Jack Bogle is one of the great unsung heroes of our age. Together with Ingvar Kamprad of IKEA, Amancio Ortega of Zara and Michael O’Leary of Ryanair, Bogle has led the cost-cutting revolution which, over the last 40 years, has brought goods and services which previously were only available to the privileged few into the reach of the masses.
Bogle’s specific achievement is to have thought about, and later gone on to establish, the world’s first index-tracking mutual fund. Vanguard Index Trust launched in 1975 with $11 million from investors. Just over four decades later, the Vanguard Group has $4.5 trillion in assets under management. Its offerings have broadened since the early days, but the group remains largely focused on low-cost index and exchange-traded products.
The remarkable fact about Bogle’s insight is that it was sparked by an academic finding. From the mid-1950s, economists began to show interest in modelling and measuring the performance of the stock market. Leading lights of the profession theorised about the optimal way to invest, concluding that the goal must be to maximise returns and minimise risk (volatility). They then used the wealth of recorded stock-market data to measure performance against the benchmark suggested by theory.
The verdict was scathing: nine out of ten mutual fund managers failed to outperform the market with any degree of consistency. When fund charges were included, it became clear that ordinary investors were leaving a large share of their gains on the table and getting no skin in the game from the people managing their money in the bad times. It was a far from optimal state of affairs, ripe for market-based innovation.
Bogle’s solution, bolstered by university luminaries such as Chicago’s Eugene Fama and Princeton’s Burton Malkiel, was to acknowledge the hard truth that future market performance couldn’t be predicted, and to simply buy the stock market as a whole. The long-term returns of the worldwide capital stock wouldn’t only assure investor gains, but also mitigate volatility, since different stocks fluctuate in different ways.
The advent of the Vanguard Index Trust sparked a revolution. As of 2016, passive funds accounted for 40 per cent of all US equity mutual funds. Management charges for these products can be as low as 10 basis points of assets per year, putting a strain on traditional fund managers who typically charge 50-60 basis points. Competitive pressure has not necessarily translated into lower active fund fees (although the past decade saw a small decrease). But the combination of steady capital outflows since the late 1990s and a renewed focus on fund performance have made active managers nervous.
It should not be surprising, then, that passive funds have lately faced a backlash, in the form of allegations about the deleterious impact that their spread might have on market efficiency. The power of markets, critics point out, is their ability to bring out and transmit new information about consumer tastes, changes in supply and demand, and the state of individual firms. This price discovery, however, depends on investors actively looking out for new opportunities and threats: without the capital markets’ watchful eye, bad firms will remain in business and good firms will have fewer funds at their disposal than would otherwise be the case. Index funds, according to this argument, make the market less efficient by simply tracking whatever other players decide is good.
It is said that institutional investors such as Vanguard do not speak up against bad management, delaying change within firms which would benefit shareholders and society as a whole. Furthermore, recent research has suggested that diversified investment of the sort conducted by passive funds may impair competition: the argument being that, if one owns all airlines (say), one has no interest in any single airline beating the rest. By competing on price, any of the airlines would lower its own profits and in the process eliminate its rivals. The impact for a diversified investor would be unambiguously bad.
Latterly index funds have also faced criticism for their supposed ethical ambivalence. Portfolio theory calls for investment in the broadest possible portfolio: buying the whole market is efficient. But this includes tobacco companies, gun manufacturers, diamond miners and other lines of business distasteful to some people. Activist groups have called for passive funds to divest away from these activities, placing them in the awkward position where good financial stewardship means bad public relations.
But these criticisms miss the point. Price discovery is only useful to the extent that it justifies its cost. If tracking the market, free-riding on other people’s research and insights, is cheaper than doing one’s own (imperfect) scouting for new information, then passive funds are the way to go. On the other hand, if an active manager has truly valuable information, the market will reward it in the form of higher returns: investor capital will flow in. The point of passive management is precisely the idea that not all active management is useful. Too many people are picking stocks without either success or any gain to wider society.
The argument also applies to the criticism about the competitive impact of index funds. Sure, we can envisage a scenario in which a passive investor would not want rival firms to work too hard to outbid each other. But is there any doubt that an entrepreneur with a good idea to challenge incumbents would not, in a market with free entry, be able to secure the funds required? The recent history of disruption certainly suggests otherwise. Moreover, the unavoidable fact about index funds is their promiscuity: momentary success is rewarded, and if that success is underpinned by innovative disruption that consumers like, then the shift in loyalties by passive funds will be permanent – until the next disruptor comes along.
As for the contention that passive funds shouldn’t invest in “bad” firms, the answer is clearly to let markets sort it out: those who have ethical objections to certain investments should pay the price in the form of lower risk-adjusted returns on their (narrower, less diversified) portfolios. Those who are more relaxed about the cigarette and weapons industries will reap higher gains, but the firms deemed bad by some of the public will also bear a higher cost of capital. Everyone will thus put their money where their mouth is. No cheap talk allowed at someone else’s expense.
There has lately been too much hand-wringing over passive investing: the basic truth is that their value proposition is not passive investment itself (passive is only better than active some of the time) but rather cost-cutting. No longer can active managers get away with shoddy performance at exorbitant prices, there being no available alternative. The alternative is here and readily accessible to retail investors. It is to relax about stock-picking and just buy the market.
But, if active managers can get their act together and offer reasonable performance at competitive fees, then their contribution in terms of price discovery, contrarian thinking and defiance of established wisdom will be richly rewarded. That is the history of investment legends such as Peter Lynch, Warren Buffett and Howard Marks. Consistently good performance is a scarce item and investors are happy to pay for it.
When Ryanair began to seriously eat away at flagship airlines’ market share, pundits predicted the end of leisure travel. All frills would vanish, with passengers condemned to noisy flights in tacky planes with stewards constantly pestering them with lottery tickets and duty-free items. Some passengers have, as it happens, decided that is a happier state of affairs than flying on overpriced and strike-prone Air France, or not flying at all. But many flagship airlines have adapted and thrived, both by expanding their lower-cost offerings and by improving their service to premium travellers.
So it will be for active managers. The fittest shall survive.