John “Jack” Bogle founded the Vanguard Group of mutual funds. In this first of two excerpts of our conversation, we spoke about why he favors broad market index funds, as well as his thoughts about exchange-traded funds and portfolio allocations.
—Charles Rotblut, CFA
Charles Rotblut (CR): Since you founded Vanguard, would you explain why you think investors should use index funds?
John Bogle (JB): Let’s start off with the obvious. Imagine a circle representing 100% of the U.S. stock market, with each stock in there by its market weight. Then take out 30% of that circle. Those stocks are owned by people who index directly through index funds. The remaining 70% are owned by people who index collectively. By definition, they own the exact same portfolio as the indexers do in aggregate, so they will capture the same gross return as the direct indexers. But by trading back and forth, trying to beat one another, they will inevitably lose by the amount of their transaction costs, the amount of the advisory fees they pay, and the amount of all those mutual fund management costs they incur: marketing costs, processing, technology investments, everything. When we look at the big picture of the costs of investing, including sales loads as well as expense ratios and cash drag, it is a foregone conclusion that active investors, in aggregate, will underperform index investors. It’s the mathematics.
Borrowing a phrase from Louis Brandeis: It’s the relentless rules of humble arithmetic. The 30% of investors who own index funds capture almost all of the market’s return. In a 7% return market, indexing should deliver approximately 6.95% to investors. (A typical Vanguard all-market index fund charges 0.05%.) The remainder—those who are trading back and forth, hiring managers, and all that kind of thing—will incur costs, in round numbers, of about 2% per year. So, the indexers are going to capture pretty close to a 7% return in a 7% market, while the active investors, who also collectively own the index, are getting the same 7% gross return minus about 2% for all those fees and costs, a net return of 5%. It is definitional tautology that the indexers win and the traders lose.
...To continue reading this article you must be an AAII member.