Bogle on Index Funds

January 17, 2022

Ultra-low-cost index funds tend to be exceptionally good long-term investments.  It’s not just that, on an annual basis, index funds typically do better than 60-80% of all funds.  It’s that index funds very consistently do better.  Consistently outperforming 60-80% of all funds annually virtually guarantees that index funds will beat at least 90-95% of all funds over the course of several decades or more.  It’s just a matter of simple arithmetic, as Bogle has noted.  Moreover, the past several decades illustrate this result (see Brute Facts below).

If you’re a long-term investor, then by investing in index funds, you are likely to beat at least 90-95% of all investors, net of costs, over time.  Investing in index funds is the best long-term investment for the vast majority of investors, as Warren Buffett—one of the greatest investors ever—has often noted.  See:

Jack Bogle’s Doun’t Count on It! (Wiley, 2011) is a collection of his writings on a variety of topics including capitalism, entrepreneurship, indexing, idealism, and heroes.  It’s a long book (586 pages), but well worth reading.  Below is my brief summary of Chapter 18 (pages 369-392).



The main reason that index funds generally beat at least 90-95% of all investors over time is ultra-low costs.  Bogle:

…we don’t need to accept the EMH [Efficient Market Hypothesis] to be index believers.  For there is a second reason for the triumph of indexing, and it is not only more compelling but unarguably universal.  I call it the CMH—the Cost Matters Hypothesis—and not only is it all that is needed to explain why indexing must and does work, but it in fact enables us to quantify with some precision how well it works.  Whether or not the markets are efficient, the explanatory power of the CMH holds.  (page 371)

Bogle further explains:

…The mathematical expectation of the speculator is not zero;  it is a loss equal to the amount of transaction costs incurred.

So, too, the mathematical expectation of the long-term investor also is a shortfall to whatever returns our financial markets are generous enough to provide.  Indeed the shortfall can be described as precisely equal to the costs of our system of financial intermediation—the sum total of all those advisory fees, marketing expenditures, sales loads, brokerage commissions, transaction costs, custody and legal fees, and securities processing expenses.  Intermediation costs in the U.S. equity market may well total as much as $250 billion a year or more.  If today’s $13 trillion stock market were to provide, say, a 7 percent annual return ($910 billion), costs would consume more than a quarter of it, leaving less than three-quarters of the return for the investors—those who put up 100 percent of the capital.  We don’t need the EMH to explain the dire odds that investors face in their quest to beat the stock market.  We need only the CMH.  Whether markets are efficient or inefficient, investors as a group must fall short of the market return by the amount of the costs they incur.  (page 372)



Bogle recounts:

Our introduction of First Index Investment Trust was greeted by the investment community with derision.  It was dubbed ‘Bogle’s Folly,’ and described as un-American, inspiring a widely circulated poster showing Uncle Sam calling on the world to ‘Help Stamp Out Index Funds’… Fidelity Chairman Edward C. Johnson led the skeptics, assuring the world that Fidelity had no intention of following Vanguard’s lead:  ‘I can’t believe that the great mass of investors are going to be satisfied with just receiving average returns.  The name of the game is to be the best.’  (Fidelity now runs some $38 billion in indexed assets.)  (pages 375-376)

Of course, all investors would like to get the best returns if possible.  Yet, by definition, investors on the whole will get average results.  But that is before costs.

After costs, the average investor will get less than the market returns.  And the amount of the shortfall will precisely equal the costs.



Bogle examines the long-term performance of mutual funds:

…In 1970, there were 355 equity mutual funds, and we have now had more than three decades over which to measure their success.  We’re first confronted with an astonishing—and important—revelation:  Only 147 funds survived the period.  Fully 208 of those funds vanished from the scene, an astonishing 60 percent failure rate…

Now let’s look at the records of the survivors—doubtless the superior funds of the initial group.  Yet fully 104 of them fell short of the 11.3 percent average annual return achieved by the unmanaged S&P 500 Index.  Just 43 funds exceeded the index return.  If, reasonably enough, we describe a return that comes within plus or minus a single percentage point of the market as statistical noise, 52 of the surviving funds provided a return roughly equivalent to that of the market.  A total of 72 funds, then, were clear losers (i.e., by more than a percentage point), with only 23 clear winners above that threshold.

If we widen the ‘noise’ threshold to plus or minus two percentage points, we find that 43 of the 50 funds outside that range were inferior and only 7 superior—a tiny 2 percent of the 355 funds that began the period…

But I believe the evidence actually overrates the long-term achievement of the seven putatively successful funds.  Is the obvious credibility of those superior records in fact credible?  I’m not so sure.  Those winning funds have much in common.  First, each was relatively unknown (and relatively unowned by investors) at the start of the period.  Their assets were tiny, with the smallest at $1.9 million, the median at $9.8 million, and the largest at $59 million.  Second, their best returns were achieved during their first decade, and resulted in enormous asset growth, typically from those little widows’ mites at the start of the period to $5 billion or so at the peak, before performance started to deteriorate.  (One fund actually peaked at $105 billion!)  Third, despite their glowing early records, most have lagged the market fairly consistently during the past decade, sometimes by a substantial amount… The pattern for five of the seven funds is remarkably consistent:  a peak in relative return in the early 1990s, followed by annual returns of the next decade that lagged the market’s return by about three percentage points per year—roughly, S&P 500 +12 percent, mutual fund +9 percent.

In the field of fund management it seems apparent that ‘nothing fails like success’… For the vicious circle of investing—good past performance draws large dollars of inflow, and having large dollars to manage crimps the very ingredients that were largely responsible for the good performance—is almost inevitable in any winning field.  So even if an investor was smart enough or lucky enough to have selected one of the few winning funds at the outset, selecting such funds by hindsight—after their early success—was also largely a loser’s game.  Whatever the case, the brute evidence of the past three decades makes a powerful case against the quest to find the needle in the haystack.  Investors would be better served by simply owning, through an index fund, the market haystack itself.  (pages 378-380)

Bogle continues:

In the field of investment management, relying on past performance simply has not worked.  The past has not been prologue, for there is little persistence in fund performance.  A recent study of equity mutual fund risk-adjusted returns during 1983-2003 reflected a randomness in performance that is virtually perfect.  A comparison of fund returns in the first half to the second half of the first decade, in the first half to the second half of the second decade, and in the first full decade to the second full decade makes the point clear.  Averaging the three periods shows that 25 percent of the top-quartile funds in the first period found themselves in the top quartile in the second—precisely what chance would dictate.  Almost the same number of top-quartile funds—23 percent—tumbled to the bottom quartile, again a close-to-random outcome.  In the bottom quartile, 28 percent of the funds mired there during the first half remained there in the second, while slightly more—29 percent—had actually jumped to the top quartile.

…Simply picking the top-performing funds of the past fails to be a winning strategy.  What is more, even when funds succeed in outpacing their peers, they still have a way to go to match the return of the stock market index itself.  (pages 381-382)



Bogle writes:

…What do the proponents of active management point to?  Themselves!  ‘We can do it better.’  ‘We have done it better.’  ‘Just buy the (inevitably superior performing) funds that we advertise.’  It turns out, then, that the big idea that defines active management is that there is no big idea.  Its proponents offer only a few good anecdotes of the past and promises for the future.

Also, it turns out that there is in fact one big idea that can be generalized without contradiction.  Cost is the single statistical construct that is highly correlated with future investment success.  The higher the cost, the lower the return.  Equity fund expense ratios have a negative correlation coefficient of -0.61 with equity fund returns.  In the fund business, you get what you don’t pay for.  You get what you don’t pay for!

If we simply aggregate funds by quartile, this correlation jumps right out at us.  During the decade ended November 30, 2003, the lowest-cost quartile of funds provided an average annual return of 10.7 percent;  the second-lowest, 9.8 percent;  the second-highest, 9.5 percent;  and the highest quartile, 7.7 percent—the difference of fully three percentage points per year between the high and low quartiles, equal to a 30 percent increase in annual return!  The same pattern holds irrespective of manager style or market capitalization.  But of course, with index funds carrying by far the lowest costs in the industry, there are few, if any, promotions by active managers of the undeniable relationship between cost and value.  (pages 385-386)



Bogle explains why index funds have succeeded in beating nearly all other funds over the course of several decades or more:

The reasons for that success are the essence of simplicity:  (1) the broadest possible diversification, often subsuming the entire U.S. stock market;  (2) a focus on the long-term, with minimal, indeed nominal, portfolio turnover (say, 3% to 5% annually);  and (3) rock-bottom cost, with neither advisory fees nor sales loads, and minimal operating expenses….

…While fund costs essentially represent the difference between success and failure for investors who seek to accumulate assets, they have gone up as index fees have come down.  The initial expense ratio of our 500 Index Fund was 0.43 percent, compared to 1.40 percent for the average equity fund.  Today, it is 0.18 percent or less, while the ratio for the average equity fund has risen to 1.58 percent.  Add in turnover costs and sales commissions and the all-in cost of the average fund is at least 2.5 percent, suggesting a future annual index fund advantage of at least 2.3 percent per year.  (page 387)



Bogle concludes:

Now think of this in personal terms.  What difference would an index fund make in your own retirement plan over, say, 40 years?  Well, let’s postulate a future long-term annual return of 8 percent on stocks.  If we assume that mutual fund costs continue at their present level of at least 2.5 percent a year, an average mutual fund might return 5.5 percent.  Extending this tax-deferred compounding out in time on your investment of $3,000 each year over 40 years, an investment in the stock market itself would grow to $840,000, with the market index fund not far behind.  Your actively managed mutual fund would produce $430,000—only a little more than one-half as much.

Looked at from a different perspective, your retirement plan has earned a value of $840,000 before costs, and donated $410,000 of that total to the mutual fund industry.  You have kept the remainder – $430,000.  The financial system has consumed 48 percent of the return, and you have achieved but 52 percent of your earning potential.  Yet it was you who provided 100 percent of the initial capital;  the industry provided none.  Confronted by the issue in this way, would an intelligent investor consider this split to represent a fair shake?  Merely to ask the question is to answer it:  ‘No.’  (pages 391-392)



An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.


If you are interested in finding out more, please e-mail me or leave a comment.

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Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.