Is Vanguard Too Successful?

It's a glorious time to be in the business of selling index funds, those robotically assembled portfolios that replicate a stock or bond market. Active managers are having a hard time beating the indexes and a harder time persuading savers to let them try. Vanguard Group, the leading operator of index funds, is slurping up 57% of the dollars going into the fund industry.

A victory for Vanguard and the man who built it, John C. Bogle. But... is it possible that indexing is being overdone?

That provocative question is asked by James Grant in the pages of his small but influential investment newsletter, Grant's Interest Rate Observer. Investing theories run in cycles, he argues. A success becomes a fad and a fad becomes a failure. Smart people bet against fads.

In 1972 investors overdid their buying of the Nifty Fifty, a group of glamorous companies, like Avon and Polaroid, that would supposedly grow forever. A decade later they overdid the flight from Treasury bonds, passing up a chance to lock in double-digit yields. In 1999 they overdid Internet stocks.

Now, says Grant, the masses may be taking their love affair with passive investing too far. They are thereby creating opportunities for active managers to find mispriced securities, beat the market and make both themselves and their clients rich.

Balderdash, answers Bogle, who remains, 40 years after Vanguard's founding, the world's most passionate crusader for passive investing. Indexed funds, he says, can be kept up with minute portfolio adjustments, so they reduce not just management fees but the drag of bid/ask spreads, trading commissions and taxes.

In an article published last year in the Financial Analysts Journal, Bogle calculates that the average investor in an active fund loses 2.3% of assets annually to fees and costs. Make that 3% if the customer is paying taxes on the account. Anybody can duck those costs with an index fund costing 0.1% annually. That's a smart move, Bogle says, and no less smart just because a lot of other people have come to the same wisdom.

Grant, 68, the author of a half-dozen history books, displays a long memory for past manias and panics as he delivers tips on what obscure stocks to buy and lectures on what bonds not to buy. He interlaces the analysis with acerbic commentary. Typical: "[There is] a rare burst of soul-searching on Wall Street (nothing has turned up yet)."

Groping for a historical analogue to the popularity of indexing, he asks, "Is John Bogle today's Peter Lynch?" Lynch was the face of growth investing during a 1980s heyday for that category. After a swarm of retail investors discovered the Magellan Fund (and Lynch quit running it), the fund's dazzling returns wilted.

Grant's instinct is to bet against anything popular. "I may not be a hot investor, but I'm a bloody-minded contrarian," he says. In 2006, two years before the collapse of Lehman, he urged his mostly professional-investor readers to get out of mortgage-backed bonds and the collateralized debt obligations tied to them. In late 2008 he went even more against the grain, favoring a move back into those vilified securities. Contrarianism doesn't always work. A year ago Grant was bullish on Gazprom, Putin's oil company.

Once Vanguard commands a share of new fund dollars resembling the share of car sales once held by the doomed General Motors, then a contrarian just has to bet against it. Still, translating the popularity of Vanguard's index funds into a theory of which stocks are overbought is not a simple matter. Grant suggests that the successor to the Nifty Fifty of yore is the Nifty Five Hundred, the big companies in Standard & Poor's best-known index.

That's plausible. Last year the S&P 500 beat out the majority of actively managed funds. Naive investors buy yesterday's winners. We can presume that such people are, at the moment, too avid in their purchases of S&P 500 index funds.

But is it fair to blame that mistake on the concept of indexing? Passive funds are no longer limited to the S&P 500. Today Vanguard can sell you a fund that covers the whole stock market, with 3,300 smaller companies added to the 500 big ones. Or, if you are sure that the 500 are getting too nifty, you could buy everything but those stocks; there are separate index funds for medium-size and small companies.

What will save your retirement? An active fund like Magellan? A broad index fund? A narrow one?

Consider yourself lucky that the latter two choices are even available. Indexing for the retail investor came about only because John Bogle was fired from his first big job.

He had risen to the top of a publicly traded fund management company that ran the Wellington Fund, a conservative blend of stocks and bonds. He made a big mistake. Chasing after performance, he merged the management company with the operator of a fund buying speculative stocks. When the hot stocks went cold in the 1973-74 crash, the directors of Wellington Management Co. voted to throw him out.

At 44, with six children to feed, Bogle was not just out of a job but sick. His weak heart had begun to send him on what was to be a string of a dozen trips to the hospital. A doctor had told him he had only a few years left. He did not take the doctor's advice to retire to the seaside.

Salvation lay in the curious legal structure of investment funds. By law, a fund must have its own board of directors, there to look after the interests of fund shareholders. Most of the time these supposedly independent boards apply a rubber stamp to the fee schedules and other proposals coming from the fund management company. But once in a blue moon a fund board shows its spine.

The day after losing a showdown in the boardroom of Wellington Management, Bogle went to the board overseeing the Wellington funds with a radical proposal. He wanted the directors to hand over fund management to a new company that would be mutually owned by the funds' shareholders.

Bogle didn't quite get that. But after seven months of negotiation, he got something: He would be permitted to create a new entity, called Vanguard, that would handle the back-office work--accounting, purchases, redemptions and so on--for the Wellington funds. Wellington Management would retain the glamorous work of picking stocks.

It looked at first as if Vanguard was nothing but a low-level paperwork supplier to Wellington. But Bogle had turned the tables. Since he controlled the funds, Wellington was the subcontractor. He used that fact to beat Wellington down on the pricing for its stock selection. Bogle boasts that over the years Vanguard has extracted 104 fee reductions on funds run by Wellington and other external managers.

Vanguard opened its doors in Valley Forge, Pa. in 1975. It had 28 employees and, at the end of the year, $1.8 billion in fund assets. As a mutual institution it was, and is, an odd duck in the fund industry. Competitors are for-profit ventures. Some are privately held, like Fidelity. (Wellington Management went private not long after the splitup with Vanguard.) Some are publicly traded (BlackRock), and some are subsidiaries of insurers (Pimco).

Vanguard's customers don't have any say in the operation, but they enjoy the net income (after an undisclosed addition to reserves) in the form of fee cuts. The headquarters and most of the 14,200 employees have moved one town over to Malvern, but Vanguard retains Valley Forge, with its revolutionary flavor, in its mailing address.

The upsetting of the for-profit fund model was the first part of Bogle's revolution. The other came a year later, when he did away with stock pickers altogether for a new fund. It would own shares in S&P 500 companies in proportion to the companies' market values.

The Vanguard Index 500 was a flop at first. The world had hundreds of stock funds to pick from, each offering the tantalizing possibility of an outsize return. Who wanted to sign up for guaranteed mediocrity?

But Bogle kept making the pitch for indexing, in speeches, books, articles and television appearances. There is no more fervent a believer than a convert, and this preacher was determined to repent for his sin of inviting those go-go fund managers into Wellington.

Indexing is built on the idea of getting a free ride on the costly stock research done by others. Let the bulls and bears fight their battle over Netflix. When they are done, the stock trades at $319. You are not assured that you will make money if you buy it. You can, however, be reasonably confident that $319 is a fair price for this lottery ticket on the film business.

It is easy for an actively managed fund to beat the market in any one year; luck, after all, plays a large role. Over a period of decades, though, the law of averages swamps luck. Costs, meanwhile, do a lot of damage to whatever value managers provide with their skill.

Look at what happened to big-company U.S. stock funds over the past 20 years. Morningstar shows 1,105 choices available as of Jan. 1, 1995 (counting each share class separately). From this crowd 491 survive, and 151 of the survivors have beaten the S&P index fund.

Your chance of hitting a win with an active fund over a very short period might be 50-50. Over two decades it's a 1-in-7 long shot.

In time Bogle attracted a cultlike following (the fanatics have a group called Bogleheads, with an online forum and a conference). The indexing concept has been extended, by Vanguard and others, to stock sectors and bonds and foreign securities. Vanguard has 20 million customers. Its fund assets are $3 trillion, including a small portion held abroad. Two in three of those dollars are indexed. Vanguard's cheap funds are saving savers $18 billion a year, Bogle figures, just on expense ratios. For the individual saver, cutting costs means a lot--potentially hundreds of thousands of dollars at retirement for someone with a well-funded 401(k).

His heart failing, Bogle left the job running Vanguard in 1996 and started a long wait in a Philadelphia hospital for a transplant. He got one 19 years ago. "The donor was 26, so I am 45," he says, with rational exuberance, at age 85. The preaching continues, as energetic as ever.

And as dogmatic. A recent variation on indexing now being sold (at higher fees, and not by Vanguard) has companies weighted not by market value but by sales, book value or earnings. Bogle condemns this as heretical.

Letting publicly traded corporations operate funds is, in Bogle's eyes, wicked. The people running the show are at once obliged to maximize fees for the benefit of the management company shareholders and to minimize them to help the fund shareholders. "You cannot serve two masters," he says.

With money cascading into Vanguard, Bogle seems to be vindicated. But there are grounds for debate. As business drifts away from actively managed funds, Grant theorizes, the money to pay analysts for the hard work of reading balance sheets and evaluating business methods will dry up. Stock markets will become less efficient. Netflix's price will veer away from fair value.

This does not mean the pickings will be easy for active investors. In the aggregate, they are destined to earn (before costs) the market's average return. The passive players are assured of getting the same return (before their much smaller costs). The identity of the two return numbers holds, no matter how few active investors are left. "That is not a theory. That is a mathematical fact," says Gus Sauter, retired chief investment officer at Vanguard.

Less efficiency does, however, imply that skill will play a larger role, and luck a smaller one, in what goes on among investors who don't index. You might have a better chance of finding money managers who capture excess returns. Of course, for them to succeed a pool of victims (individual investors?) must end up with subpar returns.

Bogle versus Grant: The two men continue their debate, in person, as a part of Grant's spring conference for hedge fund operators and others with large expense accounts (tickets: $2,150). You can place a bet on each.

Put 95% of your money in the cheapest index funds you can find. Put 5% in the shares of money managers. You don't have to believe they are doing God's work to want to own them; you just have to believe that their customers will not go away. Wicked or not, the for-profit money management business is quite profitable.

The Forbes survey of cost-efficient exchange-traded funds is here. Among the winners: Vanguard Total Stock Market (VTI), iShares Core U.S. Aggregate Bond (AGG), Vanguard FTSE Developed Markets (VEA), iShares Russell 2000 (IWM) and Vanguard Total Bond Market (BND).