Vanguard founder John Bogle gave a powerful speech last month at the Q Group’s Spring Seminar that lays out the case (again) for favoring basic indexing and shunning complexity in matters of portfolio design and management. As Morningstar’s John Rekenthaler points out, Bogle wields the weapon of “basic math” with devastating effect on the expectations of investment managers who aspire to rocket science in the pursuit of performance glory. Anyone who’s familiar with Bogle’s long-running advice to keep it simple and favor plain-vanilla index funds will find the usual red meat here. Nonetheless, the latest sermon from one of index investing’s founding fathers makes for awkward reading for those inclined to challenge the great man. As a sample, consider the following excerpts from last month’s oration on “David and Goliath: Who Wins The Quantitative Battle?”:
The armor of the algorithmic quants—the managers of hedge funds and other aggressive pools of capital—is the mother’s milk of finance: money. And lots of it. But even if a manager succeeds in consistently outpacing the risk-adjusted returns of the S&P 500—no mean task—higher fees place a heavy burden on the returns actually delivered to clients. The arithmetic quants typically earn the returns on the S&P 500 by holding its stocks, and charges almost nothing for doing so.
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… “Smart beta” has great momentum—the promise of ETFs to capitalize on market sectors (“factors”) that are expected to enhance return. Most observers seem to believe that this trend began a decade ago with the focus on “fundamentals” in the RAFI 1000 ETF and, a year later, the first Wisdom Tree ETF, a portfolio of stocks weighted by dividend payouts rather than market capitalizations.
But RAFI 1000 and Wisdom Tree—at least so far—haven’t destroyed anything. Both have failed to capitalize on the “new paradigm” that Dr. Siegel described. After, respectively, ten and nine years since inception, (through March 2016), RAFI 1000 has eked out a return margin of 50 basis points over Vanguard’s S&P 500 Index Fund (7.8% vs. 7.3%), but only by assuming about 15% more risk (standard deviation 17.4% vs. 15%). Result: Sharpe ratio of 0.38 for RAFI vs. 0.40 for the 500. Wisdom Tree Dividend: slightly lower return, slightly lower risk; Sharpe Ratio 0.39 vs. 0.41. Of course! When a portfolio holds essentially the same stocks as the index but weights them differently—and carries a higher expense ratio—aren’t those shortfalls in risk-adjusted return pretty much what we should have expected?
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In my experience, as assets of a particular fund or style or class grow and competition for performance increases, declining relative returns are normal and to be expected. More and more brilliant, energetic, STEM-educated individuals enter the field, seeking to prove themselves and earn such extraordinary compensation. Then, in theory at least, price discovery becomes more challenging; spreads between stock prices and intrinsic value narrow; and strategies that have won in the past become more popular and draw increasing assets. Result: factor returns ultimately revert to the mean.
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Harsh criticism of S&P 500 indexing also comes from William Ackman. In the 2015 Annual Report of Pershing Square Capital Management (whose fund lagged the S&P 500 by 21.9 percentage points for the year), he writes, “Index funds have very low fees and have outpaced the average manager in recent years.” Fact: the 500 has outpaced the average actively-managed equity fund by a reasonably consistent annual rate of 1.6 percentage points over the past 70 years. Mr. Ackman also seems to believe the canard that index funds are “forced to buy more [of a stock] as stock prices rise. Not so. When a stock rises in price, the value of the index fund’s investment rises by precisely the same amount.