Bogle on Indexing and the Future of Investing
Jack Bogle discusses why indexing works and why it was important for the financial industry. And he and Betterment CEO Jon Stein look to the future of indexing and ETFs.
The article below offers an annotated, abbreviated part of a conversation between Jon Stein and Jack Bogle in 2016. The words are their own as individuals, and they don’t reflect the views of Betterment. If major sections have been removed, we’ve done so for readability or because a claim was made that’s out of date or unsubstantiated.
Jon Stein: I’m curious, Jack; was there a certain piece of data or insight—or maybe an innovation—that made the index fund take off? If I think about what you’ve told me, I would think it was something about data and transparency of returns. And that you saw this before no one else had seen it. But maybe you see it differently. What was the necessary data, insight, or innovation that really made index funds take off?
Jack Bogle: Well, the whole theory of Vanguard–this is an important point, and the indexing comes right out of this–was to be the low cost provider of investment services in the world.
And we were an industry—we’re in very round numbers now— that if you took the average fee (mutual fund fee was one percent) the managers were making a 50% profit margin. And that meant if you took out the profit margin, you all of a sudden were operating on half of one percent—50% below the competition. Where of course now it’s, I think, 14 basis points. And there’s no way anybody can ever catch us.
So the central idea is that cost matters. It matters a little bit over the short term. It matters hugely—as you know, from your compounding data—it’s the difference between success and failure, over an investment lifetime.
And I should say, more than parenthetically, that just about every project, every “innovation” that I see, has nothing to do with an investment lifetime. You can talk about Smart Beta until the cows come home. But how many of these Smart Beta funds will be left here if you’re (let’s say you’re 40 years old now) going to be investing for the next 50 years.
Will any of them?
The first question would be, “Will any of those funds still be in business?” And I doubt it. It’s just too much coming and going. And I would argue, Jon, at least in the sense of investment management, there is such a thing as too much innovation.
The Shredded Wheat biscuit ads: they just showed a picture of the shredded wheat biscuits, saying they’ve been making it with the same ingredients for 100 years, with the same machinery, with the same care, and so on. And they say, “We put the ‘no’ back in innovation.” And I think this industry could use a little dose of that, because these innovations have, as a group,…well this is what we know: As a group, they have no chance of beating the index, any more than the average fund does. They’re going to perform on average, before cost and below average after.
So, low cost [that was the focus.]
And then it was coming out of mutuality, which was another central idea. And then it was: Where does indexing really matter? Where can you observe it every day?
One answer is the money market fund, because the yield was published every day. It was that with your expenses, and the industry was probably charging 0.75%, back when the yields were 8-10% or even higher than that. And we were charging – I can’t remember exactly, but let me say 0.15%.
…And then the index fund. All index funds are equal. They should be commodities. They were not really, then, but they were very close. Now they’re really a commodity. We’re talking decimal points here. And take a look at all the index funds out there in any given category, and add back their expense ratio, and they’re all identical in returns. There’s no secret about adjusting for changes or anything like that.
Jon Stein: I want to stay with that idea of innovation. And you said maybe there’s too much innovation, and we need a fair dose of keeping things the same. I’m curious about your thoughts on this: Do we know what’s coming in the next 50 years? And how do we think the next 50 years of money management will look, compared to the last 50 years?
Jack Bogle: Well, there’s no question that change is in the air. We’re talking simple mathematics with the index fund. And if you’re managing somebody’s money for 0.5%, and your world is managing money for 1%, you are going to win this—all the other investors—and it really is more like 2%, when you take the internal transaction charges on all that trading. And investors’ bad behavior, 2% is probably low for what the average investor will lag the return of his funds, and in turn, the return of the market.
So, those numbers are too big to be ignored.
And the idea that cost matters went from nobody paid any attention to it at all, and now it’s very hard to read an article about mutual funds or ETFs that doesn’t say “cost matters,” one way or another. Maybe in those exact words.
So once you deal with that, well, that is the new world that we’re in. As I said in my first book, “And no army can withstand the force of an idea whose time has come,”—Victor Hugo, just for the record. And this idea, a low cost and indexing, is an idea whose time has come. And when you look at it, unbelievable.
Jon Stein: Did you think that the indexing would be more than 25% of the market, as it is today?
Jack Bogle: I’ve got to confess, I didn’t really think in those terms. But I did think, back when we were starting to go after institutions, and have them start to develop a small institutional market for us, that I didn’t see how they could ever lose the competition.
We had the platform. Low cost. It was easy to explain, and sure to repeat itself. And last year (2015) was not just a flash in the pan. Jon, if you look at this year, we have done in one month $23 billion, even higher than last year’s rate. And the industry has done $30 billion out. Much higher. Much, much higher than last year’s rate.
So one looks out and says, “What’s going to happen?” Among the questions I would ask were, basically given the structure of the industry, so heavily owned by outside firms, conglomerates like Sun Life owning Mass Financial, some industrial bank owning Putnam. And that’s repeated over and over again.
And brokerage is going to change. People are going to realize that activity is costly. The more you trade—every study ever done confirms this—the more you trade, the less you make. Over, and over, and over again. The higher turnover of a fund, the less well it does. The returns very much revert to the main, but cost does not revert to the main.
So people have got these ideas, and Jon, I’ve got to tell you. I hear from them almost every single day. I have shareholders. I answer them all by hand. Exhausting. I pray there aren’t any more of them. They’re from all over the country. They’re from young people and old people. They’re from people who wish they’d come here earlier, much earlier, when they learned the lesson. And there are people so happy that they’ve been at Vanguard almost since the beginning.
Ask the person that’s running [another fund company], for example. How many letters like that do you get? Actually one letter to me said, “I bet Mr. Johnson never gets any letters like this.” I’m sure he doesn’t. But it’s there, and it’s moving.
Jon Stein: So, more and more people are in index funds. Is there a point where that becomes too popular?
Jack Bogle: Well, that’s a good question, but not maybe in the way you think. The good question is, what is indexing? And that is, is it buy and hold, what I call TIF? TIFs, traditional index funds, which were designed to be bought and held for your entire investment lifetime.
Or is indexing ETFs? Which turn over in a frightening rate. We had a week back here that the SPDR, the Standard & Poor’s 500 ETF, turned over $150 billion of its shares. And the fund is a $150 billion fund, in a week. And when you look at an awful lot of these index funds, including, to maybe a lesser extent, even some of Vanguard’s, you look at the institutional holdings. And these people keep all this. You can look it up on the Internet and see who are the largest holders of these funds. And the top 10 holders are all banks that are doing something funny with them. And they turn them over very, very rapidly, no matter what the case is, not only is the SPDR rate, but a pretty good rate.
So I’m not sure how the market deals with that, if there’s any kind of a crisis. Does the ETF structure accommodate mass runs? Everybody says there will never be a problem with liquidity in ETF. And I’ve never seen anything where there couldn’t be a problem with liquidity. So who’s right and who’s wrong? I don’t know.
The conversation continues between Jack and Jon, moving on to how investors behave and why trading can hurt long-term returns. Check out the full series of their conversation collected here.
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