To Veterans and Principals:

            It seemed only appropriate to celebrate (as it were) the 35^th anniversary of the index fund, the first major innovation of the then-tiny and young Vanguard Group. So last week, I wrote an essay on the creation of the fund and its initial public offering, which took place on August 31, 1976.

            I sent the essay to the op-ed editors of The Wall Street Journal, hoping they could help me get it placed in the “Review” section, which runs on Saturdays. But they wanted to publish a significantly shortened version on “their” page, so I (reluctantly) did the merciless editing required.

            I’m attaching the the piece as it appeared in the Journal on September 3, but also the full essay as originally penned. I like my title better (of course!); and I loved the flourish of my final sentence, sadly absent from the published version.

            Can you even imagine Vanguard without index funds?

                                                                        Jack

To Principals and Veterans:

In case you missed my op-ed in this morning’s Wall Street Journal, I’m attaching a copy. I’m pretty sure you’ll enjoy it. Also attached is a lovely article from the coming edition of Forbes.

Best,

Jack

He spent an hour on Tom Ashbrook’s show, On Point.

Op-Ed Response from Readers, and Mr. Bogle’s Reply

Six Lessons for Investors

Text of letter in response to Mr. Bogle’s 2/9/07 article:

Contrary to Mr. Bogle’s belief, the first index fund was created by Barclays Global Investors (BGI) for institutional investors in 1971. As the world’s largest index manager and the global leader in ETFs, we have enabled investors to access our institutional indexing strength in their portfolios. We’ve responded to what investors and their financial advisers want today — better tax efficiency, flexibility in trading, increased transparency, and access to hard to reach markets that help them diversify their portfolios.

ETFs have attracted significant assets because they appeal to many different types of investors. The vast majority of ETF owners are buy-and-hold investors. On the other hand, about 90% of the ETF trading volume is done by institutional investors such as mutual funds and hedge funds for short-term exposure or to hedge risks. Importantly, this trading happens outside the fund at the stock exchanges; thus long-term ETF investors don’t subsidize the costs of active traders in ETFs.

Lee Kranefuss
CEO of iShares at Barclays Global Investors
San Francisco

Text of Mr. Bogle’s response to Mr. Kranefuss:

Among the responses to my Feb. 9 editorial-page commentary “‘Value’ Strategies” on exchange traded funds (Letters to the Editor, Feb. 24), one from Lee Kranefuss of Barclays Global Investors (BGI) contained errors:.

1. While he denies that I created the first index fund, I have claimed only that I created the first index mutual fund (now Vanguard 500 Index Fund), incorporated on Dec. 28, 1975.

2. BGI did not create the first index fund. The first pension account to use an index strategy was created by Wells Fargo Bank in 1971, acquired in 1996 by Barclays.

3. That index strategy was a failure. It relied on a price-weighted — not market-cap-weighted — index, and was thus overwhelmed by frequent trading and its attendant transaction costs.

4. In 1976, the year after the creation of Vanguard 500, the pension account finally switched to the cap-weighted S&P 500 as its tracking standard, and the strategy at last began to work.

Attempts to rewrite history — even in its seemingly arcane aspects — should not be attempted.

John C. Bogle
Founder
Vanguard Group

While we have witnessed many “new paradigms” over the years, none have persisted. The “concept” stocks of the Go-Go years in the 1960s came, and went. So did the “Nifty Fifty” era that soon followed. The “January Effect” of small-cap superiority came, and went. Option-income funds and “Government Plus” funds came, and went. High-tech stocks and “new economy” funds came as well, and the survivors remain far below their peaks. Intelligent investors should approach with extreme caution any claim that a “new paradigm” is here to stay. That’s not the way financial markets work.

The full piece is available here.

To the Editor of the Wall Street Journal:

While I greatly respect the major contributions that Professors Fama and French have made to modern portfolio theory, I take strong exception to their recommendation to change the tax code so that mutual fund investors pay taxes only as gains are realized when they sell their shares, rather than be subject to taxes paid as their funds realize gains on their underlying portfolios. (“Keep it Simple,” February 25, 2006.)

First, their proposed system is in fact far more complex. Now, fund shareholders receive from each fund they own a single tax statement providing the information required on the tax return. Under the new system, investors would have to report the amount and date of each share purchase, worry about wash sales, and post multiple gains (or losses) on their returns. What is more, the conversion from the old system to the new would require the complex recreation of prior data of perhaps hundreds of individual purchases and liquidations in each account. Finally, relying on the accuracy of cost information from investors when they sell their holdings of individual stocks has already proven difficult for the Internal Revenue Service to enforce; in the case of mutual funds, it would be even more difficult.

Second, their article completely ignores the fact that traditional open-end funds can easily provide the same tax deferral as do exchange-traded funds. So far, all (or virtually all) ETFs are index funds, providing returns that parallel those of the underlying market indexes, and are barely, if at all, more tax-efficient than regular index funds, many of which are operated at extremely low cost, yet free of the brokerage commissions on purchasing ETFs. Neither Vanguard’s 500 Index Fund and Total Stock Market Index Fund, for example, have paid capital gains distributions since 1999, with annual distributions averaging less than 0.5 percent of asset value during the preceding five years.

The authors also ignore the availability of tax-managed traditional funds for taxable investors. Again, Vanguard’s five tax-managed funds, in nearly 50 cumulative years of operation, have yet to realize a single capital gain distribution, all the while providing superior pre-tax returns, and truly stunning after-tax returns (outpacing, on average, 92 percent of their peers over the past decade).

The real problem is not with the tax code, but (unrecognized by the authors) with the mutual fund managers themselves. They turn over their fund portfolios at a stunning average rate of 91 percent per year—a holding period of barely 13-months for the average stock in their portfolios, reflecting a trading strategy that is far more akin to short-term speculation than long-term investing.

Unsurprisingly, because of all those execution costs, high fund turnover is clearly associated with low fund performance. During the past decade, for example, the highest-turnover quartile of funds (165 percent annually) provided an annual pre-tax return of just 9.8 percent, while the lowest-turnover quartile (13 percent) returned 11.5 percent, an advantage of 1.7 percent per year—a cumulative extra profit of nearly 30 percent. What is more, the high-turnover quartile of funds took nearly 30 percent more risk (standard deviation of 20.6 percent vs. 16.2 percent).

Looking at risk-adjusted returns, then, the low-turnover funds earned 11.6 percent per year compared to just 8.9 percent for their high-turnover cousins. Result: $10,000 invested ten years ago grew by $20,000 vs. $13,300—a 50 percent enhancement in profit even before taxes are considered. After taxes, the enhancement in cumulative profit approached 100 percent, a difference that is truly astonishing.

Like the mutual fund industry that is now vigorously campaigning to change the tax law, Professors Fama and French simply ignore the economic realities described in this letter. It is not the tax code that needs changing; it is the “short-termism” exhibited by the vast majority of mutual fund managers, and the short-sightedness of mutual fund shareholders who refuse, out of naiveté or even ignorance, to look after their own economic interests. “The fault, dear Brutus, is not in our tax code, but in ourselves.”

John C. Bogle