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Pearls of Wisdom From an Investing Legend

Pearls

John Bogle might not be a household name in our corner of the world in Singapore, but the man is a bona fide investing legend. 39 years ago, he started the Vanguard Group, a company whose focus was on bringing passively-managed index funds with low expenses to the world.

Ever since then, Vanguard and Bogle (especially Bogle) have been championing low-cost investing for individual investors (and rightly so, in some Fool’s opinions).

The Motley Fool’s chief executive Tom Gardner recently had the chance to interview the man. Here are some highlights:

On how index funds work

In Singapore, there are currently two exchange-traded funds (ETFs) that track our stock market barometer the Straits Times Index (SGX: ^STI). They are the SPDR Straits Times Index ETF (SGX: ES3) and Nikko AM Singapore STI ETF (SGX: G3B).

There are slight differences between an ETF and an index fund with the most important one being how the former is traded like a share in a stock exchange while the latter is purchased from the fund management company or its sales channels.

Nonetheless, an index fund and ETF that tracks the same index would have very similar mechanics. Let’s see what Bogle has to say about it.

Tom Gardner:

“Can you describe fundamentally how an index works for somebody who is watching and owns a Vanguard index fund? How does the process work behind the scenes? Is it five robots, three monkeys and a bunch of data, or are there human choices that are going into the index?”

John Bogle:

“Well first, you can match the index in a very casual way. If Microsoft is 2% of the index, you just put 2% of the portfolio in Microsoft. And then the same thing is true with every other fund. Not very complicated.

And if you don’t do it with great professional skill and all kinds of quantitative support, you will do a perfectly good job, but not a perfect tracking job.

In the long run, you’ll match the index, but you might beat the index by 50 basis points, half of 1% in the year and lose to it by 0.5%. The tolerance is very small.

Our investors like to see a tight tracking, so you do all these quantitative things. They call for quantitative mathematical skills, particularly when there are additions to the index or subtractions. That happens more in the Standard & Poor’s 500 [the S&P 500 – a broad measure of the American stock market] than in the total stock market.

It’s a very simple thing conceptually – but to do it with something that approaches perfection is just what you say – a lot of quantitative people hidden behind the wall.”

On whether different methods of weighting stocks in an index can work

The STI in Singapore is a market-capitalization-weighted index, much like how the S&P 500 in the USA is as well.

For example as of 28 June 2013, the bank Oversea-Chinese Banking Corporation (SGX: O39) occupies 10.16% of the STI while aircraft-servicing firm SIA Engineering’s (SGX: S59) weight in the index is only 0.42%.

The big difference there stems from the gap in their market cap: OCBC’s worth something like S$35b while SIA Engineering’s market value is “only” around S$5.4b.

We’ve previously discussed some of the flaws of a cap-weighted index and how investors could perhaps do better for themselves.

Here’s Bogle’s take on the issue.

Tom Gardner:

“If we take the concept of “too big to succeed” and apply it to a capitalization-weighted index fund, isn’t that a bad idea? Wouldn’t it be better to set the index fund up on a different set of criteria rather than weighting it by capitalization?

Aren’t we buying the largest opportunities and the most successful companies which have the smallest future market opportunity and underweighting the small, potentially upstart, disruptive future Vanguards?”

John Bogle:

“Well, you’re saying that the cap-weighting indexes gives you a flawed index, in effect. I guess my first comment would be since such an index beats the heck out of money managers, what kind of trouble would we be in if there was a perfect index?

More importantly than that, the idea of indexing (as Paul Samuelson described it when he wrote the foreword to my first book) was you will get better returns than your neighbours and sleep better than your neighbours. And your neighbours own the capitalization-weighted index.

Now, will a value-weighted index do better or a dividend-weighted index do better? Probably it will do better some of the time. I do not believe it will do better in the long run. That remains to be seen.

But when you think about it, if fundamental indexing (whatever that means exactly – but a weighting by some company’s corporation data rather than by market price) still owns essentially all the stocks that the S&P 500 owns (which is somewhat different weights) they may do better or they may do worse, but if they continue to do better, what will happen?

Everybody will take their money out of the market-weighted index and put it into the value-weighted index and then the opportunity will vanish. That’s the way the markets work.

I don’t think it’s going to work and I don’t think that it’s worthwhile to add that risk. I know what I can get. I can do better than my neighbours. I can own the whole market – that’s a little beyond the S&P but that’s a perfectly good way of looking at it. Should I give that – let’s call it the certainty of relative return – up for the uncertainty of whether one of these schemes that’s out there (equal weighting, value weighting, dividend weighting, fundamental weighting, all kinds of weighting)…

Tom Gardner:

“I feel like equal weighting would be smart, but I guess time will whether that plays out.”

John Bogle:

“We have data going back forever – but don’t let past data impress you. When people start actually doing these things – you know this from your own experience – what comes out of the lab is seldom reflected in the real world.”

On when to hold / ditch losing funds

It’s not uncommon to find investors holding on to losing funds much too longer than is necessary, paying off expensive fees to managers for no reason at all.

But, it’s also fair to say that it’s not easy to know when exactly it is the right time to ditch a losing fund. Here’s what Bogle has to say about it.

Tom Gardner:

“Even the most successful, actively traded funds at Vanguard have a period of three years – sometimes even five years – where they underperform, but net-net they’ve outperformed in the case of outperforming actively managed funds.

Let’s just say they have a few qualities that we probably both love: very low turnover, tenured leadership, a fundamental business-focused analytic approach.

But even in those cases where the fund is very well run… even Warren Buffett and Charlie Munger are going to have a year or a period of a couple of years, potentially, where they lose to the market.

What’s the appropriate amount of time to hold something before saying, “This team doesn’t really know what they’re doing?” “

John Bogle:

“Well, let me start off by explaining Vanguard’s philosophy as I implemented it – not as they necessarily do today. That is very early after we closed Windsor Fund back in 1985 – it was getting too big – and we started Windsor II.

Everybody said it would never do nearly as well as Windsor. Of course, it’s done better a little. They track each other very closely, so I don’t want to make an issue about that.

Then we had U.S. Growth, and that was run by Wellington. We decided we needed a new manager. I wasn’t so sure about them, so I did what set the standards for everything I did since then, and that is bring in another manager and then another manager and then another.

We have a lot of equity firms that have five managers. It’s not that it’s easy to pick five managers, but if you’re comparing yourself with the universe of large-cap value funds and there are fifty funds in that universe, five is going to have the same return. It’s a law of large numbers thing.

Most of our equity funds have five to seven managers, so there’s not much premium on manager selection. You hope they will do well. We happen to be having a good year this year, but we’ll have a bad one because that’s the nature of the business.

What you don’t want is something that departs so far from the market, particularly on the upside (and you don’t like it on the downside) but on the upside, it draws money in. It brings in these investors who are looking for the next big thing, the next hot thing.

And we win by about a point and a half a year on average – not because we pick better managers, but because we have very low operating costs in our expense ratio. We negotiate the fees way down with the advisors, because the advisors are not starving to death in terms of the dollar fees.

And then we’ve looked, as you said, for long-term managers with lower turnover. And then we have no loads. If you look at all those numbers – if we’re good enough to be average, or lucky enough to be average, we win by about a point and a half a year which is 20% over 10 years, and I always thought that was quite good enough.”

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. This article was first published on fool.com. It has been edited for fool.sg