The ideas, as published
Everything in this section is a paraphrase in this site’s own words. Nothing is quoted. The works it comes from are listed in the next section.
- Hold the whole market instead of choosing from it.
- An index fund holds every share in a published index, in proportion to each company’s size. It gives up the chance of choosing a winner and with it the risk of choosing a loser, or of choosing a manager who does. What remains is the risk of the market itself, in full. The Little Book of Common Sense Investing makes this case in its plainest form.
- Together, investors are the market.
- Before costs, the return of all investors added together is the return of the market, because between them they hold all of it. After costs, the group earns the market’s return less what it paid. So the average actively managed pound must lag the market by its costs. That is arithmetic, not a finding about skill. William Sharpe set it out in a short paper in 1991; Bogle called his version the cost matters hypothesis and returned to it in his 2005 paper.
- A yearly cost compounds, like a return.
- A charge taken every year is taken from the whole sum, including everything it has grown to. Over decades the money lost is the charges themselves and all that they would have earned. Common Sense on Mutual Funds works through this at length. The index investing page on this site has a working example.
- The investor’s own timing is a second cost.
- Bogle distinguishes the return a fund reports from the return its holders actually receive. The second is usually lower, because money tends to arrive after a rise and leave after a fall. His answer was to buy, add steadily and not respond to the market.
- An index of market weights nearly runs itself.
- When each share is held in proportion to the company’s market value, the weights move with prices and need no trading to stay in line. The fund deals only when the index changes its members, when money comes in or goes out, and when dividends are paid. Little dealing is a large part of why the cost can be low.
- Who owns the manager matters.
- Bogle arranged Vanguard so that the management company is owned by the funds it manages, and so by their investors, and runs at cost. He argued that an ordinary fund manager serves two masters: the fund’s investors and the manager’s own shareholders.
The sources
Named by title, author, publisher and year so that they can be found and checked. No links are given.
- Common Sense on Mutual Funds: New Imperatives for the Intelligent InvestorJohn C. Bogle. John Wiley & Sons, 1999; a revised tenth-anniversary edition followed.Used here for: The long argument on costs, compounding and the gap between fund returns and investor returns.
- The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market ReturnsJohn C. Bogle. John Wiley & Sons, 2007.Used here for: The case for owning the whole market at low cost, in short form.
- The Relentless Rules of Humble ArithmeticJohn C. Bogle. Financial Analysts Journal, 2005.Used here for: The cost arithmetic stated as a paper.
- The Arithmetic of Active ManagementWilliam F. Sharpe. Financial Analysts Journal, 1991.Used here for: The proof that the average actively managed holding must lag the market by its costs.
- Challenge to JudgmentPaul A. Samuelson. The Journal of Portfolio Management, 1974.Used here for: The call for a fund that simply tracks an index, which Bogle said encouraged him.
- Stay the Course: The Story of Vanguard and the Index RevolutionJohn C. Bogle. John Wiley & Sons, 2018.Used here for: His own account of the 1976 launch, of his earlier mistakes and of his later doubts.
A documented example: the launch of 1976
The fund was called First Index Investment Trust. It set out to track the Standard & Poor’s 500 index of large American companies. The banks that underwrote its launch in the summer of 1976 aimed to raise 150 million dollars. They raised about 11 million.
That was too little to buy all five hundred shares in the right proportions at a sensible cost, so by Bogle’s account the fund began by holding a sample of the index. In the trade it was called Bogle’s folly. It was later renamed, and still exists as one of the largest funds in the world.
What makes the episode worth studying is the time it took. The arithmetic in the argument was the same in 1976 as it is now. For years almost nobody acted on it, because a fund that promises to be average is hard to sell. An idea being right did not make it popular, and its later popularity is not what makes it right.
What went wrong, and what an index fund does not do
Bogle’s account of his own career begins with a mistake. In 1966, as a senior executive of an old and cautious fund management company, he arranged its merger with a firm of fashionable growth-stock managers. The funds did badly in the falling market of 1973 and 1974, and in January 1974 he was dismissed. He later described the merger as his own serious error. Vanguard was what he built next.
An index fund removes the risk of choosing badly. It does not remove the risk of the market. A fund tracking large American shares fell by more than half between October 2007 and March 2009, with the index it tracked. Over the ten years from the start of 2000 to the end of 2009 that index ended a little lower than it began, dividends included. A holder who needed the money in those years had no protection from the low cost.
An index weighted by market value holds most of whatever has risen most. At the top of a boom it is heavily invested in the shares that are about to fall furthest, as it was in technology shares in early 2000.
Bogle also recorded doubts about what he had started. He criticised the use of exchange-traded index funds for rapid trading, which he saw as the opposite of his purpose. In 2018 he warned, in paraphrase, that if index funds came to own most of every large company, a handful of fund managers would hold the votes over them, and that this would not serve the public interest.
What can be studied with a small paper portfolio
This is the study in which most of the idea can be examined with arithmetic alone. The exercise uses an invented sum and rates you choose yourself. No rate is a forecast.
- Open the index investing example and set a yearly fee of 0.1%, then of 1.5%, over thirty years at the same assumed rate of growth. Write down the two end figures and the difference.
- Change the assumed growth rate, including to a low one. Note that the money lost to the fee changes but never goes away.
- In the regular investing calculator, enter a monthly amount and your assumed rate less each fee in turn. Compare what was paid in with what the rate added.
- Write down, now, what you would do in a year in which the holding fell by a third. Keep the note. The arithmetic assumes the holder does nothing; the note is a record of whether that is realistic for you.
- Index investing, explainedAn invented index held by weight, and one sum grown with and without a yearly fee.
- Regular investing calculatorA fixed amount every month at a rate you assume, with the working shown.
Both tools use one steady rate, which no market provides. They show what a cost does to compounding. They do not show what a fund will return.
What does not scale down to a private account
- Most of this one does scale down
- That was the design: a fund that a person with a small sum could hold on the same terms as everyone else. The points below are the exceptions, and they matter.
- Costs on top of the fund’s own
- A private holder may pay a platform charge, a dealing charge and a currency conversion as well as the fund’s yearly fee. Large institutions often pay a lower fee for the same fund. The figures differ by country and provider and are in the documents of the product itself.
- Tax treatment
- How dividends and gains are taxed depends on the country, the kind of account and where the fund is based. This page holds no country’s rules.
- Time horizon
- The argument is about decades. Over a few years the cost saved is small beside what the market may do, in either direction.
- Operational resources
- Tracking hundreds or thousands of shares closely and cheaply takes scale: dealing desks, systems and settlement. A private person cannot build an index by hand at a sensible cost, which is why the fund exists.
- Ownership structure
- A management company owned by its own funds is unusual. Most index funds are run by companies with outside shareholders, and a low fee today is a commercial decision that can change.
- A leveraged CFD on an index is not an index fund
- It holds no shares and pays no dividends as an owner receives them. It is usually leveraged, usually carries a financing charge each night, and can be closed out by a margin call. It is a short-term agreement on the level of an index, and a yearly-cost argument made over decades does not apply to it.
Questions people ask
- What is an index fund and how is it built?
- An index fund is a fund that holds the shares in a published index, usually in proportion to each company’s market value, so that its return follows the index less a small cost. It deals only when the index changes its members, when money enters or leaves the fund and when dividends are paid. A fund may hold every share in the index or a representative sample.
- Why do costs matter so much in investing?
- Because all investors together earn the market’s return before costs, so as a group they earn that return less what they pay. A yearly cost is also taken from the whole sum every year, so over decades the money lost is the charges and everything they would have earned. John Bogle and William Sharpe both set this arithmetic out in print.
- Does an index fund protect against a market fall?
- No. It removes the risk of choosing a poor share or a poor manager, and it leaves the risk of the market in full. When the index falls, the fund falls with it. An index of large American shares fell by more than half between October 2007 and March 2009, and funds tracking it did the same.
The words on this page
A summary for study of ideas that are on the public record, in this site’s own words. It is not endorsed by, or connected with, anyone named. Nobody at GIO4X has access to their portfolios. Studying a method does not reproduce its results, and a leveraged CFD is not ownership of an investment and does not behave like one. Educational information, not investment advice or a recommendation to trade.