If the world knows John Bogle, it knows him mainly because of his advocacy of index mutual funds. In chapter five of “Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor,” he dove into his favorite subject more deeply.
Discerning observers will first ask, “Which index?” The best known of the indexes may be the S&P 500, which is comprised of the 500 largest American corporations. The entire market, he noted, is indexed by the Wilshire 5000, which includes all actively-traded stocks; it is made up of 3,486 stocks, despite its name. In addition, there are indexes that measure small- and medium-cap stocks, growth stocks, value stocks, industry sectors, nations, geographic regions and more.
The emergence of so many indexes and types of indexes highlights this important point for Bogle:
“The index fund is a most unlikely hero for the typical investor. It is no more (nor less) than a broadly diversified portfolio, typically run at rock-bottom costs, without the putative benefit of a brilliant, resourceful, and highly skilled portfolio manager. The index fund simply buys and holds the securities in a particular index, in proportion to their weight in the index. The concept is simplicity writ large.”
Bogle’s second important point in chapter five is that indexing is a long-term strategy. Investors who jump into an index fund hoping to ride short-term momentum are sure to be disappointed. In the case of the S&P 500, he reported it has “encountered intervals of significant shortfall relative to the average mutual fund.”
Third, he asked if it matters which index is chosen. The answer was a simple “No,”https://www.gurufocus.com/news/757287 at least in the long run. Bogle noted that between 1970 and 1999, the Wilshire 5000 and the S&P 500 indexes had generated identical returns, an annual average of 13.7%. What’s more, the Wilshire 4500 Equity Index, made up of small- and medium-cap companies, also generated that same average annual return.
That’s what he called a “precise coincidence” and “The precise parity of returns may overstate the case somewhat, but I am confident that we have learned something important when we observe that the returns of stocks with different investment characteristics converge so tightly over nearly three full decades.”
Fourth, Bogle argued that indexing was a winning strategy, mainly because of costs. For the managers of active funds, achieving parity with index funds means they must earn as much as the index funds, plus an additional increment to account for costs.
As he wrote in 1999, “Indeed, over the past 15 years, the 16.0 percent return on the Wilshire 5000 Index exceeded the 14.1 percent net return on the average growth and value fund by 1.9 percentage points, precisely what we might have expected based on total estimated fund costs of 1.9 percent.” The Wilshire 5000 refers to passively managed index funds, while “growth and value fund” refers to actively managed funds.
Fifth, he said that the indexing is even more efficient than simple comparisons would suggest. Passively managed indexes have three advantages over actively managed funds: (1) fund sales charges, where they exist, (2) the comparison is biased by survivorship among actively managed funds and (3) there are no adjustments for taxes on income dividends and capital gains distributions.
Sixth is the issue of risk. Bogle’s strawman here was the argument that equity funds are not as risky as index funds because managers can shift into cash in anticipation of market declines. While the argument is “superficially reasonable, the record is bereft of evidence to support it.” Indeed, he argues fund managers tend to hold large amounts of cash when the markets are low, and small amounts when the markets are high.
Seventh, all index funds are not created equal. There were, at the time Bogle was writing, 140 index funds; of them, 55 were modeled on the S&P 500 Index while the others were based on everything from the Wilshire 5000 to international funds. So investors must consider what they want to track when choosing index funds.
Also, a third of those funds carried front-end of asset-based sales charges. Bolge wrote, “Why an investor would opt to pay a commission on an index fund when a substantially identical fund is available without a commission remains a mystery. The investor who does so starts out on day one by falling as much as 5 percent or more behind the target index—behind the eight ball, as it were—and falls further behind each year, as fund expenses take their toll.”
Eighth, indexing works in all markets. Critics have argued that indexing only works in efficient markets, but Bogle had an answer for that: The success of indexing is based not on market efficiency, but on the simple inability of investors to “outpace the universe of investments in which they operate.” He also reminded his readers that the excess returns earned by good managers “must inevitably” be offset by the poor returns of bad managers.
Ninth is what he called the “The Triumph of Investing.” Bogle wrote that indexing had become a success in the quarter-century before 1999, and its virtues were being observed in the academic community and in the financial media, as well as by investors such as Warren Buffett (Trades, Portfolio), Peter Lynch and Charles Schwab. In addition, he reported nearly all the major no-load fund complexes had begun offering index funds of their own.
Tenth and finally, Bogle pointed to several reasons why he expected indexing to continue its gains in the future. They included the possible advantages of: holding less or eliminating cash balances in equity funds, further reductions in index fund costs and portfolio turnovers might decline from what he called “current excessive levels”.
Summing up, in chapter five of “Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor,” John Bogle has offered advice about choosing index funds, as well as several reason for their previous and future outperformance.
Note: Although this article uses the second edition of the book, published in 2010, much if not all of the content in this chapter is based on the first edition published in 1999.
(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)
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