The Real Reason to Index

Bogle's Case

Vanguard Founder Jack Bogle portrayed active management as being outright dangerous for an investor's health because of its exorbitant costs. For example, in this 2014 article Bogle appraised the annual "all-in investment expenses" for investors in actively run retirement plans as 2.27%. That amount involved four elements:

1. 1.12% for fund expenses;
2. 0.50% for active management's trading costs (which are not captured by official expense ratios);
3. 0.15% for "cash drags," caused by active funds' higher cash positions;
4. 0.50% for ongoing advisory fees (Bogle reached this figure by assuming that half the investors paid no such fees, and the other half paid 1% annually).

In contrast, wrote Bogle, index-fund investors paid just 0.06%. They were therefore 2.21 percentage points per year better off than those who held actively managed funds. Bogle then compounded that result: Over 30 years, he stated, a portfolio of index funds would have turned a hypothetical investment into $412,000, while one using actively run funds would have accumulated a mere $286,000.

Such claims were dramatic and highly persuasive. However, they did require an asterisk. Bogle used industry averages. His expense-ratio estimate was derived by determining the mean expense ratio for all share classes of all mutual funds. Similarly, his plugs for trading costs and the drag of cash were calculated by measuring the actions of all fund managers. Those were reasonable decisions, but there was more that could be said on the matter.

Another Perspective

What applies for the typical fund does not necessarily hold for the typical investor. This is particularly true for 401(k) participants. Large plans with assets in excess of $1 billion possess half the industry’s assets. With rare exception, their funds’ expense ratios are far below 1.12%. Being cautiously run, such funds also tend to have low trading costs. Finally, they are not accompanied by advisory fees, so the final 0.50% of Bogle’s equation can be discarded.

After making those adjustments, the cost difference greatly shrinks. Consider the competition between Vanguard’s cheapest index funds (the Institutional Plus share class) and American Funds’ actively run R6 shares. Roughly speaking, the Vanguard funds have expense ratios of 0.03%, while those for the American Funds are 0.35%. A gap remains, to be sure, but it would take heroic assumptions to give Vanguard’s funds a cost advantage of 1 percentage point per year, never mind 2.

Of course, investors only receive after-cost dollars. Usually when I measure fund results, I assess total returns for the sake of simplicity. However, for today's article, I followed academic protocol by evaluating risk-adjusted outcomes. Specifically, I computed the 10-year alphas for the R6 shares for the 10 largest American Funds offerings--the size being determined at the start of the period, December 2011--then contrasted that with the figure for Vanguard's Institutional Plus shares.

(Those interested in the details of the alpha calculation can learn more here. Otherwise, suffice it to say that the alpha scores’ usefulness depends upon finding appropriate benchmarks. Fortunately, American Funds' products tend to be conventional, and Morningstar’s database contains 127 category indexes, so the comparisons were reasonably precise, thereby making for valid computations.)

By the Numbers

The average alphas for the two groups of funds appear below. With Vanguard’s funds, I did not directly calculate the alphas--which was a laborious exercise, as my usual source of Morningstar Direct lacked that data point--but instead took the shortcut of assuming the funds exactly echoed the returns of their indexes save for expenses. The alphas are therefore those funds’ expense ratios.

For all practical purposes, employees in large 401(k) plans would have received the same investment outcome, whether they bought Vanguard’s oft-praised index funds or held instead unpopular active funds, courtesy of American Funds.

From American Funds’ perspective, “unpopular” might downplay the sentiment. Although the performances for those major Vanguard and American Funds entrants were virtually identical, their sales diverged dramatically. The 10 biggest Vanguard index funds became even bigger, attracting more than $1 trillion of net new investment. Meanwhile, American Funds shed assets. Among its 10 top funds, nine faced net redemptions. Only American Funds American Balanced RLBGX bucked the trend.

The New Reality

It may be objected here that American Funds is an exception to the general rule. Not really. Once, American Funds stood out in a sea of pricey mediocrity by consistently offering cheap, well-run funds. Today, though, the fund market is awash with institutionally priced shares from reputable firms. Investors have become far more selective. These days, they rarely buy either expensive funds or those offered by second-tier organizations. Their choices are overwhelming solid.

Consequently, future active-passive contests will likely resemble the Vanguard/American Funds outcome rather than Bogle’s projections. Ironically, this will make Bogle wrong by being right. His critique about how most fund companies operated was entirely correct. However, through his efforts, Bogle taught investors to change their behavior. They no longer operate as they once did, which means index funds no longer enjoy such a significant cost advantage.

Which brings us, at long last, to index funds’ key benefit: blessed simplicity. They require much less research than actively managed funds. Finding them is straightforward, as is monitoring their results. Index funds don’t perform inexplicably, forcing shareholders to ascertain why. Nor is it cause for concern when their portfolio managers depart. Finally, index funds minimize regret. Buying the wrong active fund can cause investors to second-guess their wisdom. That rarely occurs with index funds.

Add index funds’ undisputed tax advantages--another frequent Bogle topic, although not in the aforementioned article, which covered retirement plans--and the verdict is straightforward. Indexing might well lead to greater wealth. But it is likelier yet to lead to investor satisfaction. And that, ultimately, is what sells.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.