John Bogle’s latest book, “The Clash of the Cultures:Investment vs. Speculation,” is a must-read for investors everywhere. His multidecade career in the fund industry resonates on every page, as he continues to preach the gospel of low-cost index funds and diagnose what ails modern markets. When IndexUniverse.com Managing Editor Olly Ludwig visited with Bogle, they talked about the book, the state of indexing, his ongoing reservations with overly traded ETFs and the wisdom of adding corporate bonds to fixed-income allocations in this age of financial repression.
Ludwig:Reading the book, it seemed like an extension of the 1951 thesis you did at Princeton. It’s as if you’ve been saying the same thing through the years, but each time it’s a bit more trenchant, well organized and to the point.
Bogle: You’re very kind to say that. I guess the basic values and ideals are there. I’ve lived a long time between the thesis and the book, so I’ve had a lot of experience. And at a certain point in life, you start to get a little wisdom. So I think it’s maybe a little more impassioned now, and maybe a hair more sophisticated. But the basic value is and basic strategy has been really quite consistent throughout my long career.
Ludwig:Well it was certainly a pleasure to read. When I’m feeling dark, I think the financial world is full of mendacity and legalized theft. And then I encounter you and I think:“Hey, there is hope after all!”
In any case, there are some people who say that Rob Arnott in Newport Beach, Calif. is the second coming of John Bogle, and that this fundamental indexing thing is the next logical chapter. Do you have any opinions about that?
Bogle: Well, yes. His backtesting thing is wonderful. I never saw a backtest that wasn’t. Obviously, if you backtest and it doesn’t work, it’s never heard from again. And when after X number of tries you finally find one that works, you can brag about it. But I’m struck by the fact—I was just looking at this the other day—in a recent period looking at his returns to Sept. 1, 2012, his RAFI 1000 ETF (PRF) is up 448, and our total stock market ETF (VTI) is up 413. I think we can call that a tie.
But when you look at the risk involved, the standard deviation is a good 15 percent higher, at 22.8. We have a deviation of 19.8. So that’s higher risk for an indifferent improvement and reward.
I can’t quite get a grip on what the system is, but he made it, and I’m sure he’s doing as best he can. All these things are much harder when you go away from market weight. A company improves its dividend by 20 percent, and you’ve got to adjust. There are a lot of adjustments. And he probably runs a significantly higher turnover than we do.
Ludwig:It’s basically a fund with a small-cap and value tilt, isn’t it?
Bogle: That’s exactly what it is.
Ludwig:So you’re going to stick to your knitting in terms of market-cap weighting until the bitter end.
Bogle: Exactly, until the last dog dies. I want to say in both cases—cap-weighting and RAFI—because everything in this business is so nonsymmetrical, he can’t be a lot better and he can’t be a lot worse.
Ludwig:And you make the argument for cap weighting mindful that at its worst, it has brought us mispricings like Cisco—which everyone always talks about when they talk about the weakness of cap weighting. You talk about in your book quite a lot that the equity rally of the past generation in many ways really was unrealistic because it's just beyond the pale in terms of the historical pattern of returns. And that’s because it was fictitious on some level, if I may paraphrase your narrative a little bit.
Bogle: I think the point you read into is really a very good one. There are a lot of problems with cap-weight indexing. You’re going to have these big stocks—many of which are now gone after the early 2000s. And Cisco is now probably down 80 percent. And you say well, therefore, the index isn’t very good. The rejoinder to that is, if the index is lousy and it beats 55 to 75 percent of all the managers, they ought to be thankful that we aren’t starting a good index.
Ludwig:Now here’s a cliche question for you:Is there anything that keeps you up at night as you think about the investment landscape, the political landscape, the overall outlook for this country and for the financial markets?
Bogle: That’s a good question. But at this stage of my life, there is nothing that keeps me awake at night! I need a good night sleep too much to be troubled about things I can’t control. But let me respond to your question in a whole different way, or ask you to change the question.
Are there things I worry a lot about? The answer is unequivocally yes. It’s just that they don’t keep me awake. There’s only so much that can keep you awake at night if you have no control over how it’s going to come out.
But even as I worry, I’m quite confident that stocks will give higher returns than bonds over the next 10 years. I start with the fact that the return on bonds will be around 2 percent—that’s the yield of our Total Bond Market Fund, though it’s actually less than that. The interest coupon is what you get when you get a bond, and that dominates the return.
And on the stock side, a lot of the dividend yields are around 2 percent. Let’s call that a standoff with the bond market.
And then the fact of the matter is stock earnings, as corporate American earnings grow, about the pace of the GDP. And I look at GDP as having maybe a 5 percent nominal growth, 3 percent real growth over the next decade. I may be a little high on that. But if you add that 5 percent to that 2 percent, that’s a 7 percent return. And I don’t think you can change that a lot assuming those numbers reflect how much people are willing to pay for a dollar of earnings—the P/E ratio.
But there is a possibility of an apocalyptic event, world Depression, crash, war, famine, disease—all the things that can happen in this increasingly crowded world. Most apocalyptic events do not happen, but some can happen. And I’ve estimated a 15 percent chance of that happening. And if you want to take that 15 percent chance, I’d be a little more conservative, a little more heavily in bonds than in stocks.
Ludwig:And you’re presumably talking about the short end of the yield curve too if you’re going to take that position?
Bogle: I don’t like the short end at all. I mean, for money market funds, short is fine. But I think you’re going to almost guarantee a better payoff in the intermediate term than you are in short term. Short-term bond yields are probably less than 1 percent. Intermediates are probably 2.75 percent, something like that. But if you’re willing to go out about 15 years, have a heavier investment in corporate bonds, because I’m really concerned about governments because they produce such a small income.
So the bond index fund is about 73 percent in government bonds—U.S. Treasury-backed one way or another. And I think that is in fact heavier than most investors should have. So if they can’t handle that very small bond yield of 2 percent, you can lift it pretty close to 3 percent if you want to have 50 percent corporates and 50 percent governments.
Ludwig:So the extra yield on corporate debt is worth the risk to get away from lower-yielding government debt?
Bogle: Exactly. I wouldn’t abandon governments. It’s a question of weighting, reasonable weighting.
Ludwig:One of the heartening undercurrents in your book for me is that you’re not one of these people who look at the problems this country faces and says, “The government’s broken; I’m walking the other way.” To the contrary, you actually proffered your services to the federal government to head a commission that is aimed at restructuring the retirement system. I took you at your word. If a new president, or the current president, should give you a call, I’m inclined to think you would actually have a serious discussion. Am I right?
Bogle: Well, the answer to that question is unequivocally yes and no. The yes is I can’t think of anything I’d rather put my remaining energies into. But no, I’m happily married.
Ludwig:But in terms of the spirit that you bring to this whole endeavor, at the end of the day you seem to be an optimist. It reminds me of what Churchill said:“Americans will do the right thing after they’ve exhausted all the other possibilities.”
Bogle: What a great quote.
Ludwig:Isn’t it, though? Not that you’re exactly Churchillian, but you have a fundamental optimism that this country has the wherewithal to dig in and actually address these problems, or are you more of a skeptic at the end of the day?
Bogle: Well, I have the optimism, but I should say I know that this is a tough task in a political system, and a financial system that moves with glacial speed. Look:Glass-Steagall is gone, and looking at Dodd-Frank, they still haven’t gotten started really with many of the regulations. They’re working on them. And that’s two years later. And every single comma seems to be fought over by people with vested interests.
So I know I can only make so much difference, and I have to confess I figure it’s a small difference, although I’ve got a lot of followers out there, a lot of believers. There are the Bogleheads, the Vanguard shareholders, and the leading financial academics, the ones who, beyond any question, are the best people around—former government people like Paul Volcker and Arthur Levitt.
Ludwig:You have quite a constituency on your side, but you’re not sure it’s enough to move the mountain sort of thing, but you’re not going to stop trying.
Bogle: Well, change is going to happen—it has to happen sooner or later. I try to make that point in the book. And investors are going to learn from their own hard experience that what they’re doing today does not work. They’re going to act in their own interest, and they will bring about a betterment of society. And that means more index funds, moving to money managers that behave as fiduciaries and not as marketers. And money managers who are prepared to charge a fair price for their services and invest in a prudent long-term way, and who will live up to the rights and responsibilities of corporate governance. That’s a very important part of all this, because the corporations are all getting away with murder. Not all of them, but quite a few, metaphorically speaking at least.
So I don’t spend a lot of time saying, “Will this ever work?” All I know is I’m focused on doing my best to make it work. And if it never works, well that’s just too bad; I did my best.
Ludwig:Now as you think about what you’ve achieved at Vanguard, clearly there is an indexing trend in place. People seem to be getting it. Where does it all end? Do you think 50 percent of the market, 60 percent; 70 percent of the market starts indexing? Or are there some clear limits, in your judgment?
Bogle: I think it’s going to take a long time to get there. But right now it’s about 25 to 28 percent indexed—I’m talking now in equity mutual funds, and probably around 20 percent in the pension area. And any portfolio manager who looks at his portfolio and each one of his holdings classifying them as “overweight” or “underweight,” he’s sort of an indexer.
You can become a great skeptic of what’s going on out there that leaves you with the sense that indexing and its low costs, low transaction costs, high tax efficiency is the answer, and people get it every day.
Ludwig:Let’s talk about ETFs for a moment. They are grow ing in popularity. The ETF revolution is definitely happening. One of the points in your book, which you’ve talked about separately quite a lot as well, is that ETFs are being traded too much. That said, I imagine you’ve taken measure of the fact that Vanguard clients do this much less than the broader public, right?
Bogle: When they did that study, three-quarters of these funds are owned by speculators. I’m talking about these institutions that trade all the time.
Ludwig:You’re talking about Vanguard funds too, yes?
Bogle: Oh yes. Just look in there at the contrast at the end of that chapter, look at the turnover rate of these Vanguard funds. They’re like 500 percent a year for emerging markets, 300 percent of the year for total stock market. There’s some speculation going on there. But if you leave that out, you get mostly investors. And that study showed I think in sort of a shorthand way that the ETF shareholders here trade about 25 percent more traders than investors is what the Vanguard data shows. And I don’t regard that as shocking. I think that’s probably what one might expect.
But they used the Vanguard data to make the industry generalization. And I am absolutely certain without one shred of data that we have by far the lowest shareholder turnover rate leading up to speculators again of any fund in the business.
Ludwig:So what you’re saying is that the Vanguard numbers are better, and that that should be explicitly noted. However, the Vanguard numbers aren’t so low that it has to be free of making you a little troubled about them.
Ludwig:Any other worries about indexing?
I do worry that Vanguard is getting too big. For years the highest market share in the mutual fund industry, going back into the beginning of the industry’s history, was about 13 percent.
And Vanguard today is at 18 percent and it’s not going down. So the concentration of assets in this industry—the five largest firms are getting close to 50 percent. And the norm used to be maybe 35-40 percent. So that concentration troubles me.
Frankly, I wish we had some index competitors and some price competitors. When you’ve got to serve two masters—the theme of the book, that no man can do, that’s from Matthew—the managers are putting the food on the table for them. I’d love to have a few competitors who want to capture us—fight us on our own ground.
Ludwig:The only way to achieve that actually would be to have another mutual, which you’ve been dreaming about for decades, right?
Bogle: Yes, and then did you read the story in the book about Putnam?
Ludwig:Yes, and I’ve heard you speak about that before. That was a case of "close but no cigar," right?
Bogle: Yes, close but no cigar!
Ludwig:One of the things in your book that just left me scratching my head was the part about the rise of the institutional investor and how that sort of plays very closely into the “short-termism” that you worry about in this battle of investment vs. speculation. I found myself thinking, “wow!”—these are supposed to be the most sophisticated investors on the planet. And yet they are encouraging behavior that is, at the end of the day, not even in their own best interest.
Bogle: You could argue they were demanding it.
Ludwig:Right. How do you make heads or tails of that? These are the best and the brightest supposedly, and yet their behavior—what they’re demanding, as you just now said—is the height of folly. What is going on?
Bogle: The answer is pretty simple. And that is, they know the truth of what I’m saying there. But they think they are better than their rivals.
Ludwig:So they are in the throes of their own conceit and their own self-deception?
Bogle: Arrogance and economic interest.
Ludwig:There’s a healthy dose of cynicism there too, I presume?
Bogle: Their incentive is to get big. And they get big by promising performance. Everyone delivers for awhile, and we talk about this in the book. One of the big problems is—and look at those reversions to the mean in the back—every single fund you ever heard of that was a big success is back there, eight of them:“The bigger they are, the harder they fall.” Whoever wrote that little aphorism knew what he was talking about.
Ludwig:Now as you survey the decades that you’ve been in this business, what is your greatest surprise, and what is your biggest regret?
Bogle: Well, I’m surprised it’s taken this long, but I know there’s an awful lot of inertia in the world.
Ludwig:“It” being what, the index revolution?
Bogle: Yes, and the course of the revolution, they’re really tied pretty closely together. And you can also put them under the rubric of the shareholder-first trend. They’re all part and parcel of the same thing. That should have happened faster. I’m obviously delighted it’s catching on now. But time is money in this business. The more you contribute your hard-earned dollars to the casino, the less you get. There aren’t any questions about any of these things. So that’s a surprise. I’m also surprised that more firms haven’t gone no-load.
Ludwig:Any personal regrets?
Bogle: Well, I could have created a structure at Vanguard where I still had some kind of an equity interest in it, a tiny equity interest, and would have a little more influence. But it didn't happen, so I’m not worried about it. My fault.
Ludwig:I want to say thank-you for writing this book. It really for me was very illuminating and just a great read. You’ve been at it for awhile, but you’ve got a nice turn of phrase and it’s a pleasure to read your writing. And thanks for spending the time with me today. It’s been really a pleasure. Best of luck to you—I hope that the indexing revolution continues to unfold before your eyes.
Bogle: I’m sure it’s going to, and I thank you for your support. I see IndexUniverse.com a lot; it’s getting a lot of citations.
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- John Bogle