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Monday, 29 June 2009

Jack Bogle and the Bogleheads

Bogle's Folly

Back in 1946 Ben Graham, doyen of value investors, opined thus:
"Furthermore, there is nothing to prevent the investor from dealing with his own investment problems on a group basis. There is nothing to prevent the investor from actually buying the Dow-Jones Industrial Average, though I never heard of anybody doing it. It seems to me it would make a great deal of sense if he did."
It was to take another thirty years before Graham’s "great deal of sense" was heeded when Jack Bogle set up the Vanguard Fund tracking the S&P500. Bogle’s contention was that by keeping costs down, avoiding unnecessary transactions and avoiding the behavioural biases associated with active trading an index tracker would outperform the majority of active funds over time.

Unsurprisingly the fund industry labelled Vanguard as “Bogle’s Folly” and "UnAmerican". Funny guys . Who's laughing now?

Mutual Fund Survivorship

By and large he’s been proven right. We can only see this with hindsight – picking the winners in 1976 was like trying to pin a tail on a gazelle at night in the fog. As Bogle’s own figures relate, many of the active funds from way back have gone mysteriously missing. Out of 355 mutual funds he was tracking 237 have vanished, killed off by the fund managers when their returns failed to meet marketing expectations, while a mere 22 have beaten the market. In real terms only 6% of those funds beat the market but if you calculate on a survivor basis it looks like one in five funds outperformed. Remember that there are lies, damned lies and historical mutual fund returns.

Bogle’s approach and forthright views have justly earned him a devoted following, known as the “Bogleheads”. The Bogleheads even have their own forum (www.bogleheads.org). Unlike most internet bulletin boards it comes with a built-in filter for the off-topic, opinion based rubbish that fills up most sites. That’s not to say it’s perfect, but you know what you’re getting and you can be pretty sure that half-assed logic will be dissected for what it is.

Mad Markets Make For Inefficient Trackers

Opponents of index tracking by market capitalisation point to the weaknesses of the approach. There are occasions when even the major markets go mad, when behavioural biases start to dominate and the herd effect leads to unsustainable highs and unconscionable lows. At these points tracking by market capitalisation will overweight the wrong stocks – ideally you wanted to avoid buying technology stocks in 1999 and you want to avoid buying relatively riskless stocks right now.

Adherents of market capitalisation based index tracking can argue that they’re following Charlie Munger’s dictum – “markets are efficient, most of the time”. By ignoring the extreme swings of the mood pendulum standard index tracking will, over time, turn out all right because markets will eventually return to equilibrium. What goes around comes around.

Others, though, suggest that the approach ensures that what you lose on the roundabouts you also lose on the swings. We’re not talking about the return obsessed active fund industry either but respected analysts like Eugine Fama, James Montier and Rob Arnott. They believe that it’s possible to capture some of the gains to be made during the market’s periodic manic-depressive phases without taking on the extra risk normally associated with active management.

Montier on Bogleheads

Montier, a renowned opponent of standard fund management approaches, is particularly scathing on market capitalisation weighted index tracking. He argues that most index changes actually reduce investor returns, making the average indexer effectively a momentum investor calling upon a paper by Cai and Houge entitled "Index Rebalancing and Long-Term Portfolio Performance". In Montier's words:
"It focuses on one of the misnomers of investing, that index investing is passive. This simply isn't true. Many indices are relatively actively managed. In fact most indices are really momentum players effectively adding stocks that have done well and deleting stocks that have done badly. This raises the question as to whether this 'active' element adds or destroys value. That is to say would you be better off if you ignored the index changes made by the index setters?"
What Cai and Houge show is that a buy and hold portfolio outperforms the periodically rebalanced Russell 2000 by 2.22% per year, which is a hell of a lot when compounded over time. Which begets the question – so what? Most Bogleheads can figure out that there’s an in-built element of underperformance in index trackers but they have no way of capitalising on it which doesn’t involve massive extra costs thus negating any advantage. In fact, of course, the Russell index is an odd one to choose anyway, focussing as it does on small caps. A broad based large index would be a more obvious choice for most investors and would suffer less from churn.

Even so, adherents of fundamental indexing such as Fama and Arnott – who believe that market capitalisation is simply an artefact of indexes which causes unnecessary underperformance – reckon that there are ways around this problem. By indexing on value based fundamentals they expect to safely outperform market cap weighted index trackers.

Bogle Bites Back

Unsurprisingly Jack Bogle disagrees. In a typically forthright response, "Turn on a Paradigm?", co-authored by Burton Malkiel, he argues that fundamental indexers are using the rear-view mirror as a basis for future navigation, a driving technique not recommended outside of Cairo. History is full of backtested approaches that worked right up until they were tested in the real markets when they promptly and ingloriously fell over.
"Eugene Fama and Kenneth French have suggested that higher returns can be generated by indexed portfolios of stocks with small capitalizations and low price-to-book-value ratios. Robert Arnott has argued that a better method for indexing is to weight the stocks in the index not by their total capitalization, but rather by certain "fundamental" factors such as sales, earnings or book values. Jeremy Siegel has proposed that the "fundamental factor" should be the dividends that companies pay. These analysts have all argued that fundamentally weighted indexes represent the "new paradigm" for index-fund investing. Are they correct?

We think not."
If fundamental indexing succeeds it must almost certainly do so at the cost of greater volatility. Although value based investment strategies have been shown to provide better returns over long periods – probably because of behavioural issues where investors overpay for growth stocks and ignore value stocks – they can also underperform for significant periods, which is will likely mean that many investors are unable to stand the pain.

One of the great beauties of market cap index tracking is that it involves little psychological trauma over and above that associated with investing in stockmarkets. A lot of active investor underperformance come from ritualistic self-harming, chasing winners and cutting losers. Artificially anchoring and measuring performance against the index return is an irrelevance for Bogleheads.

The End is Only The Beginning

Jack Bogle is now 80 and has heart trouble, which means he may not be around too much longer to dispense his pithy version of investment logic. He’ll probably take great pride in the fact that those who’ll most celebrate his demise are the adherents of active management. However, it’s unlikely that the Bogleheads will be going away anytime soon because, for the vast majority of people, a simple index tracker is the best and most logical investment they can make.

Not a bad legacy.


Related Posts: Fundamental Indexing Can't Save You From Aliens, Markowitz's Portfoilio Theory and the Efficient Frontier, The Rediscovered Ben Graham, Survivorship Bias in Magical Mutual Funds

5 comments:

  1. The problem with weigthing by price, as conventional trackers do, is that the more the price goes up the larger the weighting. So ordinary trackers are always overweight expensive shares.

    Consider a market that has earnings of £100m and is valued at a PE of 10. Assume half the market has a PE of 11 and half a PE of 9. Weighting by price means that £550m is invested in the half of the market valued at 11 times and only £450m in the chunk valued at 9 times. That means the average PE of the portfolio is 10.1.

    The investor ends up paying a premium for the market. Using a fundamental measure means you buy earnings not value and that gives a value tilt to the portfolio.

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  2. As Warren Buffet said: "Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb.

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  3. Bogle started a revolution in middle-class investing. He offered us dozens of important insights. But I believe his legacy will be mixed. He is the biggest advocate of the idea that there is no need for an investor to change his stock allocation when prices go to insanely dangerous levels. That idea has already led to the greatest loss of middle-class wealth in the history of the United States and has brought the world's strongest economy to its knees (our failure to lower our stock allocations when prices went insane produced the price bubble, which caused the stock crash).

    The Bogleheads.org board is a great board. I link to it regularly at my site. But I see irrationality in evidence there on the valuations question on a daily basis.

    I believe that Bogle's ideas take us halfway to where we need to be. The question today is whether he and his followers will work up the grace to make the changes needed to get us the rest of the way home or will stick stubbornly to efficient-market-theory ideas that I think can fairly be said to have been discredited years ago by the academic research.

    Rob

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  4. It is certainly true that price-weighted trackers are overweight expensive shares. So the argument proceeds: let's adjust the weightings to allow for that. The presupposition is that you know (or can calculate) which shares are the expensive ones. Good luck. The market can remain "irrational" longer than you can remain "right".

    ReplyDelete
  5. Bogle started a revolution in middle-class investing. He offered us dozens of important insights. But I believe his legacy will be mixed. He is the biggest advocate of the idea that there is no need for an investor to change his stock allocation when prices go to insanely dangerous levels. That idea has already led to the greatest loss of middle-class wealth in the history of the United States and has brought the world's strongest economy to its knees modelleri fiyatlari(our failure to lower our stock allocations when prices went insane produced the price bubble, which caused the stock crash).

    ReplyDelete