Index funds’ key flaws – and how we overcome them

Without resorting to Google, try to guess who said this: “if everybody indexed, the only word you could use is chaos, catastrophe. The markets would fail.” It’s none other than John Bogle! Long known and widely lauded as “the father of indexing,” he founded and for decades ran Vanguard Group; since the 1970s it’s been at the forefront of the “indexing revolution.” In 1999, Fortune magazine named him as “one of the four investment giants of the twentieth century” (the others were Warren Buffett, Peter Lynch and George Soros); and in 2005, Time magazine included him in that year’s list of the world’s 100 most influential people.

Bogle issued his warning at Berkshire Hathaway’s AGM in 2017. He conceded the most fundamental – and, if trends persist, eventually fatal – weakness of index funds: there’s a limit to the amount of passive investing which financial markets can absorb without buckling. As index funds’ collective size waxes, markets increasingly lack participants who consciously seek price discovery; and as fewer people exercise judgment, more turmoil erupts.

Index funds don’t buy and sell on the basis of securities’ subjective values in relation to their prices, but rather according to their objective weightings in indexes like the Standard & Poor’s 500. When for whatever reason the price of one of these 500 stocks rises, so does its weighting – and index funds buy commensurately. As these funds’ collective influence increases, their increased volume of buying causes this security’s price to rise further – which prompts them to buy even more of its shares. Conversely, when the price of a given security falls, so too does its weight in the Index – and the index fund sells; and the more this security’s price falls, the more of this stock index funds dump.

As the power of index funds grows, Bogle reckons, markets necessarily become more unstable and “less efficient” (see “Jack Bogle Envisions ‘Chaos, Catastrophe’ in Markets If Everyone Were to Index,” Yahoo Finance, 7 May 2017). Under these conditions, some (activist) managers can outperform by greater amounts, and others will underperform more egregiously. “This is the equation, (but) I’m not concerned about it. It’s going to take a long, long time (for indexing to reach) anywhere near 50% (of the market) ...”

Bogle was rarely glaringly mistaken, but in this critical respect he increasingly is: index funds now own one-third of all American equities, and their share of total funds under management (FUM) in the U.S. is now approaching – and in the next couple of years will likely surpass – 50%. Moreover, and as Bogle acknowledged, since 2016 Exchange-Traded Funds (ETFs) have often constituted more than 40% of the daily trading volume on the entire U.S. stock market. Indeed, JPMorgan Chase estimated in 2019 that 90% of this volume derived from “trend-following” traders (quant, index, ETF, futures and options-related strategies) “whose trading decisions are often driven by algorithmic or programmatic trading systems rather than fundamental reasons.”

The theoretical issue caused by excessive indexing that Bogle foresaw before his death in 2019 is now becoming an actual – yet unheralded and growing – problem.

An Overview of My Analysis and Conclusions

This is the most fundamental – and potentially fatal – of index funds’ weaknesses; in this article I’ll detail it and two other big ones. Bogle understood index funds’ weaknesses as well as their strengths. For that reason, I’ll make my case largely using his words, particularly from his book The Little Book of Common Sense Investing (John Wiley & Sons, revised and updated 10^th anniversary ed., 2017). Unless otherwise indicated, all quotes and page numbers refer to this book.

From my analysis emerge seven key conclusions:  

1. Bogle was correct: low-cost index funds’ costs are almost always lower than actively managed funds’ costs. Largely for this reason, these index funds’ returns usually exceed actively managed funds’.
2. Accordingly, Warren Buffet is also right: “a low-cost index fund is the most sensible equity investment for the great majority of investors.”
3. Yet Bogle also overlooks a crucial point: net of fees, half of the active managed funds which existed throughout the period 1991-2016 (i.e., those whose total fees were below the median) outperformed the ultra-low fee traditional index fund.
4. Leithner & Company is long-lived (it was founded in 1999), and its expenses are far lower than most actively-managed funds’ – and are even lower than some low-cost index funds’. Additionally, it charges no entry, management or exit fees – only a performance fee based upon profits earned rather than assets amassed.
5. Partly for these reasons, its long-term return since 1999 has exceeded the All Ordinaries Accumulation Index’s – and thus most Australian managed funds’. Its returns have also been less volatile than its benchmark’s and rivals’.
6. Bogle expected, and my update of his analysis concurs, that stocks’ – and thus index funds’ – returns during the next decades will likely be more modest and volatile than they’ve been since the early-1980s.
7. Given conclusions #3-6, for conservative investors who can think independently but don’t have the time or inclination to invest for themselves, long-established and low-cost vehicles like Leithner & Company might be a more sensible choice than most index funds, ETFs and the like.

Index Funds’ Inexorable Growth

An “active” fund’s manager seeks to generate results that match or exceed its benchmark’s. Only by constructing portfolios whose composition differs from the benchmark can active funds outperform it. The risk is that they underperform. A “passive” (more commonly known as “index”) fund eliminates this risk. Its managers – which, in effect, are computers – construct a portfolio that reproduces as closely as possible the composition of its benchmark (commonly a key financial market index such as the S&P 500 Index). By mimicking its benchmark, the passive fund will – assuming it can reduce its costs to a bare minimum – match (or nearly match) its performance.

Using data compiled by Morningstar Direct, PWL Capital has sorted into “active” and “passive” categories almost all managed funds (including exchange-traded funds) in Canada, the U.S. and the rest of the world. To mitigate survivorship bias, their data include funds that disappeared during the period it analysed (for full details, see The Passive vs. Active Fund Monitor, Spring 2023).

Figure 1 plots market shares (as a percentage of total, i.e., active plus passive management) of “passive” investments. Over the past decade in Canada, indexing has grown modestly from a low base (from 10% in 2013 to 16% in 2022). Outside Canada and the U.S., growth has doubled from a somewhat higher base: passive investment has risen from 13% of total managed investment in 2013 to 28% in 2022. Finally, growth in the U.S. has advanced furthest and from the highest base: passive investment has risen from 24% of total managed FUM in 2013 to 45% in 2022.

Figure 1: “Passive” Managed Funds’ Market Share (Percentage of Total Managed FUM), 2013-2022 

If an “index revolution” has occurred, as the proponents of indexing claim, then thus far it’s an American but not yet a global revolution.

Two Definitions and Two Distinctions

Bogle emphasises “that not all index funds are created equal. Although their index-based portfolios are substantially identical, their costs are anything but ... Some have miniscule expense ratios; others have expense ratios that surpass the bounds of reason. Some are no-load funds, but nearly a third ... have substantial front-end loads ... Worse, the high-cost index funds also saddle investors with front-end sales loads of at least 1% of assets and as much as an astounding 5.75% of assets” (pp. 158-159).

“The wise investor,” Bogle urges, “will select only those index funds that are available without sales loads, and those operating with the lowest costs. These costs – no surprise here! – directly relate to the return delivered to the shareholders of these funds” (p. 160; see also Table 1 below).

It’s also vital to distinguish “traditional index funds” (TIFs), as Bogle has dubbed them, from Exchange-Trade Funds (ETFs). An ETF, says Investopedia, “is a type of pooled investment security that operates much like a mutual fund. Typically, ETFs will track a particular index, sector, commodity, or other assets, but unlike mutual funds, ETFs can be purchased or sold on a stock exchange the same way that a regular stock can. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. ETFs can even be structured to track specific investment strategies.”

“The quintessential aspect of the original paradigm of the TIF,” Bogle writes (pp. 180-181), “is to assure, indeed virtually guarantee, that investors will earn their fair share of the stock market’s return. ETF traders, however, have nothing remotely resembling such a guarantee. In fact, after all the selection challenges, timing risks, extra costs and added taxes, ETF traders can have absolutely no idea what relationship their investment returns will bear to the returns earned in the stock market.” Hence “these differences between the traditional index fund – the TIF – and the index fund nouveau represented by the ETF are stark.”

“If long-term investment was the paradigm for the original TIF,” Bogle adds, “surely using (ETFs) as trading vehicles can only be described as short-term speculation. If the broadest possible diversification was the original paradigm, holding discrete sectors of the market offers far less diversification and commensurately more risk. If the original paradigm was minimal cost, then this is obviated by holding market-sector index funds that carry higher costs, entail brokerage commissions when they are traded, and incur tax burdens if one has the good fortune to trade successfully” (pp. 179-180).

Bogle is unequivocal: “in almost every respect, most ETFs have strayed far from the concepts of buy-and-hold, diversification and rock-bottom costs that are exemplified by the traditional index fund” (p. 186).

ETFs are growing even more quickly than TIFs. “From a single S&P 500 ETF (in 1993),” Bogle notes, “the number of ETFs has grown into the thousands – and account for fully half of the asset base of all index funds (in 2017, $2.5 trillion of the $5 trillion total). The profile of ETF offerings differs radically from the profile of TIF offerings, and the dollar volume of ETFs’ traded sometimes constituted as much as 40% or more of the daily trading volume on the entire U.S. stock market” (pp. 183-184).

Bogle’s objection to ETFs is thus three-fold. First, because many of them track something other than a major market index such as the S&P 500, their returns depart from – and are usually lower than – major indexes’. Second, ETFs’ costs, which usually exceed TIFs’ (sometimes greatly), further hamper their inability to generate competitive returns. Thirdly, promoters of ETFs “claim (or at least strongly imply) that their new index strategies will consistently outpace the broad market indexes ... ETF managers charge a higher fee for that higher potential reward, whether or not it is actually delivered (usually not)” (p. 196).

Numerous studies have substantiated Bogle’s doubts: the most recent one, led by Derek Horstmeyer, a professor of finance at George Mason University, was summarised in The Wall Street Journal (see “Factor ETFs Fail to Deliver Their Promised Outsized Returns,” 5 October).

Bogle draws a sobering parallel: “with the rise of ETFs, ... remember the ‘Go-Go’ fund craze of 1965-1968 and the ‘Nifty Fifty’ craze of 1970-1973; popular fads are driving product creation in the fund industry. These products are great for fund sponsors, but almost always awful for fund investors” (p. 200).

Bogle concludes: “I urge you not to be tempted by the siren song of paradigms that promise the accumulation of wealth that are far beyond the rewards of the traditional index fund” (p. 205).

Why Do Low-Cost TIFs Outperform Most Actively-Managed Funds?

Late in his life, in an interview published in 1976 (he died later that year), “Benjamin Graham acknowledged the failure of most active investment managers to outpace the market ...” His interviewer asked him: “Can the average manager obtain better results than the Standard & Poor’s 500 Index over the years?” Graham replied: “No. In effect that would mean that stock market experts as a whole could beat themselves – a logical contradiction” (p. 216). 

Why, over short and medium (but, as we’ll see, not necessarily over long) terms, do low-cost TIFs outperform most active managed funds? The first reason, which Graham mentioned, is a matter of basic logic. To appreciate it, consider a simple example and a simplifying (but, as we saw in the previous section, incorrect) assumption: assume that no investor, institutional or private, is a passive (index) investor; although it’s possible that a minute number of portfolios coincidentally mirror the market, no investor’s portfolio consciously mimics it. Let’s also ignore all management and other costs, fees, etc., and assume that by “the market” we mean the S&P 500 Index. The market’s return over a given interval is thus the Index’s return.

Under any conditions, the only way to outperform the Index is to construct a portfolio whose components and weights differ from the Index’s – which for this example's sake we’re assuming that virtually 100% of investors do. Whether or not we also assume that they’re striving to outperform the market, clearly they can’t all succeed: investors as a whole can’t outperform investors as a whole.

Equally clearly, but imprecisely, under these conditions and over a given interval, it’s reasonable to expect that some investors will outperform the Index, some will match it and others will underperform it. For the sake of brevity, excluding statistical details and ignoring the cut-off points between matching and outperforming the Index, and between matching and underperforming the Index,

it’s hard to posit reasonable assumptions under which more than ca. 30% of investors will outperform the Index during a given interval; and assuming that investors’ returns are mean-regressing (which they are, and which Chapter 11 of Bogle’s book details) it’s hard to posit scenarios under which more than 10-20% of investors’ outperform the Index over extended periods.

Why do low-cost TIFs outperform most active managed funds? The second reason is empirical (but in a sense is tautological): as I’ll detail in the next section, low-cost TIFs’ expenses and fees are usually considerably lower than active funds’. “All of that swapping of stock certificates back and forth,” for example, (p. 198), “however it may work out for a given buyer and seller, in the aggregate it enriches only our financial intermediaries.”

Combining these two reasons, “assuming that it comprises 100% of the market, active management as a whole cannot achieve gross returns exceeding the market as a whole. Therefore it must, on average, underperform the (Index) by the amount of expense and transaction costs” (pp. xxix-xxx).

In other words, when we subtract the costs of financial intermediation – that is, advisers’ and managers’ fees, the portfolio turnover that generates brokerage commissions, the sales loads, marketing costs, operating costs (including high salaries, extensive marketing, etc.) – “the returns to investors as a group must, will, and do fall short of the market return by an amount precisely equal to the aggregate amount of those costs. That is the simple, undeniable reality of investing” (p. 40).

Bogle adds: “how much do the costs of financial intermediation matter? Hugely! In fact, the high costs of equity funds have played a determinative role in explaining why fund managers have lagged the returns of the stock market so consistently and for so long” (p. 44).

The annual S&P Indices versus Active (SPIVA) report provides comprehensive data comparing active mutual funds grouped by various strategies (e.g., large cap, small cap, etc.) with relevant market indexes. Over the years, its results have been unequivocal: certainly more than 80% and probably more than 90% of actively managed mutual funds have underperformed their benchmark indexes; specifically, “the S&P 500 Index has outperformed ca. 95% of actively managed large cap funds” (pp. 32-33).

Bogle concludes: “a low-cost (TIF), then, is guaranteed to outpace over time the returns earned by equity investors as a (whole). Once you recognise this fact, you can see that (it) is guaranteed to win not only over time, but every year, month and week ... No matter how long or short the time frame, the gross return in the stock market, minus intermediation costs, equals the net return earned by investors as a (whole)” (p. 31).

Funds’ Expenses and Fees

According to Bogle (pp. 40-41), “in actively managed equity mutual funds, management fees and operating expenses – combined in what we call a fund’s expense ratio – average about 1.3% (of assets) per year, and about 0.8% when weighted by fund assets. Then add, say, another 0.5% in sales charges ... (and) then add another giant additional cost, all the more pernicious by being invisible. I am referring to the hidden costs of portfolio turnover (which includes brokerage commissions, bid-ask spreads and market impact costs), which I estimate average a full 1.0% per year” (pp. 40-41). 

As a result, “the ‘all-in’ cost of equity fund ownership can come to as much as 2-3% (of the fund’s assets) per year” (p. 42).

Bogle provides a startling example of these costs’ implications. Assuming that the cost of a managed investment is at least 2% per year, and that the market generates a total return averaging 7% per year over a half-century, the result is “a net annual return of just 5% for the average fund.”

Over 50 years – “an investment lifetime is actually even longer than that” – ignoring costs an initial investment of $10,000 grows to $294,600. Taking these costs into consideration, however, it grows to just $144,700. Costs of $179,900, in other words, comprise 63% of total pre-cost proceeds! (pp. 45-48)

“In this example,” writes Bogle, “the investor, who put up 100% of the capital and assumed 100% of the risk, earned less than 40% of the total potential market return. Our system of financial intermediation, which put up 0% of the capital and assumed 0% of the risk, essentially confiscated 60% of that return. What you see in this example ... is that over the long term, the miracle of compounding returns has been overwhelmed by the tyranny of compounding costs” (pp. 48-49).

Adding portfolio turnover costs (which Bogle estimates at 1% of its turnover rate) to each fund’s expense ratio (but ignoring sales charges and advisers’ fees), ranking funds according to cost and expressing results by quartile “makes the relationship between fund costs and fund returns sheer dynamite. Taking into account both costs, we find that all-in annual costs of actively managed equity funds range from 0.9% of assets in the lowest-cost quartile to 2.3% in the highest-cost quartile” (p. 54; see also Table 1, which summarises Bogle’s results on p. 58).

By comparison, since 2018 Leithner & Company’s expense ratio has averaged 0.17% of assets – which is extremely low (quartile #1) by Table 1’s standards. Moreover, its portfolio turnover is also extremely low and it levies no establishment, contribution and exit fees; nor does it (or do any of its shareholders) pay fees to advisers. It does, however, charge a performance fee. As a result, its total annual impost (expenses plus performance fee) over the past five years, which has averaged 1.07% of its assets, likely places it at the boundary between quartiles #1 and #2 of  Table 1.

Table 1: American Managed Funds, Returns versus Costs as Percentages of Assets, Annual Average 1991-2016

Crucially, Bogle’s analysis included only those funds that survived the entire 25-year period under consideration. Accordingly, Table 1 accurately states the fees and results of long-lived funds, but “significantly overstate the results (of active managers as a whole) ... due to survivorship bias ... The index fund’s return over the past 25 years is all the more impressive since the returns of the active equity funds are overstated by the fact that only the funds that were good enough to survive ... are included in the data. Adjusted for this ‘survivorship bias,’ the return of the average equity fund would fall from 9.0% to an estimated 7.5% (p.61).”

Note that when we add funds’ costs to their net returns, the gross annual return in each quartile is virtually identical. “In each quartile, costs account for essentially all of the differences of annual net returns” (p. 59).

Bogle’s concludes his discussion of Table 1: “ ... if investors could rely only a single factor to select future superior performers and to avoid future inferior performers, that factor would be fund costs. The record could hardly be clearer: the more the managers and brokers take, the less the investors make. Again, if the managers take (next to) nothing, the investors receive (almost) everything ...” (p. 62).

Index Funds’ First Achilles’ Heel

TIFs’ first major shortcoming can be stated concisely: their cost advantage over active funds is real, but it’s easy to overstate. Did you notice the two crucial points in Table 1 that Bogle overlooks? He showed that (1) the gross returns of actively-managed funds that operated throughout this 25-year period exceeded the low-cost S&P 500 Index fund’s gross return, and (2) the lower-cost (quartiles #1 and #2) funds’ net returns also outperformed the index fund’s net return. Low-cost TIFs often (half the time according to Table 1) outperform long-lived active funds not because active funds’ gross (that is, pre-cost) returns are too low, but because their costs are far too high.

This result’s implication is also critical: if they can reduce their expenses and fees to or below the average of index funds’ expenses and fees, then some – particularly long-lived – active funds will likely outperform low-cost TIFs.

Index Funds’ Second Achilles’ Heel

Because they mirror their benchmark, low-cost TIFs’ results reflect their benchmark. When the S&P 500 Index generates hefty gains, so do the low-cost TIFs that benchmark it; when the Index produces hefty losses, so do these TIFs. Since the early-1980s, the direction of equity markets has been mostly upwards – and hence the memories of long stretches when returns were negligible or negative have mostly faded. 

The rise to popularity of TIFs has occurred during the longest and strongest bull market in American history. An epochal decrease – and cumulative collapse – of interest rates fuelled this bull market. If and when it dies, will TIFs’ extended honeymoon also end? Investors have embraced TIFs and related creatures such as ETFs during a balmy investment climate; will they abandon them when the climate cools and the weather becomes stormy?

Bogle emphasises “the remarkable, if essential, linkage between the cumulative long-term returns earned by U.S. business – the annual dividend yield plus the annual rate of earnings growth – and the cumulative returns earned by the stock market ...” (p. 10). He divides stocks’ returns into two parts: “(1) investment return (enterprise), consisting of the initial dividend yield on stocks plus their subsequent earnings growth (together, they form the essence of what we call ‘intrinsic value’) and (2) speculative return, the impact of changing price/earnings multiples on stock prices” (p. 15).

“Look,” he says, “at the record since the beginning of the 20^th century. The average annual total return on stocks was 9.5%. The investment return alone was 9.0% – 4.4% from dividend yield and 4.6% from earnings growth.”

The difference between the total return and the investment return “of 0.5% per year arose from ... speculative return. (It) may be a plus or a minus, depending on the willingness of investors to pay either higher or lower prices for each $1 of earnings at the end of a given period than at the beginning” (pp. 10-11).

What underpins the speculative return? “The price/earnings (P/E) ratio measures the number of dollars investors are willing to pay for each $1 of earnings. As investor confidence waxes and wanes, P/E multiples rise and fall.” Bogle acknowledges that changes of interest rates affect the market’s P/E multiple. Whether it’s rates or some other reason, “when greed holds sway, very high P/Es (and positive speculative returns) are likely ... When fear is in the saddle, P/Es are typically very low (and speculative returns become negative)” (p. 11).

Speculative returns – positive and negative – punctuate some periods more than others: “to be sure, stock market returns sometimes get well ahead of business fundamentals ... But it has only been a matter of time until, as if drawn by a magnet, they ultimately return to the long-term norm, although often only after falling well behind for a time, as in the mid-1940s, the late-1970s and the 2003 market lows. It’s called reversion (or regression) to the mean” (p. 13).

“In our foolish focus on the short-term stock market distractions of the moment,” warns Bogle, “investors often overlook this long history. When the returns on stocks depart materially from the long-term norm, we ignore the reality that it is rarely because of the economics of investing – the earnings growth and dividend yields of our corporations. Rather, the reason that annual stock returns are so volatile is largely because of the emotions of investing, reflected in those changing P/E ratios” (pp. 13-14).

He doesn’t stop there: “while the prices we pay for stocks often lose touch with the reality of corporate (profits and dividends), in the long run reality rules. So, while investors seem to intuitively accept that the past is inevitably prologue to the future, any past stock market returns that have included a high speculative stock return component are deeply flawed guides to what lies ahead” (p. 14).

With that caution in mind, I’ve updated Bogle’s results to June 2023. I’ve followed his approach but in one respect have improved his method: rather than disaggregate one-year results into their three components, I’ve disaggregated the S&P 500’s five-year CAGRs (i.e., January 1871-January 1876, February 1871-February 1876, ... June 2022-June 2023) into their three components. I’ve used the data collated by Robert Shiller; Figure 2 presents my results.

They don’t just corroborate Bogle’s; they also add additional crucial information. Over the entire 147-year period since 1876, as well as since 1900, the message is clear: “stock returns depend almost entirely on the ... investment returns earned by our corporations. The perception of investors, reflected by the speculative returns, counts for little. It is economics that controls long-term equity returns; the impact of emotions, so dominant in the short term, dissolves (in the long term)” (p. 20). Specifically, of the S&P 500’s average five-year total CAGR of 9.2% since 1876, the contributions of the three components are: (1) growth of earnings 49%, dividends 46% and change of P/E ratio 5%.

Figure 2: Decomposition of the S&P 500’s Five-Year CAGRs since 1876

As time has passed, however, the average five year total CAGR has risen and its components’ weightings have changed greatly. Most significantly, in each of the successive intervals in Figure 2 the dividend’s weighting falls and the speculative return’s weighting rises.

Of the S&P 500’s average five-year total CAGR of 11.6% since 1982 (the commonly-accepted start of the mega-bull market), the contributions of the three components are: (1) growth of earnings 56%, (2) dividends 21% and (3) change of P/E ratio 23%. Speculation, in other words has contributed more to returns than dividends!

“With today’s lower dividend yields,” cautions Bogle, as well as “the prospect of lower earnings growth and aggressive market valuations (in the form of high speculative returns), it would be foolish in the extreme to assume that such a return (from 1976-2016 the S&P grew at an annual rate of 10.9%) will recur over the next four decades” (p. 35).

“On balance over more than four decades,” he adds, “equity investors have enjoyed extraordinary returns. But since speculative return was responsible for fully 25% of the market’s annual return during this (1976-2016) period, it is unrealistic to expect P/E multiple expansion to repeat that performance, nor to give much, if any, momentum to the investment returns earned by stocks in the decade ahead. Common sense tells us that compared to the long-term annual nominal return of 9.5% since 1900, we’re again facing an era of subdued returns in the stock market (p. 96).

Bogle says “again” because in the first (2007) edition of The Little Book of Common Sense Investing he estimated that during the decade to 2016 stocks’ returns would average 7% per year. The actual return was 6.9%. He hastens to add: “hold the applause. I underestimated speculative return by about the same amount as I overestimated investment return.” (p. 97).

“Why the continued caution? Simply because the sources of stock returns tell us to be cautious. First, today’s dividend yield on stocks is not 4.4% (the historical rate) but 2%. Thus we can expect a deadweight loss of 2.4 percentage points per year in the contribution of dividend income to investment return. As for corporate earnings, let’s assume that they will continue to grow ... at about the pace of the economy’s expected nominal growth rate of 4-5% per year in gross domestic product (GDP) over the coming decade, below the U.S.’s long-term nominal growth rate of 6%-plus.”

If these expectations are reasonable, then according to Bogle “the most likely expectation for the investment return on stocks would be in the range 6-7%. I’ll be cautious and project an annual return averaging 6%” (p. 98). That’s roughly half the S&P 500’s average five-year CAGR since 1982.

“Now consider speculative return. (In) 2017, the price/earnings multiple on stocks was 23.7 times (it was much the same during the first half of this year). If the P/E ratio remains at that level a decade hence, speculative return would neither add nor subtract from that possible 6% investment return.” Bogle’s guess, “an informed guess but still a guess, is that by decade’s end (2019), the ratio might ease to, say, 20 times or even less. Such a revaluation would reduce the market’s return by about 2 percentage points per year, resulting in an annual rate of return of 4% for the U.S. stock market.” (p. 99).

Bogle emphasises: “you don’t have to agree with me. If you think today’s (2016) P/E multiple of 23.7 will be unchanged a decade hence, speculative return would be zero, and the investment return would represent the market’s entire return. If you expect the valuation to rise to 30 times (I don’t), add 1.5 percentage points, bringing the annual return on stocks to 7.5%. If you think the P/E will drop to 12 times, subtract 7 percentage points, reducing the total nominal return on stocks to minus 1 percent” (p. 100).

“My point,” he concludes, “is that you don’t need to accept my cautious scenario. Feel free to disagree. Project the coming decade for yourself by applying the current dividend yield (there’s no escaping that!), your own rational expectations for earnings growth, and your own view of the P/E ratio in 2027. That total will represent your own reasonable expectation for stock returns over the coming decade” (pp. 100-101).

What kind of return should you expect from your portfolio? On 22 March 2019, The Sarasota Herald-Tribune quoted Warren Buffett: “stocks are a decent way to make 6-7% annually. However, anyone who expects to make 15% (year in and year out) ... is living in a dream world.” “Now, maybe you’d like to argue a different case,” he famously wrote in “Mr Buffett on the Stock Market,” (Forbes, 22 November 1999).

“Fair enough. But give me your assumptions. If you think the American public is going to make 12% a year in stocks, I think you have to say, for example, ‘Well, that’s because I expect GDP to grow at 10% a year, dividends to add two percentage points to returns, and interest rates to stay at a constant level.’ Or you’ve got to rearrange these key variables in some other manner. The Tinker Bell approach – clap if you believe – just won’t cut it.”

Index Funds’ Third – and Potentially Biggest – Achilles’ Heel

In The Wall Street Journal (“Bogle Sounds a Warning on Index Funds,” 29 November 2018), “the father of indexing” wrote: “it’s probably only a matter of time before (index funds) own half of all U.S. stocks ... If historical trends continue, a handful of giant institutional investors will one day hold voting control of virtually every large U.S. corporation.” (In 2018, three giant fund managers collectively comprised 81% of index fund assets: Vanguard’s market share was 51%, BlackRock’s was 21% and State Street Global’s was 9%; since then, nothing much has changed.)

John Coates, a Professor of Law at Harvard University, agrees. In the near future, he contended a few years ago, just 12 management professionals – meaning a dozen people, not a dozen firms or management committees – will likely have “practical power over the majority of U.S. public companies.” The implications for corporate governance are simply staggering (see “The Future of Corporate Governance Part I: The Problem of Twelve,” Harvard Public Law Working Paper No. 19-07, 14 March 2019).

Bogle concluded: “public policy cannot ignore this growing dominance (of index funds) and (must) consider its impact on the financial markets, corporate governance, and regulation ... I do not believe that such concentration would serve the national interest. These will be major issues in the coming era.”

For millions of investors, the “index fund revolution” has delivered good returns in exchange for low fees. Yet it’s also pushed the U.S. even further towards financial oligarchy – which surely is bad for its economy, consumers and investors as a whole. Other major consequences – including price distortion – have accompanied the seismic shift to index investing.

In plain English, passive investment is degrading the quality of information that markets convey: index funds are muddying price signals and as a result are making business decisions harder and thus more prone to error (see, for example, Jonathan Brogaard et al., “The Economic Impact of Index Investing,” The Review of Financial Studies, vol. 32, issue 9, September 2019).

The result, says Merryn Somerset Webb (“The Future Looks Messy for Passive Investors,” Bloomberg, 6 February 2023), is that index funds necessarily “buy high and sell low. In the technology bubble of the 1990s, passive investors were, as researchers at Cass Business School put it at the time, ‘effectively forced’ to buy bigger and bigger stakes in overpriced companies. They were forced to do the same during the growth bubble of the last decade. This all reached nutty extremes in 2009 and 2021 ...”

“The truth,” Webb concludes, “is that passive investing is simply momentum investing: buy in and you get to hold lots of stuff that has done well recently (and the more overpriced they are, the more you hold) and not much of the stuff that hasn’t. That can be just fine – until conditions change.”

Indexing has further inflated the prices of popular stocks, and a considerable amount of trading is now based not upon fundamentals but index weightings.

For some investors this could end very badly, Frank Holes, a columnist in Forbes, told CNBC in September 2018. “If there’s a rush to the exit,” he wrote on 19 September 2019, “the selloff would cut through a significant swath of index investors unawares. And just as Warren Buffett once said, ‘Only when the tide goes out do you discover who’s been swimming naked.’”

Conclusions and Implications

“In previous chapters,” Bogle wrote on p. 195 of The Little Book of Common Sense Investing, “we’ve demonstrated – pretty much unequivocally – the success of index funds in providing long-term returns to investors that have vastly surpassed the returns achieved by investors in actively managed mutual funds.” 

Bogle’s conclusion isn’t false, but it requires two vital caveats. First, it’s low-cost TIFs that outperform: like most actively-managed funds, index funds whose costs aren’t rock bottom, as well as ETFs that reference other indexes – and particularly “factor” ETFs – that also typically underperform.

Second, long-established activist managers lag their benchmarks not because their gross returns are too low but because their expenses and fees are too high. As Bogle emphasised, he’s likely overstated the returns of active managers as a whole by only including the returns of those who operated throughout the period in question.

What ensues logically also occurs empirically: long-lived active managers whose expenses and fees are low outperform over the long term.

Burton Malkiel agrees. In his Foreword to Charles Ellis’ book, The Index Revolution: Why Investors Should Join It Now (John Wiley & Sons, 2016), he writes: “funds with low expense ratios and low (portfolio) turnover tend to outperform funds with high turnover and high expenses ...” Low-expense and low-turnover funds include some TIFs; but Malkiel neglects to mention that they also include some active funds and exclude some TIFs and many ETFs.

Bogle’s conclusion is overstated and requires qualification. Nonetheless, “it is fair to say that by Graham’s demanding standards the overwhelming majority of today’s mutual funds, largely because of their high costs and speculative behaviour, have failed to live up to their promise” (pp. 218-219). So have some TIFs and most ETFs.

Consequently, and as Warren Buffett told Bogle in 2006: “a low-cost (traditional) index fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth” (p. 221).

Bogle and Buffett aren’t wrong, but what’s been good for a growing minority of investors will likely be bad for the great majority – as well as society as a whole.

Bogle therefore asks (p. 153) “what lessons have we learnt?” He nominates four: (1) “costs matter; (2) selecting equity funds based on their long-term past performance doesn’t work; (3) fund returns revert to the mean; and (4) relying even on the best-intentioned advice works only sporadically.”

Lessons #1 and #3 are indisputable. Accordingly, if expenses and non-performance fees comprise more than (say) 50 basis points (0.5%) of your invested assets – which is true of some TIFs and many ETFs – then you’re paying too much. More to the point, your returns are suffering.

Lesson #2 is also true. Summarising a large and often esoteric literature, past performance doesn’t reliably predict future returns – but past and current expenses and fees do (for a readable overview, see Russel Kinnel, “Fund Fees Predict Future Success or Failure,” Morningstar, 5 May 2016). From indexers’ point of view, Lesson #2 is thus a double-edged sword. “The case for the success of indexing in the past is compelling,” says Bogle, “and with the outlook for subdued returns on stocks for the decade ahead, ... fund costs will become more important than ever” (pp. 156-157).

If Lessons #2 and #3 are true, and if equities’ outlook for the next decade is subdued, then investors mustn’t assume that low-cost TIFs’ healthy long-term returns since the early-1980s will continue. If so, then successful investment will become less a matter of blind indexing and more a matter of astute – that is, cautious – judgement.

Given (a) the perverse consequences that occur as indexing advances, and (b) the distinct possibility – which Bogle accepted and I’ve corroborated – that future long-term returns won’t be as rosy as they’ve been since the 1980s, what’s a conservative investor to do? First, follow Bogle: “select funds with rock-bottom costs, minimal portfolio turnover and no sales loads” (p. 108). Leithner & Company fulfils these criteria.

Second, heed Buffett: as he detailed in his famous – but these days mostly ignored – speech, “The Superinvestors of Graham-and-Doddsville” (delivered in 1984 to commemorate the 50^th anniversary of the publication of Ben Graham’s and David Dodd’s book Security Analysis), choose value-oriented managers whose expenses and portfolio turnover are very low and whose incentives align with investors’. Leithner & Company also meets these criteria.

Our conservative approach, intensive research and – at crucial junctures – bold contrarian action are the antithesis of passive (index) investing. Our expenses are far lower than most actively-managed funds’ – and are even lower than some low-cost index funds’. And we charge no entry, management or exit fees – only a performance fee based upon profits earned rather than assets amassed.

Virtually all managed funds, whether they’re actively or passively managed, levy fees irrespective of results – including when they generate losses. Superficially, Leithner & Company’s total impost (expenses plus performance fee), expressed as a percentage of assets, doesn’t differ greatly from many other funds’. Below the surface, however, its composition is unique: our expenses are extremely low and relatively fixed; and our performance fee (which over the past five years has comprised an average of 84% of the total) occurs only when investors receive a positive return – and rises only when they receive a higher return.

Leithner & Company doesn’t suit everybody. Equally, since 1999 we’ve unfailingly paid dividends, generated relatively steady returns and outperformed the All Ordinaries Accumulation Index (see our web site for details).

For investors who can think independently but don’t have the time or inclination to invest for themselves, Leithner & Company may be a more sensible choice than most index funds, ETFs and the like.

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