John Bogle on Index Investing

Success In Investment Management: What Can We Learn From Indexing? A Presentation by John C. Bogle Founder, The Vanguard Group President, Bogle Financial Markets Research Center To the Investment Analysts Society of Chicago Chicago, Illinois October 26, 2000 Unless you’re Peter Bernstein, it will probably be news to you that the year 2000 marks the 100th Anniversary of a truly seminal academic paper. Dr. Bernstein is well known to all of you, I’m sure, both through his bi-monthly publication, Economics and Portfolio Strategy, and his books, including his marvelous chronicle of risk, Against the Gods. But it was in his Capital Ideas, published in 1992, that I first learned of Louis Bachelier’s 1900 dissertation, The Theory of Speculation. In that paper lay the roots of the huge volume of academic research that we now refer to as Modern Portfolio Theory. Bernstein—perhaps our preeminent expert on capital markets history—credits Bachelier as the father of MPT and of the Efficient Market Hypothesis as well. At its outset, Capital Ideas quotes the French academic’s key words—“past, present, and even discounted future events are reflected in market price . . . and it is impossible to aspire to mathematical predictions of [price]”—and then moves on in history.

The Wisdom of Investment – The Folly of Speculation Keynote Address by John C. Bogle, Founder and Former Chairman The Vanguard Group at The Sixth Superbowl of Indexing Phoenix, AZ December 5, 2001 Way back in 1968, the Stanley Kubrick-Arthur Clarke film 2001: A Space Odyssey—at once a story of human civilization, the space age, and the power of computer technology—put a durable imprint on this first year of the third millennium. But 2001 also marks a double anniversary year for indexing. Thirty years ago, in 1971 at Wells Fargo Bank, James Vertin, William Fouse, and John McQuown pioneered the effort by establishing the first indexed pension account for the Samsonite Corporation. And twenty-five years ago, in August 1976, the first index mutual fund, established by Vanguard eight months earlier, completed its initial public offering. In both cases, the starts were precarious. At Wells Fargo, the tiny $6 million index account was invested in an equal-weighted index of New York Stock Exchange equities. Its implementation proved to be a nightmare, and in 1976 it was replaced with the market-capitalization-weighted Standard & Poor’s 500 Common Stock Price Index. At Vanguard, we had earlier selected that same index as the standard for our newly-formed 500 Index Fund—known at the outset as First Index Investment Trust—and its offering raised but just $11 million.

JCB Remarks at “25th Anniversary” Dinner May 20, 2000 I stand before you, my fellow crew members, to thank you for this celebration of the 25th Anniversary of the company I founded on September 24, 1974. While it is doubtless traditional for the creator of a company to make a speech on such an occasion, I put you at ease by assuring you that I have no speech to make. But I do have just a few thoughts I’d like to leave with you on this gala evening.    We read much today about the need, in this decidedly new era, for what is called business concept innovation, the need for radical, not incremental, change. As you all recognize, that is exactly what Vanguard did a quarter-century ago, changing, within our first three years of existence, the very way that investors look at mutual funds. Call it mutualization if you will, but the idea of funds being managed with their owners’ interests paramount began right then. That structure called for rock-bottom operating costs, a recognition that almost instantly led to our creation of the industry’s first index fund and then to the industry’s first defined-asset-class bond funds, and to the complete elimination of distributors and sales commissions. Together, these revolutionary changes have constituted the driving force that has carried us to the pinnacle of industry leadership that we enjoy today.

“The Case of the Dog that Didn’t Bark” Remarks to Mutual Fund Directors Education Council By John C. Bogle, Founder, The Vanguard Group Washington, DC January 11, 2001 Good evening. By way of full disclosure, let me say a few words about Vanguard. We are a large mutual fund complex (assets of some $560 billion), managed under a unique corporate and governance structure that shapes the perspective I’ll present. Our management company is owned by the mutual funds themselves. We operate on an “at cost” basis, and this year our expense ratio will average a bit more than 0.25%. We provide investment advisory services for almost $400 billion of our assets. The remaining assets are supervised by external advisors under contracts negotiated at arms-length, with a weighted average fee rate of about 0.09%. You are unlikely to see any of this information in the studies prepared for fund directors by consultants. We are omitted, I am told, because we are “different”—as indeed we are. One can argue that difference is “good,” and I suppose one can also argue it is “bad.” But it is unarguable that our structure is cheap in terms of the services we provide our funds. I appreciate Dean Ruder’s gracious invitation to be with you, and to discuss my views on the role and responsibilities of fund directors. I have given several talks on this subject, and I understand that you have in your folders a copy of my last year’s speech to the Practicing Law Institute.

diversification, and focus on the long term—to say nothing of being skeptical of stock-picking and market-forecasting wizards—would be an understatement. (Indeed, it’s pretty much what I wrote in my Princeton senior thesis in 1951.) What’s more, an entire chapter of my latest book2 is devoted to showing that, given the radical change in our investment environment during the past three decades, Ben Graham would have gone even further, and endorsed the stock market index fund as the core strategy for the vast majority of investors. (Warren Buffett, who worked closely with Ben Graham, not only personally assured me of Graham’s endorsement, but put it in writing in his endorsement of my new Little Book.) The fact is that, even when I entered the mutual fund industry 56 long years ago—hired by fund pioneer Walter Morgan, whose Wellington Fund was, and remains today, the paradigm of these sound principles—this industry invested pretty much in the way Graham prescribed. The portfolios of the major equity funds consisted largely of a diversified list of blue-chip stocks; and managers invested for the long-term, eschewed speculative operations, managed their funds at costs that were (by today’s standards) tiny, and delivered market-like returns to their investors. (As the record clearly shows, those fund managers were hardly “wizards in picking winners.”) What a difference a half-century makes! How different?

How huge? A long-term investor who owns a portfolio of stocks of all of the companies in America, holds them for Warren Buffett’s favorite holding period—forever—and pays no management fee will!—will—end up with a financial stake that is at least double that of all other investors as a group. How to do that? Own an all-stock-market index fund. That now-pervasive idea began with the creation of the Vanguard 500 Index Fund more than 27 years ago. At first it was dubbed “Bogle’s Folly.” But today it is the largest mutual fund in the world. (Memo to young entrepreneurs: never worry about disdain for your ideas!) Energy and Persistence Low-costs and indexing are the simple rocks on which Vanguard was founded, an enterprise built on the majesty of simplicity in an empire of parsimony. So never underrate the power of common sense. Never underrate your ability to recognize the obvious, for, paradoxical as it may seem, the obvious is often the hardest thing to see. And then pursue your vision with energy and with persistence. Why? Because “energy and persistence conquer all things,” as that timeless epigram of Founding Father Benjamin Franklin reminds us. With all of his other talents, this great patriot also qualifies as the first American entrepreneur.

To make matters worse (from the standpoint of most investors), the passive, invisible hand of the market is putting to shame the returns earned by the active investment professionals who don’t “buy the market” (or so they say), but “buy stocks.” (They allege “it’s not a stock market; but a market of stocks,” as silly a statement as one could possibly imagine.) For example, while our passive Standard & Poor’s 500 Index fund is up 104% in 2 1/2 years, the average actively-managed mutual fund is up but 76%. (Given our global focus today, I should note that the average international fund is up just 37%). As an aside, given the stiff competition of the index funds, the average fund manager is, I think, making it even stiffer, by vigorously buying the giant index stocks in which mutual funds are underinvested. Mutual funds, which own nearly 20% of all stocks, own “only” 3% of Coca-Cola, 6% of Procter and Gamble, 7% of GE, 7% of Microsoft, and 8% of Merck, five of the very largest firms in the S&P 500 Index. These stocks are up 40% on average this year, far above the 25% gain in the index. (It’s not, it seems, that index funds are the problem, but that envious non-index funds, anxious less they fall still further back, are the problem.) In all, similarities with 1929 abound, and I don’t hesitate to haul up the warning flag. The worrisome signs include not only the high valuations I have described, but the similarity of the words we read today with those of that now-forgotten era.

and contentious start arose one of the most important and powerful investment ideas of the age, an age whose anniversary we celebrate at this Sixth Annual Superbowl of Indexing. Two Schools of Indexing—Quantitative and Pragmatic I think it’s fair to say that there were two principal schools of index development. I’ll call one the Quantitative School—the masters of mathematics led by Harry Markowitz, William F. Sharpe, and the Wells Fargo Financial Analysis Department, who reached their conclusions after doing complex equations and conducting exhaustive research on the financial markets. Princeton’s Burton Malkiel also deserves a share of the credit. In 1973, in the first edition of his persuasive and ever-popular A Random Walk Down Wall Street, he endorsed the efficient market hypothesis and called for a no-load, low-fee mutual fund that simply buys the market and does no trading. In essence, the Modern Portfolio Theory developed by the Quantitative School proved that a fully-diversified, unmanaged equity portfolio was the surest route to investment success. While the Quantitative School developed its profound theories, what I’ll call the Pragmatic School simply looked at the evidence. Dr. Paul A.

Samuelson’s 1974 article Challenge to Judgment noted the incontrovertible brute fact that academics had been unable to identify any consistently excellent investment managers, challenged those who disagreed to produce “brute evidence to the contrary,” and pleaded for someone, somewhere to start an index fund. And in 1975 in an article entitled The Loser’s Game, Charles D. Ellis argued that, because of fees and transaction costs, 85% of pension accounts had underperformed the stock market. “If you can’t beat the market, you should certainly consider joining it,” Ellis concluded. “An index fund is one way.” In mid-1975, when I decided to start the Vanguard index fund, I was both blissfully unaware of the work the quants were doing and profoundly inspired by the pragmatism of Samuelson and Ellis. It was then that I pulled out all of my annual Weisenberger Investment Companies manuals, calculated by hand the average annual returns earned by equity mutual funds over the previous 30 years, and compared them to the returns of the Standard & Poor’s 500 Stock Index. Annual Returns, 1945-1975: S&P Index 11.3%; average equity fund, 9.8%. To give that seemingly small percentage difference a high impact, I then showed that a hypothetical initial investment of $1,000,000 would have grown over the 30-year period to $25,000,000 in the Index vs. $16,500,000 in the average fund.and

This new book, subtitled The Only Way to Guarantee Your Fair Share of Stock Market Returns, focuses on the simple, straightforward, and, I think, unarguable premise that all of this activity is extremely harmful to the wealth of investors . . . . in fact, to the tune of about $400 billion per year. Why? Because of these simple facts; (1) that owning American business for the long term is a winning game (businesses, after all, earn a return on their capital and distribute a major part of those earnings or dividends); (2) that beating the market (before the costs of financial interdiction) is a zero-sum game; and (3) that beating the market after costs is a loser’s game. I call these obvious principles “the relentless rules of humble arithmetic,” in the long-ago words of Supreme Court Justice Louis D. Brandeis. The Index Fund The way to guarantee your fair share of the returns generated by business, of course, is to hold the market portfolio and eliminate all intermediation costs. While I’m confident that this room holds many skeptics about indexing, I’m equally confident that there is also a significant group here that agrees with my reasoning.with

chief executives—which last year averaged something like $7½ million annually, or 200 times the earnings of the average worker—is stunning, how about paying $257 million per year to the management company (other fees go to the distributor and the administrator) of a money market fund, a fund that inevitably underperformed its peers by the precise amount of its excess fees? How about paying some $3.6 billion(!) over the past decade to the management of an equity mutual fund that was promoted heavily, and grew so large as to become a closet index fund, but in fact fell short of the Standard & Poor’s Index by more than twice the costs it incurred? Surely nowhere has the triumph of Managers Capitalism been more obvious than in the money management field, where substantial waste of corporate assets is taking place right before our eyes. While the governance models of both corporate America and mutual fund America have the same flaw, however, the remedies to deal with the fundamental causes of the systemic failures we have observed in both areas are quite different. If that handful of giant institutional owners merely acts to bring corporate America back to its roots, it will happen, and happen relatively quickly.

“indexing” as such, and almost everything to do with simply owning U.S. business (or global business) in its entirety, through a capitalization-weighted portfolio of our total stock market, and then holding that portfolio for Warren Buffett’s favorite holding period: “forever”. Simply put, if an investor buys the market portfolio, pays no sales loads, no management fees, tiny operating costs, and no portfolio transaction costs, and holds it forever, that investor will capture virtually 100 percent of the stock market’s annual return. On the other hand, for the average investor buying actively-managed funds (or for that matter, engaging in any strategy that involves heavy trading), usually carrying commissions, substantial management fees, heavy operating and marketing costs, huge costs of portfolio turnover (the average equity fund now turns its portfolio over at an astonishing rate of 100 percent per year!), that investor’s return will fall far short of the market’s return. How far short? Well, those all-in mutual fund costs that I just enumerated presently come to something like 2 ½ percent of assets per year. Since the average mutual fund manager is, well, average—you heard it here!—the return of the average fund has fallen short of the return of the Vanguard 500 Index fund by about 2 ½ percentage points over the past quarter century. And simply because of those costs, the average fund is destined to fall short by a similar amount in the years to come.

1965. But, by the early 1970s, the total-return teetotaler of the old days had become a social drinker. It may not be stretching things to say that by the early 1990s he was on the verge of becoming an alcoholic—comparisonwise, to be sure. It doesn’t really matter whether today’s omnipresent S&P comparison has been fomented by the information overload in this miraculous age of communications technology. Or by the self-styled sophistication of the institutional client, who seems to have a vested interest in frequently changing advisers. Or by the appetite of the burgeoning mutual fund industry—with its daily asset valuations—as funds have become the investment of choice among American families. Or by the overly aggressive marketing of funds. (Have any of the funds you see advertised ever fallen short of the S&P 500?) Relative investment performance—“investment relativism” if you will—is the order of the day. The problem with all of this is not that managers should not be held to a performance standard—of course they should—but that they are held to a single standard irrespective of client objectives, and that the measurements take place during extremely short periods. We might well ask: “To what avail?” Enter “Closet Indexing” Surely it is no service to our clients that many fund managers, caught up in the perception that beating the market each quarter is happiness and losing is misery, seem to use the 500 Index as the mandatory measuring stick for their own portfolios—i.e.

If the words about efficiency, honesty, and economical operation strike you as a design for a firm called Vanguard, and if the idea that funds can’t beat the market seems to lay the groundwork for the index fund, so be it. But those things are probably what any young college student, idealistically seeking to build a new and better world, would have written. Whatever the case, the thesis led me directly into a career in this industry, for it was read by Walter L. Morgan, long-time member of the Union League, fellow Princetonian, legendary fund pioneer, and founder in 1928 of Wellington Fund. When I graduated in 1951, Mr. Morgan hired me. With few hardy souls having come into the beleaguered investment field during the 1930s and 1940s, my ascent was rapid. This fine gentleman groomed me, challenged me, trusted me, and liked me—we were friends for nearly half a century until his death at age 100 four years ago—and by 1965, at age 35, I was running his company. Mr. Morgan told me “to do whatever it takes” to prepare Wellington for the future. Headstrong, self-confident, and immature, I took a radical step, merging Wellington Management Company with a Boston investment firm. But I relinquished too much of Wellington’s voting control for my own good. While at first the merger was an extraordinary success, the end of the speculative boom of the “go-go” 1960s and the onset of the great 1973-74 bear market brought tough times.

enthusiasm again, this time in a different way (!), I plunged into the exciting challenge of building a new enterprise, an enterprise that would stand for something powerful: Stewardship—giving average investors a fair shake at building their own financial independence. And what else could explain that, at the very moment I was searching for an appropriate name for the firm, I came across a book recounting the history of the Napoleonic wars and the Duke of Wellington? I opened it to the very page that described the sweeping victory over the French at the Nile, won by Admiral Nelson aboard (you guessed it!) HMS Vanguard, the name I immediately chose for my new enterprise. And as we began, providence moved yet again: Some words that I’d written in my Princeton thesis nearly a quarter-century earlier happened to come back to me: “Mutual funds can make no claim to superiority over the market indexes,” words that led us to pioneer the index mutual fund—a fund that wins the investment race simply by owning the stock market and holding it forever. That first index fund, the backbone of our firm’s success, is now the largest mutual fund in the world. A Second Chance at Life If that series of unforeseen incidents in my life is not proof enough that commitment is rewarded by providence, I still have one more. Five years ago, at death’s door after fighting against a rare genetic heart disease for 35 years, I became the beneficiary of a heart transplant.

Ellis articles, to persuade a dubious Vanguard board of directors to approve the creation of the first index mutual fund. The idea of an index fund was hardly anathema to me. Way back in 1951, the anecdotal evidence that I had assembled in my Princeton University senior thesis on the mutual fund industry shaped my conclusion that funds “can make no claim to superiority to the market averages.” When the newly-formed Vanguard began operations in May 1975, I had realized my dream of establishing the first truly mutual mutual fund complex. While the idea of an index fund would have hardly appealed to a high-cost fund manager whose very business depended on the conviction that, whatever his past record, he could outpace the market in the future, indexing would be a natural for Vanguard. Uniquely, we operated on an at-cost basis and sought to become the world’s lowest cost provider of financial services. What is more, at the outset Vanguard provided only administrative services to our then-$1.4 billion fund group, which continued to rely on Wellington Management Company for all investment management and distribution services. Added to my conviction that indexing was a winning strategy, my powerful itch to expand our narrow mandate provided an irresistible urge to create the first index mutual fund. As I’ve often noted, many firms had the same opportunity, but like the prime suspect in a murder mystery, only Vanguard had both the opportunity and the motive.

2. Soaring Fund Portfolio Turnover. Portfolio turnover has leaped from 17% annually during the 1950s to 108% in 2000. With this change from long-term investing (a six-year holding period for the average stock) to short-term speculation (an 11-month holding period) has come higher transaction costs and far higher tax costs to fund investors. Part of the increase reflects a shift from conservative, even staid, investment committees to individual portfolio managers, who themselves last for an average of but five years. There is no evidence whatsoever that this change has been good for shareholders. (Chart 2) 3. Soaring Turnover of Fund Shares. With the erosion of the industry’s focus on funds with long-term staying power, fund shareholders are turning over their own shares at an unprecedented rate. In the 1950s, share redemptions averaged 6% of assets, an effective 16-year holding period. By 2000, the rate had leaped to nearly 40%, a 2½ year holding period. All of this shuffling around in the chase for performance has resulted in an incalculable—but significant—diminution of shareholder returns. (Chart 3) 4. Soaring Fund Expense Ratios. In 1950, fund expenses averaged just 0.77% of tiny assets of $2½ billion. By 2000, with equity fund assets having grown to a gargantuan $4 trillion, the expense ratio had more than doubled, to 1.65%. Naturally, the rates are lower when weighted by fund assets, but even then the increase (from 0.62% to 1.03%) was 70%. In the face of a 160,000%(!)

While the Quantitative School relied heavily on its capital asset pricing model and the belief that the financial markets were highly efficient, the Pragmatic School relied on the brute evidence of pension fund returns and mutual fund returns relative to the market, and the obvious fact that investment costs were largely responsible for the shortfall. But both schools agreed that owning the entire stock market, as represented by the Standard & Poor’s 500 Index, was a way to capture close to 100% of the market’s annual return. In a world in which the average manager, simply because of advisory fees and transaction costs, could capture only 75% to 85% of the market’s annual return, indexing was certain to be a winning strategy. From Heresy to Dogma Well, what began as the heresy of a few fanatics a quarter-century ago and more has become the accepted dogma of the academic community, individual and institutional investors alike, and even a large number of investment practitioners. Market index strategies, unheard of at the outset, have grown to $6.5 billion in 1981, $235 billion in 1991, and $1.3 trillion(!) in 2001— from zero to 1% to 6% to 10% of the market value of all U.S.stocks

There’s nothing quite equal to a second chance at life. “Something no man could have dreamed would come his way,” just as Goethe promised. Without that miracle, I would not be standing here today. Since then, providence has continued to favor me. What else could explain that just two weeks ago, FORTUNE magazine stuck again, just as it had a half-century earlier. As if to prepare me for these remarks, its feature article on Vanguard began with the headline, “Say It Loud: They’re Average and Proud,” and concluded, “two (of their original) old ideas, low fees and indexing, make Vanguard the company of the moment.” The story’s final words about what is now the industry’s second largest firm: “If Vanguard becomes No. 1, it would be the ultimate validation of its co-op style management structure, of its low costs, and of index funds too . . . a positively freakish event: A triumph of humility over those vain investors who think they can beat the market.” Yes, boldness can lead to magic.

increase in fund assets, that expense ratio increase presents clear evidence that it is not fund shareholders have enjoyed the staggering economies of scale available in the money management field. No, it is the fund managers who have been the beneficiaries. (Chart 4) 5. Inferior Relative Performance. The bottom line: fund investors have not received their fair share of the stock market’s bountiful rewards. That shortfall is easily measured. Over the past 30 years the average surviving equity fund provided an annual return of 0% 10% 20% 30% 40% 50% 60% 70% Total Redemptions Redemptions Excluding Exchanges 39 %* 28 %* Investor Turnover of Equity Fund Shares 7 % 11 % 12 % 20 % 62 % *2000 - Through November, annualized Mutual Funds: Funds vs. Common Stocks Chart 3. 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000E Average Equity Fund Expense Ratio (basis points) Mutual Funds: Cheap vs. Dear Chart 4.

Now let’s assume that we’re fortunate enough to enjoy future nominal returns in the stock market averaging 7 percent per year, roughly what reasonable expectations suggest for the coming decade. (We can talk about that later.) Let’s also assume that the inflation rate will be about 2 ½ percent, leaving a 4 ½ percent real stock market return. If equity fund costs continue at today’s 2 ½ percent rate (and there’s no evidence that they are declining), they would confiscate about 60 percent of that annual real return. But don’t stop there. Compounded over an investment lifetime—say, 50 years—$10,000 invested at 4 ½ percent (let’s make it 4.4 percent to take into account the minimal costs of an index fund) would produce a real profit of $76,100. On the other hand, $10,000 invested at a return of 2 percent (net of that 2 ½ percent cost) would grow by just $16,900 in real terms. Rather than taking the road less traveled by—passively owning the entire market—the investor who travels the traditional road of active management would earn less than 25 percent of a stock market profit that is there for the taking. (The exact figure is 22 percent.)

To give the fund shareholder a fair shake, quoting Great Grandpa Armstrong, “the first step must be to reduce expenses.” Industry Expenses Soar Yet industry expenses are not only not being reduced, they are soaring. Since 1980 the annual expense ratio of the average equity fund has risen by more than 40%—from 1.10% to 1.57% of fund assets. It has been documented, well, everywhere. But, the industry takes the position that the cost of fund ownership is declining. Or that’s what the industry’s Investment Company Institute says. What it means is that, according to its rather tortured and convoluted methodology, the cost of purchasing equity funds has, in fact, declined, from 2.25% annually in 1980 to 1.49% in 1997. The industry reaches this conclusion by including sales charges plus expense ratios, and then weighting the results by the sales volume of each fund each year.High

“Serious mistakes,” I indicated, included such errors as investing in funds with spectacular records (“no investor ever went broke by failing to invest in a hot new product”), as well as those persistently at the bottom of the deck; excessive reliance on narrowly-based funds (say, emerging market funds); and using mutual funds for short-term trading. As the stock market bubble inflated, some of these dos and don’ts didn’t seem especially necessary. Now, after the fall, their validity has been reaffirmed. Pillar 2. When All Else Fails, Fall Back on Simplicity. There are an infinite number of strategies worse than this one: Commit, over a period of a few years, half of your assets to a stock index fund and half to a bond index fund. Ignore interim fluctuations in their net asset values.your

In the early years, pension funds accounted for by far the largest portion of indexed portfolios. But during the 1990s and through 2001, index mutual funds have been the driving force. While the rising market has carried pension fund index assets up eight times, since 1990, from $172 billion to $830 billion, the percentage of pension equity assets invested under index strategies has risen only slightly from 20% in 1990 to 23% today. During the same period, assets of index mutual funds have risen eighty fold, from $5 billion to $400 billion, from 2% of equity mutual fund assets to 12%. Truly, we are witnessing the triumph of indexing. Disquieting Cross-Currents But beneath the surface of this triumph lie disquieting cross-currents. In its original incarnation, indexing was a way to bring the wisdom of investment to those who could grasp the merit of complete diversification, buying essentially all of the stocks in the U.S. market, operating without advisory fees and at rock-bottom operating costs, minimizing turnover costs and extra taxes, and hanging on to each stock for Warren Buffett’s favorite holding period—forever. All that was required was that investors accept the self-evident fact that capturing nearly 100% of the 1% 8% 10% 5% 0.1% 0% 2% 4% 6% 8% 10% 12% 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 Domestic Equity Indexed Assets as a Percentage of U.S.Assets

holding period for the average fund is just over one year (1.1 years, to be exact). More charitably, on a dollar-weighted basis, the average holding period is about 1.4 years. Either way, today mutual funds are largely focused on the folly of short-term speculation. 6. Industry Mission. Over the past half-century-plus, the mission of the fund business has turned from managing assets to gathering assets, from stewardship to salesmanship. We have become far less of a management industry and far more of a marketing industry, engaging in a furious orgy of “product proliferation.” Our apparent motto: “If we can sell it, we will make it.” During the 1950s, the number of equity funds grew nicely, by about 35 percent. But during the 1980s, the number of equity funds soared by 110 percent, with another 125 percent increase during the 1990s (most of which, alas, were technology, internet, and telecommunications funds, and aggressive growth funds focused on these areas). Since every action leads to a reaction, of course, the 13 percent fund failure rate during the 1950s has also soared. The failure rate is now on track to reach nearly 60 percent this decade. “As ye sow, so shall ye reap.” 7. Costs. Ah, costs! Costs have soared. On an unweighted basis, the expense ratio of the average fund has doubled, from 0.77 percent in 1951 to 1.54 percent last year. (All right, to be fair, when weighted by fund assets, the expense ratio has risen from 0.60 percent to 0.

buy a 1.5% portfolio position for protection. Since that’s less than Coca-Cola’s 2.0% weight in the S&P 500 Index, I’ll have a good defensive position versus the Index when it takes the tumble it so richly deserves.” Whatever the case, isn’t that philosophy the antithesis of professional investment management? Hasn’t it become the formula followed by a nervous portfolio manager anxious to hold his or her job? Isn’t it the result of the marketing department’s holding sway over the investment department? In each case my finding would be: “Guilty as charged.” Such a “closet indexing” strategy is, in my view, more pervasive than most investors recognize (or have been led to recognize). But, whether it takes place at the margin of a portfolio or permeates it, I’ve never seen it disclosed in a fund’s prospectus. (A cynic might wonder whether fund independent directors and trustees have been fully informed on the subject.) To be sure, so far it largely applies, when it does, to the large-cap managers. Closet indexing is a relatively simple process when the ten largest stocks in the S&P 500 Index represent nearly 20% of the Index, the largest 50 stocks, 50%. Even if it creeps into the small cap side of the business, it seems unlikely to permeate it, since the largest ten stocks comprise just 1.7% of the Russell 2500 Small Cap Index, the largest 50 stocks just 8.2%. That said, the fact is that large-cap strategies dominate the financial markets.

positions for as long as you live, subject only to infrequent and marginal adjustments as your circumstances change. When there are multiple solutions to a problem, choose the simplest one. Although the stock market’s wild and wooly odyssey since I wrote them makes those words seem an eon away, I believe more than ever in that basic principle: Rely heavily on index funds, and begin with the idea of a 50/50 bond/stock ratio, adjusting the ratio in accordance with your own financial profile. In my book, I noted that this approach was consistent with the philosophy of Benjamin Graham, author of The Intelligent Investor1. This simplicity surely has continued to prove itself. During the past decade, the annualized return on a low-cost index fund modeled on the Standard & Poor’s 500 Stock Index has been 14.4%, while the average general equity fund has earned +12.3%. The low-cost bond fund modeled on the Lehman Aggregate Bond Index has earned +8.0% annually, while the average taxable bond fund has earned +6.8%. These solid margins in returns—2.1% per year for the stock index fund and 1.2% per year for the bond index fund—were highly predictable, for they largely reflect the cost advantage index funds hold over actively-managed funds. Once again, the majesty of simplicity—the broadest possible diversification at the lowest possible cost—has proved itself. Pillar 3. Time Marches On. Time dramatically enhances capital accumulation as the magic of compounding accelerates.

Exhibit III: Returns After Costs BHB Study Vanguard Study Index Composite Return 11.8% 12.5% Average Fund Return (before costs) 11.2 12.3% Average Expense Ratio 0.6 1.0 Average Fund Return (after costs) 10.6% 11.3% Difference -1.2% -1.2% The total shortfall was 1.2% annually, reducing the market index return by 10%. Expenses accounted for 83% of their shortfall, and consumed fully 9% of the funds’ average return. As it turns out, moreover, there is a fairly systematic relationship between the cost and net returns of the balanced funds in our sample. Indeed, the gross returns of the 2nd, 3rd, and 4th quartiles are virtually identical when costs are eliminated from consideration. The results are illustrated in the table below. Unsurprisingly, lower costs lead to higher returns. Exhibit IV: Balanced Funds: Returns vs. Costs Costs Quartile Net Return Expense Ratio Gross Return 1st (lowest costs) 12.7% 0.5% 13.2% 2nd 11.3 0.9 12.2 3rd 10.9 1.0 11.9 4th (highest costs) 10.7 1.4 12.1 Average 11.3% 1.0% 12.3% What is more, costs systematically magnified the gross return advantage earned—for whatever reason. Randomness seems an unlikely explanation; perhaps reaching for a higher income yield to offset expenses is traded off against capital return at a net cost. In any event, every 10 basis points of lower expenses accounted, on average, for 20 basis points of enhanced net return.

stock market’s annual return was an achievement earned only rarely and inconsistently by active managers, who were in any event almost impossible to identify in advance. The wisdom of index investing for the long-term was simple. It was straightforward. And it did exactly what it promised. But the upsurge in mutual fund indexing in recent years has not been based solely on the wisdom of investing. It has also been based on the folly of speculation. Increasingly, and to an astonishingly unrecognized extent, indexing is being used, not to match the market but to beat it. Long-term ownership of the stock market as a whole is apparently not good enough. A whole variety of new index funds have been designed as engines to enable investors to capture superior returns. In some cases, the funds are based on indexes representing various styles or sectors of the market (small-cap growth indexes and large-cap value indexes, for example) In other cases, the funds are based on traditional broad market indexes (Standard & Poor’s Depository Receipts—Spiders—for example), trading vehicles structured for short-term speculation rather than long-term investing. In still other cases, by a combination of both—for example, the technology-driven NASDAQ Qubes and the i-shares that index the South Korean stock market. In my view, owning the market and holding it forever is the ultimate strategy for winners.

There is an obvious—and optimal—way to closely approach this 100% target: Simply own the market. It is easy. An all-stock-market index fund, in substance, owns shares in every publicly held business in America, and holds it for as long as the business exists. By slashing the croupiers’ take, such ownership is available at extremely low cost. There is no advisory fee, for there is no adviser; no sales charges, for there need be no broker; nominal fund transaction costs, for there is almost no portfolio turnover; with so little turnover, few realized gains and minimal taxes. It is fair to say that the all-market index fund is the croupier’s worst nightmare. And, therefore, the investor’s sweetest dream The simplest of all approaches to equity investors, then, is to invest solely in the shares of a single all market equity index fund—just one fund. It is a good plan. 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 too smart for that;” you may think. “Even if the game is expensive, it’s fun.” “It can’t be that simple.” These are the 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,” as Alexander Pope reminded us.breast;

Large-cap stocks account for roughly two-thirds of the assets of all equity mutual funds, and an even higher proportion of institutional assets. And closet indexing may well be having an impact on stock returns. While I’d never ascribe causality to any of the myriad factors that affect the price of a stock, it seems more than coincidence that so far in 1997 the largest gains among the blue chip stocks whose capitalizations dominate the market have come to those stocks in which mutual funds have the smallest relative positions. Yet the five largest stocks in the 500 Index most underowned by mutual funds are up almost 50% so far this year, compared to an average gain of roughly 30% for the remaining 495 stocks. Put another way, could it be that active managers, in their passion to compete with the passive Index, are primarily responsible for driving up the price of the underowned large stocks in the Index, giving it, over the past three years, the most formidable record of outpacing active fund managers in the history of the Index, surpassing 90% of equity funds? Are managers forcing their portfolios to become more Index-like, so as to avoid serious shortfalls in the quarterly comparison “sweepstakes” (another word from the world of gambling)?are

While these might seem rather meager credentials, that structure set in motion all that was to follow. We quickly went to work to expand our mandate. Ignoring the limitations in our charter, we created the world’s first index mutual fund, and then the industry’s first targeted maturity bond funds, now the industry standard. We eliminated the seller-driven broker-dealer distribution force that had marketed the Wellington funds for nearly half a century, replacing it with our own buyer-driven “no load” system. By mid-1977, with our fund assets still below $2 billion, each of the critical elements of today’s Vanguard was not only in place, but set on a firm foundation. We had built it. Now we would test our thesis: “If you build it, they will come.” Our innovation, our structure, our strategy, our faith in stock indexing and in disciplined bond management, our over-bearing focus on low cost, and our attention to serving the needs of our clients were what we built, and millions of investors came. Year after year, unremittingly, our market share of industry assets increased, and our fund assets now total $560 billion. The Vanguard Experiment has worked.

When investors, in the hope of carving out an edge, use index funds to make outsized bets on narrow market sectors or to vigorously trade their portfolios, they have adopted the ultimate losers’ strategy. When investors abandon the wisdom of investment and undertake the folly of speculation, using a great idea to implement a flawed strategy, they are bound to be disappointed. There is an old prayer that reads: God grant me the serenity To accept the things I cannot change, The courage to change the things I can, And the wisdom to know the difference. I hope it is wisdom rather than stubbornness that persuades me that I can help to change what is going on today in indexing and return us to our roots. First, I’ll present a perspective on the remarkable success investors have achieved when indexing has been properly used for investment purposes, and then I’ll discuss why investors will achieve self-defeating results when index strategies are abused for speculative purposes.

of the three higher-cost quartiles averaged about .76; the lower-cost quartile averaged .95.) This relationship drives home the “costs matter” thesis, with powerful force. Our conclusion, then, adds a key caveat to the BHB phrase, modifying it as follows: “Although investment strategy can result in significant returns, these are dwarfed by the return contribution from investment policy, and the total return is severely impacted by costs.” This conclusion is derived, not only from the limited evidence provided by our study of balanced mutual funds, but in an exhaustive study of the returns of all 741 domestic equity mutual funds in operation over the past five years. The analysis separated the equity funds into nine “style box” objective categories—large, medium, and small capitalization stocks on one axis, growth, value, and a blend of the two on the other. In each style box, without exception, funds in the low-cost quartile consistently outpaced funds in the high-cost quartile. What is more, each 10 basis points of expense ratio advantage was accompanied by a 21-basis-point advantage in net return. That is to say, a 10% return on a high-cost fund would translate, not merely into an 11.1% return for a fund with a 1.1% expense ratio advantage (high-cost balanced funds 1.6%, low-cost funds 0.5%), but a 2.3% total return advantage. That is a 23% enhancement of annual return.

in mind that the industry costs reflect fund expense ratios only; they ignore sales charges, paid on the purchase of shares in almost one-half of all mutual funds. Since we offer only no-load funds, Vanguard’s cost advantage is in fact substantially larger than it appears.) The impact of cost is greatest where the time horizon is longest. If a low-cost complex operates at a cost of ¼ of 1% (assuming a market return of 10%) over 25 years, it captures 95% of the market’s return. A high-cost complex (at 2%), would capture but 63%. So here is another form of the tyranny of compounding—cost compounds, too! Since 1980, the expense ratio of the average Vanguard fund has dropped from 59 to 28 basis points, even as the industry’s expense ratio has risen from 99 basis points to 125 (Chart 5). Thus our margin of advantage has risen from 40 basis points to almost 100—by two and one-half times—an 80% competitive advantage in unit costs. This advantage is pervasive—in our U.S. and international stock funds alike; in our balanced funds; in our tax-exempt and taxable bond funds; and in our money market funds. After all, given Vanguard’s unique mutual structure, we have two ways of earning profits for our shareholders: Investing in portfolios of securities that provide generous long-term returns; and minimizing the drag of intermediation costs so as to provide the highest possible portion of those returns.

investment is $108,000, at the end of 25 years, nearly a tenfold increase in value. Give yourself the benefit of all the time you can possibly afford. Of course, time has marched on since I wrote those words. Even taking into account the sharp market decline during the dismal past year, the decade-long 14.4% return on the S&P 500 index fund has already carried the value of an initial $10,000 investment in the index fund to $38,400. While the 25-year period that I noted in the book is not yet half over, Pillar of Wisdom #3 is looking pretty good. Even a modest return of 7.2% on stocks during the next 15 years— one-half the rate of the past decade—would result in the realization of that 10% target and the accumulation of the resultant $108,000 of capital over 25 years. Surely this example of the march of time bears out the words of the poet Maya Angelou: “Since time is the one immaterial object which we cannot influence, neither speed up nor slow down, add to nor diminish, it is an imponderably valuable gift.” And so it is that time provides among the most valuable of all gifts in investing. Do your best to ignore the short-term events that, day after day, seem to overwhelm our thinking, and follow the very first principle for managing your money: Give yourself all the time that you possibly can. Pillar 4. Nothing Ventured, Nothing Gained. It pays to take reasonable interim risks in the search for higher long-term rates of return.

So we had to seek yet another diamond. And we quickly found what was to prove to be the rival of the fabled Kohinoor diamond in size. The fact that investment management was outside of Vanguard’s mandate led me, within months, to what may seem obvious, a great idea that I’d toyed with for years. And before 1975 had ended, we started the world’s first index mutual fund. Our first index portfolio—based on the Standard & Poor’s 500 Stock Index—was derided for years, and first copied only after a full decade had passed. But very soon this fund, once called “Bogle’s Folly,” will be the largest mutual fund in the world, one of 28 index mutual funds that today constitute nearly one-third of our business. The trick of the index fund, I argued to the Board, was that it didn’t need to be “managed;” it would simply buy all of the stocks in the Index. The argument narrowly carried the day, and with this quasi-management step, we had edged into the second side—the investment side—of the triangle. How to get the final and third side—the marketing function? Why, just find another diamond. Our idea was to eliminate the very need for distribution, doing away with the Wellington network of brokers and relying, not on sellers to sell fund shares, but on buyers to buy them. So, in 1977, after yet another divisive battle, we made an unprecedented conversion to a no-load, sales charge-free marketing system. Once again, we’ve never looked back. We’ve never had to.

Man never is, but always to be blest.” Just as the dream of the perfect plan lies little chance of coming true, so the anticipation of being blessed, Pope tells us, inevitably falls short of realization. It occurs to me that the main fact or that causes investors to ignore the good plan of indexing is not just that it is boring—the market return is only, well, the market return—but that the index strategy seems dumb. In a sense, of course, it is. Perhaps it is also deaf and blind. But as it turns out, the dumb strategy leads to a smart, even brilliant, decision. Hear Warren Buffett on this subject: “By periodically investing in an index fund . . . the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.” But if the index fund strategy is a good plan—maybe even the best plan available to most of us mere mortals—it need not be the end. While the odds against picking a superior mutual fund have been powerful, they have not been insurmountable. In a given decade, perhaps one fund in five has beaten the market (before taxes). And there are some simple common sense principles that should help you to select funds that can earn a generous portion of the market’s return, although they too are all too likely to fall short of 100%.

1977 we made the leap into fund marketing. We took the then-unprecedented step of eliminating all sales commissions, seeking to appeal to the financial advantage of investors rather than the financial advantage of distributors. And we took the final step in becoming the full-line mutual fund complex we are today by assuming our first investment management responsibilities just four years later, in 1981. After seven long years, our structure was at last in place. And in the ensuing 16 years we have built the assets we manage internally to some $150 billion, about 60% of our total asset base. It wasn’t easy, but I think we can mark persistence--call it determination if you will—as yet another attribute of leadership. Paradoxically, our persistence had to be accompanied by patience, another trait of leadership. My favorite example is our pioneering foray into market index funds—today, sadly enough, the “industry darling” or, God forbid, “hot product.” (I cannot abide such concepts.) Struck by the insight that matching the stock market at minimal costs would over time give a low-cost passively-managed index fund a near-certainty of outpacing the vast majority of high- cost actively-managed funds, we formed the first index fund in 1975. This grand and pioneering idea was scorned by others—”Bogle’s folly” was said more than once—but patience and conviction were rewarded as our $10 million in index assets at the outset two decades ago exceed $75 billion today.

managers sowing the seeds of their own performance inferiority today? Stranger things have happened. Well, these trends suggest why I describe the present era as the Age of Investment Relativism, in which the overarching goal is to avoid inferior short-term returns relative to the S&P 500, rather than to achieve superior absolute long-term returns. Since quantitative science entered the business of mutual fund performance in the mid-1980s, relativism has become the basis of a comprehensive performance measurement system. Beta (risk, measured by the fund’s price volatility relative to the 500 Index), and Alpha (the fund’s rate of relative return adjusted for risk) have entered our lexicon. We also have the Sharpe Ratio, measuring a fund’s excess return over the Treasury bill relative to its risk (standard deviation), not to be confused with the information ratio (Selection Sharpe Ratio), which measures excess return over a benchmark standard—usually, of course, our devilish friend, the S&P 500. I do not believe that this focus on simplistic mathematical precision is an entirely healthy state of being for managers or for their clients, nor for the market itself. Yet there is, as yet, no end in sight—no Omega on the horizon. The Real Villain: The Index Fund Surely the most important reason by far for the defensive reaction of managers to index comparisons is the index fund itself. The index is a mean adversary, but the index fund is the real villain of the piece.

a star system not unlike Hollywood’s has emerged, with the brightest stars attracting the largest cash flows from investors. Doubtless some managers have used this New Era of infinite information to their advantage. After all, the new Compaq 700 has 5000 times(!) the power of a 1985 IBM PC. But it is in the nature of markets that for each winner there must be a loser. Beating the market is a zero-sum game. The average fund manager can’t win. When asked if the average manager could win, Columbia University’s legendary Benjamin Graham, mentor to the even more legendary Warren Buffett, said: “No. That would mean that the stock market experts as a whole could beat themselves—a logical contradiction.” Which quickly leads to the second truth: While all investors as a group share the market’s gross return, their net return is reduced, dollar for dollar, by the costs of financial intermediaries. After costs, beating the market is a loser’s game. Yet in the New Era, the relative returns earned by mutual fund investors have not merely stayed the same; they have gotten worse. Why? Because the costs paid by mutual fund investors have risen. Result: the share of market return earned by fund investors has declined even further. How much have costs risen? In the Old Industry, the average equity fund carried an expense ratio of about 0.75% of assets per year; in the New Industry, the average is more than 1.6%—an increase of more than 100%.

What is more, external circumstances could exacerbate the situation. A market decline which caused net liquidations would increase per share distributions. Conversely, rising markets, which bring in new money at ascending prices, dilute per share distributions. That is why mutual fund unrealized gains have been small relative to the rise in stock prices. Curiously, investors don't seem to mind paying $10.00 per share for a fund with a tax liability on, say, $2.50 in unrealized capital gains. In a down market, when share prices tumble, it is possible, if not likely, that new fund investors with unrealized losses would nonetheless receive substantial taxable capital gains distributions. (Fund accounting practices give rise to strange outcomes!) "Forewarned is forearmed." With all this background, let's look at tax impact in a longer-term context. On the income distribution side, the tax impact is, in a perverse sense, beneficial. Equity mutual funds are today earning gross income before expenses-at the rate of about 2.1 %. (Their equity holdings yield about 1.7%; their 7% average reserve position 6%.) But fund expenses average 1.5%, meaning that equity fund investors receive a puny 0.6% yield on which to pay taxes. Expenses, in fact, are consuming 71 % of fund income. In the paradoxical world of mutual funds, then, the higher the expense ratio, the more "tax efficient" the income component of total return. "Alice in Wonderland" writ large! Alpha Takes Another Hit ...

The board approved (9 to 2—a landslide for a change) our assumption of responsibility internally for our money market and bond funds in 1981. Slashing the expenses of these funds by doing the job ourselves at rock-bottom cost, we raised net income accordingly. Our resultant superior yields, combined with our existing strategies of peerless investment quality and defined maturities, has made us the dominant force in the fixed-income fund field today. So by 1981—just six years after we began as a tiny administrative business—we had become the full-fledged mutual fund organization that I had sought to become, without success, in 1974. The modern Vanguard was in place. There was, really, just one more action we took that established the firm that the world knows today, and that was our very first action after we got up and running in 1975. We formed the first index mutual fund. The Inescapable Logic of our Index Fund I’ve always had a bit of an intellectual bent to go with the opportunism and determination that were required to conceptualize, form, and develop the full Vanguard structure. As an avid reader of the academic journals, I had become intrigued by the concept of index investing, and had watched it gain a toe-hold among a few banks and pension funds during the mid-1970s. The idea of index investing was simply to match the market and, by keeping costs at minimal levels, to winning the game in the long-run.of

Once upon a time, managers could (and did) use the argument, “yeah, but who can buy the market?” And later, “yeah, but the index is theoretical, and it would cost a lot to buy, be expensive to operate, and you wouldn’t be able to nearly match the index.” The low- cost index fund has given the lie to these foolish make-weight arguments. But even though Vanguard founded the first index mutual fund began in 1975, fully 22 years ago (perhaps the bogle goblin really was the data devil), it was not until the mid-1990s that index funds began to catch the fancy of investors and become a formidable competitor for their assets. And tough competition they are. As recently as 1994, index funds accounted for only 3% of equity fund flow ($4 billion). In 1997, index fund inflow should reach a 15% share ($30 billion). What is more, tough in the marketplace they should be. For they have been tough in the market. As I noted at the outset, the total return on the original S&P 500 index fund (net of costs) over the past 15 years was 18.2% annually, compared to 15.7% for the average U.S.equity

The magic of compounding accelerates sharply with even modest increases in annual rate of return. While an investment of $10,000 earning an annual return of +10% grows to a value of $108,000 over 25 years, at +12% the final value is $170,000. The difference of $62,000 is more than six times the initial investment itself. Over the past decade, that a two-percentage-point differential I chose in my book characterized almost exactly the spread between a low-cost S&P 500 index fund (+14.4% per year) and the average U.S. stock mutual fund (+12.3%). Final value of an initial investment of $10,000: Index mutual fund $38,400; Managed mutual fund $31,900. And, I should note, that substantial increase in reward came hand-in-hand with no increase whatsoever in risk. In fact, the index fund was some 15% less volatile than the average equity fund.

50%, his profits would be gone, and the impact on the market would be no more than minimal. And at 0.20%, the manager would probably be bankrupt. So the manager of Fund A doesn’t reduce his 2% expense ratio. Price competition is defined, not by the behavior of consumers, but by the actions of producers. What would real price competition look like? The answer is as simple as it is obvious. Since Vanguard’s success has been based on long-term investing at low-cost, competitors would have to: (i) cut their management fees and the portfolio turnover of their managed stock and bond funds; and (ii) plunge enthusiastically into the index fund fray; a “kicking and screaming” entry won’t do the job. These changes would make money for their investors. But they would slash profits for their management companies (and their shareholders), for it costs managers money to give shareholders the fair shake they deserve. The simple economic truth is this: As long as today’s awesome level of profitability is priority number one for the managers, fund shareholders will pay the price, and industry expense ratios will continue to edge ever upward.Advisers

Average Equity Mutual Fund % of Average Assets 1. Advisory Fees 1.1% 2. Other Operating Expenses 0.5 Total Expense Ratio3 1.6% 3. Transaction Costs4 0.7 4. Opportunity Cost5 0.4 5. Sales Charges6 0.6 Total 3.3% 6. Taxes7 1.6 TOTAL 4.9% You don’t need me to tell you that 330 basis points—490 basis points if we include even a modest estimate of taxes—is a lot of Embedded Alpha. Now let me show you how all of this works out in practice. First, to be conservative, I’m going to slash that 330 basis point charge, first by ignoring the 60 basis points for sales charges (which are ignored in most industry performance data), then by using an expense ratio weighted by fund assets (another 50 basis point drop), reducing costs to 220 basis points. Let’s use that conservative figure as a benchmark for the Embedded Alpha of the average fund. Next, I’m going to assume that funds earn average returns equal to those of the stock market itself. Of course, managers have the opportunity to earn higher returns (or, for that matter, lower returns) than those of the market. While my own data for the past 15 years suggest that, before the deduction of all that Embedded Alpha, the average fund actually outpaced the stock market (Wilshire 5000 Total Market Index) by 50 basis points per year, these data include only the records of funds that survived the period. (And, believe it or not, only about one-half survived.) So a market matching return seems not only fair, but generous.

You might as well enjoy that moderation in risk, for the stock market is a risky place. Even the value of the index fund fell 28% from the March 2000 high to the recent low. The $10,000 investment in the S&P Index had grown to $48,700 by March, 2000, only to tumble to $38,400 a year later. But consider, if you will, the risk of not being willing to assume market risk. $10,000 invested in a money market fund a decade ago would be worth but $15,500 today—a $5,500 profit that was less than one-fifth of the $28,400 appreciation in the index fund, even after the sharp market decline. These numbers reinforce the reputation of equities both as productive investments and as risky ones—a reminder that is both valuable and long overdue. Reasonable expectations suggest to me that we might see stock returns in the 6% to 10% range during the coming decade. If that seems too modest an expectation for common stocks based on past history, don’t forget that a possible 8% return on stocks would take each dollar to $2.16 by 2011, while a possible 4% future return on savings would take each dollar to $1.48, less than half the gain. Eschewing the risk of stocks, therefore, carries a risk of its own. Yes, “nothing ventured, nothing gained.” Pillar 5. Diversify, Diversify, Diversify. By owning a broadly diversified portfolio of stocks and bonds, specific security risk is eliminated. Only market risk remains.

As these costs are ranked from the table of the market casino, the croupiers with the largest rakes are the fund managers. The fees and expenses you pay to them are rising even faster than the industry’s soaring asset base. Since 1980, the expense ratio of the average equity fund has risen from 0.96% to 1.52%—a 58% increase. But, yes, larger fund groups have lower costs. For example, in the fair city of Boston, the expense ratios of the three largest fund managers—together managing a cool $1 trillion of fund assets—average 1.09%. But despite the awesome growth of these firms, that figure is far high than their 0.64% average expense ratio in 1980, a leap of 70% that is even larger than the 58% increase for the industry as a whole. “Big Money in Boston” all over again! It is high time that this industry does something to reverse this steady uptrend. And it’s not impossible. During that same 20-year span, one large fund firm has in fact gradually, but substantially reduced the costs paid by its investors. There ought to be a lot more firms doing precisely that. You owe it to yourself to select from among funds where the manager-croupiers exercise at least some restraint, evidenced by expense ratios that are well below industry norms. Rule 2. Emphasize Funds with Low Portfolio Turnover Once your money is invested in a fund, the rake of the next croupier begins to sweep.

Since I came into this industry 50 years ago, fund assets have grown by more than 200,000%(!), from $3 billion to $6.5 trillion. Yet the expense ratio of the average equity fund, then about ¾ of 1% per year, has more than doubled, to 1.6%. Fund portfolio turnover, 18% annually in those ancient days, has risen to more than 100%, far larger than the decline in unit costs that our highly-efficient electronic stock markets have provided, and leading to an additional, say, 0.7% of annual costs. Together, these two costs alone come to 2.3%. Add in fund sales charges and other fees, and a 3% all-in cost hardly seems hyperbolic. All else held equal, then, equity fund returns should lag the stock market return by about 3% per year. From Theory to Practice Practice confirms theory. Since 1984, stocks, as measured by the S&P 500 Index, have provided a 16.3% return. The average equity mutual fund turned in a return of 13.1%—3.2

We are accustomed to thinking of fund expenses as a percentage of assets—in the mutual fund field ranging from 0.2% of assets annually for the lowest-cost equity funds (often, as it happens, market index funds) to 1.5% for the average fund, to 2.2% for high-cost funds (those in the top expense ratio quartile). Too rarely—although I’ve urged the SEC to mandate this concept in prospectus disclosure—expenses are thought of as the percentage of an initial investment consumed over ten years. Here, the range would be 2.8% for the lowest-cost funds, 19.8% for the average, and 28.1% for the high-cost funds. That is to say, a 0.2% annual cost on an investment of $10,000 costs $280 over ten years compared with $2,810 for a fund with annual costs of 2.2%. (As you can imagine, our industry is not particularly smitten by this concept, for it brings the cost issue into sharp relief.) Costs can also be thought of in a third way—as a percentage of annual return on equities. Using the same examples and assuming a long-term market return of 10%, costs would consume 2%, 15% and 22% of annual returns, reducing the net return earned by investors to 9.8%, 8.5%, and 7.8%. This substantial drain is all too obvious, even as it is all too infrequently referenced. But it is a stark fact of investment experience. And now is the time to introduce a fourth concept of costs, a new concept (at least one I have not seen before): cost as a percentage of the equity risk premium.

between the hedgehog and the fox. “The fox knows many things,” Archilochus told us 2200 years ago, “but the hedgehog knows one great thing.” In an industry filled with brilliant, sly, ambitious, impatient, high-cost investment manager-foxes, trading portfolio securities with a vengeance and ever seeking the holy grail represented by outpacing the financial markets, we are the principal hedgehog. We know the one great thing: that the closest we will get to that holy grail will come by owning a widely-diversified portfolio of high-quality stocks (or bonds) that effectively represents the market, trading those securities only when absolutely necessary, and operating at low-cost. Our best-known strategy, of course, is stock market indexing. We now manage 28 index funds (including four bond index funds and six balanced index funds), but more than 75% of our $210 billion in index fund assets is represented by two funds modeled on the S&P 500 Index, and one modeled on the Wilshire 5000 Total Stock Market Index. We pioneered the first index mutual fund in 1975; our level of conviction reflected in the fact that, following our commencing operations in May of that year, it was Vanguard’s very first business decision. As it has turned out, indexing was a transforming decision for the firm, the apotheosis of all we stand for in linking cost and value—low cost and high value, inextricably intertwined.

fund. While this period was an especially fine one for the large cap stocks in the S&P, even a total stock market index fund—the Wilshire 5000 Equity Index, adjusted to account for estimated costs—would have returned 17.7%, only 0.5 percentage points shy of the 500 and still an advantage of two full percentage points in annual return. (And that’s even before fund sales charges are taken into account!) The fact is that, at least in my judgment, the index fund should be the investment of choice. It is the odds-on (pardon another expression from the world of gambling) favorite to win the race (another!) against three of every four managers. We know that, for the market as a totality, low-cost investing—which is really all that an index fund is about—ineluctably beats high-cost investing over the long run. And while I happen to prefer the all-market index because of its complete diversification and nominal portfolio turnover, I can’t imagine that the long-term return of the S&P 500 Index, comprising as it does 70% of the market, will vary significantly from the return of the total market. In any event, the marketplace, now dominated by S&P 500 indexing, is increasingly moving in the direction of all-market indexing. I fully expect that over the next few years this broader strategy will become the principal choice for institutional indexers and fund indexers alike.

declines. Always remember--in good times and bad times alike--“this, too, shall pass away.” (I spent a full page on that sage piece of wisdom in my book.) Your emotions can kill you. You should keep them out of your investment program, for impulse is your foe. Fourth, rely on simplicity. There are too many witch doctors in this business . . . with too many patent medicines. Basic investing is simple--a sensible asset allocation to stocks, bonds, and reserves; a middle-of-the-road selection of diversified funds; a careful balancing of risks, returns and (lest we forget) costs, which can kill long-run returns. Don’t disregard low-cost index funds. (Warren Buffett just happens to agree on the importance of cost and the value of indexing--a nice “third person” endorsement.) And fifth, when you’ve followed these four rules--as I’ve said, and meant, a thousand times- -“stay the course” no matter what happens. Good luck in your investing during these interesting times. * * * Flash: A bright Vanguardian just provided me with the definition of “meme”: A contagious idea that replicates like a virus, passed on from mind to mind. Memes function the same way viruses do, propagating through communication networks and face-to-face contact between people . . . the basic unit of cultural evolution.

that, over a lifetime of investing, only a relative handful of investors can succeed in doing so by any significant margin. If this is iconoclasm, so be it. Accepting this reality-that investors as a group will inevitably capture less than 100% of the rates of return provided in any asset class-is the first step in simplifying your investment decisions. Where should you begin? Consider that the ultimate in simplicity comes with the additional virtue of low cost. For the simplest of all approaches is to invest solely in a single balanced market index fund-just one fund. And it works. Such a fund offers a broadly diversified middle-of-the-road investment program for a typical conservative investor, allocating about 65% of assets to large growth and value stocks and 35% to high-grade bonds. Over the past 15 years, it would have captured 99% of the rate of return of the combined stock and bond markets. It doesn't get much better than that. Let me prove the point by comparing the cumulative returns of this industry's balanced mutual funds-a group whose portfolios tend to be quite homogeneous, composed as they are primarily of large stocks with both value and growth characteristics, and good quality bonds with intermediate-to-long maturities. This chart compares the returns of the average balanced fund with the no-load balanced index fund, using the S&P 500 Index with its annual return reduced by estimated costs of 0.2%.

I also strongly favor the use of indexes from market segments as the standards for funds with particular investment styles (i.e., large-cap value, small-cap growth, etc.) However managers should be warned that, taking into account relative return (generally solid for the segment indexes across the board) as well as relative risk (generally significantly lower for the indexes, a point almost universally ignored), the advantages of an index strategy are equally apparent at all market cap levels and in all investment styles and venues. So, market segment index funds seem certain to take their proper place in the marketplace, and all forms of indexing—now about 15% of institutionally-managed equity assets, will continue to grow, perhaps to as much as 25% to 30% a decade hence.

It would seem clear, to take an extreme example, that if equities were to carry a risk premium of 2.5% over long-term U.S. Treasury bonds, the choice between an equity fund with an expense ratio of 2.5% and a Treasury bond would be indifferent: Theory would say that the long-term returns of the two investments over time would be identical. Cost would have consumed 100% of the equity premium. Viewed in this light, all of the costs of investing—advisory fees, other fund expenses, and transaction costs—bite into the risk premium. The difference is simply a matter of degree, although at the highest cost levels it is arguably a difference in kind. This table shows the percentage of the risk premium consumed by mutual fund expenses at various premium levels (for the purpose of simplicity, transaction costs, which could add another 0.1% to 1.ignored):

With this remarkable insight, we could say (though we didn’t dare to say it for quite a few years) that the central task of investing is to realize the highest possible portion of the returns earned in the financial markets by the asset class in which you invest—stock, bond, money market alike—recognizing and accepting that (and here is the key phrase) that portion will be less than 100%. The recognition of this reality finds its apotheosis in our low-cost index fund, which provides 99% of the market return. For the record, the portion provided by the average mutual fund—stock, bond, and money market—has been about 85%. With the fundamental Vanguard diamonds—our mutual structure and our focus on low-costs—we have had the best possible opportunity to approach that 100% desideratum. The second idea may surprise you. It was to make human beings the focus of our firm.and

Here are the results, based on an initial investment of $10,000 in 1983. Three key conclusions: 1. The managed funds provided an annual return of 13.0%, the Index Fund 15.1%--85% of the market's return for the managers, 99% for, if you will, the non-managers. 2. After 15 years, the investment in the managed fund was worth $62,700, the index fund $81,900 (wow!) The managed balanced fund provided 71% of the market's cumulative return, versus 97% for the index fund. Time and compounding have joined forces to turn a 2.1 point annual advantage into an advantage of $19,000 in accumulated wealth-twice the initial stake! "Little things mean a lot." 3. The superiority of the index fund is accounted for, not by magic, but by costs. The heavy costs of the managed funds were primarily responsible for their shortfall.

Our defined-asset class fixed-income strategy, while far less renowned, has been equally effective for investors. Our bond and money market funds now constitute $140 billion of our assets. Just as our indexing strategy reflects, finally, a skepticism that any firm, including ours, can discover the holy grail of outpacing the stock market—and then hang onto it for decades, which is every bit as important— so our bond strategy strongly manifests a similar skepticism about the ability of any firm, including ours, to consistently and accurately forecast changes in interest rates. As a result, when we joined the wave of firms offering new municipal bond funds in 1977, we followed, not the conventional path of forming a “managed” municipal bond fund, but created, for the first time in mutual fund history, a three-tier bond fund—a long-term series, a short-term series, and (this will hardly surprise you!) an intermediate-term series. We would win by approximating the pre-cost returns of the benchmarks of each sector of the bond market, then keeping our costs at the industry nadir and maintaining quality at the industry pinnacle. Result: The delivery of outstanding bond returns to our shareholders. If this simple strategy hardly sounds to you like genius at work, you are very perceptive! No more genius, indeed, than the basic mathematics of indexing: Earning the market’s return at low cost trumps earning the market’s return at high cost.“the

The Total Stock Market Index Nonetheless, I continue to favor the Wilshire Total U.S. Stock Market Index as the prime benchmark for an index strategy—not to the exclusion of the S&P 500, but as the place to begin for most investors who are not yet indexing. While returns of the two indexes are apt to be identical over the long-run, there seems little to be gained by accepting any short-run deviation from the market. At Vanguard, we began to implement the total market strategy in 1987 with the creation of the industry’s first Extended Market Index Fund, (based on the Wilshire 4500 Index), enabling investors to fill out their S&P 500 portfolios by adding the rest of the market. But, convinced that this two-pronged strategy might someday result in surprisingly high portfolio turnover as stocks moved back and forth between the indexes, in 1992 we introduced the first total stock market index fund, based on the Wilshire 5000 Index. I believe that it is only a matter of time until the total stock market, most easily measured by the Wilshire 5000, becomes the basic standard for the broad-based indexing strategy. The Wisdom of Stock Indexing After more than a quarter of a century of stock indexing, how has it worked? Unbelievably well! Consider the results of Vanguard’s 500 Index Fund since its initial underwriting in 1976. First, it survived, something that can’t be said about 160 of the 356 equity funds in existence when we made our debut.

The average balanced fund incurred annual operating expenses of 1.2% on average during the period, and perhaps another 0.5% in portfolio turnover costs, a total handicap of 1.7%. The index fund all-in cost was 0.2%, an advantage of 1.5% that made up the lion's share of the 2.1 % difference in return. The fact is that the unmanaged index fund had, at the end of this long period, outperformed all but one of the 29 managed balanced funds in the list. This almost universal failure of expensive professional managers to earn pre-cost returns sufficient to pay their keep relative to a passive1y managed index fund suggests how tough it is to break par in the financial markets. Nonetheless, like most investors, you may well prefer to control your own investment balance, and you may well prefer tax-exempt bonds to the taxable bonds held in nearly all balanced fund portfolios. Fair enough. So I tum to a second example of the value of simp1icity-a single equity index fund for your stock portfolio. The identical conclusions we found in our balanced fund analysis prevail agam: 1. Managed equity fund return 14.0%, index fund return 16.5% (using the Wilshire 5000 total stock market Index, a lower hurdle than the large-cap-dominated S&P 500) percentage of market return. Result: 84% ofthe market (look familiar?) for managed funds, 99% for index. 2. After 15 years, managed fund value $70,900; index fund value, $98,600.

Public Domain, Not Private Profit Vanguard provides at least one parallel with Franklin’s concept of placing his inventions in the public domain rather than seeking private profit. Vanguard’s innovative structure was designed to reduce the claims against investment returns by institutional managers and distributors to the bare minimum, the better to enhance the residual returns remaining for investors. Shortly after we began operations in May 1975, it occurred to me that the best way to bring our common sense principles of investing to their logical conclusion: Since an index of stock market prices provides a fine replication of the actual returns earned by the entire stock market, then investors could capture almost 100% of that annual return simply by owning the market at nominal cost. This obvious insight quickly led to the simple invention that has been the most powerful manifestation of Vanguard’s philosophy of mutuality—the world’s first index mutual fund. A Thesis in 1951, An Index Fund in 1975 But that was not the first time that the idea had occurred to me. Some 25 years earlier, in my Princeton University senior thesis on the mutual fund industry, I had written that mutual funds “could make no claim to superiority over the market averages,” and that mutual funds should, above all, serve their investors, and serve them “in the most honest, efficient, and economical way possible.” Those insights were based solely on anecdotal data.

Second, it has provided just what it promised: performance excellence. On average, the surviving funds delivered an annual return of 12.6% compared to 13.2% for our 500 Index Fund. If we reduce the average fund return by 1.5% to account for the estimated survivor bias, the value of the average fund’s return would drop to 0.1 1000 10000 1933 1941 1949 1957 1965 1973 1981 1989 1997 S&P 500 CRSP Growth of $1, CRSP and S&P 500: 1926 - 2000 Avg. Ann. Return 11.0% 10.6% Correlation 0.98

uncanny ability to recognize the obvious.” For better or worse, I accept that criticism. (Or was it intended as praise?) But our indexing and bond strategies, radical for their time and once considered heresy, have now become dogma. And in the marketplace, they have proven, using the current lingo, to be the “killer apps” of the mutual fund business. Our huge cost advantage has the effect of nicely elevating Vanguard fund performance relative to the performance of our peers. In U.S. equity funds, over the past five years, for example, our average ranking rose from the 41st percentile to the 28th, and international funds, from 68 to 54 (Chart 7). For balanced funds, from 29 to 21. (It gets harder to improve when a fund is already near the top quartile.) For taxable bonds, from 33 to 11; tax-exempt bonds, from 74 to 31. And for money market funds, our percentile soars from the 61st to the 4th. “Out of the commonplace into the rare” might be a fair description of the thrust that low cost delivers to our performance leadership. Given what we observe in most competitive industries—and the mutual fund industry is ferociously competitive in all respects save one, the setting of prices—we might expect our competitive edge in cost to be challenged. But it is not. No fund leader, as far as I can tell, has looked at the market share numbers, called a meeting of his senior officers, and said: “These guys are eating our lunch! Let’s take them on, toe to toe! Now!” That hasn’t happened.

The Rise of Quantitative Investing And the bad news for traditional managers continues. Another form of index-like competition is emerging, and I’m confident it too will take its place in the field. I refer to what are called “quantitative” investment strategies, which I define to be computer-driven strategies that rely rigidly and exclusively on mathematical formulas to manage investment portfolios. I differentiate the use of quantitative techniques as the foundation of portfolio strategy and selection from the clearly pervasive use of computers to screen and value individual stocks and stock groups as part of the traditional security-analyst-based management process. (“We’re all quants now.”) Today, industry estimates place the assets managed by quants at $100 billion, and the growth rate is strong. Some of these quantitative strategies might fairly be described as the ultimate form of investment relativism. But they must not be confused with closet indexing. With fully disclosed policies and strategies, they are hardly hidden in the closet; their strategies are rigorous and controlled, not random and intuitive; and their costs are often well below conventional norms. (It’s far less costly to run a computer program than to employ a large portfolio research and management staff.) Typically known as enhanced index funds, these funds seek to outpace a market index.

As the bear market of the past year makes clear, investing in stocks is risky:  First, there is individual stock risk. We have seen some stocks soar and some plummet, with little means of knowing which stock will do which, and when. Who would have expected that Cisco, whose $500 billion market capitalization a year ago made it the largest stock in the world, would soon plummet by 80%, erasing $410 billion in value?  Second, there is style risk. Growth funds trumped value funds during the first nine years of the decade, rising an amazing 609% through last March, more than double the 281% increase for value funds. Since then, growth funds have fallen 38% on average, while value funds have actually risen 5%, erasing nearly the entire growth fund and their cumulative records are now virtually identical. Who among us is wise enough to know how to “time” those changes?  Third, there is manager risk. A growth fund manager, for example, may outpace his peers, or may fall short, and the difference is apt to be enormous. Consider that in the past decade, the top decile of growth fund managers produced an average annual return of 17%, almost three times the 6½% return for the bottom decile. How would you go about picking the winners in advance? Happily, each and every one of these three risks can be easily eliminated. For when you own the entire stock market through an index fund, there is neither individual stock risk, nor style risk, nor manager risk. Only market risk remains.

This mathematical tautology is what I call the CMH—the Cost Matters Hypothesis—and it explains why the return of the low-cost, all-stock-market index fund consistently outpaces the returns achieved by costly active managers. That is why the Hedgehog beats the Fox. As Archilocus wrote so many years ago: “The fox knows many things, but the hedgehog knows one great thing.” The Intellectual Basis for Indexing2 Indexing—owning all of the stocks in the U.S. market is that one great thing. It works, as it must. At the outset, the intellectual basis for indexing was the EMH—the Efficient Market Hypothesis—which suggests that by reflecting the informed opinion of the mass of investors, stocks are continuously valued at prices that accurately reflect the totality of investor knowledge, and are thus fairly valued. But the reality is that sometimes the stock market is efficiently priced, and sometimes it is not. But few—if any—investors can consistently tell which is which. But 2 What, one might ask, is the intellectual basis for active management? I know of none.

When compounded over this grand 20-year era for investing, and adjusted for inflation, the average investor has captured but 16 percent of the market’s compounded real profit. (I’m not kidding! $1,000 invested in a simple index fund mimicking the Standard & Poor’s 500 Stock Index in 1984 and held today produced a profit of $5,490 after inflation; for the average fund investor, the real profit came to just $910.) No wonder that David Swensen, the integrity-laden and remarkably successful manager of the Yale endowment fund, characterizes such a shortfall as “the colossal failure of the mutual fund industry.” Where is the Public Discourse? It ought to be obvious that there is an urgent need to face up to these and other failures in the changing world of capitalism.“the

In fairness, an index fund modeled on the Standard & Poor’s 500 Index would also have fallen well short of the index itself, but still performed quite remarkably relative to the mutual fund. Assuming costs of 20 basis points, its 13.1% return would have compounded to $471,000 vs. $193,000 for the fund; after a 120 basis point charge for taxes (index funds are typically about twice as tax-efficient as ordinary funds), its net total value would be $276,000 vs. $65,000. And the Index fund total would have been cut to $45,000 after inflation, vs. $10,000. That too may seem like a far cry from $514,000, but it’s hardly realistic to eliminate taxes from the real world of investing. The important reality is that the Index fund would have provided 2.4 times the after- cost value of the mutual fund, 4.2 times the fund’s after-tax value, and 4.5 times the fund’s real terminal value. Yes, Embedded Alpha is a powerful destructive force. What Active Managers Can Learn From Indexing Paraphrasing the Greek philosopher Horace, I fear that, like the mountains, the financial giants and fund managers who developed the ML/BARRA study have “labored and brought forth a mouse.” Had they made their own calculations of annual Embedded Alpha, then compounded the resultant return over the long-term, and then considered the reality that costs and taxes are paid in current dollars but long-term returns are received in real dollars, they would have realized the enormity of the issue.

11.1%1, and an investment of $1,000,000 made on August 30, 1976 would have grown to $14.1 million; the final value of the same investment in Index 500 would have grown to $22.7 million. Interestingly, the difference of $8.6 million was almost exactly the same as the $8.5 million index fund advantage reflected in the 30-year study of fund performance that I presented to the Vanguard directors when I proposed the first index mutual fund way back in 1975. Clearly, the index advantage has remained substantially intact over the years. If 55 years of experience constitutes a reasonable standard, stock indexing has met the test of time, and its wisdom now seems beyond reasonable challenges. The Wisdom of Bond Indexing While it is seldom acknowledged, bond indexing works every bit as well as stock indexing. Indeed, because the returns of individual bond funds have such a high cross- correlation, the index advantage is even more obvious. It took me until 1986 to get around to starting Vanguard’s Total Bond Market Index Fund, and it has been an unarguable investment success2, outpacing fully 170 of the 192 managed bond funds that survived the subsequent 15 years. Since the fund’s inception at the close of 1986, our bond index fund has delivered a return of 8.0% per year, vs. 7.

The first mutual fund in this category began in 1986, and has slightly bettered the index itself, by enough to give it a significant edge over an index fund. The overall evidence of success in such “disciplined” and/or “sector neutral” strategies, as they are known, is quite mixed, but my guess is that they’ll prove attractive to investors who realize the value of indexing, but can’t quite abandon all hope that they can identify in advance active managers who will outperform. Other strategies—sometimes known as “Positive Alpha” or “market neutral”—are based on achieving, not a rate of relative return, but an absolute rate of return. These strategies may gain an advantage by their ability to use specialized investment techniques (including short- selling, hedging, etc.) and often rely on strict quantitative discipline. These managers may gain an advantage by capitalizing on the fund industry’s Achilles’ heel: asset size. When assets under management are limited, the drag of transaction costs is held within tolerable levels that do not themselves frustrate the implementation of aggressive investment policies.these

(Ihis $27,700 gap is what this industry has cost its equity fund investors during the great bull market.) Final value as percent of market, 67% vs. 97%. This industry consumed one-third of the market return! "My how mightily your money grows when costs are minimized!" 3. Costs, again, are the villain of the piece. The 2.5% annual lag compares with about 2.2% in estimated fund expenses and turnover costs. As you can see, this IS-year equity fund comparison-just as in the case of the balanced funds-amply justified a simple index approach to capture the highest realistically-possible portion of the market's annual returns-in this case, again, 99%. It is fair, of course, for you to say: "Well, the index fund is always fully-invested in stocks, so why not hire a manager, who can reduce stock holdings in anticipation of market declines?"sound

Given the inevitable mathematics of the stock market that I described at the outset, the industry began to develop passive, low-cost mutual funds that assured a market-like performance, and thus virtually guaranteed superiority over peer funds. The index fund could merely buy all of the stocks in the market and hold them forever, paying no advisory fees, engaging in no costly portfolio trading, holding administrative and marketing costs to rock- bottom levels, and charging no sales loads. While its concept is simple—buying American industry and holding it forever—however, its implementation is not.Growth

Many state taxes—and Massachusetts, I need not remind you, is hardly the most tax-friendly state—consume even more of these unnecessary fund gains. So look for tax-efficient funds—not only those that have been so in the past, but those that have policies that emphasize on going tax-efficiency. 4. Be Careful About What You Pay for Fund Selection Advice Many investors need sensible advice in fund selection and asset allocation—and many do not. If you are convinced you do not need advice, it is unwise to pay for it, either in the form of front-end sales commissions (about 5% of the amount invested), or 12b-1 sales fees included in a fund’s expense ratio (up to 1% of assets), or fees paid to registered investment advisers and financial planners, usually beginning at about 1% of assets and paid directly by the investor. I have no hesitancy in saying that some of these providers of fund selection advice can be characterized as croupiers.see

I may have called it that, but I really look at it as a fair competition between two firms with approaches toward investors that are polar opposites—philosophically, conceptually, and strategically. He adds a word about my 35-year fight to conquer a failing heart, capped by the miracle of receiving a new one just one just eighteen months ago. I guess those three examples are a fair basis for him to affirm my fighting impulse. The Yale senior concludes this section by agreeing that I’ve enjoyed success for its own sake, not for its fruits, for I own none of a company worth (his guess, and fair enough) between five and ten billion dollars. When he says, in a neat term of phrase, “once a man has more than enough for himself, only the fool measures his success in terms of coin and treasure.” Entrepreneurs or not, we should all take heed of that thought. “Third, the joy of creating, getting things done, of simply exercising one’s energy and ingenuity.” These words, the author argues, are at the heart of the Schumpeterian understanding of the entrepreneur. He finds this evident in the innovative Vanguard structure and in the creation of the first index fund. This innovation, he points out, “was scorned by the investment community . . . but today is hailed as the hallmark of responsible investing.‘the

come to make your asset allocation decision. For the purpose of argument, let’s assume you expect to maintain a stock-bond ratio of 65%/35%, and you determine to consider the implications of cost on your decision. Further, let’s assume a long-term return of 10% on stocks and a risk premium of 3.5% over long- term Treasuries. You decide to hold a Treasury bond for the bond allocation. For the equity allocation your choice is between a fund in the lowest cost range of 0.20% and an equity fund in the highest cost quartile, with an expense ratio of 2.2%. Here are the differences in the returns on the two programs: Exhibit VIII Annualized Return Low-Cost Fund High-Cost Fund Equity Allocation 9.8% 7.8% Bond Allocation 6.5 6.5 65/35 Composite 8.6% 7.3% The resulting 1.3% spread in assumed return—with risk (the stock/bond ratio) held constant—it is safe to say, is a meaningful difference. The low-cost program would build your $10,000 to $22,800 in 10 years and $78,700 in 25 years (taxes excluded). The respective results for the high-cost program would be $20,200 and $58,200. But now let’s look at the situation slightly differently, from the standpoint of risk premium. You accept my basic premises—a 10% return in stocks and a 3.5% equity risk premium—and are investing with the hope and objective of receiving a long-term return of 7.5%. Question: what allocation would you make, given a choice between a low-cost equity fund and a high-cost equity fund?

whether or not markets are efficient, investors as a group must fall short of the market return by the amount of the costs they incur. Therefore, we don’t need to accept the EMH to be index-fund believers. There is a better reason for the triumph of indexing, and it is not only more compelling but unarguably universal. As I mentioned earlier, I call it the CMH—the Cost Matters Hypothesis—and it is all that we need to explain why indexing must work and does work, and it in fact enables us to quantify with some precision how well it works. Investors, in totality, are the market. On average, those investors must be, well, average. But investors fail to match the market’s return precisely by the total of their investment costs. By matching the market with only minimal costs, indexing is mathematically certain to win. Whether or not the markets are efficient, the explanatory power of the CMH holds. Enter Paul Samuelson More than a century has passed since Louis Bachelier, in his Ph.D. thesis at the Sorbonne in 1900, wrote: “Past, present, and even discounted future events are (all) reflected in market price.” Nearly half a century later, when Nobel Laureate Paul Samuelson discovered that long- forgotten thesis, he confessed that he “oscillated . . . between regarding it as trivially obvious (and almost trivially vacuous), and regarding it as remarkably sweeping.” But the words of Bachelier and others seem to have lit a spark of interest that would lead to Dr.

I’ve been talking about it, arguably, since 1951, when I mentioned the failure of mutual fund managers to beat the market (even then!) in my Princeton senior thesis. But it took me until 1975 to start the world’s first index mutual fund (Vanguard Index 500), and its tiny $11 million IPO was something of a failure (“Bogle’s folly”). But over the next quarter century, indexing took hold, and today the assets of index mutual funds now total more than $1 trillion, about 16 percent of the assets of all equity funds. But it is ironic that while mutual fund indexing continues to grow apace, the means by which investors index has taken a U-turn—a U-turn for the worse. Classic indexing has been overwhelmed by what I call indexing nouveau, represented by the exchange traded fund (ETF). The ETF is simply an index fund designed to facilitate trading in its shares, dressed in the guise of the traditional index fund. Think of the differences: First, if long-term investing was the original paradigm for the classic index fund of 30 years ago, surely using index funds as trading vehicles can only be described as short-term speculation.widely-diversified—

size of the funds they are leaving has impeded their ability to deliver outstanding returns. The fact is that today the average fund portfolio manager has an average tenure of just three and one-halfyears. To say that these are especially critical issues for wealthy investors considering investing in mutual funds in the accumulation and distribution of their estates would be a powerful understatement of the issue. As James P. Garland, President of The Jeffrey Company, has observed, "Taxable investing is a loser's game. Those who lose the least-to taxes and fees-stand to win the most when the game's all over." In an article in The Journal of Investing [Spring 1997], Garland presents an imposing case, comparing the performance of two $100 investments over a quarter century: one in an idealized index-assuming no expenses, turnover, or taxes-and one in a mutual fund with an expense ratio of 1%, a turnover rate of 80%, a capital gains tax rate of 28%, and an income tax rate of 36%. The terminal market values are strikingly different: $1,721 for the index versus $706 for the fund. This example dramatically illustrates the powerful long-term impact of costs and taxes. By the end of 25 years, the government has consumed 47% of the optimal ending dollar amount, while the manager pocketed 12%, leaving the investor with only 41 % of the investment on an after-tax, after cost basis. And it is the investor who put up 100% of the initial capital.

developing quantitative approaches—Enhanced Indexing and Positive Alpha—represent important challenges to the status quo. The Changing Role of the Traditional Active Manager Faced with this competition, how should the traditional manager respond? If closet indexing is the wrong response, indeed a counterproductive one—as I believe it is—what is the right one? First, a given: today and for as far ahead as the eye can see, each adviser should freely acknowledge that he or she should be expected to outpace an agreed-upon market performance standard over the long run, and strive to do just that. What else is an adviser supposed to do? How else can we measure whether any economic value being created is sufficient to justify the cost of retaining the adviser in the first place? Of course, the standard need not necessarily be the S&P 500 Index (though it would be appropriate for large cap funds with a blended—growth stocks and value stocks—style). Broader all-market indexes will also become part of the world of investing. And other styles may also be considered as standards. Indexes measuring returns for style/market cap “boxes” (nine, under the Morningstar system) will also become part of our world. It is simply unrealistic for small-cap managers, or mid-cap managers (or for that matter high-cost large-cap managers, though they have the best chance) to duplicate the long-term record of an all-market index.

fund began operations with only $11 million in assets. While what quickly became known as “Bogle’s folly” had an infinitely modest beginning, however, it was a beginning. It took two decades of energy and persistence for us to bring that tiny original index fund to its present eminence. But today its assets of some $90 billion mark it as the largest mutual fund in the world. We made no attempt to patent the investment, and indeed “freely and generously,” in Franklin’s words, encouraged others to follow suit. And while some of our rivals copied it, however, their high cost structures precluded success. Even without a patent, the index fund has become our trademark, the backbone of the Vanguard book of business. Together the assets of our stock index funds, our bond index funds (another of our inventions, if an obvious one), and our other funds that are managed with index-like strategies total $410 billion, all because of that original invention of 1975. Opportunity and Motive Just as Franklin’s desire to enhance the public weal undergirded his invention of the Franklin stove and the lightning rod, so Vanguard’s investor-friendly mutual structure undergirded the invention of the index fund. While I was hardly the only person who understood the simple principles behind the index fund—there must have been hundreds of others—the traditional fund firm would have had little interest, regarding it with suspicion if not horror.

0% for the average bond mutual fund, that one percentage point difference is accounted for largely by the costs of investing (an expense ratio advantage of about 1 Actual survivor bias is probably considerably higher. Princeton’s Burton Malkiel estimates it at 4.1% per year during the 15 years ending in 1991, and it would doubtless be even larger over 25 years. 2 I apologize for using the Vanguard bond and balanced index funds in these comparisons, but our Total Bond Market Index Fund is the only publicly-available such fund with a long history; our three defined- maturity bond funds are still unique; and our Balanced Index Fund remained one of a kind until 2000. $0 $5 $10 $15 $20 $25 500 Index Fund Avg. General Equity Fund Millions The Wisdom of Stock Indexing Growth of $1,000,000: Aug. 1976 - Oct. 2001 $22.7 Avg. Ann. Return: 500 Index: 13.2% Avg. Fund: 11.1% $14.1

sectors of the market offers less diversification and commensurately more risk. Third, if the original paradigm was minimal cost, it’s clear that holding market sector index funds that are themselves low-cost obviates neither the brokerage commissions entailed in trading them nor the tax burdens incurred if one has the good fortune to do so successfully. And as to the fourth and final, quintessential aspect of the original paradigm—assuring, indeed guaranteeing, that you will earn your fair share of the stock market’s return—the fact is that an investor who trades ETFs—and especially sector ETFs—has nothing even resembling such a guarantee. The typical ETF investor has absolutely no idea of what relationship his or her investment return will bear to the return earned by the stock market itself. But, after all of the selection challenges, the timing risks, the extra costs, and the added taxes, I’d bet on a substantial shortfall. (Think Gotrocks here.) But the fact is that, despite the demonstrated success of the classic indexing strategy over three decades now, the growth in market share of traditional index funds stopped dead in 1999, at 10 percent of equity fund assets. All of the increase since then—the remaining 6 percentage points of that 16 percent total has come in ETFs. This stampede into exchange traded funds (ETFs) has been dominated overwhelmingly by highly specialized funds that, in the words of an ETF advertisement, “can be traded in real time, all day long.

them with new traditions. To be persistent in pursing the mission. To look ahead as far as my vision can see, and to speak out on our goals with the zeal of a missionary, the stubbornness of an idealist, and the soul of a street fighter. To be as smart as my limited brain-power will allow. It is up to others—indeed to history—to evaluate what it is this one human being has accomplished, and the extent to which Vanguard shareholders—indeed all mutual fund shareholders—have been served by the voyage of the HMS Vanguard. But I know, as I hope you know after hearing these comments, that whatever the answer is, it would never have come to pass if I had not come here as a young man quite by accident of fate, and fortuitously discovered, indeed often at exactly the opportune moment, the Golconda that began with FORTUNE Magazine in 1949, and then Walter Morgan and Wellington Fund; then my family; and then Vanguard itself and the “Vanguard” name; and then the first index fund and the novel distribution strategy—one diamond after another right here in my own backyard, just as Russell Conwell’s words promised that I would. All that I had to do was dig for them. Oh, yes. I referred earlier to that one other diamond I found here. Paradoxically, it was a diamond in the form of a heart. (And as we all know, in games of cards, a heart beats a diamond every time.) It’s true in life, too.

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.

Mutual Fund Costs Are Declining ICI Position: Ownership cost of equity funds down 40%. • 1980 231 bps; 1998 135 bps (Load 200 bps, no-load 83 bps). Specific Flaws: 1. Weighted by sales volume. Unweighted expense ratio up 64% — 96 to 158 bps. 2. Lowest cost decile up 28% from 71 bps to 90 bps (1997). 3. Ignores hidden cost of portfolio turnover (50 to 125 bps). 4. Ignores opportunity cost (60 bps). 5. Ignores fees on “wrap accounts.” 6. Amortization of sales loads based on 25 year-old data. If updated, 1998 cost up by 50 bps, to 185 bps (estimated). Fundamental Flaw: Price competition is (correctly) defined by the actions of producers, not the actions of consumers. Thus price competition is not “intense” in fund industry; it is barely alive. Myth #4: 1 1 0 1 2 0 1 4 1 1 5 2 9 6 1 5 8 1 3 9 9 0 1 0 0 1 1 0 1 2 0 1 3 0 1 4 0 1 5 0 1 6 0 1 7 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 Average Equity Fund Expense Ratio (basis points) Mutual Fund Costs Are Declining ICI Shareholder Costs - 1998: Average 193 bps Avg. Sales-Weighted: 135 bps Avg. Asset-Weighted: 132 bps 1998 Total Cost: $ 44.0 B 1980 Total Cost: $ 0.8 B Myth #4: 1999

So if you can’t be certain about the future—and who among us can?—“diversify, diversify, diversify” remains the essence of wisdom. Pillar 6. The Eternal Triangle. Never forget that risk, return, and cost are the three sides of the eternal triangle of investing. Remember also that the cost penalty may sharply erode the risk premium to which an investor is entitled. You should understand unequivocally that investing in a fund with a relatively high expense ratio—more than 0.50% per year for a money market fund, 0.75% for a bond fund, 1.00% for a regular equity fund—bears careful examination. Unless you are confident that the higher costs you incur are justified by higher expected returns, select your investments from among the lower-cost no-load funds. Up-to-the minute evidence reaffirms exactly what I demonstrated in my book. During the past decade, the lowest-cost decile of money market funds provided an average annual return of 5.1%, 11% above the return of 4.6% for the highest-cost decile. For the lowest-cost decile of intermediate-term bond funds, the return was 7.8%, 24% above the return of 6.3% for the highest- cost quartile. And for the lowest-cost decile of large-cap equity funds (excluding index funds), the average return was 13.1%, fully 18% above the return of 11.1% for the highest-cost decile. (Low-cost bond index funds and low-cost stock index funds, I should note, provided even higher returns than their low-cost counterparts that were actively managed.)

From its lowly beginning in 1948 with my struggle to absorb his Economics textbook, my association with Paul Samuelson had a wonderful turnaround. While I had hinted at the merit of an index fund in my Princeton thesis (mutual funds “can make no claim to superiority over the market averages”), I ignored that important finding for years. But in mid-1975, I decided that the time was ripe for the world’s first index fund, importantly because of Paul Samuelson’s inspiration. That inspiration came when I read his lead essay in the inaugural edition of The Journal of Portfolio Management (Fall 1974). In his essay, “Challenge to Judgment,” Dr. Samuelson explicitly called for those who disagreed that a passive index would outperform most active managers to produce “brute evidence to the contrary.” (None was forthcoming.) He pleaded “that, at the least, some large foundation set up an in-house portfolio that tracks the S&P 500 Index—for the purpose of setting up a naïve model against which their in-house gunslingers can measure their prowess.” Confronted with his express challenge for somebody, somewhere to start an index fund, I could no longer stand back. It now seemed clear that the newly-formed Vanguard Group (then only a few months old) ought to be “in the vanguard” of this new and logical concept, so strongly supported by the data on past fund performance, and so well accepted in academia but so little acknowledged by fund industry leaders.

When we put them all together, the comparison of the actual results of the average fund with the results of simply owning a market index is truly a revelation, albeit one that is virtually—if understandably— ignored by the mutual fund industry. So, here are the results: Over the past 15 years, the average pre-tax return of the total U.S. stock market was 16.4% per year. But after the costs of all of the croupiers—fund sellers, fund managers, stock brokers, and the Federal Government—the return for the average fund investor was just 10.2% per year. By way of contrast, a low cost, no-load, low turnover all-market index fund would have provided an annual rate of return of 15.2% to the investor—fully 50% higher. And as both returns and costs compound, the difference widens. The value of an initial $10,000 investment at the end of the period: managed equity fund, $43,000; index fund, $83,300. In short, in search of the perfect plan, the investor in the equity fund relinquished 56% of the market’s gain to the croupiers, with but 46% left for himself. On the other hand, by holding the croupiers’ share to 14% of the market’s cumulative return, the investor who relied on the good plan of a market index fund retained 86%. His $73,000 profit was more than double the $33,000 profit of the regular investor. The point of this chart is not to attempt to persuade you to abandon the active management strategy that you likely follow, much as I might wish to do that.the

After all, in a given decade, about one of every five actively managed funds has outpaced the total market index (after taxes, only one of nine). These are powerful, but not insurmountable odds. And there are some simple common sense principles that should help you to select funds that can earn a generous portion of the market's return, although, all too likely, less than IOO%-and maybe a lot less. If there are long odds against outpacing the market, at least going about the task of fund selection intelligently can help to ensure against a significant failure. Even master investor Warren Buffett, a strong proponent of the index approach, concedes that there may be other ways to construct an investment portfolio: Most investors, both institutional and individual will find that the best way to own common stocks is through an index fund that charges minimal fees.

70 basis points and turnover cost about 30 basis points lower). I hardly need note that an advantage of a full percentage point in the bond market—easily explained, achieved without extra risk, and virtually certain—is the functional equivalent of a license to steal for the bond fund investor. And that saving adds up. A $1 million investment in the bond index fund would have grown to $3.13 million from 1986 through October 2001, compared to $2.73 million for the average bond fund—a $400,000 advantage that comes not by mathematical legerdemain but simply by shifting the allocation of the returns generated in the bond market from the fund managers to the fund owners. From the croupiers to the gamblers, if you will. While the returns of bond funds are less diffuse than the returns of stock funds, the bond group nonetheless includes a diverse array of maturity and quality classes, meaning that comparisons of bond funds as a group with an index of the total bond market is not always representative of reality. Further, many investors don’t seek to own “the bond market.” Rather, they may prefer to commit to its short-term or intermediate-term or long-term segment. For this reason, back in the winter of 1994, we also formed the first (and, inexplicably, still the only) series of defined-maturity bond index funds. When compared with their peers following similar policies, they show the same magnitude of advantage.

In the fund arena then, just as costs matter, so taxes matter. A Good Solution: The Index Fund At this point, you are probably thinking either (a) that you should just forget about mutual funds for taxable accounts, or (b) that there must be a better way for them to achieve the valuable diversification that mutual funds clearly provide. Well, there is a better way, through which you can avoid suffering the negative consequences of both high costs and excessive taxes, and come as close as the law of the financial markets allows to achieving a positive Alpha. For there are a relative handful of funds that operate at a minimal cost and with a minimal tax burden. Most are market index funds, usually owning all of the stocks in a given arena (i.e., the Standard & Poor's 500 Stock Index, composed of large cap stocks that represent 70% of the value of the total market) or in a few cases the entire stock market (the Wilshire 5000 Equity Index). And they are working well, especially the latter, since significant changes to its composition simply do not take place. Let's begin with a baseline: the after-tax return of the Standard & Poor's 500 Stock Index. We'll deduct income tax from the dividends, and assume no capital gain realization, deferring all capital gains taxes. With a pre-tax return of 16.7% over the past 15 years and an estimated tax impact of -1.6% (largely because of income taxes), it produces an after-tax return of 15.1 %.

Myth #4. Mutual Fund Costs are Declining Back in 1950, when I was writing my thesis, the expense ratio of the average equity fund was 0.77%. It has been rising ever since, hitting 0.96% in 1980, 1.20% in 1987, leveling off at about 1.40% through 1995, and then, with the rapid formation of new—and higher-cost, always higher-cost—funds, rising to 1.58% last year. In all, the expense ratio of the average equity fund has risen by more than 100%—a doubling of unit costs. Yet, sparked by heavily-publicized industry data, a myth that fund costs are actually declining has developed. Specifically, one industry study says, using a thoroughly inaccurate formulation, that the “costs of fund ownership” are declining. What it meant to say is that the costs of purchasing funds is declining. The industry study concedes that the average unit cost of equity funds is now 1.93% (35% higher than even my 1.58% figure). But it alleges that the average cost of purchasing equity funds—when weighted by each fund’s sales volume—has declined from 2.26% in 1980 to 1.35% in 1998. The study leaves, dare I say, much to be desired. Loading the dice by making sales volume the basis of cost measurement, the study merely captures the remarkable shift in investor choice from high-cost funds to a relative handful of no-load funds, low-expense-ratio funds, and minimal-cost index funds. But price competition is defined, not by the actions of consumers, but by the actions of producers.

How would such a firm make money on a fund that generated no advisory fees and no sales commissions, a fund in which virtually the entire investment return goes to its shareholders? While every firm in our industry had the opportunity to invent the index fund, like the prime suspect in a murder investigation, only Vanguard had both the opportunity and the motive. I cannot tell you exactly how many modern-day investors have enjoyed the warm comfort provided by the remarkably efficient index mutual fund, but it may well be far less than the proportion of homeowners who were warmed by the efficient Franklin stove all those years ago. Nor can I assure you that the widely-diversified index fund has protected more investors from losses from the lightning bolts that have struck some widely ballyhooed individual stocks, causing them to become, well, toast, than the proportion of the Colonial citizenry protected by Dr. Franklin’s lightning rod. But I can tell you that in the 25 years since the Vanguard 500 Index Fund was invented, it has outpaced the annual return of the average stock fund by an estimated two percentage points.million,

” Among 690(!) ETFs today, 678 are narrowly focused, some on individual foreign countries (Korea, Germany, whatever you wish) or industry sectors (technology, small-caps, even most recently, HealthShares Emerging Cancer). Only 12 of the 690 ETFs are highly diversified index funds holding the entire U.S. stock market or the entire non-U.S. stock market, close cousins to our diversified blue-chip funds of yore. Of course such ETFs, held for the long term, are perfectly fine investments. But actively pursuing these popular narrow strategies that drive the ETF business, too often chasing past performance, will surely be hazardous to the wealth of our investors and in the long-run, that can’t be good for our industry. All things considered, the burgeoning growth of ETFs is a dream come true for fund managers, industry entrepreneurs, financial advisers, and brokers. They offer the excitement of a new idea, massive publicity, and the marketing flexibility of the fund industry’s asset gatherers to focus on whatever sectors are hot and whatever strategies have paid off in the recent past, all the better to attract the capital of performance-hungry investors. But is it too much to ask whether these index funds nouveau are an investor’s dream come true? I don’t think that they are. Indeed, in a real sense, the ETF is a trader to the cause of classic indexing.investment

From the inception date of our funds, here are the annual returns, net of all costs: Short- Term Bond Index Fund, 7.1%; average short-term managed fund, 6.3%. Intermediate-Term Bond Index Fund, 8.4%; average intermediate-term managed fund 7.6%. Long-Term Bond Index Fund, 9.7%; average long-term bond fund, 8.4%.3 Seven years to be sure, is a fairly short period to test the efficiency of defined-maturity bond index funds. But the obvious reasons for the index 3 The average long-term active fund has a significantly lower maturity than the bond index, and accordingly earned an actual return of 7.5%. The 8.4% return represents the return adjusted upward to reflect its lower risk. The Wisdom of Bond Market Indexing Growth of $1,000,000: 1986 - Oct. 2001 $1.0 $2.0 $3.0 Bond Index Fund Avg. Bond Fund Millions $3.1 $2.7 Avg. Ann. Return: Bond Index: 8.0% Avg. Fund: 7.0%

Let me put some dollars-and-cents meat on the bones of these ratios to show you how much we have had to spend to handle our present growth, to invest for our future growth, and to maintain our cutting edge in service quality. Five years ago, our annual expenditures were about $480 million—$400 million for operations plus $80 million of fees to our external investment advisers. This year we will spend about $1.3 billion, some $1.150 billion for our own operations and $150 million in advisory fees. Our own budget, then, has risen by $750 million, nearly tripling in just five years—hardly a sign of being, as the old saw goes, “penny wise and pound foolish.” Much of this increase arises from providing services to 14 million shareholder accounts rather than six million. But it also reflects the huge increase required to maintain and enhance service quality, including heavy spending on technology, now approaching, in very rough terms, one-third of our budget. We have been blessed by having our average assets burgeon during this bull market period—rising from $150 billion to $485 billion—enabling us to support our efforts without impinging on our low expense ratio. Indeed, our weighted fund expense ratio, 28 basis points in 1999, has eased downward from 30 basis points in 1994. That two point decline, coming in a period in which the expense ratios of our major competitors have risen by 20 basis points (to 125), we are doing just fine.

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.

It was the opportunity of a lifetime: to at once prove that the basic principles enunciated in Samuelson’s “Challenge to Judgment” could be put into practice and work effectively, and to mark this upstart of a firm as a pioneer in a new wave of industry development. With the inspiration of Keynes and Samuelson, and even a touch of foresight, luck, and hard work, the idea that had begun to germinate in my mind in my ancient senior thesis could finally become a reality. The initial press reception to the announcement of Vanguard’s filing of the groundbreaking index fund IPO had been reasonably good, but bereft of a single hint that the index fund represented the beginning of a new era for the mutual fund industry. In fact, the reaction was best illustrated by a cartoon of Uncle Sam stamping out index funds, captioned “Index Funds are un-American.Professor

professionals to stay the course with the proven strategy. While I can’t say that classic indexing is the best strategy ever devised, I can assure you that the number of strategies that are worse is infinite. Creating Indexes that Beat the Market. The New Paradigm? It is a curious irony that the ETF has been adopted as the format for the new “fundamental” indexes. This “new breed” of indexers—although they are not, in fact, indexers, but active strategists—focuses on weighting portfolios by so-called “fundamental” factors. Rather than weighting by market cap, they use a combination of factors such as corporate revenues, cash flows, profits, or dividends. (For example, the portfolio is weighted by the dollar amount of dividends distributed by each corporation, rather than the dollar amount of its market capitalization.) They argue, fairly enough, that in a cap-weighted portfolio, half of the stocks are overvalued to a greater or lesser extent, and half are undervalued. The traditional indexer responds: “Of course. But who really knows which half is which.” The new fundamental indexers unabashedly answer, “we do.” They claim to know which is which. And—this will not surprise you—the fundamental factors they have identified as the basis for their portfolio selections actually have outpaced the traditional indexes in the past. (We call this “data mining.

owning the market through a low-cost index fund, we know next to nothing about the records of SMA Managers.  Fourth, the challenges of operating SMAs is substantial. Few registered advisers and brokers are satisfied with today’s (largely) APL technology. And while tomorrow’s technology will surely be better, it’s hard to imagine that it can ever be as economical as the simple pooling of accounts that has been the crux of mutual fund operational efficiency since the industry began. A New Mutual Fund Industry Nevertheless, if mutual funds fail to change, our dominance will come to an end. We hold no permanent monopoly on the good will of our owners; we must re-earn it every day. Fund managements can no longer bask in the warm noonday sun and continue to place their own needs ahead of the needs of their clients. During the great bull market, many firms that trod the wrong path prospered. Even where prudence, principles, and stewardship took a back seat to marketing, the money rolled in. Hundreds of new aggressive funds were formed and backed with more than a billion dollars of advertising. “We’ll focus on short-term rewards, momentum, and concept stocks,” was the implicit strategy, “and don’t worry about higher fees, and portfolio transaction costs.” In an era of exploding returns on stocks, the sky seemed to be the only limit to excess. Those strategies won’t play well in the years ahead. We must make speculation passé, and put stewardship in the driver’s seat.

So the trend that this tortuous methodology measures is hardly evidence of what is described as “vigorous price competition” in the fund industry. Indeed, since few, if any, fund groups have slashed their fees to take on the low-cost funds in the marketplace, price competition is hardly intense; it is barely alive. And the study has still more weaknesses. It completely ignores a huge cost of fund ownership, fund portfolio turnover. That would add 0.50% to 1.00%-plus to the putative 1.35% total. It amortizes sales loads based on 25-year old data, ignoring today’s infinitely shorter (and therefore far costlier) holding period. It ignores the opportunity cost that funds incur by their failure to be fully invested in stocks—another 0.60% cost. And it no longer even reports the fact, buried deep in the first of its two studies, that the average expense ratio of the lowest cost decile of funds has actually risen by 27% since 1980—from 0.71% to 0.90% in 1997—perhaps up 35- 40% if Vanguard were excluded. Even the lowest cost funds will not be denied their fee increases.two

If that 7 percent projection is correct, investors would be wise to do their best to capture it. That means low-cost, long-term investing—yes, just what an index fund does—that will guarantee you with your fair share of whatever returns our financial markets are generous enough to provide, the consummate winner’s game. And it means recognizing and accepting that high-cost, short-term speculation—with all of its trading costs, expensive management fees, and unnecessary taxes—is the consummate loser’s game. Despite the failure of our financial system, then, there is no reason you can’t avoid its myriad potholes, and by so doing be a winner. Wrapping Up As I look back over the institutions whose lives I’ve been privileged to touch, I confess to letting a little pride peep out—much as I’ve tried (in Benjamin Franklins pungent words) to “disguise it, beat it down, stifle it, mortify it as much as one pleases, pride will nonetheless every now and then peep out.” And so it does when I concede that I’ve likely left the National Constitution Center, Blair Academy, and Vanguard, to some degree at least, better than I found them. Alas, I cannot say that I’ve done the same in my against-all- odds fight to restore the mutual fund industry to its proud heritage, to build a better financial system for our nation, and to return capitalism to a more productive role in our society.

Pillar 8. Do Not Overestimate Your Ability to Pick Superior Equity Mutual Funds, nor Underestimate Your Ability to Pick Superior Bond and Money Market Funds. In selecting equity funds, no analysis of the past, no matter how painstaking, assures future superiority. In general, you should settle for a solid mainstream equity fund in which the action of the stock market itself explains about 85% or more of the fund’s return, or an low-cost index fund (100% explained by the market). But do not approach the selection of bond and money market funds with the same skepticism. Selecting the better funds in these categories on the basis of their comparative costs holds remarkably favorable prospects for success. While I’ve shown you earlier the near-causal relationship between costs and returns among fixed-income funds, the futility of picking stock funds based on their past returns has seldom been more forcefully demonstrated than in the past two years. Among the twenty top-performing equity funds for the year ending March 31, 2000, 15 of the Top-20 tumbled to ranks ranging from #3453 to #3891 among 3896 funds during the year that followed. Only one fund even ranked higher than #1000. Picking equity funds on the basis of past performance is not a good idea!

But if we had to spend, say, an extra $100 million on technology this year, it would raise our expense ratio by only two basis points, a change that the world would little note nor long remember. (But we would notice. So I assure you that our severe cost discipline remains intact.) The point is that our huge expense ratio advantage enables us to spend what is required to provide state-of-the-art financial services—services that meet and, ideally, exceed the ever-growing expectations of our clients. It also enables us to pay our crewmembers fairly, for our success depends on a terrific effort from each of the 10,000-plus human beings who serve on our crew. We offer competitive salaries, to which we add an extraordinary benefit program. On top of that, we provide the Vanguard Partnership Plan, affording each crewmember, from his or her first day on the job, ownership in units in a partnership. Earnings are based on a formula driven by the dimension of our cost advantage and the performance of our funds relative to their peers. By so doing, we share a small portion of our clients’ extra earnings with those who labor ceaselessly in their behalf. The Partnership Plan reemphasizes to our crew the low-cost mission that is central to all we do, focuses crewmembers on operational efficiency and cooperation, and drives home the message that providing more-than-competitive returns to our shareholders is essential to our growth, indeed to our survival.

” For you can be sure that no one would have the temerity to promote a new strategy that has lagged the traditional index fund in the past.) Even including this recent advantage, the long-term margins of superiority achieved by these theoretically-constructed back-tested portfolios are not large—between 1 and 2 percentage points per year over the cap-weighted S&P 500 Index. How much of that edge would have been confiscated by their expense ratios? (The lowest is 0.28 percent; the average is about 0.50 percent; the highest that I’ve seen is 1.89 percent.) How much would have been confiscated by their extra portfolio turnover costs compared to the classic index funds? How much would have been confiscated by extra taxes paid by shareholders when that turnover results in gains? Even if the modest margins claimed in the past were to repeat—which I believe is highly unlikely—these back-tested hypothetical returns, ignoring fund expenses, sales charges, and portfolio turnover costs, would be significantly eroded if not totally erased by those costs.

Samuelson himself. Writing in his Newsweek column in August 1976, he expressed delight that there had finally been a response to his earlier challenge. Now such an index fund lay in prospect. “Sooner than I dared expect,” he wrote, “my explicit prayer has been answered. There is coming to market, I see from a crisp new prospectus, something called the First Index Investment Trust” (the original name of what is now Vanguard 500 Index Fund). He noted that the fund met five of his goals: (1) availability for investors of modest means; (2) proposing to match the broad-based S&P 500 Index; (3) carrying an extremely small annual expense charge, (4) offering extremely low portfolio turnover; and (5) “best of all, giving the broadest diversification needed to maximize mean return with minimum portfolio variance and volatility.” While our IPO almost failed (the goal was $150 million; the capital finally raised came to but $11 million), we began operating our tiny index fund in August 1976. Mutual Admiration Paul Samuelson and I met face-to-face only perhaps a half-dozen times during our (arguably) 61-year relationship. But he often sent me notes, and must have made at least a score of telephone calls to me in my office. But as time went on, I appreciated not only his brilliance,

fund advantage—expense ratios that are 70% lower on average and portfolio turnover that is reduced by some 50%—strongly suggest that bond indexing will continue to deliver superior returns in the future. While the wisdom of bond indexing, like the wisdom of stock indexing, seems beyond challenge, there is precious little bond indexing going on in the fund industry. Not a single fund sponsor has yet to challenge Vanguard’s monopoly in the three defined-maturity categories, and the total assets of all of the bond market index funds managed by our rivals has yet to reach $6 billion. By contrast, assets of the Vanguard bond index funds now themselves approach $26 billion and assets of our Total Bond Market Fund, at nearly $21 billion, mark it as the second largest bond mutual fund in the world. Clearly, we need more education, awareness, and development of bond indexing for those with the wisdom to invest for long-term returns in the bond market. The Wisdom of Balanced Indexing If both stock index funds and bond index funds are so demonstrably and explicably effective, why not a balanced index fund? That’s exactly what we created in 1992. The fund allocates 60% of its assets to the Wilshire 5000 Total Stock Market Index and 40% to the Lehman Brothers Aggregate Bond Index, rebalancing essentially on a daily basis. It has worked inordinately well. The Wisdom of Bond Series Indexing Avg. Annual Returns, Apr. 1994 - Oct. 2001 1% 3% 5% 7% 9% 11% Short-Term Int.

Equity mutual funds incur operating expenses-largely payments to funds' managers-that average about 100 basis points (1 %), a levy likely to cut the returns their investors earn by 10% or more over time. Sadly, Mr. Buffett was misinformed. The average equity fund now carries total annual expenses not of 100 basis points, but of upwards of 200 basis points (2%), "a levy," if! may revise the master's words, "likely to cut the returns their investors earn by 20% or more over time." Such costs are, well, unacceptable. And bond fund all-in costs-unbelievably-average some 1.2%, a simply unjustified levy on any gross interest yield. In fact, such costs would cut today's yield of5.1% on the long U.S. Treasury bond to 3.9%, or nearly 25%. Why would anyone buy a high cost bond fund? Expense Ratios: A low expense ratio is the single most important reason why a fund does well.low

The managed fund then provides an ever more index-like portfolio, until it becomes a virtual index fund—but without the added value provided by low operating and advisory expenses, microscopic portfolio turnover and commensurately lower taxes, and a fully invested participation in equities. In short, today’s chance of victory, as small as it demonstrably is, will become tomorrow’s certainty of defeat if managers offer tacit index funds with high fees, high portfolio turnover, and a significant position in cash reserves. And it is the mutual fund shareholder who will pay the price. Relativism suggests that managers are becoming more similar to the enemy—“if you can’t beat ‘em, join ‘em.” But in the long-term, it is being different that gives an individual manager at least a fighting chance to win the battle for extra market return. Surely holding to a clearly differentiated strategy—and, for mercy’s sake, keeping a tight lid on fees and other costs—to cope with the realities of index competition is better than just standing there and hoping, again in Mr. Micawber’s words, that “something will turn up.” I acknowledge that not all fund managers subscribe to the new relativism. Indeed, some of the better managers in the field find it repugnant.magazine

I should also note that the universally accepted use of the S&P 500 Index as the de facto indexing standard is subject to the criticism that it consists mostly of large-cap stocks, and represents "only" 70% of the entire market. The Wilshire 5000 Equity Index is, I think, a better basis for indexing, not only because it encompasses mid-cap and small-cap stocks as well as large cap stocks, but because a portfolio linked to the entire stock market can be expected to have the lowest possible portfolio turnover. Yet while there is a high degree of certainty that the low cost advantage of indexing will persist, there is a somewhat lower level of certainty that the deferral of gain realization will persist. First, index funds, by virtue of their low turnover, build up their unrealized gains over time. Somewhere way down the road, those gains will inevitably be realized. Second, despite the intention of an index fund to avoid realization, it is susceptible to a run of shareholder redemptions that could force it to liquidate highly appreciated portfolio holdings. Nonetheless, given the value of tax deferral even for a limited period, it is difficult to visualize a circumstance under which the potential tax advantage offered by index funds, relative to traditional actively managedfunds, will not persist.

but his warmth and his patience with a mind far smaller than his own. When I wrote my first book in 1993 (Bogle on Mutual Funds), I asked him if he would be willing to endorse it. He said “no.” But to my utter astonishment, he offered to provide the foreword. A few excerpts: “99 out of 100 books written on personal finance are dangerous to your health. The exceptions are rare. Benjamin Graham’s The Intelligent Investor is one. Now it is high praise when I endorse Bogle on Mutual Funds as another . . . As a disinterested witness in the court of opinion, perhaps my seconding his suggestions will carry some weight. John Bogle has changed a basic industry in the optimal direction. Of very few can this be said.” Surely his highest accolade for the index fund came in Dr. Samuelson’s speech at the Boston Security Analysts Society on November 15, 2005, only a few years before his death in 2009: “I rank this invention along with the invention of the wheel, wine and cheese, the alphabet, and Gutenberg printing: a mutual fund that never made Bogle rich but elevated the long-term returns of the mutual-fund owners. Something new under the sun.” Those words from a giant—according to The New York Times “the foremost academic economist of the 20th century”—mean much to me, but it is the intellectual challenge, the friendship, and the unfailing support of this fine human being that I shall miss most profoundly.

Just one more example. In 1980, with the quantum surge in oil prices and high expectations for the petroleum industry, the energy sector’s weight rose to an all-time high of 32%. It would have seemed, I suppose, foolish to own such a single-industry-dependent index fund back then, and in fact during 1976-1985, the index didn’t, well, fly very impressively. Nonetheless, the long-term record of the S&P 500 over the past half-century, as we have seen, brooks no apologies. Like the bumble bee, the index can fly. And on long trips, it can soar. Today, of course, the index has an equally heavy weighting in the “New Economy,” including an important dependence on technology stocks (32% as year 2000 began, now 27%). I admit that concentration unnerves me a bit. But I’m such a believer in the magic of indexing that I remain unshaken in my conviction that, no matter what the short-term holds, indexing continues to represent the best way to invest for the long-term. Finally, broad diversification, low cost, minimal portfolio turnover, and tax-efficiency conquer all. Is the S&P Really “The Market”? For all of its well-known idiosyncrasies, the S&P 500 has proven it can be an excellent representation of the stock market itself. Composed solely of large-cap stocks, it represents about three-quarters of the market’s total capitalization; its returns have maintained a fairly stationary correlation (R2) of 0.

Who Earns the Market Returns? But whatever returns the financial markets are generous enough to deliver, please don't make the mistake of thinking investors actually earn those returns. To explain why this is the case we need only to understand the simple mathematics of investing: All investors as a group must necessarily earn precisely the market return, but only before the costs of investing are deducted. After all the costs of financial intermediation are deducted—all of the management fees, the transaction costs, the distribution costs, the marketing costs, the operating costs, and the hidden costs of financial intermediation— the returns of investors must—and will, and do—fall short of the market return by an amount precisely equal to the aggregate amount of those costs. Result: Beating the market before costs is a zero-sum game; beating the market after costs is a loser's game. The returns earned by investors in the aggregate inevitably fall well short of the returns that are realized in our financial markets. The great paradox of investing is that you don't get what you pay for. The fact is quite the opposite: You get what you don't pay for. Consider the costs of equity mutual funds. Management fees and operating expenses—the "expense ratio"—average about 1.6% per year of fund assets.

When managers of traditional active equity funds claim to have a way of uncovering extra value in our highly- (but not perfectly-) efficient U.S. stock market, investors will look at their past record, consider the manager’s strategies, and then invest or not. These new index managers are in fact active managers. But they not only claim prescience, but a prescience that gives them confidence that most sectors of the market (such as dividend-paying stocks) will remain undervalued for as far ahead as the eye can see. But, if these factors are underpriced, why won’t investors, hungry to capitalize on that apparent past inefficiency, bid up prices until the undervaluation no longer remains? Put another way, if these promoters of the purported new paradigms actually have been right in the past, won’t they therefore be wrong in the future? Interestingly, the choice of the ETF structure—rather than the standard mutual fund format—by these confident entrepreneurs would seem to belie the fact that their “fundamental indexing” approach may take decades to prove itself, if indeed it does so at all. Because by choosing the ETF format, they imply even more strongly that investors who actively buy and sell their new fundamental funds will lead to even larger short-term profits than buying and holding them for the long term. I recommend skepticism about these purported “new paradigms.” I’ve witnessed too many new paradigms over the years. None has persisted.

Index. Result: Average annual fund return, 9.8%; S&P 500 return, +11.3%. To magnify that 1½ percentage point difference, I assumed a large initial investment, and compounded it. Thirty years later, the original $1,000,000 investment had grown to $16,500,000 in the average fund, but to $25,000,000 in the S&P 500 Index. Difference: $8.5 million. Our mutual low-cost structure gave us the ability to match the index at nominal cost, and quickly led to our formation of the world’s first index mutual fund. Our structure was also the linchpin of the strategy to abandon our funds’ half-century commitment to a seller-driven broker distribution channel and move to a buyer-driven no-sales- load channel in February 1977. We made that unprecedented decision just five months after the index fund initial public offering was completed. (It had raised a less-than-mind-boggling $11 million.) Ditto for our second major innovation in fund management just four months later, this time in the bond market. Casting tradition to the winds, we formed, not a single so-called managed bond fund, but a troika: Long-term, intermediate-term, and short-term. This simple innovation, while less recognized than our creation of the first index fund, changed the way investors regarded bond funds. It quickly became the industry modus operandi. So, in less than two years from our start as a tiny administrative company, Vanguard had been transformed into the full-line fund complex it is today.

folly of short-term speculation—are obliged to own (surprise!) stock and bond market index funds. As evidenced from the substantial shortfall in returns experienced by mutual fund investors in the example that I cited earlier, the investment merits of indexing—the broadest possible diversification, at the lowest reasonable cost, without sales loads or marketing fees, and with maximum tax efficiency—have proven themselves over and over again. Yes, I concede that owning such funds is as interesting as watching the grass grow, or perhaps as interesting as watching paint dry. But since less than 10 percent of investors or investment managers are apt to beat the market over the long-term, buying and holding a low-cost index fund and capturing nearly 100 percent of whatever annual returns the financial markets are generous enough to deliver to us seems a far better option than plunging headlong into a game rigged with such overpowering odds against success. Of course, since I started the first index mutual fund a little over three decades ago— Vanguard Index 500 is now the largest fund in the world—you would be wise to discount my passionate advocacy of indexing. So ignore me! But listen to Warren Buffett. Listen to Yale’s David Swensen. They both say exactly the same thing. Listen to Jack Meyer, the former—but equally sensational—manager of Harvard’s endowment fund. Listen to any Nobel Laureate in Economics, beginning with Paul Samuelson.

Given our fund’s relative youth, let’s look at balanced indexing over a longer-term time horizon. Using the fund’s actual results during the past eight years and recreating the results of a composite 60/40 balanced index for the earlier years (and deducting appropriate costs), we can examine a full 15-year period. The results are impressive: The average annual return for the balanced index fund from the end of 1986 through October 2001 came to 10.9%, vs. 9.2% for the average balanced fund, a 1.7 percentage point advantage, once again explained largely by relative costs. An initial investment of $1 million grew to $4.64 million in the balanced index fund vs. $3.69 million in the average managed balanced fund—an advantage of nearly $1 million, again obtained simply by shifting the allocation of market returns away from the managers and toward the investors. The consistency of the balanced index fund’s superiority was remarkable. It provided virtually the same returns in five years, and lower returns than the balanced fund average in only a single year (2000), earning a higher return in nine of the 15 years. What is more, it achieved its superiority with a risk exposure 10% below that of the average balanced fund (standard deviation of 9.2% vs. 10.3%). While most balanced mutual funds have traditionally hewed to a fairly steady equity ratio of around 60% in stocks, the same can not be said about pension funds. To their obvious detriment, U.S.

success, exercising his talents with a view not toward personal gain and private profit, but toward serving the community. “America’s first entrepreneur” may well be our finest one. The idea of a contributor—“one who bears a part in some common design,” according to a 1793 dictionary—seems archaic to our ear. But 250 years later, Franklin’s idea of contributionship—a shared mutuality of interest for a common purpose—is the defining characteristic of Vanguard. As Franklin’s stove and lightning rod and all of his other contributions to science and to mankind fostered the public good, so we have freely shared with others the fruition of our mutuality, the index fund. And both our structure and our invention arise almost entirely from our firm’s value system and the corporate character that we firmly established more than a quarter-century ago, which have undergirded all that we may be judged to have achieved thereafter. I hope you will forgive my boldness in comparing the peerless accomplishments of our nation’s first entrepreneur with my own humble enterpreneurship and inventiveness, my own joy in what providence has led me to create, my own energy and persistence, and my own attempts to improve the lot of the American investing public. Of course I’m proud, but I console myself with these words of Benjamin Franklin, written when he was 78 years of age: In reality, there is, perhaps, no one of our natural passions so hard to subdue as pride.

97 with the total market; and its performance has been virtually identical to that of the Wilshire 5000 Total Equity Market Index over the nearly three full decades in which both indexes have been available. That is not to say the S&P is an easy target for an investor—or even an average index fund manager—to track. Change it does! Indeed in the past 20 years there have been an astonishing 489 changes in the 500 Stock Index. These are not trivial changes; on average during that period, each year has resulted in the addition of stocks accounting for 2.8% of the index’s capitalization—an aggregate two-decade replacement equal to 58% of its value. Typically, these changes are represented by mergers; the few stocks deleted from the index for other reasons typically have very small market caps. In essence, we have a process in which old stocks are deleted from the Index at a rate of about three percent per year, meaning that the weightings of each of the other holdings is reduced by about three percent per year.the

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. In the late 1990s, high-tech stocks and "new economy" funds came as well, and even today the asset values of the survivors remain far below their peaks. Intelligent investors should approach with extreme caution a claim that any new paradigm is here to stay. That's not the way financial markets work. We do know that traditional low-cost all-market-cap-weighted index funds guarantee that you will receive your fair share of stock market returns, and virtually assure that you will outperform, over the long term, 90 percent or more of the other investors in the marketplace. Maybe this new paradigm of “fundamental” indexing—unlike all the other new paradigms I’ve seen—will work. But maybe it won’t, too. I urge you investment professionals not to be tempted by the siren song of paradigms that promise the accumulation of wealth that will be far beyond the rewards of the classic index fund.general

respectively. The brute fact: All-in fund costs have consumed about one-third of the annual investment returns earned by their bogeys, even after the benchmarks are adjusted for estimated index fund expenses and taxes. Alas for the fund shareholder, that’s the least of it. Even as we have the famously accretive magic of compounding of investment returns, so we have subtly decretive tyranny of compounding investment costs. Result: the cumulative investment returns earned by mutual funds over the past 15 years have been a pale shadow of the cumulative returns by comparable market indexes: Large-cap funds have provided 51% of the cumulative after-tax profit generated by the S&P 500 Index: Mid-cap funds have provided 37% of the profit generated by the S&P 400 Mid-Cap Index. Small–cap fund have provided 56% of return generated by the Russell 2000 Small Cap Index. That’s just not good enough. Large-cap 15.0% 12.2% $ 81,400 $ 56,200 Pre-tax After-tax S&P 500 17.9 16.7 118,200 101,400 Mid-cap 12.8% 9.8% $ 60,900 $ 40,600 S&P 400 17.5 16.0 112,300 92,700 Small-cap 10.2% 7.5% $ 42,900 $ 29,600 Russell 2000 12.2 10.5 56,200 44,700 Mutual Funds are Meeting the Reasonable Expectations of Investors Fund Type The Cost of Cost* 49% 63% 44% Myth #5: Pre-tax After-tax 15 Year Returns on $10,000 Investment - Blend Funds vs. Index Funds *Appreciation of active fund investment as % of index fund. Fund returns adjusted for survivor bias of 0.3, 1.2 and 2.0 percent, respectively.

The Triumph of Indexing Through the intellectual inspiration of Lord Keynes and the brilliance, moral support, and friendship of Dr. Samuelson—and huge amounts of good luck!—the simple logic and elementary mathematics of indexing are beginning to reshape the way investors think about the financial markets that confront us today. They are a mess! The folly of short-term speculation has crowded out the wisdom of long-term investing, giving us a financial system in which millions of investors have lost their trust. Indexing has become the counterculture to the speculative culture that has shaped our markets in the recent era.Sir

public and private pension funds had just 42% of assets invested in equities at the start of the great bull market in 1982, but 63% at the March 2000 high. Hardly a winning timing strategy! So the simple wisdom of holding a balanced index fund with a fixed bond-stock ratio, for individuals and institutions alike, seems yet another winning long-term investment strategy. The record, then, is clear: the wisdom of investment has resulted in a clean sweep for stock, bond, and balanced index funds alike. The Wisdom of Balanced Indexing Growth of $1,000,000: 1986 - Oct. 2001 $1.0 $2.0 $3.0 $4.0 $5.0 Balanced Index Avg. Balanced Fund Millions Avg. Ann. Return: Bal. Index: 10.9% Avg. Fund: 9.2% $4.6 $3.7

 Our original index fund is now the world’s largest mutual fund, and our panoply of stock index funds total $180 billion. Our market share of no-load stock index fund assets is a dominant 82%.  Our original troika of tax-exempt bond funds, and the similarly-structured taxable bond funds that followed—all relying on index-like strategies—total $112 billion in assets, including $24 billion in bond index funds. Market share: Now 45%, vs. 18% in 1980.  Our money market funds, also capitalizing on the low-cost-equals-high- return equation have assets totaling $93 billion. Market share: 33%, vs. 4% two decades earlier.  And the assets of our traditional actively-managed equity funds total $144 billion. Market share: 15% down from 25%, the inevitable result of our focus on indexing. The magnificent returns in the financial markets—stock, bond, money market—through most of our history, really right up to the spring of 2000, have given HMS Vanguard a powerful wind at her back. Our assets have grown at a compound rate of 25% per year, and at a remarkably steady pace, carrying our asset base from $1 billion to $565 billion. But the overwhelming portion of that huge increase has come from our rising share of market. Had our share held steady, our assets today would be $110 billion. The remaining $455 billion is accounted for by the increase of our share of total industry assets from 1.7% in 1981 to 8.3% today—without a single year of decline.

past six years, Microsoft, Cisco, and Intel, for example, would have apparently represented, not the 4.9%, 2.8%, and 2.3% of the Index that they represented as 2000 began, but 5.5%, 3.2%, and 2.5%. While these are not to be taken as hard numbers, they do suggest that a strategy of gradually selling winners may have helped to marginally improve the performance of the index. Active managers may want to take note. No similar adjustments are required in the Wilshire 5000 Total Stock Market Index, which includes not only the large-cap stocks in the S&P 500, but mid- and small-cap stocks as well. Yet despite modest short-term variations, it has tracked the S&P 500, as I noted, with virtual perfection over the long-term. Stocks normally come into the index when they are very small and there is no reason to remove them when they hit an arbitrary size. And they are held forever . . . or at least until they are merged into another corporation. It is largely for these reasons that I favor the all-market index fund as the best choice for most investors. “Benchmarking” The compelling data I’ve presented shows a substantial shortfall in the long-term returns of mutual funds despite cost and tax assumptions that are remarkably conservative. I’ve also assumed that domestic funds as a group can be fairly compared with the S&P 500 Stock Index, which closely tracks the total U.S. stock market.

The belief that technology companies would continue to soar captured the mind of many inexperienced investors. One fund manager even wrote a book describing why he had cast his vote with the crowd, assuring his readers that his funds had jumped aboard the fast-moving large-cap, high-growth, high-tech bandwagon. He applied his new strategy to the equity funds he managed, and his aggressive growth fund leaped by 82% during the two years through the first quarter of 2000. His moderate growth equity fund rose 51% during the same period. That performance was nonetheless insufficient to give him a victory in a bet I’d made with him that an index fund would do better during the five years ended March 31, 2000.points--+226%

In short, to be successful in a world in which indexing and quantitative strategies will become increasingly pervasive—and fully competitive—the successful traditional investment manager must serve the client’s interest . . . first, last, solely. To conclude, I rely again on Charles Dickens, this time in A Tale of Two Cities: “It was the best of times. It was the worst of times.” It has been the best of times for the stock market, a 15-year bull market of unprecedented magnitude, creating happiness beyond measure. But it also has been the worst of times (though it is hardly perceived as that . . . yet), creating misery for the average mutual fund manager, who has lagged the S&P 500 Index by an unprecedented annual margin of nearly three percentage points—surely less than a ringing tribute to professional management. Looking ahead to a new century, the mutual fund industry must be challenged to serve its clients much more effectively.

The Folly of Speculation This wisdom of investment has been the powerful engine that has driven indexing to its position of dominance in institutional and individual portfolios today. That wisdom continues to dominate indexing in public and private plans. But in the mutual fund industry—now responsible for 41% of total indexed assets compared to just 3% in 1990—change is in the air. Most of the growth of indexing during recent years has been based, less on the wisdom of investment, than on the folly of speculation. This speculation is based in part on the idea that betting on particular market sectors—say, technology or growth or small-cap or emerging markets—will enable investors to outperform the market for a time. The fund industry has helped to foster this trend not only by forming hundreds of actively-managed technology and aggressive growth funds, but also by offering index funds that focus on relatively narrow market segments. The speculation is also based on the offering of funds that, while they own broad stock market indexes, enable and indeed encourage market timers and traders to opportunistically trade the index in, as it is said, real time. While it has not been fully recognized, the development of speculative index funds is a major trend. As recently as 1998, assets of market segment funds and exchange-traded-funds (ETFs) totaled $50 billion, just 25% of the $195 billion assets of the traditional S&P 500 and all- market index mutual funds.

William of Occam. Writing 700 years ago, he postulated that when there are multiple solutions to a problem, the simplest choice is the best. “Occam’s Razor” has proved itself in many areas of intellectual focus, and it has surely done so in the world of investing. Indexing is now a major force in investing. Today it represents about 25 percent of the assets of America’s $5 trillion in pension assets, and almost 30 percent of the $6 trillion assets of our equity mutual funds. (Chart 4) Those percentages are bound to grow. Over the past five years alone, for example, more than $500 billion of investor dollars have poured into equity index funds, while $370 billion has been cashed out of active-managed funds. (Chart 5) This difference offers nearly $1 trillion worth of proof that investors are starting to “get it.” And the final triumph is yet to come. Equity Index Fund Market Share 0% 5% 10% 15% 20% 25% 30% 1992 1996 2000 2004 2008 2012 3% 5% 10% 14% 20% 28% Equity Fund Cash Flow Since 2008 Index funds have taken in over $500 billion; active funds have lost almost $400 billion $136 $83 $108 $93 $98 $518 -209 -5 -7 -86 -63 -370 -500 -400 -300 -200 -100 2008 2009 2010 2011 YTD 2012 2008-12 Index Funds Active Funds $ $ billions

of the early 19th century, “the greatest enemy of a good plan is the dream of a perfect plan.” Put your dreams away, I would warn investors, and stick to the good plan represented by the classic index fund. What Would Benjamin Graham Have Thought About Indexing? So of course I’m troubled by this era’s focus on what I regard as potentially counterproductive investment strategies. In writing in my Little Book about these truths about how our financial system actually works, why classic indexing is the ultimate winning strategy, and puzzling over the trading index funds is—so popular and whether there are new “paradigms” that assure beating the market from now till doomsday, I mused about what the legendary Benjamin Graham might have thought about these developments. I’d studied his wonderful book The Intelligent Investor, published in 1949, and decided to see what I could discover. Although Graham is best known by far for his focus on the kind of value investing represented by the category of stocks he describes as “bargain issues,” he cautioned, “the aggressive investor must have a considerable knowledge of security values—enough, in fact, to warrant viewing his security operations as equivalent to a business enterprise . . . It follows from this reasoning that the majority of security owners should elect the defensive classification.” Why?

Wrapping Up It was Bernard of Chartres who said in the twelfth century that a dwarf standing on the shoulders of a giant may see further than the giant himself.3 And so this plain-thinking, common- sense-reliant mutual fund veteran stood on the shoulders of Lord Keynes and Professor Samuelson in his efforts to cut through the fog surrounding the foxes of Wall Street and focus on the great idea of the hedgehog. The clear message: history often teaches us the wrong lessons about the financial markets. The past, truth told, is rarely prologue to what lies ahead. The real lessons of sound investment strategy depend upon focusing on the sources of stock and bond returns, and minimizing to the nth degree the costs extracted by our bloated investment system. So, my fellow members of The American Philosophical Society, you thoughtful and intelligent movers and shakers of American thought, please think about the implications of indexing for the financial markets in the years ahead. And while you’re about it, consider whether you should rely importantly on indexing in your own investment programs. That’s important too! 3 Perhaps this idea was the inspiration for the acknowledgement by Sir Isaac Newton in 1676 that “If I have seen further, it is by standing on the shoulders of giants.”

A New Idea, Sixty Years Old With all of the high-priced creative and imaginative talent in this industry, I find myself wondering why someone, somewhere, hasn't dreamed up a still better way to enhance after-tax mutual fund returns. Surely the opportunities abound. Let me describe my own idea. I start with a fund that simply buys a large sampling of high quality blue-chip growth stocks, and holds them unless fundamental circumstances change radically. Where, you ask, do we fmd the budding Warren Buffett to manage it? Honestly, I don't know. So, I shift gears. Why not a fund that buys, say the 50 largest stocks in the Standard & Poor's Growth Index universe? (That's nearly 30% of the capitalization of the entire stock market.) Simply hold them "forever" and don't rebalance as prices change. If there is a merger, keep the merged company; if a company is bought for cash, reinvest the proceeds, either in the next largest company or in the fund's other holdings (it probably won't matter which you do); ifit fails and goes out of business, well, just realize that can happen. Then, run the fund at an expense ratio of 20 basis points, just incurring bare-bones operating costs. Minimize exposure to shareholder redemptions with a stiff redemption fee and/or strong limitations on daily liquidity (i.e., open the fund for redemption only, say, on the last day of each quarter). These latter steps will, of course, make it difficult to attract quick-triggered opportunists. That's good!it

vs. +156%.) When I wrote to thank him for sending me the $25 to settle our bet (huge for me!) I expressed my opinion that his new strategy was “fighting the last war”. And so it quickly proved to be. In the year since then, the manager’s two growth funds have plummeted by 45% and 55% respectively, more than double the 22% decline for the index fund. But just because some investors insist on “fighting the last war,” you don’t need to do so yourself. It doesn’t work for very long. Pillar 11. You Rarely, If Ever, Know Something The Market Does Not. If you are worried about the coming bear market, excited about the coming bull market, fearful about the prospect of war, or concerned about the economy, the election, or indeed the state of mankind, in all probability your opinions are already reflected in the market. The financial markets reflect the knowledge, the hopes, the fears, even the greed, of all investors everywhere. It is nearly always unwise to act on insights that you think are your own but are in fact shared by millions of others. Well, here we are again, in the grip of a bear market, and worried about whether it will get worse. No one knows when it will be over. Maybe it is over.

Since then, those non-traditional index assets have more than doubled to $115 billion, and now are equal to more than 50% of the $225 billion for the traditional funds. In 1998, $32 billion of investor capital flowed into investment indexing and $13 billion into speculative indexing. But so far in 2001, just $10 billion has flowed into investment indexing—one-third of the 1998 level—while nearly three times as much—$27 billion—has flowed into speculative indexing. This new generation of speculative index funds may well provide a better way to bet on market sectors than owning actively-managed sector funds, or a better way to trade securities and time the market than day-trading in individual stocks. But mark me down as one who is not a betting man, and one who believes that speculation is not only a loser’s game, but a game in which most losers lose big, and many losers lose all. If so, the current trend in which speculative indexing is overwhelming investment indexing is a counterproductive transmogrification of the values that the original index pioneers held high.

Size, as such, is not necessarily bad. A giant market index fund, indeed, may have inherent advantages over a very small one. And the past record of a fund investing in large cap stocks on a long- term basis is likely relevant even if the fund has grown to a multi-billion asset base. But giant size limits the investment universe from which a manager must select the fund’s investments, as well as limiting (for better or worse) his ability to actively trade the fund’s holdings. As a result, funds that were once actively managed gradually come to resemble market index funds, without disclosing it, and without the benefit of low cost that indexing provides. The “closet index fund” is now a staple of the industry. While it looks like a duck, however, and walks like a duck, and quacks like a duck, it denies being a duck. But “duckness” can be measured. A correlation statistic known as R2 measures the portion of a fund’s return that can be explained by the return of the Standard & Poor’s 500 Index. The average equity fund has a correlation of 83, meaning essentially that 83% of the average fund’s return can be Index- explained. But 18 of the 30 largest blend funds investing in large cap stocks have correlations of 94 or above, very close to the 100 correlation of a S&P 500 Index Fund. If these funds are not closet index funds, they are something terribly close.

realistic about what fund managers might accomplish. Even excluding the oppressive impact of sales loads, Graham’s view was that fund returns “were not very impressive . . . on the whole, the managerial ability of invested funds has been just about able to absorb the expense burden and the drag of uninvested cash.” Graham’s timeless lesson for the intelligent investor, as valid today as when he described it in his book, is clear: “the real money in investment will have to be made—as most of it has been made in the past—not out of buying and selling but of owning and holding securities, receiving interest and dividends and increases in value,” again exemplified in the distinction between the business market and the expectations market that I mentioned earlier. Owning and holding a diversified list of securities? Wouldn’t Graham recommend a fund that essentially buys the entire stock market and holds it forever, patiently receiving interest and dividends and increases in value? Doesn’t his admonition to “strictly adhere to standard, conservative, and even unimaginative forms of investment,” eerily echo the concept of market indexing? When he advises the defensive investor “to emphasize diversification more than individual selection,” hasn’t Benjamin Graham come within inches of describing the modern-day stock index fund?

But in the inevitably uncertain world of investing—and with the counterproductive interference of our emotions—I also think that betting the entire ranch on equities would be unwise. We are all fallible human beings, driven toward greed at market highs and toward fear at market lows. So, it is best to resist the temptation to turn emotion into investment action. A balanced approach has been validated over centuries, not, to be sure, because it provided the highest returns—it clearly didn’t. But it did provide solid long-term returns, achieved without excessive short-term risks, and that’s hardly an unacceptable outcome. With the stage—or stages!—thus set for future market returns, what does RTM suggest about equity investment selections? I come quickly to the obvious solution: the choice of a low-cost stock index fund for your equities, or at least as the core of your equity commitment. Such a fund should, given the power of mean reversion, provide the maximum participation that is realistically possible in the future returns of equities as a group. Surely it has proved its worth in the past. I would caution you, however, that despite the recent success of—and accompanying accolades for—index funds modeled on the Standard & Poor’s 500 Stock Index, they may not be the optimal choice.providing

Indexes of Market Segments The problem with segment indexes is not that they have failed to perform effectively. Over the past decade, equity index funds have outpaced their comparable actively-managed peers in eight of the nine Morningstar style boxes, and when the bias of returns in favor the better- performing funds that have actually survived the decade is taken into account, the index advantage rises even further. Rather, the problem is that once we move away from large-cap and all-market indexing, portfolio turnover soars, with attendant turnover costs and tax-inefficiencies that erode the advantage that indexing usually carries. For example, more than 600 stocks have exited the Russell 2000-stock small cap index in each of the past two years, replaced by 600 new entrants. I think we owe it to ourselves to challenge the way these indexes are constructed, and to ask ourselves whether the rapid circulation of dollars (about 60% per year) among a floating menu of small-or mid-cap stocks represents a valid long-term investment strategy, even granting that the returns of the smallest-cap stocks (but not small- and mid-cap stocks as a group) seem to have garnered a long-term advantage over the returns of the market as a whole. Nonetheless, problems remain, including the fact that there is considerable diffusion among the returns of the various sub-indexes. The average rate of return over the past decade, for example, was 17.4% for the S&P 600 Small-Cap Index, but 15.

commensurately easy to attract serious long-tenn investors (today, an endangered species). The rewards for them should be far larger than the risks. The potential rewards, in fact, are huge. In a stock market which averages a 10% pre-tax return, an average fund, assuming a 2% expense ratio, should provide a pre-tax return of 8.0% and an after-tax return of 6.5%. A low-cost buy-and-hold fund with a 10% gross return and expenses of 0.2% should achieve a net return of 9.8% before taxes and 9.0% after taxes. (This is a conservative hypothesis, with an after-tax spread of 2.5% that is well below the shortfall of 3.3% that actually existed between active funds and the Standard & Poor's 500 Index during the past 15 years.) For the long-term investor, these numbers would be little short of dynamite. $100,000 invested at the outset would, after 25 years and after all taxes, have grown in the actively managed fund to $483,000. But the buy-and-hold fund would have almost doubled that amount to $862,000. I guess it's fair to conclude: "Yes, costs and taxes matter." The potential risk to investors is small. Essentially, it's the risk that the 30% of the entire investment universe represented by the 50 largest growth stocks today would underperform the remaining 70% of the market by more than 3.0% per year over the long-term. (At that figure, the choice between the two funds would be indifferent.)

participation, not only in the giant cap stocks of the S&P 500, but also in the small-cap and mid-cap segments of the market. (While I see no compelling reason to include international equities in your program, I would note that they can be successfully indexed too.) The index fund is the ultimate response to the power of RTM in the selection of mutual funds. It avoids “the loser’s game” of selecting individual funds based on past performance that overpoweringly reverts to a mean that persistently falls short of the market return. Rare indeed is the serious study that suggests that it is possible to select significant winners in advance. Indeed, I accept the general notion of RTM among market segments such as growth stocks versus value stocks and U.S. stocks versus international stocks. But even if you believe that the clear lessons of history are pointing us in the wrong direction—always a risky bet—there would remain the equally risky bet of determining just which of the countervailing segments will in fact prove to be superior. If, for example, large cap and small cap stocks do not each revert to the market mean over the next 10 to 20 years, which of the two is the more likely to provide the superior return? Indeed, it is the extraordinarily broad diversification—the total, absolutely complete, diversity—of the total stock market index fund that commends it to investors. But only if that diversity comes with minimal cost.

Late in his life, in an interview published in 1976, Graham candidly acknowledged the inevitable failure of individual investment managers to outpace the market. He was asked, “Can the average manager obtain better results than the Standard & Poor’s Index over the years?” Graham’s blunt response: “No.” Then he explained: “In effect that would mean that the stock market experts as a whole could beat themselves—a logical contradiction.” Then he was asked whether investors should be content with earning the market’s return. Graham’s answer: “Yes.” Finally, he was asked about the objection made against the index fund—that different investors have different requirements. Again, Graham responded bluntly: “At bottom that is only a convenient cliché or alibi to justify the mediocre record of the past. All investors want good results from their investments, and are entitled to them to the extent that they are actually obtainable. I see no reason why they should be content with results inferior to those of an indexed fund or pay standard fees for such inferior results.” Graham was also well aware that the superior rewards he had reaped using his valuation principles would be difficult to achieve in the future.this

Let’s let narrow style benchmarking dictate neither our investment decision-making nor our standard for appraising long-term accomplishment. Variations on Long-Term, All-Market Indexing If the all-market index standard should—finally, must—be the long-term standard for equity accounts of all stripes, what use is served by the scores of index variations on this basic theme over the past decade-plus? I confess that, with the passage of time, I have become increasingly concerned about the utility of these variations, and I owe this audience the professional courtesy to tell you what bothers me and why it does so. First, confession being good for the soul, it was primarily because of my own drive and conviction that Vanguard became the pioneer in index funds. We formed the first S&P 500 Index fund in 1975, and then in 1987 pioneered the completion (“Extended Market”) index fund, tracking the small- and mid-cap stocks unrepresented in the S&P 500. The idea: To enable investors to make a commitment to the entire stock market, which I consider as the full fruition of the index fund concept.as

It behooves you to know the R2 figures for the funds you own or are considering owning, and to decide whether the implicit limitations on extra return are too great to justify the costs involved. But I fear that in most closet index funds, you are unlikely to find either a perfect plan or a good plan. Rule 9: Don’t Own Too Many Funds—And Don’t Trade Them Let me ask your indulgence as I set forth one final rule: Limit the number of funds you own, and don’t trade them. To paraphrase the old adage, “too many funds spoil the perfect plan.” Why should this be so? First, the more funds you own, the greater the chance that a truly inspired fund selection will have its success spoiled by another fund that falls on its face. The problem has been called “diworsesification,” for it leads investors to build a portfolio of funds containing so many individual stocks that it becomes itself a closet index fund, again bereft of the index fund’s positive attributes of exceedingly low cost, minimal portfolio turnover, high tax efficiency, and clarity of investment objective. To me, that is too much good to relinquish in the search for the perfect. Recent studies have shown that the average mutual fund investor owns six mutual funds, and one of every four investors own ten funds or more.to

Indexing wins because it is an exceptionally low cost strategy that is competing, finally, with all stocks as a group, by definition an equally-diversified universe. And the mutual fund portion of that universe—nearly one-quarter of it—is composed of thousands of different individual funds operating at high cost. In such circumstances, an equity index fund cost advantage conservatively estimated at 1.5% annually should provide 1.5% in added return over time. Yes, it is really just that simple. If the stock market’s return is 9% in the future, the typical fund should be expected to deliver 7.5% at best. (If you cannot accept my thesis about RTM in the relative returns of mutual funds, I believe your chances of selecting the future good performers will be highest if you choose from among those with low expense ratios and low portfolio transaction costs.) As shown in Exhibit XII, this difference in compounding causes $10,000 to grow to $61,000 at 7.5% over 25 years, but to $86,200 at 9%. Over 40 years, to $180,000 at 7.5%, but to $314,000 at 9%. It seems almost too easy a way to earn an extra nest-egg of almost $100,000, holding risk constant. But there it is. In short, excessive mutual fund operating costs carry a high penalty in shareholder capital accumulations over the long run. Cost matters.

stocks moved in and out of the 500, creating portfolio turnover and potential tax-inefficiencies. So, in 1992 we created the all-in-one Total (U.S.) Stock Market Index Fund. That same year, when Standard & Poor’s/BARRA answered my public prayer and developed a growth index and a value index—each regularly adjusted to represent one-half of the weight of the 500—we started our Growth Index and Value Index Funds. I stated then—and reiterate now—my expectation that the long-term total returns were unlikely to differ significantly. The idea was to allow more aggressive long-term investors to hold the growth index fund for lower taxable income, higher tax-efficiency, and higher likely volatility. More conservative investors could hold the value index fund (for higher retirement income and lower volatility, at the cost of some tax-efficiency). Still earlier, in 1989, we converted a tiny actively-managed Vanguard small-cap fund into a passive Russell 2000 Index fund, creating the industry’s first small-cap index fund. And a few years ago, my successors at Vanguard added three more index funds—mid-cap (S&P 400), small- cap growth (half of the Standard & Poor’s 600), and a small-cap value fund (the other half). Over their histories, the segment funds formed before 1992 have done quite respectably—if largely unspectacularly. The newer funds, in even narrower market segments, have not been around long enough to fairly evaluate.

Work” in the Harvard Business Review. Nor did I ever coherently attempt to build what that article describes as, “a corporate culture centered around services to customers and fellow employees.” But as I look back over some fifty speeches I’ve given to our dedicated crew over a quarter-century—“If You Build It, They Will Come” is but one example—it seems clear in retrospect that that is precisely what I was doing. But the reality is that I only did what came to me naturally as a human being. It was the right thing to do. There just may be an important message here! At the outset, my focus was on providing the right types of funds that would meet investor needs. If no one else had thought of them, well, it would be up to us to create them—the first S&P 500 stock index fund, then the defined asset-class bond funds, then more stock index funds and the first bond index funds, then the tax-managed funds. All were ideas that anyone could have implemented, but, given our focus on low-cost, we alone had both opportunity and motive. Offering “the majesty of simplicity in an empire of parsimony,” is one way that I have described our strategy. For focusing heavily on controlling costs was also at a top priority. We knew that we had to reach low-cost provider status (it took only about five years) both because it would work in assuring outstanding relative investment returns, and because it was the right thing to do for our clients.

” When it’s so easy—in fact unbelievably simple—to capture the stock market’s returns through an index fund, you don’t need to take extra risks—and wasteful costs—in striving for superior results. With Benjamin Graham’s long perspective, common sense, hard realism, and wise intellect, there is no doubt whatsoever in my mind that he would have applauded the index fund, and I say just that in my Little Book. Now, the surprising denouement. Last autumn, I happened to have dinner with Warren Buffett in Omaha (at Gorat’s, of course). He asked how the new book was coming, and I made so bold as to ask him whether he thought I had gone too far with my conclusion that Ben Graham would have endorsed the index fund. Without a moment’s hesitation Warren (who was Graham’s protégé and collaborator in the final edition of The Intelligent Investor) replied, “I know he would. He told me so himself, saying that ‘A low-cost index fund is the most sensible equity investment for the great majority of investors.’ Ben Graham took this position many years ago, and everything I have seen convinces me of its truth.” (Of course, I used this endorsement on the book’s back cover). Wrapping Up Let me conclude with a stunning example of the effectiveness of traditional indexing, and then offer a few final words.the

When I led Vanguard to offer the fund industry’s first small-cap index fund in 1989, and its first growth and value index funds in 1992, I found nothing in stock market history to suggest either such high turnover or such radical changes in the composition of style indexes. My idea was to offer particular funds that investors would buy and then hold for the long-term, either to diversify an actively-managed portfolio by adding market segments that were not included, or to do some intelligent portfolio allocation under special circumstances; i.e., a growth index fund for a young investor accumulating assets and seeking capital growth and tax-efficiency, a value index fund for the investor seeking higher dividend income and perhaps lower risk at retirement. Alas, to an important degree, those good intentions have been frustrated by investors who seem to use the growth and value index funds to make counterproductive investment decisions, just as they do even more spectacularly with actively-managed funds. At first our two index funds proved equally attractive. During 1992-96, investors placed approximately $700 million in both growth and in value. But as growth stocks soared, the temptation to jump on the bandwagon proved too strong to resist. During 1997 through the first quarter of 2000, investors poured $10.6 billion into the growth index fund, vs. $2 billion into value.

If you make your own investment decisions with common sense and intelligence, the industry will be forced to change and serve shareholders more efficiently and effectively, reducing costs, risks, turnover, and hyperbole alike. Finally, you—the fund shareholders, the owners of the fund—must be served. You deserve a fair shake, and I’ll keep speaking out until you get it. Until that great change comes, however, you can’t afford to ignore the good plan. Index funds work well. The problem is that most actively managed funds—burdened by excessive costs, promoted based on outlandish claims of performance success, and managed with strategies that call for a short-term focus—don’t work very well. Almost alone, the index fund follows a strategy designed to protect your capital from the many croupiers who haunt the stock market casino. It is for that reason that the index fund has proved to be the optimal way “to realize the highest possible portion—albeit slightly less than 100%—of the return earned in the market.” It is a curious irony that many fund managers who once knocked indexing (and many who still do) now offer index funds. There are now some 380 index funds from which to chose, though precious few of them offer durably low costs.vigorously

If the longer-run past results of our market-segment index funds are at least respectable— and given the survivor bias that significantly overstates the achievements of actively-managed small-cap and mid-cap mutual funds, they are doubtless far better than that—what’s my concern? First, my instinctive feeling is that the use of segment funds is unlikely to add long-run value to the total market return. Second, I believe too many investors are using these funds to shift among market segments based on past performance, a formula apt to result in failure. Given the market trends that have favored growth stocks during the past five years, for example, the assets of our Large-Cap Growth Index Fund currently total $14 billion, compared to $3½ billion for its Value Index counterpart. (Surprise!) Third, segment funds carry far higher portfolio turnover: Small- Cap Growth and Small-Cap Value, each about 80% last year; Small-Cap (total), 42%; Large Value, 41%; Large Growth, 33%; and even Extended Market, 26%. In fairness, the extraordinary index fund management strategies of Vanguard’s skilled director of Quantitative Management, Gus Sauter, have resulted in virtually zero net cost for all of these purchases and sales, and each fund has tracked its appointed index with extraordinary precision.(6%)

And our Partnership Plan served the purpose—and not a moment too soon—of making it clear to crewmembers that while low cost was crucial, it wasn’t antithetical to their own financial interests. The Plan provided a clear link between crew satisfaction and client satisfaction, with crewmembers earning incentives step-by-step with enhanced profits for our shareholders as our expense ratio declines and our asset base grows. Yes, the Plan built loyalty. But it was also the right thing to do for our crew. Today, I am still brimming with investment ideas. Most of them, as ever, are founded on skepticism about the existing financial canon. But the original ideas on which Vanguard has been built will remain at our core. For all their simplicity, these investment ideas and human values are not only enduring, but eternal. Today, my self-appointed role is to carry on the mission to give fund investors everywhere a fair shake, writing, speaking, teaching, and dreaming of ways to improve their lot. But, as I’ve done from Vanguard’s first day, I continue to do my share in forging key links in our “service-profit chain” by corresponding with shareholders, sitting down with them, exchanging ideas, encouraging them, and, increasingly, talking to them over the Internet. The “Bogleheads” web-site at Morningstar is hard to resist.

and our Total Stock Market Fund (3%!) and you’ll clearly see what a difference a benchmark makes. Tax impacts too have been nicely constrained. But if our shareholders move their money around rapidly in less generous markets than these, or heavily withdraw substantial assets in a bear market, the roadblocks to maintaining that excellence will be formidable. Nonetheless, I have not lost all hope for the market-segment index fund, for most of these problems could be solved by the creation of better market-segment indexes—indexes with new definitional concepts that offer less sensitivity to stock substitutions, and therefore lower portfolio turnover—and the imposition of redemption fees to reduce short-term trading in these funds. For those investors who cannot resist the urge—which they probably should resist!—to overweight or underweight one market segment or another, such funds may well provide the most sensible approach. In any event, indexing of all types continues to grow. But much of the growth is coming, not through conventional index funds, but through novel index funds known as ETFs (exchange- traded funds), an acronym that trips from the tongues of almost every industry maven worth his or her reportorial salt, if only of a small subset of market speculators. The assets of these funds, I read in The New York Times last Sunday, totaled $53 billion at mid-year, and they are aggressively promoted. But—make no mistake about it—few of their holders are long-term investors.

At just the wrong time, shareholders had $16 billion invested in the growth index, but only $3½ billion invested in the value index— all too similar to the trends among actively managed growth and value funds. While segment indexing has provided good relative returns, I am confident it can provide even better returns if we design improved indexes, better risk disclosure, and perhaps redemption fees to deter short-term investors. I assure you that I will be thinking long and hard about how to create better segment indexes, and how to avoid their counterproductive use as trading vehicles rather than as investment vehicles. I hope you will do the same.Funds

5) Thou Shalt Compare the Dollar Fees Thy Fund Pays with Those of Competitors. This industry has done a marvelous job at one thing: Placing public focus on fee rates rather than fee dollars. It brags that the cost of mutual fund ownership has fallen from 2.26% to 1.35% of assets since 1980. When the total dollar costs paid by all funds (excluding sales charges) have soared from $800 million in 1980 to $65 billion in 1999, it takes some kind of brass to make that argument. Expense ratio comparisons are fine as far as they go, but they don’t go far enough. It is dollars that fund shareholders pay and dollars that the managers extract. A 1.00% expense ratio may look low—indeed is almost universally acclaimed as low—but on a $25 billion fund, it produces $250 million for the manager every year, $1 billion over four years. Make sure you know how the dollars your fund spends compares with the dollars spent by its peers. 6) Thou Shalt Challenge Thy Fee Consultants. Many fund managers retain fund consultants to provide comparative data to the Board. But like executive compensation consultants, fund consultants know what their job is: To justify existing compensation (fee) levels, and to provide a basis for compensation (fee) increases. “Heaven forbid,” they suggest, “that your (sic) fund should be in the bottom quartile in expense ratio.” But let me assure you that when you’re down there, it’s really good for shareholders. Honest!

The record is clear that, for the overwhelming majority of funds, their best years came when they were small. "Small was beautiful" ... but "nothing fails like success." When funds catch the public fancy-and are vigorously hawked to a public unsuspecting of their potential exposure to the problems of size-their best years are behind them. Unbridled growth should be a warning to any intelligent investor. How many funds should you own? If a single ready-made 65%/stock-35%/bond index fund can meet the needs of many investors and if a pair of stock and bond index funds with a custom-made balance can meet the needs of many more, what is the optimal number of funds for investors who elect to use actively-managed funds? Probably no more than four or five equity funds. Owning too many funds can easily result in a dangerous combination of over-diversification and excessive cost.

This year, the Spiders (SPDRS) are being turned over at an annualized rate of 1415%, and the NASDAQ 100 Qubes at a rate of 5974%: Respective average holding periods: 26 days, and six days. Why not? They are not only being used for short-term goals, but promoted as short-term investments. A full-page advertisement for SPDR index shares in BARRON’S magazine dated September 18, 2000, is headlined: “Buy and sell the S&P 500 just as easily as you trade a single stock.” (Then adding, “with real time pricing, you can trade your position throughout the trading day.”) Yet Sunday’s Times also reported this statement by a SPDRs executive: “Our customers are long-term investors.” (Italics added.) That doesn’t seem consistent with either the facts or the ad. So, lest we forget, I reiterate: There is a critical difference between designing a product to sell to customers and creating an investment to serve its owners. Indexing: Losing its Way?

Using the S&P 500 to Speculate. Why? I now turn to my second concern about the folly of speculation—the perversion of the S&P 500 and total stock market index into uses for which they were never intended. To be clear, I think the ETF is a brilliantly designed product. It can provide virtually complete exposure to the U.S. stock market; it generally operates at a cost fully competitive with the lowest cost regular index funds and so far below the numerous high-cost index funds that have been foisted on unsuspecting investors that it ought to be an embarrassment; and it provides at least the same tax- efficiency as its conventional index fund counterparts. Those are not trivial advantages, and they will serve well those investors who buy them and hold them for the long-pull. But they have been overpowered by one enormous disadvantage. Just like an individual stock, an ETF can be traded all the day long, in real time, and it is obvious that the overwhelming majority of their holders use them for that purpose. During the past year alone, investors have traded $1 trillion (!) in Spiders and the Qubes combined. It is beyond my comprehension how all of this thrashing about in the stock market can possibly serve those investors well. The Spiders were the original ETF, and remain the largest. Their assets now total $25 billion, down from $30 billion last June. About $1.

life. When the fund industry uses information technology to present investors with hypothetical information clothed in the mantle of precision, we mislead them. We would be giving better advice to long-term investors if, instead of offering complex advice that implicitly encourages investors to try to outguess the unguessable and to try to select winning stock funds based on their past returns, we offered a simple, basic asset allocation plan balanced between a stock index fund and a bond index fund. Despite its patent simplicity, such an investment strategy, it seems to me, is the ultimate killer app. (7) A Better Cost Structure? With all of the enhancements in mutual fund operations, communications, services, and infrastructure that have been made possible through technology, its important to ask whether it has made this industry more cost-effective. In short, has our technology initiative made our cost structure better or worse? There is no industry wide data on cost-effectiveness,1 so I can use only Vanguard as my model. The cost of information technology is our largest single cost, last year accounting for some $450 million of our $1.3 billion dollar operating budget—some 40% of the total, vs. 18% a decade earlier. Technology, obviously, doesn’t come cheap! Indeed, our tech expenditure is more than six times the $70 million we spend on marketing, and 15 times the $30 million we spend on the in-house portfolio management of our index, quantitative, and fixed-income funds.

5 billion of their shares are traded each day— an annualized total of nearly $400 billion, for a turnover rate of 1380%. This is hardly your traditional index fund, which (at least in our case) has a total redemption rate of about 20%, about 98% below the turnover of this ETF. Clearly, investors are using Spiders just as the advertisements recommend: “Buy and sell the S&P 500 just as easily as you trade a single stock. . . with real time pricing, you can trade your position throughout the trading day.” To state the obvious, this is a blatant appeal for investors to engage in the folly of speculation, not to the wisdom of investment. Spiders are by no means the least of the ETF problem. The Qubes that replicate the NASDAQ 100 Index win that distinction. In less than two years, the assets of the Qubes have soared from $5 billion to $20 billion. Bear in mind that the technology-stock-driven NASDAQ Index represents a sector of the market so large that at the peak of the bubble its “new economy” market capitalization of $7.2 trillion threatened to exceed the “old economy” market cap of $10.2 trillion of stocks listed on the New York Stock Exchange. (There may be a message in the fact that no ETF invested in the NYSE index has yet been created. But be patient!) On an average day in 2001, $2½ billion of Qubes change hands (much more when markets turn volatile), for an annualized total of nearly $700 billion.behold:

A recent study by Morningstar-to its credit, one of the few publications to systematically take on issues like this one---(;oncluded essentially that owning more than three funds, randomly chosen, didn't reduce risk appreciably. Rule 7. Don't Own Too Many Funds. As shown in this chart, risk remains fairly constant all the way from 3 funds to 30 funds (an unbelievable number!) Note also that owning only a single large blend fund-given its lower risk---(;ould provide a lower standard deviation risk measure than any of the multiple fund portfolios. So could a single all-market index fund. Chart 25 I'm not at all sure what the real point is of owning as many 20 diversified funds in a portfolio (i.e., 5% of assets in each fund), and thus owning, at excessive cost, perhaps 2,000 individual common stocks. Perhaps a simple balanced portfolio with five stock-funds and a bond fund like this one would suit the needs of investors seeking a portfolio that varies from those of the market itself. This portfolio would be somewhat riskier than an all-market balanced index fund-less in large caps, more in small caps, perhaps a specialty fund (in healthcare, or technology, or real estate), and some international stocks. Because of costs, the odds are against its adding value. But it might, provided you select the funds on a rational basis. (These rules I've presented should help.) Chart 26 Nonetheless, don't assume that successfully selecting a portfolio of a limited number of funds is easy.

Whether it is Louis Bachelier speaking, or a group of Nobel Laureates, or Malkiel or even Bogle, now buttressed by the Embedded Alpha paper of Merrill Lynch/BARRA, the mathematics of the markets are eternal. The investment success of investors in the aggregate is defined—not only over the long-term but every single day—by the extent to which market returns are consumed by financial intermediaries. So capitalize on the failures of so many other managers that I’ve laid out before you today, and learn from the simple reasons behind the success of the index fund. Opportunity beckons!

Five expert investment advisers have been picking equity funds for an initial $50,000 model portfolio for The New York Times during the past five years, and not one of them has even come close to matching the record of a low-cost S&P index fund. (The standard chosen by The Times.) The advisers' portfolios provided an annual return of 14.1 %, capturing only 60% of the market return, compared to 23.1 % for the index, capturing 99.5%. The final, astonishing, capital accumulation: $103,000 for managed funds picked by knowledgeable advisers, and $156,000 for merely picking a non-managed fund without any advice at all. Clearly, wisely selecting a winning portfolio of funds, even by persons of intelligence and experience, following sensible policies, is a tough challenge.

These rules are for selecting stock funds. Rules for Bond Funds. They are similar but easier. First, it's up to you to decide on how to balance your income needs against your risk tolerance. Short term bond funds provide stable returns but varying income; in long-term bond funds, variable returns but higher income; intermediate term bonds are in-between. But whatever profile fits your needs, place special emphasis on two things: Low Cost and High Quality. Cost is the single-most important determinant of a bond fund's future standing relative to its peers. What is more, in their struggle to earn competitive returns, high cost funds tend to hold lower quality bonds. For high consistency in returns and low risk, stick to low-cost funds investing in Treasury bonds or high-grade corporate bonds. Take your risks in the stock market, not the bond market. And when you look for this delectable combination of low costs, high quality, and superior performance, there's a good place to begin. Bond Index Funds. They can operate at a minuscule cost of as little as 0.20% annually (compared to all-in costs of 1.25% for the average managed fund), all the while bringing you the benefits of maximum diversification and low risk. Once you decide on your long-term objectives, define your tolerance for risk, and carefully select an index fund or small number of actively managed funds that meet these first seven Rules. Then follow the final rule. Rule 8: Hold Tight. Stay the course.

No matter what, don't select funds as if they were simply individual common stocks, to be discarded and replaced with the inevitable ebb and flow of performance. Select a fund with the same thoughtful consideration you would give to appointing a trustee for your assets and establishing a lifetime relationship. That approach is the very essence of simplicity. In this complex world, if you invest with simplicity, you will be given "the gift to come down where you ought to be." Buy right and hold tight. To the extent you decide indexing is not for you, my eight rules should afford you considerable advantage in the quest for solid long-term returns. However, I fear that you will find a fairly small number of funds that filter through my screens. There ought to be lots and lots more. This industry needs to get its house in order. So demand that funds measure up to your standards. If you make your own investment decisions with common sense and intelligence, the industry will be/orced to change and serve shareholders more efficiently and effectively, reducing costs, risks, turnover, and hyperbole alike. Finally, fund shareholders-you, the owners of the fund-must be served. Even if, or when, that great change comes, however, the low-cost index fund cannot be ignored.

Indexing works so well-in stock funds and bond funds alike--only because most managed funds burdened by excessive costs, promoted based on outlandish claims of performance success, and managed with strategies that call for a short-term focus---don 't work very well. It is for that reason alone that the index fund has proved to be the optimal way "to realize the highest possible portion-albeit slightly less than 1OO%----of the return earned in the market." But it need not be-it should not be-the only way. Indexing, just like politics, "makes strange bedfellows." My own endorsement of index funds can hardly surprise you-after all, 24 years ago I founded the first index fund. But, as you now know, Warren Buffett, the greatest stock picker of our age, shares my view. Three other bedfellows may be even more surprising. One is the founder of the largest mutual fund supermarket casino--designed for actively trading more than 1000 mutual funds, with the emphasis, relentlessly advertised on television, on funds with hot records ... in the past. But his heart belongs to indexing. Heed his words: " ... I'm a firm believer in the power of indexing." As they say here in the Nation's capital: "Follow the money." And that's where his money is.

Another strange bedfellow is "The Motley Fool." "If you've had trouble with your investments, use an index fund," they state categorically: "we don't think there's any other fund out there worth buying." And even active fund managers now accept the reality of the index message. The former CEO of one industry giant recently made light of my comments about the scarcity of funds that beat the index. "People ought to recognize," he said, "that the average fund can never beat the market." To sum up this keynote talk on "Intelligent Investing," I've tried to show you both the value of simplicity as it is reflected in the fundamental principles of investing, in market indexing, and in the rudiments of how to select funds successfully. If you decide to follow these simple approaches, you will have acquired "the gift to be simple" from an investment standpoint, and "the gift to be free" of the cacophony of information and emotion that, seemingly without remission, pounds our minds. And you will, I am confident, then be given "the gift to come down where you ought to be" in your long run financial plans.

stock is not about concepts; not revenue growth, nor price-to-sales, nor site visits, nor eyeballs, nor the growth rate in the exciting early years of a new venture. Whether we’re talking about the New Economy or the Old Economy, the market value of a stock is about money—tomorrow’s earnings capitalized in today’s dollars. Second, don’t make an excessive commitment to any individual stock (especially employer stock) or to technology stocks as a group. If the past year and a half haven’t taught you that lesson, then you either aren’t paying attention, or you are truly brilliant (or lucky!) Technology is a competitive business, changing at exponential speed, and rapid future growth is hardly assured for any company. You should be aware that the technology sector of the market has provided a steady 12% to 16% of the market’s earnings during recent years, meaning that earnings growth has been no more than average. But the tech sector began the decade at 8% of the market’s value, rose to 35% (!) at the market high in March 2000, before tumbling to 15% currently, a figure more in keeping with its earning potential. Even though that relationship looks a lot more like fair value, the tech share of earnings this year is crumbling and its earnings visibility is close to zero. That means very high risk, as well as high return potential. That stock index fund I recommended to you earlier, obviously, also has 15% in technology stocks today.

Acceptance Remarks John C. Bogle 2017 CME Group Melamed-Arditti Innovation Award Naples, Florida November 14, 2017 I’m delighted to share this remarkable Innovation Award with my fellow Scotsman, the quantitative investment pioneer John “Mac” McQuown. I’m especially honored because the CME Group Melamed-Arditti Innovation Award is based, not only on the invention of a financial innovation that has “created significant change to markets, commerce, or trade,” but also on “the practical application of the idea . . . in improving the economic well-being of individuals, an industry, or a nation”—in the public interest. That’s always been the goal of my long career. Surely First Index Investment Trust (the original name of today’s Vanguard 500 Index Fund) was designed to do exactly that. I’m still sort of amazed that it fell to me to create this pioneering index mutual fund way back in 1975. How did it happen? But first, how did it not happen? First Index was not a product of complex algorithms, nor of Modern Portfolio Theory (MPT), nor of the Efficient Markets Hypothesis (EMH). For me, the uneven efficiency of the market makes the EMH an unreliable basis for indexing. Truth told, when I decided to start our index fund, I possessed neither the training nor the talent for applied statistics, and, embarrassingly, I had never even heard of the EMH. Nor was the first index mutual fund a product of the quantitative work done at the University of Chicago and at Wells Fargo.

__________________ Substantial portions of this essay were the basis for a speech delivered to the Morningstar Investment Conference in Chicago, Illinois on April 27, 2017. The opinions expressed in the essay do not necessarily represent the views of Vanguard’s present management. The Road Less Traveled An Essay by John C. Bogle Founder of The Vanguard Group (1974) and Vanguard 500 Index Fund (1975) April 26, 2017 I. The Prophesy Almost 43 years ago, in July 1974, one of the most memorable events of my long career took place. I was in Los Angeles at the headquarters of the American Funds, meeting some of the friends that I had gotten to know during my long service as a governor of the Investment Company Institute, and chairman during 1968-1970. During the day, the late Jon Lovelace, head of the firm, came into the conference room where we were gathered and asked me to meet with him privately. He had some important industry issues that he wanted to discuss. Jon, son of Jonathan Bell Lovelace, founder of the American Funds in 1931, had a high reputation for business integrity, independence of thought, and wisdom, and I was eager to meet with him. Following my visit to his firm, however, I had scheduled a dinner meeting before flying back to Philadelphia on the 7:30 a.m. flight the next morning. “That’s fine,” Jon said, “I’ll meet you at the LAX breakfast room counter at 6 a.m.” When I arrived, Jon was already seated at the counter.

“Surviving Defeat, Surviving Victory”1 By John C. Bogle When I was paid the high honor of being inducted into the FIASI Hall of Fame on November 10, 1999, I spoke about the triumph of indexing—the investment strategy based on passively-managed funds designed to track, at rock-bottom cost, the returns earned by broad market indexes of stocks and bonds, and to be held forever—a long-term investor’s entire investment lifetime. Then, I mentioned the struggle to survive the early defeat of the world’s first index mutual fund, founded in 1975. (Now known as Vanguard 500 Index Fund, tracking the returns of the S&P 500 Stock Index.) Before exploding upward in the late 1990s, our acceptance grew at a glacial pace. Similarly, our early municipal bond funds, first offered in 1977, were also slow to gain investor favor. But, defeated at the outset, both would survive, and then prosper. Patience! In my 1999 acceptance speech, I also expressed my concerns about the high growth rates and burgeoning assets that the Vanguard family of stock and bond funds were experiencing—then nearly $100 billion, now closing in on $5 trillion. Vanguard’s remarkable growth has been driven by our index funds, now numbering 59 stock funds, 18 bond funds, and 61 balanced funds (largely our target-date retirement funds-of-funds, a field in which our market share exceeds one-third). So I also wondered if we could survive victory.

Indeed, when I later read the Chicago version of the origin of the index fund, I realized that I had then never heard of a single one of those star-studded names that graced the Chicago article at the time I created First Index. Mac McQuown, Jim Vertin, Bill Fouse, Fisher Black, Harry Markowitz, Eugene Fama, Dean LeBaron, Jim Lorie, Merton Miller, Myron Scholes, and Bill Sharpe . . . surely a “who’s who” is of the biggest names in the financial academy. This 1951 graduate of Princeton University with a mere A.B. degree was, in a word, ignorant of what was going on in the academy. No, the genesis of First Index was casual and intuitive. Short version, according to Jan Twardowski, Princeton B.S.E.E. degree and recently-minted Wharton M.B.A.28

institutional investors—first mutual funds, then pension funds, then thrift plans—began to grow, and grow rapidly. In 1945, these institutions owned only 8% of all publicly-held stocks. By 1962, 18%. By 1982, 50%. Today, institutional holdings of stocks stand at an estimated 73%. It’s hard to imagine a change more sweeping than this change in the ownership of corporate America . . . well, maybe the index fund! The Double-Agency Society The Berle-Means model no longer explains how our modern corporations are governed. What has emerged instead is a “double-agency” society in which corporate agents (as a practical matter, CEOs) who are duty-bound to represent their shareholders face money-manager agents who are themselves duty-bound to represent their mutual fund shareholders and their other clients, often pension funds.

original crew members of our tiny, shiny new firm named Vanguard. I’ll let Jan tell the story of what happened in mid-1975: “One day you surprised me by asking if I could run an index fund and after a couple days research I said yes . . . I wrote the index fund programs in APL on a time-sharing system, using simple cap-weighting algorithms and public databases. It was, frankly, easy, although I was quite nervous when you sold the idea to underwriters and the road show began. Actual money was going to be managed based on my little set of APL programs!” There was, of course, much more to the story than that simple anecdote.1 So let me take you through a brief time line of the confluence of events and circumstances that made my timing and my 1975 decision almost inevitable: 1. March 1951. The Thesis. I handed in my Princeton thesis focused on the then-tiny ($2 ½ billion) mutual fund industry, which was entitled “The Economic Role of the Investment Company.” After a skimpy statistical analysis, largely anecdotal, I concluded that mutual funds “could make no claim to superiority over the market indexes.” In mid-1975, as I prepared to recommend the formation of the first index fund to the Vanguard directors, I recalled those words. 2. 1960-January 1974. The Learning Experience. Through my experience on the Wellington Fund Investment Committee, I learned first-hand how tough it is to find portfolio managers who could consistently distinguish themselves.

Indexing, Costs, and Consumerism It is this combination of strategy and structure that has paved the way to Vanguard’s leadership: 80% of the assets of traditional index funds (TIFs)—largely based on buying and holding broad market, low-cost stock and bond indexes such as the S&P 500—and 30% of the assets of ETFs—largely based on active trading of both broad market indexes and narrow market segments, and often appealing to investors who wish to speculate. Combining both TIFs and ETFs, Vanguard holds a dominant 50% share of the U.S. index fund market.

” Call it creative destruction. Call it disruptive innovation. Call it luck. (Good luck for Vanguard; not such good luck for our peers.) But more than anything else, call it good karma. For surely fate would have eventually awakened the investment world to this fundamental truth: before intermediation costs are deducted, the returns earned by equity investors as a group precisely equal the returns of the stock market itself. After those costs, therefore, investors earn lower-than-market returns. Fact: The only way to maximize the share of the financial market returns earned by the 100 million families whom the fund industry serves is by minimizing the costs borne by fund shareholders. I’ll soon celebrate my 66th anniversary in this wonderful business, beginning when I joined Wellington Fund in July 1951. I decided to mark the occasion of my (I think) unprecedented record of service in the fund industry by offering a brief history of how I came to found Vanguard and First Index Investment Trust (now Vanguard 500 Index Fund). The world of investing knows too little of this history and of the revolution that, decades later, would follow.

Strategy and structure have also made Vanguard a hero to Main Street. The letters I get from shareholders almost every day say exactly that. But Vanguard is an anti-hero—dare I say “villain”? —to Wall Street. Our distinction—focusing on serving clients, rather than supplying “products” to intermediaries—is the foundation upon which Vanguard has been built. For investors as a group, lower costs lead to higher capture of whatever returns the stock market gives us, or—let us not forget—takes away from us. There is no rational argument against this tautology. Therein lies the reason that the low-cost, buy-and-hold index revolution is here to stay. Indexing is not a fad; it is not a fashion; it is a fact of life, indeed of elemental arithmetic. Placing the interests of Main Street investors ahead of the interests of Wall Street intermediaries is simply a reflection of the fundamental economic principle enunciated by Adam Smith in the Wealth of Nations in 1776. Paraphrasing: “The producer’s sole duty is to serve the consumer.” Of course it is! That principle is universal; investing other people’s money is no exception. Past Returns, Future Returns The failure of active fund managers in the strong bull market we have enjoyed (on balance!) since 1982 was well concealed by the fact that few fund investors seemed disappointed in their returns. Of course!

Few, if any, industry leaders contemplated this outcome. They were bound by “presentism.” In a recent issue of The New Yorker, essayist Adam Gopnik tells us that, “of all our prejudices, the strongest is presentism . . . the assumption that what is happening now is going to keep on happening, without anything happening to stop it.” Surely that assumption was held by mutual fund industry leaders (except Jon Lovelace!), who paid no attention to this new fund complex with its new name and a new structure, at once both ridiculous and logical. These leaders tacitly assumed that the existing fund framework would keep on happening. That was a big mistake. The industry thought that a truly mutual structure was not even worth acknowledging. Even 43 years later, it has yet to be copied. And our peers snickered at the index investment strategy that the mutual structure facilitated, even demanded. One leader said, “The great mass of investors aren’t going to be satisfied with average returns. The name of the game is to be the best.” Another asked, “Who wants to be operated on by an average surgeon?” And a popular poster on Wall Street declared, “Help Stamp Out Index Funds! Index Funds are Un-American.” The indexing idea was so absurd that it took until 1988— 13 years later—before the first (and pretty much the last) of the industry’s “Old Guard” reluctantly joined the embryonic index fund movement. III.

S&P 500 Index). Indexing would prove to be the apotheosis of that “democratic ideal” of which Baltzell spoke earlier, the democratization of investing for our nation’s average citizen investor. But it didn’t happen in Boston. It would make Vanguard the dominant firm in the fund industry by an unprecedented margin. Vanguard’s novel structure (mutuality and low cost) and pioneering strategy (indexing) were essentially the tools that moved the mutual fund industry’s “Big Money” from Puritan Boston to Quaker Philadelphia. In retrospect, I have come to realize that my design for Vanguard reflects many of the basic Quaker values that William Penn fostered—simplicity, economy thrift, efficiency, service to others, and the conviction, in the words of George Fox, that “the truth is the way.” (I confess that I’m not so strong on some of the other Quaker values, in particular, consensus, patience, silence, and humility.) I take comfort in the fact that Benjamin Franklin too, struggled to balance his pride with humility. Here’s what he wrote in his autobiography: In reality, there is, perhaps, no one of our natural passions so hard to subdue as pride. Disguise it, struggle with it, beat it down, stifle it, mortify it as much as one pleases, it is still alive, and will every now and then peep out and show itself. . . . Even if I could conceive that I had completely overcome it, I should probably be proud of my humility.

administrative, investment management, and share distribution services, basically terminating the funds’ relationship with Wellington Management. That was a bridge too far for the Board, but they authorized me to provide a study of the options available to them.2 5. September 24, 1974. Vanguard Is Founded. The options that I presented to the Board ranged from the Funds’ acquisition of Wellington Management (my first choice) to having the Funds assume responsibilities for their own administration but retain Wellington Management for their investment management and share distribution (my last choice). They voted for that last choice. But it was better than nothing, and 43 years ago Vanguard—the name that I had chosen— was founded as a truly mutual mutual fund organization, designed to serve its shareholders. Part of our strategy focused on minimizing the management fees paid to our advisers. Now, an index fund would give me the opportunity to start a fund with no management fees. This confluence of opportunity and motive may well be the most powerful single force undergirding innovation. 6. October 10, 1974. “Challenge to Judgement.” That’s when I read Paul Samuelson’s article in the very first issue of the Journal of Portfolio Management. What a coincidence! I felt as if he had written it directly to me. Dr. Samuelson sought “brute evidence” that any mutual fund manager could consistently outpace the S&P 500 Index, but found none.

The S&P 500 Index Fund earned an annual return of 12% per year, a 51-times increase; the annual return of the average large-cap blend fund was 10% per year, an increase of “only” 30 times. But investors in mutual funds looked at their wonderful absolute returns, and disregarded (or were not even aware of) their terrible relative returns. Indeed, they likely applauded their money managers. There is little, if any, chance that 12% annual return on stocks during the era that we have witnessed (or at least heard about) is going to recur during the coming decade. Why? Because as John Maynard Keynes warned us long ago, “It is dangerous . . . to apply to the future inductive arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was.” So let’s look to the sources of stock returns to create rational expectations for the coming decade. What were those sources of that 12% annual return of the S&P 500 on stocks since 1982? A 3.3% dividend yield and 5.4% annual earnings growth, for an Investment Return of 8.7%.that

He demanded, in effect, that someone, somewhere start an index fund based on the S&P 500. That bolt from the blue set my 1951 idea on the road to reality. 7. September 27, 1975, Morning. Friendly Persuasion. Given Paul Samuelson’s unquestioned credibility, I marked his essay “Exhibit A” in my presentation to the board. The next presentation was my own statistical study showing the average annual return of equity mutual funds compared to the S&P 500 over the previous 30 years ending in mid-1975, which I calculated on a Monroe mechanical calculator. Result: S&P 500 annual edge, 1.6%.3 8. September 27, 1975, Afternoon. The Index Fund Is Born. To resolve that unpleasant political struggle, the newly formed Vanguard was barred by its Board from providing investment management services to our mutual funds. That door was closed to us. But the index fund allowed me to open a window: “This fund is not managed,” I told the Board. Result: the unanimous approval of the Vanguard Board to form the world’s first index mutual fund. (Again, “you can’t make this stuff up.”) 2 The Board was closely divided, and the directors were anything but aligned in their views. Were it not for the leadership of the late Charles D. Root, Jr., chairman of the independent director group, the events that followed would never have taken place. 3 Factoid: I repeated the study for my paper published in the January/February 2016 issue of The Financial Analysts Journal for the 30 years ending 2015: S&P edge, 1.6%.

The Opportunity to Speak Now is the time that I’ve chosen to speak out on the fund industry today. But this is not a victory lap. I‘ve been around too long to take victory laps before the game is over. Nor is it a valedictory. I’ve got much more to accomplish in my life and in my career. It begins with the saga of the improbable creation of Vanguard, the firm I founded almost by accident, and the even less probable creation of the index fund. I’ll then describe how Vanguard became a colossus, the most dominant firm in the history of the mutual fund industry—$4 trillion in assets, 23% market share of assets, an incredible $304 billion in 2016 cash flows (an unprecedented 171% of industry cash flows), and of course in costs. Asset-weighted, an expense ratio of just 12 basis points—the industry’s lowest-cost provider. As Psalm 118 tells us: The stone that the builders rejected has become the chief cornerstone. Next I’ll discuss two business strategies that today’s active fund managers might adopt to respond to the new environment, now dominated by index funds.starkly

rose from 7.8 times to 26.5 times (Wow!), an annual Speculative Return of 3.4%. Total Return on stocks 12.1%. (Chart 3) That was yesterday. Tomorrow is a different matter. Today, the dividend yield is 2.0%. Guessing at earnings growth, I use a lower figure, 4.0%. Investment return, 6.0%. Were the P/E declined to 19 times (just a guess, but a reasonable one), the annual speculative return would be -2%. Total stock market return 4%.1 Investment Costs Become Even More Important It must be obvious that if future returns on stocks fall well below the extraordinary returns of the Great Bull Market, fund expenses will take an even larger chunk out of returns. In that 12% stock market era, 2% expenses consumed “only” one-sixth of the annual return, although the net cumulative return would have dropped from 5180% to 2710%. In a 4% annual stock market, 2% expenses would consume fully one-half of the annual return, reducing the cumulative return from 295% to 100%. As expenses take on such a dominant role in shaping returns, the index fund cost advantage will become even more obvious. Individual investors who look to the past to tell them about the future are foolish at best. They are courting disappointment, and, given the likelihood of lower returns on stocks, will likely be ill-served if they haven’t revised upwards the amounts they are saving each month. (If returns are higher than I suspect, they’ll simply have built a larger nest-egg.) 1 Feel free to disagree.

Pension funds that fail to take into account lower future returns are courting not merely disappointment, but disaster. Pension plans—public and private alike—are now facing a $1.5 trillion deficit, assuming future returns of 7 ½% per year. In an environment of 4% gross returns on stocks, 3% gross returns on bonds, and even (generously!) 8% gross returns on alternative investments. 7 ½% looks impossible, especially when investment costs are taken into account. Even a 5% net return after costs for pension funds looks like a stretch. Here, the word “crisis” seems appropriate. Challenges to Traditional Indexing The index revolution, like all revolutions—is not without its flaws. The most recent flaw is the focus on the concept of “Smart Beta”—replacing market-cap-weighted portfolios by portfolios weighted by so-called “fundamental” factors: dividends, earnings, book values, assets, etc. As a concept, Smart Beta is not a terrible idea . . . nor is it a world-changing one. But it suffers from the assumption that past data, heavily mined, will identify factors that will provide sustainable performance leadership. Mark me as from Missouri on that one. It ignores the principle of reversion to the mean (RTM) in stock returns, market returns, and mutual fund returns. That’s a huge mistake. Once again (remember the “Go-Go” fund craze of 1965-1968 and the “Nifty Fifty” craze of 1970- 1973?)

9. August 31, 1976. The IPO. First Index was off to a bad—near-fatal—start. The initial public offering, led by Wall Street’s four largest retail brokers, was planned for $250 million. It produced $11.3 million, an abject failure. One of the Wall Street managers of that IPO recently asked: “How is it possible that the worst underwriting in Wall Street history became the greatest innovation in modern finance?” Answer: “It’s a long story.” Afterword The poster announcing this CME award for innovation shows photos of me and Mac McQuown—my friend and enormously deserving co-recipient of this award—with the title of this conference: “Taking the Long View and Never Looking Back.” But looking back, as I have done this afternoon, reminds us how fragile the path to an innovation can be, and yet somehow, against all odds, can result in an index fund, and ultimately an Index Revolution. Surely such a tortuous path to success— one that included a university thesis, a catastrophic merger, a firing, a journal article, a novel corporate structure, a fortuitous (perhaps even disingenuous) reading of an agreement, and yes, an unshakable determination—is an extreme example of what it took to turn a great idea into a reality that changed an industry and served investors. That 1976 First Index mutual fund, with its pathetic $11 million in assets, struggled to gain traction. It didn’t attract its first mutual fund competitor until 1984 (Wells Fargo).

, popular fads are driving “product” creation in the fund industry—great for fund sponsors, awful for fund investors. Let me remind you of this time-honored principle: successful short-term marketing strategies are rarely—if ever—optimal long-term investment strategies. Recent experience with “Smart Beta” funds provides a classic example of the pitfalls faced by investors who create strategies through data mining. Renamed “Strategic Beta” by Morningstar, this category has boomed, even though the pioneering RAFI 1000 fund—formed a decade ago—has demonstrated only that its risk-adjusted return and its Sharpe Ratio both lag the S&P 500. Otherwise, it looks more like a closet index fund, with an R2 of 0.97 relative to the S&P 500. Yet the assets of these strategic beta funds have ballooned—from $100 billion in 2006 to $810 billion currently.despite

I believed—as any champion of the index fund must believe—that such a flawed premise was nonsense. Where were these experts who could successfully time the bond market? So Vanguard took a different approach. We formed a series of three separate “defined maturity” bond funds—long-term, intermediate-term, and short-term. Each would hold to their particular mandate. With each series focused, not on shifting maturities but on credit quality, investors could decide for themselves what combination of risk and yield would best meet their financial goals.those

the sharp lag in the returns of value funds (Chart 4). In 2016, value stocks rose 16.9% while growth stocks rose only 6.2%. So far in 2017, growth stocks are up 12.2% and value stocks are up but 3.3%. Remember RTM? The Role of the Professional In this new era where indexing is already such a powerful force, what is our role as investment professionals in financial analysis, stock selection, and helping our clients implement their investment programs? In the most recent issue of the Financial Analysts Journal, you’ll find my essay entitled “Balancing Professional Values and Business Values.” In that essay, I cite the ideas of Adam Smith and Benjamin Graham, as well as some of the characteristics and attitudes that I have done my best to help investors develop. I commend this paper to investment professionals in general, and to CFA charterholders in particular. An Investment Lifetime We have moved a long way from a past in which information was precious and where “customers men’” made a (nice) living by trading stocks for wealthy investors; where data on investment returns—absolute and relative—were scarce; where “professional management” was assumed to add value; where no index fund existed to establish the benchmark; where little thought was given to retirement planning. It’s all so different today, and it’s our duty as investment professionals to respond to this new environment. In the coming era, what considerations should investment professionals emphasize?out:

It now seems clear that the pioneering creation of that First Index mutual fund in 1975 provided the spark that ignited the index revolution. And it seems reasonable to conclude that my two best-selling books, both focused on index funds—Bogle on Mutual Funds: New Perspectives for the Intelligent Investor (1994) and The Little Book of Common Sense Investing (2007), together with a total of 500,000 sales, and read by an estimated 1.5 million readers, played a major role in fueling the extraordinary revolution that followed. It continues to this day. I’m proud to be counted as one of the principal pioneers of that revolution. Thank you again for the high honor that you have bestowed upon me today, and the privilege of sharing it with fellow pioneer Mac McQuown. * * * PERSONAL NOTE: My relationship with the remarkable Dr. Samuelson began with his Journal of Portfolio Management article, and was reinforced by his Newsweek column of August 16, 1976, “Index Fund Investing.” We met several times thereafter and became a “mutual admiration society” of two. When, in 1993, I asked him to endorse my first book Bogle on Mutual Funds, he graciously turned me down . . . but he quickly offered to write the foreword, and I accepted his offer with surprise and delight. In his foreword, he credited me with having “changed a basic industry in an optimal direction.” On November 15, 2005, Dr.

The idea of splitting the two jobs—the fund role, traditionally titular in nature; the management company job, holding the implicit power to control the funds—seemed sort of, well, weird. But to me, the concept of putting the fund directors—and thus the shareholders to whom they are responsible—in the driver’s seat was a far more rational structure for mutual fund governance than the traditional convoluted structure. We called it “the Vanguard Experiment” in mutual fund governance. By eliminating the profits to an outside firm, Vanguard would quickly become the low-cost provider in an industry where costs are (almost) everything, and where—except for the highly cost- competitive index fund segment—our peers have little interest in competing on costs. (It’s bad for management company profits!) The mutual “at cost” structure would put the fund clients first. A declaration of independence of the funds from their investment adviser. This solution appealed to my logic, my contrarian streak, my determination, and my idealism. But in addition to those (I think) noble motives, I had a less noble motive: I wanted to survive. I wanted to continue my then 23-year career in this wonderful industry.may

who were seeking a higher yield and were willing to assume the higher price volatility that inevitably accompanies it, the long portfolio, and so on. Changing the Standard for Bond Funds This solution gave Vanguard a large competitive edge. For sorting the funds into three maturities muted much of the “noise” in the performance of “managed” municipal bonds. With comparative performance of the funds sorted by maturities, the lowest-cost funds would be almost sure to win, and Vanguard was already the fund industry’s lowest-cost provider of bond funds. Over time, investors’ perceptions of bond funds changed. The three-tier (or more!) approach became the industry standard—not only in municipal bond funds, but in taxable bond funds as well. Today, with $150 billion of assets, Vanguard’s tax-exempt and taxable bond funds are the collection of bond funds largest in the industry. (Exhibit 6) Six Vanguard muni funds are ranked among the industry’s ten largest. Our taxable bond funds also adopted a similar defined maturity strategy, with assets that now total $836 billion. Three Vanguard funds made the list of the top ten taxable bond funds. Our Total Bond Market Index Fund, with assets of $328 billion, is a mere $229 billion larger than the #2 fund with assets of $99 billion. In all, bond investments under the Vanguard mantle now total just short of $1.1 trillion (See Appendix I), including some $260 billion our balanced funds, LifeStrategy Funds, and Target Retirement Funds.

Yes, this new focus will change our profession, but business values must still be balanced with fiduciary values. Strong ethics and professional competence must still be the bulwark of finance. We must develop a keener awareness of how our financial system works, a profound introspection about how we can make it better, a knowledge of the long history of finance, and a deep involvement in fostering in our profession the high character it requires if we are to serve investors effectively, efficiently, honestly, and prudently in the years ahead. Balancing Business Values and Professional Values I hope you will read my impassioned paper on business values and professional values in the most recent edition of the Financial Analyst Journal, and will consider my perspective. I’ve plied my trade of investing for almost 66 years, and I’ve seen so many of my principles find acceptance—not just on indexing, on the importance of low costs, and on short-term speculation vs. long-term investment, but on investment standards, ethics, and fiduciary duty. Of course I’m pleased to have been alive long enough to see the growing acceptance of these ideas. But we still have far to go— “The trees I planted still are young.” “The songs I sing will still be sung.” I suppose it’s ironic that I close my remarks to this distinguished audience of investment professionals with the word “cash.” But those words are the words of Johnny Cash. Take heed. Thank you.

well have been my only chance to do so, and I appealed to the board of directors of the Wellington funds depart from their normal presentism mindset and take this drastic step. It would not be easy. The structure that I proposed quickly led to a bitter fight—the fired CEO vs. those who had fired him. The outcome was in doubt until the battle ended, six months after it began. The new firm had perhaps one chance out of ten to survive. But finally, Vanguard was born. In 1975, we made our first strategic move—to create an index fund. While all of our peers had the opportunity to create the first index fund, only Vanguard, with our unique mutual structure, had not only the opportunity, but the motive. The seed of the idea of the index fund was planted in my 1951 senior thesis (remember, funds “can make no claim to superiority over the market [indexes]”). The foundation of our philosophy was my first-hand experience in trying but failing to select winning managers. And a timely and fortuitous inspiration from Nobel Laureate Paul Samuelson then precipitated the creation of the first index mutual fund. Dr. Samuelson’s essay, “Challenge to Judgment,” was published in the first edition of the Journal of Portfolio Management in the fall of 1974. It struck me like a bolt of lightning. By happy coincidence, I read his essay just as the stock market hit bottom and moments after Vanguard was founded.

His credibility was a vital factor in my ability to persuade Vanguard’s board to approve of the creation of the world’s first index mutual fund. Once considered unthinkable, indexing has triumphed, and active managers will have to either join the index revolution and/or expand their range of investment options by developing new active investment strategies. Or do nothing. Whatever the case, active fund management is not going to vanish from the earth. But to think that change stops here would seem like rank presentism. Recent data from Standard & Poor’s reaffirms the tough job facing active managers. For the first time, S&P SPIVA (“Index Versus Active”) produced comparative data for the past 15 years on a broad matrix of funds. S&P calculated the percentage of funds in each category that were outperformed by their relevant market index.funds:

The leader of our new Fixed Income Group was Ian MacKinnon, who put together a team of about six professionals plus a small administrative staff. When we began to manage our municipal bond and money market funds, then combined assets came to about $1.75 billion. As our assets have grown, so has our staff, both in number and in professional skill. Greg Davis led the Fixed Income Group for 3 years until he was named Vanguard’s Chief Investment Officer in July 2017. He was succeeded by John Hollyer, a 28-year Vanguard veteran and a solid bond professional, formerly in charge of Vanguard’s risk management efforts. At present, our Fixed Income Group includes more than 140 professionals, including 62 CFA charterholers, with global offices in Valley Forge, PA; Scottsdale, AZ; London; and Melbourne, Australia. Dare I say that the sun never sets on the Vanguard bond empire? An Index Fund for Bonds The internalization of fixed income asset management in 1981set the stage for Vanguard’s rise to dominance among bond fund managers. But the climactic change was still to come: the creation of the bond index fund. As 1986 came to a close, given the decade-long success of our stock index fund in tracking the returns of the S&P 500 Index, I decided to create a bond index fund, Vanguard Total Bond Market Index Fund. (The SEC staff objected to the name, “Vanguard Bond Index Fund.”) The new bond fund opened its doors to investors on December 11, 1986.

Since then, Wellington has been a remarkably consistent performance leader over its balanced fund peers, largely because of its consistent one-to-two-percentage-point expense ratio advantage and its low portfolio turnover. Vanguard Wellington Fund has regained its rank as one of the nation’s two largest balanced funds. I also selected the managers for the new active funds that we would form. Vanguard’s success in active management continues to this day. With a strong tailwind of low costs, in 2016 Vanguard ranked #1 in cash flow among actively-managed stock and bond mutual funds.

Slow to grow at first, its assets topped the $100 million mark in 1989 and the $1 billion mark in 1995. With current assets of $380 billion, Total Bond Market is now, far and away, the world’s largest bond fund.3 2 We had arguably “broken the ice” in acting as an investment adviser to mutual funds in 1975 when we created Vanguard S&P 500 Index Fund in 1975. Or not. 3 There are actually two such Vanguard funds, with substantially identical portfolios.

The addition of the bond index fund to Vanguard’s internally-managed asset base was followed by our creation of major additions to our menu of bond funds: three Admiral (lowest-cost) U.S. Treasury funds in 1991; the Intermediate-Term Investment-Grade (taxable) Bond fund in 1993; and Short-Term, Intermediate-Term, and Long-Term Bond Index Funds in 1994. This new wave of funds grew slowly but surely, with aggregate assets of $140 billion in October 2017. Industry Leadership Together, the combination of the bond market index fund and its defined-maturity cousins (and, of course, our rock-bottom costs) brought Vanguard to its leadership in the bond fund arena. (Exhibit 7) From a mere 4% of bond mutual fund assets three decades ago to 13% in 2005, to 23% today. Today, industry leadership is highly concentrated. The six largest bond fund sponsors (Exhibit 8) oversee a dominant 50% share of total assets of bond funds of all types. Vanguard’s bond fund assets are more than two-and-one-half times the $390 billion of our next largest peer.

During the past two decades, index funds have created a revolution, one in which the interests of our citizen/investors (“Main Street”) are increasingly taking priority over the interests of money managers, brokers, marketers, and financial buccaneers (“Wall Street”). But—mark my words—it is the traditional index fund that will remain the prime mover in the revolution in the field of corporate governance that is now emerging. Yes, it’s taken a long time. But remember that the impact of the first index fund on the world of finance also took a long time. That index fund (“Bogle’s Folly”) was the subject of sarcastic jokes and skepticism. Fully two decades (1975-1995) passed before index funds began to gain traction. Yet today index funds hold some 41% of the assets of all U.S.mutual

funds, on the way to topping 50%. Indexing is an idea whose time has finally come, a disruptive innovation that places the interests of investors ahead of the interests of fund managers. Early Signs of Progress We have a long way to go before corporate governance participation by active money managers and passive index funds reaches full fruition. But the tide is moving strongly in that direction. One encouraging sign is the “Commonsense Corporate Governance Principles,” an open letter from a group of major institutional managers that calls for a focus on “long-term value creation.” Its set of governance principles was developed by a group of giant index fund managers (Vanguard, BlackRock, and State Street) and active money managers with a strong tendency to invest for the long term (including American Funds and T. Rowe Price). Another encouraging sign of greater participation in corporate governance (especially to yours truly!) is the evolution of Vanguard, now the world’s largest index fund manager ($3 trillion) and second largest money manager ($4.5 trillion). The turnaround in the firm’s philosophy has been dramatic. In 2003, Vanguard joined Fidelity in a major public statement opposing even the disclosure of its proxy votes at corporate annual meetings. But by 2012, Vanguard was actively engaging with the managers of its portfolio holdings. Then in 2017, Vanguard came full circle, providing its first formal annual report on “Investment Stewardship.

Our huge expense ratio advantage accounts for much of Vanguard’s success. (Exhibit 9) The expense ratios of Vanguard’s bond funds are some 40% below our closest competitor (0.27%) and 80%(!) below the industry norm of 0.87%. Bond index funds account for 61% of Vanguard’s bond assets, and some 72% of Vanguard’s taxable bond fund assets, with our actively managed bond funds accounting for but 28%. In reality, “actively-managed” is somewhat of a misnomer, since the firm’s defined-maturity municipal funds, held to rather precise maturity standards and closely tracking comparable muni indexes, represent about one- third of the “active” total. Perhaps “virtual index funds” would be the more appropriate term form them.

to do nothing, at least in the foreseeable future. These large firms also have the resources to pursue other lines of business beyond investment management, although I don’t see how that strategy could create value for their mutual fund shareholders. They may try to offer new active funds; they may (with great reluctance) put a toe into the traditional index-fund water. But there’s little point in cutting their management fees, for minimal cuts won’t help. (What’s the point of cutting your fees, say, in half from 100 to 50 basis points when index funds cost as little as 4 basis points?) Severe fee cuts would decimate profits—resulting in sharp compensation cuts for insiders that would be hard to tolerate, and for firms with minority public shareholders, a slap in the face for investors who have become used to powerful profit growth. (I continue to have grave reservations about public ownership of fund managers.) Boring as that “do-nothing” strategy might seem, it is far more likely to preserve the profits of managers than slashing fees, or more aggressive marketing, or jumping (likely fruitlessly) on the bandwagon of low-cost traditional indexing. But some of these firms may wish to launch ETFs to capitalize on the popularity of passive indexing by active investors. That might help to maintain their profitability—albeit at far lower profit margins than traditional active funds.

Vanguard’s dominant share of bond fund assets—and the concentration of assets in bond index funds—tells us what has happened in the bond fund marketplace, but it doesn’t tell us exactly why it has happened. Two reasons stand out: One, our remarkably higher yields, so critical for bond investors today, driven largely by our huge expense ratio advantage. Two, the absence of sales loads on our funds, making them far more attractive to individual bond fund buyers and corporate thrift plans, whose administrators have no interest in incurring the unnecessary drag of sales loads. Small wonder, then, that index funds are gradually winning the battle for investor assets in the bond fund arena. While the $1 trillion invested in bond index funds represents a 23% share of all bond fund assets—lower than the 41% presently in stock index funds—that figure seems destined to grow. Since 2011, cash flows into bond index funds have totaled $802 billion, fully 38% of the total flows of $2.1 trillion into bond funds. High Fees, High Loads, and “Compromises” Given the critical advantage of rock-bottom expenses, (relatively) low portfolio turnover, and superior expected risk-adjusted returns, it’s a small wonder that bond index funds are becoming a significant and growing factor in the bond fund marketplace. First, consider fund expense ratios (annual expenses as percentage of fund assets) for bond index funds vs. actively-managed bond funds.

Opportunistic marketers might develop a niche strategy, inducing narrowly focused ETFs (think lithium ion battery producers, or Israeli tech firms) and hope that they attracts assets. Another strategy might be to translate a quantitative, rules-based active strategy into a proprietary index and sell an ETF that tracks it. This sort of strategy is often referred to as “Smart Beta,” really an actively managed wolf in an index fund sheep’s clothing. Mark me down as dubious as to their long-term staying power. Offering narrow, even speculative ETFs could well be the optimal short-term marketing strategy for attracting cash inflows and generating trading commissions. But it is unlikely to be the optimal long-term investing strategy. For the fund managers owned and controlled by financial conglomerates (including banks), I believe a totally different strategy will emerge. Using the terminology of The Boston Consulting Group, maintain your fund business as the “cash cow” that it is today—delivering high margins and generous profits, albeit likely at a declining rate. Don’t invest more capital. Don’t cut management fees. Nominal cuts won’t help, and severe cuts would eliminate those cash flows. While fund cash outflows are highly likely to continue, a sharply rising stock market, however unlikely, would help offset the outflows, slowing the declines in assets under management, fee revenues, and profits.strategy,

4 Not merely the yield differential itself, but the huge percentage of portfolio yields that is confiscated by the expenses borne by investors in actively managed funds. Let’s examine these differences in three bond categories. In active corporate bond funds (Exhibit 10), the average fund’s gross yield of 3.05% comes with expenses of 0.78%, consuming 26% of the yield and leaving an actual net yield of 2.26%. Compare that outcome with the corporate bond index fund: gross yield 3.22%, expense ratio 0.07%, income consumed just 2%. Net yield 3.15%, 35%(!) higher than the active fund. Similarly, actively managed government bond funds consume 32% of income vs. 3% for the low-cost funds. For active munis, 37% consumed vs. 5% for the low-cost funds. 4 Vanguard’s actively managed bond funds carry expense ratios much lower than the industry average—even those that are managed by outside managers. For example, the GNMA Fund, with $25 billion in assets, is managed by Wellington Management Company for an advisory fee of a mere 0.01%. Its asset-weighted expense ratio is only 0.14%.

these conglomerates will have a perfectly good business rationale, but I’m guessing that many of their mutual fund subsidiaries will ultimately be sold at bargain prices or merged with other similarly-situated firms. As we consider today’s index fund tsunami, it’s critical to understand its two distinct components, a distinction largely ignored by the industry and the media. One component is the ETF—the exchange traded fund—enabling investors to trade a seemingly infinite variety of index funds using almost 2000 different indexes, often tailor-made by their sponsors. As the original ETF advertisements said, “now you can trade the S&P 500 Index all day long, in real time.” (I’m compelled to point out that broad market ETFs are fine, as long as you don’t trade them.) ETFs are also a key ingredient in the growth of robo- advisors, which are bringing down the costs of advice for investors. The other component is the TIF, the acronym that I’m struggling to establish (so far without much success) for the traditional index fund, essentially a low-cost, broad market index fund designed to be bought and then held forever. That first S&P 500 Index fund that I created way back in 1975 was (and is) a TIF. When the late Nathan Most, creator of the ETF, offered Vanguard the opportunity to join forces with him by making our TIF available in ETF form, I declined his offer without hesitation.

I stood on the principle that trading mutual funds is ultimately a loser’s game, and that our 500 Index Fund was designed for long-term investors. I have nary a regret about my decision. Yet without its own acronym, our data collectors have largely turned “a blind eye” (as Lord Nelson did at Copenhagen) to TIFs. As 2017 begins, TIF assets—$2.5 trillion—are identical to the ETF total. In fact, TIFs have grown at a slightly faster rate than their tradeable cousins since 2011. (Both TIFs and ETFs have grown at about 18% annually.) I expect both kinds of index funds to continue to grow, eventually at a much slower rate, and for very different reasons. But I concede that challenged active managers are most likely to go the ETF route. Good news for active managers. Presentism leads us to assume that today’s powerful dominance of index funds will continue indefinitely. But as Herb Stein, Chairman of President Nixon’s Council of Economic Advisers, pointed out, “If something cannot go on forever, it will stop.” But will index fund dominance fade? Or will it grow? Will it end? When? Only time will tell.

Note that the confiscation of income is as high as 60% for the 529 C class. Also note that some of the convoluted mathematics involved in deciding which of the 16(!) classes the broker will offer clients from a single sponsor of the same fund with such different costs. Some classes have front-end loads, some have deferred loads, 11(!) have hidden loads paid by the investor in the form of 12b-1 fees for fund distribution. As a result, the net dividend yields received by investors in the 16 classes vary—in this case, from a low of 1% for the 529 C class to high of 2.16% for R6 class of this intermediate-term bond fund. Since the gross (pre-expense) yield of this fund was 2.4%—43% of the yield has been effectively confiscated. If that table tells us anything, it is that the salesmen must be paid. That’s fine for a particular firm, I guess, but investors should make sure that they receive commensurate value in return. The Metamorphosis of an Index Let me close with a few broad thoughts about how the world of bonds might change in the years ahead. As the driver of Vanguard’s dominant 23% share of bond fund assets, Vanguard Total Bond Market Index Fund offers an interesting case study of how bond market indexing works. In 1986, when I first considered the creation of a bond index fund, the sole broad bond index was the Salomon Brothers Investment Grade Bond Index. Then, U.S. Treasury bonds accounted for 50% of its weight, government agency obligations 32%, and corporate bonds 18%.

If presentism leads this industry to believe that such mammoth returns will recur from this point forward, or that the federal government has some further gifts to bestow on our industry, we are fooling ourselves. Indeed, I believe that it is more likely that the administration will act to take away some of these gifts (which tend to favor high-income investors) by limiting the tax deferrals available to corporate thrift plans and individual retirement plans. VII. The Economies of Scale The remarkable growth of mutual fund assets has served the owners of fund management companies bountifully, but it has bypassed the owners of mutual fund shares. All of the economies of scale in investing—and more—have benefitted fund managers. None of these economies were shared by fund investors. Can that allegation really be true? Let’s look at the record. During 1951, the year that I joined the industry, fund assets were $3 billion, the asset-weighted expense ratio was 63 basis points; and total expenses were $20 million ($187 million in today’s dollars). As the industry grew, dominated by equity funds in those early years, the asset-weighted average expense ratio actually declined, to 55 basis points. But then the rise began. By 1980, equity fund expense ratios had risen 120% to 121 basis points, double the 1951 level. In 1980, equity fund assets were $44 billion. By 2016 these assets had soared to more than $8 trillion.

As I look at these changes, I cannot help but wonder: “Is a position of 18%—or even 26%—in corporate bonds the optimal level for an individual investor? Might not some informed investors prefer a portfolio of, say, 65% in investment-grade corporates and 35% in Treasuries and agencies with a slightly higher yield that would come hand-in-hand with slightly higher volatility and a slight reduction in credit quality?” Much as I believe in the bond index fund (and the index it tracks), it occurs to me that the final form of an index fund tracking the bond market may yet be determined. The Future of Bonds . . . and Bond Funds Most of today’s bond investors have experienced only the sharp and unremitting drop in bond fund yields that has occurred over the past 35-plus years—the yield on the Bloomberg Barclays Aggregate Bond Index has plummeted from 14.6% at the close of 1981 to 2.6% today, a decline of a mere 83%. (Exhibit 12) Today’s low rates have led some experts to say that we’re in a bond fund bubble, one which will soon burst and send yields soaring and prices tumbling. Since anything can happen in a financial crisis, these predictions may prove correct. But I believe bursting bubbles is a concern largely for short-term speculators in bond prices, not long-term investors planning for their financial futures. After all, if an investor purchases a 30-year U.S. Treasury bond paying an annual coupon of 2.

8% for the next three decades, that investor has made a bargain that will be honored—no bubble there!. For the vast majority of investors, bonds should be bought and held for relative price stability and regular income, not traded in a vain attempt to capitalize on momentary fluctuations in market price. Despite the current low interest rate environment, bond mutual funds, driven largely by the total bond market index fund, have flourished in this challenging environment. In 2017, cash flow has totaled some $335 billion. About 50% of that total ($162 billion) has flowed into bond index funds.investment

Expense ratios of actively-managed funds had declined to 84 basis points, still 53% above the 1960 level. With the growth of lower-cost bond funds, the industry-wide asset-weighted expense ratio for long-term funds is now at 68 basis points, almost 25% above the 1960 level. With total fund assets averaging $17 trillion in 2016, fund advisory fees and operating expenses come to a total of $110 billion per year—5,600 times the 1951 level of $20 million in an industry whose assets grew by 5,400 fold. Economies of scale for fund investors—zero. The industry’s huge revenue growth has been a bonanza for the owners of fund managers. Just look at the returns on the stocks of publicly held fund managers. Over the past two decades alone, the shareholders of the three largest publicly-owned fund managers have enjoyed annual returns averaging 13%, almost double the annual return of 7.7% on the S&P 500 Index, a return earned by remarkably few mutual funds. Cumulative returns: fund managers +1167%, S&P +339%. More than triple. Wow!

Presenting some ideas and opinions is what I’ve tried to do today. Good luck to all of you bond professionals (including you active bond managers), and to the entire fixed-income community. Yes, having survived defeat, I’m confident that Vanguard and indexing will continue to survive victory.

“When students enter business school, they believe that the purpose of a corporation is to produce goods and services for the benefit of society. When they graduate, they believe that it is to maximize shareholder value.” Adam Smith would have concurred with that opening proposition: the purpose of the corporation is to produce goods and services that benefit society. In 1776, in The Wealth of Nations, he articulated the point clearly: “Consumption is the sole end and purpose of all production; and the interest of the producer ought to be attended to only so far as it may be necessary for promoting that of the consumer. The maxim is so perfectly self-evident that it would be absurd to attempt to prove it.” X. A Personal Perspective At the outset, I promised you a personal perspective on some of the thoughts that cross my mind during this 66th year in the fund industry. (Dare I say that few in this audience have even lived that long!) First, this is an extremely happy time in my life and career. To live to see my dream come true of “The Triumph of Indexing”—the title of a small history that I penned and published in 1993—is, well, a nice thing. It’s something that wouldn’t have happened without the heart transplant that I received on February 21, 1996, 21 years ago. Of course I’m thankful for that miracle. If my career means anything, I hope it means that caring counts.

So that’s it. To sum up my long career (so far!): My enthusiasm for life and for this industry, ever changing, remains; caring about our investors, making them the primary focus of our efforts; earning— and, I believe, deserving—their trust; helping to build a fiduciary society with a noble purpose; making a difference in an industry that I’m proud to have joined almost 66 years ago; and still striving to measure up to Paul Samuelson’s 1993 appraisal of me as a man who “changed a basic industry in the optimal direction.” Whatever the case proves to be, whatever the future may hold, the mutual fund industry has changed, in part because I took the road less traveled—indeed, never traveled before—all those years ago. What better way to close these remarks than with these words by Robert Frost? “I shall be telling this with a sigh Somewhere ages and ages hence: Two roads diverged in a wood, and I— I took the one less travelled by, And that has made all the difference.” * * * On the very day that I completed this final draft of this essay, I received a neatly handwritten note from a young and appreciative shareholder who had read my book Common Sense on Mutual Funds. He then invested in the Vanguard Total Stock Market Index Fund, and intends to hold it forever. In one more of the happy coincidences that have marked my long career; his closing words were, “And that has made all the difference.”

5/4/2015 13. Actively Managed Fund Index Fund Expense Ratio 1.12% 0.06% Transaction Costs 0.50 0.00 Cash Drag 0.15 0.00 Sales Charges/Fees 0.50 0.00 All-In Expenses 2.27% 0.06% Tax Inefficiency 0.75 0.30 Total Costs 3.02% 0.36% Gross Return (assumed) 7.00% 7.00% Net Return 3.98% 6.64% Loss in Annual Return -2.66% “The Arithmetic of All-In Investment Expenses” Financial Analysts Journal Note: Counterproductive investor behavior (buying high and selling low) has historically reduced returns to active fund investors by another 1.5-2.0% annually according to Morningstar. 14. $248,890 $70,387 100,000 200,000 300,000 0 10 20 30 40 50 Index Fund (6.64%) Actively Managed Fund (3.98%) Years $ Growth of $10,000 over a 50-year investment lifetime The Miracle of Compounding Long-Term Returns Without the Tyranny of Compounding Long-Term Costs Impact of Compounding Costs on Wealth: Loss in Capital Accumulation: 75% 15. 0.8 1.9 2.5 2.1 1.1 1.8 1.3 0.05 1.0 0.07 1.3 0.09 Active Index Active Index Active Index Expense Ratio Net Yield to Investors U.S. Stock Funds Bond Funds Balanced Funds % 2.2% 1.9% 3.5% 2.1% 2.4% 1.9% Dividend Yields and Expense Ratios Source: Morningstar. Note: Index fund yields and expenses for Vanguard Admiral share classes. Percent of Income Consumed: Active Funds vs. Index Funds 62% 3% 29% 3% 54% 5% 16. Better than the Morningstar Rating System? “Investors should make expense ratios a primary test in fund selection.

5/4/2015 21. “The Colossal Failure” “[T]he colossal failure of the mutual fund industry; resulting from [its] systematic exploitation of individual investors . . . extract[ing] enormous sums from investors in exchange for providing a shocking disservice. … Thievery, even when dressed in the cloak of SEC-approved governance, remains thievery . . . as the powerful financial services industry exploits vulnerable individual investors.” David Swensen, manager of Yale University’s endowment fund 22. “The vast majority of American families are sentenced to a lifetime of investing in the existing mutual fund penal system. But if they’re smart, they’ll do their time in an index fund.” John Bogle Grant’s “Great Debate” April 7, 2015 Mutual Funds Are the Only Practical Option for Individual Investors 23. Enter Vanguard “The Vanguard plan actually furthers the objectives [of the Investment Company Act of 1940] by ensuring that the Funds’ directors … are better able to evaluate the quality of services rendered to the funds … improved disclosure to shareholders … promotes savings from economies of scale … clearly enhances the Funds’ independence … provides them with conflict-free control over distribution … and promotes a healthy and viable fund complex within which each fund can better prosper.” (Unanimous decision, 1981) 24.

Journal Papers by John C. Bogle Winter 2016 (Forthcoming) Putting Investors First Fall 2015 (Forthcoming) Occam’s Razor Redux: Establishing Resonable Expectations for Financial Market Returns (with Michael W. Nolan) Summer 2014 No Speed Limits: High-Frequency Trading and Flash Boys Fall 2013 Big Money in Boston… Spring 2011 The Clash of the Cultures Fall 2009 The Fiduciary Principle: No Man Can Serve Two Masters Summer 2009 Peter Bernstein Commemorative Issue Winter 2008 A Question So Important… Spring 2002 An Index Fund Fundamentalist Summer 1998 The Implications of Style Analysis… Summer 1995 The 1990s at the Halfway Mark Winter 1992 Selecting Equity Mutual Funds Fall 1991 Investing in the 1990s--Occam's Razor Revisited Spring 1991 Investing in the 1990s Journal of Portfolio Management (14 papers) * * * “Outstanding Article” Award FROM “OCCAM’S RAZOR REDUX” . . .

5/4/2015 29. 82% 56% 18% 72% 15% 21% 56% 19% 3% 23% 26% 9% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Equity Bond Balanced Total Active Virtual Index Index Note: “Virtual Index Fund” – R-Squared of 0.96 or higher relative to its best-fit index. Index Funds Dominate Vanguard’s Assets Percentage of Assets Under Management 30. -800 -600 -400 -200 1,000 2006 2010 2014 Index Active U.S. Equity Fund Cumulative Net Cash Flow, 2006-2014 Passive Index Funds versus Actively Managed Funds $ Billions of Dollars +$917 Billion -$597 Billion Source: Strategic Insight Simfund Cumulative Net Cash Flow into Index and Active Mutual Funds and ETFs 31. 2004 2009 2014 Mutual Funds Pension Funds 18% Indexing Market Share % 37% 26% 31% Source: Strategic Insight Simfund, Empirical Research Partners Index Strategies as a Percentage of Total U.S. Institutional Equity Assets Total Indexing Assets and Market Share 2004: 24% 2014: 32% 32. 1,000 10,000 100,000 1,000,000 10,000,000 1975 1985 1995 2005 2014 Active Index $6.4 Trillion $3.2 Trillion $10.6 Trillion $49B $1.1T $1.5T Millions of Dollars $ Growth of Equity Index Fund Assets Total Index Fund Assets 1995 2015 Annual Increase TIFs* $48B $1.63T +19% ETFs $1B $1.68T +45% Total $49B $3.31T +23% $4.5T

5/4/2015 33. Convergence! The Great Paradox: Just as Active Fund Management Becomes More and More Like Passive Indexing, So Passive Indexing Becomes More and More like Active Fund Management John C. Bogle “The Art of Indexing” Conference Washington, DC September 30, 2004 A Speech Title Sums It Up 34. First Index Mutual Fund (1974)—Principles • Own the U.S. stock market • Diversify to the Nth degree • Minimize transaction costs • Tiny expense ratio—500 Index: 0.05% (Admiral) • Bought to be held “forever” (redemption rate 10%) Exchange-Traded Index Funds (1993)—Principles • Pick your own index (1,100 now available) • Diversify within sector you chose • Lower expenses … but not too low (0.50%) • Bought to be traded (average annual turnover of large ETFs: 1244%) “What Have They Done to My Song, Ma?” Enter the Exchange-Traded Fund (ETF) 35. 725% 274% 319% 144% 524% 337% SPDR Gold Shares iShares Russell 2000 Vanguard S&P 500 ETF Vanguard FTSE Emerging Markets ETF Vanguard Total Stock Market ETF iShares MSCI EAFE iShares Core S&P 500 SPDR S&P 500 ETF 200 400 800 0 2600 4200% 2014 Dollar Turnover as a Percentage of Average Annual Assets Asset-Weighted Turnover, 20 Largest ETFs: 1244% 4274% 2724% ETF Turnover 36. ETFs—The New Way to Speculate 2014 Trading Volume 100 Largest Stocks: $18.6 Trillion 100 Largest ETFs: $15.7 Trillion 2014 Turnover Rate 100 Largest Stocks: 179% 100 Largest ETFs: 1428%

5/4/2015 37. Costs and Indexing— More Important than Ever -3% 4.5% 5% 4.5% 2% -4% -2% 0% 2% 4% 6% 8% 10% Historical Next 10 Years Dividend Yield Earnings Growth Speculative Return ? Gross Return 9% Gross Return 4% Historical Returns 9% -1 8% Active 4% -2 2% Index 4% -0.05 3.95% Prospective Gross Return Costs Net Return 38. What’s a Competitor to Vanguard to Do? What’s a race car driver to do when he’s in last position? • Increase speed—i.e., improve performance, more aggressive marketing, more money to distributors (a la life insurance) • Reduce friction—i.e., cut fees, cut staff, cut research • Copy the car in front—i.e., more indexing, less innovation • Get a new car—i.e., focus on other lines of business, recordkeeping, benefit plans, venture capital, limousine services, etc. 39. The “Golden Rule” of the ‘40 Act Put the Shareholder First! “… the national public interest and the interest of investors are adversely affected … when investment companies are organized, operated [and] managed … in the interest of directors, officers, investment advisers … [or] underwriters … rather than in the interest of … such companies’ security holders …” Investment Company Act of 1940, Section 1.B.2. 40.

A Year in My Life . . . II. Vanguard April 7 NYC – “Great Debate” on Indexing, at publisher James Grant’s Forum. 16 Lecture, Aspen Institute, D.C. 20 Blair Academy—Speech to student assembly. 28 Lecture, SEC Enforcement Staff, D.C. May 6-7 ICI General Membership Meeting. June 4 Speech to the CFA Society of Philadelphia, “Putting Investors First.” July/August “Working Vacation” in Adirondacks. Editing book chapter on Adam Smith, AQR extended interview, and JPM papers, correspondence; DOL and Labor Secretary Perez on fiduciary duty rule; and more. September 24 Skype Interview, iMoney 29 SEC-Lead Presenter at 1940 Act 75th Anniversary Forum. October 2 Princeton Humanities Seminar. 7 Princeton Lecture on “Business Ethics and Modern Religious Thought.” 14-16 Bogleheads XIV! . . . . And the “Day-to-Day” Events: Awards for Excellence 21 TV Appearances 11 Client Visits 18 Crew/Team Meetings 84 PR Interviews 45 Speeches 32 TOTAL 211* *Oh, yeah. Also 17 appointments with doctors. And 40 physical therapy sessions. NOW LET’S TURN TO THE INDUSTRY . . .

that a 1966 fund merger, the catastrophic failure of one man’s career, would, in a matter of months, lead to the creation of Vanguard, or that during the 40-plus years that followed, this uniquely structured, fund- shareholder-owned firm would become the unquestioned leader of the mutual fund industry—now managing over $3 trillion of OPM. Or that the embodiment of its principal investment strategy—the index fund—would, simply by buying and holding the stocks of the largest companies in America, begin to change the very nature of finance? And on a far larger scale, who could have imagined the enormous consequences of the creation of IRAs (1974) and corporate thrift plans (1978)? The federal government’s loss of trillions of dollars in federal tax revenues by making these tax-deferred plans available to investors? The gradual displacement of defined benefit (DB) retirement plans by defined contribution (DC) plans? (Assets of DB plans now total $6 trillion; DC Plans and IRAs, $12 trillion or twice as large.) In the aggregate, the assets of these two distinct retirement systems alone come to $18 trillion—six times, for example, the assets of the Social Security Trust Fund. And who could have imagined that the ownership of stocks by institutional investors would rise from 10% in 1950 to 70% in 2015? Well, Peter Drucker did.

My Long Career in the Fund Industry How Many Hits, How Many Eras? (“Follow the Money”) An Industry that Sells What It Makes • 1924-59. The mutual fund industry in its promising formative era An Industry that Makes What Will Sell • 1960-64. Public ownership of advisors—The New Paradigm • 1965-69. The “Go-Go” Era—Equity “junk” • 1970-74. The rise and fall of the “Favorite [Nifty?] Fifty” • 1975-90. Money market funds and bond funds—a new industry • 1991-01. The Information Age and the rise of technology funds • 1995-07. The TIF (Traditional Index Fund) Era • 2008-15. The ETF (Exchange-Traded Index Fund) Era What’s Next? • 2015-25. The return to a new normalcy—The triumph of TIF indexing A GROWING INDUSTRY . . .

See his 1976 book The Unseen Revolution, describing the 1950 genesis of General Motors’ precedent-setting pension plan, designed to invest in “The American Economy.” But he would have been appalled—appalled— to see how rarely these institutional owners would exercise their immense voting power. Even a decade ago, who could have imagined that the intersection of technology and indexing would lead to the creation of a whole new way of providing investment guidance to individual investors. Asset allocation—not stock-picking or fund picking—is now well on its way toward becoming the principal function of the registered investment adviser (RIA). Or that low costs (low fees, and low-cost index funds) would become the desideratum of the rapidly emerging new system? Will “Robo” advice work? Why not? The record is crystal clear that while the average RIA should be expected to match the gross return generated in our financial markets, and to lag the net return (after costs), even that expectation has proven to be optimistic. As professor Burton Malkiel wrote in a recent Wall Street Journal op-ed piece, a strict fiduciary standard—echoed in the theme of CFA Institute, “Putting Investors First”—“is likely to result in massive changes in traditional ways of doing business.”

Along the Way, a Funny Thing Happened Ownership of 50 Largest Mutual Fund Management Companies—2015 Privately Owned (10) Plus Mutual (1) Publicly Owned Conglomerate Total Firms with Public Ownership: 39 Note: Firms with Public Ownership in 1951: 1 (Includes 3 largest firms) BUT LOTS OF OTHER BIG CHANGES, INCLUDING THE RISE OF INDEXING . . . Rankings for the 5 years ending 2009 Where they ranked in the subsequent 5 years Quintile 5-Year Return* Number of Funds Highest Quintile Lowest Quintile Merged/ Closed 1 Highest 1,091 14% 24% 10% 2 High 1,083 12 16 22 3 Medium 1,084 15 13 26 4 Low 1,085 14 10 38 5 Lowest 1,032 14 9 45 Total 5,375 14% 14% 28% Equity Fund Returns: No, Pal, The Past Is Not Prologue. RTM *Excess return vs. benchmark. Note: Number of failed funds—1,499 NOW LET’S TURN TO THIS CHANGING INDUSTRY . . .

5/4/2015 49. What’s All This about “Basis Points?” Jones v. Harris Associates Brief for John C. Bogle as Amicus Curiae in Support of Petitioners It is important to distinguish between the already-high rates (as a percentage of assets) that advisers charge and the even more excessive dollar amounts that are produced by those fee rates. It was the huge increase in mutual fund assets and, therefore, the amount of mutual fund fees, that concerned the SEC in 1966, since the cost of providing advisory services (essentially, managing an investment portfolio) rises far more slowly than the fees generated by taking a percentage of the increase in assets . Yet courts have generally acceded to the advisers’ desire to frame any debate about fees in percentage—not dollar—terms, thereby giving advisers a license to charge fees that are unjustifiable by any standard. 50. High-Priced Index Funds and Fiduciary Duty Fund Assets Expense Ratio Principal Large Cap S&P 500 Index $4.7 B 0.74% Voya US Stock Index 4.6 B 0.66 Columbia Large Cap Index 3.7 B 0.83 MM S&P 500 Index 3.6 B 0.68 Dreyfus S&P 500 Index 2.9 B 0.50 JP Morgan Equity Index* 1.9 B 1.20 Total (87 Funds) $19.3 B 0.85% Vanguard 500 Index-Admiral Shares $143 B 0.05% -Institutional Plus Shares $85 B 0.02% What were directors of these funds thinking? S&P 500 Index Funds with Expense Ratios of 0.40% or More * “A” series shares carry an expense ratio of 0.45% and a sales load of 5.25% 51.

Heed Yale’s brilliant endowment manager David Swensen in Unconventional Success, his book about personal investing: “The fundamental market failure in the mutual-fund industry involves the interaction between sophisticated, profit-seeking providers of financial services and naïve, return-seeking consumers of investment products. The drive for profits by Wall Street and the mutual-fund industry overwhelms the concept of fiduciary responsibility. The powerful financial services industry exploits vulnerable individual investors. . . . Ultimately, a passive index fund managed by a not- for-profit investment management organization represents the combination most likely to satisfy investor aspirations.” The accumulated wisdom of Messrs. Buffett, Graham, and Swensen—three of the great minds of investing—hardly requires a genius to understand. But acting on that wisdom is never easy. Why? Because our investment system is based on action. (“Don’t just stand there. Do something!)is

Large Blend Large Growth Large Value Mid-Cap Blend Mid-Cap Growth Mid-Cap Value Small Blend Small Growth Small Value Percentage of Active Funds Outpeforming Their Benchmarks 15 Years through 2014 Do You Like These Odds? Average: 20% Outperform Source: Vanguard, Morningstar. % 30% 14% AND SO, THE TRIUMPH OF INDEXING . . . -100 -50 Series2 Series1 $ Vanguard Dominates Industry Cash Flow Mutual Fund Industry Net Cash Flow YTD Through August 2015 Vanguard +$168 Billion All Other Firms -$48 Billion Vanguard accounted for 141% of the mutual fund industry’s year-to-date net cash flow through August 2015 Industry Total $119 Billion OUR CASH FLOW EXPLODES . . .

-50 1988 1995 2000 2005 2010 2015* Index Stock and Bond Funds Active Stock and Bond Funds Money Market Funds Vanguard Cash Flow, 1988 – 2015 Annually, in billions $ Billions of Dollars *Annualized based on actual data through 8/2015. $251B $4B $18B $57B $46B $58B $100B DRIVEN BY INDEX FUNDS . . . -500 1,000 1,500 2,000 2000 2005 2010 2015 "The Indexers" Vanguard, BlackRock, and State Street The Rest of the Industry The Triumph of Indexing: Rolling 3-Year Net Cash Flow $ Billions of dollars Net Cash Flow 2009-2015 $1.3 T -$4.5 B RESULT: COMPETITION’S LEFT IN THE DUST . . . SO FAR . . .

First Index Mutual Fund (1974)—Principles • Own the U.S. stock market • Diversify to the Nth degree • Minimize transaction costs • Tiny expense ratio—500 Index: 0.05% (Admiral) • Bought to be held “forever” (redemption rate 10%) Exchange-Traded Index Funds (1993)—Principles • Pick your own index (1,100 now available) • Diversify within sector you chose • Lower expenses … but not too low (0.50%) • Bought to be traded (average annual turnover of large ETFs: 1244%) Yes, There Is a Difference Traditional Index Funds vs. Exchange-Traded Funds “BUY AND HOLD” vs. “TRADE IN REAL TIME” . . .

Vanguard Fund Correlations The Triumph of Indexing (and Virtual Indexing) R2: The percentage of a fund’s return explained by the return of its best-fit index. Fund Name R2 (10-Year) R2 (3-Year)* Index Funds Total Stock Market Index 1.00 1.00 Total Bond Market Index 0.99 0.99 Active Funds STAR Fund 0.99 0.99 Explorer Fund 0.99 0.97 Wellington Fund 0.97 0.97 Intermediate-Term Tax-Exempt 0.97 0.99 Windsor Fund 0.95 0.94 PRIMECAP Fund 0.93 0.88 Health Care Fund 0.92 0.90 Average Vanguard Active Equity Fund 0.95 0.93 Average Industry Active Equity Fund 0.88 0.79 In 1974, “Relative Predictability.” Now, “High R2.”

Note: “Virtual Index Fund” – R-Squared of 0.96 or higher relative to best-fit index. “Relative Predictability” Dominates Vanguard’s Asset Base 91% of Vanguard’s Assets Have High Relative Predictability (Average pre-cost returns . . . superior post-cost returns) Index Funds Virtual Index Funds 19% Active Funds 9% NOW LET’S LOOK AHEAD AT FUTURE RETURNS ON STOCKS AND BONDS . . .

Balanced Portfolio Returns Also Below Norm of 7% Reasonable Expectations: Nominal Gross Return (50/50 Stock/Bond): 4.5% Don’t Forget These Deductions -1.5% Active Fund Costs or -0.05% Index Fund Costs * * * -2% Inflation -0.5% Taxes -1.5% Investor Behavior Looking Ahead 3.—No Great Alternatives 50 YET MUTUAL FUNDS WILL CONTINUE TO DOMINATE INVESTOR SAVINGS. WHY? . . .

“The vast majority of American families are sentenced to a lifetime of investing in the existing mutual fund penal system. But if they’re smart, they’ll do their time in an index fund.” John Bogle Grant’s “Great Debate” April 7, 2015 Mutual Funds Are the Only Practical Investment Option for Individual Investors AS YOU CONSIDER YOUR FUND STRATEGY, REMEMBER THESE WORDS . . .

“Ultimately, a passive index fund managed by a non-for-profit investment management organization represents the combination most likely to satisfy investor aspirations. … Out of the enormous breadth and complexity of the mutual-fund world, the preferred solution for investors stands alone in stark simplicity.” 3. David Swensen Manager, Yale University Endowment Fund

transaction costs to a bare minimum; produced greater liquidity, and improved (perhaps only slightly) price discovery and greater market efficiency for professional investors. That’s all to the good. But the huge risks of a technology breakdown in our increasingly computerized stock market remains hidden out there, beyond the horizon. In our data-intensive, speed-driven society, yes, HFT is here to stay. ETF Toys I find it both astonishing and deeply discouraging that index funds have become one more example of the apparently irresistible impulse of investors to speculate. Imagine! In 1975, Vanguard created the world’s first index mutual fund, following this elemental strategy: (1) buy and hold all of the stocks in the Standard & Poor’s 500 Index; (2) operate at rock-bottom cost; and (3) attract long-term investors who wish to hold the stock market portfolio, well, forever. Those original sensible strategies of indexing have reshaped investing in a highly positive way for long-term investors. But the exchange-traded index fund (ETF) is the antithesis of that third key to index success—holding the market forever. Formed in 1991,6 the first ETF was also based on the S&P 500, but with the added “feature”—embodied in its advertising slogan—that its shares could be “traded all day long, in real time.” (I’m not making this up!) With $160 billion of assets, the so-called “SPY” is now the world’s largest ETF.

Here, of course, I’m speaking of the world’s first index mutual fund—Vanguard’s disruptive innovation that would ultimately reshape the mutual fund industry. We had tough going at first. Vanguard suffered huge net cash outflows in each of our first four years of existence, and the IPO of that first index fund was virtually ignored—not even raising enough money to buy round lots of each stock in the S&P 500. But investors eventually took notice and came around to the Vanguard way of investing. Today, our asset base is dominated by index funds (71% ,but another 25% is composed of virtual index funds) which, while “actively managed,” are designed to deliver returns that are closely linked to their relevant market sectors. (Together, that’s 96% of our asset base.) When Vanguard was founded in 1974, we supervised just $1.4 billion of OPM. Today, we manage over $3 trillion worldwide.in

I’ll make one final comment about indexing, and yet one more biblical reference. In her sermon several weeks ago, Bryn Mawr Presbyterian Church pastor Dr. Agnes Norfleet cited one of my favorite Biblical passages, from Psalm 118 (repeated in Matthew 21, Mark 12, and Luke 20). “The stone which the builders rejected has become the chief cornerstone.” Similarly, in the field of finance, the index fund—originally scorned, derogated, and rejected by Wall Street as “un-American” and worse (try “Bogle’s Folly”)—has become our industry’s chief cornerstone. Index funds now account for more than one-third(!) of the assets of all U.S. equity mutual funds. The triumph of the index fund has even broader implications for corporate governance, at least as profound as their implications for investing. Today, the dominance of index funds belies the old “Wall Street Rule”—“if you don’t like the management, sell the stock.” A new “Index Fund Rule” is emerging. Since index funds can’t sell the stock (if it’s in the index, it stays in the fund, no matter what), the new mantra must become, “if you don’t like the management, fix the management.” This is a truism for permanent investors in each corporation’s shares. While it is yet to be honored, that sound principle will, sooner or later, alter profoundly the relationship between Financial America and Corporate America, and ultimately, I fervently hope, re-establish a proper relationship between business and our society.

By owning the entire stock market (or almost all of it) and eliminating about 95 percent of the frictional costs of investing, Vanguard 500 Index Fund would be guaranteed to beat the returns earned by financial managers in the aggregate. Our Index Fund was formed in 1975 and, after a pathetically small IPO—$11 million—was offered to investors a year later. 1975 and 1976. Innovation # 2. At the outset, our mutual funds, like almost all others, carried substantial sales loads. Like their peers, they were offered to investors via our wholesale distributor through a network of stockbrokers. Now that the fund industry had begun to mature, it seemed obvious that the U.S. investing public— growing older and better-educated, and hence more cost-conscious—would someday easily support a no- load framework, with funds directly offered to investors. So we eliminated those pesky sales loads and abandoned our distribution system—the first firm to take this daring step. We did it only after much consideration of the huge risks involved, and without prior notice. February 1977. Innovation # 3.

investment portfolios. Everything else is incidental . . . The principal role of the investment company should be to serve its shareholders. Over the centuries (or so it seems), such idealism has likely been typical of an inexperienced college senior. But, as you’ll see this afternoon, despite the passage of more than 63 years since I read that FORTUNE article, my idealism has hardly diminished. Indeed, likely because of my lifelong experience in the field, it is even more passionate and unyielding today. Following my graduation in 1951, Walter L. Morgan, Princeton Class of 1920, read my thesis. Mr. Morgan—the great hero of my long career, and the founder of industry pioneer Wellington Fund, offered me a job. I decided to join his small but growing firm—managing but a single fund, with assets of $150 million. “Largely as a result of this thesis,” he wrote to our staff, “we have added Mr. Bogle to our Wellington organization.” Although I wasn’t so sure at the time, it was the opportunity of a lifetime. Here’s a profile of the fund industry that I joined in 1951. Exhibit 2. There were but 125 mutual funds, with assets aggregating $3 billion. The field was dominated by a few large (for those days) firms, accounting for about two-thirds of industry assets. With assets of $472 million, M.I.T. was overpoweringly dominant, by far the industry’s largest fund, and by far the lowest cost provider (expense ratio 0.42 percent). Indeed while “Big Money in Boston” focused on M.I.T.

The new, higher dividend would be earned by emphasis on more stable, income- producing value stocks, rather than on volatile, low-yielding growth stocks. It has worked splendidly, and shareholders have rejoined the fund in droves. Taking Wellington back to its roots but adding a specific dividend objective led to its renaissance. 1978. Innovation #5.1 How Have Our Innovations Worked Out? So, innovation has been the key to Vanguard’s remarkable growth. Let’s measure the results of each of those innovations: 1. Our mutual at-cost structure (combined with our extraordinary growth) has enabled us to slash our complex-wide expense ratio (expenses as a percent of assets) to less than 20/100 of 1 percent, fully 80 percent below the 1 percent industry norm, now saving our investors a cool $17 billion annually. 2. Our index innovation has changed the world of finance. Index funds now constitute fully 28 percent of equity fund assets, and assets of that original Vanguard 500 Index Fund have grown to $250 billion. Its sister fund, Vanguard Total Stock Market Index Fund also totals $250 billion, and assets of all of our index funds combined now total $1.3 trillion. 3. Our no-load (non-distribution) system last year produced a net cash inflow from investors of $142 billion, the largest inflow in the fund industry’s 1 Really a reverse innovation. But it saved the day.

assets, each with his or her own hopes and fears and financial goals. Isn’t that what managing other people’s money—a fiduciary duty—should be all about? “The Optimal Direction” Although the remarkable growth of this organization has earned us our position as first in the industry in investor trust and respect, Vanguard has become the firm that our competitors love to hate. Despite moving the industry in “the optimal direction” for investors—Dr. Samuelson’s words—not a single one of our competitors has changed its conflict-ridden structure to a mutual structure. Doing so, of course, would be ruinous to the wealth of their managers and their public shareholders, to say nothing of the detriment of the financial conglomerates that own them. (40 of the 50 largest fund complexes are publicly held; only 10 remain private.) But if the Vanguard example has so far failed to change the self-serving structure of the mutual fund industry, we have surely changed the industry at the margin. Those who have copied our strategies of indexing and bond fund management have had to at least pay lip service to cost-control, for the essential difference between funds tracking the same index is simply the difference in costs. (Obviously, low costs serve the fund investor; high costs serve the fund manager.) But a dramatic change is underway. Investors have begun to look after their own interests, as if by an invisible hand, they are improving the interests of society. Adam Smith strikes again!

speculation. (3) The rise of “product proliferation” with thousands of new funds formed each year, embracing aggressive share distribution as integral to the manager’s interest in gathering assets and increasing fee revenues. (4) The conglomeratization of the mutual fund industry, a change that served the monetary interests of mutual fund managers and a disservice to the interests of mutual fund shareholders, and finally, (5) the triumph of the index fund, which did precisely the opposite; shareholders first, managers second. Let’s take a look at each of these changes. 1. The Stunning Growth of Mutual Fund Assets When I joined the industry in 1951, fund assets totaled just $3 billion7. Today, assets total $13 trillion, a remarkable 15 percent annual growth rate. When a small industry—dare I say a cottage industry?—becomes something like a behemoth, almost everything changes. “Big business,” as hard experience teaches us, represents not just a difference in degree from small business—simply more numbers to the left of the decimal point—but a difference in kind: More process, less human judgment. For the first half-century of industry history, equity funds were our backbone. Equity fund assets topped $56 billion in 1972, and then, after a great bear market, tumbled to $31 billion in 1974. Recovering with the long bull market that followed, equity assets soared to $4 trillion.

Further, many commentators credit Vanguard for keeping downward pressure on excessive fees and other fund costs—the so-called “Vanguard effect”—staring down those who would make a bad situation worse. Exchange-traded funds (ETFs)—now itself a trillion dollar business—owe their very existence to Vanguard’s innovations in the burgeoning index fund field. Yes, ETFs are, in fact, index funds, with the “bonus” (to what avail?) of providing investors the ability to “trade the S&P 500 Index all day long, in real time” (as their early promotional ads said). But ETFs have in fact provided another no-load alternative for fund owners, a trend that is only now accelerating. The fact is that ETF portfolios have tiny turnover (a big plus, despite the huge turnover of their own shares among those aggressive, largely institutional investors who trade them).costs,

the ETF may well be a harbinger of lower costs of investing throughout the financial system. Look Out! Change is Coming. Innovation and the Financial System In our world today, praising innovation has become a commonplace. Why not? Looking back to the great innovations that changed our world—among others, the steam engine, the railroad, electricity, the telephone, the automobile, and most recently the computer, the iPad, and “the cloud” of our new information age. But it is more than the Luddite in me that compels me to throw my wooden boot into the wheels of financial innovation, which has, in general, ill-served investors. Here, I ally myself with one of our nation’s financial heroes, Paul Volcker, Princeton Class of 1949. He famously said that “the ATM is the only useful financial innovation of the past quarter-century.” (He recently told me that, if he’d been asked about the past half-century, he would have included the index fund.) And the iconic Warren Buffett—the most celebrated money manager of our age, who also praises the index fund—described all those innovative but highly risky derivative securities that now permeate our financial markets as “financial weapons of mass destruction, carrying dangers that . . . are potentially lethal.

That shift toward higher volatility began during the “Go-Go Years” of the late 1960s, when “hot” managers were treated like Hollywood stars and marketed in the same fashion. It has largely continued ever since. (The creation of index funds was a rare and notable exception. An all-market index fund has Beta of 1.00.) But as the inevitable “reversion to the mean” in fund performance came into play, these aggressive manager stars proved more akin to comets— speculators who too often seem to soar into the sky and then flame out—focused on changes in short-term corporate earnings expectations, stock price momentum, and other quantitative measures. Too often, they forgot about prudence, due diligence, research, balance sheet analysis, and other old-fashioned notions of intrinsic value and long-term investing. With all the publicity focused on the success of these momentary stars, and the accompanying publicity about “the best” funds for the year or even the quarter, along with the huge fees and compensation paid to fund management companies and the huge compensation paid to fund portfolio managers of the “hot” funds, of course the manager culture changed. But even a short-term failing in performance became a career risk, so it became best to be agile and flexible, and watch over the portfolio in, as they say, “real time.” As equity fund assets soared, more aggressive funds proliferated, and steady and deliberate decision making was no longer the watchword.

funds that operate under the original industry model rise by 84 percent, and the expense ratio of one fund group that operates under a new business model falls by 69 percent, it is at least possible that there’s a message there. Mutual Fund Expense Ratios 1951 & 2013 Percent of Assets Percent Change +220% +121% +108% +98% +65% +62% +53% +17% +84% -69% 0.42 0.56 0.64 0.66 0.63 0.50 0.75 0.84 0.62 0.55 1.33 1.23 1.32 1.31 1.04 0.81 1.14 0.98 1.15 0.17 0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 MIT/MFS (c) Investors Mutual/Columbia (c) Eaton Howard/Eaton Vance (sh) Putnam (c) Fidelity (p) T. Rowe Price (sh) Affiliated/Lord Abbett (p) American (p) Average (ex. Vanguard) Wellington/Vanguard (m) Ownership Type: (c) conglomerate; (sh) public shareholders; (p) private; (m) mutual 9. The data in the chart are comprised of fund expense ratios unweighted by assets. While weighted ratios can only be approximated, one can conclude that the aggregate fees paid to these eight firms rose from $58 million in 1951 (measured in 2012 dollars) to $26 billion in 2013— more than a four-hundred fold jump in the cost of fund management. One might have hoped that all those dollars available to improve the quality of stock selection and investment strategy would have improved the returns earned by fund shareholders. Alas, there is no “brute evidence” whatsoever that such is the case. None. 4. The Conglomeratization of the Fund Industry April 7, 1958—A Date that will Live in Infamy.

As Matthew suggested, this obvious conflict in serving two masters will cause them “to love the one and hate the other,” and I think that this audience knows which master gets the love. There can be only one resolution to the conflict: a federal policy that prohibits the ownership of fund managers by holding companies. 5. The Triumph of Indexing December 31, 1975 – A Date that will Live in Infamy. Part II If April 7, 1958 is “a date that will live in infamy” for mutual fund shareholders, then surely December 31, 1975, is a date that will live in infamy for mutual fund managers.than

Investment Companies” was born on September 24, 1974.9 As I took on my new job, I was once again, “fired with enthusiasm.” (Again! Think about that!) Recalling the analysis of the fund industry that I had presented in my senior thesis, and buttressed by my research data (in those days, using a hand calculator and a slide rule), I documented the failure of mutual fund managers generally to gain “superiority over the market averages” (using the Standard & Poor’s 500 Index) during the previous three decades. Equally important, I was inspired by powerful encouragement from Nobel Laureate Paul Samuelson. Result: We formed the world’s first index mutual fund. Our board was skeptical, for its mandate to the warring partners precluded Vanguard from providing investment advisory services to the funds. But when I explained that an index fund required no adviser, the board reluctantly acceded to my recommendation. That day of infamy for mutual fund managers “changed a basic industry in the optimal direction,” as Dr. Samuelson wrote in his 1993 foreword to my first book.10 It was the beginning of a far better direction, one aimed at placing front and center the interests of the mutual fund shareholders. The IPO for our index fund took place on August 28, 1976. It was a flop. The underwriters raised only $11 million of initial assets. It barely grew for years, and industry leaders scorned it publicly.

(“You wouldn’t settle for an ‘average’ brain surgeon, so why would you settle for an ‘average’ mutual fund?”)11 A midwest brokerage firm flooded Wall Street with posters screaming “INDEX FUNDS ARE UN-AMERICAN. Help Stamp Out Index Funds!” Exhibit 12. 9 One could easily argue that “the date that will live in infamy” for fund managers was Vanguard’s precedent- breaking formation on September 24, 1974. For it replaced the industry’s business model with a truly mutual model that was virtually essential to the creation of our index fund. More about that later. 10 Bogle on Mutual Funds, John Wiley & Sons, 1993. 11 Fidelity’s Chairman Edward C. Johnson III doubted Fidelity would follow Vanguard’s lead. “I can’t believe,” he told the press, “that the great mass of investors are [sic] going to be satisfied with just receiving average returns. The name of the game is to be the best.” Fidelity now oversees $126 billion of index fund assets.

12. To make matters worse, during the index fund’s early years it appeared to lag the returns of the average fund manager (largely because of flaws in the data). The fund attracted few additional assets. Even with the acquisition of a $40 million actively-managed Vanguard fund, First Index didn’t cross the $100 million mark until 1982.12 Indeed, it wasn’t until 1984 that a second index mutual fund joined the industry. By 1990, total assets of, by then, five index funds reached $4.5 billion, only about 2 percent of equity fund assets. Exhibit 13. The experiment in indexing was stumbling. Growth in Assets of Equity Funds— Active vs. Index 13. 1,000 10,000 100,000 1,000,000 10,000,000 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Active Index $39 billion $14 million $1.9 trillion $167 billion $590 million $1.5 trillion $84 billion $4.8 trillion $900 billion $ millions $5.1 trillion Annual Growth Rate Active Funds: 14.4% Index Funds: 38.4% Net Cash Flow, 2008-April 2013 Active Funds: -$386 billion Index Funds: +$667 billion 12 In 1980, the Trust’s name was changed to Vanguard 500 Index Fund.

But as Thomas Paine reminded us all those years ago, “the harder the conflict, the more glorious the triumph.” And just as Paul Samuelson predicted, indexing changed the fund industry in the optimal direction. Index fund assets leaped to $100 billion by 1996, and to $1 trillion by 2006, and to more than $2 trillion today. So, no, I don’t think that the word triumph in the subtitle of this section is hyperbolic. Consider that during the past five years, investors have liquidated some $386 billion of their actively-managed equity funds and poured $667 billion into passively-managed index equity funds—a $1 trillion-plus shift in investor preferences. Today, assets of passively-managed equity index funds are equal to almost 40 percent of the assets of their actively-managed peers, their superiority confirmed by scores—perhaps hundreds—of independent academic studies, and denied by none. Index fund growth seems certain to continue, and likely even accelerate, even from today’s massive total. “The Moral History of U.S. Business” The polar nature of those two days of infamy—one in 1958 and one in 1975—the first placing a heavy burden of costs on the returns earned by mutual fund investors, the second an automatic boost in the returns that they earn—can be said, I think, carry a subtle lesson for fund investors and their managers. For the first reflects a diminution of the power of the fiduciary, the second reflects a clear buttressing of the concept of fiduciary duty.

Boston Still Huge, But No Longer Dominant* Boston 46% Other 7% Minneapolis 13% Philadelphia 7% New York 27% Boston 18% New York 21% Philadelphia 18% Other 23% Los Angeles 14% San Francisco 6% 1951 2013 15. *Percentage of mutual fund assets by location of firm headquarters. Similarly, staunch old Putnam Management Company was bought from its manager/trustees by U.S. insurance giant Marsh and McLennan in 1970, and resold in 2008, for almost $4 billion, to yet another Canadian conglomerate. Its fund assets have stumbled from $250 billion in 1999 to $60 billion today. You decide whether or not the SEC conclusion about the onset of trafficking in management contracts was justified! The change in the business model of M.I.T.—that old exemplar of Puritan Boston—left a void that was filled by Vanguard—in Quaker Philadelphia. The vaguely accidental creation of Vanguard’s index fund has been the prime force in its rise to industry’s largest firm. Now overseeing $2.2 trillion of assets, the firm’s remarkable growth is a reflection of the triumph of indexing and of the pervasive realization that lower fund costs lead to higher fund returns. Vanguard’s share of industry assets has set an all time industry high of 15 percent. Since 2010 the firm has accounted for more than 70 percent of industry cash flows. (Don’t worry, that share will surely decline.) But it seems only a matter of time until a serious challenger emerges.

followed, Swensen would earn a compound annual return of some 13 percent on the Yale University endowment fund, likely the highest among all of its peer institutions. A truly brilliant choice! Michael Price, for many years the guiding light of Mutual Shares, recommended heavy reliance on equities, focusing on those companies selling at a 30 or 40 percent discount from what other companies would pay to acquire them. “The whole goal is to compound at 15 percent . . . even when the market is up 25 percent (annually).” During the challenging 15 years that followed, neither Mutual Shares (which Mike Price hasn’t managed since 2001) nor the market came anywhere near these returns. But Mutual Shares compounded at 8.1 percent, well ahead of the 6.8 percent annual return for the Total Stock Market Index Fund, a splendid achievement. The recommendations of “Adam Smith” (George J.W. Goodman), trustee, author and publisher, are a bit hard to replicate. He recommended hedge funds and especially “Julian” (presumably Julian Robertson), a good choice for a while. But Robertson’s firm ceased operations in 2000, and we can’t know who came next. “Hire talent whenever you find it,” was “Adam Smith’s” message. Fine! But as we know, talent is hard to identify, and—as in “Julian’s” case—frequently evanescent. John M. Templeton, Dartmouth Professor Peter Williamson, and Charles R. Schwab were all true believers in equities. Templeton was unequivocal: “invest 100 percent in common stocks.” (The 6.

Looking Back So there you have it. Lots of opinions; lots of common themes too. So let’s cut to the chase, look back, and now see how the portfolio I recommended worked out in hindsight, compared to the returns achieved and risks assumed by the average college and university endowment fund over the subsequent era, the fifteen fiscal years ended in June of this year. During that period, the average endowment fund earned a return of 7.3 percent compounded, a return far lower, I suspect, than most, if not all, of the commentators that I just cited would have anticipated. My principal recommendation would obviously have been best implemented with the lowest cost stock and bond index funds, so I had no choice but to rely on Vanguard Total Stock Market Index Fund and Vanguard Total Bond Market Index Fund, rebalanced each quarter to 50/50. Our institutional shares—net of all fund expenses—provided an annual rate of return of 7.1 percent—6.2 percent for the bond fund and 6.0 percent for the stock fund, itself a surprising outcome. (That the total portfolio provided a higher return than either of its components is explained by the quarterly rebalancing.) While that 7.1 percent return was not quite equal to the 7.3 percent return of the average endowment, it was at least competitive, and—taking into account other important measures of

Past returns tell us absolutely nothing about the return that a Treasury note purchased at the end of any period would earn during the subsequent decade. For example, the returns on the 10-year Treasury note. During 1926-1981, its return averaged 3.8 percent. But with the entry yield in 1981 at 13.7 percent (!), the return over the 1981-1991 decade turned out to be 13.1 percent. So both our arithmetic and our logic confirm that the current yield of a bond has been—and should almost certainly continue to be—a highly reliable guide to its future return. (The correlation between year-end yield and subsequent ten-year return for Vanguard Total Bond Market Index Fund is a still impressive 0.80.) Stock Returns The methodology for stock returns is similar but more complex. Keynes focused on the two broad sources that explain the returns on stocks. The first was what he called enterprise—“forecasting the prospective yield of an asset over its entire life.”3 The second was speculation—“forecasting the psychology of the market.” While Keynes made no attempt to quantify the relationship between enterprise and speculation in shaping stock market returns, however, it occurred to me, decades later, to do exactly that. What Keynes had described as “enterprise,” I defined as investment return—the initial dividend yield on stocks plus the subsequent annual rate of earnings growth.

mutual funds that was truly mutual, doing away with the conflict of interest that exists between funds and their advisers; by returning the enormous profits that accrue to external managers directly to the fund shareholders themselves. The now-150 funds in our group actually own our manager, The Vanguard Group, Inc., roughly in proportion to their share of the Group’s aggregate assets, and share in the total expenses incurred by the funds in their operations in approximately the same proportion. (That is, if a given Vanguard fund represents one percent of our assets, it would own one percent of Vanguard’s shares and assume one percent of Vanguard’s operating expenses.) The directors of the funds and their management company are identical. Eight of our nine directors are otherwise unaffiliated with the company, and only one (the chief executive) serves as an officer. No director is permitted to be affiliated with any of the funds’ external advisors.4 Our funds essentially operate and manage themselves on an “at-cost” basis, enabling our shareowners to garner the extraordinary economies of scale that characterize investment management (i.e., the costs of managing $10 billion of assets is nowhere near ten times the cost of managing $1 billion). It is fair to describe Vanguard as the only truly “mutual” mutual fund complex. This shareholder-first structure has produced enormous savings for investors in the Vanguard funds. For example, in 2007, our composite expense ratio of 0.

21 percent (21 “basis points”) was 76 basis points below the 0.97 percent (97-basis-point) composite weighted average expense ratio of our largest competitors. That saving, applied to our average assets of $1.2 trillion during the year came to almost $10 billion for 2007 alone. By 2009, cumulative savings for our mutual fund owners will have crossed the $100 billion mark. Whence “Mutual”? The Vanguard structure is unique in industry annals. While the first mutual fund (Massachusetts Investors Trust, formed in 1924) was managed by its own trustees rather than by an external company—a structure it abandoned in favor of the external structure in 1969—its shares were marketed and financed by a separately-owned distribution company. And while the funds in the Tri-Continental (now Seligman) group were for many years operated at cost by their management company, the manager reaped 4 The investment advice for approximately 70 percent of Vanguard’s fund assets—largely index, bond, and money market funds—is provided internally by Vanguard itself. The remaining 30 percent is advised under contracts held by a score of external advisors.

No sooner than the ink was dry on the various agreements, the situation began to change. The creation of Vanguard, as I’ve written, “ . . . was a victory of sorts, but, I feared, a Pyrrhic victory . . . and the narrow mandate that precluded our engaging in portfolio management and distribution services would give Vanguard insufficient power to control its destiny. Why? Because success in the fund field was not then, and is not now, driven by how well the funds are administered. Though their affairs must be supervised and controlled with dedication, skill, and precision, success (will be) determined by what kinds of funds are created, by how they are managed, by whether superior investment returns are attained, and by how—and how effectively—the funds are marketed and distributed.” We first determined to start a new fund that we would manage internally. Paradoxically (if not disingenuously), it would be a fund that arguably didn’t conflict with our limited mandate, for, technically speaking, it wasn’t managed. It was the world’s first index mutual fund, modeled on the Standard & Poor’s 500 Stock Index. Incorporated late in 1975, its initial public offering was completed in August 1976. While the offering raised a puny $11 million, despite that unhappy start, Vanguard 500 Index Fund is now among the largest mutual funds in the world.

ratings, even though much of the impact of those variations evens out over a period as long as a decade, and even more of the disparity is mitigated when the management firms run a hundred funds or more. It turns out, however, that there is one factor that plays a major role in the relative returns of peer funds. Happily, it is a factor that persists over time: the costs that funds incurred in delivering their returns to investors. It must be obvious that funds with similar objectives, managed by competent and experienced professionals, and compared over an extended period of time are more likely to achieve similar (and inevitably market-like) returns. But only before the costs of investing come into play. Fund costs come in many guises. The major costs are: (1) the expense ratio (annual percentage of asset value consumed by management fees and operating expenses). (2) Sales loads, representing the cost to acquire fund shares. (3) Transaction costs, the real—but hidden—expenses incurred in the execution of the investment decisions made by the fund’s portfolio managers. Since transaction costs are not publicly available, the “all-in” expense ratios I’m using—including sales loads built into the B and C share classes—are the most satisfactory measure of fund costs. Now let’s add to our previous chart a column showing the expense ratios for the equity funds in each group.21 Chart 3.

Sharpe is equally unequivocal “The smaller a fund’s expense ratio, the better the results obtained by its shareholders.”23 He wrote those words in 1966(!), and confirmed them in 1996. “If you had to look at one thing only (in selecting a fund), I’d pick expense ratio.” 24 Sharpe’s observations have met the test of time, nicely confirmed by the data that I have just presented. Crude data showing the relationship between expense ratios and Morningstar ratings suggests that an extra percentage point of cost means one less star in ratings; a percentage point reduction in cost means one more star. That is, if a three-star fund had an expense ratio one percentage point lower, it would be transformed into a four-star fund; if the same fund had a ratio one percent higher, it would become a two-star fund. Despite this powerful data, however, despite the opinion of experts, and despite the common sense that tells us that investment costs are the central element in determining the relative returns of mutual funds within their peer groups, price competition remains conspicuous by its absence from the mutual fund industry. Price Competition? Investors seem to be largely unaware of the direct and causal relationship between fund costs and fund returns. The industry’s only three very low cost firms dominate the performance statistics, yet together they constitute a mere 14 percent of industry assets. How can the industry continue to maintain expense ratios that average 1.

industry overwhelms the concept of fiduciary responsibility, leading to an all too predictable outcome . . . the powerful financial services industry exploits vulnerable individual investors . . . “The ownership structure of a fund management company plays a role in determining the likelihood of investor success. Mutual-fund investors face the greatest challenge with investment management companies that provide returns to public shareholders or that funnel profits to a corporate parent—situations that place the conflict between profit generation and fiduciary responsibility in high relief. When a fund’s management subsidiary reports to a multi-line financial services company, the scope for abuse of investor capital broadens dramatically . . . “Investors fare best with funds managed by not-for-profit organizations, because the management firm focuses exclusively on serving investor interests. No profit motive conflicts with the manager’s fiduciary responsibility. No profit margin interferes with investor returns. No outside corporate interest clashes with portfolio management choices. Not-for-profit firms place investor interest front and center. Ultimately, a passive index fund managed by a not-for-profit investment management organization represents the combination most likely to satisfy investor aspirations.” I regard these two powerful endorsements of the positions that I hold as a clarion call for action.

By so doing, we would be in a position to be the “low- cost provider” in an industry where, as we saw it then—and see it now—cost was, well, everything, the ultimate competitive weapon. Following approval by the SEC and our fund shareholders, we began operations on May 1, 1975. But we were hardly unaware that if our new firm was to shape its own destiny we had to quickly move to control our investment services and distribution services as well. We immediately began that process. Within six months, we had gained our Board’s approval for the world’s first index mutual fund and entered the investment arena. Now known as Vanguard Index 500, its IPO took place on August 30, 1976. The new index fund (“Bogle’s folly”) began with a frustratingly tiny asset base of only $11 1 I also spoke to you in 1999, when I was honored to receive your Robert L. Gould Award for commitment to excellence in shareholder service. All five of my speeches are posted on my Bogle eBlog (note the anagram!), www.johncbogle.com. Note: The opinions expressed in these remarks do not necessarily represent the views of Vanguard’s present management.

75% 55% 100% 0% 20% 40% 60% 80% 100% Money Market Bond Funds (expected) Equity Funds Share of Assets in No Load Funds 2A. to 5.3 percent for the bottom-tier funds, reducing their disadvantage by 0.9 percentage points, more than a 40 percent reduction in the spread. Clearly, before costs are deducted, remarkably small rewards—indeed, almost non-existent rewards—can be attributed to manager skill, luck, and randomness. The Great Marketing Machine In the great marketing machine we know as the mutual fund industry, these perhaps obvious findings are largely ignored, even as the costs of mutual fund investing are themselves largely ignored. Think with me for a moment of how mutual funds are distributed in relationship to the clarity of the impact of costs on returns. In money market funds, when the correlation between expense ratio and total return is virtually 1 to 1, even on a daily basis. Here, 100 percent of total money market fund assets of $1.8 trillion is represented by no-load funds. (Chart 2A) In equity funds, the correlation of costs with returns over, say, a single year is cloudy but negative, at about the minus 0.13 level. The correlation of costs with returns over three decades is much more visible, and negative at an imposing minus 0.69 level. Yes, higher costs are associated with lower returns.

plus “non-income statement” costs) equal to something like 1.10 percent of assets last year. Thus, the unit cost increase is really almost 100 percent. 2. Second, the assets of the average major complex were $2 billion in 1977, but $18 billion in 1986. Thus the total dollar expenses borne by the shareholders of the typical complex have risen from $12,000,000 to $200,000,000, an increase of about 1,500 percent. (In fairness, the average number of shareholder accounts has risen by 400 percent during the same period.) If, a decade ago, I had merely predicted a “price war” in this industry, I would have given myself a higher grade, for surely we are witnessing on of the great price wars in the economic history of the United States. My higher grade, however, would have been a sham, because today’s great mutual fund price war is not a conventional price war. Indeed, it is not a war to lower prices, but to raise them. With the pervasive imposition of 12b-1 fees, deferred sales charges, direct fees for exchanges, redemption fees, and a surprising number of advisory fee increases, costs of existing funds are heading skyward. And new funds often begin with fees at a still higher plateau—2 percent is no longer an extraordinary expense ratio. My credentials as a prophet are clearly deteriorating!

(Before I turn to “product line” and “principal markets,” I should note my view that more imaginative ways of pricing operational services will develop by the 1980’s. For example, I wonder if it is not time to consider “externalizing” the shareholder account fee. It is difficult for me to conceptualize why a single investor who owns, say, $2 million of a $200,000,000 fund’s shares, should pay for 1% of its transfer agency costs. Why should he pay, say $2,000 per year, when the cost of handling that single account is $5. This concept has obvious implications for future marketing strategy.) Turning to the 1980’s product line, it will inevitably relate directly to the pricing structure. This is hardly a subtle point. When we were strictly an equity-oriented industry, the sales charge and expense ratio did not appear to be critical or differentiating factors. If they were high, they got lost in a matrix of good performance and bull markets. And if they were low, it really did not help all that much if performance was bad. In short, our equity products were perceived as “differentiated”—if you could pick a fund that “performed,” the cost did not really matter.

That perception is, to say the least, no longer universally valid. Thus, we have “index funds” which put forth the general proposition that consistently low operating and transaction costs is a valid approach toward above-average results. And, in the 1980’s, this low cost strategy, which assures relative performance that is highly predictable, will spread beyond index funds based on the Standard and Poor’s 500 Stock Index. Indeed, I suspect that a “growth stock index fund” awaits only the development of a growth stock index. If these changes come to pass, of course, they will make life difficult for what has be come known as “closet” index funds—those stock funds which behave much like an index, and emphasize substantially the same stocks, but cannot match its performance because of high portfolio turnover and high operating costs. An even clearer example of the relationship of product line and price can be seen in the income fund segment of the industry. It has now, I think, been proven beyond doubt that money market funds cannot be sold with a sales charge. The same proposition seems to have gained considerable validity in the municipal bond field (though the generally high level of annual operating costs are, in my view, somewhat oppressive to the “bottom line” yield).

Contrast this strategy with the typical mutual fund strategy, not owning businesses but trading pieces of paper. Few investors are going to be Warren Buffetts, so let’s consider the closest thing to his hedgehog-like strategy available to us mere mortals. What fills the bill is buying a participation in every publicly-held business in America, and holding it forever. Yes, an all market index fund. Managed with virtually no portfolio turnover and operated—as it must be—at minimal cost, such an index fund is simply a hedgehog that enjoys three priceless certainties: (1) a certain participation in the growth of corporate America; (2) certainty that the crafty investment foxes as a group must earn the market’s annual return before costs, but deliver only about 85% of the return after costs; and (3) a certainty that, given its own minimal costs, it will deliver 98% of the market’s annual return to its investors. Clearly, just as the performance data show, the one great thing that characterizes the hedgehog approach—pristine simplicity—is the winning strategy. Perhaps it goes without saying that Vanguard is the industry’s principal hedgehog. While indexing need not be the only hedgehog strategy (witness Warren Buffett), it works, and we are the only firm that is deeply and fiercely committed to index funds.also

Redesigning the Fund Industry “I have a dream.” Or rather, five dreams for redesigning the mutual fund industry in the years to come. I’ll discuss first, mutual fund pricing, and second, the burgeoning of our retirement plan business, in both cases using the predictions I’ve made in my various talks to NICSA as a springboard. Then I’ll discuss, third, a new design for investment policy, fourth, a new design for “product development,” and fifth, a new design for governance structure, three of my other perennial favorites. Here, then, is the design of my dreams. 1. The Dream of a Fair Shake for Shareholders The first dream is to design a new industry in which we give our investors a fair shake in terms of costs. In my 1977 speech, I boldly predicted that investors would come to focus far more heavily on fund costs, evaluating “total price—or total cost-effectiveness over time, including any initial sales charges and fund operating and advisory expenses.” Alas, by my 1987 talk, I could only grade myself with an “F” on that prediction. Over the decade then ended, the expense ratio of the average equity fund had risen from an average of 0.96 percent to an estimated 1.38 percent, a 44 percent increase in unit terms. This increase came despite the fact that total industry assets had grown from $37 billion to $588 billion, and the dollar amount of annual fund costs had risen 4000 percent, from $232 million to $4.2 billion.

Dissecting the Impact of Costs With that background, let’s now take a careful look at the impact of costs on returns; using three charts (“scatter diagrams”) that largely update those that I presented to FIASI in 1998. They differ only slightly from one another in the message that they uniformly present: Beating the bond market is a loser’s game, largely because of the high costs—heavy sales charges and large expense ratios, and, to some degree, excessive transaction costs—incurred by the vast majority of bond mutual funds. The corollary of this message is equally obvious and equally important: The more the managers take, the less the investors make. There are too many types of bond funds to try your patience by examining all of them. So let’s examine the three basic maturity levels (intermediate-term, long-term, and short-term) that have become the industry standard, one in each of the three major bond segments—taxable corporate bonds, tax-exempt municipal bonds, and U.S. Government issues. We’ll start with taxable intermediate-term bond funds; then turn to tax-exempt long-term bond funds; and finally evaluate funds investing in short-term U.S. Treasury notes. Intermediate-Term Corporate Bonds Among intermediate-term taxable corporate bond funds, the Lehman 5–10 Year Credit Bond Index (the red star) set a demanding hurdle rate. (A finding that indexing wins should not surprise you!)

 Three, mutual fund returns fall drastically short of market returns. And they fall short by almost exactly the amount of the costs they incurred—all those management fees, operating expenses, sales charges, and hidden portfolio transaction costs. How could it be otherwise? Over the past two decades, for example, the annual return of the average equity fund (10 percent) has lagged the return of the S&P 500 Index (13 percent) by three percentage points per year, largely because of those pesky fund costs. To make matters worse, largely because of poor timing and poor fund selection, the return actually earned by the average fund investor has lagged the return of the average fund by another 3 percentage points, reducing it to just 7 percent per year—roughly 50% of the market’s annual return. Warren Buffett accurately describes the problem: “the principal enemies of the equity investor are expenses and emotions.” The fund industry has failed investors on both counts. A return of 7% in a 13% market is a shocking gap, but the reality is far worse. When compounded over this grand 20-year era for investing, and adjusted for inflation, the average investor has captured but 16 percent of the market’s compounded real profit. (I’m not kidding! $1,000 invested in a simple index fund mimicking the Standard & Poor’s 500 Stock Index in 1984 and held today produced a profit of $5,490 after inflation; for the average fund investor, the real profit came to just $910.)

(Chart 3A) Its 10-year return (reduced by 20 basis points to account for estimated expenses) was 6.72 percent, just a hair higher than the 6.65 percent return of the comparable Vanguard Intermediate-Term Bond Index Fund, oddly enough, the only index fund of its kind in the field with a ten-year history. Vanguard Total Bond Market Index Fund—with more than 70 percent of assets in Treasury and government mortgage-backed bonds and about 30 percent corporate bonds—albeit provided a net return averaging 6.1 percent.

considerable assurance—that America itself will continue to have a population that is growing in age, education, professional status, real income, and asset accumulation—the same five areas in which no-load funds have found their greatest relative strength. I wish I had more time today to deal with the institutional markets of the 1980’s, and their relationship to pricing and product strategy. Let me simply state my conclusion that these markets—pension, endowment, corporate, foundation—should become extremely important to our industry’s future growth. Why? Because a mutual fund group—especially one with a nominal or no sales charge, and with a low expense ratio—offers extraordinary opportunity to such institutions, from the largest to the smallest, in terms of simplicity, efficiency, liquidity, and flexibility—to say nothing of investment performance. One of the great canards of recent years is that mutual funds are somehow “second class citizens” when it comes to performance results. I would like to take a moment to put that ridiculous apprehension to rest right now, because as we approach the 1980’s the information explosion will mean that institutional investors will be even more informed—if that is possible— about relative performance than they are today. And the simple fact is that mutual funds have a significantly better record than any type of adviser to corporate pension accounts.

Affiliated Fund* Assets (million) Mgmt. Fee Rate Other Expenses Expense Ratio Mgmt. Fee Dividend Shares* Fidelity Fund Incorporated Investors* Mass. Inv. Trust Wellington Fund* Average $116 $142 0.41% 0.50 0.50 0.50 0.33 0.40 0.44% 0.31% 0.24 0.16 0.05 -0- 0.20 0.16% 0.72% 0.74 0.66 0.55 0.33 0.60 0.60% $476k 410k 215k 485k 1,200k 616k $566k Management Fee Rates and Amounts, 1950 *Now, respectively, Lord Abbett Affiliated, AllianceBernstein Growth & Income, Putnam Investors, and Vanguard Wellington 3. fund is offering a dividend yield of just 0.4 percent. Where did all the income go? It was slashed by fund expenses. The expense ratio of domestic stock funds averages 1.4 percent, reducing the funds’ gross dividend yield of 1.8 percent to 0.4 percent. Unsurprisingly, then, it appears that the average stock fund earns the stock market’s present dividend yield of 1.8 percent and then consumes fully 80 percent of that yield in fees and expenses. It didn’t need to be that way. When I began my research on this industry in 1950 for my Princeton University thesis, an interesting fact came to my attention. The first mutual fund— Massachusetts Investors Trust, founded in 1924—calculated its expenses, not on the basis of a percentage of assets, but as a percentage of its investment income. During its first 25 years, MIT charged investors the then-standard trustee fee of 5 percent of income.

Vanguard’s very first strategic decision, made in 1975, only months after we began, was obvious: To form the first market index mutual fund—an unmanaged portfolio of the 500 stocks in the Standard & Poor’s 500 Index—in history. Derided for years as “Bogle’s folly,” it took, unimaginably, another full decade until a single competitor had the guts—or wisdom—to follow. In the words of The Wall Street Journal, the Vanguard Index 500 Fund has become, heaven forbid, “the industry darling.” With $80 billion of assets, our pioneering index fund is now the second-largest mutual fund in the world, well on its way to becoming the largest before the new century arrives. The decisions that followed over the years took the same direction. Following that first 500 Index Fund, we formed index funds covering our entire stock market, a wide variety of U.S. stock market sectors, international equity markets, and the bond market. We also developed stringently-managed bond funds that offered investors market-like portfolios with clearly-defined quality and maturity standards, entailing little trading and operating with minimal expenses. What is more, we shaped most of our managed equity funds to parallel particular investment styles, focusing on long-term horizons, relatively low portfolio turnover, and, yes again, minimal costs, achieved by negotiating fees at arm’s length with external advisory firms. This hedgehog strategy remains the rock on which our investment philosophy rests.

8 percent return the funds reported. Cumulatively, then, these fund investors experienced but a 27 percent increase in their capital over the decade. Yet, simply by buying and holding the market portfolio through an index fund, they would have produced an increase in capital of 141 percent. Thanks to the innovation and creativity of fund sponsors, then, investors lost an astonishing 114 percentage points of return relative to the market itself. So much for the well-being of investors! As to the well-being of managers, we can roughly estimate that the total fees and sales loads (excluded from our calculations, which therefore understates the gap) paid to fund managers and distributors (including brokers) totaled in the range of $20 billion. So yes, to answer the question posed by the title of these remarks, even as in the banking and derivative sectors of our financial economy, innovation has gone too far in the mutual fund sector. And the Beat Goes On One might have hoped that the fund industry would have learned from its past history of over- reaching innovations. But the evidence goes the other way. In recent years, we’ve created “130/30” funds, in which managers implicitly suggest that over-investing the traditional 100 percent long position in stocks by 30 percentage points, offset by a 30 percent short position, will produce higher returns. Maybe yes, maybe no—only time will tell—but the drag of the higher fees on these funds is a certainty.

0.0 0.5 1.0 1.5 2.0 2.5 Vanguard IT Index Fund: 6.65% Leh 5-10 Credit, less 0.20 bps: 6.72 Vanguard Tot Bond Mkt Inst: 6.20% Vanguard Tot Bond Mkt Inv: 6.07% Vanguard IT Inv Grade: 6.43% Avg IT Corp Fund: 5.52% Slope: -1.09 Number of funds: 313 Intermediate-term Corporate Bond Funds 10-Year Returns versus Expenses 3A. Vanguard IT Inv Grade Fund Average IT Inv Grade Fund Volatility (vs index) 85% 75% Quality (A or above) 98% 81% Turnover (5 yr avg) 55% 213% Expense Ratio 0.21% 0.93% 6.44% 5.52% 10-yr Annual Return $8,670 $7,110 Profit on $10,000 Vanguard IT Bond Index Fund 100% 100% 97% 0.17% 6.65% $9,040 3B. Duration 5.2 4.6 5.9 The adjusted annual return of 6.7 percent for the index was more than 20 percent higher than the 5.5 percent return of its average peer. Since the slope of the cost/return line is -1.09 (meaning that each percentage point reduction in cost increases return by 1.09 percentage points), actively managed bond funds as a group in fact earned a lower gross return than either the index fund or the adjusted index. Clearly, relative cost proved to be the principal differentiator in net return. (Chart 3B) Vanguard Intermediate-Term Investment Grade Bond Fund, for example, has an expense ratio of 0.21 percent, less than a quarter of the 0.93 percent expense ratio of its average peer. Similarly, the slightly-longer-duration Vanguard Intermediate-Term Bond Index Fund carries an

Throughout that quarter-century, MIT was the nation’s largest mutual fund, and its growth was substantial. By 1950, its assets had grown to $362 million. The dividend income on its investments grew commensurately, and the 5 percent charge against income was soon producing far too much money for the fund’s trustees to accept. (Imagine that!) So they promptly reduced the annual fee to 2.9 percent of income.4 Since dividend yields were then relatively high (MIT’s stocks were yielding about 5½ percent), the net dividend yield received by MIT’s shareholders was 5.3 percent. (For the record, measured against fund assets, MIT’s expense ratio was 0.33 percent.) For reasons lost in history, few of the mutual funds organized in the years after MIT began followed the pioneer’s precedent. Instead they chose to set their management fees as a percentage of net assets rather than as a percentage of investment income. The typical annual charge was set at ½ percent of assets, typically scaled down to 3/8 of 1 percent on fund assets in excess of $100 million. 5 Modest fee structures, then, for an industry then managing modest amounts of assets. A 1950 snapshot of that tiny mutual fund industry (Chart 3) shows both management fees and total expenses at a reasonably low level, along with a recognition by fund managers that, as their funds grew large (then, “large” meant more than $100 million in assets!)

Another innovation is a variety of fixed-payout funds in which specific rates of annual withdrawals are offered, along with a warning that these payouts may, over time, exhaust the investor’s capital. (One can only hope that warning is in large boldface type.) Other innovations have included tax-deferred variable annuities that assure continued payouts (as a percentage of a fluctuating asset value), a perfectly good idea—except that the grossly excessive costs, commissions, surrender charges, etc., that burden most of these “products” have proved to erase much of their alleged advantage. And we also see new equity indexed annuities, usually providing only a portion of the stock market’s return while guaranteeing a minimal annual return in the 1 percent to 3 percent range. Even a rudimentary financial analysis suggests that these modest added values are unjustified by costs (and sales practices) that are anything but modest. Of course the major innovation of the recent era is the exchange-traded fund (ETF). I suppose there’s nothing wrong, as such, with an index fund that can be traded (as the advertisements say) “all day long, in real time.” But I have to wonder why any serious investor would want to do such a crazy thing.on

expense ratio of 0.17, explaining almost all of its return superiority over the actively-managed competition (6.65 percent vs. 5.62 percent). In addition, its return benefits from the absence of sales loads. “All bond funds are not created equal.” And that is true of investment grade intermediate-term corporate bond funds, too. The outliers in the chart have usually departed radically from bond market norms. For example, the top performer with that terrific 8.9 percent return (and blessed with no sales loads and a relatively low 0.55 percent expense ratio), held fully 41 percent in credits rated BBB or less, compared to only 2 percent for the index. Overall, the Vanguard managed fund and the Vanguard index fund not only operated at far lower expenses, but maintained significantly higher quality (almost 100 percent A-rated, vs. 81 percent for the average managed fund). In addition, the Vanguard funds exhibited starkly lower portfolio turnover (55 percent and 97 percent, vs. a stunning 213 percent average). That said, both the Vanguard funds were slightly more volatile, carrying a slightly longer duration than the typical managed bond fund (5.2 and 5.9 years respectively, vs. 4.6 years). And so the message echoes. Among intermediate-term taxable bond funds, in terms of maximizing investor return and minimizing quality risk, low-cost funds are superior performers. And over time that annual advantage matters even more!

(Reversion to the mean is alive and well in the mutual fund industry!) Yes, the large-cap Standard and Poor’s 500 Stock Index not only seems high—at an astonishing 29 times earnings it is high—but also seems significantly overvalued relative to the small- and mid-cap stocks that represent the remaining 25% of the market’s $13.5 trillion value . . . but the fundamental theory of indexing is grounded in owning the entire stock market, and that option is available in at least a few index funds. What is more, some 75% of the $2.8 trillion of equity mutual fund assets is invested in those same 500 S&P stocks. So, for the “500” index funds and the industry as a whole, the exposure to market risk is not significantly different. Yes, interim variations in the gap between industry and index returns will surely expand and contract in the future . . . but in the long run the mutual fund industry will have to recognize the inevitability of the failure of its existing investment modus operandi to earn returns that are sufficient to overcome its costs, and add economic value for fund shareholders.Speculation

With a cumulative final value of an initial investment of $10,000 over the past decade growing by $9,040 in the Vanguard Index Fund, more than 25 percent higher than the $7,110 earned for its average actively managed rival, the index strategy proved to be a winning strategy, outpacing an amazing 297 of its 313 peers over the past decade. Importantly, among the 50 top-performing corporate bond funds in that universe, only a single one is a load fund, whereas among the bottom 50, only 4 are no-load funds. Long-Term Municipal Bond Funds Now let’s consider long-term maturities, with a focus on tax-exempt municipal bond funds. Because of complexities in the construction of municipal bond indexes, there are no pure index funds in this category. But the results of the major index in the field (the Lehman Brothers Tax-Exempt 10-Year Municipal Index) confirm the power of indexing in surpassing the returns provided by the average active bond manager.gross

 a broad product line, with innovations as required. (For example, our index fund, and an innovative concept of the municipal bond fund, which we are now just developing.)  Finally, operational facilities that will assure our ability to service shareholders effectively and efficiently, to expand the range of our services, and to control our marketing efforts. We do not believe our precise strategy would necessarily be right for anyone else in the industry. We do believe that it is right for us. But it comes only by relinquishing our marketing relationships—but maintaining our execution and research relationships—with the brokerage community that we worked with for many decades. I regret that departure, above all.troublesome

hand, is simply to buy a diversified list of stocks and hold them, well, forever. This is, of course, a fair depiction of the strategy of Warren Buffett. But it is also the driving force in Vanguard’s success: The passively managed market index fund. In its most pristine form, the index fund—operated at a cost best described as trivial—owns a share in every business in America, and never sells it. Who wins, the fox or hedgehog? Well, let’s look at the record. If you had invested $10,000 with the typical mutual fund fox at the outset of this 17-year bull market—the greatest in all history—it would today be valued at $136,000. The same investment with the all-market fund hedgehog would be valued at $182,000. Just owning American business—at low cost—and doing nothing else, resulted in an extra $46,000 in return. The difference lies solely in relative cost. No wonder investors are starting to appreciate indexing. And no wonder the financial foxes hate it. For, as the record shows, foxy active management, with its heavy fees and costs, simply results in a diversion of the market’s returns from the shareholders to the managers.

 Reduce your focus on the Standard and Poor’s 500 Index as the basic indexing standard. Given its extraordinary and unrepeatable margin of superiority over the past five years, S&P 500 Index Funds have clearly drawn huge assets from short-term investors who buy hot past performance, as well from long-term investors who recognize the merits of low-cost, tax-efficient investing in high grade stocks. Begin to implement formalized redemption-in-kind procedures. When the giant growth stocks with their lofty price-earnings multiples revert to, and below, the market mean, as they inevitably will, substantial redemptions could follow. Protect the long-term shareholders.  Remember that while the return on the all-market index fund—the best index standard—will always outpace the returns of all actively-managed accounts as a group, that may not always appear to be the case, since half of all mutual funds are small and mid cap funds. Make sure your investors are aware of this difference.alike:

3.5 4.5 5.5 6.5 7.5 0 0.5 1 1.5 2 Long-term Municipal Bond Funds 10-Year Returns versus Expenses Vanguard LT Tax-Ex: 5.66% Lehman 10-Yr Muni less 0.20 bps: 5.46% Vanguard Ins. LT Tax-Ex: 5.71% Avg LT Muni Fund: 4.72% Slope: -0.85 Number of funds: 143 Expense Ratio Return 4A. return of 5.66 percent, a comparable index fund, after assumed costs of 0.20 percent, would have provided a 5.46 percent net annual return. By way of comparison, the Vanguard Long-Term Tax-Exempt Bond Fund happened to provide an even higher return of 5.66 percent, net of its tiny expense ratio of 0.15 percent, even less than the costs assumed for the index fund. Once again, low costs lead to higher returns. Each percentage point reduction in costs increases returns by 0.85 percentage points. The 5.66 percent annual return of the long-term Vanguard fund was roughly 20 percent more than the 4.72 percent earned by the average long-term municipal fund, even though many of the actively managed funds were assuming higher risks. The top performing outliers, for example, held barely 50 percent in AAA-rated bonds, compared to 86 percent for the average fund, and 91 percent for the uninsured Vanguard fund. Like the index itself, the Vanguard managed bond fund is broadly diversified and holds a high-quality portfolio: 100 percent rated A or better, even higher than the 86 percent figure for its actively managed peers.

” Meanwhile, the fund itself is incurring heavy trading costs and charging heady advisory fees, to the point where an electronics fund, for example, cannot conceivably match the return of electronics stocks as a group. (At least an “industry index fund” could do that.) If I am correct in this analysis, today’s specialty stock funds, having come and gone once in the 1940s, will come and go again in the 1980s. When the speculator sours on mutual funds—an eventuality that will accelerate when we get the next sharp market correction—what then do we have to offer the investor and the saver? The obvious and, I think, correct response is “back to basics”—back to broadly-diversified, economically-managed funds with sensible objectives. Indeed, I expect that the pendulum will swing even further away from today’s speculation. If the investor wants (and needs) broad diversification among equities, and if the saver wants (and needs) broad diversification among bonds, perhaps unmanaged stock index funds and bond index funds will become important factors in this industry in the decade ahead. There is not much evidence to support this view. Our stock index fund—Vanguard Index Trust— during its first decade has been, as they say, an artistic but not a commercial success.

Affiliated Fund Assets (million) Expense Ratio Dividend Shares Fidelity Fund Incorporated Inv. Mass. Inv. Trust Average $116 $140 0.72% 0.74 0.66 0.55 0.33 0.60% Growth in Assets and Expenses, 1950 - 2006 1950 $21,200 4,600 7,700 4,100 4,900 $8,500 2006 Wellington Fund $154 0.60% $45,700 Expenses (million) $0.8 0.6 0.3 0.5 1.2 $0.7 1950 $191 $79 2006 $0.9 $114 1950 2006 0.90% 1.32 0.55 1.16 1.09 1.00% 0.25% % of Div. Income 12% 10% 12% 1950 2006 44% 57% 8% 4. But a funny thing happened on the way to 2006. Those old values seemed to vanish. Remarkably, each of those six industry pioneers still exists, but, with a single exception, the idea of sharing substantial economies of scale with shareholders has gone up in smoke. (By 1969, alas, even MIT had abandoned its dividend-based fee rate in favor of the conventional asset-based fee rate. Its expense ratio subsequently more than tripled, from 0.33 percent to 1.09 percent.) Amazingly, despite the truly staggering growth in total fund assets, expenses have grown at an even faster rate, resulting in expense ratios that have actually increased. For five of these six funds, more and more of that priceless component of investment return known as dividend income was consumed by costs, (Chart 4) from 10 percent of income in 1950 to nearly 60 percent in 2006. Even as assets have increased nearly 60 times over, from $770 million to $42 billion, their expenses have increased even faster—more than 100 times over, from $3.

More than any other firm, Vanguard has been the fund industry’s hedgehog, applying its one great thing to pioneer in many of the fund industry’s most productive and investor-friendly innovations: the mutual (investor-owned) structure; the index fund; the tax-managed fund; the money market fund; the management of bond funds in defined asset classes; the direct marketing of shares to investors through no-load funds, without salesmen or commissions; and many others. While we were not always first to adopt these strategies, we have been widely credited as being the driving force in their acceptance, for our single-minded focus on low cost has made them work for investors in an extraordinarily effective way. It was said of Wilson, “he may not have coined all of his vital ideas, but he mined them as no others did.” So too it might be said of Vanguard.

After a half-century observing this industry, I may have become too much the philosopher, maybe even too much the cynic. But it occurs to me that most mutual fund managers are barking up the wrong tree. I just can’t imagine that any of those foxes in the mutual fund industry don’t understand the simple arithmetic that gives the all-market index fund its powerful advantage, let alone the extra boost added by its extraordinary tax-efficiency. That I am virtually the industry’s sole apostle of indexing makes the thesis easy to ignore. But even when Warren Buffett, with his unchallenged credentials, speaks—“Most investors will find that the best way to own common stocks is through an index fund that charges minimal fees. . . it is certain to beat the net results delivered by the great majority of professionals”—this industry fails to listen. Except, that is, for the former chairman of one giant fund complex who defends his firm against the clear truth that underlies the superiority of the index with these words: “Investors ought to recognize that mutual funds can never (his word) beat the index.” The index fund is not merely another kind of mutual fund. It approaches investing, not as a matter of trading pieces of paper for advantage, but as a matter of owning businesses and watching them grow. Through an all- market index fund, investors own the shares of virtually every publicly-held business in the U.S., and hold them forever.

” The seminal Vanguard innovation was to reverse that tautology: “the less the managers take, the more the investors make.” And so we created our novel and unique structure. Rather than having the mutual funds run under contract by the investment manager (the industry’s traditional structure), in business to earn a profit on its own capital, at Vanguard the mutual funds would actually own their management company operating to serve solely the interests of its fund investors, offering its services on an “at-cost” basis, and in business to earn a profit on their capital. This structure may not be—and is not—entirely conflict-free. But the proof of the pudding is in the eating: Vanguard today operates at a weighted expense ratio of about 21 basis points, compared to about 95 basis points for the fund industry. Applying this differential of 74 basis points to our present asset total of $1.3 trillion—up from $1.4 billion when we began—means savings of nearly $10 billion  I don’t have time to discuss in depth another promising fund innovation: “Target retirement funds,” in which the investor selects his year of retirement and the fund gradually moves from a heavy equity position to a substantial bond position as retirement nears.

4 million to $395 million. Result: expense ratios have nearly doubled, from 0.57 percent to 1.0 percent. This evidence totally contradicts the consistent stand of the industry, articulated over and over again at the annual membership meetings of the Investment Company Institute, that “the interests of mutual fund managers are directly aligned with the interests of mutual fund shareholders.” It’s just not so. But there is a case—just one, and one with which I am well-familiar—in which the ICI was right. That fund’s assets also soared—from $154 million to $46 billion. But while its expenses leaped from $924,000 to $114 million, the expense ratio actually declined by 60 percent, from 0.60 percent of assets to 0.25 percent. Most importantly, after absorbing 12.5 percent of income in 1951, Wellington Fund’s costs actually absorbed even less of the fund’s income—8.0 percent—in 2006. I attribute this obvious success largely to the facts that (a) The Fund is a unit of Vanguard, a unique mutual mutual fund group owned by its fund shareholders, and is operated on an “at cost” basis; and (b) in the 1980s and 1990s, we vigorously renegotiated the advisory fee scale with our external advisor, demanding that our fund’s owners share in the economies of scale. (Today, the annual advisory fee we pay to Wellington Management Company comes to just 3/100 of 1 percent of assets—a measly three basis points.) And now, a dream.

We have consistently matched the Standard & Poor’s 500 Stock Index within on-half of one percent per year, during a period when the Index itself has been a solid performer—usually outpacing about two-thirds of pension equity accounts. Nonetheless, our modest (by today’s standards) $600 million no-load index fund still finds itself without a counterpart. In an industry where mimicry is a way of life, I am almost embarrassed that our competitors have failed to ape our pioneering product. So, undaunted and perversely, we have formed “Vanguard Quantitative Portfolios,” which will seek to harness the incredible power of the computer to manage a diversified equity portfolio, all the while remaining in lock-step with the Index, but trying to eke out a 2 percent to 3 percent annual performance advantage. This approach toward “relative predictability,” you will note, is essentially diametrically opposite to our industry’s direction today. (We dare to be different!) And, we have also just formed the first publicly-available bond index fund—Vanguard Bond Market Fund. The unmanaged bond indexes, like the unmanaged stock indexes, have been formidable competitors for America’s professional money managers, usually outpacing about two-thirds of pension bond accounts. This Fund too will provide substantial relative predictability to investors. Like our stock index fund, our bond index fund will employ no advisor, pay no advisory fee, and operate at an expense ratio in the 0.25 percent range.

(2) We formed the world’s first index fund, a passive portfolio designed simply to provide the returns provided by the stock market, a challenge that precious few portfolio managers have measured up to over time. (3) We developed a new paradigm for bond fund management, using innovative three- tier structure of short-term, long-term, and intermediate-term portfolios that quickly became the industry standard. (4) We abandoned, overnight, a proven broker-dealer, commission-oriented “supply” push distribution system in favor of a new and untried no-sales-charge, demand-pull system for self-motivated investors. None of these changes that we all take for granted today came easily. To accomplish them required a devil-may-care attitude, a blasé disregard for risk, a profound conviction, without hard evidence, that they would work, and the sheer energy required to get it all done. What’s more, they were, well, “contentious.” Despite what we regarded as our noble intentions, the completion of our structure was initially opposed by our industry’s regulatory agency. The Securities and Exchange Commission rejected our structure, and dawdled over our appeal for four long years. When it finally gave us its unanimous approval, it came with a nice bonus and a snappy salute: “The Vanguard plan actually furthers the (1940) Act’s objectives, and promotes a healthy and viable complex in which each fund can better prosper.”

This overarching principle—the one great thing that the fund hedgehog knows—is not merely a good strategy for the long-term investor. It is a winning strategy. Here, I am reminded of Occam’s Razor, the principle that advises: When faced with a problem having multiple solutions, choose the simplest one. (This “principle of parsimony”—shaving away all complex solutions—was recently given the attention it deserves by William Safire in his Sunday New York Times Magazine column.) Occam’s Razor is right on the mark in pointing to the solution to the seeming riddle of investment success, for index funds are the essence of simplicity. I should add that, contrary to much of what we read in the financial press, the principle that Sir William of Occam set out in the 14 th century, works—as it must work—in all financial markets. Whether in markets in which fund returns are widely divergent—small stocks or international stocks, for example—or in markets in which fund returns are narrowly-spaced—bonds, for example—there is no longer any question of the power of the universal principle of low-cost indexing. It may threaten the financial interests of the fund industry, but it fosters the financial interests of the fund shareholders. The Hedgehog as Businessman Let me now turn to my second contrast between fox and hedgehog: From the industry’s investment conduct, to its business conduct.hedgehog

Vanguard LT Municipal Fund Average LT Municipal Fund Volatility (vs index) 91% 82% Quality (A or above) 100% 86% Turnover (5 yr avg) 12% 41% Expense Ratio 0.15% 1.0% 5.66% 4.72% 10-yr Annual Return $7,340 $5,860 Profit on $10,000 Vanguard Ins LT Muni Fund 88% 100% 18% 0.16% 5.71% $7,420 4B. Duration 5.6 6.1 5.7 3.0 3.5 4.0 4.5 5.0 5.5 6.0 0 0.5 1 1.5 2 Vanguard ST Fed: 5.07% Lehman 1-5 Treas, less 0.20 bps: 4.8% Vanguard ST Treas: 4.95% Avg ST Gov’t Fund: 4.43% Slope: -0.67 Number of funds: 90 Expense Ratio Return Short-term Government Bond Funds 10-Year Returns versus Expenses 5A. Over the past decade, $10,000 initially invested in the Vanguard Long-Term Municipal Bond Fund provided a profit of $7,340, 25 percent larger than the $5,860 earned by its average rival, achieving that extra gain with a higher quality portfolio. With low costs, broad diversification, and no serious attempt to outguess the market in long-term tax-exempt bonds, once again the index-like strategy wins. Both Vanguard Long-Term Tax-Exempt Bond Fund and its close counterpart, Vanguard Insured Long-Term Tax-Exempt Bond, ranked in the top decile of the 143 funds in the category. Once again, load funds were conspicuous by their paucity among the top 20 funds (only 4 with loads) and dominated the bottom-20 fund group (18 with loads). Short-Term U.S. Treasury Bond Funds Our sweep of the bond fund arena concludes with an examination of short-term funds investing in U.S. Government obligations.

dollars per year to our fund investors. That’s enough savings to keep our money market and bond funds consistently in the 95 th (or higher) percentile among their peers, and to place our equity funds fairly consistently in at least the 75th percentile in terms of the returns we generate for our shareholder/owners. It is that innovation—based on the common sense observation that costs matter, and that funds should be, well, “of the shareholder, by the shareholder, and for the shareholder”—that has engendered the other major innovations that we have been responsible for over the years. By far the most important of these was our second strategic innovation. Immediately after Vanguard began operations in May 1975, we created the world’s first market index mutual fund, simply tracking the returns of the S&P 500 Stock Index. To do its job, the basic index fund takes diversification to the nth degree. It owns the lion’s share of the entire U.S. market, and thus assures that its investors are guaranteed to capture the gross return of the stock market (or the bond market, or any discrete segment of each). But if this diversification assures that the index fund earns the market’s return, it is rock-bottom costs that assure that it delivers to its investors nearly 100 percent of whatever returns the market may provide. (With its passive strategy, it also virtually eliminates portfolio trading costs, and also provides commensurate tax efficiency.)

Bond Funds: Current Yields and Expenses IT Corporate Gross Yield Expense Ratio Net Yield 5.4% 1.1% 4.3% IT Government 5.2% 1.0% 4.2% IT Municipal 4.6% 1.0% 3.6% 5. Well, I can dream can’t I? But in any event, it’s high time that we require mutual funds to disclose to investors and prospective investors the amount of their dividend income that is consumed by costs, and its impact on the fund’s long-term returns. Bond Funds Now a brief word about bond fund expenses. While in bond funds the consumption of income by expenses is lower, the impact on long-term returns is higher. (Chart 5) The average bond fund is presently earning a gross yield of about 5 percent, but after the average expense ratio of 1.0 percent, the net yield averages 4.0 percent. In all, bond fund expense ratios, on average, are consuming about 20 percent of the interest payments the funds receive. (Here, I’ve ignored the impact of sales loads and transaction costs.) But income takes on a special importance in the case of bonds. Why? Because the income yield on a bond fund at the point of purchase establishes the parameters of its future return. 6 Said straight out, today’s yield on a bond fund is an excellent proxy for its total return in the subsequent decade. For example, the initial interest rate on a ten-year U.S. Treasury bond has had a correlation of a mere 0.91 with its returns over the subsequent ten years. (1.00 is perfect correlation.)

As Warren Buffett says, “When the dumb investor realizes how dumb he is and buys a low-cost index fund, he becomes smarter than the smartest investors.” Our third major innovation was a reverse innovation. Early in 1977, shortly after the index fund began operations, we eliminated the sales loads on all Vanguard Funds, moving from a supply-driven broker-dealer selling system to a demand-driven system dependent on investors’ buying decisions. That change was designed in part to eliminate any incentive to create those fad-and-fashion funds that so devastated the returns of investors in the earlier eras I’ve described. Our fourth innovation, also precedent-breaking, came in the bond fund sector. Up until 1977, bond funds were just that: “managed” portfolios of bonds whose maturities could be extended or reduced depending on the portfolio manager’s outlook for interest rates. But skeptical that bond managers had— or ever could have—such prescience, we again did the obvious. We launched the industry’s first defined- maturity series of bond funds, including a long-term portfolio, a short-term portfolio, and (I’m sure you know what’s next!) an intermediate-term portfolio, all operated at rock-bottom cost. The idea was to hold broadly diversified portfolios of top-quality bonds (first tax-exempt municipals, later taxables), and maintain essentially constant maturities in each category.

(Chart 5A) There are few surprises here. The net return earned by the Lehman 1-5 Year Treasury Index itself (4.8 percent per year, net of an adjustment for an assumed expense ratio of 0.20 percent) outpaces the return of 4.4 percent for average short-term government fund.

Vanguard ST Treasury Fund Average ST Gov’t Fund Volatility (vs index) 93% 100% Quality (A or above) 100% 99% Turnover (5 yr avg) 119% 155% Expense Ratio 0.26% 0.88% 4.95% 4.43% 10-yr Annual Return $6,200 $5,400 Profit on $10,000 Vanguard ST Federal Fund 90% 100% 81% 0.20% 5.07% $6,400 5B. Duration 2.2 2.4 2.2 While the Vanguard Short-Term Federal and Treasury funds are not, technically speaking, index funds, they track the index return with remarkable precision, turning in net average annual returns of 4.95 percent and 5.07 percent over the past decade, slightly higher than the index net return of 4.8 percent and outpacing 71 of the 90 short-term government funds. The low-cost, no-load option wins again. Treasurys being Treasurys, investment quality is virtually uniform. (Chart 5B) Both the Vanguard funds and the index itself hold 100 percent of their portfolios in short-term U.S. Government notes, and the actively managed funds hold 99 percent. With its towering 0.88 percent average expense ratio, however, the average short-term bond fund has a lot to overcome. It doesn’t succeed—it can’t succeed—in overcoming that handicap, even by assuming somewhat more volatility risk than the index and the Vanguard funds. The other outliers earning above- market returns did so simply by holding longer maturities, with the highest-returning funds carrying 3.3- to 3.9-year durations, compared to the duration of 2.2 years for the Vanguard funds.

The tracking of their benchmark, their quality parity, and their extremely low expenses mark the Vanguard Short-Term Treasury Bond Fund and the Short-Term Federal Fund—its counterpart which holds largely agency securities—as the functional equivalents of the Lehman 1–5 Year Treasury Bond Index. While there are no bond funds that track this index, those Vanguard funds are the virtual equivalent of an index fund. (Most of the actively-managed funds carry fees and sales charges (averaging 3 percent), which are incorporated into the rates of return shown.)

Initial Yield Expense Ratio 10-Yr Ann. Return IT Corporate Bond Funds 10 Cheapest 6.6% 6.1% 10 Most Expensive 5.9% 1.9% 4.5% The Relationship Between Expenses and Returns Profit on $10,000 $8,100 $5,500 0.2% Low Cost Advantage +11% (89%) +35% +47% 7. Intermediate-Term Corporate Municipal Treasury 12/96 Yield 6.2% 4.7 6.2 10-Yr Ann. Return Through 12/06 5.2% 4.3 4.9 Long-Term Corporate Municipal Treasury 6.9% 5.1 6.1 6.1% 4.4 6.9 Current Yields and Future Returns Note: Yields and Returns exclude impact of sales charges. 6. If investors were more aware of this relationship, surely they’d seek out the lowest-cost—and, therefore, generally highest-yielding—bond funds. For example (Chart 7), here are the returns earned by today’s ten lowest-cost intermediate-term corporate bond funds—expense ratios averaging 20 basis points—and the ten highest-cost funds—expense ratios averaging an amazing 190 basis points—their yields a decade ago, and their returns over the subsequent 10 years. The low-cost group provided an enhancement of fully 35 percent to the investor’s annual return, and a compounded enhancement of almost 50 percent, with zero increase in risk. Investors are largely unaware of these clear relationships between bond fund costs and yields, and between today’s net yield and tomorrow’s total return. Expenses are the principal determinant of relative yields, and yields are highly predictive of future returns.

Then, too many fund managers—including, as I noted earlier, some of the industry’s largest firms—conspired with favored hedge fund clients to allow rapid short-term trading in fund shares that diluted the returns of their long-term shareholders—a classic example of the change from the days “when there were some things one just didn’t do,” to “everyone else is doing it, so I can do it too.” And I’ve seen both, first-hand. 7. Importantly, fund costs have increased by staggering magnitudes since I joined the field all those years ago. In 1951, with fund assets at $2.5 billion, the average equity fund carried an expense ratio (expenses relative to assets) of 0.77 percent. Last year, with equity fund assets at $6.3 trillion, the average fund carried an expense ratio of nearly double that amount: 1.43 percent. Result, expressed in dollars: fund expenses rose from $15 million to $51 billion—260 times as large.5 Not only have basic fee structures risen, but the staggering economies of scale in managing other people’s money have been arrogated by fund managers to their own benefit. Exceptions to this pattern are rare: Among seven of the eight largest funds of 1951, the average expense ratio has actually increased from 0.60 percent to 1.10 percent. Only one fund actually reduced its costs to investors, from 0.60 percent to 0.32 percent. (That fund would be Vanguard’s Wellington Fund.)

2.75 2.26 4.67 2.80 2.95 3.74 0.5 1.5 2.5 3.5 4.5 Corporate Government Municipal Load No Load Bond Fund Holding Periods (years)* 6. holding periods for load funds are in fact shorter among the government funds (2.3 vs. 3.0 years), and only slightly longer in the municipal area (4.7 vs. 3.7 years). All of these holding periods, of course, are incredibly short—a problem for load-fund investors but indifferent (in performance impact) for no-load investors. How much is that overstatement? If the typical 4 percent front-end sales charge on bond funds were spread over ten years, the reported rate of return would be reduced by just 4/10 of 1 percent per year. But if the same charge were spread over just three years, the hit, as it were, would come to fully 1.4 percent per year. Tacked on to an expense ratio averaging about 1.1 percent for load funds, that total of 2.4 percent would now consume about 50 percent—one half!—of the 4.7 current yield on the 10-year Treasury. (Even a higher fraction—virtually expropriation—for municipal fund investors, but a slightly lower fraction for corporates.) I can’t help but wonder whether (and to what extent) any of you bond professionals here tonight would invest in a bond fund with such a confiscatory handicap. A Word about Vanguard Of course, you may regard me as biased in my presentation this evening.fees,

$31,200 $38,700 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Vanguard Total Bond Mkt Avg Taxable Bond Fund Actively Managed Bond Funds Versus Vanguard’s Total Bond Market Index Fund Avg. Annual Return 5.9% 7. 7.0% Fund operates at an effective advisory fee rate of 2 basis points, and our High Yield Bond Fund at less than 4 basis points. That is what negotiating fees for the benefit of the fund investor is all about. It’s unfortunate that such negotiation is conspicuous by its total absence—or at least near- total absence—elsewhere in the mutual fund industry. Owning the Bond Market It is because of low investment expenses, low operating expenses, low marketing expenses, low portfolio turnover costs, and the absence of sales charges that Vanguard Total Bond Market Index Fund most clearly reflects the optimal approach to capturing for investors the maximum possible portion of whatever returns the bond market is generous enough to favor us in the years ahead. At the end of 2006, VTBMF, if you will, celebrated its twentieth anniversary. Given the magic of compounding investment returns—and the tyranny of compounding large costs—the Fund’s record during these two decades speaks for itself. Let’s look at the record. (Chart 7) Based on an initial investment of $10,000 on December 31, 1986, the total value on December 31, 2006, would have come to $38,700, a cumulative rate of return of 7.

0 percent, bringing a profit of $28,700 on the initial stake. In stark contrast, a similar investment in the average taxable bond fund carried a return of just 5.9 percent,1 producing a final value of $31,200, or a profit of $21,200. The Index fund profit, then, was fully 35 percent higher. 1 The average return on net asset value was 6.3 percent. Adjusting for the impact of sales loads on 70 percent of the funds, and assuming a holding period of 3 years—a total added cost of 0.4 percent per year— decreased the average return to investors to 5.9 percent.

As you look at that imposing long-term record for low-cost bond indexing, you might be surprised to learn that it could have been even more imposing. In its first decade, beginning with a tiny asset base of less than $100 million and ending at $4 billion, the VTBMF tracking error relative to its target, the Lehman Aggregate Bond Index, was about 45 basis points per year, largely as a result of higher (if still low) expenses and implementation costs on a relatively small asset base. Then, with larger asset size and superior implementation, the annual tracking error fell to an average of 14 basis points through 2001. Then in 2002, misfortune befell the Vanguard Total Bond Market Index Fund, providing lessons that tell us as much about the need for rigorous index management and rigorous control as they do about the risks of active bond management. After some bumps in the summer of 2001, the bond market fell into serious disarray early in 2002, largely because of a series of sharp downgrades in credit quality. The problems continued through June and July, when they reached crisis stage before at last stabilizing. In those two months alone, VTBMF lost nearly 140 basis points of tracking error, bringing the fund’s total lag to its target index for 2002 to an incredible 200 basis points, even more significant since it was derived entirely from the corporate sector (not the Treasury and mortgage-backed sector) which represented only 40 percent of VTBMF’s assets. Why did it happen?

I’m treading on dangerous ground here, so let me offer Vanguard management’s explanation. From the Fund’s semi-annual report on June 30, 2002: Over the past six months, one of the principal differences between the funds and their indexes resulted from a decision by our portfolio managers and analysts to overweight the telecommunications sector. This decision rested on the belief that the prices of these bonds were cheap relative to those in other sectors. While our exposure to telecoms was diversified, the damage in the sector was widespread. The declines in the value of bonds issued by telephone companies and wireless providers accelerated immediately after WorldCom’s implosion in June. To make matters worse, our funds also held larger stakes than their indexes did in bonds issued by several energy-trading companies, which plunged precipitously in the wake of the Enron scandal. In short, our decision to overweight these sectors hurt the returns for our shareholders. The funds also were hurt by our “corporate substitution” policy—buying corporate bonds instead of Treasury securities in the short-term end of the market. From the Fund’s annual report on December 31, 2002: Our “sampling” approach to indexing . . . is necessary because it would be impractical and very costly to own all the bonds in the target indexes.to

Result: over the past twenty years, the typical mutual fund investor has captured only one- quarter—yes, 27 percent—of the compound real (inflation-adjusted) return on stocks that was there for the taking by simply holding the U.S. stock market portfolio through an index fund. (I’m speaking, of course, of the Vanguard 500 Index Fund.) Facing Up to the Reality It must seem obvious that there is an urgent need to face up to these and other failures in the changing world of capitalism. But despite the contentious nature of the issues I’ve just described— broadly reflecting the triumph of the powerful economic interests of the oligarchs of American business and finance over the interests of our nation’s last line investors—it is remarkable that so little public discourse has been in evidence. In the investment community, I have seen no defense of the inadequate returns delivered by mutual funds to investors, nor of our industry’s truly bizarre, counterproductive ownership structure; no attempt by institutions to explain why the rights of ownership that one would think are implicit in holding shares of stock remain largely unexercised; and no serious criticism of the virtually unrecognized turn away from the once-conventional and pervasive investment strategies that relied on the wisdom of long-term investing, toward strategies that increasingly rely on the folly of short- term speculation.

provide our funds with characteristics that are similar to those of their targets. Our portfolio managers and analysts carefully select bonds so that the funds’ weightings among sectors closely match those of the indexes. However, during June and July, the relative performance of some “subsectors”—in contrast to historical experience— diverged widely. At that time, our funds had larger stakes than their indexes in several subsectors. In particular, at a subsector level we had heavier weightings in bonds issued by telecommunications and energy-trading companies. These groups were hit extremely hard by the WorldCom bankruptcy, the Enron scandal, and accounting irregularities at a number of other companies. In recognition of the radical change in the market’s reaction to credit risk, we have made some adjustments to ensure greater diversification and less exposure to lower-quality bonds. Do those comments suggest that active management, reduced diversification, and investing for higher yield had found their way into indexing? I’ll let you make the call. I’m confident that the Vanguard Fixed-Income Group has learned much from the cascade of ill-tidings that led to such a shocking 200 basis point shortfall in the return of VTBMF to its target index, an assumption borne out by the fact that our annual tracking error has returned to its earlier excellence, and in fact looks even better.

managed, low-cost, broadly-diversified, and tax-efficient no-load index fund would provide even higher real returns relative to those earned by actively-managed equity funds than the enormous advantage it has achieved over the past quarter century. Like it or not, the index fund remains, if I may take the liberty of citing the subtitle of my new Little Book, “the only way to guarantee your fair share” of whatever returns our markets are generous enough to provide in the years ahead. I conclude by reiterating my theme that the link between fiduciary duty and financial markets is not only an unbreakable one, but that in today’s risky investment world, it is more important than ever. Trusteeship, fiduciary duty, and professional standards are not just idle phrases. They represent the very essence of good business—ethical conduct, fair-dealing, “just and equitable principles of trade” (in the lexicon of NASD regulations)—in which service to clients, and for that matter, service to society, is the paramount value. Writing about professional obligations in the spring edition of the Yale School of Management Quarterly Review, Harvard Business School professor Rakesh Khurana suggests this stern standard as the watchword of the true professional: “I will create value for society, rather than extract it.

annual cost and without sales loads is the obvious winning strategy. Broadly-diversified, actively managed (but not too actively managed) bond funds on attractive terms of ownership are an excellent choice, and the index fund is the paradigm of that strategy. That being the case, how can it be that only a single firm offers very low-cost no-load funds, and only that same firm (or now perhaps two or even three) seriously offers bond index funds? And how can that continue to be the case? Especially since we can be highly confident that bond returns in the years ahead will be far lower than that 7 percent return of the past two decades. Surely no one here tonight can be oblivious to the fact that today’s entry yield of about 4.8 percent on taxable bonds (4.2 percent for municipal bonds) establishes the reasonable expectation for returns over the coming decade. So now understand the simple arithmetic: Those low gross returns, reduced by the excessive all-in annual costs of about 2.1 percent for the average load fund—say 1 percent per year in expense ratios plus heavy sales loads (amortized) of about 1.1 percent per year—will enviably lead to shockingly low net returns for investors. Costs will likely consume 45 percent or even 50 percent of the coming annual returns in the bond market, and therefore 50 or 55 percent of the market’s cumulative ten-year return. What’s to be done?

For the record, a 9 percent nominal return increases capital by 762 percent over a quarter-century; at a real rate of 6 percent, the increase is only 329 percent—barely 40 percent of the putative capital accumulation.) (5) The actual dollar amounts of expenses paid by each fund shareholder each year. This need be neither complicated nor precise. Simply calculate the fund’s expense ratio for the year just ended, and multiply it by the dollar value of the shareholder’s investment at year-end. The actual dollars they spend, I believe, are more meaningful than ratios to investors. (6) The total annual costs incurred by fund investors. Not merely the fund’s expense ratio, but its estimated costs of portfolio turnover, and the annual impact of the initial sales charge. While the industry leaves the self-serving impression that a fund’s expense ratio represents the total cost of owning a fund, that is far from the truth. The fact is that often there is sort of a three-legged stool of costs that drag down fund returns. The expense ratio of the average equity fund is 1.4 percent; the average (hidden) cost of portfolio turnover probably runs between 0.5 percent and 1.0 percent; and, for funds with sales changes, the amortized cost of the typical 5 percent load runs to more than 1.0 percent per year. (The average holding period is now about 4 ½ years). So average total all-in costs may reach as much as 3 percent a year or more.

(8) We also ought to disallow the publication of records of incubation funds and funds with hypothetical past returns. Full-page ads bragging about back-tested, cost-free, and entirely theoretical returns that allegedly were earned by funds following today’s “fundamental indexing” fad—now appearing in all their full-page glory—are simply improper, inappropriate, and materially misleading. The practice must be stopped. The “Statement of Policy” Time does not permit me to go into more detail with my litany of reforms designed to assure that fund investors get the straightforward information to which they are entitled, and are protected from deceptive information that can only mislead them. So let me conclude with a constructive suggestion: my recommendation that FINRA adopt a new “Statement of Policy” regarding the sales and sales literature published by fund sponsors, stockbrokers, and financial advisers. Hardly anyone in this business today remembers (although I do!) that from 1950 until 1969, mutual funds operated under a fairly rigorous code of standards for advertising and sales literature. It was called the “Statement of Policy,” and was administered by the NASD.

In the Fund Industry, Mutuality and Indexing Rule the Seas A Conversation with John C. Bogle Founder, The Vanguard Group National Rural Utilities Cooperative Finance Corporation Conference on Capital Ideas: Powering into the Future Chantilly, VA November 13, 2012 As the founder of Vanguard way back in 1974, it’s a special honor for me to have this opportunity to discuss our truly mutual structure, and how it is at last beginning to reshape the mutual fund industry. And it seems particularly appropriate, for much like your organization, Vanguard is also a “cooperative.” Our vision, our mission, our principles, and our values are very much like yours. Paraphrasing CFC’s stated mission, “our goal is not to maximize our income, but to offer our shareholders affordable financial products and services, consistent with sound financial management.” So-called mutual funds—they’re not really mutual at all—are quite different; they are largely corporate shells, diversified portfolios of stocks and bonds with no employees of their own. Their few corporate officers usually hold the same posts with the funds’ management company, which organizes the funds, operates them, and provides, in return for a substantial fee, essentially all of the services necessary for the funds’ existence. These services include administration; portfolio strategy and investment selection; and distribution of fund shares to the public. The fund is, from birth, a captive of its management company/adviser.

John C. Bogle Opening Remarks The John C. Bogle Legacy Forum Museum of American Finance New York, NY January 31, 2012 I know of no precedent for Wall Street (as it were) honoring one of its own, marking a legacy of 60 years in the investment profession. (Not so many souls hang around that long!) So I’m greatly honored, truly humbled, and profoundly appreciative that so many industry leaders, financial and academic professionals, friends and colleagues, are joining in this wonderful day of celebration. I’ve done the best I could to build a better world for investors. Yes, in Philadelphia the press has described me as an entrepreneur, creator, inventor, and citizen, and even compared me—not unfavorably—with Benjamin Franklin . . . But Walter Isaacson, having completed his biography of Franklin some years back, next turned to Albert Einstein, and then, only a few months ago, to Steve Jobs. I’m not hanging by my thumbs awaiting Mr. Isaacson’s phone call (nor his note on my iMac). Yes, I did start the world’s first index mutual fund (though lots of people claim to have thought of it long before I did so). It is now the world’s largest equity fund . . . But the index fund concept represents the essence of simplicity, the triumph of Occam’s Razor. It required no genius, and so I’ve never won a MacArthur “Genius” grant (and don’t deserve one).

Vanguard operates on an “at-cost” basis, and our structure and fiscal discipline have resulted in cumulative savings to our shareowners of nearly $100 billion so far, subtracting less value from society than any financial firm on the face of the globe. In short, our rise to dominance in the financial field has come simply because we are (1) structurally correct; (2) mathematically correct; and (3) strategically correct. It is hardly a stretch to say that, although your implementation of those principles is vastly different from ours, you share them in philosophy and spirit. Our core investment strategy is the index fund—a fund that, at its best, simply owns the entire stock market (or the entire bond market). Operated at rock-bottom cost, this strategy guarantees that our shareholders receive neither more nor less than their fair share of whatever long-term returns on investment that our stock and bond markets are generous enough to provide. The index fund, arguably, is an exercise in plain and simple engineering. Think about it. In the 2005 book, Power, Speed and Form. Engineers and the Making of the Twentieth Century,1 the best engineering is described as embodying “efficiency, economy, 1 David P. Billington and David P. Billington Jr., Oxford University Press, 2005.

leader of a company in crisis and given the responsibility of saving it, I continued to publish papers and write essays, many of which became parts of my later books. Even when I got fired in early 1974 and barely survived a career crisis, I kept on writing. Later in that same year, out of the ashes of that crushing personal defeat, I created a tiny new company—and against all odds, succeeded in building it. (I had lots of help!) Throughout this trying time, my pen was my constant companion. Yes, as it is said, “the pen is mightier than the sword.” That new firm, which I named “Vanguard,” was founded with a truly mutual structure without precedent in the still misnamed mutual fund industry. Its growth would ultimately be driven by an investment strategy that was also without precedent . . . and, yes, that would be the index fund. That combination of a structure designed to serve the public—to serve fund shareholders rather than fund managers—and a strategy dominated by our creation of the world’s first index mutual fund in 1975 have changed the mutual fund industry as we knew it. Operated at rock-bottom cost, that index fund requires no money manager. It simply buys and holds the 500 stocks in the S&P Index, effectively guaranteeing that its investors will earn their fair share of the stock market’s return, neither more nor less, and whether that return is good (mostly) or bad (sometimes).

while The Vanguard Group, manager of the Vanguard funds, earned precisely zero. (As the only mutual mutual fund organization, all of our profits are, in substance, returned to our shareholders.) History has not been kind to those earlier monarchs of the mutual fund kingdom. The MFS market share, which peaked at 15 percent all those years ago, has now fallen below 1 percent. The IDS/Columbia market share also peaked at 15 percent and is now less than 2 percent. And Fidelity’s market share has fallen from 13 percent in 1999 to 11 percent today. What explains these declines? As I look at this history, I date the decline of MFS from 1969, when it abandoned its original unique mutual structure (similar, but not identical to Vanguard’s) in favor of private ownership of its management company. The firm was sold to Sun Life of Canada in 1982; it joined the performance-chasing game; and it saw its composite expense ratio rise from 0.19 percent to 1.20 percent, more than a six-fold rise. IDS operated during the golden age of captive sales forces, capitalized on its huge (insurance-oriented) client base, but ultimately failed to develop a strategy for a world in which giant brokerage firms and no-load funds would dominate fund marketing. As for Fidelity, I see it as a firm heavily oriented toward the superior performance of their funds (especially Magellan) during and beyond the short-lived “Go-Go Era” of the late 1960s, achieved when the firm was managing some $3.

and elegance”2—the very kind of ingenious simplicity and effectiveness that characterize the index fund. It is the antithesis of the discredited “financial engineering,” the excessive costs, the product complexity, and the rampant speculation that created the global financial crisis that Wall Street has inflicted on Main Street. We created the first index mutual fund in 1975, and today it is the largest mutual fund in the world.3 This afternoon, I’d like to discuss the current state of our economy and financial markets, with the emphasis first on what went wrong, and second on what we might do to assure that our financial system takes on a greater sense of public purpose. I’ll do so by focusing on four quotations from Adam Smith, ranging from the obvious to the prophetic, to the idealistic. I’ll conclude with a few closing words about how all of this fits in with the message of my new book, Enough. True Measures of Money, Business, and Life. Adam Smith I – The Invisible Hand To say that the nation’s financial sector has ignored the principles of efficiency and economy—to say nothing of elegance—would be to put one’s head in the sand. The fact is that the bubble that led to the current financial and economic crisis; the easy credit; the cavalier attitude toward risk taken by our bankers and investment bankers; “securitization,” in which the traditional (and essential!)

Well, those eight “ifs” are surely a lot! And if, at any one of those junctures (and, truth told, more than a few others), the coin had landed on “tails” rather than “heads,” the industry would, I think, look rather different then it does today. But please be clear: I’m not saying that this industry needs Vanguard. Rather, I believe that every industry needs a Vanguard—a firm that says, “I see what you’re doing, but I have a different design that will serve consumers better, with better products and services, and at lower prices.” Whatever the case, Vanguard has become the world’s largest manager of mutual funds, with a market share of industry assets recently reaching 16 percent, yes, again, a summit that, by a wide margin, no fund firm seems to have reached before. 1 And we continue to grow apace, accounting for some 40 percent of industry cash flow during the past five years. (I doubt that such a dominant share is sustainable.) In 1976, indexing was heresy. “Indexing is un-American!” said a famous poster of that time, and our index fund was known as “Bogle’s Folly,” with a market share of just 0.1 percent of equity fund assets. Today indexing is dogma, the widely accepted core standard for evaluating investment performance, and having a 25% share of equity fund assets. What’s more, index mutual funds have accounted for $688 billion of the $672 billion total cash flow into all equity mutual funds over the past five years.

link between borrower and lender was severed; the complicity of our rating agencies with the issuers of all those collateralized debt obligation; the extraordinary leverage built into the financial system by derivative securities of mind-boggling complexity; the failure of our regulators to do their job, and the susceptibility of our elected representatives to the temptations of political contributions. But the larger cause of the present crisis was our failure to recognize the sea-change in the nature of capitalism that was occurring right before our eyes. The crisis in capitalism also comes, in part, from our conviction that the Invisible Hand— described by Adam Smith more than 230 years ago in his seminal work, The Wealth of Nations— would benignly serve our society. Hear Smith’s words: 2 In fact, in my 1951 thesis at Princeton University, I urged that mutual funds be operated “in the most efficient, economical, and honest way possible.” If honesty is understood to represent a certain kind of elegance, the ideas are identical. 3 Assets of our Index 500 Funds total $125 billion; assets of their near-counterpart, our Total Stock Market Index Fund, total $95 billion, $220 billion in all.

But in the very long run, speculative returns account for nothing—zero. Speculation simply reflects the optimism or pessimism—the hopes and fears—of the mass of investors, reflected in the “expectations market” rather than garnered through the stern arithmetic of the “real market” of investment returns—authentic earnings growth and dividend yields. In this sense, as I wrote in my 2007 book The Little Book of Common Sense Investing, “the stock market is a giant distraction to the business of investing.” Of course it is! But the market is more than a mere distraction. It is an expensive distraction. For it must be obvious that all investors as a group exactly capture the market’s return. If stocks return 8 percent, we earn a gross return of 8 percent. But only before the costs of our investment system are deducted, say about 2 percent per year. After these costs, our net return drops to 6 percent. “Gross return minus cost equals net return.” What else is new? So, those who invest in business—buying and holding a diversified list of stocks that may encompass the entire U.S. stock market (yes, I’m speaking of the index fund)—capture virtually the entire return of the market. Those who speculate on stock prices, on the other hand, lose to the market by the amount of “croupier costs” they incur. (My choice of this gambling term is deliberate; speculating on whether the momentary price of a stock will rise or fall is, simply put, gambling.)

It was certain that if we acted always with caring, with integrity, and with candor, Vanguard would grow, and indexing would lead the way. While I concede that “growth is the only evidence of life,” my attitude was to let our growth just happen, not by forcing it, for example through expensive sales promotions, aggressive marketing schemes, nor the offering of faddish new funds that would attract the evanescent and therefore useless assets of short-term speculators. Rather we sought to attract the durable and therefore priceless assets of long-term investors by earning their trust. I was confident that an enterprise whose mantra is not salesmanship but stewardship would grow organically, a natural result of our philosophy. And so it did. We began in September 1974 with $1.4 Billion of investor assets, today our asset base exceeds $1.2 Trillion. Business or Profession? 1 Dean Howard M. Johnson, chairman of the Massachusetts Institute of Technology.

ratios average 0.23 percent. The average mutual fund charges 1.19 percent—more than five times as much! Does it matter? Think about it: over the past decade, our funds, largely passive rather than active, have earned net returns that outperformed 82 percent of their peers in the various fund objective categories in which we compete. I do not believe that any large fund manager has matched that figure. But our gross returns—before the deduction of our lower expense ratios and our competitors’ far higher ratios—exceeded those of just 51 percent of our peers—a hair above average. Yes, costs matter. I don’t think I’m hyperbolizing when I use the phrase sustainable cost advantage. I simply can’t see how any of our peers could possibly reduce their expense ratios in the aggregate to anything like 0.23 percent, where we are today—let alone the even lower expense ratios we’re likely to establish in the coming years. As the industry leader, we have huge economies of scale; we’ve worked hard to achieve excellence in shareholder services; we employ state-of-the-art technology; we have a solid leadership team, and our 12,000 able crewmembers include thousands of veterans who revel in passing along the human values and the investment strategies that have carried us to our present industry position. How to Compete? Could others compete with us on costs? I don’t see how. Among our large management company peers, the average expense ratio is about 1 percent. To reduce that ratio to 0.

basis, and our structure and fiscal discipline have resulted in cumulative savings to our shareowners of nearly $100 billion so far, subtracting less value from society than any financial firm on the face of the globe. In short, our rise to dominance in the financial field has come simply because we are (a) structurally correct; (b) mathematically correct; and (c) strategically correct. Our core investment strategy is the index fund—a fund that, at its best, simply owns the entire stock market (or the entire bond market). Operated at rock-bottom cost, this strategy guarantees that our shareholders receive no more and no less than their fair share of whatever long-term returns on investment that our stock and bond markets are generous enough to provide—or, on occasion, mean-spirited enough to take away. The index fund, arguably, is an exercise in the very kind of plain and simple engineering that your own careers will demand. Think about it. In the 2005 book, Power, Speed and Form. Engineers and the Making of the Twentieth Century,4 the best engineering is described as embodying “efficiency, economy, and elegance”5—the very kind of ingenious simplicity and effectiveness that characterize the index fund. It is the antithesis of the discredited “financial engineering,” the excessive costs, the product complexity, and the rampant speculation that created the global financial crisis that Wall Street has inflicted on Main Street.

It may sound simple. But it is true. The mutual fund field is one in which investors, as a group, as a matter of mathematical certainty, not only do not get what they pay for, but get precisely what they do not pay for. Let me put the conclusion in its sharpest formulation: if investors pay nothing, they get everything—that is, 100 percent of the gains that our stock market is generous enough to bestow on us, and for that matter, 100 percent of the losses that our market can be mean enough to inflict on us. Costs Matter! In the short run, investment costs may seem inconsequential. But in the long run, costs can overwhelm stock market returns. As I’ve so often said, “the magic of long-term compounding returns virtually assures investment success for owners of stocks as a group . . . provided that it is not overwhelmed by the tyranny of compounding costs.” Here, let’s look at the facts. Let’s assume a nominal compound annual return on stocks of 7 percent over an investment lifetime—let’s say 60-years—and compare it with an investment system that incurs costs of 2 percent, delivering a net return of 5 percent. The 2 percent cost is a reasonable—maybe even conservative—estimate of equity fund all-in costs, including an expense ratio of 1 to 1 ¼ percent; plus turnover costs of ½ to 1 percent; plus (often) sales loads, when annualized, of ½ percent to 1 ½ percent.

So perhaps their strategy should be—I apologize for thinking like a business school professor here—to keep prices high on those funds in which costs are not particularly visible (i.e., funds that are not “closet” index funds); and to cut prices for their largest shareholders, particularly on funds where costs are the obvious differentiator in providing superior returns—obvious at least to the intelligent adviser or intelligent investor—index funds, bond funds, and money market funds. But this strategy has already been tried by several of our peers, and it has failed. Why? Because ever since 1992, when we introduced our first high-minimum-investment, minimal-expense-ratio Admiral shares, we’ve cut prices to stay a step ahead of the competition. As I said to our Vanguard crew in 1992, “the Admiral concept is (based on) the obvious insight that, since the costs of handling a shareholder account are relatively fixed, larger investors generate substantial economies of scale . . . (It is) our way of firing a shot across the enemy’s bow—letting our rivals know that they’d better get ready for even tougher price competition.” That 1992 strategy, to state the obvious, lies at the root of the continuing expansion of our Admiral franchise, most recently in lowering the asset threshold for individual index fund investors from $100,000 to $10,000, with expense ratios running as low as 0.07 percent (seven basis points).

shareholders, in the miniscule costs that they bear, and in the overwhelming trust that our shareholders have placed in us. But I couldn’t forget Kipling’s implicit warning, “if you can meet both Triumph and Disaster, and treat those two imposters just the same.” After my earlier brush with Disaster in my career, it was easy for me to understand that Triumph too is an imposter. Far better than preening over the past, please realize that it is focusing on the future that must be the order of the day. Creating a new kind of fund company defied the conventional wisdom. So did creating a new kind of fund which would not trade stocks in the market, but simply buy all of the stocks in the stock market—owning corporate America, and holding it, well, forever. The world doubted that this tiny new firm called Vanguard would make a go of it. In fact, our index fund was called “Bogle’s Folly” for years. (But no longer!) So, yes, “when all men doubt you,” as Kipling put it, simply “trust yourself.” And when opportunity knocks, don’t forget to answer the door! Reflections on Today’s Crisis In our present financial and economic crisis, Vanguard’s simple strategies have paid off in spades. In a fund industry now deeply troubled by its aggressive marketing of investment fads, its speculative policies, its excessive costs, and its periodic scandals, our firm remains vibrant, healthy, and pristine.

the net returns that investors actually earn—and too powerful, too meaningful, and far too important to ignore. 2. Focusing on providing market returns and assuming market risks (but no more) is the obvious strategy for the low-cost provider—simplicity, and delivering to clients their fair share of what ever gains, or losses, the markets deliver. (The correlations of our funds average about 96 with their best-fit targets—call it “commoditization” if you will—compared with about 87 for our peers.) Our passive funds—index funds and virtual index funds, including nearly all of our bond funds—account for about 85 percent of our asset base. 3. It’s only a matter of time until investors recognize the bite that expenses take out of fund dividend yields, especially in today’s low-yielding markets. The 2.0 percent gross yield of the average equity fund, reduced by an expense ratio that averages 1.3 percent, slashes the yield to a pathetic 0.7 percent. How long will intelligent investors allow two-thirds of their dividends to be eaten up by expenses? 4. The no-load (direct distribution) segment of the industry has yet to fully realize its marketing potential. Amazingly, load funds currently represent fully 62 percent of industry sales volume, even higher (this surprised me!) than it was way back in 1996 (57 percent). Will investors continue to invest in bond funds in which the load consumes the first two years of income? I doubt it.

The moral of the story, then, is that successful investing is about owning all of America’s businesses and reaping the huge rewards provided by the dividends and earnings growth of our nation’s—and, for that matter, our world’s—corporations. The higher the level of our own activity by investors, the greater the costs of financial intermediation and taxes, the smaller the net returns that our business owners as a group receive. The lower the costs that investors as a group incur, the higher rewards that they reap. So to realize the winning returns generated by businesses over the long term, the intelligent investor will minimize to the bare bones the costs of our financial system. That’s what common sense tells us, and it’s the truth. 3. The Index Fund While on first impression it might seem intimidating to own a share in all of America’s businesses and thereby capture whatever returns our stock market is generous enough to deliver, in fact it is amazingly simple. It is, of course, by investing in an index mutual fund, that fund I mentioned early in these remarks, hinted at in my senior thesis and realized by Vanguard’s creation of the first index fund in 1975.

For the investor feeds at the bottom of the costly food chain of investing, paid only after all the agency costs of investing are deducted from the market’s returns.” We Are All Indexers So what’s to be done? First, we need our citizens to understand the difference between investment and speculation, and to recognize that—simply because of the costs of the financial system—long-term investors must win and short-term speculators must lose. I dare say that the optimal solution lies right before our eyes: Owning the entire stock market as our equity position, and holding it forever. Yes, I’m speaking of the stock market index fund. But please don’t think about that as a self-interested statement on my part. Think, instead of this reality: As a group, we are all indexers.

The original creation was a fund (“First Index Investment Trust,” now Vanguard 500 Index Fund) that tracked the returns of the Standard & Poor’s 500 Stock Index, whose blue-chip components represent about 80 percent of the value of the U.S. stock market. Later, we created a fund that held 100 percent of the U.S. market (Vanguard Total Stock Market Index Fund), and now also offer an index fund that holds the world’s non-U.S. stocks (Vanguard Total International Index Fund). In some combination of these last two funds, then, an investor can easily hold a pro rata share in the ownership of the world’s equity securities.2 All these index funds do is capture the returns of the stock market indexes they mirror. They deduct only trivial amounts of costs (less than 0.2 percent per year) from those gross returns. In a stock market that delivers 8 percent per year, for example, the investor would earn a return of about 7.8 percent. That 0.2 percent cost is represented by the fund’s expense ratio—the amount it costs to operate the fund. By way of contrast, the typical mutual fund has an expense ratio of about 1.4 percent. But this typical actively-managed equity fund also incurs two additional costs that the index fund does not entail.

If saying that I’ve been fighting this battle since I wrote that thesis in 1951 is a push (and it is!), it is clear that I’ve been at it since at least 1971 (note that earlier speech) and surely since 1974, with the formation of Vanguard as the first mutual, shareholder-owned firm, driven ahead largely by our 1975 creation of the first and ultimate fiduciary-oriented, consumer-oriented mutual fund: the index mutual fund. Our First Index Investment Trust was designed to track the S&P 500 Index. The beginning of an indexing strategy that was the logical, even obvious, result of our mutual structure. Indeed, it was our first strategic move. That index fund began with an IPO in 1976 that was, to be blunt, a flop, raising only $11 million—far less than the underwriters’ goal of $150 million. But, now known as Vanguard 500 Index Fund, its assets exceed $450 billion. With its sister index funds at Vanguard, indexing strategies now account for some $2.4 trillion of the firm’s $3.2 trillion asset base. Most of my books touch on (pound on?) the same theme: “Put the investor first.” Bogle on Mutual Funds (1993), Common Sense on Mutual Funds (1999/2009), and The Battle for the Soul of Capitalism (2005) all emphasize this message of fiduciary duty.

While the passively-managed index fund has virtually no turnover of the stocks in its portfolio, the average equity fund buys and sells stocks at an astonishing rate, currently about 100 percent per year, adding a hidden (but nevertheless very real) further cost of about 0.5 percent to 1.0 percent per year. Further, while most index funds are available without sales loads, most mutual funds carry a front-end load of about 5 percent, adding an annual cost of another 0.5 percent to 1.0 percent per year (depending on how long the investor holds his or her shares). Total annual “all-in” cost, then: Index fund, 0.2 percent, regular equity fund roughly 2 percent to 3 percent.3 Doesn’t seem like much, does it? Well consider its impact over say, a 50-year investment lifetime. $10,000 invested at a return of 8 percent would grow to a total of $469,000. On the other hand, $13,000 invested at 5 ½ percent (8 percent less a 2 ½ percent cost) would grow to just $139,000 or less than 30 percent of the return offered by the index fund. 2 Index funds also exist for other sectors of the U.S. and global stock markets, as well as for a variety of taxable and tax-free bonds. 3 And I haven’t mentioned taxes. Index funds, which sell stocks only when they are removed from the index (a fairly rare occurrence), are highly tax-efficient. Managed equity funds, with their astonishing levels of buying and selling are highly tax-inefficient.

When we individually compete to beat our fellow market participants, we lose. But when we abandon our inevitably futile attempts to obtain an edge over other market participants and all simply hold our share of the market portfolio, we win. Corporate Citizenship In addition to its excessive costs, the speculation that permeates today’s financial system has another unfortunate consequence. Investors must care about corporate governance. Speculators do not care, and arguably—much as I hate to say it—should not care. So when our money management agents fail to exercise the rights and responsibilities of corporate ownership, in particular, by assuring that the governance of the corporations in our portfolios is focused on serving the interests of the shareholders of those corporations rather than the interests of their management. The massive substitution of agency ownership of stocks for personal ownership, then, is one of the major challenges of twenty-first-century capitalism, and it is high time for our agents to represent their principals.

So it is that through the deduction of a “mere” 2.5 percent in annual costs, the miracle of compounding returns is overwhelmed by the tyranny of compounding costs. For in the investment field, time doesn’t heal all wounds. It makes them worse. Where returns are concerned, time is your friend. But where costs are concerned, time is your enemy. The investor in this example, who put up 100 percent of the capital and assumed 100 percent of the risk, earned less than 30 percent of the market return. Our system of financial intermediation, which put up zero percent of the capital and assumed zero percent of the risk, essentially confiscated 70 percent of that return—surely the lion’s share. An investment in a low-cost index fund, held for the long term, eliminates all of the terribly harmful costs of financial intermediation, and thus guarantees that you’ll earn your fair share of whatever returns our stock market offers. If it sounds like I’m pushing Vanguard’s index funds on you, well, there’s something to that. But only because soundly-operated index funds are the ideal way to invest for the long- term, by reason of their rock-bottom costs and long record of tracking their respective indexes with a remarkable precision. But don’t take my word for it. The index fund has received incredibly strong endorsements from the most respected financial experts in the nation.

Only a few weeks ago, the impact of costs was also recognized by two high-cost providers of Target Date Funds. After a failed foray into the TDF sector, both Goldman Sachs and Oppenheimer threw in the towel. After it became apparent that investors had no interest in buying, holding, or trading their Target Date Funds, they shut them down. In their few years of operation, Goldman had attracted only $55 million in assets; Oppenheimer, only about $500 million. The fact is that when competitive TDFs are available at as little as 0.18 percent, no sensible investor or trader would buy a TDF with an expense ratio of 1.22 percent per year (Goldman) or 1.52 percent (Oppenheimer). Of course, their fund performance was dragged down by these debilitating costs, with five-year annual returns averaging a loss of -2.0 percent, a shortfall of fully 3.averaging

Warren Buffett, his partner Charlie Munger, Nobel Laureates Paul Samuelson, William Sharpe, and Gary Becker (Princeton’51); respected endowment fund managers from Yale (David Swenson) and Harvard (Jack Meyer). Innumerable financial professors including Burton Malkiel (Princeton ’64). Journalists, financial authorities—the list is almost endless. What’s more, the giant $140 billion Federal Thrift Savings Plan is invested largely in index funds, along with trillions of dollars in the nation’s public and private pension plans. But perhaps the crowning endorsement comes from investors who have actually owned Vanguard 500 Index Fund during its entire history. Let me present a specific example: at a dinner held in September, 2006, celebrating the 30th anniversary of the fund’s initial public offering, the counsel for the fund’s underwriters reported that he had purchased 1,000 shares at the original offering price of $15.00 per share—a $15,000 investment. He proudly announced that the value of his holding that evening (including shares acquired through reinvestment of the fund’s dividends and distributions over the years) was $461,771. Of course that was a year ago. At the close of business yesterday, the value was $543,657. There’s a number that requires no comment!

Not only are they more likely to be short-term speculators than long-term investors, but because they are managing the pension and thrift plans of the corporations whose stocks they hold, they are faced with a serious conflict of interest where controversial proxy issues are concerned. As one manager has said: “There are only two types of clients we don’t want to offend: actual and potential.” And in mutual fund America, an industry lost its way. Once a profession with elements of a business, mutual funds became a business with elements of a profession—and too few elements at that. Once dominated by small, privately-held organizations run by investment professionals, the mutual fund industry is now dominated by giant, publicly-held financial conglomerates run by businessmen hell-bent on earning a return on the firm’s capital, not the return on the capital invested by the fund shareholders. Result: over the past twenty years, the typical fund investor has captured only about 20 percent of the compound return on stocks there for the taking by holding a simple S&P 500 index fund. (I’m speaking, of course, about the Vanguard 500 Index Fund.)

But no matter how flawed the nature of our financial system has become, invest we must. It is our responsibility to put our money to work where the money changers and croupiers to the tune of $362,950 per person mail room) in the last year alone, great country, or what?”) I know that many of you share my equity index funds is the optimal strategy guarantees your clients their fair share of whatever returns tenets apply to owning the bond market through a low strategy that is as simple as it is profound empire of parsimony.” If you favor actively-managed over the long term is not easy. Even if you or her fund portfolio will inevitably roll over again and again. But no matter how flawed the nature of our financial system has become, invest we must. It is our responsibility to put our money to work and then stay out of the casino— croupiers of Wall Street sit in the dealer’s chair and get rich . . . per person (including everyone from partners to those who labor , the average salary reported just a few weeks ago many of you share my belief that a strategy focused largely on low equity index funds is the optimal strategy—simply because it focuses on the long fair share of whatever returns our stock market delivers. apply to owning the bond market through a low-cost bond index fund.)

4. Our Financial Economy If you’ve been following my argument, you might well be thinking that the reason that the index fund does so well is that it doesn’t fall prey to the shortcomings of our financial system as a whole, yet our financial system now dominates over economies that fact that over the past two centuries, our nation has moved from being an agricultural economy, to a manufacturing economy, to a service economy, and now to a predominantly financial economy. But our financial economy, by definition, subtracts from the value created by our productive businesses. Think about the Gotrocks family again. While investing in American business is a winner’s game, beating the stock market before those costs is a zero-sum game. But after intermediation costs are deducted, beating the market—for all of us as a group—becomes a loser’s game. Yes, the more that our financial system takes, the less our investors make. Yet the financial field is where the money is made in modern-day America, the breeding ground for the wealthiest of our citizens. (If you made less than $140 million dollars last year, you didn’t make enough to rank among the 25 highest-paid hedge fund managers.)

benefits to fund managers and brokers, and commensurately great costs to fund investors. 3. Failure to exercise adequate due diligence in the research and analysis of the securities selected for fund portfolios, enabling corporate managers to engage in various forms of earnings management and speculative behavior, largely unchecked by the professional investment community. 4. Failure to exercise the rights and assume the responsibilities of corporate ownership, generally ignoring issues of corporate governance and allowing corporate managers to place their own financial interests ahead of the interests of their shareowners. 5. Soaring fund expenses. As fund assets soared during the 1980s and 1990s, fund fees grew even faster, reflecting higher fee rates, as well as the failure of managers to adequately share the enormous economies of scale in managing money with fund shareholders. Example: the average expense ratio of the ten largest funds of 1960 rose from 0.51 percent to 0.96 percent in 2008, an increase of 88 percent. (Wellington Fund was the only fund whose expense ratio declined. Excluding Wellington, the increase was 104 percent.) 6. Charging fees to the mutual funds that managers control that are far higher than the fees charged in the competitive field of pension fund management. Three of the largest advisers, for example, charge an average fee rate of 0.08 percent of assets to their pension clients and 0.

commissions and offering funds directly to investors; and emphasizing funds that focused on broad, discrete market sectors offering returns that are relatively predictable. Of course the apotheosis of this strategy is the market index mutual fund, which, given its minimal costs, can consistently and closely match the returns generated by the entire stock market (or the entire bond market). It’s fair to say that the fund industry hated these ideas. It’s also fair to say that, at the outset, even investors themselves barely understood their implications. But in September 1974 when the new firm began, I had no doubt that we would ultimately revolutionize mutual fund investing and become the industry leader. That’s why I chose the name “Vanguard.” Our first decision was to start the world’s first index mutual fund. Originally dubbed “Bogle’s Folly,” that once tiny index fund is now the largest equity fund of all. As I have often said, “I took on my new job as head of Vanguard under the same circumstances that I left my old job as head of Wellington: “Fired with enthusiasm.” And so I was indeed fired with enthusiasm as I set out to build a better mousetrap and, finally, to build a better financial world. The Financial Markets Today Now, let’s move from the human side of enterprise to the business side, and talk a bit about our American financial markets today. These lessons are also reflected in The Clash of the Cultures.

(If these relentless rules of humble arithmetic are a plug for the low-cost, no-load, buy-and-hold, all-stock-market-index fund I began to design 31 years ago, well, so be it.) The Invisible Hand While fixing the system will not be easy, it’s easy to conceptualize the two parallel paths we need to follow. One is what I call the “Adam Smith Solution,” the Invisible Hand of competition that he described in The Wealth of Nations. If each individual investor out there— those who hold their stocks directly and those who hold their stocks through their mutual funds— would only look after his or her own economic interests, then great progress would be made. Intelligent investors would move away from the costly folly of short-term speculation to the priceless (and price-less!) wisdom of long-term investing—abandoning both the emotions that betray sound investment strategy and the expenses that turn beating the market into a loser’s game.a

gone by, you’re certain to run through scores of funds and fund managers. History suggests that about 3,500 of today’s 7,000 active funds will go out of business during the coming decade. And even if a fund that you favor endures, the data tell us that in the next 25 years alone, it’s likely to be run by five different managers. Even if your client owns, say, four mutual funds and—defying the odds—all survive, his or her money will have been run by 20 different managers, with little regard to tax efficiency. In 50 years, there will likely be 40 managers! Given their high costs, the chances of a portfolio of funds outpacing the index fund over the very long term are insuperable, if not inconceivable. Only the index fund is a fund for a lifetime. Looking Ahead In a New York Times piece in August, I was quoted (correctly) as saying “this is the worst time for investing that I’ve ever seen.” Why? Because the prospects for future returns on stocks are highly likely to be well below long-term norms. Nonetheless, based on the methodology I developed for realistic return expectations a quarter-century ago—a model that has met the test of time—they should be nicely positive. My idea was to separate stock returns into two components: investment return, and speculative return. It turns out that ten-year investment returns are fairly predictable, speculative returns much less so. (Chart 4) Speculative Return: Impact of P/E Change 0.8% -3.4% 3.3% 0.3% -6.3% 9.3% -1.0% -7.5% 7.7% 7.2% -3.

at about 4 ¾ percent, or about 2 ¼ percent after inflation—but before all-in bond fund costs of 1½ to 2 percent.) III. Innovation, Simplicity and Complexity To be sure, while all of us collectively are bound by the returns that are generated by the stock and bond markets, some of us will do better, some worse. Financial innovations designed to help us do better have been created all through history. But during the last decade, innovation has burgeoned to levels that are truly remarkable. Part of the reason is the expectation that stock and bond returns will lag behind historic norms—and far behind the halcyon norms of the 1980s and 1990s, when stock returns averaged 17 percent (!) and bond returns averaged 9 percent (!) (“We never had it so good.” Literally!) But if we know (within a fairly narrow tolerance) what returns to expect from broadly-diversified portfolios of stocks and bonds, what explains our expectations (or our hopes) that we can out-guess the markets and add additional returns by selecting strategies or managers that hold optimal subsets of the market portfolio? I fear that it is the triumph of hope over experience. The incredible rise—and fall—of so many derivative instruments in the present era should raise a red flag of caution regarding the value of financial innovation to investors. The flood of complexity—and its attendant high costs—seems to have overwhelmed simplicity—with its attendant low costs.

precisely equal to the aggregate amount of those costs. In a market that returns 10 percent, we investors as a group earn 10 percent (Duh!), pay our financial intermediaries, and then pocket whatever remains. Two conclusions: 1) Beating the market before costs is a zero-sum game; 2) Beating the market after costs is a loser's game. The returns earned by investors in the aggregate inevitably fall well short of the returns that are realized in our financial markets. How much do those costs come to? In equity mutual funds, management fees and operating expenses—the "expense ratio"—average about 1.4 percent per year of fund assets. (Chart 3) Add another half of 1 percent to 1 percent in portfolio turnover costs—let’s call it 0.7 percent—and, say, another 0.5 percent to 1 percent in the annual impact of front-end sales loads; say, another 0.7 percent. Result: the total cost of equity fund ownership comes to roughly 2.8 percent per year. So yes, costs matter. The great irony of investing, then, is not only that you don't get what you pay for. The reality is quite the opposite: You get precisely what you don't pay for. So if you pay for nothing, you get everything. How much do costs matter? A ton! Indeed, fund costs have played the determinative role in explaining why, for example, during the quarter-century from 1980–2005, when the return on the stock market itself averaged 12.5 percent per year, the pre-tax return on the average mutual fund averaged just 10.0 percent. That 2.

5 percent differential is about what one might have expected, given our 2.8 percent rough estimate of fund costs. Simply put, fund managers have arrogated to themselves an excessive share of the financial markets' returns, and have left fund investors with too small a share. On first impression, that annual gap may not look large, but when compounded over 25 years it reaches really staggering proportions. (Chart 4a) In fact, $1000 invested in a simple S&P 500 Index Fund returned 12.3 percent per year during that period (the market return of 12.5 percent less costs of just 0.2 percent), growing by $17,080. By way of contrast, the average equity mutual fund’s return of 10.0 percent grew that original $1,000 by just $9,820, or little more than half as much (57 percent of the total). But it gets worse for the equity funds. With all of their frantic portfolio turnover— trading stocks, essentially with one another, at a rate of 100 percent per year—the average actively-managed fund surrendered 1.after-

today’s yields are excellent predictors of the total returns you’ll earn on bonds over the coming decade. Worst case: the (so-called) risk-free rate—based on the 10-year Treasury bond—is now 1.6 percent, down from a high of 11.6 percent in the early 1980s. (We could call them “the good old days.”) Two more shocking mathematical facts: a 1.6 percent return would increase capital by just 17 percent during the next 10 years; an 11.6 percent return for the same length of time would have multiplied capital three times over. So, yes, holding a balanced stock-and-bond allocation is essential today, but it will not likely provide the kinds of handsome returns we were lucky enough to experience during the 1980s and 1990s, albeit much better than we have seen thus far during the 21st century. (During the past 12 years, when a 60/40 stock/bond index portfolio earned 4.3 percent, it was bonds that did the heavy lifting. In the coming decade; it is stocks that will have to do that job.) Of course, investors are not limited to U.S. Treasury 10-year bonds. Owning an investment-grade corporate bond index fund with a somewhat longer maturity should produce a yield of perhaps 3 percent. So it seems it is reasonable to own a mix of Treasurys and corporates, which might earn about 2 ½ percent. The Total Bond Market Index Fund—70 percent in Treasuries and other governments—now yields only 1.7 percent. But a Total Corporate Bond Index Fund would generate a yield about 3.2 percent.

tax return to 8.2 percent and reducing the compound cumulative profit to $6,170. (Chart 4b) If that sounds like a pretty good profit, just compare it with the after-tax profit with our 500 Index Fund, which has virtually no turnover. Its owners were subjected to income taxes of only 0.6 percent per year (largely on the divided income generated by the fund), with a net after-tax return of 11.7 percent. Result: a net profit of $14,820, or nearly two-and-one-half times the profit on the average managed fund. And now a cold shower of financial reality. Let’s make one final adjustment to our returns. So far, we’ve done all our measurements in nominal dollars, ignoring the fact that it is only real dollars—dollars that are adjusted to take inflation into account—that are available for us to spend. During the past 25 years, inflation averaged 3.3 percent, reducing the real after-tax return of the index fund to 8.4 percent, and the average fund to but 4.9 percent. (Chart 4c) Cumulative real profit after compounding on the original $1,000 investment: just $2,270 for the average actively-managed equity fund; $6,450 for the passively-managed index fund. The average fund produced only about one-third of the profit earned by the market itself through the simple index fund, which was there for the taking. Dare I remind you yet again, fund expenses and taxes matter! Indeed, they make the difference between investment success and investment failure.

. . (provides) substantial savings from advisory fee reductions (and) economies of scale . . . and promotes a healthy and viable mutual fund complex in which each fund can better prosper. A Prescient SEC? Indeed. The SEC’s words now seem prescient. In fact, “can best prosper” would have been more accurate. Measured by Morningstar’s peer-based rating system (comparing each of our funds with other funds having distinctly comparable policies and objectives), Vanguard ranked first in performance among the 50 largest fund complexes.* Advisory fee reductions and economies of scale? Once again, indeed. Vanguard’s low- costs are legendary, by far the lowest in the field. Last year, over all, our operating expense ratio came to 0.20 percent of average assets, compared to 1.30 percent for the average mutual fund. That 1.1 percentage point saving, applied to one trillion of assets, now gives our shareholders an average savings of $11 billion annually. Do low costs matter? Of course they do! As the world of investing is at last beginning to understand, low costs are the single most reliable indicator of superior fund performance. Yes, as we read in Homer’s The Odyssey, “fair dealing yields more profit in the end.

But I see little in it that persuades me that the complexity that is being offered will serve the interests of fund investors—as distinct from the interests of fund marketers—nearly as effectively as the simplicity that combines sensible asset allocation, broad diversification, and low costs, a strategy that has demonstrably served investors so effectively in the past. Let me be clear: I favor innovation when it serves fund investors. And I’m pleased that I’ve been lucky enough to have played a key role in such innovations in the past: the stock index fund; the bond index fund; the defined-maturity bond fund; the tax-managed fund; even the first fund-of-funds, absent an additional level of expense ratios. (I’ve also been involved in some innovations that haven’t worked for investors as I’ve hoped. We’ll save them for the question and answer period!)

In recent years, there have been other investor-friendly innovations, including target retirement funds and life strategy funds. Properly used (and properly costed!) these funds can easily serve as an investor’s complete investment program for the long run. But in today’s wave of fund innovation, I see little else that seems likely to serve investors effectively. Let me give a brief thumbnail sketch of the “products” that have been created in recent years, and offer my own perspectives. ETFs. Exchange traded funds are clearly the most widely accepted innovation of this era. Of course I admire their endorsement of the index fund concept—and (more often than not) their low costs. And how could I not admire the use of broad-market index ETFs that are held for the long term, and even broad-market-segment ETFs that are used in limited amounts to accomplish specific goals? But I have serious questions about the negative impact of brokerage commissions when ETFs are rapidly-traded. Further, I wonder why there are only 15 ETFs broadly-diversified in stocks and bonds; but 675 in market sectors that range from the reasonable to the absurd. In this latter category I’d include sectors as narrow as “Emerging Cancer,” and leveraged funds that now promise to double the market’s returns in either up or down markets. Not to be outdone, a few ETFs now offer the opportunity to triple those swings. Could quadruple be next?

Investing Today But no matter how flawed the nature of our financial system has become, invest we must. It is our responsibility to put our money to work but to stay out of the casino—that casino where the money changers and croupiers sit in the driver’s seat and get rich . . . to the tune of $362,950 each in the last year alone (the average salary reported this very day). “Is this a great country, or what?” Of course, I believe that a strategy focused largely on low-cost equity index funds is the optimal strategy—simply because it focuses on the long-term, and guarantees you of your fair share of whatever positive returns the stock markets are generous enough to deliver—or, for that matter your fair share of whatever negative returns our markets are mean-spirited enough to inflict on us. (The same factors apply to owning the bond market through a low-cost bond index fund.) As investment strategy that is as simple as it is profound. “The majesty of simplicity in an empire of parsimony.” If you favor actively-managed funds, you should know that picking winning managers over the long term is not easy. Even if you wish never to liquidate one of your fund holdings, your fund portfolio will inevitably roll over again and again. In the years ahead, you’re sure to run through scores of funds and fund managers. History suggests that about 3,500 of today’s 7,000 active funds will go out of business during the coming decade.

So, let’s put these projections together. If it’s reasonable to expect stocks to return around 7 percent annually during the coming decade, and bonds to return as much as 3 percent (before costs), a traditional balanced index portfolio with 60 percent stocks and 40 percent bonds should provide a return of about 5 percent, not so different from the past twelve years (although, as I noted earlier, it was bonds, not stocks that led the way). This return is far below the 7 percent historical return on such a portfolio. And those are nominal dollars, not real dollars. If we are lucky enough to hold the inflation rate to 2 ½ percent, that 5 percent market portfolio return drops to a real return of 2 ½ percent. That figure, of course, is before the costs of investing—say, very conservatively, at least 1 ½ percent—and perhaps another 1 percent in taxes for taxable investors—a real, after-cost, after-tax return of, well, zero. (It’s frightening to do the math!) As we meet today, however, that is the investment reality. Seeking Income that Is “Enough” Considering income generation alone, such a portfolio could yield up to 2 ½ percent, before costs, in nominal dollars.moderate

Largely because of the competitive returns that we’ve delivered to our fund shareholders, our market share of the assets of long-term funds (stock and bond funds) has risen from 4 percent of industry assets in our early years to 15 percent today. Advisory fee reductions and economies of scale? Once again, indeed. Vanguard’s low- costs are legendary, by far the lowest in the field. Last year, over all, our operating expense ratio came to 0.20 percent of average assets, compared to 1.30 percent for the average mutual fund. That 1.1 percentage point saving, applied to one trillion of assets, now gives our shareholders an average savings of $11 billion annually. Do low costs matter? Of course they do! As the world of investing is at last beginning to understand, low costs are the single most reliable indicator of superior fund performance. Yes, as we read in Homer’s The Odyssey, “fair dealing yields more profit in the end.”

And even if a fund that you own endures, it is apt to have about five different managers in the next 25 years. If you own, say, four mutual funds and—defying the odds—all survive, your money will have been run by 20 different managers. You must realize that, given their higher costs, the chances of their outpacing the index fund are insuperable, if not inconceivable. Only the index fund is a fund for a lifetime.

amounts of your capital—but an investor can’t do that forever; (4) Reach for higher yields by using junk bonds—with their far higher credit risk—or shift some of the bond portion into high dividend stocks—with much more volatility risk. But in general, make only moderate changes in your asset allocations; avoid box-car changes in favor of marginal changes. For in the real world, as you see above, for every pro, there’s a con. As it is said, there’s no such thing as a free lunch. . . . Or is there? In fact, there is one remarkably easy way to increase your clients’ income returns while leaving risk absolutely unchanged. And this brings me full circle in my discussion. The simple mathematical fact is that, because of high mutual fund expenses, the passively- managed all-stock-market index fund typically holds the same composite portfolio as the average actively-managed fund, and generates about the same gross dividend yield, say, 2.1 percent for stocks and 2.9 percent for taxable bonds. (Chart 6) But active stock funds (the managed funds are in red) subtract expenses averaging about 1.2 percent, leaving less than 90 basis points for the investor. Active taxable bond funds generate gross income of about 3 percent, but subtract about 0.9 percent in expenses on average, consuming more than 30 percent of the yield and leaving just 2.0 percent to distribute.

Put another way, ETFs used for investment are perfectly sound, but using them for speculation is apt to end badly for your clients. “Fundamental” Indexing. While this method of value investing has been presented as some sort of Copernican Revolution, the idea behind the methodology is many decades old. But offering such funds in ETF form suggests that they are useful for short-term trading—a dubious proposition on the face of it. And bringing them out only after the sharp upsurge in value fund relative returns during the 2000-2002 stock market collapse suggests the kind of marketing motivation and performance chasing that, as I’ve noted earlier, has ill-served investors. Of course, we’ve been assured that “value investing wins” (not “has won in the past”), especially in troubled markets. But the troubled markets of the last twelve months the leading “fundamental index” fund is down nearly 12 percent, almost double the 6 percent decline in a standard S&P 500 Index fund. Mark me down (Surprise!) as a market-cap-weighted indexer. As for value-weighted versus dividend-weighted strategies, I’m interested to read that they’re now arguing with each other! “Absolute Return” Funds.equity/venture

The Impact of Investment Costs on Fund Yields, October 2012 Net Percent of Yield Gross Yield Expense Ratio SEC Yield Consumed by ER LARGE-CAP STOCK FUNDS 2.09 1.22 0.87 58% Vanguard Total Stock Market Index Admiral 2.10 0.06 2.04 3% BALANCED FUNDS 1.91 1.29 0.59 68% Vanguard Balanced Index Admiral 1.93 0.10 1.83 5% INTERMEDIATE-TERM BOND FUNDS 1.74 0.65 1.09 37% Vanguard Total Bond Market Index Admiral 1.76 0.10 1.66 6% INTERMEDIATE-TERM MUNICIPAL BOND FUNDS 1.73 0.78 0.95 45% Vanguard Intermediate-Term Tax Exempt Admiral 1.74 0.12 1.62 7% Notes: Sales loads not included.2012

On the other hand, for an equity index fund with a cost of a mere 0.1 percent, the net yield on the stock index fund comes to slightly above 2.0 percent, the Intermediate-Term Bond Index Fund to 2.1 percent. The yield enhancements are 120(!) percent for stock funds and about equal for the bond funds (with higher quality and shorter maturity)—are there for the taking, without any increase whatsoever in risk exposure. (The same arithmetic applies to annuities, with annuities invested in index funds available at costs as low as 0.25 percent, compared to more than 2 percent per year for their highest cost cousins.) The Dominance of the Index Fund In recent years, with sharply lower income yields now available, and the demonstrated importance of low costs as the major factor in producing optimal total returns in stock funds and bond funds alike, the move toward index funds has come into its own. During the past six years, fund investors have moved almost $300 billion out of relatively high-cost, actively-managed equity funds and poured more than $650 billion into low-cost, passively managed equity index funds, a swing of almost $1 trillion. (Chart 7) In today’s low yield environment, with clients starving for income, indexing is even more attractive than ever before, and intelligent investors are voting for it with hundreds of billions of dollars.billions

What seems to be ignored by the fund industry, for obvious reasons: Serving retired investors by increasing fund investment income, the forgotten man of the fund industry. The only way to increase payouts from fund income—while holding risk constant (something some deeply trouble short-term bond funds obviously forgot)—is to slash expense ratios. Aren’t equity fund shareholders ill-served when 75 percent (!) of investment income of the average equity fund is confiscated by costs? (And that’s precisely what happens when the gross yield on stocks is 2 percent, and the fund’s expense ratio is 1.5 percent.) Similarly, the all-in costs of the typical bond fund, including amortized sales loads, consume about 50 percent of the yield on the average bond fund. (As investors in some deeply-troubled short-term bond funds have learned, increasing the net return by holding higher-yielding CDOs wasn’t a good idea.) BRIC Funds and International Funds. No doubt about it. With returns in Brazil, Russia, India, and China soaring in recent years, fund sponsors were quick to market them. Perhaps their recent declines will squash investor appetites for them, but my experience is that it’s all too easy to jump on the bandwagon of superior past performance. Just consider the ebb and flow of equity fund capital flows into international markets, consistently declining as U.S. stocks lead and then soaring as non-U.S. issues lead.

The Total Bond Market Index Fund—70 percent in Treasuries and other governments—now yields only 1.7 percent. But a Total Corporate Bond Index Fund would generate a yield about 3.2 percent. So, much as I love the total bond market index fund, it needs to be more heavily seeded with corporates. So, let’s put these projections together.a

” Shunning faddish new strategies focused on short-term fashions, in favor of simplicity and winning on the long-term arithmetic (gross return, minus cost, equals net return). 6. Indexing. Focusing on index funds, unattractive to active managers because of the minuscule fees they generate, but guaranteeing investors their fair share of whatever returns our markets generate. (As I suggested in that 1951 thesis, passive index funds must ultimately demonstrate performance superiority over their actively-managed peers.) 7. Bonds. Focusing on fixed-income securities, whose long-term returns are derived entirely from interest coupons, where the yield advantage will be obvious, narrowly define the maturity range for each fund.

The simple mathematical fact is that, because of high mutual fund expenses, the passively- managed all-stock-market index fund typically holds the same composite portfolio as the average actively-managed fund, and generates about the same gross dividend yield, say, 2.1 percent for stocks and 2.7 percent for bonds. But active stock funds subtract expenses of about 1.3 percent, leaving just 0.8 percent for you. Active bond funds subtract about 0.8 percent in expenses, leaving just 1.9 percent for you. On the other hand, for an index fund with a cost of a mere 0.1 percent, the net yield on the stock index fund comes to 2.0 percent, bonds to 2.6 percent. The respective yield enhancements—120(!) percent higher for stock funds and almost 40 percent higher for bond funds—are there for the taking, without any increase in risk exposure.

The Dominance of the Index Fund In recent years, the move toward index funds has come into its own. During the past five and one-half years, fund investors have moved some $300 billion out of relatively high-cost, actively-managed equity funds and poured over $600 billion into low-cost, passively managed equity index funds. In today’s low yield environment, indexing is even more attractive than ever before, and wise investors are voting for it with their hundreds of billions of dollars. So am I satisfied with how our financial system is working today? No I am not! But I am pleased with how those remarkably simple ideas that I expressed at Princeton all those years ago have began to work. Index equity funds are rapidly approaching 50 percent of the assets of active equity mutual funds, and growing apace. In these days of low market yields and high mutual fund expenses, I expect that growth to accelerate. A journalist recently reported that I take “almost childlike delight” in seeing my idealistic dreams come true. (He was accurate, I think, except for the almost!) But I’ve long since realized that what passes for success in this funny world of ours is really a journey, not a destination. My long journey, one that arguably began some 65 years ago right across the street, on that dark, bitterly cold, and snowy early morning hike down Montgomery Avenue to the Ardmore Post Office, continues. Perhaps it will never end . . .