Veryan skewers Bogle...

John Bogle and index funds

from Hedge fund by Veryan Allen

The S&P 500 index is back at an all time high after 7 long years and a multitrillion dollar drawdown so it seems appropriate to review John Bogle's new novel "The Little Book of Common Sense Investing". I say novel because it would be worrying if anyone considered this book anything but fiction. Despite its title I couldn't find a single page about common sense investing. No-one disputes that index funds will likely do better than the AVERAGE long only manager over time but that reflects the fact that UNHEDGED funds are too constrained and that anyone who has investment skill is likely to be at a hedge fund NOT a mutual fund. John, the 70s are over; there's a lot more SAFER ways to make money these days than just holding stocks.

I wouldn't want to be in a car driven by John Bogle. I guess he would just put a brick on the accelerator, remove the steering wheel, stare out of the back window and sit back for the nice destination he anticipates. No need to worry about turns and obstacles in the path when nirvana awaits in the so-called long term. Just ride out that volatility? Is it really common sense to own every stock Standard and Poor's happen to choose no matter what the underlying economic conditions and business environment for those companies? Is it really common sense to imply investment skill does NOT exist and investors should not bother trying to identify good fund managers? Is it really common sense to buy and hold value destroying corporations when you could be shorting or actively engaging them?

He claims index investing is the "only way to guarantee stock market returns". Really? I think absolute returns is what a common sense investor wants not guaranteeing their fair share of stock market crashes, drawdowns, horrendous volatility and years, sometimes decades, of losses. There is no need to take outright market risk when there are so many inefficiencies and mispricings to exploit in global financial markets. Skill does exist and CAN be identified ahead of time. Alpha is actually more reliable than beta. Risk management and hedging are surely more sensible than rear view mirror speculation.

He doesn't mention hedge funds until the "Funny Money" section on Page 203 of a 214 page book. His negativity and misunderstanding of hedge funds is quite remarkable. "Too much hype"! Really? Most hedge fund commentary is negative so what hype is he referring to? Does he mean the hype of delivering absolute returns each and every year after fees unlike the "bargain" toxic waste he advocates? "Too many different strategies". Wow! That's a criticism!? You want as many strategies as possible; it is a strength of the industry not a weakness. But that is what you get from someone who recommends a risky, unhedged single strategy like his. Some managers are successful and closed because their investors made far, far more. Index funds are the compensation strategy - you don't have to do anything but you still receive your 18bp! The extra layer of fees of a good fund of funds more than justifies itself in paying for evaluation, due diligence and monitoring of common sense investments like hedge funds.

He extols the merits of owning all the nation's publicly held companies. Which nation? All of them or just the biggest firms? Why just the public ones? Most companies are private. Good venture capital and focused (smaller!) private equity funds offer excellent performance. By the time a company makes it to public status most of its growth is often over so why shouldn't investors access private companies. By the time a firm makes into the S&P 500 it has already been a winner for many years.

Although considered passive the S&P 500 is actually actively managed as holdings go bankrupt or get taken over. Interestingly if you had bought the ORIGINAL 500 components and held on with no adjustments whatsoever you would have outperformed the "real" S&P 500 even though only 86 names survived the past 50 years. That has to be a very strong argument for TRUE indexation but John Bogle doesn't mention it in the book, prefering the constantly updated product that the firm he founded, Vanguard, sells. Of course he is also not a fan of the better fundamental index innovations that have emerged in recent years.

Another broad market index got going in the 1950s: the Japanese Nikkei which over the long term has vastly outperformed the US S&P 500, though of course not over the short or medium term! Even though still far from its high and having trod water for 17 years, US investors would have done much better buying and holding Japanese stocks the last 50 years than US stocks. John Bogle does not mention this either and is generally quite negative on "foreign" stocks. Japan "outperformed" because in the 1950s it was a frontier market similar to some opportunity-rich countries today. But based on his relentless rules of humble arithmetic the dollar return on the Nikkei has been much higher than the dollar return on the S&P. In the book, his "advice" to have only 20% invested outside USA equities is simply wrong. The world has moved on and such geographic constraints make no sense these days.

Successful practitioners like Warren Buffett and David Swensen join the pro-index fray despite avoiding index funds themselves. This "Do as I say, not as I do" is ridiculous. Why does Warren have a quote on the book's cover supporting index funds when he has been successfully managing a macro, foreign exchange, commodities trading, merger arb, event driven, distressed securities, bid for LTCM, own a few core stocks multistrategy hedge fund called Berkshire Hathaway and outperformed the S&P 500 since inception? In actions, not words, his is an argument against "passive" indexing.

Investing is not simple. Bogle mentions Occam's Razor where the simplest solution is considered optimal. Unfortunately William of Occam has been misinterpreted and as Bogle accurately notes actually said "Entities should not be multiplied unnecessarily". It is not simple solutions but actually the simplest choice amongst complicated solutions that works. Index funds are too simple to be a "solution" as the last 7 years has demonstrated. The simplest viable solution is multiple strategies within and across multiple asset classes and reducing risk as much as possible. In 1320 gold index funds were available in Occam yet not long afterwards gold entered the 700 year bear market from which it has yet to recover. William would have seen hedge funds as the solution not the non-solution of holding assets. Entia non sunt multiplicanda praeter necessitatem as they used to say.

Bogle also talks of the miracle of compounding but fails to mention the misery of negative compounding. Then there is tyranny of fees. For what you are getting in terms of risk-adjusted absolute returns hedge funds fees are actually lower than index fund fees. But whether it is Vanguard charging 18bp for its VFINX or less for institutional managers there is a much higher cost called opportunity cost. While trillions have been languishing for nearly a decade in index funds, huge absolute return money making opportunities have been missed. The "common sense" option of index funds is extremely expensive as this dead money waits for the supposed upward trend to reassert itself.

Bogle relies greatly on history. Long term performance has little to do with long term investing. In fact some investors with the best long term track records have the shortest holding periods. Slow and steady does indeed the win the race but index funds are anything but slow and steady. Hedge funds are the reliable tortoise to the volatile index hare. You can read the John Bogle blog and the first chapter of the book. After reading it why anyone would become a Boglehead boggles the mind. Past is not prologue and staying the course only makes sense if you know the destination and the route. Common sense surely means going with investment skill and the hedging of risk not this index fund non-sense. Investors need to guarantee their fair share of ABSOLUTE RETURNS not necessarily stock market returns. They ONLY way to do that is with good hedge funds.