The honest steward who charges least, wins most. But not for himself; for those investors who entrust their assets to his care. It is not all that complicated.
—JOHN C. BOGLE
© Bogle Financial Markets Research Center
Savvy stock market investors put their focus on costs. They can’t control the ups and downs of the market, but short-term price movements aren’t of great concern for investors who are in it for the long haul. They have faith that the age-old upward trajectory of market prices will continue and that their patience will ultimately be rewarded with attractive investment returns.
Costs are a different story. They are killers when it comes to long-term results. Commissions, advisory fees, management fees, administrative costs, and taxes all add up, year in and year out, to undermine investment success. But unlike the stock market, they are very controllable, and the tight-fisted investor who keeps them in check will inevitably do well.
For most of the twentieth century, however, investing in the stock market was an unavoidably expensive proposition. Charles Merrill was the great friend of the small investor, yet Merrill Lynch—like Wall Street in general—was a costly place for the retail investor to do business. That state of affairs changed dramatically for the better due to two events that took place on May 1, 1975.
One of the May 1, 1975 events was the abandonment by the New York Stock Exchange of its fixed-commission schedule. Since the exchange’s founding in 1792, the NYSE had forbidden the investment firms that traded on its floor from charging their customers a commission below its published rate schedule. But after many years of protests from investors, primarily from the large institutional investors, the Securities and Exchange Commission finally ordered an end to the practice—busting the cartel-like system that had set artificially high rates for almost two centuries.
The securities industry predicted that Mayday, as it became known among brokers, would mark the demise of its business by removing the crutch of dictated rates. And while hundreds of weak firms eventually failed or merged as commissions plummeted in a newly free market, a vibrant new kind of discount broker soon emerged to take up the slack. With now-familiar names such as Schwab, Scottrade, and TD Ameritrade, these discount brokers moved in quickly to become a new sector in the securities industry. Many had electronic trading platforms and promoted cut-rate costs for the small investor. The retail investor, in fact, was the primary beneficiary of the Mayday dictate from the Securities and Exchange Commission—institutional investors had already figured out how to avoid fixed fees through “soft-dollar” arrangements and operating in the “third market”—as the average commission cost per share of stock traded fell dramatically, from 80 cents per share before Mayday to around 4 cents per share in recent years.
The other Mayday event, one that would ultimately prove equally momentous for individual investors, was the founding of the Vanguard Group by John “Jack” Bogle. While the elimination of the NYSE’s fixed-commission schedule made headline news, Bogle’s new company went unnoticed. The mutual fund business had reached a level of maturity and acceptance, and there were already 389 mutual funds available in the market. But the mutual fund the Vanguard Group would shortly launch would have a radically different approach than the 389 funds that had preceded it: it would not try to beat the market, just to match it.
The claim to fame for the typical mutual fund in 1975 was “superior performance,” measured by the investment return it provided to the fund’s shareholders as compared to some benchmark return, such as the Standard & Poor’s 500 Index. Today, this type of mutual fund is referred to as “actively managed,” and these funds search for success by hiring the best and brightest available research analysts, portfolio managers, and traders in an attempt to outperform the market. The costs of this talent—all borne by the funds’ investors—are necessarily steep.
Bogle’s new approach was shockingly different. Based on his well-supported view that few, if any, fund managers are able to consistently beat the market, the goal of his new fund was to merely match market performance rather than try to exceed it. The strategy is simplicity itself, since it is just a duplication of the S&P 500’s investment results. That task requires no expensive investment talent, just a computer and a competent programmer, and is now referred to as “passive management.” Passive management has built-in economies of scale, with the fixed costs, moderate as they are, spread across more shareholders as the fund grows. Cost control, not stock-picking prowess, is the key to success of an index fund.
Immediately after the First Index Investment Trust was rolled out in 1976, it became the subject of widespread derision. There was something un-American about a fund that aspired to be just average, and the dean of mutual funds at the time—Edwin Johnson III, head of the Fidelity Fund—said aloud what most competitors likely thought: “I can’t believe that the great mass of investors are going to be satisfied with an ultimate goal of just achieving average returns on their funds.”1 The index fund was referred to as “Bogle’s folly,” and not given much chance of success. But the idea had been germinating in Bogle’s mind since he was a college student twenty-five years earlier at Princeton University. He continued to believe the idea had merit and forged ahead with his low-cost idea despite skepticism from the mutual fund establishment.
Madly in Love with Mutual Funds
It was not a foregone conclusion that Bogle would ever go to college, much less Princeton. When he was born in May 1929, his family was prosperous. But things soon changed, beginning with the stock market crash later that year, which wiped out much of the family’s wealth. The ensuing Depression deepened their problems. The family spiraled toward poverty, moving often, and always into progressively less desirable housing. Young Jack and his two brothers worked throughout their school years to keep the family afloat, and he held jobs ranging from paperboy to bowling alley pinsetter. With the benefit of scholarships and financial assistance from an uncle, however, all three boys were able to attend boarding school at the prestigious Blair Academy in northwestern New Jersey.
But college was a different story, and only Jack—by far the best student among his siblings—could be spared from the need to support the struggling family. So his brothers stayed home and Jack went to Princeton, helped by a scholarship and part-time work waiting tables in the university’s Commons. Determined to justify his good fortune, he worked hard at Princeton and did well, including the receipt of an A+ grade on a senior thesis titled The Economic Role of the Investment Company. Bogle chose the thesis topic somewhat by chance after reading a 1949 Fortune magazine article on the emerging mutual fund business that he came upon in Princeton’s Firestone Library. But during his thesis research, Bogle “fell madly in love” with the mutual fund industry—an industry to which he would devote his long career and that he would eventually transform.2
A mutual fund is a basket of a large and diverse group of securities—sometimes bonds, sometimes stocks, and sometimes a combination of the two. By purchasing a fund, investors hope to achieve the kind of diversification and expertise that they could not achieve on their own. Mutual funds, however, were not often the investment of choice when Bogle entered that industry in 1951, right out of school. Charles Merrill, for one, was a lifelong skeptic about the value of mutual funds and did not allow Merrill Lynch’s account executives to sell them during his 1940 to 1956 tenure atop the nation’s largest retail brokerage firm. Merrill was sincere and conscientious about treating the retail investor fairly, yet he felt that his well-selected and well-trained account executives, aided by quality investment research, could tailor a securities portfolio to the unique requirements of the firm’s customers.
But over time, the virtues of mutual fund investing prevailed, as the expanding middle class found the stock market to be an enticing place for savings and mutual funds to be a sensible investment vehicle. Investors came to realize that while an individual and his advisor can, in theory, construct a portfolio with the same amount of diversification as a mutual fund, it’s hard to do in practice—and isn’t very likely to happen. Also in theory, individuals, with the aid of good research, can pick stocks and bonds as ably as a mutual fund’s professional managers—but that’s even less likely to happen, and individual investors, on the whole, are not successful stock pickers.
And as institutional investors gained prominence in the stock market in the latter part of the twentieth century, the challenge to the retail investor choosing to go it alone only grew more formidable. In an interview with Institutional Investor, the legendary institutional money manager and market commentator, Charles Ellis, offered a graphic view of the retail investor’s plight:
Retail investors make certain characteristic mistakes repetitively. Today over 80 percent of the transactions are done by institutional investors. Now, these people are different. Smart, competitive, tough, they work all day, every day—weekends and nights—getting ready in advance to be on the other side of each and every one of your transactions. So when the retail investor says, “I intend to beat the market,” the market he is talking about is not some neutered beast; it’s the sum of all the smartest, toughest minds in this business. When you come to market to sell, the only buyers you’ll find are the ones who are thrilled that you just came into the cross hairs on their sniper scopes.3
Aside from anecdotal evidence such as that offered above, there is also, thanks to the fast-growing field of behavioral economics, ample evidence that individuals acting alone make poor investors. University of California finance professors Brad Barber and Terry Odean painstakingly tracked the trades of ten thousand retail investors over a six-year period between 1991 and 1997, looking for instances in which one stock was sold and shortly thereafter another was bought in its place. The investors, as a whole, realized returns that were spectacularly bad, approximately 3.3 percent lower per year than if they had simply held on to their original investments.4
Yet the arguments for holding common stocks still remain compelling. Over any sufficiently long period, common stocks provide investors with highly attractive returns, and those investors with the patience and stomach to ride out the inevitable ups and downs of the markets are generously rewarded. So despite the cynical aphorism in the investment business that mutual funds are “sold not bought,” a professionally managed mutual fund is a good choice for retail investors. Buying a fund is the logical if-you-can’t-beat-them-join-them investment strategy. Nowadays, buoyed by the advent of 401(k) plans, about half of all Americans own common stocks. Some 401(k) participants own stocks directly, but the preponderance own stocks indirectly through mutual funds. And Jack Bogle has been along for the entire ride.
A mutual fund–based strategy of common stock investing eventually caught fire with Americans in the latter half of the twentieth century, but when Bogle joined Philadelphia-based Wellington Fund in 1951—his first job after college and one that he got based on the strength of his senior thesis—the amount of savings of U.S. households dedicated to mutual funds was tiny. Families were more inclined to put their investment money into life insurance programs, savings deposits at the bank, or U.S. savings bonds. The total amount of savings in those three savings programs was $178 billion; by contrast, just $3 billion of savings were invested in mutual funds.5
It didn’t take long for Bogle, ambitious and talented, to become the heir apparent to the Wellington Fund’s founder, Walter Morgan, and Bogle’s close relationship with Morgan gave him much influence regarding the direction of the firm. By 1958, when he was just twenty-nine, he convinced Morgan to establish a new all-equity fund, later to be called the Windsor Fund. The Wellington Fund, like most of the substantial mutual funds at that time, was “balanced,” meaning that it invested in both stocks and bonds. The idea of creating a family of funds under one management company, each with a separate set of investment policies such as the common stock-focused Windsor Fund, is common today, but was novel in the 1950s.
The Windsor Fund enjoyed early success, but it remained dwarfed by the Wellington Fund, and Bogle wanted to do more. He wouldn’t have to wait long. In 1965, Morgan gave his protégé the title of executive vice president and the authority to increase the diversity and vitality of the Wellington Fund management organization as a whole. As Bogle relates it, his promotion came with a broad mandate to transform Wellington by fixing its problems, including “(1) an overreliance on a single, highly conservative balanced (stock and bond) fund; (2) the lack of an aggressive equity fund during the “go-go” era of the Sixties stock market; (3) a paucity of investment management talent at the firm; and (4) a complete dependence on the mutual fund business.”6
It wasn’t long before Bogle came up with what looked to be a brilliant and comprehensive solution: a 1967 merger with one of the “hot” fund management teams of the day, Thorndike, Doran, Paine & Lewis. The firm of young and ambitious investment managers looked to have the energy and market expertise needed to reenergize the tradition-bound Wellington firm. He would later call the move impetuous and stupid but at the time it appeared to be a coup in the mutual fund industry, and Bogle was anointed president and chief executive of the combined company. During the next several years, he and the management talent that came with the merger put an aggressive expansion program in place for the Wellington Management Company. The number of Wellington-managed funds increased from two to ten, including funds whose investment policies were based on rapid growth (Ivest Fund), emerging industries (Explorer Fund), technology (Technivest Fund), and with an investment philosophy that would become anathema to Bogle in later years, a fund structured to capture short-term price trends and turn over its portfolio rapidly (Trustees’ Equity Fund).
While the stock market cooperated, Bogle and the Wellington Management Company enjoyed good fortune, and the merger with Thorndike, Doran, Paine & Lewis seemed well conceived. But with the severe falloff in stock prices in the mid-1970s—the major indexes fell around 50 percent—things came apart. His high-flying investment strategies and the addition of new and aggressive equity funds to the Wellington family of funds produced performance that was even worse than that of the market overall. As would be expected, Wellington’s funds suffered massive withdrawals by their unhappy shareholders. Since the reinvention of Wellington through rapid growth and fund diversification was Bogle’s initiative, he was rightfully assigned the blame, and the Wellington board of directors, in January 1974, fired him as their president and chief executive.
On the very next day, however, Bogle met with the collective boards of the funds that were managed by Wellington Management. Like other mutual fund management companies, Wellington was paid an annual fee by the funds to select investments, market the funds, and handle administrative tasks. By law, each of the individual funds has a governance structure separate from that of the management company—their own board of directors—but in reality the boards of those funds are typically handpicked by the management company, and they are generally ineffectual. Bogle reengineered that arrangement by appealing to the boards themselves and bypassing the management company.
In an adroit feat of boardroom maneuvering, Bogle, after meeting with the boards of the individual funds, negotiated an arrangement with Wellington that shifted the control over day-to-day administration to a new company owned by the funds’ shareholders—and managed by him. Under the arrangement, Wellington continued to run the vital investment management and marketing activities, with Bogle’s new company handling the routine tasks of bookkeeping and reporting. His ingenuity in reshaping the management structure helped him keep his job and cement his leadership position—and it eventually led to the creation of a shareholder-friendly, mutually owned corporate structure unique in the mutual fund industry.7 A great admirer of Admiral Horatio Nelson, Bogle renamed his reconstructed mutual fund enterprise the Vanguard Group, after the HMS Vanguard, one of the flagships Nelson sailed throughout many of the sea battles of the Napoleonic Wars.
Proscriptions and Prescriptions
The dramatic change in Bogle’s professional life must have led to some soul-searching. While still in his thirties he had become the hard-charging chief executive of Wellington; at age forty-five he was fired. Yet he was still just at midcareer and had a new mutual fund vehicle to start over with. What directions would he take? Surprisingly, he reached back to the ideas he advanced in his 1951 Princeton thesis, and those ideas shaped the mission of the Vanguard Group. He called the ideas “proscriptions and prescriptions.” In a mixture of boasting and self-deprecation he said:
Today it’s easy for me to make two diametrically opposed statements about those proscriptions and prescriptions: (1) They represent the mindless prattle of an idealistic, immature college student, unwise in the ways of the world; and (2) they represent a carefully thought out philosophy and a remarkably prescient design for the firm I would found twenty-three years later.8
The strongest prescription the twenty-one-year-old Bogle made in his thesis was on the matter of responsible governance—“the prime responsibility of mutual funds must always be to their shareholders”—arguing that their overarching goal was to “serve those shareholders in the most efficient, honest, and economical way possible.” While the strongest proscription was to avoid promising the investor that mutual funds could outperform the overall market—“mutual funds should make no claim of superiority over the market averages.”9
Both his prescription and proscription, in fact, turned out to be remarkably prescient and would serve as the two guiding principles of the Vanguard funds into the twenty-first century. They were also given strong undergirding in 1962 with the SEC’s publication of the Study of Mutual Funds, conducted by professors at the Wharton School of the University of Pennsylvania.
The Wharton study covered the years 1952 through 1958 and, coincidentally, was commissioned by the SEC to address Bogle’s two areas of concern: governance that was not often in line with the best interests of the mutual fund’s shareholders and misrepresentation about investment performance. The study pointed out that the board of directors of a mutual fund was, in theory, beholden to the shareholders and was charged with selecting the most effective management company to handle the distribution (sales and marketing of new shares), investment advisory (management of the portfolio), and fund administration. The way it worked in practice, however, was that the management company itself organized the fund and then handpicked compliant directors to do the fund’s bidding. Despite the appearance of independence, the management company often ran the fund according to its own best interests rather than those of the shareholders. So it was hardly a surprise that the study found virtually no instances of a mutual fund board dislodging a management company that was ready and willing to continue as the fund’s advisor.10
In a position of effective control of a mutual fund, a management company enjoyed an unfettered ability to charge yearly management fees of its choosing rather than fees that came about as a result of good faith negotiation with an independent board. The Wharton study found that the investment management fees charged to mutual funds run for the benefit of retail investors were a multiple of the fees management companies charged their institutional investor clients through arm’s-length negotiations. In addition to the yearly fees for running the funds’ portfolios, the management companies could also determine the commissions required to be paid by the funds’ shareholders when they bought or sold shares in the funds—the so-called front-end and back-end loads. The study found that the loads paid were generally in the neighborhood of 8.5 percent on the front end. But the handful of no-load funds in existence at the time—those funds charging no commissions to buy or sell mutual fund shares—performed as well as the funds with a load. Contrary to the expected outcome in commerce, investors were not getting what they paid for.
Bogle, invoking the idealism of his senior thesis from many years earlier—“fund managers must treat their shareholders in the most efficient, honest, and economical way possible”—converted the newly organized and mutualized Vanguard Fund into a no-load fund in 1977. He abided by the precept of treating the fund’s shareholders as owners—for the simple reason that they are the owners. He likened the act of charging the industry standard 8.5 percent fee to starting 8.5 yards back in a 100-yard race. Put another way, if investors are buying only $91.50 of underlying securities for a $100 investment, it’s hardly possible for them to realize competitive returns—and they are certainly not being treated in the manner owners deserved to be treated. For that reason, Vanguard operated without the mutual fund industry’s customary sales load.
Reducing the other major cost borne by fund shareholders, the annual fee the fund paid the management company to supervise the investments, was a more complicated decision. Obviously, someone had to perform those vital functions. Professional management and portfolio diversification was the sine qua non of a mutual fund, and under the mutual structure that he had engineered for Vanguard, Bogle was able to monitor and control expenses by bringing the investment advisory functions in house.
Rather than paying a highly padded fee to an affiliated management company that in reality controls the fund management, Vanguard’s funds dictate the terms to the management companies they employ. Under the Vanguard approach, the shareholders pay the actual costs associated with their funds rather than the costs plus a markup. As a result, they often wind up paying a management fee that is as much as a full percentage point lower. Despite its shareholder-friendly mission, the SEC initially and inexplicably declined approval of the mutualized structure of the Vanguard Group. But after four years of appeal, the commission gave its unanimous approval in 1981, stating, “The Vanguard plan actually furthers the Investment Act of 1940 objectives, and promotes a healthy and viable complex in which each fund can better prosper.”11
Cost control became the new byword of Vanguard, and Bogle, in trumpeting the success of his mutual fund enterprises, cited this as a major explanation for superior returns to shareholders. Each year he would point to the funds’ overall expense ratio, calculated by taking the funds’ total costs and dividing them into the assets under management. The biggest chunk of fund expenses is almost always attributable to managing the portfolio, but a not inconsequential amount of expenses are incurred in connection with record keeping, custodial services, taxes, legal expenses, and accounting and auditing. In any case, the cost-conscious Bogle could point to a constant decline in the Vanguard expense ratio over the years, reaching just 0.35 percent in 1996, the year he relinquished his CEO title.12
While costs measured in one-hundredths of a percentage point may seem miniscule, they add up and punish the investment returns of the shareholder. By Bogle’s estimate, the combination of management fees, sales charges, marketing costs, brokerage commissions, and operating expenses amounts to an annual cost of more than 2.5 percent for the typical mutual fund.13 If one accepts that 2.5 percent number as reflective of a mutual fund that charges front-end loads and pays nonnegotiated fees to outside management companies, and then compares that number to a Vanguard 0.35 percent all-in cost, the results are striking.
Consider a stock fund in which the underlying annual return for the investments in the portfolio is 8 percent per year. After expenses, the shareholder of the typical mutual fund would net just a 5.5 percent return, whereas the Vanguard shareholder’s net return would be 7.65 percent. In terms of the effect on capital accumulation, that means that over a ten-year period, the investor who makes a $10,000 investment in the first year and realizes the 5.5 percent annual return would see his or her money grow to $17,081; if he or she invests as a Vanguard shareholder, the investment would be worth $20,899. If the investor is saving for the longer term, perhaps retirement in thirty years, the results are even more dramatic due to the power of compounded interest. The typical fund investor would have accumulated $49,840, compared with the Vanguard investor’s $91,290.14 Based on such examples, Bogle summed up much of his investment philosophy with this advice: “Don’t let the miracle of long-term compounding of returns be overwhelmed by the tyranny of long-term compounding of costs.”15
But more is involved in comparing one fund’s expense ratios with another. For one thing, the decline in the Vanguard average cost ratio reflected the changing nature of the funds being managed under the Vanguard umbrella. In 1974, stock funds and balanced funds (those containing both stocks and bonds) accounted for 97 percent of the assets managed; by 1990, that had dropped to only 35 percent, with the remainder accounted for by bond funds and money market funds that required far less investment management.
The major reason for the Vanguard’s tiny fee structure, however, is more fundamental—and monumental. The overwhelming reason for the reduction in costs was the move that Bogle and his Vanguard Group began in 1975 toward index-based investing. Such funds require no high-powered and high-priced investment analysts and portfolio managers, but rather just a market technician and a computer program to structure a fund to exactly mimic the results of an index, most often the S&P 500. The costs of running this kind of fund are next to nothing. In reality it is a simple concept, yet this low-cost, passive management approach would ultimately change the face of mutual fund investing and result in Vanguard’s becoming the world’s largest mutual fund organization.
The argument for index fund investing harkens back yet again to Bogle’s Princeton thesis and its assertion that fund managers should “make no claim to superiority over the market averages.” The twenty-one-year-old Bogle recognized, perhaps intuitively, that investing, whether through mutual funds or otherwise, was essentially a zero-sum game. With hundreds of thousands of participants in the stock market, all of them scrutinizing publicly available information to maximize their investment returns, the burden of proof would seem to be on any individual or fund management claiming superior knowledge or instincts.
Sophisticated investors have long known that beating the market is a fool’s errand. As a well-read young student who was infatuated by the market, Bogle may have gained early wisdom from the seasoned stock market traders of the day. It’s likely he had read Reminiscences of a Stock Operator, Edwin Lefevre’s thinly fictionalized 1923 biography of Jesse Livermore, the most famous stock speculator of the early twentieth century. In that book, Lefevre has his subject assert,
I have been in the speculative game ever since I was fourteen. It is all I have ever done. I think I know what I am talking about. And the conclusion that I have reached after nearly thirty years of constant trading, both on a shoestring and with millions of dollars in back of me, is this: A man may beat a stock or a group at a certain time, but no man living can beat the stock market! It’s like the track. A man may beat a horse race, but he cannot beat horse racing. If I knew how to make these statements stronger or more emphatic I certainly would. It does not make any difference what anybody says to the contrary. I know I am right in saying these are incontrovertible statements.16
But prior to the 1962 Wharton study, there was little hard evidence to challenge the allegations coming from the newly emerging mutual fund industry that professionally managed funds would produce investment returns in excess of the market overall. Mutual fund organizations and salespeople made uncorroborated claims that their highly trained and experienced securities analysts and portfolio managers, through active management, were market champions. Going beyond the legitimate claim that mutual funds were a sensible alternative for people unfamiliar with the financial markets, sponsors often claimed that their funds could actually outperform those markets. The Wharton study of mutual funds provided a rigorous test of those claims.
Since there was no broad index of the stock market during the 1952–1958 time frame of the study (the Standard & Poor’s 500 Index debuted in 1957), the Wharton researchers compared a mutual fund’s performance with a randomly selected portfolio of stocks made up of the same asset class as the fund. In a nutshell, the study found no significant difference between the performance of the funds studied and the randomly selected portfolio of stocks, and in fact, the funds studied usually performed worse than the randomly chosen portfolio after taking into account the fees and expenses of running the portfolio.
The study drew widespread popular and political notice, with the finding regarding the actual success of actively managed funds garnering the most attention. In 1967, U.S. Senator Thomas McIntyre constructed stock portfolios by throwing darts at the stock listings in the newspaper and found that they were as profitable as those produced by the professional market analysts. Burton Malkiel, a Princeton professor and author of the best-selling A Random Walk Down Wall Street, took the comparison further, opining that “a blindfolded chimpanzee throwing darts at The Wall Street Journal can select a portfolio that can do just as well as the experts.”17 The Wall Street Journal itself got into the act itself by sponsoring a dartboard contest in which professional investors were invited to compete with selections chosen by merely throwing darts at its stock listings. (After one hundred separate contests, the “pros” won sixty-one times and the “monkeys” thirty-nine times, resulting in the Wall Street Journal proclaiming victory for securities analysis. But the academics, including Malkiel, countered that the Journal used incorrect methodologies in the dartboard contest, absent which the professionals would have done no better than the dart throwers.)
Since the time the Wharton study came out, more than fifty years ago, its methodologies have been challenged, but its conclusions have been confirmed and reconfirmed—the results are always the same. Of the thousands of mutual funds available to investors—and today there are more mutual funds than there are publicly traded stocks—precious few have been identified that consistently beat the Standard & Poor’s 500 Index or other appropriate yardsticks. When adjusted for risk or investment goals, they perform no better than a similarly adjusted index. Most tellingly, the amount of fees charged to their investors has no correlation with the funds’ results.
In investment and finance textbooks, the reason professionals do no better than randomly made investments is ascribed to the “efficient market hypothesis.” And the EMH is based on what is pretty obvious: all market movements occur with new information, and no single individual has a crystal ball that can predict when that new information will occur or what it will be. With millions of investors seeking profitable information on which to trade, and ready to pounce in an instant, the results of the Wharton study and its successor studies are not surprising.
Though Bogle would never fully embrace the notions of the EMH, he offered it up as a worthy challenge for anyone professing to outperform the market: “I know of no serious academic, professional money manager, trained security analyst, or intelligent individual investor who would disagree with the thrust of the EMH: The stock market itself is a demanding taskmaster. It sets a high hurdle that few investors can leap.”18 And there is little question that Bogle was greatly influenced by work of the theory’s prominent advocates. He was inspired by Professor Malkiel’s Random Walk Down Wall Street and also by institutional investor Charles Ellis’s 1975 article “Loser’s Game” in the Financial Analysts Journal, which made the case that investors did not—and could not—outperform the market.19 But his primary inspiration came from Nobel laureate Paul Samuelson’s open call for a retail-oriented index mutual fund. In a 1974 article titled “Challenge to Judgment” in the Journal of Portfolio Management, Samuelson threw down the gauntlet by challenging anyone to “produce brute evidence” that an active investing strategy can be superior to a passive index strategy. He further suggested that “some large foundation set up an in-house portfolio that tracked the S&P 500—if only for the purpose of setting up a naïve model against which a mutual fund’s in-house gun-slingers can measure their prowess … The American Economic Association might contemplate setting up for its members a no-load, no-management-fee, virtually no-transaction-turnover fund.”20
Bogle viewed Samuelson’s challenge as the opportunity of a lifetime—his chance to put into reality the ideas he had first conceived at Princeton a quarter of a century earlier. Ever his own man, he diligently performed his own confirming work “by hand” on the comparative results of equity mutual funds and a stock index. He analyzed thirty years’ worth of average investment returns from mutual funds and then compared their results to the S&P 500, and found that the index enjoyed a 1.6 percent per year advantage in investment returns—and, of course, that advantage sprang from the fact that the index returns are not burdened by significant management fees.21 To distinguish his framework from the EMH, which was then derided on Wall Street, Bogle came up with his own principle: the CMH, or cost matters hypothesis. If the cost of running a fund could be reduced by using an index-based passive management approach rather than employing highly paid managers, the fund’s costs could be dramatically lowered with the aim of providing its shareholders with much higher investment returns. He would declare that “we don’t need to accept the EMH to be index believers … not only is the CMH all that is needed to explain why indexing must and does work, but it in fact enables us to quantify with some precision how well it works. Whether or not the markets are efficient, the explanatory power of the CMH holds” (Bogle’s emphasis).22
His custom-made analyses of stock market history and his formulation of the CMH formed the cornerstones of his successful argument to the Vanguard board for the creation of an index fund. And so in August 1976, Vanguard created a fund designed to exactly duplicate the Standard & Poor’s index of 500 stocks: the First Index Investment Trust.
It was also at that time that Vanguard began its transition from a minor affiliate of Wellington to a powerful and independent mutual fund company. As described earlier, Wellington ceded only the administrative functions of fund management to Vanguard, keeping the investment management and marketing for itself. But with a no-load commission structure, the First Index Investment Trust, later renamed the Vanguard 500 Index Fund, was sold directly rather than through the brokers that Wellington controlled, so there was no significant marketing required. By the same token, with a fund that aims only to duplicate the S&P 500, there is no real investment management. Thus, the Vanguard 500 Index Fund—and the succeeding Vanguard funds—could now operate independently from Wellington. Bogle later stated that the emergence of a separate, shareholder-controlled Vanguard Group from beneath the Wellington umbrella, “was one of the great acts of disingenuous opportunism defined by the mind of man.”23
The Vanguard Flywheel
Like many revolutionary ideas, the index fund movement was at first dismissed as a ludicrous and unmarketable idea—“the pursuit of mediocrity”—and its debut was anything but propitious. There were, however, some high-level supporters. Both Malkiel and Ellis sat on the First Index Investment Trust’s board and became investors, and Malkiel later credited the Vanguard’s index funds for providing for the education of his six children and fifteen grandchildren.
And there was also interest in the idea within certain institutional firms. David Booth and Rex Sinquefield, both MBA graduates of the University of Chicago, where much of the groundwork for the efficient market hypothesis was laid, used an indexing strategy beginning in the 1970s for their institutional clients. Booth worked at Wells Fargo Bank and Sinquefield worked at the American National Bank of Chicago. In 1981 they teamed up to form the highly successful Dimensional Fund Advisors, providing indexing strategies for institutional clients and financial advisors.
But even with its impressive supporters, it was difficult in 1976 to find a Wall Street firm willing to handle the initial stock offering for an endeavor that aimed to be average. Dean Witter & Company ultimately agreed to take on the project, but it could only sell $11 million of the targeted $150 million offering. And that tepid reception was followed by Vanguard’s lackluster growth through the remainder of the 1970s. The mainstay of its mutual fund family, the Wellington balanced fund, was redeeming more shares than it was selling and the First Index fund was not catching fire with the investing public. Total assets under management for the fund family remained essentially flat during the period at approximately $2 billion, and they were only at that level because of the growth of new money market funds and bond funds.
Eventually, of course, index funds would attain remarkable success, conforming to a flywheel type of growth that Jim Collins described in his best-selling Good to Great. In that book he explains how “great” companies often begin slowly but surely and eventually gain great momentum, “Pushing with great effort, you get the flywheel to inch forward, moving almost imperceptibly at first. You keep pushing and get the flywheel to complete one entire turn. You keep pushing, and the flywheel begins to move a bit faster. Then at some point—breakthrough! You’re pushing no harder than during the first rotation, but the flywheel goes faster and faster.”24
During the start-up years of the late 1970s, with his Vanguard organization employing as few as 28 employees and the assets under management at the funds hovering at something less than $2 billion, Bogle would often invoke his message of confidence: eventually the fund will catch on as customers begin to understand that the low-cost approach best serves their long-term needs. But the First Index fund, with its controversial and decidedly unexciting passive, index-based investment strategy, continued to be a tough sell.
By 1980, however, the flywheel finally began to turn, and Vanguard’s assets under management increased to $3 billion. That achievement was cause for celebration, and Bogle began his custom of gathering all of the “crew members,” Vanguard’s term for its employees, and delivering a congratulatory speech. The first, in September 1980, was titled “A Time to Dance,” and like the forty-two similar speeches that would follow during Bogle’s reign, it was laced with literary allusions and closed by exhorting the crew to aim for even higher goals. In the first speech, he chose a verse from poet Robinson Jeffers: “Lend me the stone strength of the past and I will lend you the wings of the future.”25
During his speeches, some of the more jaded crew members likely rolled their eyes at the drama and importance Bogle attributed to the firm’s accomplishments, especially as he quoted the likes of Shakespeare, Rudyard Kipling, the Bible (mainly Ecclesiastes), and, of course, Lord Nelson. And the omnipresent nautical theme was everywhere—the company cafeteria was referred to as the Galley, and the fitness center and company store were called Ship Shape and the Chandlery, respectively. When Vanguard reached the size that supported its own campus, each of the various buildings carried the name of one of Nelson’s ships—Victory, Zealous, and so forth.
Bogle’s approach may have been cornball, but it succeeded. Vanguard’s assets reached the $4 billion milestone in the following year, commemorated by his September 1981 speech, “Growth Has Its Season,” which featured Marcus Aurelius’s comments about the river of passing events. Then, in August 1982, less than a year later, he and the crew members celebrated passing the monumental $5 billion asset level with a speech that was titled “The More Glorious the Triumph” and drew upon both Thomas Paine and the ever-quotable Lord Nelson for inspiration. The flywheel was in motion now, and passing subsequent billion-dollar levels was occurring too frequently to justify a special event or speech. By 1985, Vanguard would top $16 billion; by 1990, $55 billion; and by 1995, Bogle’s last year as chief executive, $180 billion.
A large part of Vanguard’s extraordinary growth is rightfully attributed to Jack Bogle’s vision and leadership, but the mutual fund industry itself was the beneficiary of several very favorable trends during the 1980s and 1990s. The long bull market in stocks that began in 1982 had the effect of rekindling investor interest in equity investing, and of course the asset value of the underlying stock funds increased along with the rising market values. At the same time, the prices of bonds increased substantially with the rapid fall in interest rates. From the double-digit levels of the late 1970s and early 1980s—some bonds carried rates of over 20 percent to attract willing investors during that time—interest rates quickly fell back to a more normal range of between 5 and 7 percent, and bond prices soared.
And most important of all, the Revenue Act of 1978 that provided for the creation of employer-sponsored 401(k) plans beginning in 1980 caused a sea change in how pension plans were created and funded. Where defined-benefit plans had once been standard, the defined-contribution approach took their place, and individuals became increasingly responsible for funding their own retirement—and making their own investment choices. For that reason, the percentage of U.S. households owning common stock, either directly or through self-directed pension plans, grew to well over 50 percent in 2000. And increasingly, the vehicle of choice for making those stock (and bond) investments was the mutual fund.
Over the same time span, Vanguard was increasing its market share of the mutual fund business in each and every year.26 The gospel of index investing had spread beyond its early champions in the academic community and within a few institutional advisory firms, and Vanguard was the beneficiary of this increased interest in passive management. And at the same time, indexing at Vanguard was developing well beyond just tracking the S&P 500 stock index. In 1986 Vanguard introduced the first bond market fund, and later in that decade it introduced the Total Stock Market Index Fund to match the broader Wilshire 5000 Index. (The S&P 500 includes the largest 500 U.S. stocks by market capitalization; the Wilshire 5000 Index includes the next 4,500 largest.) The Small-Cap Index Fund was created based on the widely followed Russell 2000 Index of smaller publicly traded companies.
The index fund proliferation at Vanguard only increased in the 1990s. As a result of Bogle’s persistent goading, Standard & Poor’s developed separate indexes for growth stocks and value stocks, and Vanguard quickly developed the two new funds designed to track them. In 1992, an international equity index fund was launched, followed in 1994 by an emerging market index. By 1995 Vanguard was managing a family of eighty-two funds, and of the twenty-nine funds added in the 1990s, twenty-five were index funds.
Years of Setbacks, 1996 to 2000
The momentum of the Vanguard enterprise carried through the remainder of the 1990s and into the twenty-first century, but beginning in late 1995 Bogle suffered a succession of serious health problems and professional disappointments. He had lived throughout his life with heart arrhythmia, experiencing a major heart attack at age thirty-one, followed by a succession of additional attacks requiring extended hospital stays.
It appeared that, like Charles Merrill, Bogle would be required to retire prematurely from the business world. Although the installation of a pacemaker in 1967—he was one of the early beneficiaries of that procedure—and the use of various heart medications worked marginally well, by October 1995 his heart had deteriorated to such an extent that his cardiac physician delivered the news to Bogle that he was threatened by “a catastrophic cardiac arrest—a guillotine about to drop.”27
To the congenitally optimistic Bogle, however, that was good news—and his optimism was warranted. With the right side of his heart no longer pumping, he became eligible for a heart transplant, his last-ditch hope for survival. He soon found himself in an in-residence cardiac unit at Philadelphia’s Hahnemann Hospital, where he was kept alive by intravenously administered liquids and, along with several other patients in need of a heart transplant, awaited a new heart. The medical profession honors a no-favoritism policy in the awarding of a transplant—Bogle described the process as being “as democratic as a traffic jam”—but his turn finally came in February 1996 after a four-month wait.
During the ordeal of waiting, he continued to work on business. The Vanguard family of funds by that time numbered eighty-five, and he wrote the annual letter to shareholders for each one. But at this point his role at Vanguard had become, if not ceremonial, greatly reduced since his 1995 decision to turn over the CEO position to longtime Vanguard employee John Brennan. Bogle remained chairman of the board and had managed the transition of operating control to Brennan by the book, making him president in 1992 and conferring the chief executive and chairman titles officially as of January 1996. He acknowledged his own age—sixty-seven years old when he stepped down—as well as his faltering heart, and said all of the right things about Brennan’s capabilities and his “confidence that my vision had been firmly established and that we had built an organization fully capable of carrying on our mission.”28
It is not uncommon for founders of a business to have difficulty letting someone else take full control of the reins, but in Bogle’s case a better than expected recovery from his health problems made the transition even tougher. When he entered Hahnemann Hospital in 1995 he was desperately ill, and it was not at all certain he would receive his transplant in time or, if he did, would regain his energy. But after a short recovery period, Bogle was back in fighting form. He began damning Brennan with faint praise and resented those instances when Brennan was given credit for Vanguard’s solid performance in the latter half of the 1990s.
By all accounts, Brennan was a highly competent CEO and particularly skilled in moving the company into Internet applications, an area in which Vanguard had lagged behind some of its competitors. But Bogle bristled when the later successes at Vanguard were trumpeted in the media without giving due notice to his own influence, and he gave voice in the press to what he thought was second billing—or worse, no billing at all—regarding his past and ongoing contributions to the company’s success. Brennan, not a self-aggrandizer by nature, refused to comment on Bogle’s public statements regarding Vanguard’s management, but the board took the steps it believed were needed to remove the disruptive founder, who now carried the title of “senior chairman.” It took action in 1999 by asking for Bogle’s resignation when he reached the mandatory retirement age of seventy. Bogle maintains that it had always been an understanding of the board that the policy would not apply to him as the founder, and other Vanguard directors had been allowed to remain on the board past the age of seventy. But for whatever reason, the board—probably in the spirit of removing the distraction of further feuds and giving a vote of confidence to Brennan—voted to require Bogle’s resignation.
The news of his involuntary resignation spread rapidly among Vanguard shareholders, stirring a massive protest to the board’s decision. In retreat, the board members reconsidered, but Bogle turned down their offer for reinstatement on the board. As with his earlier 1974 firing as CEO of Wellington Management, however, he ultimately landed on his feet, finding a position that was a perfect match for his talents, experience, and time of life. His new title was founder of Vanguard and president of a newly established Bogle Financial Markets Research Center.
Happy Endings
For well over a decade Bogle has continued to write and deliver speeches to an expanding audience. While his early efforts borrowed from a wide spectrum of intellectual thought, they were primarily inspirational in purpose and had a fairly narrow focus on Vanguard and on reforming the mutual fund business. Today at the Bogle Center, he and his small think tank staff continue to focus their efforts on reform, but the scope has expanded well beyond Vanguard and mutual funds to issues such as shareholder rights, corporate governance, entrepreneurship, and most especially, personal and business ethics. He also serves as a Vanguard ambassador, visiting the company’s far-flung offices, and with his latest moniker of Saint Jack, makes an appearance at the reunions of the “Bogleheads,” a fan club of investors who have benefited emotionally from his homey inspirational messages, as well as financially from his creation of an indexing strategy for investing.
Meanwhile, the Vanguard flywheel has continued to turn faster and without apparent limits. Under the direction of its third CEO, veteran Vanguard employee Bill McNabb, Vanguard was managing over $3 trillion in assets by 2014—some 35 years after Bogle and his crew celebrated the addition of the companies first billion dollars of growth. And those crew members now total around 14,000, up from the original 28 on hand for that celebration. At the time of this writing, Vanguard had 74 index funds under management, including the Total Stock Market Index Fund, which, with $370 billion under management in 2014, was the largest in the industry. Perhaps most significantly for the company’s shareholders—Bogleheads or no—the expense ratio has continued to decline and now sits at an average 0.19 percent, so investors are paying just 19 cents for every $100 dollars under Vanguard management.
His “cost matters hypothesis” continues to overarch his thinking, and in 2009, in a lecture on business ethics at Columbia University, Bogle estimated the effect of Vanguard’s low-cost structure for its shareholders. He pointed out that his fund’s expense ratio of 0.20 was a full 1.1 percent below the 1.3 percent for the average mutual fund. Applying that difference to the $1 trillion under management at Vanguard at the time resulted in savings of $11 billion to its shareholders. He used that example to underscore the benefits of a mutual fund that was structured to serve just one master: the fund’s shareholder. He told his audience that he was probably naive in naming his low-cost fund Vanguard, since the word connotes being the leader of a new trend, saying “under our at-cost structure, all of the profits go to the fund shareholders, not to the managers, resolving the transcendent conflict of interest of the mutual fund industry. In any event, the leader, as it were, has yet to find its first follower.”29 (Many imitator index funds have been formed—including several within the Fidelity Funds family—but there are no known funds that fully employ Vanguard’s investor-friendly mutual structure.)
Bogle has not had to rely on himself to sing the praises of low-cost, index investing. In 1999 Fortune pronounced him to be one of the four most influential investment figures of the twentieth century, and in 2010 William Baldwin, longtime writer of Forbes, took the occasion of his last letter as editor of the magazine to issue an apology (of sorts) for the magazine’s hypercritical commentary on Bogle and Vanguard. “It’s a bit late in coming,” Baldwin wrote, “but I’d like to officially retract a story Forbes published in May 1975 that pooh-poohed the creation of Vanguard Group by John C. Bogle.” After chronicling the success of Vanguard, Williams writes, “Bogle, 81, is retired from management but is as vociferous as ever an evangelist for cost-cutting. I think he has done more good for investors than any other financier of the past century.”30
And in a 2005 speech before the Boston Security Analysts Society, the ninety-year-old Paul Samuelson, Bogle’s inspiration and one of the foremost economists of the century, went even further: “I rank this Bogle invention along with the invention of the wheel, wine and cheese, the alphabet, and Gutenberg printing: a mutual fund that never made Bogle rich but elevated the long-term returns of the mutual-fund owners. Something new under the sun.”31
