John Bogle on Risk Management

And it seems inconceivable that the huge boost that investment returns received from the 1979 – 1999 increase in the price-earnings ratio from 7x to 30x—a speculative return of more than 7% per year!—can possibly recur. Indeed, it is reasonable to predict that p/e ratios, having added so much to previous stock returns, will now begin to subtract from them. That is, having seen the bright upside of speculative return, we are now seeing its dark downside. Reversion to the mean strikes again. Current bond yields of 6% set the stage for average bond returns at a roughly similar level over the next decade. And while today’s money market yields of about 2% can and will change, perhaps substantially, it would take some leap of faith to forecast a return to the earlier average. So, while I’m the first to admit that even the most reasonable expectations for future financial market returns may be wide of the mark—either way!—it seems sensible for both investment professionals and investors themselves to plan for an era of lower financial market returns.Not

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.

performance—even superior. For, looking solely at total returns always conceals more than it reveals. Consider, for example, the substantial downside protection offered by the index portfolio in fiscal years 2001, 2002, 2003, and especially 2009, when the average endowment portfolio tumbled 19 percent, nearly double the 10 percent drop for the balanced portfolio Given those differences, we cannot and should not ignore risk. The indexed portfolio had a standard deviation of annual returns of 8.9 percent, exposed to some 20 percent less risk than the 11.3 percent volatility of the average endowment. As a result, the risk-adjusted return of the 50-50 portfolio, measured by the Sharpe Ratio was 0.45, well above the 0.38 Sharpe Ratio for the average endowment. Another risk, of course, is the risk of differing from the average, and the dispersion of returns among the endowment funds is significant. Today’s 990 endowment funds in the sample are not “a group.” Performance among individual endowment funds has diverged widely. While we don’t have nearly enough data on this point, one study limited to just 28 endowment funds for the period 1999-2009 showed that, with average annual return for the decade of 6.3 percent, their standard deviation of returns was 1.7 percentage points. One-sixth of the funds earned returns of 8.0 percent or more, and one-sixth earned returns of less than 4.7 percent. (The absolute range, even for this limited sample, ranged from 10.5 percent to 4.3 percent.)

Black Monday and Black Swans Remarks by John C. Bogle Founder and former chief executive, The Vanguard Group before the Risk Management Association Boca Raton, Florida October 11, 2007 Just a week from tomorrow, we’ll mark the twentieth anniversary of what came to be known as “Black Monday,” October 19, 1987. On that single day, the Dow Jones Industrial Average dropped from 2246 to 1738, an astonishing decline of 508 points or almost 25 percent. The drop was nearly twice the largest previous daily decline of 13 percent, which took place on October 24, 1929 (which became known as “Black Thursday”), a distant early warning that the Great Depression lay ahead.1 From its earlier high until the stock market at last closed on that fateful Black Monday of 1987, some one trillion dollars had been erased from the total value of U.S. stocks. The stunning decline seemed to shock nearly all market participants. But there were some veterans whom it didn’t surprise. Ace Greenberg, former chairman of Bear Stearns, was quoted in the newspapers as saying, “So markets fluctuate. What else is new?” And only a year before Black Monday, I observed to the Vanguard crew that even a 100-point decline in the Dow—something that had never before occurred—was possible. Why? Because, as I observed, “in the stock market, anything can happen.” That truism remains, but I’d argue the point even more strongly today.

In the late 1990s, fund investors again paid a high price for our focus on the promise of the technology-driven information age, and on the promised land of the great bull market. The price they paid can be measured by the errors that fund investors made in the timing of their fund purchases and the selection of the funds they chose. The next two charts reflect those destructive patterns. The timing penalty (Chart 8) was evidenced by the fact that fund investors placed little money into equity funds during the cheap markets of the late 1980s and early 1990s (less than $10 billion per year), but invested more than $500 billion at the peak market levels of 1998-2000. The selection penalty (Chart 9) made a bad situation worse. Investors poured the lion’s share of that $500 billion into those “New Economy” growth funds, technology funds, telecommunication funds, and even internet funds. It was these funds that led the market upward, and then led the market downward, with late-to-the party fund investors paying an awful price. Ironically, at the height of the bubble, investors were actually liquidating their stodgy old value funds, which would provide excellent downside protection during the bear market that followed.

Equity-linked annuities, where downside protection is provided—at a grossly excessive cost—are but one more way to escape NASD regulations on the technicality that they are actually (exempt) insured products, not securities subject to federal oversight. A Business Week article describes them as “a sucker’s game dressed up to look like a free lunch.” I hope the SEC will demand the investor protection and disclosure that is clearly required. What’s more, we now have 130/30 funds (or 120/20 funds), whose respective ratios speak to the fund’s long and short positions, our sad attempt to challenge the hedge fund industry. When I see these kinds of innovations, I say, “Watch out!” Also on the drawing board are funds that make automatic monthly payouts directly from capital—which I pray will include a “worst case” disclosure—and funds offering “growth and guaranteed income.” Where this innovation will end, knows God. But my long experience tells me that many, perhaps most, of today’s innovations will end badly for investors. For we know that complexity is usually associated with higher—and often hidden—costs, and with higher—and usually undisclosed—risks. As these “new products” (as we are wont to call them) proliferate, the new Statement of Policy I propose must have the flexibility to deal with them.

Risk Management Strategy ∑ Mutual—Low portfolio risks and costs, but still providing competitive income yields. ∑ Manager—Reaching for higher yields, with higher risks, to compensate for their higher costs. 5. “Product” Strategy ∑ Mutual—Sell what you make: Middle-of-the-road funds; defined market segments; love index funds. ∑ Manager—Make what will sell: Aggressive funds and fad funds; hope for home runs; hate index funds. (Why? Low—if any—profit to managers.)