John Bogle on Cash Reserves

Exhibit I: Source of Variations in Return* Factor BHB Study Vanguard Study Allocation Policy 92.5% 88.7% Allocation Changes and Security Selection 7.5 11.3 Total 100.0% 100.0% _________________ *Average of BHB’s 1986 and 1991 studies; Vanguard study based on ten years ended December 31, 1996. Turning from variations in return to total return, both the pension plans and the mutual funds displayed returns before expenses that fell slightly short of the returns of the market index benchmarks. For the balanced funds, we used the Standard & Poor’s 500 Index for stocks, the Lehman Intermediate-Term Corporate Bond Index for bonds, and U.S. Treasury Bills for cash. (In neither the BHB study nor in our study did the results vary significantly if the all-market Wilshire 5000 Equity Index were used instead of the S&P 500.) What we are witnessing, as has been reaffirmed over what seems like time immemorial, is the failure of active mangers, on average, to outperform appropriate market indexes. Exhibit II: Returns Before Costs BHB Study Vanguard Study Index Composite Return 11.8% 12.5% Fund Composite Return (before costs) 11.2 12.3 Difference -0.6% -0.2% It seems likely that portfolio transaction costs were a material factor in both the pension plan and the mutual fund shortfalls to the unmanaged index portfolio. Undistinguished individual stock selection (or, if you will, highly efficient markets) simply meant that the active manager failed to add value.

Because here the conflict is clear: The manager seeks to charge high fees so as to maximize the return on its capital; the fund wants to pay low fees so as to maximize the return on its capital. And the amount of the fee represents virtually the sole differentiation in return. We’ll follow the money in a $61 billion group of money market funds managed by a large financial conglomerate. In 2000, the funds paid some $254 million in management fees, $64 million in distribution fees, and $71 million in shareholder service fees and operating costs. Total: $389 million, equal to 0.63% of assets. (Chart 7.) The fees spent on distribution and shareholder services probably cover the cost of those services. What about the amount spent on investment management? Consider a good-sized money market fund, regularly rolling over short-term U.S. Treasury bills and high-grade commercial paper, with absolutely no hope of materially exceeding the returns available in the money market.but

principle, but a failed practice. In fact, fund managers have done precisely the reverse. For example, equity funds held an average cash position equal to about 12% of assets at the start of the great bull market. Near the recent market highs, fund cash had been cut to only 5% of assets, providing little protection against the decline that ensued. Being bearish when you should be bullish, and bullish when you should be bearish, is not a formula for investment success! Chart 12 The case for indexing, then, is the very essence of simplicity: owning the entire U.S. stock market or bond market; putting aside the fruitless attempt to select the best manager; holding the asset allocation fairly constant; making no attempt at market timing; reducing transaction activity, minimizing taxes; and eliminating the excessive costs of investing that characterize most mutual funds. And it works. But, I'm a realist. I recognize that in the real world, lots of all-too-human traits get in the way of a simple, all-encompassing index fund approach. "I'm better than average;" "I can pick the best funds;" "Even if the game is expensive, it's fun;" "It can't be that simple"-are all too common refrains in the minds of investors-am I speaking for you?-who choose to pursue the conventional strategy of relying entirely on actively-managed funds to implement their investment strategies. "Hope springs eternal." But if the beginning of simplicity is the index fund, it need not be the end.

the fund’s volatility during those inevitable times when stock prices tumble. But “slightly lower” must be what the client is given to expect. In any event, it is important that the client understand that it is next to impossible to “market-time” a changing cash position. And most important of all, the client must understand that, in a positive stock market over time, he will pay a commensurate price in relative rate of return. Put simply, he should understand that, over the long-run, a percentage point increase in volatility is meaningless; a percentage point increase in return is priceless. That powerful, and, I think virtually unarguable syllogism, should give both adviser and client ample food for thought. Confronting the Index Challenge In this age of investment relativism, I’m convinced that—faced with the competition of index investing and quantitative investing—too many managers today are responding in the most ineffective manner possible, by “closet indexing.” But shaping an inchoate and undisclosed policy around the structure of an index is, finally, managerial suicide. It is the ultimate concession to the unarguable economic value of the low-cost, passively managed index fund over the high-cost, actively managed traditional fund.

The characteristics of those who do so will be individuality, training, experience, savvy, determination, contrarianism (or sheer iconoclasm), and hard work. The Puritan Ethic is not all bad! Importantly, they will limit the assets of the funds they manage relative to the market cap of the asset class in which they utilize their expertise, and relative to their proclivity to actively trade the portfolio rather than analyze, buy, and hold. Some successful managers, rather than being concerned with short-term relative risks, will run fully invested equity positions to capitalize on the fundamental long-term opportunities of equity investing. Others will succeed simply by investing with the courage of their convictions, rather than slavishly relying on short-term standards, and holding cash reserves when they judge market risk as excessive. Both groups will manage their funds at reasonable costs, allocating their fee revenues toward human talent and investment productivity, rather than engaging in marketing profligacy designed not to improve investment returns for fund shareholders, but solely to advance the manager’s own profitability.

That simple concept of defined-maturity segments revolutionized the bond fund sector, and the three-tier bond portfolio quickly became the industry standard. Our fifth major innovation came in 1992, when we determined to share the obvious economies of scale generated by our largest shareholders. It began with the creation of Vanguard “Admiral” funds, which slashed expenses for large shareholders in our newly created series of U.S. Treasury bills, notes, and bonds, a concept which would later spread to similar Admiral share classes in most of our other funds, to the benefit of these key owners. The sixth major Vanguard innovation—my final example today—is one that, like our bond innovation, would quickly be widely imitated (except, of course, for the low costs): Our creation in 1993, of the industry’s first series of tax-managed funds. Unnecessary taxes are this industry’s Achilles Heel, and we determined to create three funds that would serve the industry’s taxable investors, incorporating both minimal costs and maximum tax efficiency. This series of funds is one more innovation that has sprung from our unique organizational structure. But despite the power of our early innovation, the unremitting growth in our market share, and the growth in Vanguard assets to $1.3 trillion, that structure has yet to be emulated by a single one of our competitors. (Think about why that might be.)