While there are many big names in the financial services industry, few individuals command the widespread respect and admiration enjoyed by John Clifton Bogle, known as “Jack,” who founded the Vanguard Group. Bogle died this week at age 89.
Vanguard’s own press release paints a clear and compelling portrait of the influential “inventor of the index mutual fund.”
“Mr. Bogle had legendary status in the American investment community, largely because of two towering achievements: He introduced the first index mutual fund for investors and, in the face of skeptics, stood behind the concept until it gained widespread acceptance; and he drove down costs across the mutual fund industry by ceaselessly campaigning in the interests of investors,” Vanguard writes. “The company he founded to embody his philosophy is now one of the largest investment management firms in the world.”
Many publications have already published obituaries detailing various aspects of his life and work. But it is also important to step back and consider to what extent the challenges Bogle so commonly talked about remain unsolved.
The Vanguard Experiment
Bogle coined the term “The Vanguard Experiment” to describe his first attempt to create mutual funds that would operate “at cost and independently,” with their own directors, officers and staff. He talked about this as being a radical change from the traditional mutual fund corporate structure, whereby an external management company ran a fund’s affairs on a for-profit basis.
“Our challenge at the time,” Bogle once recalled, “was to build, out of the ashes of major corporate conflict, a new and better way of running a mutual fund complex. The Vanguard Experiment was designed to prove that mutual funds could operate independently, and do so in a manner that would directly benefit their shareholders.”
Vanguard’s statement on Bogle’s death says his approach was “ridiculed by others in the industry as un-American and a sure path to mediocrity,” and the fund collected only $11 million during its initial underwriting. Now known as the Vanguard 500 Index Fund, the still-running fund has grown to hold more than $441 billion in assets, while the sister fund, Vanguard Institutional Index Fund, has $221.5 billion in assets. Today, index funds account for more than 70% of Vanguard’s $4.9 trillion in assets under management.
Bogle and Vanguard again broke from industry tradition in 1977, when the firm ceased to market its funds through brokers and instead offered them directly to investors. The company eliminated sales charges and became a pure no-load mutual fund complex. Bogle at the time said this was a move that would save shareholders hundreds of millions of dollars in sales commissions.
Since that time, passive mutual funds and exchange-traded funds (ETFs) have exploded in popularity and now comprise more than 40% of all U.S. stock fund assets. The last two decades have seen the fastest growth for index funds, which held only 12% of U.S. stock fund assets in 2000. As passive investing has grown more popular, new technologically enabled approaches have been introduced, including most recently “smart-beta” ETFs.
Interestingly, Bogle was often quoted to the effect that he did not like the idea behind ETFs, basically because they can be bought and sold more like individual stocks. Thus, ETFs are used for fast trading and for the shorting and hedging of dynamic positions. Bogle argued this arrangement causes their prices to jump around too much to be useful for long-term investors.
Progress Made and Progress Needed
A day before news broke that Bogle had died, PLANADVISER sat down for a fee-focused conversation with America’s Best 401k President Tom Zgainer. He talked about a firm that, like Vanguard in the 1970’s and 80’s, sees itself as working hard to revolutionize the investment services industry—particularly within the tax-qualified retirement plan arena.
Bogle was not directly talked about in that conversation, but Zgainer channeled a similar enthusiasm in discussing what he sees as the ethical shortcomings of the traditional approach to investment management for the masses. He agreed that the investment services industry has made some progress on growing more transparent about fees and lowering fees to the benefit of individual investors. But from Zgainer’s perspective, there is still a huge amount of progress that needs to be made, especially in the 401(k) world.
“The vast majority of 401(k) studies that talk about the lower fees being paid today are compiled using data from the publicly available Form 5500, which is required of all 401(k) plan sponsors,” Zgainer said. “The challenge is, for plans under 100 participants, the government only requires a ‘short’ Form 5500, which contains very little data and excludes very pertinent information such as the name of the plan provider; the compensation paid to brokers and advisers; the compensation paid to recordkeepers and third-party administrators, and the mutual funds in the plan, along with their corresponding expenses.”
Thus, the information discussed and disseminated by the industry—talking about the fact that fees have fallen by significant amounts in the last decade—effectively excludes the plans with under 100 participants.
“This is a massive blind spot because of the approximately 533,000 401(k) plans in the US, 89.8% of them have under 100 participants,” Zgainer said. “By omitting nearly 90% of all 401(k) plans from comprehensive analysis, one might draw false conclusions about broader industry trends such as the lowering of fees or greater access to low-cost index funds.”Pace of Industry Change Exaggerated?
Decades after Vanguard proved the concept of index-based mutual funds, investors and asset managers are still deeply engaged in debate about alpha, beta, smart beta and passive versus active strategies. Hundreds of billions of dollars have shifted from active strategies to passive index investing. Depending on the study cited, something in the ballpark of 85% of active managers consistently underperform their stated benchmark index over long time horizons.
While index funds have some clear advantages in terms of costs and transparency, retirement industry research suggests many investors have expectations that don’t reflect a full understanding of the risks of index funds versus the benefits.
According to Natixis Global Asset Management, for example, 64% of investors believe “using index funds will inherently help minimize investment losses,” despite the fact that the simple category title of “index fund” says next to nothing about the actual risk characteristics of the investment being considered. Similarly, nearly seven in 10 investors believe “index funds offer better diversification,” and nearly the same number (61%) believe index funds “provide access to the best investment opportunities in the market.”
According to research from Cerulli Associates, most advisers serving individuals and retirement plans believe that both active and passive investing play a vital role. More than 80% believe that passive investments can reduce fees and that active managers are ideal for certain asset classes.
“Approximately 75% of advisers agree that active and passive investments complement each other,” said Brendan Powers, senior analyst at Cerulli. “We would argue that the debate of active or passive has shifted to active and passive, with more focus on how to best use both as tools to build the most efficient and effective client portfolios.”
In general, active will retain a key role in asset classes where it adds value over passive, Powers explained. “The asset classes where more than half of advisers prefer actively managed mutual funds include international/global fixed income (61%), multi-asset class (60%), emerging markets fixed income (58%), emerging markets equity (53%) and international/global equity (51%).”
Despite these figures, Cerulli found advisers continue to pretty strongly favor active funds. Cerulli discovered that advisers currently allocate 64% of client assets to actively managed strategies, 25% to passively managed exchange-traded funds (ETFs) and 11% to passively managed index funds. Fifty-five percent of advisers create customized investment portfolios for each client, with 42% starting with investment models that they then alter. Among those advisers using models, 80% use models created by their practice, 68% use home-office models, and 66% use asset manager models.