Secrets of Success: Bogle's evidence: why index funds work

What are they doing to my baby? That is what Jack Bogle, the man who founded the world's largest index fund, wants to know.

What are they doing to my baby? That is what Jack Bogle, the man who founded the world's largest index fund, wants to know. It is a good question, and one that merits careful thought by anyone who has bought into the idea that active fund management is an alluring, but risky and expensive, way of building your wealth over time. The rise of indexing - the idea that it may be best to settle passively for certain but average performance rather than chasing less certain but potentially market-beating returns, has been one of the phenomena of the past 30 years in financial markets.

At the last count, in the United States, where the indexing revolution began, US equity index funds had some $550bn (£300bn) of investors' money, equivalent to around a sixth of all the money invested in equity funds on the other side of the Atlantic. They account for about one in three of the dollars that flow into the equity mutual fund business each year. The figures for the UK are not that different - and there are many more funds still that are "closet indexers", funds that charge you an active management fee but run portfolios that differ barely at all from the make-up of the market index.

The huge growth in indexed assets is not a bad outcome for a business that effectively did not exist 30 years ago, when Bogle persuaded his fellow directors at the newly formed Van- guard Group to establish the first commercial index fund. That fund, now known as the Vanguard 500, is today the largest single investment fund in the world, and has spawned thousands of imitators. As he rightly notes, the jury is in on whether indexing works: it does the job it sets out to do.

The reason it works is not always as clearly understood as it should be. Intellectually, the idea of an index fund has its roots in the work of the academics who trawled through data on past market returns and came up with the so-called Efficient Markets Hypothesis. This was conceived as a way of explaining the surprising but unavoidable empirical finding that even professional investors seemed unable to beat the market consistently over time.

The EMH has gone through refinements since it was first advanced, but the basic idea remains the same: namely that the current market price for a share faithfully reflects all currently available information that might affect its value. That is what makes it difficult even for professionals to outperform the market consistently merely by picking stocks.

The validity of the EMH remains contested today, the general view being that while it is broadly right, it does not hold all the time or in every market. But the key point is that it is a distraction from understanding the reasons for the success of indexing. You don't need to believe in the hypothesis to see why indexing works. To do that you need only look more practically at the things that make index funds different to actively managed funds.

The important point about index funds, properly conceived, is that they are well diversified funds with extremely low portfolio turnover and extremely low management charges. As an investor, you are gaining reliable exposure to the returns that the stock market has to offer while minimising the deductions that eat into the return of anyone who buys an actively managed fund. These costs, which typically take 2-3 per cent a year out of the investment return of the fund, are substantial and relentless and are the reason that investment funds in aggregate must underperform the market.

Bogle says we should ignore the EMH and concentrate instead on what he calls the CMH, the Costs Matter Hypothesis. There is a clear and direct correlation between the running costs of funds and their performance relative to the market. The higher the cost of a fund, the lower its chances of beating the market. That does not mean that individual actively managed funds with high fees cannot beat the market over time, but for the investor the probability of picking one that does are quite long odds against.

The chart summarises some of Bogle's evidence. It shows what happened to the 355 equity mutual funds that existed in 1970. Of these, fully 200 have since disappeared. Of the remaining 150 odd, about half failed to beat the market. Another 50 or so produced returns that were within plus or minus one per cent of the market. Forty three funds beat the market by more than one per cent per annum, and 23 by more than 2 per cent. Of the funds outside the central band, many more underperformed than outperformed.

What is notable, though, says Bogle, is that even the promoters of index funds don't always seem to understand how and why indexing works. Apart from closet indexers, there is also the problem of high cost index funds. They are a contradiction in terms. So, too, are some of the highly specialised index funds covering individual countries and sectors.

Bogle also has doubts about the new index funds known as exchange traded funds (ETFs). These are effectively funds that you can buy and sell like a share throughout the trading day. They are popular with institutional investors, but his question is: why would anyone want to trade an index fund as a speculative instrument? Low portfolio turnover is another of the legs on which the success of indexing depends, and you mess with it at your peril.

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