Interview: John C. Bogle
If you can’t beat the market, be the market: That’s the logic behind index funds. More than 30 years ago, John Bogle set up shop to help investors capture market returns at minimal cost. He had realized a quarter-century earlier that complex mutual fund investing strategies don’t consistently outperform market returns.
Even Bogle’s detractors have had to admit that the wisdom of his investing model has been borne out by time. Somewhat uncomfortable in his status as a present-day folk hero, Bogle remains an ardent defender of the common investor, and his zeal shines through in his 2007 book, “The Little Book of Common Sense Investing,” published by John Wiley & Sons.
Hometown: Valley Forge, Pa.
Education: Magna cum laude economics degree from Princeton in 1951
- Founded Vanguard in 1974
- Voted one of the “world’s 100 most powerful and influential people” by Time magazine in 2004
- Institutional Investor’s Lifetime Achievement Award (2004)
- Named one of the investment industry’s four “Giants of the 20th Century” by Fortune magazine in 1999
- Received the Woodrow Wilson Award from Princeton University for “distinguished achievement in the Nation’s service” (1999)
At age 80, the founder and former CEO of The Vanguard Group is still going strong. When he’s not traveling to teach at a college seminar or to deliver a speech, he works 60 hours a week running Bogle Financial Markets Research Center, a unit of Vanguard that’s funded by the company. His latest book, published in 2008, is “Enough: True Measures of Money, Business and Life.” He took time out of his hectic schedule to talk about investing with Bankrate.
History of the index fund
You wrote your senior thesis 55 years ago on index funds. Did you understand their potential back then, or have you been surprised with the developments since you founded Vanguard in 1974?
It was just a thought that I had in my thesis, not about index funds, but about outperforming the market by managed funds. I’m quite happy I wrote it down, this little kid, one year out of his teens. In that thesis, I wrote: “Mutual funds may make no claim to superiority over the market averages.”
We didn’t have as much data as we do today, but I looked at performance of a great number of funds and found that they couldn’t beat the market. That was the seed that was planted that by 1974 had burst into flower when I created the first index mutual fund.
Simplicity is key
What is the most important piece of advice you have for someone who is new to investing?
Rely on simplicity; own American or global business in broadly diversified, low-cost funds.
Do you think the average person could safely invest for retirement and other goals without expert advice — just by indexing?
Yes, there is a rule of thumb I add to that. You should start out heavily invested in equities. Hold some bond index funds as well as stock index funds. By the time you get closer to retirement or into your retirement, you should have a significant position in bond index funds as well as stock index funds. As we get older, we have less time to recoup. We have more money to protect and our nervousness increases with age. We get a little bit worried about that nest egg when it’s large and we have little time to recoup it, so we pay too much attention to the fluctuations in the market, which in the long run mean nothing.
Switching to indexing
Should people who do not currently hold index funds sell their actively managed funds and move the money to index funds, or should they hold those and start investing their new money in index funds?
A lot depends on the kinds of funds they own. We’ve got an industry that makes life very complicated for investors because we’ve got dozens of different types of funds, different investment styles, different market capitalizations, specialty funds that are in telecommunications, gold, technology or whatever it may be, and a whole variety of international funds, including some that invest in just a single country. The more concentrated those investments are, say, in a single country or a single industry, I’d say the answer is generally yes, move to an index fund — but watch out for taxes. If the funds are in your retirement plan, you can ignore taxes, but if they’re in your own account, you want to take into account the tax cost involved.
Another factor to consider is how much it’s costing you. The record is very clear: High-cost funds do considerably worse than low-cost funds. How could it be otherwise?
Think about diversification when you’re deciding what to do, and think about cost.
Costs add up
That brings me to my next question. You’ve made the point time and again that costs dramatically impact investor returns. No-load funds are preferable to load funds, naturally, but how important is the expense ratio?
Let’s take the question a little bit differently, if I might. There are three costs that are involved in mutual funds. The one that we talk about the most and the one that is the easiest to calculate is the fund’s expense ratio. That averages about 1.5 percent for an equity fund and about 1 percent for a bond fund. That’s a heavy drain on your returns, unless the money manager has superior ability, which over the long term very few do. People look good in the short term and then they fade in the long term. Working with low-expense ratio funds — as I call it, fishing in the low-cost pond — is one way to make sure your returns are improved.
There’s a second cost that we don’t pay nearly as much attention to and which we don’t quantify very often, and that’s the impact of a sales commission — if you buy a fund with a load. For example, if the load is 5 percent, which is the typical load today, and you hold the fund for five years, that has cost you 1 percent a year. If you hold it for 10 years, it’s a half a percent a year. Think about three-quarters of 1 percent a year, the combination of those two, as cost No. 2 after the expense ratio.
The third cost is hidden, but we know it exists; we just don’t know exactly how large it is. That’s the portfolio turnover cost. Mutual funds turn over their portfolios at an astonishing rate, averaging about 100 percent per year. By my estimates, any fund that turns its portfolio over at that rate is costing you an extra 1 percent per year: a half percent to buy all those securities, including market impact costs, and a half percent to sell them. A 100 percent turnover means a billion-dollar fund buys a billion dollars’ worth of stock and sells a billion. That’s our definition of 100 percent, but that’s $2 billion of transactions. You have to take into account that cost.
If you find lower-turnover funds, and very few funds turn over at lower than 30 percent per year, you’re talking about not 1 percent per year, but about a three-tenths of 1 percent cost per year. In other words, the turnover rate with the decimal point moved over two places (0.003). So 100 percent turnover would cost 1 percent roughly. And a 30 percent turnover would cost three-tenths of 1 percent. So let’s call it an average of seven-tenths of 1 percent per year for portfolio turnover.
So adding costs together, we have a 1.5 percent expense ratio, if you’re paying a sales commission, another 0.7 percent on average for a seven-year holding period plus another 0.7 percent for turnover costs if you’re average, so that adds up to roughly 3 percent. That’s an astonishingly high cost and investors are almost oblivious to nearly all of it, but totally oblivious to the second and third costs. We’ve got to pay attention, or as we say in “Death of a Salesman,” “Attention must be paid.”
I usually estimate total costs at 2.5 percent; if someone wants to argue that’s too high, say a minimum of 2 percent paid by the typical fund investor. If you don’t like my estimates, knock them down a little bit.
How much to pay
What’s the highest expense ratio that one should pay for a domestic equity fund?
I’d say three-quarters of 1 percent maybe.
For an international fund?
I’d say three-quarters of 1 percent.
For a bond fund?
One-half of 1 percent. But I’d shave that a little bit. For example, if you can buy a no-load bond fund or a no-load stock fund, you can afford a little more expense ratio, because you’re not paying any commission. You’ve eliminated cost No. 2.
One of the ironic things about this is if you want to eliminate turnover cost, the third cost I mentioned, it’s like rolling off a log — it’s the easiest thing in the world: Buy an index fund.
If you buy a no-load index fund, with an expense ratio of, say 0.15 percent a year, you’ve taken that typical 2 (percent) to 3 percent cost and reduced it by about 95 percent a year. And it’s there for the taking. In the long run it’s really quite certain, because the data show us that only about 5 percent of the managers will outperform the market over an investment lifetime.
Do you own any actively managed funds?
I’m largely indexed, 85 (percent) to 90 percent in my equity funds, but I’ve hung onto some of my, what I call “legacy funds” that I’d been investing in over the years that I was running Wellington Management Co. That would include Wellington Fund, Windsor Fund, Explorer Fund, Primecap Fund, other funds like that. I’ve owned them, and they’re going to give me more or less a market return because they’re very diversified, but that’s 20 percent of my funds and I don’t intend to change that.
I should say that on the bond side, in my retirement plan account, which is my largest investment — because I never owned Vanguard, which is sad to relate because I’d be a billionaire, multibillionaire — but I don’t own that, so my retirement plan is my largest investment, and in my personal account I own 100 percent municipal bond funds, which are very indexlike in their nature.
Money market investing
You have said that most people hold five different funds, and that people should hold equity index funds and bond index funds. How much, if anything, should people hold in money market funds?
In general I look at investing as having no money market funds. If you’re concerned about risk, you’re better off holding a short-term bond fund. While the returns will be a little jagged if you draw them on a chart, they’re upward about 95 percent of the time. Whereas a money market fund, if you put it on the same chart, will go in a straight line but will end up at a lower level, because that reduction in risk comes with a reduction in return.
When investing, do not own money market funds. In saving for your emergency reserves, yes, own money market funds. An important caution: Money market funds are pure commodities. What differentiates the highest- and lowest-yielding money market funds is cost. The correlation between high cost and low return or low cost and high return in money market funds is 0.99 — almost perfect. Avoid high-cost money market funds at all costs in your emergency account.
ETFs vs. index funds
We published a profile on Ben Stein in 2007, and he mentioned you. Basically he said that you might disagree as to which are ultimately better — index funds or exchange traded funds — but that he finds them equally attractive. You have been critical of ETFs. What don’t you like about them?
It is not the idea of ETFs that I find unpersuasive. After all, if someone wants to buy the Vanguard Total Stock Market ETF compared to the Total Stock Market fund directly, or to that point buy the SPDR, which is an S&P 500 ETF, compared to the Vanguard 500 (Index Fund), I don’t have a bone to pick with them. I would tell smaller investors who are dollar averaging: Don’t touch the ETF because every time you touch them, you pay a commission.
In fact, I wouldn’t buy the Vanguard ETF because you pay a commission. What’s the matter with that? The answer is nothing. So Stein and I are on the same square. What troubles me and troubles me deeply is: What are ETFs? They are index funds that you can trade all day and they are index funds you pay a commission on. Those two things strike me as a great disadvantage.
Trading is your enemy, because it’s based on emotion. People do trade them with great rapidity. So I have a problem with trading ETFs, which you are lured into doing if you watch the market all day long, and also, the types of ETFs we have.
(In 2007) there (were) 690 types of ETFs, and only 12 are broad-market ETFs, like the S&P 500 or the World Stock index or similar total-stock indices. That leaves 678 funds that are vehicles for speculating. Whether it’s in emerging cancer shares or the Taiwanese stock market, or the Nasdaq, those are speculative things to do. I can’t tell you they won’t work, but I can tell you that when you have a speculative instrument that you can trade all day long, I would bet an awful lot of money that you would be better off instead of doing a lot of trading over the next 10 years in those narrow, specialized, undiversified and, in terms of commissions, costly instruments — you don’t have a fighting chance of beating the kind of index strategy that I just described.
Investing for everyone
You were the first to introduce index funds in the form of mutual funds for everyday investors. Would you say that this was your greatest contribution to the investing public?
Vanguard 500 Index Fund is unequivocally the first index mutual fund. I don’t dwell on my contributions such as they may be to the investing public. I’ve tried to do my best to build a better world for the average investor and, for that matter, for pension funds and institutional investors, too. Central to that was the creation of Vanguard, which was and is the only truly mutual mutual fund organization.
The management company is owned by the funds. Its profits, running about $12 billion a year (in 2007), are largely rebated — 98 percent or something — to our fund shareholders in the form of lower expenses. Without that kind of structure, it would be very difficult to bring out an index fund.
We went no-load around the time the index fund was introduced. We then focused on being a low-cost provider in the mutual fund industry. And therefore following, when we became effective operationally in May 1975, the first thing on my agenda was to start an index fund, which depended on low cost to work. The chicken-and-the-egg is that Vanguard was the chicken, and the index fund, the egg. But which was the most important?
We’ve been the most innovative company in this industry. And, I would argue quickly, soundly innovative. I don’t give you points for innovation if you bring out an Internet stock fund at the height of the stock market boom in early 2000. That’s bad innovation. In terms of good innovation, I think it’s pretty clear we’ve led the way.