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Index Funds

If you Google Index Funds, then you’ll get more than 70 million hits, but most of you probably already know what an index fund is. If you don’t, then here’s an official definition:

An index fund is a fund that matches the components of a market index, such as the Standard and Poor's 500 Index or any other index.

The S&P 500 index is a sector index that restricts itself to diversified large and giant sized companies of the United States economy. The S&P 500 captures about 75% of the value of the US Stock Market.

The Wilshire 5000 index is a diversified index that includes all US stocks with readily available prices. The Wilshire 5000 captures the Total US Stock Market

A large number of sector index funds defined by size (large, mid, small, etc.), by style (growth, value, etc.), by industry (tech, health, finance etc.), by region (US, China, Europe etc.), by type (Developed Markets, Emerging Markets etc.) and by many combinations of the preceding are available.

There are about 80 countries in the world that have at least one stock market. If the country has a stock market, then at least one index fund is generally available for that country. Sector index funds are also available for many of the larger countries, and for many of the world's regions.

Every investor has an infinite number of choices, but several of the most important questions to ask yourself are these:

Should individual stocks from a specific index be purchased?
Or should the index fund of that country, sector or region be purchased?

Those questions are relevant whether you’re an individual investor with a modest portfolio, or a professional manager in charge of a multi-billion dollar portfolio, but before you buy a stock, ask yourself this: What do I know about this stock that thousands of professional analysts and scores of insiders do NOT know?  

If you cannot convince yourself that you know more than ALL of them, then you are what Business Week calls a turkey i.e., an outsider playing an insider's game. 

Most investors try to beat an index, but most investors have no idea how difficult that is.

In March 1964, John Andrew McQuown, a mechanical engineer with an MBA from Harvard, arrived in San Francisco as the head of Wells Fargo’s Management Sciences division. Wells Fargo is one of the largest banks in the world, and Wells Fargo Securities is one of the world’s largest investment banks.

McQuown was hired to develop a scientific “Investment Decision Making” system, because by 1964 almost everyone that was paying attention realized that many professional portfolio managers were essentially playing a guessing game.

McQuown had spent a few years on Wall Street before going to Wells Fargo.

At that time, everyone on Wall Street thought it was easy to beat the S&P 500

The Wells Fargo project was the first known attempt to apply scientific principles to the investment decision making process. It was also the first time computers were extensively used to optimize the process.

McQuown started the project with a team of six members who were either mathematicians, statisticians or computer scientists. None of them had financial backgrounds. The team eventually grew to 35, and included William Sharpe, Harry Markowitz, Merton Miller, Eugene Fama and Myron Scholes.

Sharpe, Markowitz, Miller, Fama and Scholes all ultimately received Nobel prizes in Economics.

After working about one hundred hours a week for three years, McQuown announced that they needed to start over because they had been boxed in by dead ends. They went back to the drawing board and ultimately focused on using Bill Sharpe’s CAPM model with its ideas of low-beta stocks outperforming high-beta stocks. And they thought that they had finally figured it out.

It was all ready to go until Fischer Black and Myron Scholes made up their minds that there was something wrong with the betas. They were concerned that they had encountered a period of time in which low beta stocks outperformed, but there was no evidence that it was going to persist into the next period.

In the final analysis, they found that even though the conventional wisdom proclaimed it was easy to beat the S&P 500, not ONE professional portfolio manager was beating the S&P 500 consistently.

The proof had finally arrived, but it was wildly unpopular.

At that point the 35 member team had been working on the Investment Decision Making project for SIX years.

Jim Vertin, the director of the Financial Analysis Department at Wells Fargo said,
This cannot possibly be right. We spend all this money on analysts and computers, and you’re saying that all we really need to do is buy the S&P 500?

What would Donald Trump have done?

We all probably know what the Donald would have done, but if you google “Donald Trump and index funds”, then you will learn that this self-proclaimed “genius” would have a lot more money now if he had simply invested the millions he inherited in an S&P 500 index fund.

In 1970 Bill Fouse was hired by Wells Fargo to reconcile the scientists and the portfolio managers. When he arrived at Wells Fargo from Mellon Bank, he found two groups of people screaming at each other.

Ultimately McQuown prevailed, and he decided that the greatest risk adjusted return over the long run would be realized by holding an equal dollar amount of each of the stocks listed on the New York Stock Exchange, which consisted of 1,500 stocks at that time.

That was the first index fund and it was born in 1971

That was five years before John Bogle started his Vanguard 500 fund

McQuown’s fund worked, but there were heavy transaction costs and daily management was difficult because constant rebalancing is required if a fund holds an equal dollar amount of each stock in the index.

Why did McQuown chose an NYSE 1500 instead of an S&P 500 index?

The S&P 500 is a large stock index that captures about 75% of the value of the US stock market.

For as long as accurate records have been maintained, small stocks have had higher returns than large stocks. Including small stocks in an index fund should have resulted in a higher long run return than the S&P 500.

Also, about 25% of the stocks listed on the NYSE are large foreign stocks, and over the long run, a significant foreign component will generally increase the risk adjusted return of a portfolio that restricts itself to US stocks.

Why did McQuown chose an equally weighted NYSE 1500 ?

Equally weighting an index fund gives the smaller stocks in the index fund more weight than they normally have i.e., normally their weight is proportional to their value.

However, there have been many ten year periods during which small and foreign stocks underperformed the large stocks, and an S&P 500 index fund is much easier to manage.

The S&P 500 is a float adjusted cap-weighted index. Float adjustment takes market-cap weighting one step further by only counting shares that are available for purchase on open markets rather than simply the total shares outstanding. Most cap-weighted indices are now float adjusted.

Market Cap refers to the market capitalization of a stock or a stock market.
Market Cap of a stock = Number of Shares outstanding X Price per Share

If you had invested $100 in an S&P 500 index fund during December 2015, then about $3 of your $100 would have been used to buy Apple. At that time, Apple was the largest stock in the index, and it represented about 3% of the S&P 500’s value.

If Apple lost half its value one or two days later, how would the manager of the index fund respond?

The manager of the index fund would do nothing.

Cap-weighted index funds require no rebalancing as the prices of their underlying components change.

If you had invested $100 in an S&P 500 index fund during December 2015, then about one penny of your $100 would have been used to buy the Fossil Group (FOSL). At that time, FOSL was the smallest stock in the index, and it represented about 0.01% of the S&P 500’s value.

The rest of your $100 would be used to buy proportional shares of the remaining companies

The trades of a cap-weighted index fund have an equal impact on ALL the components of the index i.e., if the purchases made by a cap-weighted index fund raised the price of Apple by 1%, then the price of the Fossil Group should also rise by 1%, if all other things were equal.

However, all prices do not rise or fall by the same amount because the stock pickers i.e., the active investors who are attempting to beat the index are not buying and selling proportional amounts of the index.

During a downturn, small cap stocks generally decline more than large caps, but not always.
During a rising market, small cap stocks generally outperform the large caps, but not always.

Most index funds are cap-weighted index funds.
ALL of Vanguard’s index funds are cap-weighted index funds.

The Vanguard 500 fund owns a little over one percent of the S&P 500
(On January 31, 2016 the Vanguard 500 Index Fund's Market Value was about $211 Billion)
That makes the Vanguard 500 fund the largest fund in the world.

According to the S&P Dow Jones Fact Sheet dated November 30, 2015, index assets account for about $2.2 Trillion of the value of the S&P 500, or a little more than ten percent of the S&P 500.

More than fifty years have gone by since the first index fund was created, and many investors still believe that it is easy to outperform an index. That belief fails the simplest test of logic imaginable because fifty years of evidence has shown that it is essentially impossible to beat an index.

Obviously there will always be exceptions, but when the strategies of the exceptions are carefully examined, then the outperformance is almost always attributable to blind, dumb luck.

Luck is a very important factor in life.

Note: I, Henry Wirth, knew that Wells Fargo created an index fund before John Bogle created the Vanguard 500 fund before I added this page to my website, but I was not aware of the details.

I learned about the founding of the first index fund after downloading a PDF file titled The Origin of the First Index Fund. It was published during 2012 by The University of Chicago Booth School of Business, and it contains considerably more information than the condensed version above. I highly recommend downloading a free copy of this fascinating story. It will give you far more information than I published here, and it will help you learn what needs to be done to beat an index.

Five practical conclusions

1. There will probably always be exceptions, but the stock selection process is almost always a waste of time and money.

2. A total US stock market index fund is a better long run bet than the S&P 500, but anything can happen over a short run of 10 or 20 years.

3. A strategy that equally weights large caps and the extended US market is a slightly better long run bet than the total US market i.e., invest 50% in a cap weighted S&P 500 fund and 50% in a cap weighted extended market fund.

Over the 28 Year period ending December 31, 2015

The Vanguard 500 Fund returned 1,358% or 10.04% per year
(The Vanguard 500 fund contains 505 stocks ≈ 75% US Market Cap)

The Vanguard Extended Market returned 1,482% or 10.36% per year
(The Total US Market = S&P 500 + The Extended Market)

However, I doubt that we’re gonna see 10% per year returns again anytime soon,
but hope springs eternal.

4. Tax consequences are an important part of the investment decision making process,
but they are almost never mentioned. An index fund is generally highly tax efficient.

5. A compelling case can be made for a portfolio consisting of 50% high-quality domestic bonds and 50% stock. See Asset Allocation in # 3 below

There are at least THREE reasonably well known ways to beat an index

1. Using Blind, Dumb Luck


A. Buy and hold a group of stocks that were intuitively or randomly selected
B. Buy one or more actively managed mutual funds
        A NY Times article written on March 14, 2015 by Jeff Sommer asked,
        How Many Mutual Funds Routinely Rout the Market?
        The answer is Zero
        The article reported that the top 25% of all diversified actively managed
        mutual funds during 2010 ALL  lost their winning positions during the next
        five years. For more, go to Mutual Funds
C. Buy a sector (tech, health, finance etc.) fund
D. Buy a lottery ticket

You may beat an index fund with any of these methods, but there is a far greater
chance that you will underperform over the long run.

2. Using a Scientific Investment Decision Making Process

Five things you need to beat an index over the long run using a scientific
investment decision making process

1. A clearly defined quantifiable written objective
2. A highly disciplined written strategy
3. An ability and willingness to devote your life to the task
4. Enough intestinal fortitude to implement your strategy
5. Luck.

Luck is a very important factor in life

You may beat an index fund with a Scientific Decision Making Process, but it requires an enormous amount of work, and there is a far greater chance that that you will underperform
over the long run unless you are very, very lucky.

3. Using an Asset Allocation Model

The risk adjusted return of appropriate indices can be beaten with an asset allocation model, luck is NOT a factor, it's tax efficient and it requires remarkably little effort.

For more, go to Asset Allocation


Earlier I wrote that McQuown started the first index fund five years before John (Jack) Bogle started his Vanguard 500 Index Fund. Jack Bogle's Vanguard 500 Index Fund celebrated its  40th birthday during 2016.

The article that follows was published in
The Wall Street Journal
on September 2, 2016

Jack Bogle: The Undisputed Champion of the Long Run
Vanguard’s founder on 40 years of indexing success and how to invest in today’s
‘extremely risky world.’

Mr. Jenkins writes the Journal’s Business World column.

Jack Bogle is ready to declare victory.

Four decades ago, a mutual-fund industry graybeard warned him that he would “destroy the industry.” Mr. Bogle’s plan was to create a new mutual-fund company owned not by the founding entrepreneur and his partners but by the shareholders of the funds themselves.

This would keep overhead low for investors, as would a second part of his plan: an index fund that would mimic the performance of the overall stock market rather than pay genius managers to guess which stocks might go up or down.

Thus was born the Vanguard 500 Index Fund, which this week celebrated its 40th birthday. Vanguard holds, on behalf of its 20 million investor-clients, more than $3 trillion in mostly passively managed, index-style investments. Not even Warren Buffett has minted more millionaires than Jack Bogle has—and he did so not by helping them get lucky, but by teaching them how to earn the market’s long-run, average return without paying big fees to Wall Street.

At age 87, Mr. Bogle is marking his 65th year as an industry leader. His relationship with the Vanguard colossus he created has rewarmed after a period of hard feelings. And that prediction of four decades ago is coming true. The mutual-fund industry is slowly liquidating itself—except for Vanguard. Mr. Bogle happily supplies the numbers: During the 12 months that ended May 31, “the fund industry took in $87 billion . . . of which $224 billion came into Vanguard.” In other words, “in the aggregate, our competitors experienced capital outflows of $137 billion.”

Ouch. And the trend has been running this way for at least a decade. According to Bank of America, $600 billion in investor cash has exited actively managed funds since the 2008 crash, while some $961 billion has flowed into index-style investments of the sort pioneered by Vanguard.

Hyperventilating on Wall Street is only to be expected. Bill Ackman, the hedge-fund manager, recently alluded to an “index bubble.” In a widely noted research report a couple of weeks ago, analysts at Sanford Bernstein even alleged that passive investing was “worse than Marxism.”

We’ll get to what all that means (not much). We’re meeting at the Bogle clan’s Adirondack retreat, where we first spoke 10 years ago. This time Mr. Bogle has some hard news for investors. The basic appeal of index funds—their ability to deliver the market return without shifting an arm and leg to Wall Street’s army of helpers—will only become more important given the decade of depressed returns he sees ahead.

Don’t imagine a re-visitation of the ’80s or ’90s, when stocks returned 18% a year and investors, after the industry’s rake-off, imagined they “had the greatest manager in the world” because they got 14%. Those planning on a comfy retirement or putting a kid through college will have to save more, work to keep costs low, and—above all—stick to the plan.

“When the climate really gets bad, I’m not some statue out there. But when I get knots in my stomach, I say to myself, ‘Reread your books,’ ” he says. Mr. Bogle has written numerous advice books on investing, including 2007’s “The Little Book of Common Sense Investing,” which remains a perennial Amazon best seller—and all of them emphasize not trying to outguess the markets.

That said, Mr. Bogle finds today’s stock scene puzzling. Shares are highly priced in historical terms; earnings and economic growth he expects to disappoint for at least the next decade (he sees no point in trying to forecast further). And yet he advises investors to stay invested and weather the storm: “If we’re going to have lower returns, well, the worst thing you can do is reach for more yield. You just have to save more.”

Mr. Bogle relies on a forecasting model he published 25 years ago, which tells him that investors over the next decade, thanks largely to a reversion to the mean in valuations, will be lucky to clear 2% annually after costs. Yuck.

Then why invest at all? Maybe it would be better to sell and stick the cash in a bank or a mattress. “I know of no better way to guarantee you’ll have nothing at the end of the trail,” he responds. “So we know we have to invest. And there’s no better way to invest than a diversified list of stocks and bonds at very low cost.”

Mr. Bogle’s own portfolio consists of 50% stocks and 50% bonds, the latter tilted toward short- and medium-term. Keep an eagle eye on costs, he says, in a world where pre-cost returns may be as low as 3% or 4%. Inattentive investors can expect to lose as much as 70% of their profits to “hidden” fund management costs in addition to the “expense ratios” touted in mutual-fund prospectuses. (These hidden costs include things like sales load, transaction costs, idle cash and inefficient taxes.)

Mr. Bogle, to the surprise of many, is not fantastically wealthy. Vanguard was born as a “mutual” mutual-fund company, with the management company owned by the funds’ investors. So there was never any billion-dollar payday from a public stock offering or the creation of a closely-held private company of the sort enjoyed by Fidelity’s founding Johnson family.

He also knows the heartache of having just about everything he has saved tied up in volatile, sometimes irrational markets, especially now. “We’re in a difficult place,” he says. “We live in an extremely risky world—probably more risky than I can recall.”

Confidence is especially hard to come by given the antics of central banks, which many say is the only reason for today’s relatively good stock market performance. Nor does he like his options in the U.S. presidential election: “My friends, they want to vote for Hillary, a lot of them. I don’t want to but I’m going to.”

Investing, he says, always is “an act of trust—in the ability of civilization and the U.S. to continue to flourish; in the ability of corporations to continue, through efficiency and entrepreneurship and innovation, to provide substantial returns.” But nothing, not even American greatness, is guaranteed, he adds.

If an investor wants to put 5% of his portfolio into gold as a hedge against inflation or political chaos—surprise—Mr. Bogle doesn’t have a problem with that. He also emphasizes his long-held but contrarian wisdom that it’s unnecessary for U.S. investors to invest outside the U.S. Domestically listed companies already get a high percentage of their sales and profits abroad. He adds, “When you invest overseas, you get into currency changes, you get into governments that are much less stable than this one at the moment.”

The last bit is said with a chuckle, a reference to what he considers the disturbing wild card of a potential President Trump. Still, he adds: “I’d rather stick with the risks that I think I understand.”

Mr. Bogle suspects he’s probably the longest-surviving heart transplant recipient who received his heart after age 65. Back in 1996, his doctor told him the operation would be a simple one: “cut, cut, cut, sew, sew, sew.” “You forgot to mention, ‘pray, pray, pray,’ ” Mr. Bogle responded.

He knows nothing of the donor but happened once to be sharing a stage with a liver recipient who got his organ in Atlantic City the same day Mr. Bogle received his heart in Philadelphia—and who had been confidentially informed that his nameless benefactor was a 26-year-old male.

The transplant rejuvenated what had been a very sick, debilitated mutual-fund chief, but Vanguard’s board and Mr. Bogle’s anointed successor decided nonetheless to enforce the company’s mandatory retirement age of 70. Mr. Bogle professes not to understand the hard feelings that persisted for a decade, but relations are much warmer now. He’s feted on the company’s suburban Philadelphia campus. Teams of Vanguard workers seek him out for briefings. Mr. Bogle tells me a couple of senior managers have been detailed to hear out any ideas or criticisms he cares to offer.

Mr. Bogle is no idolater of the management art, not even his own. “I think a lot about leadership and I’ve come to the conclusion, by and large, it’s overrated, and that includes you know who.”

Companies operate mostly on “momentum,” he says, plus dedication of the rank and file. Vanguard has thrived on the low-cost momentum he imparted 40 years ago. But Mr. Bogle points out that he pursued the idea only after authoring a disastrous merger that nearly brought down Vanguard’s predecessor company. “My incentive in starting Vanguard, I’m very blunt about this, it was my means of preserving my career. That’s a very selfish thing.”

But he’s also equally realistic on the bad merger decision, which involved bringing in some go-go managers from Boston to run the then-illustrious but dowdy Wellington Fund during the 1960s stock boom. “The reality of life is, if you have a bagel shop and everybody is pouring into the doughnut shop across the street, if you want to stay in business, you start selling doughnuts. So I did.”

Wall Street continues to live partly off doughnuts, of course. Hence the outcry against indexing from Mr. Ackman and Sanford Bernstein. One complaint is that passive, index-style investing distorts stock prices and the allocation of capital across the economy.

Mr. Bogle laughs this off. Suppose half of all investor money went into index funds—today it’s less than a quarter—it would mean only that half the money theoretically available for trading would not be trading. So what? Prices would still be made, second-by-second, by active investors chasing the latest bit of information or analysis, as accurately or inaccurately as ever.

Yes, says Mr. Bogle, an absurdity would be a market that consisted 100% of indexing. “It would be chaos. There would be no current valuations.” But it would never happen, not least because smart big-money investors—and Mr. Bogle believes there are some; he names Cliff Asness of AQR Capital Management—would quickly pounce on any opportunity created by mispricing of valuable securities.

Nonetheless, the growth of indexing is obviously unwelcome writing on the wall for Wall Street professionals and Vanguard’s profit-making competitors like Fidelity, which have never been able to give heart and soul to low-churn indexing because indexing doesn’t generate large fees for executives and shareholders of management companies.

“The active management business will still be around but it will shrink,” Mr. Bogle predicts. “In five years, Fidelity will be sold.” He adds: “I could characterize [the potential buyer] but I don’t think that would be good for my public image.”

From our earlier conversation, it’s clear he means what he calls the financial buccaneer type, an entrepreneur more interested in milking what’s left of the active-management-fee gravy train than in providing low-cost competition for Vanguard—which means Vanguard’s best days as guardian of America’s nest egg may still lie ahead.