John C. Bogle, The Little Book of Common Sense Investing. (New York: John Wiley & Sons, Inc., 2007).

John Bogle, the founder of Vanguard who introduced the first index fund to the general public in 1975, espouses the virtues of passively managed funds that track a particular market index for all investors in his 2007 book, The Little Book of Common Sense Investing. Bogle’s closing recommendation for index funds reveals his affinity for this type of investment vehicle: Deep down, I remain absolutely confident that the vast majority of American

families will be well served by owning their equity holdings in an all-U.S. stock market index portfolio and holding their bonds in an all-U.S. bond-market portfolio. (Investors in high tax brackets, however, would hold a very low-cost quasi-index portfolio of high grade intermediate-term municipal bonds.) (p. 200)

Most of the 18 chapters of Bogle’s book focus on equity index funds, but bond index funds are also treated. Although this is a fast read from start to finish, I would recommend only certain chapters be assigned to the students as essential to understanding Bogle’s argument—Chapters 2, 3, 8, 12, 13, 17 and 18. In Chapter 2, Bogle identifies how the strong historic returns of the U.S. stock market --9.6 percent per annum over the decades of the 20th century-will always accrue to the index investor rather than the speculating trader. Chapter 3 presents Bogle’s observation that the Standard & Poor’s 500 fares even better than the entire stock market and an index fund with S&P 500 companies weighted based on market capitalization is an ideal choice for investors. Chapter 8 contains Bogle’s research into all 355 large-cap core mutual funds on the market in 1970 and identifies the three equity funds that consistently outperformed the S&P 500 by at least two percent from 1970 to 2006—Davis New York Venture, Fidelity Contrafund and Franklin Mutual Shares. Chapter 12 contains Bogle’s helpful research on low-cost S&P 500 index funds and Chapter 13 does the same for bond index funds. Chapter 17 includes a listing of important figures in investing who advocate for index mutual funds, like Yale Endowment Fund’s David Swensen. The final chapter concludes with some of Bogle’s additional suggestions to investors, including the advice that balanced funds be considered for a fraction of a portfolio, which is contrary to Benjamin Graham’s advice on that particular type of investment. In the second chapter, Bogle reveals his analysis of the percentage of stock market returns that are associated with investing and speculating. Like Graham, Bogle does not believe that investors should be involved in speculation. Graham states that investors who “lack the proper knowledge and skill” to speculate should never do it, and even then when an investor has the requisite knowledge, that investor should never attempt “risking more money in speculation that you can afford to lose” (Graham, p. 21). Bogle affirms this viewpoint with this quote:

My advice to investors is to ignore the short-term noise of the emotions reflected in financial markets and focus on the productive long-term economics of our corporate business (p. 20).

To justify this position, Bogle describes his research into U.S. stock market activity during the 20th century. He shows that only a tenth of a percent of the 9.6% in returns to equity investors are the result of successful speculation (p. 17). The majority of the returns, 9.5%, relate to the business activities of the companies in the stock market—4.5% in dividends and 5.0% in earnings growth (p. 15). The third chapter of Bogle’s book focuses on the S&P 500 and reasons why it makes sense to buy and hold it in an index fund for a long period of time. From 1930 to 2005, the S&P 500 earned a

10.4% annual return, and in the 1980s, it was 15.6% (p. 27). Bogle goes on to show that if an investor bought the S&P 500 in 1968, the S&P 500 outperformed the other large-cap core funds by an average of 58%, with a high of 88% in 1996 (p. 30). Bogle also shows that the S&P 500 was in the bottom quartile of funds twice, and not since 1979. This data mostly validates Bogle’s recommendation that an S&P 500 index fund is an ideal investment vehicle for most Americans. To provide further justification for this recommendation, Bogle concludes this chapter with the fact that index funds were the available investment type in President George W. Bush’s proposal to replace Social Security with the Personal Savings Account. In Chapter 8, Bogle provides further proof why it is very difficult to consistently do better than the S&P 500 index fund. He compares the S&P 500 index fund to the successes and failures of the 355 equity funds that were on the market in 1970 and their status in 2006. Amazingly, nearly two-thirds, or 223, of the 355 large-cap core equity funds on the market in 1970 were defunct by 2006 (p. 81). Of those that remained, only 24 funds enjoyed a return over the S&P 500 of greater than 1%. Over that 36-year period, just nine funds exceeded the S&P 500 by at least 2%. The list of nine funds includes Lynch’s Fidelity Magellan Fund, but Bogle argues that Magellan and six other funds had their best returns years ago in the 1980s when they had fewer assets under management. Only three large-cap core equity funds enjoyed a record of sustained excellence by consistently beating the S&P 500 by at least two percent--Davis New York Venture, Fidelity Contrafund and Franklin Mutual Shares. (I checked and found that only one could continue to make that claim in 2015--Davis New York Venture.1) Bogle also highlights the success enjoyed by the Legg Mason Value Trust under the stewardship of Bill Miller. (He retired in 2011). However, as the MarketWatch data reveals, the ClearBridge Value Trust has seen some down years since 2006 and has a current year to date return of nearly minus five percent.

ClearBridge Value Trust (LMVTX) Lipper Ranking & Performance

Fund return Category Index (S&P 500) % rank in category Quintile rank

YTD -4.72% 0.41% 2.00% 97% 5 1yr 0.61% 5.61% 7.50% 95% 5 3yr 15.36% 14.44% 15.90% 33% 2 5yr 11.09% 12.58% 14.20% 84% 5 10yr 1.86% 7.21% 8% 100% 5 The fate of ClearBridge Value Trust is another reminder to Bogle’s readers of the sagacity of his advice to invest in an S&P 500 index fund, so long as it has low costs (operating costs, transaction costs generating tax liabilities for the fund, and loads). To address this final point about low costs, Bogle includes charts in Chapter 12 with five low cost S&P 500 index funds on the market in 2006 and five high cost versions. Bogle, a firm believer in minimizing costs to maximize returns to investors, researches the universe of S&P 500 index funds available in 2006 and compares the combined effect of their annual expense ratios and sales charges. The lowest cost option he provides in his list of five low cost funds is the Fidelity Spartan Fund, with combined costs of .07% of returns. Bogle then states that two of his own company’s funds, the

1 Sources: Davis New York Venture, available at http://davisfunds.com/funds/nyventure_fund; Fidelity Contrafund,

available at https://fundresearch.fidelity.com/mutual-funds/summary/316071109; Franklin Mutual Shares, available at https://www.franklintempleton.com/retail/app/product/views/fund_page.jsf?fundNumber=474.

Vanguard Admiral Fund and Vanguard Regular Fund, are also quite low, at .09% and .18% respectively. Another Vanguard fund, the Vanguard S&P 500 Index Fund, has an annual expense ratio of .28% but its sales charges are not noted. The sales charges or loads add to the highest of the high cost options in Bogle’s second chart, UBS. UBS has the highest expense ratio of all the charted S&P 500 index funds, .69%, and when sales charges are considered, UBS’s combined costs total 1.45%. Earlier in Bogle’s book, he explains how costs eat away at compounded overall fund returns to erode the possible profits that may be earned by the investor. (Only one of Vanguard’s S&P 500 funds had a quote in the Wall Street Journal. At the close of trading on October 29, 2015, the Wall Street Journal reported returns for the Vanguard S&P 500 Index Fund (VFINX) at 3.1% on the year and 16.2% over three years. Source: Wall Street Journal online, available at http://online.wsj.com/mdc/public/page/2_3048-usmfunds_V-usmfunds.html.) Chapter 13 indicates that there are bond index funds to help the vast majority of Americans achieve the ideal investment mix, but does not indicate what percentage should be allocated in a stock index fund versus a bond index fund. The bond index funds that Bogle discusses in Chapter 13 for the vast majority of Americans include two Vanguard products, the Vanguard Long-Term Municipal Bond Fund and the Vanguard Short-Term Treasury Bond Fund. Vanguard’s Long-Term Municipal Bond Fund has an annual return of 5.85% and expense ratio of .15% in 2006. The Short-Term Treasury Bond Fund offered by Vanguard achieves a 5.06% return and has an expense ratio of .16% in the same year. He compares Vanguard’s bond index funds to Lehman bond funds (which have recently rebounded in value after the bankruptcy of that firm associated with the financial crisis of 2007-8. Source: BloombergBusiness Week, available at http://www.bloomberg.com/bw/articles/2014-05-22/lehman-brothers-debt-pays-off-for-hedge-funds). Bogle also considers the Vanguard Intermediate-Term Government Bond Fund as the option for well-to-do investors, noting how it generates annual returns of 6.79% with an expense ratio of .18% in 2006. (None of the bond index funds identified by Bogle in Chapter 13 were listed in the Wall Street Journal on October 29, 2015.) Chapter 17 is Bogle’s reprise of the messages contained in the book, including a listing of names of all of the leaders in the investment community who recommended that investors favor index funds. Bogle includes the commentary by Yale’s Swensen that selecting an index fund avoids all of the pitfalls associated with actively managed funds—sales costs, management fees and manager profits: Invest in low-turnover, passively managed index funds…and stay away from profit-driven investment management organizations…. The mutual fund industry is a colossal failure… resulting in systematic exploitation of individual investors in exchange for providing a shocking disservice…. Excessive management fees take their toll, and (manager) profits dominate fiduciary responsibility (p. 198). (Although Alex Frey’s IvyBytes Guide also includes wisdom from Swensen, Frey states that “owning the S&P 500 is not enough” and offers Swensen’s advice for an appropriate diversification strategy—30% U.S. stocks, 20% real estate, 15% international developed markets stocks, 5% emerging-markets stocks, as well as bonds, specifically, 15% Treasury Inflation-Protected Securities, and 15% other Treasury bonds (p. 68-69). However, Frey argues that the S&P 500 has advantages over other investments. In his October 10, 2015 newsletter, Frey argues that money put into an S&P 500 index fund would earn a better return than entrusting the investment with an active fund stock picker or a hedge fund. The active fund with a stock picker generates returns greater than those of the S&P 500 only 2% of the time. Hedge funds have positive marginal returns but all of their associated fees erode potential profits severely to the level of the principal amount invested. Source: Alex Frey, “Who Is Getting Rich from

Your Investments?” IvyBytes Newsletter, October 10, 2015). Bogle relies upon Graham’s distinction between an investor as opposed to a speculator, arguing in the manner of Graham that “in investing, the winning strategy for reaping the rewards of capitalism depends on owning businesses, not trading stocks” (Bogle, p. 192). (This affirms the quote in Chapter 2 about an investor doing well to rely on the economics of businesses in the stock market and buy and hold.) At the end of Chapter 17, Bogle adds that the two greatest enemies of an investor are “expenses and emotions,” suggesting that costs erode returns and profits and the desire to do better is an emotional urge that should be kept in check as it usually leads to losing money. Chapter 18 provides a final set of recommendations about investing that covers a wide ground, including his recommendations of bond funds for wealthy investors and balanced funds for investors who want to speculate. Bogle’s basic advice remains the same: the vast majority of Americans should invest in an index fund, one for stocks and one for bonds. He amplifies this prescription with separate advice for those whose wealth puts them in higher tax brackets—invest in a tax-friendly municipal bond index fund. (Although bond index funds did not exist when Graham wrote The Intelligent Investor, Graham suggested that the enterprising investor who wanted to try to achieve higher returns should consider bond funds, including those associated with municipalities receiving payments from large, well-financed companies (Graham, p. 155). If an investor wants to try stock picking, Bogle recommends doing so with a small amount of money and not with funds allocated for expected bills to be paid in the future, like a house or education. Here he advises that the enterprising investor consider a balanced fund comprised of both stocks and bonds. This is diametrically different from Graham who suggested that balanced mutual funds be avoided (Graham, p. 241). However, Bogle recommends that only a small percentage of investment funds be put in a balanced fund, before returning once again to his overriding view that the best investment recommendation of all would be some money in an all-stock index fund and the remainder in an all-bond index fund.

(Bogle concludes with a statement from a 2005 speech by the late MIT economics professor Paul Samuelson to the Boston Society of Security Analysts that the index fund created by John Bogle was “the equivalent of the invention of the wheel and the alphabet” (p. 216). This is the final testimonial that Bogle includes in his book for index funds and the strategy of investing in them. Other strong endorsements are given in the writings of Alicia Munnell, Kathy Kristof and Dave Kansas, although Kansas adds a word of caution. In Falling Short, Munnell and her co-authors recommend index funds for retirement accounts for most people. “...index funds have become a sensible vehicle for investment. The only areas where index funds may not be appropriate are complex categories where research is not widely available, such as high-yield bonds. But individuals saving for retirement probably should not be investing in such assets in the first place. So driving individuals toward index funds for their retirement saving would be an increasingly positive development” (Munnell, et al, p. 118). Kristof favors index funds like those that track the S&P 500 or the Dow Jones Industrials, especially because they do not trade their holdings and generate additional costs to the investor in these funds. “…because index funds don’t actively trade shares, they generate fewer taxable gains…. Of course, paying less tax as you go along leaves you with more money to invest” (Kristof, p. 139). This is similar to a comment made by Bogle in a chapter of his book that concerns taxes generated through trading by a fund manager. Kansas suggests that index funds are a popular choice but notes how they may not be “safer” than other investments because when the S&P 500 dips, the S&P index fund also suffers (Kansas, p. 139). Given the state of the Vanguard S&P 500 Index Fund in 2015, with its 3.1% return to date, this is a valid consideration for those who may be dependent on the typical double-digit annual returns as fixed income.)