An interview with John C. Bogle
this means is if the market had a 10% return over a long period of time, and you had costs of 2% year after year, you would eventually have a return of 8% unless your managers could beat the market.
In other words, you’re getting 80% of the market’s annual return. If you compound that over time – just take 8%
and 10% on a 25-year table; it’s easily calculable – you probably end up with barely 60% of the final value of someone who earned the full 10%. That’s how much that 2% cost you.
Commonfund Then how can an endowment beat that cost trap?
Bogle Well, let’s compare that with an indexing strategy.
An all-market index fund will virtually guarantee you 98%
or 99% of the market’s annual return, depending on the cost structure of the fund. By contrast, you’re very close to guaranteed that a random selection of managers would produce 80% of the market’s return. Why, then, would you take that long shot, trying to get more than 100% of the market’s return?
In fact, if you put all the managers together, you can gen- eralize that all investors are by definition going to get the market return before costs. And after costs they’re going
of their costs. There is no argument about this thesis.
Gross return minus cost equals net return.
In this sense a very important fact emerges: in the long run investment success is determined by the division of market return between the intermediaries and the investors themselves. There is no way around it.
There may be a way around it for A, but if A can beat the market by 1% after costs of 2%, then B or C is going to lose by 3% plus costs, or 5%. Plus 1% for manager A;
minus 5% for manager B. It’s asymmetrical, and there’s just no way around it. All investors can’t possibly out- perform the market.
Commonfund In the face of these facts, what mistakes do trustees make, generally speaking?
Bogle First of all, they pay far too much attention to past performance. Good performance rarely perpetuates itself.
If you’re investing for a lifetime, managers are going to come and go. Use a strategy that’s good forever, not just a manager that’s been good in a given past period.
Second, I think they spend too much time on manager picking, looking over people who are, of course, all smart, attractive, articulate and well-dressed, the kind of people, as Warren Buffett says, you would love to have as your
“All investors in aggregate fall short of the market’s return by the precise amount of their costs.”
V ie w poin t s
But the fact of the matter is that it is very difficult for anybody to get a sustained edge; securities markets are highly efficient. I do want to add, however, that market efficiency is not required for the system I’ve described to work – only that investors as a group must fall well short of the market’s return.
Some sectors of the market – say, small caps, or interna- tional – appear to be less efficient than large domestic stocks. But in any of those markets, efficient or inefficient, all investors, in aggregate, still get the market return minus costs. There is simply no way around it. And the evidence is powerful. Very few investors can beat the market. It’s said that 40% of investors do it. In the long run, it’s probably more like 5 or 10%.
Commonfund So, I take it that your basic recommenda- tion to trustees is to index, if you want to contain those costs.
Bogle That’s right, using a broad market index. But, you know, I’m a realist. Everybody says indexing is boring; it’s like watching paint dry. If you maintain a belief in active managers, I say go ahead and use some, but have the core of your portfolio indexed. And then see if the managers can beat it. We often give managers credit for achieving
high returns without ever asking ourselves whether the returns are higher than we could have gotten by just own- ing the market.
Then, we hear a lot of questions about which index to use.
But it’s a non-issue. The main body of the portfolio should be in the entire U.S. stock market, including large cap stocks, and mid cap stocks, and small cap stocks – the whole gamut.
Now, is the Standard & Poor’s 500, which contains only large cap stocks, a bad substitute for that? No, it’s a good substitute, because in the long run the S&P will mirror the returns of the total stock market. So I wouldn’t advise anybody that’s happy with the S&P 500 to abandon it for total-stock-market indexing. But I think the truth of the theory is that owning a total stock market is the way to go.
Commonfund What about international?
Bogle I happen to believe it’s unnecessary to own inter- national stocks. Many respected people disagree with me;
in some cases, they disagree violently. My advice happens to have been the best advice during the past decade. But international did much better in the decade before that, when Japan was in its heyday. In the long run – and that’s what’s important to an endowment fund – I don’t believe international will add value.
“Have the core of your portfolio indexed, and then see if the managers can beat it.”
International creates a certain kind of risk without a demonstrable ability to enhance the end return. So I don’t think you need it. I also rely on the fact that U.S. stocks get about 25% of their profits from abroad. U.S. companies are, by and large, global companies, particularly the large ones that dominate the index.
If you want to use international, consider international index funds. They offer even greater advantages than a domestic index offers relative to U.S. managers, because fees for running money abroad tend to be higher, and transaction costs tend to be much higher. If you want to put some of the portfolio into international, I recommend no more than 20% of equities.
Commonfund How does the average trustee at a midsize school get a handle on this? There are trustees who are not financially sophisticated.
Bogle I would say, make sure that your Investment Committee has a reasonable level of financial sophistication.
Recruiting such trustees from your alumni body is an important part of this.
Also, there are some good consultants out there that academic institutions use. The problem is that consultants generally don’t agree with the indexing theory. Consultants that recommend indexing would have a very short-term job.
And the consultants themselves are a cost. If the educa- tional institution has, let’s say, a $50 million portfolio,
$200,000 a year is about what it’s going to generate in a combined portfolio of stocks and bonds. And a $10,000 fee is going to be a big hunk of that. All these fees add up.
Charlie Munger, Warren Buffett’s partner, once gave a very persuasive speech to endowment officers, in which he said just what I’m saying to you – that the croupiers take too much out of the system.
Beating the stock market is clearly a zero-sum game before costs. Every purchase that you make is a sale for someone else. After cost, the stock market, like the gambling casino, is a loser’s game. When you talk about croupiers and financial intermediaries alike, you’re talking about costs. Cost matters!
“After cost, beating the stock market, like a casino, is a loser’s game.”
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A roaring bull market, which glamorizes the investment process, can make a seat on a school’s Investment