Jack Bogle looks back on the 40th anniversary of the index fund

Vanguard's founder weighs in on the future of index funds, his critics, robo-advisers, Donald Trump and the fiduciary rule

Nov 28, 2016 @ 12:14 pm

By Bloomberg News

John “Jack” Bogle wrote his Princeton senior thesis in 1951, arguing that mutual funds “may make no claim to superiority over the market averages.” Sixty-five years later, the Vanguard founder is still being forced to defend his argument — perhaps now more than ever.

When Bogle started the first index fund in 1976, his goal was capturing the overall market's return at much lower costs than the stock picking fund managers who so often failed to match it. The wisdom of this passive approach has become so conventional that Vanguard's assets under management have swollen to $3.5 trillion, mostly in index funds.

(More: John Bogle's advice to advisers)

While Bogle, 87, has long been retired as head of Vanguard, he can still be found there in an important research and advocacy role — keeping alive the revolution he fomented decades ago. He has no shortage of critics. Indexing, after all, has caused higher-priced active managers to hemorrhage hundreds of billions of dollars. Some naysayers have gone so far as to say that “passive investing is worse than Marxism”; others toil away trying to make a better mousetrap. Even Vanguard's mutual ownership — in which profits are returned to its clients to keep costs low — has been attacked in court by a whistle-blower who says the company owes tens of billions of dollars in taxes.

Yet as Bogle makes clear in this interview, he continues to defend his thesis with the passion of a college kid: “The math is the math,” he says.

BLOOMBERG NEWS: You started the first index fund at Vanguard in 1976. How'd you celebrate its 40th anniversary?

JACK BOGLE: We had a lunch gathering for the underwriters just recently. They were the kings of the world in those days. At lunch one of the underwriters said he remembered thinking, “We can do $250 million on this!” Before long it became, “$200 million seems like something we can do!” Then maybe $150 million or $100 million. Later it was, “We're still trying to get to $50 million.” And, at the end, “We're hoping for $25 million.” Finally the check arrives: $11,300,000. And he brought up this paradox, that what may well be the worst underwriting in the history of Wall Street turned out to be, 40 years later, the most powerful idea in finance — one that's reshaped the entire industry. “Let's get together again 10 years from now,” he said. And I replied, “What do you think about five?”

BN: A lot of people now use index funds, either yours or those of your competitors, but it's still a fraction of the overall pie. How do you see the trend progressing from here?

JB: What's clear is we're in the middle of a revolution caused by indexing. It's reshaping Wall Street, it's reshaping the mutual fund industry. And it's doing something very simple: shifting the allocation of stock market returns away from Wall Street and toward Main Street. We're beyond the beginning, but nowhere near the end.

BN: I want to play devil's advocate. The pendulum seems to have swung so far that there is, to some extent, almost a backlash against indexing. Has any of that resonated with you?

JB: I've been in this business for 65 years. I've seen many pendulums. Every one swings back and forth, and the further it goes left, the further it will go right. So pendulums are there, and they can be scary when something gets very popular. But this isn't a pendulum anymore. People are going to be using more index funds in 2025 than they are today. This is an underlying, fundamental trend — not one built on opinion, but on the relentless rules of humble arithmetic.

BN: A Sanford C. Bernstein strategist, Inigo Fraser-Jenkins, caused quite a buzz with a note he published in August titled “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism.” One thing he says is that the rise of indexing could cause stocks to move in the same direction more often: “If correlation of stocks increases,” he writes, “then that impedes the efficient allocation of capital.” How do you respond to that?

JB: I glance at anything favorable to indexing; I pore over anything unfavorable. You don't need people to tell you you're right all the time. You need people to tell you that you're wrong. But this was an absurd paper. First, take the simple part. The stock market has nothing — n-o-t-h-i-n-g — to do with the allocation of capital. All it means is that if you're buying General Motors stock, say, someone else is selling it to you. Capital isn't allocated — the ownership just changes. I may be an investor, you may be a speculator. But no capital goes anywhere. This is basically a closed system. You have new IPOs and whatnot, but they're very small compared to this vast thing we call a market, which is now around $24 trillion. The allocation of capital? That's just nonsense.

BN: And the correlation of stocks?

JB: There is some evidence that the correlation of stocks, which has always been very high — something like 65%, maybe 70% now — could very well be caused by indexing. But so what? The efficient market theory ignores the fact that for every buyer there's a seller. I don't know why we can't get this through people's heads. Cliff Asness is the one who got everything right. He's one of the smartest guys in the business. One of his headlines was, “Indexing Is Capitalism at Its Best.” I'll let him be the defender of that, but this Bernstein note was just a sensational thing. It's a bit like asking your barber if you need a haircut: He has a vested interest in this.

BN: How did that happen?

BN: Is it a problem if indexing gets to 100%?

JB: It's 10 to 15% now, and it could easily get to 50%. The example I use is stock market turnover, which has run between 150 and 250% of late. If we went from no indexing in this theoretical thing to half indexing, say, the turnover would be 125%. You immobilize half of the market. For decades the turnover was 25% a year, not 125%. We don't need all that turnover, but we have a brokerage business in which turnover generates the returns that the brokerage business earns. And, as everybody knows, if a salesman sells nothing in a month, he brings home nothing — so he has to sell something. He has to believe what he's doing is right. And he may be doing what's right, but as a rule he can't be doing what's right because there's someone on the other side of every trade. And all that trading means zero until the croupier in the middle puts his rake down on the table and scrapes off his share of the winnings. Wall Street is a casino, that's a fact.

BN: And the house always wins. So how does this play out for active managers?

JB: I don't know what it will take to get inefficient, but they say if it gets inefficient then active managers will win. If indexing gets to 80 or 90%, I think that's probably pretty fair. But for every active manager who wins, there will be an active manager who loses at the same amount. It's symmetrical. It has to be except for the costs in the middle. Indexing is the way. The math is the math, and I think the mathematics are inarguable. Just don't take anything for granted if you're an investor.

BN: Index funds can't be expected to study every proxy resolution. The knock is that too often index funds will vote the way management wants them to vote. Is that a danger as the percentage of a company owned by an index gets higher?

JB: If that situation were to remain, it wouldn't be good. As Bob Monks, the wonderful reformer in this area, said, “Capitalism without owners will fail.” Leo Strine, the chief justice of Delaware's Supreme Court, says we have the separation of ownership from ownership — and that has been largely true, not entirely, but enough to make the statement pretty accurate. Curiously enough, I wrote about this in my Princeton thesis. Can you believe that?

BN: You're still defending it, 65 years later.

JB: I have a chapter that concluded, “I expect mutual funds to live up to their responsibility and to become much more active in the future.” And nothing happened. Oh, callow youth! Oh, boyish idealism! We totally failed to live up to that as an industry. There's no question part of it is that we didn't confront big issues. The ownership has changed and grown, and we have to bring the system in line with accepting responsibility. The fundamental task is simple: Corporations should be run in the best interest of their shareholders and not their management.

BN: What's the way forward for index funds if this threat continues?

JB: To me, index funds haven't been the problem but the solution. The old Wall Street rule was, “If you don't like the management, sell the stock.” The index funds can't follow that rule, so there's only one rule left: “If you don't like the management, fix it.” Vote, talk, discuss, cajole, applaud — and that's actually starting to happen in a major way. Earlier this year, a very distinguished group of people, including Jamie Dimon and Warren Buffett, came out with “Commonsense Corporate Governance Principles.” That's not the conclusion, but it's a good beginning.

BN: What about so much power being concentrated in so few index providers?

JB: There's a brilliant academic article by three Dutchmen about that. They talk about the implications of having three institutions — Vanguard, BlackRock, and State Street — dominate index investing. At some point these funds are going to have to worry about the fact that the Investment Company Act of 1940 says — and I'm paraphrasing here — mutual funds can't own more than 10% of the stock of any company. So we're going to get up to 10%, and the question will be, “Is it the individual mutual fund?” If it's fund by fund, we could theoretically have six funds that each owned 10% of General Motors. Regulators will have to think about that, because there's such a thing as too much concentration. Where the shovel breaks, as they used to say, I don't know. I'm sure there's a discussion of that at Vanguard, even though I'm not part of it. I'm very happy with the way our management is performing, particularly CEO Bill McNabb. He has to worry about a business. And I only have to worry about ideals. So sometimes our views aren't totally the same, but I think, in general, we care about the same underlying principles deeply.

BN: Is it easier to focus on the ideals when you don't have to run a business?

JB: Oh, you're damn right. You can say anything. But I try and stay within the rules. I don't need people to read what I'm saying and go, “That's different from what Vanguard believes.” What Vanguard believes is how this company is going to run. It doesn't matter what I believe. I sit here, pretty independently, in the Bogle Financial Markets Research Center. We're three people cranking out an enormous volume of work.

BN: Everyone focuses on indexing as the innovation. Is there not enough focus on the structure, the idea that the company's profits go back to the clients who are also the owners?

JB: I'd say not nearly enough. It's a huge cost advantage. Here's the evil thing about this business: Public ownership is the antithesis of fiduciary duty. You've got two masters to serve when that's the case.

BN: The mutual ownership has caused some legal challenges. A former Vanguard tax lawyer has alleged that by not charging as much as competing for-profit mutual fund managers do, the firm has avoided paying taxes on the hypothetical profits it would've accumulated if it did. One estimate is that Vanguard owes the IRS $34.6 billion in back taxes for the years 2007 to 2014. If you were called to testify in this case, what would you tell the court? Does Vanguard owe the U.S. $34.6 billion?

JB: I want to make it very clear — I don't speak for Vanguard, and I'm not particularly familiar with the litigation. What I'm doing here is just speaking for myself. No. 1, here's a structure that's stood the test of time for pretty close to 42 years without challenge. Indeed, the SEC, in approving the Vanguard plan to operate, described it as “consistent with the provisions, policies and purposes” of the '40 Act. “It actually furthers the Act's objectives … and promotes a healthy and viable mutual fund complex in which each fund can better prosper.” That's such a good endorsement that we printed it in annual reports. I would think it's absurd that there's even a remote possibility that some court's going to say we owe $34.6 billion.

BN: Let's talk about the Department of Labor's fiduciary rule, which will soon require broker-dealers and advisers to take clients' “best interests” at heart in regards to retirement accounts — unless a President Trump moves to repeal it, as some expect. What's your pitch to him in the Trump Tower elevator?

JB: I'm happy to have the fiduciary rule, but think about this for a minute: It doesn't really matter in the long run whether there's a fiduciary rule or not. With each passing day, shareholders get better educated, and they will move their money to people doing things right and serving them properly and away from people who are doing it wrong. That is crystal clear to me. I think we need the rule, but if the rule goes, we will fall back on the very essence of capitalism. What Adam Smith wrote way back in 1776 in the Wealth of Nations: The sole role of the producer — or money manager, in this case — is to serve the consumer.

(More: Ready or not, an expanded fiduciary is coming)

BN: Do you have any regrets about your approach to the ETF business?

JB: First, let me make an important distinction here between the traditional index fund and the exchange-traded fund. What I started in 1976 are based on very broad market segments, operated with low turnover, low cost, and held by an investor forever. That's the traditional index fund. We have almost 80% of that market. Now the ETF is a very different business. It doesn't need to be, but it is. It turns out to be a trading business. We could've launched the first one at Vanguard, but I turned it away. People have said I must be the stupidest person in the world. I don't feel stupid. You stand up for your principles. We're doing fine without it, and we started our own ETF business that sells in a different way than most firms in the business, and I think a better way because we emphasize long-term funds. We don't have a fruit-and-nut fringe in our ETF business. We're not focused on market timing, or figuring out if the market is going up or down and giving you that return times three — that doesn't have anything to do with long-term investing. It doesn't really have anything to do with speculation, either. It has to do with gambling.

BN: Your outlook is that we have pretty high valuations, very low interest rates, and very low growth. That makes for pretty measly returns — maybe low single digits — in the near future. Is that an invitation for people to start chasing performance and making risky investments to juice returns?

JB: Let's say trading costs you a couple percentage points a year on your return. The future market return on stocks is going to be 5%. That 2% is 40% of the return. It matters. Just mathematically, trading is going to be even more shunned in an era of low return. Trading can never enrich investors as a group, because — I'm glad you're sitting down — there's someone else on the other side of every trade.

BN: Well, everyone thinks they're on the right side.

JB: Great markets don't go on forever. We're certainly looking at an era of much lower returns. I don't think 4 or 5% for stocks is a bad guess. You might get lucky and get 2.5 percent on bonds and maybe almost 3% if you get into some corporates. But you put the 5 and the 3 together, and you have a 50-50 balanced fund, that's 4% for a balanced portfolio. Then you take out inflation — say we're lucky enough to have 1%. I don't think we'll get that lucky, but it should be lower than in the past. Maybe it's a 35 real return? Then you have your friendly mutual fund managers taking 2%. Easy math.

BN: What do you think of robo-advisers?

JB: I think their time is here. In a world where you're picking stocks, this wouldn't work at all. In this new world of indexing, where you're selecting an asset allocation — usually big market sectors — I think robo-advisers are in a position to do it right. Shops like Betterment are doing basic allocation using Vanguard funds. I don't think robo-advisers can add a lot of value, but for investors who need a helping hand, I think it's good and fairly priced. I happen to think our way of doing it at Vanguard is better, but it's more expensive — and you've got a live body, or at least the availability of one. It's going to make it tough on brokers and registered advisers, though.

BN: Something else that's creating some buzz is impact investing, or ESG [environmental, social, and governance]. I'm curious what you think about it?

JB: I'm very much on the ESG bandwagon. I believe companies should be way more sensitive to these issues. I don't know exactly how to measure any of it, though. And what do you do about a company that has good social values but bad environmental values? Or Berkshire Hathaway, with its governance model? They're well-governed, so no simple thing gives you an answer to a complex situation. So while I like the idea of ESG, it's still pretty fuzzy. And if you don't run a business, you won't do any good for anyone at all — it can't be at the expense of doing business well.

BN: How did Trump's election change your outlook?

JB It's going to be a long, long road. I am hoping that, when confronted by the responsibility of walking into the White House with the enormity of his responsibilities, I'm hoping he will be Saul on the road to Damascus. That's a little Biblical reference to when Saul had his complete conversion to Christianity. I don't know how likely that is, or whether you can really change that inner man that we've seen too much of. Even more important, in the long term this nation will be deeply hurt by the failure to be the nation we've always been, which is a place everyone else in the world wants to come. Walls make no sense. Any substantial reduction in our trading with the rest of the world has negative effects — on our society, our economy, and our markets. All these things are negatives. And there are many others that are part of his platform that he's going to have to move away from. There's a chance he will. Whether he'll be Saul on the road to Damascus is another question.

BN: What other issues have your attention?

JB: I would be appalled if they did away with the inheritance tax. Of all the useless changes that help only a tiny percent of Americans, what is the point? It's almost sick to think about eliminating the inheritance tax.

Infrastructure has to happen. We can borrow now at low rates. But how much debt can we handle? One of the problems with our great republic is that it's so easy to borrow in the short term. So easy. Imagine a platform that says we're going to fix everything that's broken in the U.S.? And we're going to give you a tax cut to boot. I mean, the cheering would go on forever. Those are short-term effects, and the Congress being the Congress, and the market being the market, they will look at those short-term effects very positively. Now whether we can get the Chinese to buy more long-term bonds, I don't know.

Social Security has to be fixed, too. It's a political problem, not an economic one. Congress is just going to have to make sure it works mathematically.

BN: I just remembered another anniversary you celebrated this year: your heart transplant. Still ticking away 20 years later?

JB: I have problems with it every once and a while, but it's still tickin'.

BN: How are you feeling otherwise?

JB: I don't get around as well as I used to. Traveling is really getting difficult. Just getting through the airport is tough. My wife made me take a wheelchair last time. I buried my face in my hands so no one would recognize me. But I really feel, more so than in quite a while, pretty good about my life. We also celebrated our 60th wedding anniversary this year. I have a wonderful wife, six kids, 12 grandchildren, three great-grandchildren. There's no perfection in family life, and certainly we aren't perfect, but we're probably about as close as we can be. I almost hate to say how proud I am of my career and, most of all, helping folks get the returns they deserve. And that's what these people are saying in these letters I get almost every day.

BN: Do you still respond to every one?

JB: Every single one. I love it, but it's hard to get it all done. I find myself doing my e-mail on Saturdays.

BN: What's one of your favorite letters?

JB: One of the nicest was from an airline pilot who had retired. My advice to investors is just to throw their 401(k) statements into the wastebasket. Don't peek. Open the envelope when you retire and have a cardiologist standing by, because you're going to be totally amazed. “Dear Mr. Bogle,” this pilot wrote me. “I peeked. And all I want to do is thank you.”


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