John Bogle heads the Bogle Financial Markets Research Center, a think-tank funded by Vanguard and located at the company headquarters in quiet Valley Forge, Pennsylvania. He is the founder of the Vanguard Group and author of several best-selling investment books, to name but a few of his extraordinary accomplishments.
I met Mr. Bogle before Christmas, and we sat down on the comfortable couches in his office and talked for over an hour. Looking festive in his red sweater, Mr. Bogle moved from topic to topic quickly and with ease. He spoke about investing, politics, life experiences, and his favorite historical figures with equal fervor. This is the first part of an edited version of the transcript, look for the second part later this week.
Q: What was the impetus behind your idea of the Federation of Long-Term Investors, and how are things progressing?
A: Not much has been going on lately; we had just one meeting earlier this year. I'm deeply concerned for our corporate community with the short-term focus in the market. Mutual funds don't hold stocks long enough to give a darn about corporate governance. Why would they? They're not even going to be holding the stock when the next proxy season comes around. So we have to get people in this industry who care, the people with a long-term horizon, to cooperate.
If the owners of stocks don't care about how the companies are governed, then who in God's name is going to care? So the idea is simply to organize long-term investors to speak up, but not to tell them what to say. I began the Federation of course with index funds, which are naturally very long-term investors, but I'm interested in other firms joining.
Many people I think are interested in the idea of the Federation but they're a little nervous about having their names associated with it because of all the conflicts we have in this business. People are also nervous about the potential negative publicity. So it's coming along slowly I'd say; maybe I haven't been the best leader, but it's also an indication of the truly awesome obstacles that have to be overcome simply to get [stock] owners to behave like owners.
Q: In your recent op-ed pieces, you've taken a strong stance in support of fund proxy vote disclosure and fund holdings disclosure. The fund industry generally is not in favor of more disclosure. And Vanguard, from what I've seen, appears to be against more fund holding disclosure because of the potential costs.
A: Frankly, the proxy vote issue mystifies me because I think my points which were made in my New York Times op-ed pieces are unarguable. I understand there are business issues here, but I don't see a business issue, because the fundamental relationship between agent and principal should override any business issues. Shareholders should know about relationships between the fund and corporate management. I'm disappointed that the president of the Investment Company Institute [the fund industry's main trade group], Matthew Fink, has opposed proxy vote disclosure.
Increased holdings and cost disclosure are positive things for Vanguard, partly because Vanguard is the low-cost provider. Yes, funds should tell shareholders how much they paid each year in expense ratio, both as a percentage and as a dollar amount. Shareholders are certainly entitled to know how much they're paying. Managers should also tell shareholders how the fund compared against whatever benchmark the fund is using.
The proposed way in which funds would disclose holdings is also a victory for Vanguard, because many of Vanguard's index funds own a lot of stocks. The new reporting requirement would involve a list of the largest holdings, and industry groups for the rest. All of the sudden our annual reports aren't so long, and that saves money.
Vanguard, like many other fund groups, reports a lot of information to the SEC and data providers like Morningstar every quarter. I just don't see the argument for why it would be expensive to make that information available to the public on a website.
||I like to get down to the facts; I like to get the logic and the theory straight. I guess I'm an apostle of common sense more than anything else.
Q: The mutual fund industry appeared to support more corporate disclosure after the accounting scandals. Now funds themselves are being pushed to disclose more information. Is this an opportune moment for more disclosure because it's at the forefront; should we strike while the iron's hot?
A: Sure, if you can find mutual funds that invest for the long term. If you're just trading a company I don't know how much you care about accounting standards. The average holding period of a stock in a mutual fund is eleven months. During the golden era of the fund business, annual turnover was 16%; now it's about 110%. The holding period was six years; now it's about eleven months. The industry has gone down the wrong road. I've been saying this for a long time - I don't understand why no one will take me on in a public debate about index investing. Is anyone really going to argue that the average investor can beat the market and more than offset his costs?
Q: Does it matter that most of the research on indexing has come from academic circles?
A: I don't think so. Indexing is so simple, and it really has absolutely nothing to do with efficient markets. What do we know? Some claim indexing doesn't work in the supposedly less efficient U.S. small-cap and international markets. Is there a way to violate the standard of gross return in those markets, while taking costs into account? Some claim it's easy to beat the market by 5% in small-caps. Is it possible to beat the market by 5% without someone else losing 5%? Of course not. Not every manager can win by 5% per year.
This industry has always had an anti-intellectual bias. It seems kind of funny, doesn't it? I'm not an intellectual, but I do have an intellectual bent. I like to get down to the facts; I like to get the logic and the theory straight. I guess I'm an apostle of common sense more than anything else.
Q: You mentioned the fund turnover figures from when you came into the business and the current figures. Did fund turnover balloon with the speculative market of the late 1990s?
A: Actually, it didn't. What we had when I first began , in very round numbers, was 16% annual turnover, sometimes as high as 20%. Then it roughly doubled in the go-go era, to around 35% to 40% in the mid-1960s. Then it didn't do very much until we got into the mid-1980s. Then it started topping over 100% turnover in 1987 and 1988. Then it drifted off for a while, but the last three years fund turnover has been over 100%. But the speculative bubble was just one of many factors. Part of the problem is the industry largely measures pretax performance, so managers could care less about taxes. Another problem is the move away from investment committees of the 1950s to portfolio managers - these "stars" who, truth be told, are comets. They illuminate the mutual fund world for a while and then they burn out, and the ashes drift down to earth! I really haven't found evidence of sustainability. Of course there have been some great managers - Peter Lynch, John Neff, and Bill Miller to name a few.
However, a fund's management changes every five years, according to Morningstar. Think about how many fund managers you'll have as a young person that invests in several funds! Is there any chance that you'll beat the market over long periods with that kind of manager turnover? You've got costs to overcome, tax inefficiency, fees, stock turnover, cash drag, sales charges - the list goes on. It's inconceivable to me how they will not fall short of the market by 2.5% to 3% per year.
But the point isn't that they will fall short every year, but rather that you do have in your hand a way to get the market's return with certainty with index funds.
Q: Is there a psychological barrier with indexing, in that it's decidedly un-American not to try to beat the market?
A: Sure, everyone wants to do better than the other guy, and hope springs eternal. But skill is a very hard thing to isolate in this business. The academics will tell you it takes 50 years worth of data to tell the difference between skill and luck. And even then you're not guaranteed certainty. And how many managers stick around for 50 years? Certainly not many. So to me the indexing argument is airtight. But it is boring - it's about as interesting as watching grass grow or watching an America's Cup race.
But what's going to happen, however slowly, is that people will get the facts. They'll be burned by their own experiences, and that's the one thing mutual fund investors are getting in this market. They're getting painful experience, and it's too bad they can't instead learn from reading one of my books or the others on indexing. Or by listening to Warren Buffett or Charlie Munger, who say you should buy index funds. These are not academics; these are men who have been tested in the crucible - the most respected investors in America, for God's sake. How many people have to tell you that? And you have the airtight math and theory to boot. People often ask me if my belief in indexing is shaken, but it's as strong as ever.
Q: Let's move on to your views regarding international investing. You've said the everyday investor doesn't need international allocation because of the strong correlation between global markets, and also the costs associated with international investing. Have you changed that perception at all?
A: I believe the average investor does not need international. However, if an investor says he wants to put ten or twenty percent in international - I don't do it myself - I'm not going to jump up and down about that because it's probably not going to change things very much. In the long run it's reasonable to assume that international returns are likely to be similar to U.S. returns once you wash out the dollar. The problem with international is that 25% of all revenues and profits of all U.S. companies are international. So I don't think you're diversifying further.
Well, academics say the markets fluctuate differently, and that makes a big difference. I say anyone who wants to use reduced standard deviation as a reason for owning international has to be able to define standard deviation. If you understand that, then go ahead and invest in international.
But when markets fall apart, does international diversification help? Just when we need it most, international diversification lets us down. In this bear market the international MSCI EAFE index fell harder than broad U.S. indexes. What good did international do you? People like to use standard deviation as a measure of risk. But when it comes to international investing, I think risk should be defined by how risky the nation is. Is Mexico riskier than the U.S.? I say categorically yes. There's a lot of risk out there in international. Risk in international is defined by national stability, economic growth, culture, tradition, possibility of uprisings, and other things. So in my mind you're increasing the risk in a portfolio, not decreasing it as was your original goal. There's also currency risk in international investing.
People say hedge funds reduce risk because they fluctuate differently than stock funds. But you're taking a bigger risk - a hedge fund is a very risky thing. Are you really reducing risk when you buy riskier investments? Think about that.
International investing was very popular when I wrote Bogle on Mutual Funds . For years and years international had done better than U.S. stocks. But nobody paid attention to the reason - it was the U.S. dollar. The dollar can't depreciate forever; nothing can! After the book came out the dollar started to appreciate for the next decade, and the U.S. was the better market. I would guess that for a while now international would be better, so I'm less resistant to people investing internationally now. But that's a market timing issue.
If you're going to invest internationally, do it with index funds. Because the costs are higher, the trading costs are higher, and the expense ratios are higher. So you could say international index funds are relatively more valuable than domestic ones because of the costs associated with international investing.
Q: It seems that many investors start to look at picking a fund before they even decide on their investment horizon or tolerance for risk. Are we picking out the furniture before we even buy the house?
A: Well, in my house the furniture would be the same no matter what the house looked like. I would pick out a total stock market and a total bond market index fund; I just can't tell you how big the two of them should be. Think of the bond fund as your kitchen and the stock fund as your living room; you just have to decide how big each should be.
When it comes to asset allocation, there are no easy answers. I see nothing wrong with dividing your money evenly between a total market stock fund and a total market bond fund, and holding it forever. It may not be the highest-returning strategy, but the number of strategies that are worse are infinite. I still believe in my crude rule of thumb: Have your age in bonds, and the rest in equities. It's crude and it's silly in a way, but it seems to work pretty well.
Q: What are some situations where an investor might consider changing his or her asset allocation?
A: My own view is that we know so little and that our emotions often lead us in the wrong direction, so most successful investors block out their emotions. I have a very simple formula. Start with the 50/50 stock to bond allocation I mentioned earlier. If you're younger investor with less money, then increase the stock allocation. If you need income down the road, then increase the bond allocation because bonds provide income.
You also need to figure out your emotional stability. If you can't stand big fluctuations, then increase the bond allocation. So for example, if you're a young investor able to withstand the bumpy ride in equities and you don't need income, then 80% to 100% stocks is acceptable. Of course if you're an older investor with a sizable portfolio then you want to be more defensive with the majority in bonds.
Q: We're seeing new things in indexing like enhanced index funds, exchange-traded funds, and hedge fund index funds. Is it getting too complicated?
A: Sure it is. I gave a speech last year called "The Wisdom of Investment - The Folly of Speculation." The wisdom of investment is encapsulated in buying an S&P 500 index fund and holding it forever. That's the real grown-up intelligent indexing. Everything else should be compared to that. Now remember I started the first value and growth index funds, the first small-cap index fund, and the first balanced index fund.
I just didn't know how fragile those indexes were. For people who want small-cap exposure, it seems that a small-cap index fund would make sense, but unfortunately I haven't seen any small-cap indexes that I'm completely happy with. Vanguard went with the Russell 2000, but perhaps naively I didn't anticipate all the turnover. The same with the growth and value indexes with their construction. Every time Microsoft and Intel and Cisco go up, fifteen growth stocks then become value stocks [see note at bottom]. What happened to those stocks? Did they change? No, they didn't change! Then why are they leaving growth index and going into the value index? So Vanguard is working on finding the best indexes, because all this turnover isn't necessary.
Q: What are your thoughts on the tired total stock market vs. slice-and-dice debate?
A: I'm not at all satisfied with implementing a slice-and-dice strategy with index funds until we get the indexes fixed. As you probably know, a main proponent of a slice-and-dice strategy is Dimensional Fund Advisors (DFA). But to use one of those funds you typically have to pay 1% for an advisor on top of the 0.60% expense ratio the fund charges. So that 1.60% fee makes it at least tough to beat the market over long periods.
I don't like slice-and-dice because the investor may be tempted to change allocations, for example large- or small-cap allocations, depending on what the market is doing. There's also more funds and more rebalancing involved, which further increases costs and taxes.
Q: Vanguard sells its funds directly to investors, while DFA requires that investors go through advisors. They're both passive fund managers, but they have different distribution philosophies.
A: It's an interesting psychological issue. DFA essentially educates supposedly naive investors on slice-and-dice. But what happens after a year or two when the investor become educated? Do these investors still need an advisor?
There's no easy answers. People say investors are turning to advisors because they've done so badly in the down market. I don't see any evidence that advisors have done any better. The same with brokers. Merrill Lynch introduced all these Internet funds at the peak of the market, and cost their clients about $2 billion. Who are these mighty Caesars out there?
Having said that, investors who are clueless obviously need help. They don't need help forever, but they can educate themselves with investment books that are out there. The important thing is to at least get started, and then continue learning.
Q: Your obsession with costs is legendary. For example there's a story that you wrapped up your leftover sandwich in a napkin to take home when you visited the Vanguard Diehards at a Morningstar conference. We just don't expect people in your position to do things like that. Where did this obsession come from, and how has it been ingrained so solidly?
A: I remember growing up during World War II, and how we ate everything on our plates simply because we knew people were starving in Europe. "Waste not, want not" was definitely the mantra at home. It was just the way I was brought up; money was not an easy thing to come by. I guess I haven't changed that much because to me saving money is just common sense.
Regarding the sandwich thing, I guess people might laugh about that, but why wouldn't I save it? What would be the point of throwing it out? Logic is on my side in this case, just like it is with indexing. [Laughs]. I just can't violate who I am, and I know who I am at this point in my life. It becomes part of your character.
Q: Speaking of character, you have a new book out: Character Counts.
A: The book is really about Vanguard. I just wanted to publish several of my speeches in one book. It's sort of a reflection on my life and Vanguard, and it shows that I started out fiercely idealistic, and I've remained so.