John Bogle

Memo to Pimco: Don't Mess with St. Jack!

John Bogle

Those of us who follow the financial media have been treated to a verbal slugfest featuring the Father of Retail Index Funds, Jack Bogle, going against Pimco Managing Director James Moore.

It began with Mr. Bogle stating that Pimco investors who had chosen to withdraw their funds in the wake of the departure of Bill Gross would be better served in a bond index fund rather than searching for the next bond king. Bogle claimed that the case for bond indexing is just as strong as for equity indexing. The overall performance of actively managed bond funds appears to support Bogle’s claim. The S&P Dow Jones Indices SPIVA Scorecard for mid-year 2014 showed that 59% of 1,223 actively managed bond funds underperformed their benchmark for the five years ending 6/30/2014.

Mr. Moore came out swinging with an article on Pimco’s Website titled, “Sorry, Mr. Bogle, But I Respectfully Disagree. Strongly.” He enumerated five reasons why the arithmetic of active management (that the average active investor loses to the index by the amount of his costs) “does not work out as cleanly in the bond world.”

1)      The variety of investor objectives other than maximizing total return

2)      The mechanics of bond index construction

3)      The importance of the new issue market for bonds

4)      The predominance of over-the-counter transactions

5)      The highly skewed return on individual bonds versus stocks

In fairness to Mr. Moore, his response was intelligently written and conveyed several valid points, beginning with the wide array of objectives of different bond investors (both individual and institutional). He also noted the far greater degree of difficulty in constructing a bond index vs. a stock index as well as the much lower degree of liquidity in the bond market. Lastly, as we have noted many times, bonds have a highly negatively skewed return. If you don’t get the payments that were promised, look out below! If an active manager can indeed identify bonds that are less likely to default or be downgraded, then value can be added relative to the benchmark. Moore identified other ways of adding value such as “prudent use of derivatives as substitutes for cash bonds, understanding mis-valued imbedded options due to policy or regulatory factors, etc.” Moore closes his arguments with this statement which essentially validates the findings of Dow Jones S&P Indices mentioned above.

“The key question for investors is, ‘Do I have strong reason to believe my active managers will add value in excess of their fees?’ I would not argue that all do or even that majority do, but those managers who understand and exploit the five reasons I list, plus a host of other, stand a very good chance.”

Of course, Moore does not offer a method for identifying these successful active managers in advance, but the absence of such a method is already implied in investors’ having to take a chance.

Bogle’s response to Moore was simple and direct: “Pimco executives need only look at the firm’s own performance if they want a lesson in the perils of active management.” Bogle pointed to Pimco’s Total Return Fund (now at $202 billion vs. $222 billion at the time of Gross’s departure), stating that it has lagged its benchmark for three of the past four years and has lost about 30% of its assets under management over the past 16 months, according to Morningstar. As Bogle summarized it, “Pimco has been pretty good, but they also have reverted to the mean.”

Bogle demolished the idea of standing a very good chance when he retorted, “If you want to stand a good chance, go to Las Vegas or something. If you bet on red or black, you stand a superb chance of winning. It just happens to be below 50%.”

Bogle accepted a few of Moore’s points such as the variety of investor objectives other than maximizing total return but he disputed others such as trading costs which he maintains would be minimized by bond index funds. Regarding the negative skewness of bond returns, Bogle stated that since both active and passive are equally subject to it, investors would be better off paying the lower fees of passive. Ever the good sport, Bogle conceded, “He did make some good points, I’m trying to be fair. There’s some truth but not enough to verify the basic thesis.”

If we at Index Fund Advisors were the judge of this fight, we would have to declare Bogle the winner, but in fairness, we are not unbiased.