You Can’t Beat the Market: Jack Bogle’s Revolutionary Invention
For many people, “finance” and “innovation” are two words that can’t possibly mix well in the same sentence, unless it is to make a witty comment like the one made once by Paul Volcker, the former Chairman of the Federal Reserve: “Financial innovation peaked twenty years ago… with the invention of the ATM”. While the world of technology enriches our bourgeois lives with gaming consoles, smartphones, and self-driving cars, banks seem to bring to the party only boring interest rates, mortgage-back securities and power reverse dual-currency notes – hardly the matter to show off on Instagram.
Admittedly, innovation in finance doesn’t look that sexy, but when done correctly it has a huge positive impact in the life of billions of people – more than the one made by any gadget you could think of. The minds behind those inventions exhibit the same brilliance and genius as the ones you would find in science, engineering or medicine. Among them, Jack Bogle was one of the most prominent figures for the way he revolutionized investing and our relationship with money. Last month the finance community said farewell to this giant after he passed away at the age of 89.
Bogle has been described as an investor, author, philanthropist and entrepreneur, but most importantly as the inventor of the “index mutual fund”, a product of such beauty, simplicity, and usefulness that it could rival any of the creations of Steve Jobs. And just like Apple’s personal computer brought a revolution to the way we perceive computers, the index fund launched through Vanguard, the firm he funded in 1975, changed our minds on how to invest.
The business of managing other people’s money is notoriously difficult. Fund managers are financial experts always on the look for new ideas that can provide their investors with strong returns and resilience during bad times. The complexity of their jobs resides on the almost hopeless task of analyzing vast amounts of information for deciding what stocks or bonds to buy or liquidate from their portfolios. The pressure and responsibility on them are enormous, as a bad decision can jeopardize the hard-earned savings of their trusting clients. If they can show they have genuine skills though, they can charge for their efforts handsome fees.
In the mid-1970s Bogle concluded that the whole game of trying to figure out a way of beating the market was pointless and that instead, you could serve investors better by providing them cheap access to the full market. The recipe for building the best portfolio was encoded in the market indices, and the only thing you needed to do was to create a fund that could follow them closely.
An index is just a measurement of the cumulative performance of a specific collection of companies. Even if you don’t know anything about finance, you are surely familiar with the most famous one of all, the Dow Jones index, which sits up there in the pantheon of symbols of capitalism, together with Gordon Gekko in Wall Street, and the bronze bull sculpture near the New York Stock Exchange. The Dow Jones tracks the performance of the largest 30 companies in the US and has been live for 133 years, making it one of the oldest one around.
In 1976 Bogle launched a fund tracking the S&P 500, an index of the largest 500 companies in the US. The construction of this index was particularly well suited for making it the blueprint of a fund encompassing the market, as it is a cap-weighted index, meaning that the weight of each company is proportional to its size (a large company like Microsoft can currently represent 3.5% of the index, while the smaller Mattel Inc. only a 0.2%). Instead of going through hundreds of reports and metrics of all companies to decide in which ones to invest, Bogle would just need to buy shares in all of them, in quantities mimicking the ones given by the S&P500 – a lazy strategy that became to be known as passive investing.
The humble aim of the index fund was to accurately track the market, not making any promises of performing any better or worse, but on its launch, it was received with skepticism and contempt, with active investors labeling it as “un-American”, and “a sure path to mediocrity”. Returning the average returns of the market was unappealing and boring, and perhaps even dangerous: “Would you be satisfied with hiring an average surgeon to perform complex surgery, or would you prefer having the best?”, asked the detractors.
Bogle’s idea rests on two premises that have shown to be extremely difficult to disprove. The first one is that you can’t beat the market in the long run, which means that the task of putting together a strategy that could outperform a cap-weighted index of the broad market is futile. Depending on who you talk to, this statement can be quite controversial, but empirical studies have shown, over and over again, the incapability of the vast majority of traditional funds to keep sustained returns above the ones of the market.
In academic parlance, this concept is known as the Efficient Market Hypothesis, a fundamental pillar of theoretical finance. It roughly states that prices quickly absorb and reflect all available information, rendering their behavior in a random process impossible to predict. It’s not that you don’t want to have the best surgeon, is just that you can’t identify a priori which one is good and which one is bad, but by betting on an average one, you will do better than if you pick a random one. The Efficient Market Hypothesis is a deep and elegant theory that was well established by the 1970s in academic circles, so it is fascinating when you learn that Bogle hadn’t heard the first thing about it when he invented his fund.
The second premise of Bogle is that manufacturing an index fund is relatively easy and can be offered very cheaply to investors. These days you can get access to them with fees of 0.10% or even less, a full order of magnitude lower than traditional funds. When you measure the performance of investment strategies taking into account the costs, the index fund becomes an almost unbeatable contender.
Despite the many hurdles, Bogle stuck to his philosophy and his investment advisory firm, which evolved to become the largest provider of mutual funds in the world, with $5 trillion in assets under management at the moment of writing. Bogle opened the door for others to offer similar passive strategies, and now they account some 37% of all assets in US mutual funds. His challenge to the system resulted in a benchmark against which all strategies are measured, setting a bar so high that very few dare to beat.
Though Bogle ended up transforming the finance landscape with his invention, his goals were never pharaonic. He structured Vanguard as a mutual company, owned by its fund investors rather than by its executives and shareholders. Had he done things differently, he undoubtedly would have become one of the wealthiest men in the world. However, his ambition was not that one but rather to provide the small investor a good, low-cost product that they could use to increase their wealth a bit. Perhaps the best person to give a fair verdict of Bogle’s legacy is the ultimate hero of active investing, Warren Buffett, who wrote in one of his iconic letter to shareholders: “If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle”.