The simple life

The man who invented index funds tells us why smart investors keep things as elementary as possible.



From the December/January 2009 issue of the magazine.


My career has been a monument, not to brilliance or complexity, but to simplicity and common sense: “the uncanny ability,” as one observer has said of me, “to recognize the obvious.” (I’m not sure that the comment was meant as a compliment!) I introduced the world’s first index mutual fund in 1975, not because I was a genius, but because it seemed to me the simplest, best way to invest.

In the decades since launching that index fund, I’ve learned a few things about the world in general and financial services in particular. I’ve learned, for instance, that in most cases innovation is good. Our laptop computers probabl y have enough calculating power to send a man to the moon. With tiny pocket versions, we can connect to Wi-Fi all over the world.

But I’ve learned that in the financial sector, innovation isn’t always an advantage. Why? Because in the financial sector, there’s a sharp dichotomy between the value of innovation

to the institution itself and the value of innovation to clients.

Financial institutions operate by a kind of reverse Occam’s razor. They have a large incentive to favor complex and costly products over simple and cheap versions. Innovation in finance is designed to benefit those who create complex new products, rather than those who own them.

Since there’s money to be made — lots of it — in the marketing of complex innovations, the disease is contagious. As Benjamin Graham, the famed investor, pointed out way back in September 1976, “the stock market resembles a huge laundry in which investors take in large blocks of each other’s washing, nowadays to the tune of 30 million shares a day.” (He could not have imagined today’s speculation: more than three billion shares a day.)

But all this back-and-forth washing of each other’s laundry doesn’t do much to benefit the investor. The financial industry’s creation of literally hundreds of technology funds, telecommunications funds, Internet funds, and the like to capitalize on the Information Age during the New Economy craze of 1998 to 2000 is a good example of complex innovation run amok. As the market soared, fund investors poured hundreds of billions of dollars into these highly promoted funds, only to take a huge hit in the subsequent crash.

We can measure how much that wholesale embrace of fund innovation cost our investors. Let’s compare the returns reported by mutual funds to the returns actually earned by investors in those same funds during the 25 years ended 2005. The two returns are different because investors have a habit of jumping in and out of funds to chase whatever is hot or innovative — or heavily marketed. Investors tend to move money into a fund after the big gains have already taken place and they have a habit of deserting the fund at its lowest point, just before it starts to recover.

The numbers demonstrate how painful these habits can be. The average equity fund in the U.S. reported an annual rate of return of 10% for the 25 years to 2005. That was well behind the 12.3% return on an S&P 500 index fund. But the return actually earned by the investors in these equity funds was even worse. It amounted to only 7.3%, a lag of 2.7 percentage points per year below the return the funds themselves reported.

Cumulatively, then, fund investors on average experienced a 482% increase in their capital over the period. Yet, simply by buying and holding the market portfolio through an index fund, they would have earned an increase in capital of 1,718%, nearly four times as large! Thanks to the innovation and creativity of fund sponsors — and, yes, the greed of investors — the return that investors received on their money was less than a third of the return offered by the stock market itself. So much for the well-being of the investor!

As to the well-being of managers, we can conservatively estimate that the fees and sales loads paid to fund managers and distributors during this period totaled in the range of $500 billion. So yes, someone is earning enormous profits by jumping on the bandwagon of innovation, but unless you are a fund manager or distributor, that someone is not likely to be you.

Have we forgotten that the most productive investing is the simplest investing? Apparently so. I’m afraid that the new jazzed-up iterations of the simple index fund that I spawned all those years ago are helping to lead the way. No wonder I wake up some mornings feeling like Dr. Frankenstein. What have I created?

Let me be clear: I favor innovation when it serves fund investors. And I’m pleased that I’ve been lucky enough to have played a key role in a number of such innovations in the past. In recent years, there have been some investor-friendly innovations, including target retirement funds and life strategy funds. Properly used (and properly costed!), these funds can easily serve as an investor’s complete investment program for the long run. But in today’s wave of fund innovation, I see little that seems likely to serve investors effectively. Let me give a brief sketch of some of the new “products” and offer my own perspectives.

Fundamental indexing Fundamental indexing is an attempt to improve standard indexing by incorporating several measures of a stock’s intrinsic value, such as dividends or earnings. While this so-called index method of value investing has been presented as a revolutionary idea, the idea behind the methodology is many decades old. It is really just another way to spot stocks that the market appears to be undervaluing for one reason or another.

I’m not so sure that fundamental indexing works. The sponsors of these dubiously dubbed index funds assure us that “value investing wins,” especially in troubled markets. But there is no assurance that the future will be like the past. In the sharp market tumble of mid-2007 to mid-2008, the two leading fundamental index funds were down nearly 20%, a loss nearly half again larger than the 13% decline in a standard S&P 500 index fund. The financial entrepreneurs behind the various versions of fundamental indexing can’t even agree on what factors to use in selecting stocks. Some weight their portfolios on the basis of book values, revenues, and earnings. Others weight their portfolios by dividends. I’m interested to read that the various factions are arguing with each other about which is the correct strategy, creating even more confusion for investors.

Absolute return funds Given the remarkable successes of some large endowment funds and hedge funds, it is small wonder that fund sponsors are falling all over themselves to create new funds that purport to use similar strategies. There are funds that claim to use hedging strategies (for instance, funds that have invested 130% of their money in stocks and offset that by shorting other stocks worth 30% of their capital). There are funds that claim to be market neutral (in other words, with no net exposure to the stock market). All of these innovations sound intriguing. But here are two pieces of advice: One, look before you leap. Two, don’t leap until the fund has produced a 10-year track record. Remember: “What the wise man does in the beginning, the fool does in the end.” Or, as Warren Buffett sometimes expresses it, “There are three i’s in every cycle: first the innovator, then the imitator, and finally the idiot.” No matter what fund managers may offer you, don’t you be the idiot.

Commodity funds Funds that invest in oil, metals and other commodities are growing in popularity. The thing to remember? Commodities have no internal rate of return. Their prices are based entirely on supply and demand. That is why they are considered speculations, and rank speculations at that.

In contrast, the prices of stocks and bonds depend on their internal rate of return. In the case of stocks, that internal rate of return comes from dividends and earnings growth; in the case of bonds, it comes from interest coupons. That is why stocks and bonds are considered investments.

I concede that the growing worldwide demand that has helped drive the huge rise in the prices of most commodities in recent years may well continue. But it may not. An interesting fact: From the time of the Great Fire in London in 1666 to the end of World War I in 1918, commodity prices in England were unchanged on balance. That’s two and one-half centuries with no net growth!

Managed payout funds The fund industry only recently discovered that millions of investors are moving from the accumulation phase of investing to the distribution phase, even though that demographic handwriting has been on the wall for decades. So we have new funds that, in effect, guarantee the exhaustion of your assets in whatever time period you choose. We also have funds designed to distribute 3%, 5%, or 7% of your assets without necessarily invading principal. What seems to have been ignored by the fund industry is the alternative: serving retired investors by increasing the income received by those investors. Unfortunately, the only sound way to provide more income per unit of risk is to slash fund expenses, so such client-focused innovation is unlikely to happen.

BRIC funds With returns in the so-called BRIC countries — Brazil, Russia, India, and China — soaring in recent years, fund sponsors were quick to market funds that specialized in these countries. I’m dubious. My experience warns that it’s counterproductive for investors to jump on the bandwagon of superior past performance.

Of course, the sharp declines that Indian and Chinese stocks have suffered over the past year may squash investor appetites for these funds. In general, though, it’s important to keep in mind that it’s difficult to make money by going with the herd. History tells us that when U.S. stock returns lead the world, investors reduce the amount of cash they put into international stocks. Investors do precisely the opposite when non-U.S. issues lead the pack. It’s hardly surprising, then, that only 20% of equity fund cash flows were directed into non-U.S. funds in 1990 to 2000, when U.S. stocks outpaced foreign issues. Nor is it surprising that since then, with foreign stocks outpacing U.S. issues, the tables have been turned.

In the hottest sectors of the international markets, risk is high, so be careful. And note that since 1990, the returns of non-U.S. stocks — even including their recent boom — have been dwarfed by the returns on U.S. equities: 6% annually versus 10%.

No objective veteran of the investment industry can look at this blunderbuss of innovation with other than a jaundiced eye. The problem is not only that future returns on untried strategies are unpredictable. The problem is that such a proliferation of funds results in an astonishing failure rate. A few years ago, I pointed out that of 355 funds that existed in the U.S. in 1970, only 132 made it through the next 35 years.

Let me update those numbers. Of the 6,126 mutual funds that existed in the U.S. at the start of 2001, 3,165 had already been consigned to the dustbin of history by mid-2008. Small wonder that even the portfolio managers who run the funds don’t “eat their own cooking.” Among 4,356 equity funds, 2,314 managers own no shares — none — in the funds they manage. How, I ask, can a less-informed member of the investing public successfully implement a long-term strategy involving mutual funds if only half of all funds can even make it through a period as short as seven years? And how can fund investors muster any faith whatsoever in the funds that now exist when more than half of their managers won’t put their own money on the line?

My answer is to encourage investors to use low-cost index fundsthat track the broadest markets. I think investors should buy and hold these funds, and use them to build a diversified portfolio that spans different types of assets, such as stocks and bonds, and foreign and domestic stocks. This is what I have preached for decades.

I am not a foe of innovation in itself. But mark me down as a believer in innovation that is based on clarity, consistency, and low cost; innovation that will serve investors over the long term.

If it sounds like I’m reaffirming my belief in the classic index fund, well, you read me loud and clear. Like William of Occam, I believe that the simple way is the best way. It is almost always the shortest route to long-term investment success.

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