Did John Bogle Get It Wrong?

Andy Rachleff, president of investment firm Wealthfront, called out Vanguard founder John Bogle on Forbes.com, saying he was mistaken about the failure of active management. Rachleff gives Bogle credit for his study on actively managed mutual funds underperforming, but says university endowments serve as proof that active management works if you have the resources.

Let's see if Rachleff has a point, or if it the article is just another example of investment porn. You don't have to go far to figure it out. The very first paragraph is bogus: "John Bogle, founder of The Vanguard Group, built a huge business and a cult-like following based, in part, on his theory that it's impossible for actively managed mutual funds to consistently outperform the market."

I don't recall Bogle ever having said that. And certainly the efficient market hypothesis doesn't say that. What it says is that we should randomly expect some managers to outperform the market (even over long periods), given the large number of players trying. However, because far fewer do so than randomly expected, it's difficult to differentiate the managers who beat the market because of skill from the ones who did so because of luck. That makes it unlikely that we can identify the few winners ahead of time, making active management a loser's game.

For example, if the past was truly prologue, an organization such as Morningstar, with its tremendous resources, should be able to identify future winners ahead of time. Yet, studies show that their five-star ratings are very good at predicting three-star (average) performance. And since the average fund underperforms its benchmark by a significant margin, three-star performance produces below benchmark results. Morningstar recently admitted that a better predictor of future performance is to simply rank funds by expenses.

Rachleff goes on to explain that Bogle's problem was that "he based his conclusion on an exhaustive study of the largest data set available on active portfolio management -- publicly traded mutual funds. Not only did the average actively managed mutual fund underperform its comparable index fund net of fees, but it was also almost impossible to identify actively managed mutual funds that could outperform their benchmarks on a consistent basis." But he notes that study didn't include the results of the big university endowments, which he says produced big alpha, even from public equity investments. He cites data from the 10 largest university endowments to back his claim that the future winners can be identified ahead of time.

Let's see if Rachleff's statement holds up to scrutiny. First, he compares the returns to a benchmark. Unfortunately, because Rachleff doesn't provide any analysis, we have no way of knowing if the benchmark is appropriate. Many endowments use benchmarks such as the S&P 500 Index for U.S. investments and the MSCI EAFE Index for international investments. Then they invest in asset classes that have higher expected returns, such as small-cap value stocks. Returns must be compared to appropriate risk-adjusted benchmarks, not some artificially declared benchmark.

To make the point, for the 10-year period 2001-2010, the S&P 500 returned 1.4 percent per year, while the Dow Jones REIT Index returned 10.4 percent per year, and the MSCI US Small Value Index returned 9.4 percent per year. And while the MSCI EAFE returned 3.9 percent per year, the MSCI EAFE Small Value Index returned 12.0 percent per year, and the MSCI Emerging Markets Index returned 13.2 percent per year. These are huge differences.

Now let's consider his next big claim: "The premier university endowments are able to consistently identify public equity managers who outperform the market because they have access to information typically unavailable to the public. They command such access due to the large sums of money (often in excess of $100 million) they are willing to invest with a manager. Access to all trading information associated with a manager's portfolio enables the endowments to perform sophisticated analyses to understand a manager's risk adjusted returns and how the returns were generated."

This statement sounds logical. However, I assure you it has no validity. The reason I can confidently make the claim is that there are other groups that also command similar sums of money: the pension plans of large U.S. companies. They have all the characteristics that Rachleff claims for the big endowments:

• They control huge sums of money.
• They have access to the best and brightest managers.
• They pay much lower fees than retail investors because of their scale.
• They hire top consultants to perform due diligence.
• They hire managers who have produced huge alphas.

And this is perhaps most telling blow -- a strike right into the heart of Rachleff's arguments. The study "Yale's Endowment Returns: Manager Skill or Risk Exposure" examined the performance of the public equity investments of the highly successful Yale Endowment and found that the returns were fully explained by exposure to risk factors and not manager skill. The endowment's exposure to small-cap and value stocks provided the excess returns over the Wilshire 5000 Index (the chosen benchmark). A similar result was found internationally. While the endowment beat its benchmark (the MSCI EAFE), the outperformance was explained by exposure to emerging market stocks and the same Fama-French risk factors. In other words, the benchmarks were wrong.

The authors concluded that disciplined investors with high risk tolerances could replicate Yale's results using publicly available index funds and some degree of leverage. They added that they saw value in Yale's broad diversification across asset classes with relatively low correlation. The results of this study support the assumptions made above about the use of appropriate benchmarks.

There's an entire industry that wants and needs you to believe that active management is the winner's game. Its practitioners simply can't admit the truth: active management is the loser's game -- while it's possible to win, the odds of doing so are so poor that it isn't prudent to try. If they did so, it would be committing economic suicide, which, as Nobel Laureate Paul Samuelson noted, is something few will do without a push. So, instead they continue to publish investment porn, hoping you don't have the knowledge to differentiate it from the truth.

Photo courtesy of Marc_Smith on Flickr.
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