He maintains that, “the deck is stacked against the individual.” He writes, “I see every day how competitive the markets are, and how tough. So the idea that you can do this yourself is out the window.” To gain “unconventional success” investors should adopt, as the book title suggests, “a fundamental approach.” According to Swenson, this requires a portfolio invested in a diversified group of index funds, the alternative that provides well diversified, equity oriented, “market mimicking” portfolios that will reward long-term investors who stay the course, and also rebalance periodically to the original asset allocation targets. In what is, in a sense, a tribute to John Bogle and his 30 year old invention, Swenson suggests using index funds from Vanguard, and to avoid actively managed funds.

So, Happy Anniversary to the very first index fund and to the concept of passive investing—you’re perfect—but as next month’s article reveals, there are changes afoot.


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