5 February 2019

Index fund pioneer Jack Bogle was a hero of popular capitalism

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Many politicians are sceptical that competitive markets can effectively protect consumers. They think that, in the absence of government intervention, private firms will prey upon gullible customers.

The lifework of Jack Bogle, founder of investment fund giant Vanguard, belies politicians’ incredulity. Bogle, who died in January at the ripe old age of 89, made it possible for millions of ordinary people to become global capitalists. When he created the first retail stock index fund in 1975, Bogle supplied investors with an alternative to the promise from investment managers of potential outperformance at a high cost; namely, a guarantee of earning the market return at a low cost.

Perhaps surprisingly, Bogle’s innovation was born in the seminar rooms of university finance departments. Economists – with rare exceptions, such as David Ricardo – typically make lousy investors. Irving Fisher, grandfather of modern finance theory, famously announced that stocks had reached “a permanently high plateau” – in 1929. He lost a fortune in that year’s market crash.

Index funds, on the other hand, went from academic journals into the Wall Street Journal. It all started in 1952, when then-doctoral student Harry Markowitz showed that diversified investment could maximise investor returns for a given risk appetite. Then, in the 1960s, Gene Fama at the University of Chicago argued that stock prices were unpredictable, and that any investment strategy based on using past information to anticipate future prices was doomed to fail. Owning the whole market was more advisable than attempting to pick individual stocks. Subsequent studies into fund manager performance revealed that more than 90 per cent of professional stock-pickers fail to consistently do better than the market in which they trade.

It fell to Jack Bogle, however, to bring these insights into the pockets of retail investors. Vanguard and its index-fund brethren took some years to catch on: as recently as 2008, passive funds made up just over 15 per cent of US equity assets, and 11 per cent of European equities. At the end of 2016, the slice taken up by index funds had risen to 45 per cent and 20 per cent, respectively. Vanguard currently serves 20 million individual investors. Its competitor Fidelity, another major index fund provider, caters to 27 million.

The value proposition of index funds is so simple, it’s no wonder stock-market luminaries failed to grasp its potential for so long. Instead of scrambling to achieve higher returns than the market – a zero-sum game since below-average performers must always offset above-average performers – index funds focus on lowering management costs. They do so in two ways: first, they forego the services of highly trained (and remunerated) equity analysts; second, index funds reduce transaction costs because the absence of an active strategy means the fund needn’t get in and out of trades as market circumstances change.

So, how much money have index funds saved retail investors? Consider that, in 1996, when passive management was a tiny portion of all fund management, the average actively managed mutual fund charged 1 per cent in management fees; that is, just to hold her assets in an active fund, an investor paid 1 per cent of their value to the manager. At that time, an average index fund charged 0.3 percent. In the 21 years to 2017, active fees have dropped to 0.78 percent, while passive fees declined to 0.16 percent.

Let’s assume the assets put into passively managed funds roughly doubled every five years between 1996 and 2017, and that 80 per cent of that money would instead have flowed into active funds as the next-best alternative in the absence of index fund options. Given that index funds held $6 trillion worth of equities as of 2017, passive investment saved investors around $300 billion in fees. That number excludes the downward pressure that index funds have put on active manager fees. It also excludes the hundreds of billions of dollars in additional returns index investors earned on the money they didn’t spend in fees. In other words, Bogle’s revolution, over the last twenty years, has yielded cost savings larger than the current GDP of Chile.

The point is not to argue for passive index funds or against active management. There are many people who believe that fund manager strategies will deliver superior results, for which they are willing to pay. Recent research also suggests that active management can outperform index funds, especially for institutional investors such as pension funds. The point, however, is that Bogle’s innovation has made all investing cheaper and more transparent.

In this way, index funds have made a major contribution to investor protection, a task that many people assume only regulation can perform. Consider that consumer protection typically has three objectives: to ensure consumers are adequately informed about the decisions they make; to deter and pursue fraud and deception; and to promote competition and choice, so that consumers, over time, have access to higher-quality and lower-cost products.

Index funds have made strides on those goals since Bogle founded Vanguard. They have increased the information available to investors on the cost of investing and the cumulative impact of paying high management fees. They have also made it more difficult for underperforming fund managers to attract investment, since they must explain their results by reference to a benchmark that dissatisfied investors can readily buy. Index funds have thereby increased transparency on fund manager performance.

Finally, index funds have not only expanded the range of investment options available, but the margins on which funds compete: it’s no longer just about promising high returns, but also about offering attractive fees. Vanguard itself felt the heat when Fidelity launched four zero-cost funds in 2018.

Some academics and regulators now worry about the impact that the rapid growth of index ownership might have on competition between firms that are all owned by the same funds. They also wonder if massive index-fund ownership might increase market “noise” – that is, stock price fluctuations unexplained by economically significant events – and induce greater volatility. The first fear is a matter of hot debate, but the evidence so far is inconclusive. As to concerns about noise and volatility, it may be that index funds magnify price spikes and drops because they trade in the market as a whole, without looking at whether individual stocks are fairly priced. But, because many index-fund owners buy not to speculate but to hold over long periods, index funds can also be a source of market stability. At any rate, mistakes by unthinking index buyers will be a profit opportunity for active managers. Together, active and passive funds can usher in a world where equity ownership is cheap and markets are efficient.

There’s no telling whether index funds will continue their relentless growth in the future. But, by bringing to the masses one of modern finance’s most momentous innovations, Jack Bogle set a record of helping ordinary investors that government regulation can only hope to match.

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Diego Zuluaga is a policy analyst at the Cato Institute’s Center for Monetary and Financial Alternatives.