John Bogle's Dream Fund

The Boglehead Investment Forum is one of my favorite sites for discussion on investing. Recently, a poster asked what's next for passive investing. A member responded that John Bogle has talked about a dream fund which takes the 40 largest companies and holds them forever, basically a true "buy-and-hold" mutual fund.

The good news for us is that there is actually a fund that at least approximates this strategy: the Bridgeway Blue Chip Ultra Large 35 Index Fund (BRLIX), which has an expense ratio of just 0.15 percent.

This type of ultra large-cap fund would have a low expected return, as it would have negative loading on the size risk factor and the value risk factor. (The total stock market has a zero loading on these factors.) That means that investors would have to hold higher equity allocations than if they held market-like portfolios to achieve the same expected return as the market. In fact, a three-factor monthly regression on the fund for the period August 1997-June 2011 showed that the expected return was almost 2.0 percent less than that of the overall market, and about 1.2 percent less than that of the S&P 500 Index. The lower expected return is explained by:

• The fund's beta loading of 0.93 versus 0.98 for the S&P 500
• Its negative size loading of -0.26 versus -0.19 for the S&P 500
• Its value loading of -0.08 versus 0.03 for the S&P 500.

It's also important to understand that investors in such a fund would accept the idiosyncratic risks of that small number of stocks, risks that could be diversified away without reducing the expected return. (Note that the aforementioned regression produced an r-squared of 0.92.)

A great example is Enron, which at one point had the fifth largest market capitalization of any stock. Here's another example, of the original 30 companies in the Dow Jones Industrial Index, the only survivor is General Electric (GE). Thus, the idea of holding the largest 30 or 40 stocks forever isn't possible because they're persistently changing. (One thing that should be noted is that you don't need as many large-cap stocks to diversify idiosyncratic risks as you would with small caps.)

So one might ask, is this really a "dream fund?" Before discussing the performance of the fund itself, it's important to note that there are some significant differences between the design of Bridgeway's passively managed fund and that of Bogle's "Dream Fund." While we don't know for sure how the "Dream Fund" would be designed, we do know that Bogle favors market-cap weighted funds. The Bridgeway fund isn't market-cap weighted. Instead, it holds approximately an equal weighting of all 35 stocks. Thus, it holds less concentrated positions than a market-cap weighted fund would hold. The fund also tries to have a market-cap like weighting of industry sectors. In addition, the fund rebalances every few years, not holding "forever." Also the fund doesn't rely on some "smart people" (like the S&P 500 does) to determine what's in the fund. The evidence suggests that this is an advantage, as one study found that the S&P 500 would have produced a higher return if the original stocks were never changed.

Note that the performance of BLRIX supports the logic as presented above. According to Morningstar, as of September 27, 2011, the 10-year return of the fund was 2.85 percent. This was 58 basis points below that of the S&P 500 itself and was a greater difference than the 15 basis points expense ratio. (Indexes have no expenses, but funds that replicate them do.) This is exactly what we would expect for a fund that a higher negative loading on the size effect than the S&P 500 did, and small caps outperformed large caps during the period.

The reason is that 100 percent of BRLIX is in the first CRSP (Center for Research in Security Prices) decile, while about one-third of the S&P 500 is in the second CRSP decile. Over the past decade (through June 2011), CRSP first decile stocks outperformed CRSP second decile stocks by almost 4.5 percent a year, giving the S&P 500 a huge size advantage. (Note that the long-term historical difference between CRSP 1 and CRSP 2 is 1.4 percent a year.)

During the 14+ year period of the Fund, CRSP 1 underperformed CRSP 2 (a small-cap dominated period) by 3.5 percent year, yet BRLIX actually beat the S&P 500. The outperformance can be explained by the fund's construction strategies covered in the prior paragraph, showing that intelligent portfolio design by passive funds can add significant value.

The bottom line is that while I wouldn't call the "dream fund" a nightmare, I can certainly dream up much better fund ideas, like the Bridgeway Ultra 35 fund.

Photo courtesy of Melody Campbell on Flickr.
More on MoneyWatch:
How John Bogle Changed the Investing World John Bogle: Can His Son Beat the Market? 9 Bits of Conventional Wisdom You Should Ignore Has the Small-Cap Premium Disappeared? Dollar-Cost Averaging: Does It Produce Better Results?
Three ways I can help you become a wiser investor:

• Follow me on Twitter: http://twitter.com/larryswedroe.
• Read my latest book The Quest for Alpha.
• Download the podcast of my radio show via Buckingham Asset Management's iTunes page.