Articles

False Promises
By John Bogle

Related ETFs: SHY / DON

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(Editor's Note: The following is an excerpt from John Bogle's forthcoming book, The Little Book Of Common Sense Investing, to be published by John C. Wiley & Sons.)

The New Paradigm?
Since the inception of the first index mutual fund in 1975, indexing—investing in passively managed, broadly diversified, low-cost, stock and bond index funds—has proved to be both a remarkable artistic success and a remarkable commercial success. In previous chapters, we've evaluated the success of index funds in providing returns to investors that have vastly surpassed the returns achieved by investors in actively managed mutual funds.

Given that artistic success, the commercial success of indexing is hardly surprising. Today, most indexed assets are concentrated in classic index funds representing the broad U.S. stock market (the S&P 500 or the Dow Jones Wilshire 5000), the broad international stock market (the Morgan Stanley EAFE [Europe, Australia and Far East] Index) and the broad U.S. bond market. Assets of these traditional classic stock index funds have grown from $16 million in 1976 to $445 million in 1986, to $68 billion in 1996, to $369 billion in 2006—7 percent of the assets of all equity mutual funds. Assets of bond index funds have also soared—from $132 million in 1986, to $6 billion in 1996, to $62 billion in 2006—7 percent of the assets of all taxable bond funds.

Indexing has become a competitive field. The largest managers of the classic index funds are engaged in a fiercely competitive price war, cutting their expense ratios to draw the assets of investors who are smart enough to realize the price is the difference. This trend is great for index fund investors. But it slashes profits to index fund managers and discourages entrepreneurs who start new fund ventures in the hopes of enriching themselves by building fund empires.

So how can promoters take advantage of the proven attributes that underlie the success of the traditional index fund? Why, create new indexes! Then claim that they will consistently outpace the broad market indexes that up until now have pretty much defined how we think of indexing. And then charge a higher fee for that higher potential reward, whether or not it is ever actually delivered.

Traditional indexes are cap-weighted. That is, the weight of each stock (or bond) in the index portfolio is determined by its market capitalization. The total U.S. stock market, with a value of $15 trillion, represents the collective investment of all stockholders of U.S. equities. So it follows that, together, all investors as a group earn precisely the market's return.

If the market rises by 10 percent, all investors as a group earn 10 percent (before costs). So the miracle, as it were, of the index fund is simple arithmetic. By minimizing all those costs of investing, it guarantees that its participants will earn higher net returns than all the other participants in stock ownership as a group. This is the only approach to equity investing that can guarantee such an outcome.

The only way to beat the market portfolio is to depart from the market portfolio. And this is what active managers strive to do, individually. But collectively, they can't succeed, because their trading merely shifts ownership from one holder to another. All that swapping of stock certificates back and forth, however it may work out for a given buyer or seller, enriches only our financial intermediaries.

The active money manager, in effect, puts forth this argument: "I'm smarter than the others in the market. I can discover undervalued stocks, and when the market discovers them and they rise in price, I'll sell them. Then I'll discover other undervalued stocks and repeat the process all over again. I know that the stock market is highly efficient, but through my intelligence, my expert analysts, my computer programs and my trading strategies, I can spot temporary inefficiencies and capture them, over and over again."

Some fund managers have actually succeeded in this task. But they are precious few in number. Over the past 36 years, just three funds out of 355—eight-tenths of 1 percent—have consistently distinguished themselves. Nonetheless, hope springs eternal among money managers, and they strive for excellence.

Of course, they believe in themselves. (This field has few shrinking violets!) But they also have a vested financial interest in persuading investors that if they have done well in the past they will continue to do so in the future. And if they haven't done well in the past, well, better days are always ahead.

In recent years, something new has been added to the mix. There are now financial entrepreneurs who believe, I'm sure, sincerely (if with a heavy dollop of self-interest), that they can create indexes that will beat the market. Interesting! They have developed new methods of weighting portfolio holdings that they vow will outperform the traditional market-cap-weighted portfolio that represents the holdings of investors as a group.