Jack Bogle’s folly became his greatest gift

The death last week of investing legend Jack Bogle at the age of 89 has created a wave of tributes for the low profile man who created and popularised the index fund and also founded low cost global index fund company Vanguard.

But even greater than the life of the man himself is the legacy he leaves behind which has literally changed the face of investing forever and undoubtedly created more “everyday’’ millionaires than any other person.

The basic and powerful message Bogle popularised was that a low cost index fund or exchange traded fund (ETF) that closely mirrored a share index would outperform most actively managed funds trading that same share market over time.

From US$11 million to US$8 trillion

It is hard to believe now that index funds represent more than US$8 trillion of the money invested on the US market alone but the humble $11 million index fund that Bogle first launched at the end of 1975 was initially mocked and derided as “Bogle’s Folly”.

There is now around $US10 trillion of investor funds within a staggering array of various index and ETFs around the world.

Initially, though, most investment professionals simply refused to accept that their extensive market research and trading activities could ever be beaten by a “dumb’’ fund that merely mirrored the components on an index such as the S&P 500 in the US or the ASX 200 in Australia.

Surely their buildings full of busy and highly intelligent people who studied companies in depth could not be beaten by a fund that a couple of people and a laptop could run?

Especially later when you add in massive computers using advanced algorithms that could trade virtually autonomously in the blink of an eye?

Are index funds for “average dummies’’?

Even today, some active managers still openly mock the entire concept of index funds, which are growing very quickly internationally but still only represent $41 billion of the Australian market.

Some analysts even warn that they are dangerous and destabilising for the market as a whole because they can exacerbate share market movements in both directions.

I still remember the absolute frustration of one index fund company senior executive I spoke to a good few years back who had just done the rounds of the large superannuation funds and big financial planning groups but was really struggling to overcome resistance to the use of index funds.

His data was compelling, with the low fees index funds charged often being the key difference between the much more expensive active funds that also generate bigger tax bills through buying and selling stocks and also charge large management and distribution fees that eat away any investment performance advantage.

Even though many financial planners recognised the truth that index funds would outperform around three quarters of actively managed funds, they were difficult to sign up because the index funds refused to pay the lucrative commissions active funds were happy to pay.

That is changing now with many better planners offering to construct portfolios which include index funds but as we saw in the Royal Commission into the banks, large parts of the investment industry still exist first to clip the ticket and feed themselves and then to manage whatever money remains.

I still vividly remember being escorted to the board room of Vanguard in their early days in Australia for a briefing on their funds and being amused and delighted when they served up some sandwiches for lunch.

Despite their size, Vanguard has always focused obsessively on keeping its costs as low as possible – not for them the flash cars, thick carpets and fancy parties that dominate the active management industry.

I am not saying that active funds don’t have a place – I strongly believe you should have a portion of any portfolio actively managed – but you need to be careful who you choose and keep monitoring their performance.

After all of those distribution problems, the index fund companies were forced to go direct and get their message through to individual investors and once they had done that, the money began to pour in.

According to local Australian index fund company BetaShares, the growth of index funds in Australia is accelerating and they expect it to reach between $55 and $60 billion by the end of 2019, up from the current $41 billion.

Still, that is still just a tiny percentage of the roughly $1.9 trillion market capitalisation of the entire Australian share market.

Bogle revolution has been hard won

While it is tempting to think that index funds would have been successful with or without Bogle, he was a rare Wall Street figure who was much more focused on enriching investors than himself.

He had to endure decades of scorn and derision from the big Wall Street firms – a situation echoed in a smaller way here in Australia.

He also died significantly poorer than many other Wall Street figures, leaving behind an estimated $111 million.

That is relative peanuts compared to many Wall Street billionaires who did far less to help investors and is especially laughable when compared to the US$5 trillion that the company he founded – Vanguard – manages today.

Most of Vanguard’s money under management is still in index funds around the world, including Australia.

However, Bogle’s focus was never on enriching himself – he really was trying to get a low cost, diversified investment product on the market that would suit every investor, large and small.

Arithmetic eventually won

In the end it was the arithmetic that eventually began to win the argument for index funds – on the fee front as well as investment returns – but it is a fight that continues to this day.

Another big tail wind for the index fund movement is that average annual returns from the share market have been trending down in recent years.

That makes it even harder for the active fund managers to outperform because their fees represent a greater proportion of the total returns from their funds.

If your active fund returns 40% in a year you are unlikely to quibble about a few percent that have gone to the manager, but if the return is in single figures or the low teens, a management fee of 0.19% such as that charged by State Street on the SPDR ASX 200 (ASX: STW) starts to look much more inviting.

World’s best active investor backs Bogle

If you are looking for one extra plaudit for Jack Bogle’s index fund, it comes from arguably the world’s greatest active investor, Warren Buffett.

While Buffett, 88, chairman and chief executive officer of Berkshire Hathaway, is famously strong willed about making his own investments and has an incredible record of buying sound companies at low prices, he also recognises and celebrates his mistakes and knows his limitations.

And one of those limitations is the difficulty of outperforming the S&P 500 index, particularly as Berkshire Hathaway grew much bigger.

It is this rare insight into his own behaviour – and the fact that he will not be around to invest forever – that led Buffett to recommend a low cost index fund for his wife to invest in after his death.

Buffett also won a charity bet that hedge funds would not be able to beat an S&P 500 index fund over a decade.

When he made that bet there were guffaws all over Wall Street as the smartest guys in the room looked forward to an embarrassing defeat for the folksy old guy who lived in his small house and drove an old car down in Omaha.

By the end of the decade, Buffett’s bet was a comfortable winner and hedge funds were no longer the “clever’’ investments many people thought they were.

As Buffett put it after Bogle’s death: “Jack did more for American investors as a whole than any individual I’ve known. A lot of Wall Street is devoted to charging a lot for nothing. He charged nothing to accomplish a huge amount.”

Praise doesn’t come much higher than that and Australian investors are also big beneficiaries of Bogle’s folly.