the bogle issue - IndexUniverse.com

Plus an excerpt from Bogle’s forthcoming book and an interview with the man himself,
as well as thoughts on indexes and investing from Agather and Blitzer
the bogle issue March / April 2012
The Economic Role Of The Investment Company
John Bogle
The Bogle Impact: A Roundtable
Featuring Gus Sauter, William Bernstein, Burton Malkiel, Don Phillips, Ted Aronson and more!
Lessons From SPIVA
Srikant Dash
The Case For Indexing
Christopher Philips

www.journalofindexes.com
Vol. 15 No. 2
features
The Economic Role Of The Investment Company
By John Bogle 10
Bogle’s college thesis: A revolution is born
The Bogle Interview: Big Picture, Big Challenges
With Matt Hougan and Jim Wiandt 20
Bogle examines the current investment environment
The Bogle Impact: A Roundtable
With Gus Sauter, William Bernstein and more 24
Friends and colleagues discuss Bogle’s influence
Ideas Vs Implementation
By John Bogle 30
A sneak-peek excerpt from Bogle’s forthcoming book
Lessons Learned From SPIVA
By Srikant Dash 32
Key takeaways from a decade’s worth of data
10
The Case For Indexing
By Christopher Philips 36
The argument for indexing in 2012
The Index Industry’s Changing Landscape
By Rolf Agather 46
Indexes have evolved, and so should best practices
Keeping It Simple And Making It Work
By David Blitzer 48
Index funds didn’t come out of nowhere
A True Industry Vanguard
By Bruce Greig 64
Find Bogle boggling? Test your knowledge with this puzzle
news
Index Providers To Form Trade Body 50
LSE Acquiring Remainder Of FTSE 50
Research Affiliates Files Suit Against WisdomTree 50
Indexing Developments 51
Around The World Of ETFs 53
Back To The Futures 55
Know Your Options 55
On The Move 55
data
Global Index Data 57
Index Funds 58
Morningstar U S Style Overview 59
Dow Jones U S Industry Review 60
Exchange-Traded Funds Corner 61
24
32
www.journalofindexes.com
March / April 2012
1

Contributors
Rolf Agather
Rolf Agather is the managing director of research and innovation for Russell
Investments’ family of global indexes. In this role, he oversees product development
and management, and the implementation of strategic initiatives for
the index business globally. Prior to assuming this position in 2005, Agather
was a strategic initiatives manager focusing on strategy and product development
for the investment manager marketplace. Before joining Russell, he
was a vice president at FactSet Research in its portfolio products business.
David Blitzer
David Blitzer is managing director and chairman of the Standard & Poor’s
Index Committee. He has overall responsibility for security selection for
S&P’s indexes, and index analysis and management. Blitzer previously
served as chief economist for S&P and corporate economist at The McGraw-
Hill Companies, S&P’s parent corporation. A graduate of Cornell University,
he received his M.A. in economics from George Washington University and
his Ph.D. in economics from Columbia University.
Christopher Philips Srikant Dash
John Bogle
Bruce Greig
John Bogle is the founder and former CEO of The Vanguard Group Inc., and
president of the Bogle Financial Markets Research Center. He created Vanguard
in 1974 and had been associated with a predecessor company since 1951, following
his graduation from Princeton University magna cum laude in economics.
Bogle founded the Vanguard 500 Index Fund, the first index mutual fund, in 1975.
He is the author of many books, including “The Clash of the Cultures: Investment
vs. Speculation,” which will be published by John Wiley & Sons in July 2012.
Srikant Dash, CFA, is managing director at S&P Indices, where he has overall
responsibility for channel strategy and solutions. Dash also has global responsibility
across asset classes for research and design efforts for new S&P indexes. He
has authored several research papers on index issues such as the widely followed
SPIVA (S&P Index Versus Active) and Persistence Scorecards. Dash holds a bachelor’s
of electrical engineering from the National Institute of Technology, Rourkela,
India and an MBA from the Indian Institute of Management at Ahmedabad.
Bruce Greig, CFA, CAIA, CMT, is the portfolio manager for Altin Holdings
LLC. Altin Holdings is a commodity pool operator and registered investment
advisor specializing in managed futures and alternative investments.
Previously, he was co-founder and managing director of Symphony
Investment Group LLC. Greig obtained his B.S. in mathematics and statistics
from the University of Michigan and his MBA in finance from the Ross
School of Business at the University of Michigan.
Christopher Philips, CFA, is a senior investment analyst for Vanguard
Investment Strategy Group. This group is responsible for capital markets
research, the asset allocations used in solutions for Vanguard’s funds-of-funds,
and maintaining and enhancing the investment methodology used for advicebased
relationships with high-net-worth and institutional clients. Philips has
authored several research papers on topics of concern to institutional and
high-net-worth audiences. He holds a B.A. from Franklin & Marshall College.
2 March / April 2012

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and any further disclosures please go to www.standardandpoors.com. Copyright © 2012 Standard & Poor’s Financial Services LLC, a subsidiary of
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registered trademarks of Standard & Poor’s Financial Services LLC.

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Editor
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Editorial Board
Rolf Agather: Russell Investments
David Blitzer: Standard & Poor’s
Lisa Dallmer: NYSE Euronext
Henry Fernandez: MSCI
Deborah Fuhr
Gary Gastineau: ETF Consultants
Joanne Hill: ProShare and ProFund Advisors LLC
John Jacobs: The Nasdaq Stock Market
Mark Makepeace: FTSE
Kathleen Moriarty: Katten Muchin Rosenman
Don Phillips: Morningstar
John Prestbo: Dow Jones Indexes
James Ross: State Street Global Advisors
Gus Sauter: The Vanguard Group
Steven Schoenfeld: Global Index Strategies
Cliff Weber: NYSE Euronext
Review Board
Jan Altmann, Sanjay Arya, Jay Baker, William
Bernstein, Herb Blank, Srikant Dash, Fred
Delva, Gary Eisenreich, Richard Evans,
Gus Fleites, Bill Fouse, Christian Gast,
Thomas Jardine, Paul Kaplan, Joe Keenan,
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Monaco, Matthew Moran, Ranga Nathan,
Jim Novakoff, Rick Redding, Anthony
Scamardella, Larry Swedroe, Jason Toussaint,
Mike Traynor, Jeff Troutner, Peter Vann,
Wayne Wagner, Peter Wall, Brad Zigler
4 March / April 2012
Copyright ©2012 by IndexUniverse LLC
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Editor’s Note
Tipping Our Hats
Jim Wiandt
Editor
If one person can be credited with making the existence of this publication possible,
it would be John Bogle. Yes, indexes have been around for over a century, but
it wasn’t until Mr. Bogle launched the Vanguard 500 and kick-started an entire
investment phenomenon that they were viewed as anything other than measures of
the market. So some 35 years after the advent of the first index fund, it makes sense
to pay tribute to the man who started it all.
We open the issue with excerpts from Bogle’s 1951 college thesis, “The Economic
Role of the Investment Company.” Some 60 years later, it remains a fascinating read,
and you can easily tease out the premises that eventually evolved into Bogle’s investment
philosophy. We then fast-forward several decades for a recent interview with
the man himself: Find out what Jack Bogle really thinks about our current investment
environment, taxes, politics and his accomplishments.
Next is a roundtable that asks Bogle’s friends and colleagues about his impact on
them and the investing public. Gus Sauter, Burton Malkiel, William Bernstein, Rob
Arnott, Don Phillips and others offer their personal impressions and thoughts, with
additional commentary from David Swensen, Paul Volcker and the late Paul Samuelson.
What follows is a sneak peek at Bogle’s upcoming book, “The Clash of the Cultures:
Investment vs. Speculation,” which will be published this summer by John Wiley & Sons.
After that, Standard & Poor’s Srikant Dash weighs in with his top 10 takeaways from
a decade’s worth of SPIVA reports and Persistence Scorecards—you might be surprised
by some of his findings! And Christopher Philips offers the latest version of “The
Case for Indexing,” Vanguard’s seminal research paper on why passive investment is
the only sound decision. If anything, the argument has grown stronger over time.
Rolf Agather of Russell Investments takes a look at the history of indexing and the
modern-day blending of passive and active strategies, offering suggestions on best
practices for index providers in the current environment. Then David Blitzer chimes
in with a look back at the original academic arguments underlying the advent of the
index fund. Finally, Bruce Greig rounds out the issue with a crossword puzzle built
around Bogle’s career and influences.
Let’s all raise our glasses to the marvelous, brutally honest and passionately sensible
Jack Bogle!
Jim Wiandt
Editor
8
March / April 2012

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The Economic Role
Of The Investment Company
Excerpts from the author’s 1951 college thesis
By John Bogle
10
March / April 2012

If you asked experts in the financial industry what single individual
has done the most in the past 50 years to influence how
Americans invest, you’d get a wide-ranging list of names—but
one name you’d see over and over would be John Bogle. What
follows are excerpts from his 1951 college thesis, submitted to
Princeton University, including parts of Chapter 1, “Advantages
to the Individual Investor,” and the conclusion. In it, you can see
the original seeds of many of the ideas and concerns that would
later drive him to build the Vanguard Group and become an
outspoken advocate for the best interests of investors.
That the investment company has fulfilled its functions
to the individual investor appears manifest.
The very fact that the number of shareholders has
trebled in the last ten years seems to indicate that they
have found it a suitable means to accomplish their investment
ends. 1 It will be the place of this chapter to show
what advantages the investment company gives the investor,
using particular examples wherever practicable.
Several things must be made clear, however. First,
investment companies have generally tried to encourage
the purchase of their shares by investors, not savers.
Many funds point to the need for adequate cash reserves,
insurance, and perhaps additional savings or government
bonds before placing the remainder in a mutual fund.
This chapter, then, will be oriented toward those individual
investors who can afford investment, which by its
very nature entails a certain amount of risk.
Second, the funds can make no claim to superiority
over the market averages, which are in a sense investment
trusts with fixed portfolios; e.g., the stocks composing the
particular “average.” They state, rather, that their performance
must be judged against what the individual could
have done at the same cost over the same period, with the
same objectives as has a given fund.
Third, it is evident that the open-end investment company
cannot attain perfect fulfillment of all the objectives
stated below, but makes available the most adequate combination
of facilities for the individual investor; that is, it offers
the package with the greatest total amount of management,
diversification, income, liquidity, and dollar appreciation.
There will be no claim in this thesis that the management
of the investor’s capital will produce better results than that
of an investment counsel who handles large accounts individually;
that the diversification will be sounder than that
of insurance companies under legal list requirements; that
the income will be as stable as that of government bonds or
as high as that from a given common stock; that the liquidity
will be as great as that given by a savings bank; nor that
the share will appreciate in value with the cost-of-living as
a closed-end leverage share does. The only claim will be
that the investment company offers the best combination of
these facilities to the individual investor.
In offering to the investor a greater degree of diversification
and more expert management than he could otherwise
obtain, investment companies present a wide variety
of fund types with diversified objectives, from which
the investor may choose. He may pick the balanced fund,
which attempts to plan its portfolio with regard to current
conditions, especially by shifting its ratio of “aggressive”
common stocks and “defensive” bonds; or the common
stock fund, which maintains a largely fully invested position
with a view toward selecting seasoned issues; or the
bond fund, which maintains a portfolio solely of bonds. If
the investor prefers to exercise a greater degree of management,
he may choose the specialty fund, of which
there are two types: the industry type, in which a share
is backed by a diversified list of issues in an industry of
the investor’s choice; and the objective type, in which the
investor picks his objective and participates in a diversified
list of stocks most likely to fulfill it. Thus, the mutual
fund offers the investor a wide variety of shares from
which to choose, to suit his objectives of either capital
appreciation, capital preservation, or reasonable income,
or varying combinations of each.
The advantages of management, diversification, income,
liquidity, and inflation hedging which the funds provide
will be discussed in separate sections. However, the investment
companies perform several additional minor functions
which may be mentioned here: their portfolio shares
are held by a custodian—usually a bank—and are thus safe
from damage or loss (but not depreciation in value, as the
recent Securities and Exchange Commission Statement of
Policy indicated 2 ); the dividends are quarterly, not scattered
and small, and the investor need not be concerned
with proxies, warrants, and stock splits; and finally, there
is convenience in income tax returns, with the investment
company required to send a year-end statement of the taxability
of dividends. This chapter will now proceed with an
analysis of the degree of success the funds have attained in
providing the more important advantages to the investor.
Management
… the judicious selection of securities, based on extensive
research and systematic plan, in order to accomplish
the objectives of investment …
The individual investor in most cases has neither the
time nor the knowledge to manage his own investment
account. This lacking is made clear in the oft-quoted
statement by the late Louis D. Brandeis, Associate Justice
of the United States Supreme Court: 3
…the number of securities on the market is very
large. For the small investor to make an intelligent
selection from these—indeed, to pass an intelligent
judgment on a single one—is ordinarily impossible.
He lacks the ability, the facilities, the training, and
the time essential to a proper investigation. Unless
his purchase is to be little better than a gamble, he
needs the advice of an expert, who, combining special
knowledge with judgment, has the facilities and
incentive to make a thorough investigation.
The mutual fund supplies the investor with this expert
management, at relatively low cost, with its objectives
www.journalofindexes.com March / April 2012 11

stated so that the investor can carefully determine which
fund best suits his needs. Besides these advantages,
the management usually has sufficient cash position to
“average-down” in a period of market recession, 4 and is
therefore able to take advantage of prevailing low prices.
The individual investor usually lacks the capital to do this.
Investment company management is usually steered
by a Board of Directors or a Board of Trustees, composed
largely of the company officers, established businessmen,
directors of corporations, accountants, lawyers,
bankers, and members of stock exchanges. The Boards
do not suffer by comparison with the director lists of
any large corporation, and include a Trustee of the
Committee for Economic Development, the treasurer
of American Telephone and Telegraph, an ex-governor
of West Virginia, president of the Wilson Line, and
an associate dean of the Graduate School of Business
Administration of Harvard University. 5 In accordance
with the Investment Company Act of 1940, the Board of
Directors may not be radically changed without stockholder
consent; a majority of the directors may not be
affiliated with investment bankers or the investment
company’s regular brokers, and must be independent of
the average open-end fund is likely to dampen the amplitude
of any market fluctuation. Management can scarcely
be expected to buy so that the fund can stay ahead of the
market when the very securities that it buys are a part of
that market. However, the investment company should
not saddle its investors with a greater loss than the fall in
portfolio values. The closed-end companies did this in
many cases after the 1929 crash, since their shares were
purchased at a premium and sold at a discount during the
depression. Open-end shares may not be bought or sold
in this way, however, and their comparative superiority
can be clearly seen in relative performances in the 1929–
1936 period: in 193 closed-end management companies,
the average per share asset value declined by 35.3%, while
in 49 open-end funds, the value increased by 6.7%. 7
Wellington Fund states its objectives as “ … to pay reasonable
dividends, to secure profits without undue speculation,
and to conserve principal.” 8 Its record reveals
a 3.8% dividend rate over the past sixteen years, during
which it also made security profit distributions averaging
2.6% each year. The net asset value has fluctuated only
slightly over one-half as much as the Dow Jones 30-stock
Industrial Average in the last decade. 9 Fund principal has
Investors must expect the value of their investment company shares
to rise and fall with the market, although the average open-end fund
is likely to dampen the amplitude of any market fluctuation.
the company’s sales-distribution organization; and 40%
of the board may not be investment advisers or officers of
the company. 6 These provisions give positive protection
against control of fund investment policy by sales groups,
brokerage concerns, and investment banking houses.
The cost of management is usually stated as a percentage
of net asset value per share, computed quarterly in
most cases. It ranges from 1/2 of 1% to 1% of total assets,
and is stated even as a daily figure (1/730 of 1% of average
daily net assets) in order to give the investor the impression
of an extremely low cost. Nevertheless, there is some
indication that the cost of management is too high: first,
the fees come to from 5% to 15% when computed as a
percentage of income; and second, there are costs additional
to the management fee, such as custodian and
stock transfer fees, mailing and printing, clerical salaries,
administrative and legal fees, and state and local taxes,
which usually amount to from 20% to 50% of total expenses,
the remainder being composed of the management
fee. However, the careful investor can ascertain these
percentages for himself by investigating the prospectus,
and then make his investment on the basis of his findings.
Evaluation of Management Success
Investors must expect the value of their investment
company shares to rise and fall with the market, although
been conserved quite remarkably, as revealed by the net
asset value per share variation: the high was $24.58 in
1929 (the year the fund was organized) and the low was
$11.50 in 1932. A share purchased at any year-end in the
fund’s history would have a greater value at the present,
except for purchases in 1929, 1936, and 1945, all of
which were peak market years. Assuming all dividends
were reinvested, the share value increased by 100% in the
1934-1949 period, compared with an 83% increase in the
Standard & Poor 90-Stock Average.
Diversification
…the distribution of investments among different
issues of securities in order to decrease the risk on
any one investment…
Closely connected with the concept of management
of the investors’ funds is the idea of diversification,
which is said to minimize the risk of any single commitment
and contribute to the stability and continuity
of income. Investors must realize, however, that with a
decrease in the chance of a net loss by the spreading of
risks, there is also a limitation on the effect of a windfall
gain. This aspect or a limit to profit as well as to loss is
naturally one rarely stressed by investment companies.
Investors must also realize that diversification cannot
12
March / April 2012

protect against cyclical market declines. Diversification is
tied to management by the fact that it must be informed
and intelligent, not merely wide; it must be managed
rather than random. Most funds do use sound judgment
in diversifying their portfolios, and the criticism that the
funds merely “buy the averages” is seen as invalid, since
a survey by the writer of twenty funds indicated that each
had an average of but eight of the thirty widely-known
stocks comprising the Dow-Jones Industrial Average. The
fallacy of merely wide diversification is clearly indicated
by the stock market crash of 1929. Although closed-end
leverage companies averaged 87 issues in their portfolios,
and closed-end non-leverage companies averaged 60.2
issues, their capital decline was far more severe than that
of the open-end companies, which averaged only 46.8
issues. 10 The latter were virtually required to buy sound,
seasoned, marketable issues, primarily because they had
to be able to liquidate parts of their portfolios on demand
for redemptions by shareholders.
A few examples of why the individual needs diversification
may be made. First, he cannot properly invest in a
single stock without risk, as shown by the following examples
[in Figure 1] of “blue-chip” stocks which declined in
value in 1949, a year when the averages rose about 10%.
Even over longer periods, a single investment offers a
very great risk. In the 1939–1949 period, when the Standard
& Poor 90-Stock Average rose 110% (assuming all dividends
reinvested), [the major] issues in [Figure 2] declined.
With the indication that selection of individual securities
is at best an extremely risky proposition, it seems pertinent
to indicate the requirements for diversification in the fund
portfolio. First, the Investment Company Act requires that
at least 75 percentum of the value of its total assets
is represented by cash and cash items, government
securities, securities of other investment companies,
and other securities limited in respect of any
one issuer to an amount not greater in value than
5 percentum of the value of the total assets of such
management company and to not more than 10
percentum of the outstanding voting securities of
such issuer. 11
Moreover, the investment company is not allowed to
change its basic policy statement (i.e., from a diversified
to a non-diversified company) without the consent of a
majority of its stockholders.
In the second place, many funds impose upon themselves
greater restrictions as to the amount and quality of
diversification through restrictions in their charters. The
following examples are typical:
1. To hold no more than 10% of any company’s stock.
2. To invest no more than 5% of assets in any company.
(These two restrictions in effect make the government
requirements effective for the entire portfolio.)
3. To limit borrowing to 10% of assets.
4. To limit underwriting to 5% of assets.
5. To invest not more than 2% of assets in securities
Figure 1
Figure 2
Leading Issues Which Declined In Value In 1949
Stock
Source: Wiesenberger, op. cit., p. 162
Issues Which Declined In The 1939-1949 Decade
Percentage Decline
In Market Value
Air Reduction -65% -38%
International Nickel -50% -13%
NY Central Railroad -46% -18%
United Aircraft -38% +25%
Allis Chalmers -31% +4%
Continental Can -15% +21%
Sources: Wellington Fund sales material; computations by the author
Decline
American Telephone & Telegraph -3 3 ⁄4
Electric Storage Battery -9 3 ⁄4
Gulf Oil Co. -4 5 ⁄8
Standard Oil of N. J. -5 3 ⁄8
Loss Including
Dividends Paid
of an issuer that has been in operation for less than
three years.
6. Not to invest in securities of other investment trusts.
7. Not to hold more than 5% of assets in securities not
listed on the New York Stock Exchange or on the overthe-counter
markets.
A few examples of diversification in various investment
companies [in Figures 3 and 4] indicate how wide it is.
Naturally, the investor has to pay a price for diversification.
In the open end company it is the load, or sales
charge, on the purchase of each share. 12 There has been
much criticism of the large size of the load, which usually
runs from 6% to 9% of the net asset value per share,
depending on the fund. Although, strictly speaking, the
load is the cost of distribution, since the fund itself never
receives any part of it, it may be considered as the cost of
diversification for two reasons: first, because the test of
cost is the value (i.e., the portfolio shares) obtained for
a price, and secondly, because the load is a commission
paid in buying an investment company share, just as a
brokerage commission must be paid in the purchase of
shares of listed stock, of which the portfolio is composed.
Although it is more favorable to compare the load with
any dealer commission—since both are the costs of
bringing the service to the consumer—it seems closer to
reality to compare it with the costs incurred in actually
duplicating the purchase of the investments in the portfolio
which the investment company share represents.
The funds claim that, for the individual, commissions
and other buying and selling costs in obtaining diversification
would exceed the cost of the mutual fund shares.
To buy but one share of each of the securities in the Dowwww.journalofindexes.com
March / April 2012 13

Jones 30-Stock average would cost $1,800.81. The commission
charges on the purchase and the resale of each
share would amount to 11.16% of this purchase price. 13
This example indicates the importance of the “roundtrip”
feature of the sales load, which means essentially
that the investor is paying both the buying and the selling
commissions at the same time.
The load payment, as mentioned before, does not go to
the fund itself. An eight dollar commission would be distributed
in approximately the following fashion: $2.00 to
the dealer, $3.50 to the salesman, and $2.50 to the sponsor,
or principal underwriter, who pays for the sales literature
and wholesaling. This peculiar situation, whereby the
fund does not profit directly from the sale of its securities,
means that a fall in the cost of a share (through a reduced
load) will not lead to a rise in the amount of shares
demanded: a lower load is likely to mean decreased sales,
since it entails a lower profit for the salesman, who in
turn can divert his effort to the sale of another fund, since
there are a great variety of similar fund shares available.
Merrill Griswold, chairman of Massachusetts Investors
Trust’s Board of Trustees, presented the implications of
a lowered load when he told the Securities and Exchange
Commission, at the 1939 public examination of MIT:
If we had at that time (1932) reduced our sales
load to 5 ¾ (it was then 8 ¼), I don’t think anybody
would have sold any of our shares to anybody. 14
All things taken into consideration, it would seem that
the load is perhaps too high. Although it is justified in a
purely economic sense since the public is willing to pay
that price for shares, and in a social sense since it keeps
the small investor from speculative “switching,” an even-
tual reduction in sales loads would doubtless increase the
number of holders of investment company shares, at the
same time increasing the distributors total revenue by the
higher sales volume.
Income
…the recurrent money payments proceeding from the
disbursements of the institutions in which funds are
invested…
With the fall in interest rates and bond yields the reasonable
and regular dividends provided by investment
companies are extremely important to the individual
investor. So far as is known, no mutual fund with income
as its objective has ever passed a dividend from investment
income. Although there is no guarantee or continuous
future return, it seems logical to assert that dividends
will be forthcoming as long as American industry
continues to make profits, since it is the return on the
portfolio of the investment company which provides it
with cash for its disbursements.
The increasing divergence of stock dividends and bond
interest rates is probably a substantial reason for the
growth of the investment company. The depression and
the great capital losses to investors which resulted from it
caused a greater desire for safety of principal, but gradually
confidence in stocks (and especially in a diversified
group of them) returned, and during the same period
bond rates fell. The combination of high income and safe
principal thus shifted in favor of the common stock element.
In spite of the fact that many funds urge that part
of the investor’s capital should be devoted to bonds, after
he has cash reserves and insurance needs filled, it seems
doubtful that this advice has been widely followed.
Figure 3
Diversification By Industry In Selected Funds
Fund
Number Of Industries
Largest Holding (% Of Assets)
Smallest Holding (% Of Assets)
Affiliated 19 Petroleum, 19.1 Rubber, 1.1
American Business Shares 10 Automobile, 9.7 Machinery, 1.7
Broad St. Investment 22 Building, 15.6 Publishing, 0.7
Knickerbocker 13 Steel, 11.0 Petroleum, 2.2
Scudder, Stevens & Clark 25 Retail, 4.8 Amusement, 1.0
Source: Recent prospectuses of indicated funds [ca. 1951]
Figure 4
Diversification By Issues In Selected Funds
Fund
Number Of Issues
Largest Holding (% Of Assets)
Smallest Holding (% Of Assets)
Boston Fund 101 Cities Services, 1.9 Sharpe & Dohme, 0.22
Selected Industries 180 Union Securities, 5.2 Marine Midland, 0.02
Putnam Fund 126 Gulf Oil, 1.6 Allied Stores, 0.2
Source: Recent prospectuses of indicated funds [ca. 1951]
14
March / April 2012

Figure 5
Figure 6
Investment Company Dividends From Income
Selected Funds Over A Five-Year Period
Investment Company Capital Gains Disbursements
Selected Funds Over A Five-Year Period
Fund
1944 1945 1946 1947
1948
Fund
1945 1946 1947 1948 1949
Boston 0.64 0.70 0.71 0.82 0.79
Fidelity 0.71 0.65 0.91 1.07 1.50
MIT 0.96 1.01 1.10 1.23 1.40
Boston — 0.90 1.50 0.50 —
Fidelity 1.10 0.83 0.38 — 0.15
MIT 0.50 0.70 — — —
Proof of the relative regularity of investment company
dividends can be seen from an analysis of three companies
[in Figure 5]. Boston Fund, Fidelity Fund, and MIT
averaged 4.3% in dividends from income over the past
ten years, and never missed a quarterly dividend.
There is a virtual legal requirement for the investment
company to pay out its income in dividends, for
to qualify (and thus gain tax exemptions) under the
Internal Revenue Code, Supplement Q, the investment
company must distribute as taxable dividends
not less than 90% of its net income, exclusive of
capital gains, for any taxable year. If it complies with
this requirement, it pays no tax on the amount so
distributed. This supplement prevents what would
otherwise be triple taxation, with the government
receiving a tax on corporate earnings, on the dividends
from those earnings distributed to investment
companies, and on the amount mutual fund stockholders
get from their dividends.
Capital gains distributions present a problem to the
investor as well as to the investment company. They
are derived from net profits realized from securities
transactions, and generally occur in periods of rising
stock prices. For this reason, most companies encourage
their reinvestment, and thus hope to prevent this
reduction of working assets. The encouragement usually
consists in the elimination of the loading charge
when dividends are reinvested. Examples of this policy
are evident in the Keystone prospectus, which says
that capital gains distributions “…may be reinvested
in additional shares of the fund at net asset value at
the time of reinvestment,” which must be within thirty
days after the date of payment. 15 MIT says in its 1950
prospectus that they should “ …be regarded by the
shareholders as distributions of principal and not as
income …” 16 and that “ …shareholders will be offered
the opportunity to reinvest the cash so distributed in
shares of the trust at net asset value.” 17
The instability of capital gains dividends can be seen
by a survey [in Figure 6] of the three companies whose
dividends from income were shown as quite regular.
This instability has been in many cases disregarded
by the funds in their sales literature, in which
dividends were often quoted as the total of securities
profit distributions and income distributions,
thereby showing an abnormally high rate of return.
It is clear that in a declining market, the capital
gains portion would certainly decrease if not disappear
entirely, so the practice seems misleading to
the investor. The SEC Statement of Policy of August
11, 1950 took account of this when it declared that it
is “ …misleading…to combine into any one amount
distributions from net investment income and distributions
from any other source.” 18
One advantage of capital gains dividends that has
been exploited in a few cases by specialty funds has
been the fact that the investor need only pay capital
gains taxes on security profit distributions, thus cutting
his tax roughly fifty percent. Growth and speculative
funds have therefore been made available to the
investor whose taxable position is such that capital
gains are more valuable than regular dividend income.
Liquidity
…the quality of being convertible into cash at
a price approximating the value of the investment…
Liquidity of shares, or their redeemability by the
fund at approximately net asset value, serves a dual
advantage for the investor. 19 First, it makes it possible
for him to receive the fair value of his share on
demand, and second—a corollary of this advantage—
the management must be sensitive to his desires and
is thus responsible directly to him. Although redeemability
is the unique feature of the open-end company,
the Investment Company Act of 1940 made it
statutory, giving the investor the privilege of redeeming
shares at a price approximating net asset value
within seven days, except when the New York Stock
Exchange is closed under extraordinary conditions
or SEC declares an emergency to exist, during which
it is impracticable either for the investment company
to dispose of its securities or for it to fairly determine
the net value of its assets. 20
The redemption feature establishes a continual
market for the fund shares. Incidentally, there was
no interference with the redeemability right in the
market breaks of 1929, 1937, and 1946; and the New
York Stock Exchange has been closed only once in
the twenty-five years that the mutuals have been
in business. In practice, there has never been any
appreciable waiting period between the time shares
are tendered for redemption and the fund’s payment
www.journalofindexes.com March / April 2012 15

of cash to the shareholder.
There are two factors which can relieve the company
of the necessity of liquidating its portfolio securities
to meet a run on redemptions, both of which are
provided for in the Investment Company Act. First,
section 18(f) allows bank borrowing “ …provided
that…there is an asset coverage of at least 300 percentum”;
thus the funds may borrow to meet current
(and temporary) negative net sales. Second, the issuer
is allowed, under section 2(a)(31), to compensate the
holder with “approximately his proportionate share
of the issuer’s current net assets,” rather than “ …the
cash equivalent thereof.” This provision has not been
used, however, and some funds limit their redemption
payments to cash value alone.
In practice, redemptions have proved to be a relatively
fixed percentage of total assets, so with greater
size, the investment company must increase its sales in
order to gain the same amount of net sales [see Figure
7]. During economic crises, sales and distribution efforts
have to be increased in order to offset high redemptions
by the jittery public. These increased efforts were clearly
shown in the 1927–1936 period, when only in two quarters
did redemptions exceed sales.
Besides the advantages of redeemability per se to
the investor, the concept has three very important
implications; first, a major portion of the portfolio
must be composed of highly seasoned securities of
ascertainable market value; the holding of this type of
security, the writer submits, is one of the reasons the
open-end fund survived the depression so much better
than its closed-end counterpart. Second, the redeemability
feature prevents the use of senior securities,
since redemptions could destroy the equity behind
such securities. The investor, therefore, is never in
danger of having his interests subordinated by the use
of preferential capital. 21 Third, the threat of withdrawal
means that management must continually provide satisfactory
performance, at the risk of having to liquidate
its portfolio and go out of business.
Hedge Against Inflation
…to safeguard the purchasing power of capital by
investing it in things which advance, in both price
and yield, as the cost-of-living advances…
It seems a basic economic truth that the most likely
investment to appreciate in value and in return as
the purchasing power of the dollar falls is an investment
in common stocks. Although the correlation
between stock value and price level is by no means
perfect, common stocks offer the investor far greater
purchasing power protection than do bonds or savings
accounts. It is logical to assume, therefore, that the
investment companies, varying with the market and
having portfolios composed largely of common stocks,
will also provide the investor with a “hedge” against
the rising prices of consumer goods.
Figure 7
Figure 8
Relationship Of Fund Redemptions To Total Fund Assets
Year
Changes In National Income, 1937 And 1948
All Figures but per capita income in $ billions
National
Income
Percent
Per Capita
Income
Year
Personal
Income
Taxes
Percent
1941 11.2 1946 10.9
1942 6.2 1947 6.2
1943 7.8 1948 8.5
1944 7.9 1949 5.4
1945 8.5 1950 11.1
Sources: National Association of Investment Companies figures; computations by author
Disposable
Income
1937 73.6 552 73.9 2.9 71.0
1948 226.2 1,302 211.9 21.9 190.0
Real 1948* 144.3 833 135.0 13.4 121.0
* in 1937 dollars
Sources: Statistical Abstract of the United States: 1950; “Real” computations by the author
Professor Sumner Slichter, professor of economics
at Harvard University, has said that an investment
counsel who advises his client to place his funds in
savings banks, postal savings, or government securities
“is assuming a very heavy responsibility,” asserting
that properly selected stocks should prove to be a
reasonable protection against the rising cost of living. 22
In his opinion, unless the government issues savings
bonds payable in a fixed amount of purchasing power
rather than in fixed dollar amounts, the well-managed
mutual fund is the best answer to the problem of inflation
for the small investor.
Certainly the mutual fund offers a better hedge
against purchasing power decline than would bank
deposits or bonds, which are taxed in dollar rates. The
value of common stocks, in a survey by Emerson W.
Axe, was shown to yield an average of $2.80 for each
dollar invested during twenty-year periods from 1858
to 1948, under a plan of dollar-cost-averaging which
required the investment of $1,000 each quarter in a
common stock average. 23 This procedure enables the
investor to spread his investment over time. In the
worst period (1918–1938), the amount realized was
$164,181 on an initial investment of $80,951 (plus
reinvested dividends of $56,112). The best was 1908-
1928, after which $347,474 was realized from an initial
investment of $81,015 and reinvested dividends of
$87,896. These amounts are comparable with $99,594,
the realized amount from $4,000 invested annually for
twenty years in a savings bank, at current rates.
Some funds specifically attempt to procure common
stocks which will provide a hedge against infla-
16
March / April 2012

tion. Bullock’s Dividend Shares, for example, claims
that 67.6% of the shares in its portfolio provide this
characteristic in an exceptional degree. 24 Inflation
hedge stocks are
namely, the common stocks of those companies
producing basic raw materials, as well as others
which can be expected to experience an increase
in dollar income sufficient to offset the decline in
the purchasing power of the dollar. 25
They include all stocks whose 1940–1950 net earnings
per share have increased in an amount exceeding
the rise in the cost of living.
On the basis of limited information, then, it appears
valid to assert that both income from and principal of
an investment company share will tend to keep pace
with the cost of living; at any rate it will do so better
than fixed-income investments. It must be noted,
moreover, that the last thirty-five years have been
Some funds specifically attempt to procure
common stocks which will provide a hedge against inflation.
years of extremely unstable price levels, as a result
particularly of price control during the first and second
World Wars, and extremely unstable securities,
particularly in the decade surrounding the 1929 crash.
Fund Sales Policies
With these advantages for the small investor, the
fund has left the traditional marketing area for securities
to tap wealth in other parts of the country.
The North Atlantic seaboard, which supplies some
69% of the volume of trading on the New York Stock
Exchange, bought but 31% of the one billion dollars
worth of fund shares sold in the 1946-1948 period. 26 A
study made by the National Association of Securities
Dealers showed only three states with less than 1,000
mutual fund shareholders—Delaware, Nevada, and
Wyoming—the top seven states being California, New
York, Missouri, Michigan, Massachusetts, Illinois, and
Pennsylvania. However, the states with the highest
ratio of fund investors to total population were New
Hampshire and Maine, with New York ranking twentysixth
and Pennsylvania thirty-second. Besides going
to largely new geographic areas, the funds are taking
advantage of the new distribution of the national
income in the United States [see Figure 8]: only 32%
of the population now earn less than $3,000 each year,
compared with 85% in 1937; 51% earn from $3,000 to
$7,500, compared to 7% in 1937. 27 The distribution of
the income has gravitated considerably toward the
hypothetical “line of equal distribution”, with the
highest percentiles having moved one-half the way
to perfect equality since 1937. In addition to this new
distribution of wealth, there is a new total wealth in
the economy: since 1937, savings have increased by $20
billion, disposable income by $120 billion, and liquid
assets in individual hands by $107 billion. 28 The investment
companies are trying to reach this new wealth.
There are three general ways in which the attempt is
being made: sales and distribution policies, periodic
payment plans, and advertising.
In addition to the sales forces of the distributors of
mutual funds, there are some 4,000 over-the-counter
dealers who handle mutuals. Estimates of sales forces
are unavailable, but a very high average might be indicated
in the case of Investors Diversified Services, which
is said to have 1,700 salesmen in the United States and
Canada. The number of investment houses which handle
investment company shares has increased, during
the last ten years, from only a handful to over 500, possibly
to take advantage of the small dollar-unit transactions
through mutual fund shares. The funds can bring
new investors to Wall Street more easily than the New
York Stock Exchange can, since commissions there are
too low to permit high advertising, canvassing, and
distribution expenses. Wall Street ought to be grateful
to the funds for their merchandising, since “investment
companies are the best customers for common stocks
that the market has today.” 29 Certainly one reason for
the success of the sales and distribution expansion of
the investment companies are the advantages it gives to
the dealer and salesman, the former of whom likes the
high commission, the constant supply of shares, and
the fact that he does not need to tie-up any capital; and
the latter of whom appreciates the publicly-announced
price of the shares, the generous commission, and the
variety of literature and fund facts available.
With regard to advertising, the funds (and their
distributors) have incurred large expense by the publication
of elaborate brochures and sales literature.
This expense is paid for, in effect, by the shareholders,
through the medium of the sales load. Examples
of the type of literature—generally more promotional
than informative—can be seen from the titles of several
pamphlets. “A Personal Investment Account for
the Professional Man,” “A Plan for Tomorrow for
the Woman of Today,” “Dollars at Work in American
Industry,” “The Investor’s Hour of Decision,” and
“What can a Mutual Investment Fund do for me?” All
mediums—radio, television, newspaper—are used for
advertising, with the importance of the latter having
www.journalofindexes.com March / April 2012 17

een increased in recent years due to a more liberal
interpretation by the SEC of the Securities Act of 1933,
which in part restricted the advertising of new issues
of securities (under which investment companies are
classified because of their unlimited capitalization) to
“tombstone” advertisements. However, by the summer
of 1950, the advertising became too zealous and
in many cases too misleading, so on August 11, 1950,
the SEC issued a Statement of Policy, written with the
cooperation of the NASD and several fund executives.
Its restrictions indicate where many of the malfeasances
of the investment company advertising lie, so
some of its major provisions will be listed below. The
Statement of Policy makes it “materially misleading”
for sales literature:
1. to imply assurance of stable, continuous, dependable,
or liberal return.
2. to imply preservation of capital without indicating
the market risks inherent in investment.
3. to refer to government regulation without stating
that it does not involve supervision of management
investment policies
4. to imply redemption value will exceed cost.
5. to imply shares are generally selected by fiduciaries.
6. to compare performance with market averages without
indicating that the period was selected.
7. to make extravagant claims with respect to management
competency.
It is clear that the correction of advertising abuses
will in the long run be beneficial to the industry as a
whole, since investors that are misled, even unintentionally,
will certainly not be satisfied “consumers”
and buy more fund shares.
Insofar as providing advantages to the individual
investor, then, the investment company has fulfilled
its economic role. The soundness of management, the
careful diversification, the liberal income, the share
liquidity, and the hedge against inflation all combine
to make the investment company share the most proper
investment for the middle-income investor.
Thesis Conclusion
“As...the principles of diversification on which
these (investment) companies operate is a sound
one, the only probable causes for loss of public
confidence would be gross mismanagement or,
more likely…, misunderstanding on the part of
the public as to the nature of equity investment
as such, and consequent expectation of miracles
from investment company management.” 30
The tremendous growth potentiality of the investment
company, in conclusion, rests on its ability to
serve the needs of both individual and institutional
investors. It can do this best by stating its objectives
explicitly, so that a minimum of investor misconception
as to the fundamentals of equity will exist. The
investment company industry must prepare for its next
hurdle, which is likely to come from a serious decline in
the securities market, by making it clear that its shares
are not panaceas for all the ills of investment. That the
market will fluctuate is certain, and merely because it
has experienced a general upward trend in the decade
of the investment company’s greatest growth may
have made many investors fail to realize that the share
value, like the market, is liable to decline.
To further serve the interests of investors, and
thereby increase its own size, the investment company
may institute new types of shares in the future.
There is need for a venture capital fund, as well as
funds composed of tax-exempt securities, funds with
the securities of industries in given geographic areas,
and special investment companies to serve the specific
needs of pension and trust funds by placing a higher
percentage of government and corporate bonds in the
portfolio. Aside from serving investors by increasing
the breadth of its activities, the investment company
must continue to serve them as it has in the past, with
management operating in the most efficient, honest,
and economical way possible. By this high-grade
operation, the investment companies in the future can
sell their shares to the non-investors of the present,
thereby increasing the percentage of securities holders
above the 8% of the population which hold them
today. The investment company has grown up to now
by concentrating its sales power on the prospering
stratum of the economy; perhaps its future growth can
be maximized by concentration on a reduction of sales
loads and management fees.
The fact that the investment company may serve
economic roles other than providing advantages to the
investor should in no way be construed to imply that
that is not the function around which all others are satellite.
It seems clear that through investment in equity
capital, through influence on corporate management,
and through stabilizing the securities exchanges, the
mutual funds are serving to the fullest advantage of
their shareholders. If other roles arise in the future,
they must be cautiously analyzed, and discarded if they
interfere in any way with the interests of the investors.
As it was stated in the Harvard Law Review:
It is important to bear in mind that the principal
function of investment companies...is the
management of their investment portfolios.
Everything else is incidental to the performance
of this function. 31
Mutual funds, then, are not designed to replace
bonds, the banks, and insurance companies, but rather
to supplement their stability with a more adequate
income. The investment company can realize its optimum
economic role by the exercise of its dual function:
to contribute to the growth of the economy, and
to enable individual as well as institutional investors to
have a share in this growth.
18
March / April 2012

Endnotes
1. Author’s computation from figures given by the National Association of Investment Companies.
2. [See p. 20].
3. Quoted in “Trusts and Estates,” LXXXVIII (August, 1949), p. 495.
4. That is, has sufficient cash in order to buy shares at the low market prices and therefore lower the average price of the shares in the portfolio.
5. The directors of today are presumably more cautious than was Charles F. Kettering, vice president of General Motors Corp., who invested $260,000 during the late ’twenties
in an investment trust of which he was a director, and subsequently realized but $20,000.
6. Respectively, sections 16(a), 10(b), and 10(a).
7. Securities and Exchange Commission, “Investment Trusts and Investment Companies” (Part 2), p. 508.
8. Wellington Fund, Prospectus (April 14, 1950), p. 2. Other figures from their sales literature.
9. Wiesenberger, Arthur, op. cit., p. 113. All future “fluctuation” figures also from this source.
10. Securities and Exchange Commission, op. cit., p. 546.
11. Section 5(b) (1).
12. There is ordinarily no charge in redeeming the share.
13. Wellington Fund sales brochure, Cost vs. Value, p. 3.
14. SEC, op. cit. (Part 3), p. 811.
15. General Prospectus, February 10, 1950, p. 7.
16. Prospectus, February 24, 1950, p. 4.
17. Ibid., p. 8.
18. SEC, Statement of Policy, p. 2.
19. In many cases the fund authorizes the principal underwriter to act as agent in the repurchase of shares.
20. Section 22(e).
21. Section 18(f) of the Investment Company Act makes it illegal for open-end investment companies to issue senior securities, thus incorporating this provision into law.
22. Quoted by Long, Henry A., “Mutual Funds Mature,” Trusts and Estates, LXXXIX (September, 1950), p. 606.
23. Axe, Emerson W., “The Record of Equity Investment,” Trusts and Estates, LXXXIX (August, 1950), p. 508.
24. Dividend Shares, “Today’s Tests for Common Stock Investment,” p. 1.
25. Ibid., p. 1
26. National Association of Securities Dealers figures quoted by Dorsey Richardson, “Speech to Investment Bankers’ Association,” December 6, 1949 (mimeo.), p. 4.
27. Investment Companies Committee, “Report to Investment Bankers Association of America” (1949), p. 1. (mimeo).
28. [Ibid., p. 1.]
29. Mindell, Joseph, “Wall Street Doesn’t Sell Stocks”, Fortune, XL (April, 1949), p. 79.
30. Richardson, Dorsey, Address before National Association of Securities Administrators, October 9, 1950, p. 6.
31. Motley, Warren, et al, “Federal Regulation of Investment Companies since 1940,” Harvard Law Review, LXIII (July, 1950), p. 1142.
References
Securities and Exchange Comission, “Investment Trusts and Investment Companies,” Washington: Government Printing Office; Part 1: p. 158 (1939); Part 2: p. 937 (1940);
Part 3: p. 2804 (1941); Parts 4 & 5: p. 384 (1942)
Wiesenberger, Arthur, “Investment Companies—1950” (New York: Arthur Wiesenberger & Co., 1950), p. 336.
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Redefining Credit Risk
William Mast
Credit Derivatives Indexes
Gavan Nolan and Tobias Sproehnle
A Fixed-Income Roundtable
Ken Volpert, Jason Hsu, Waqas Samad, Larry Swedroe and more
The Impact of Bond Fund Flows
David Blanchett
Plus David Blitzer on bubbles, Jeremy Schwartz on dividends and buybacks, Francis Gupta on country
classifications and a biography on Bogle
www.journalofindexes.com March / April 2012 19

A Fireside Chat
The Bogle Interview:
Big Picture, Big Challenges
Vanguard’s founder talks about the current
market environment
With Jim Wiandt and Matt Hougan
The editors of the Journal of Indexes sat down for a chat
with Vanguard Founder John Bogle to discuss his long
career and his views on the current market.
Matt Hougan, president of ETF Analytics, Index-
Universe (Hougan): What key advice would you provide
to investors who are worried about today’s markets?
What would you tell them to do, drawing on all
your experience?
John Bogle, founder, The Vanguard Group (Bogle):
Well, I’m an optimistic conservative—so I’d be careful.
As I look ahead, I think reasonable expectations are for
about a 7 percent return on stocks, and about a 3.5 percent
return on bonds, counting longer maturities and a
greater weighting toward corporates, which are only 25
percent of the bond market index.
That means you’ll double your money in stocks over
the next decade and make 50 percent on bonds if those
expectations are realized. I wouldn’t write off stocks,
despite all the scare talk. But it’s going to be a bumpy ride.
Everybody should be fully aware of that. They should be
investing for a decade.
Anyone that’s buying stocks thinking about what’s
going to happen next year is a fool, to be quite blunt
about it. Buying stocks—owning stocks—is a lifetime
endeavor. And as Mr. Buffett says—and I feel particularly
strongly about this in the context of an index fund—
my favorite holding period is “forever.”
Hougan: Do you think a traditional broad-based bond
index has enough weight in corporates?
Bogle: I don’t think it does. I mean, obviously it does for all
investors because that’s the bond market. All those bonds
are owned by U.S. investors. It’s approximately 70 percent
Treasurys, agencies and Treasury-backed mortgage banks,
and 30 percent corporate. And that ratio is not that different
from what it was when I started the bond index fund in
1986. It’s surprisingly lower today, but not much.
A Treasury is now, according to somebody, rated AA. I
don’t believe that, by the way. But even so, the yields are low:
The spread between Treasurys and corporates is 2-2.5 percent.
It’s hard for me to believe the default rate on Treasurys
vs. corporates is that wide. And so, as long as the default rate
is less than that, you’re making a better choice in corporates.
I think we ought to be thinking more about corporates in
a very-low-interest environment than we should about the
total bond market. I love the Total Bond Market Index Fund.
I started it. But it’s not the answer to all things for everybody.
If people are pinched for yield, I’d recommend they have a
higher weighting in a corporate bond index fund.
Jim Wiandt, founder and CEO, IndexUniverse (Wiandt):
Burton Malkiel sees a very bad environment for bonds
in the U.S. right now, particularly Treasurys. People are
effectively going to be, he thinks, earning less yield than
inflation, which is kind of where the government is aiming
things right now. What are your thoughts on that?
Bogle: In the bond market, today’s yield is the best predictor
we have for the returns over the next 10 years.
Certainly the 10-year Treasury doesn’t look like a very
good deal—and yet it seems to do better and better every
time there’s an international crisis. It’s the first place
people run. That, however, is not going to go on forever.
I agree with [Malkiel] up to a point. You can probably get
a 3.5 percent yield on higher-yielding equities, but you can
also get 3.5 percent on a diversified bond market portfolio.
20
March / April 2012

[Are high-yielding equities] a better strategy? Only
time will tell. But if everybody is doing it, look out.
They’re not stupid choices. But I still would not abandon
a bond position for a stock position, even with higher yield.
Wiandt: Burton Malkiel’s commentary is interesting,
because he is saying that we should look at the market
to some degree, and bonds are not only going nowhere,
they’re probably going backward in terms of yield. The
traditional asset allocation says to buy the total bond
market equivalent to how old you are. So when you’re
65 years old, you should be 65 percent bonds, etc. And
he’s really been saying you should adjust that a little bit
because the environment for bonds is very bad.
Bogle: I think that’s a correct analysis. None of us know. He is,
I’m sure, confident about that being the case. But think about
it this way: When you’ve got a 6 percent government market,
an 8 percent corporate market, the premium is 33 percent.
When you’ve got a 2 percent government market and a 4
percent corporate market, the premium is 100 percent. These
spreads haven’t changed much over time. I would just be very
cautious about telling people not to take too much risk.
I think I don’t need to get into a debate with Burt about
this, because one of us will be right, but probably not by a
lot, and one of us will be wrong, but probably not by a lot.
Hougan: Do you think international bond exposure
is going to become part of the core that every investor
should have exposure to?
Bogle: I think for the typical investor, it is not necessary.
If you look back at the record of international bonds, I
for one don’t see much to write home about. I don’t like
the risk. I don’t like the currency risk.
Wiandt: You don’t like the Greek bond market?
Bogle: I don’t like the Greek bond market. And I don’t
like the Italian bond market. And I don’t like the Brazilian
bond market. And I don’t like the Portugal bond market.
And I don’t like the Irish bond market. Shall I continue?
I’m not even sure about the French bond market. I feel
pretty good about the German bond market. But what’s
the point of guessing? The yields probably take all that
into account. The markets are very good, or have in the
past been—and I believe in the future will be—very good
arbitrageurs between the present and the future.
That’s the way I feel, as you probably know, about
international stocks. If they’re efficiently priced, I just
don’t see why they would give you a higher return in the
future than they’re giving you today.
And let me say this about a better diversifier: “Better
diversification” is the last refuge of the scoundrel. What
were we talking about five years ago as a good diversifier?
Well, I can’t remember, but it wasn’t gold. And when
gold does well, as it certainly has, then someone says it’s
a great diversifier. And when international bonds get a
little ahead of U.S. bonds—not before, but after—then
someone says it’s a great diversifier. Anything that’s done
well recently is considered a great diversifier.
Wiandt: What do you think about gold?
Bogle: What people don’t get about gold and commodities
in general is that they have no internal rate of
return. I can tell you about stocks with a 2 percent yield
and earnings growing with the economy, let’s call it 5
percent nominal, and say these are underlying strengths
to deliver a 7 percent return. And I can talk about bonds
and say there is a 3.5 percent interest coupon today, and
that’s probably 91 percent of the future return of a bond.
When you get to a commodity, there is no coupon, there
is no dividend, there are no earnings.
When I buy gold, I’m buying gold because I think I can
sell it to somebody else at a higher price. If that isn’t the
ultimate in speculation, I would not know what is. It may
be a good speculation—I don’t make that argument—but
I would full well doubt it.
Hougan: You’ve said most U.S. investors don’t need
exposure to international equities, that U.S. stocks at
this point are international firms with 50 percent of
their revenues overseas.
Bogle: This is another one of my pet peeves. If you go
through developed international nations your largest
investment is Britain. And I think they’re in deep trouble.
Everybody knows they’re putting on heavy austerity.
They’ve got terrible financial problems. I think Keynes
was right—economies around the world ought to be
stimulating, rather than cutting back. So if you want 23
percent of your money in Britain, just understand that’s
what you’re getting.
The next one is Japan, at 18 percent of your portfolio.
What’s so good about Japan? They’ve got a structured
society. They’ve had a lot of innovation in the past. Will
that continue? I don’t know.
And then you go to France, who’s next in size, believe it or
not. And I don’t know … they don’t work very hard over there.
Next are Switzerland, Australia and Germany. They
all look pretty good.
The three largest countries, accounting for almost
half of the international index, are countries that have
significant problems. But when you put them in a single
package of international, you don’t think about that.
You ought to think about that.
Hougan: What do you think about the future of the
United States? Are you as pessimistic there as you are
about Britain and Italy and France? Or do you think
we’re a different case?
Bogle: I think we are headed toward a catastrophe unless
we do something. We simply can’t be the kind of nation we
have been unless we can knock some sense into our elected
officials. But that’s going to take some common sense on the
part of those who elect them. The whole thing in politics is we
get the politicians we deserve. And I hope we deserve better
than the politicians I have seen on television night after night.
I call them the seven dwarves plus Jon Huntsman.
I’m deeply worried about the political system. I’m
worried about the monied interest in our political sys-
www.journalofindexes.com March / April 2012 21

tem. I’m worried about Citizens United and the disgraceful
decision by the Supreme Court.
Hougan: What would give you more confidence?
What’s the single thing you think we need to fix or control
most? How would we turn it around?
Bogle: Well, it’s not easy to do. All these redistrictings
that all these states are doing, it makes Elbridge Gerry,
from whom the word “gerrymander” comes, look like a
piker. Really not a good situation at all, the way seats are
locked in. And it’s not good for the nation that extremist
parties get entrenched, as with the Tea Party, which, to
me, is thoughtless. It’s not a national asset.
The role of money, particularly these special PACs that
are out there, is simply a disgrace to a civilized nation.
There must be better ways to get big money out of the
system without violating the precious First Amendment—
we could just decide that corporations aren’t persons. For
example, we know that corporations can’t commit crimes,
because they can’t go to jail. It’s a big project in which we
need to engage our best citizens in trying to fix the system.
And Congress has to, whether it likes it or not, do intelligent
things to address the budget deficit.
I happen to believe the president is maybe a little off
target in his focus on taxing the rich. That sounds a little
bit—and I’m talking more about image than anything
else—not quite American. If only someone could tell him
to tax the sources of income differently.
Just think about a society that rewards who win during
the day with a lower tax rate than people who run out of
the house every morning, work hard all day, by the sweat of
their brow, the sweat of their brain, and come home. That’s
insane. That’s socially wrong, and it’s economically wrong.
I say tax capital gains at least at the same rate as
earned income. Tax dividends at least at the same rate
as earned income.
People talk about double taxation as dividends. Seventythree
percent of all stocks are owned by institutions that aren’t
really taxable—so we can think about it a little bit differently.
I would say let the investor who’s focusing on his retirement
have—just for the purpose of argument—each year,
the first $25,000 of dividend income and capital gains with
no tax. I don’t see anything the matter with that.
And then I’d say increase capital gains taxes at least to
the ordinary income rate. Maybe there’s somewhere we
can carve out an exception and divide capital gains into two
groups: One group is those who start companies that create
value for society, and the other group is those who are gambling
in the stock market and subtracting value from society.
I’d like to be able to intellectually separate those two and tax
the one that’s a waste for society and give a more favorable
tax treatment to those that are a benefit.
Wiandt: Even in the indexing industry, we have people
reluctant to talk about politics. I’m of the mindset that
enough is enough. Why aren’t we working in the interest
of the country here?
Bogle: I’m happy to make some suggestions. My tax
suggestion, for example; I feel very strongly about that.
I’m engaged in this battle over Citizens United. And I’ve
recommended to the SEC that each corporation be presented
with a resolution to present to its shareholders,
saying, “Resolved, that this corporation shall make no
political contributions without the approval of 75 percent
of its shareholders.” Why should corporations be
able to give money away, make gifts without a majority
of shareholder approval? And a majority is not enough
for me. Actually, a Delaware law, no longer in force, said
corporations may make no gift of their assets without
approval of 100 percent of their shareholders.
One thing we badly need in our society is for investors
to stand up and be counted and not let corporations run
amok in the interest of their own agents. Executive compensation
is a mess. Mergers are made just to make companies
bigger or to fix the accounting mess they’re in, or
whatever it might be—just simply to be larger and justify
more compensation. Shareholders should get a vote on
every one of those issues.
Wiandt: Some people might say that indexing is partly
responsible for that state of affairs, since almost by
definition, in indexing, you’re buying the market, and
so you have a lot of very large institutional investors
that really aren’t holding accountable the companies
that they’re investing in, just because it’s a massive
task to read all the minutes of all 500 companies in the
S&P 500, or whatever your index is. How would you
respond to that?
Bogle: The old so-called Wall Street rule is that if you don’t
like the management, sell the stock. Index funds cannot
sell a stock, so their rule has to be that if you don’t like the
management, change the management. And index funds
indeed do have an obligation to stand up and be counted.
[The problem is that] people don’t organize mutual
funds for their shareholders. They organize mutual
funds because they think they can sell them. It’s quite
clear in the record that we used to be an industry that
sold what we made, and now we’re an industry that
makes what will sell. And there is no finer example of this
than the exchange-traded fund business.
Hougan: You’ve definitely expressed concern about
ETFs. Is that because they’ve become the venue for hot,
new, thematic ideas? Is there anything wrong with
ETFs? Can ETFs be used appropriately?
Bogle: There’s nothing the matter with certain ETFs,
properly used. So start off with the S&P 500, the SPDR.
I tell the story in my book about the day Nate Most—a
visionary for the ETF—stopped into my office, and he
tried to sell me on the idea. I found flaws in what he
showed me, and then I said even if he can fix the flaws, it’s
not for Vanguard. Index funds are designed for long-term
investors, not for short-term speculators.
So we didn’t do anything with them, and he went to
State Street, and they did it. And there’s nothing the
matter with [SPY], except it turned over last year at 7,700
22 March / April 2012

percent. It’s a trading fund, mostly for institutional trading.
In a way, it’s failed to live up to its promise.
I see nothing the matter with an investor who wants
to buy and hold a broad market index fund. It’s a sound
way to participate.
But there’s a lot of marketing. I think Jeremy Siegel [of
WisdomTree] and Rob Arnott [of Research Affiliates] had
what were perfectly reasonable ideas, and that is to give
you an index fund that was slightly, only slightly, different
from the regular index. The so-called fundamental value
products don’t seem to be doing so well, now giving you
roughly the same return over their history—it’s five years
now—as the total stock market index, although the Arnott
one has quite a bit higher volatility.
The Jeremy Siegel idea of weighting by dividends I
kind of thought was good because I could understand it.
But you look at WisdomTree, and their dividend fund is
$200 million of their total assets. Nobody wants it. They
want rupees, and I don’t know, bahts, yen, renminbi, God
knows what they’re selling in the way of currency.
The main problem with ETFs, it seems to me, is the
narrow subdivision of the markets, which makes it almost
like picking stocks. If you look at the year-end Wall Street
Journal, in tiny type, it’s a page-and-a-third of ETFs, 1,617
of them. It’s like stock-picking, and that seems ridiculous
and offensive. Risk is concentrated in individual countries
and individual industries and subindustries, and sub-subsubindustries.
And it’s not enough to speculate whether
the market will go up or down, now you’ve got to have three
times leverage. And that’s going to hurt investors.
The original paradigm for index funds is to buy the
stock market and hold it forever. That is only the paradigm
for all of 1 percent of the ETF market—or be generous
and call it 5-10 percent.
The ETF is certainly the greatest marketing innovation
so far in the 21st century. Whether it’s the greatest
investment innovation or best innovation for shareholders
is totally in doubt.
[One more thing]: What I don’t understand, and I will
never understand, is why an ETF is an attractive vehicle for
an actively managed fund. It’s bad enough to guess each
minute whether an index is going up or down. But to guess
each minute whether a manager is doing a little bit worse or
a little bit better than the market strikes me as kind of crazy.
Hougan: For the past couple of years, there’s been a massive
tilt toward passive indexes and away from active. Is there
an element of investors coming to their senses? Do you think
this pattern will continue? Or do you think this is a shortterm
phenomenon and that active funds will be back?
Bogle: It’s only the beginning for passive investing.
Index funds are now around 25 percent of equity fund
assets. They’re going to be bigger with all these target
retirement funds. They’re going to be bigger in the bond
side. According to our data, in the last five years, $349
billion has flowed into equity funds. That’s $564 billion
into index funds and $214 billion out of active equity
funds. That’s pretty dramatic.
www.journalofindexes.com
And the numbers aren’t getting any better for the
active managers. I think people are waking up. How
many Bill Millers do investors have to observe? How
many Berkowitzes do investors have to observe?
The average mutual fund manager lasts for about six
years. And 50 percent of mutual funds themselves go out
of business every decade. How the heck do you invest for
the long term if your fund doesn’t live for the long term?
Some people say new managers do better, some people
say they do worse. All my instincts would say new managers
do the same as old if you just spread it across an
industry. But who knows, really?
When we trade shares, we’re trading with each other.
And who wins when we trade with each other? Not the
investors as a group. The croupiers of Wall Street win.
There’s no way around that, is there? Not that I know.
Wiandt: What’s your view on the current state of the global
markets? How should investors be looking at the market?
Bogle: My rule is: Don’t peek. There’s so much noise in the
markets, so much volatility, and if you get captivated by
that, you’re thinking like a speculator and not an investor.
What you want to do is be prepared. You’re going to put
away $500 a month for the rest of your life, or whatever
it might be—maybe it increases with your earnings. And
every five years expect a 20 percent drop in the market—
sometimes even more. Just know it’s coming. What happens
is, we put money in before the crash—and the mutual
fund record is crystal clear here—and take it out at the
bottom. We created hundreds of technology funds. When?
When the technology boom was at its peak.
We have to get marketing out and put management
in. I call it the wisdom of long-term investing versus the
folly of short-term speculation. That’s in the math—that
is not my opinion.
Assume that every company on the S&P 500 has half
of its shares held by long-term investors who don’t trade,
and half of its shares held by short-term speculators
who do. We know that those long-term investors as a
group will capture the exact return of the S&P 500. And
we know those speculative traders will capture the exact
same return because they own the same stocks. But by
trading among one another, they will underperform the
market by the amount of their trading costs.
So speculation is, by absolute mathematical tautology,
a loser’s game—losing to the market. And investment is,
by absolute mathematical tautology, a winner’s game—
capturing the market return, almost 100 percent of it.
Wiandt: What single accomplishment are you proudest of?
Bogle: It’s a little early to think about that, but the obvious
thing is that everybody else claims to have created
the index fund, but we actually did it. And we created
a mutual company that is yet to be emulated. We gave
substance to the no-load market. All these steps—
Vanguard, the index funds, the no-load decision, the
multi-tiered bond funds—I’ll put in one lump and say
we created a better world for investors.
March / April 2012 23

The Bogle Impact:
A Roundtable
Colleagues and friends offer their thoughts
24
March / April 2012

In his long career, John Bogle has influenced countless
financial professionals and investors. The Journal of
Indexes reached out to some of his best-known colleagues,
rivals and friends to ask them about how his advocacy has
affected them and its lasting impact on how Americans invest.
Gus Sauter, CIO, Vanguard Group
JoI: What impact has John Bogle had on you
as an investor and financial professional?
Sauter: I entered the industry with a more
theoretical approach to investing, and Jack
helped me understand the practical side. Indexing works,
not because markets are efficient, but because it doesn’t
have the high cost burden of active management.
JoI: What is your current long-term market outlook? Do
you think traditional buy-and-hold index-based investing
has a place in that market scenario?
Sauter: There’s always a possibility for just about anything
to happen, but the stock market has reasonable valuations,
and so historical rates of return are quite possible over the
long term. Bond yields are extremely low, so the longer-term
prospect for bonds is likely to be less than historical returns.
JoI: What do you think John Bogle has gotten wrong?
Sauter: Jack and I agree on many things, but we also disagree
about certain topics, including the use of ETFs. I believe
they can be used as a very effective way for many advisors
and direct investors to gain low-cost, indexed exposure to
the market. Let’s just say Jack disagrees with that view.
JoI: What do you think John Bogle’s lasting impact will be
on investing and investors?
Sauter: Not only did Jack create a company solely dedicated
to the interests of investors, but he also created indexing
in the mutual fund industry. Many, many investors are
much better off today because of Jack’s contributions.
William Bernstein, Principal,
Efficient Frontier Advisors LLC
JoI: What impact has John Bogle had on you
as an investor and financial professional?
Bernstein: Two big things. First, he has
taught me the importance of institutional structure and culture.
He did that not so much through his words, which are
powerful enough, but through his deeds. His biggest deed
was of course his donation—there’s no other word for it—of
Vanguard itself to its fund investors. It’s almost as if Ford or
Procter & Gamble issued shares to the people who bought
their cars and soap, or if Bill Gates had given away a piece
of Microsoft to each purchaser of Windows. Vanguard’s
culture is thus entirely different from that of any major
corporation, and especially from any financial corporation.
The typical bank, brokerage or mutual fund company would
have you believe that the best interests of its customers and
owners are the same. If we have learned anything during the
recent financial crisis, it is that this is a fiction.
Second, he’s shown me that you never stop moving,
never stop striving. Most people in his position would have
long since gone to the beach, done the odd charity gig. He’s
still learning, still trying to improve the world, still making
a difference, still reaching out and helping people with an
almost superhuman vigor.
JoI: What is your current long-term market outlook? Do
you think traditional buy-and-hold index-based investing
has a place in that market scenario?
Bernstein: I only know what Jack taught me, which
is what I call “the Bogle modification of the Gordon
Equation,” that long-term return is simply the sum of
what Jack calls the “fundamental return”: the sum of
dividend payout and dividend growth, and what he calls
the “speculative return,” which is the change in the dividend
or earnings multiple. What that tells me is that the
expected return of stocks is perhaps 7-8 percent, which
assumes that stocks are fairly valued at the moment.
Whenever the market does poorly, people trumpet “the
death of buy-and-hold.” What they forget is that it’s not
“buy-and-hold,” but rather “buy, hold and rebalance.”
That last operation mandated that investors purchase
some equities after the declines of 1987, 1990, 2000-2002
and 2007-2009—and sell some equities when the sun
shone in between. Add to that benefit the long-run surefire
above-average performance and lower risk of deploying
stock assets in broad market indexes. Why would you ever
want to screw that up by chasing last year’s best active
manager or listening to this year’s lucky talking-head?
JoI: What do you think John Bogle has gotten wrong?
Bernstein: I can’t answer that for certain, since I only
know what we disagree about, and I could be the one who
is wrong. And given Jack’s track record, the latter could
easily be the case. Where we’re a few degrees apart on is
the existence of the value and small premiums, and on
the variability of the equity premium itself with valuation.
Actually, on that last point, he understood earlier than
most that valuation matters. He just differs on what to do
about it—I say adjust your equity allocation up or down a
small amount opposite big changes in valuation; he says
do nothing. I also think that U.S. investors should expose
themselves to more foreign assets than he recommends.
JoI: What do you think John Bogle’s lasting impact will be
on investing and investors?
Bernstein: I had dinner the other night with a friend who, like
many well-to-do individuals, has a stockbroker. In addition,
he has a low-cost 401(k) plan that is heavily index oriented.
When the broker heard that my friend had retired, he asked
him to move his 401(k) plan to his brokerage firm. My friend
wondered aloud to me, “Why would I want to do that? My
employee plan’s expenses are one-quarter of my broker’s.”
I’m not sure whether he’d heard of Jack, and I’m pretty
sure he’s never read him, but he sure as heck was channel-
www.journalofindexes.com March / April 2012 25

ing him. That will be Jack’s legacy: For the first time, large
numbers of ordinary investors are thinking about investment
expenses; that’s a very big thing.
Burton Malkiel, Chemical Bank
Chairman’s Professor of Economics,
Emeritus and Senior Economist,
Princeton University
JoI: What impact has John Bogle had on you
as an investor and financial professional?
Malkiel: As a believer in indexing before such funds were available,
I am delighted now to be able to recommend specific
vehicles to the investing public. Jack has made that possible.
JoI: What is your current long-term market outlook? Do
you think traditional buy-and-hold index-based investing
has a place in that market scenario?
Malkiel: We are likely to be in an age of financial repression,
such as the period following World War II. Interest rates are
now artificially low, and high-quality bond portfolios are
unlikely to produce positive real returns. But even though
investment returns may be low for all asset classes, I believe
a substantial equity risk premium does exist. Broadly diversified
equity portfolios (including stocks from the rapidly growing
emerging markets) will, I believe, serve investors well over
the long term. I do not believe in market timing. No one can
do it consistently, and when we try, individuals as well as professionals
are more likely to get it wrong rather than right, as
our emotions tend to get the best of us. Buy-and-hold indexbased
investing is still the best course. But techniques such as
dollar-cost averaging and rebalancing can reduce risk.
JoI: What do you think John Bogle has gotten wrong?
Malkiel: Jack has been too negative on the ETF revolution. To
be sure, his criticism that they are too often used for speculation
rather than investment is absolutely correct. But because
they can be even-lower-cost vehicles than mutual funds (and
because they can have potential tax advantages), they can be
very valuable instruments for longer-term investors. Buying
an ETF at 11 a.m. and selling it at 2 p.m. is speculation rather
than investing. But some people will want to do this, however
foolish that may be, and trading in and out of mutual funds
can create costs for long-term investors in the fund.
JoI: What do you think John Bogle’s lasting impact will be
on investing and investors?
Malkiel: Jack Bogle has made two major contributions
with a lasting impact, in particular. First, Bogle created a
unique mutual-fund company in Vanguard—owned by
its fund investors and providing the lowest-cost investment
vehicles publicly available. Vanguard is truly a
From the Foreword to “Common Sense on Mutual Funds: Fully Updated 10th Anniversary Edition” (2010)
Jack Bogle deserves the profound gratitude of the
American public. First, he devotes enormous amounts of
time and energy to showing investors how to navigate the
treacherous marketplace for financial services. Second, he
created Vanguard, a rare financial institution that places
the interests of the investor front and center. Without Jack
Bogle’s efforts, Americans would face a financial landscape
nearly barren of attractive alternatives.
Bogle offers disarmingly simple advice: employ lowcost
index funds in a low-turnover, disciplined portfolio
strategy. Unfortunately, few follow his sensible advice. The
vast majority of investors play an active management game
in which they lose two ways. First, they lose by choosing
actively managed mutual funds that almost always fail
to deliver on the promise of market-beating results. The
shortfall comes from wildly excessive, ultimately counterproductive
trading (with attendant market impact and
commissions) and from unreasonable management fees
(that far exceed the managers’ value added, if any). And, as
Bogle points out, nearly all mutual fund managers behave
as if taxes do not matter, thereby imposing an unnecessary
and expensive tax burden (that often blindsides the investing
public when they deal with the IRS on April 15).
Second, investors lose by trading mutual funds with
eyes fixed unwaveringly on the rearview mirror. By dumping
yesterday’s faded idol and chasing today’s hot prospect,
mutual fund investors systematically sell low and buy high
(which is a poor approach to making money). Moreover,
the frenzied switching of funds often triggers a further tax
burden. If investors followed Bogle’s advice to use index
funds, by dint of low costs they would beat the vast majority
of fund managers. If investors followed Bogle’s advice
to take a steady approach to allocating assets, by avoiding
perverse timing moves they would benefit from realizing
nearly all that the markets have to offer.
Of course, as a financial professional I have my own
views and offer two small amendments to Bogle’s recipe
for investment success. I would place a greater emphasis
on the value of international diversification, particularly
with respect to exposure to emerging markets. Second,
I would limit holdings of bonds to full-faith-and-credit
issues of the United States government. The experience
of investors in the recent financial crisis (as well as the
experience of investors in the market dislocations in 1998
and 1987) illustrates in high relief why exposure to credit
risk (and optionality) undermines the very reason for
holding bonds in the first place. That said, Jack Bogle gets
the essential elements right. Follow his advice.
David F. Swensen
Chief Investment Officer, Yale University
Published in 2010 by John Wiley & Sons
26
March / April 2012

“mutual” investment services company.
Second, Bogle created the first publicly available U.S.
equity index fund, followed by a family of index funds covering
a variety of investment markets. By doing so he made
an indexing revolution possible.
Don Phillips, President of Fund
Research, Morningstar Inc.
JoI: What impact has John Bogle had on you
as an investor and financial professional?
Phillips: Jack is an inspiration. His willingness
to fight tirelessly for his cause and his alignment of his
interests so closely with investors’ is a model of entrepreneurial
spirit and ethical behavior. There is no one in the
industry whom I admire more.
JoI: What is your current long-term market outlook? Do
you think traditional buy-and-hold index-based investing
has a place in that market scenario?
Phillips: I think there’s a reasonable case to be made for modest
returns from equities and a poor case for bonds over the
next decade. I think that buy-and-hold index-based investing
makes great sense in this, or any, time. Remember, however,
that rebalancing is an important part of a buy-and-hold strategy.
Given the extreme success of bonds and the poor returns
of equities over the past decade, many investors may need to
rebalance their portfolios to get back on track.
JoI: What do you think John Bogle has gotten wrong?
Phillips: Not much. He may overstate his case at times—
don’t we all?—but directionally, he has an amazing track
record. Time is on the side of his argument.
JoI: What do you think John Bogle’s lasting impact will be
on investing and investors?
Phillips: Fifty years from now, when all of the current fund
leaders and CEOs have been forgotten, Jack Bogle will still
be remembered. He’s raised the bar for the industry, and
investors are the better for it. Fees nearly everywhere are
lower because of him. Investors are, and will continue to
be, more demanding because Jack showed them the way.
Rob Arnott, Founder and Chairman
Research Affiliates LLC
JoI: What impact has John Bogle had on you
as an investor and financial professional?
Arnott: We all need mentors or heroes to
help inspire us if we want to accomplish important things.
Jack ranks as one of my heroes, alongside Peter Bernstein,
Marty Leibowitz, Bob Lovell and Harry Markowitz. His
decision to launch Vanguard Group in his late 40s was
a contributing factor in my decision to launch Research
Affiliates in my late 40s. His missionary zeal for capweighted
indexation helped inspire my missionary zeal
for the Fundamental Index. His single-minded focus on
helping the end-customer to win—in his case, by cutting
implementation slippage and costs to the bone—reminds
us all that we can do well by doing good. In my case, the
quest for low-cost alpha trumps the quest for rock-bottom
pricing, but it’s fair to say that neither of us is a big fan of
high-fee random-alpha products.
JoI: What is your current long-term market outlook? Do
you think traditional buy-and-hold index-based investing
has a place in that market scenario?
Arnott: True buy-and-hold investing is a myth, as is true
passive indexing. Is there a single investor on the planet
who has never made a trade, has never rebalanced their
portfolio, or reconstituted their index investments to reflect
corporate actions? Of course not. But the basic idea of
buy-and-hold index-based investing has a very important
place in the investing pantheon: In the absence of a strong
conviction to the contrary, it should be our default choice.
I think it’s fair to say that I have a darker view of the
future than Jack, or indeed most of the investing community.
I think that a low-yield environment means lower
prospective future returns. I think that an aging population
means slower GDP growth. I think that an addiction
to debt-financed consumption, throughout the developed
world, crowds out the private sector capital markets, and
eventually crushes healthy entrepreneurial capitalism.
I think that stocks are like any other investment: Buy
them when they’re cheap and we don’t have to wait for
the “long run” to enjoy ample profits; buy them when
they’re expensive and we may have a very, very “long
run” to wait, before we can be happy.
In short, I believe that broad diversification into a wide
array of alternative markets, often at higher yields, trumps the
classic 60/40 buy-and-hold mantra. And while I love indexing,
I don’t love the fact that conventional cap-weight indexing
puts most of our eggs in the most expensive baskets, which
is not the ideal way to earn good long-term returns.
JoI: What do you think John Bogle has gotten wrong?
Arnott: Like a lot of visionary leaders, Jack is a bit rigid
about other points of view. His visceral distaste for ETFs—
“giving kerosene to arsonists,” as he describes them—
ignores the fact that investors can make grievous errors in
their daily liquidity with mutual funds, almost as easily as
with ETFs. Witness Russel Kinnel’s study “Mind the Gap,”
in which he showed that the time-weighted returns for
mutual funds exceed their dollar-weighted returns by over
2½ percentage points a year. Jack’s vocal criticism of the
Fundamental Index ignores the fact that we’re both “on the
side of the angels” in terms of vastly lower fees, vastly lower
turnover, vastly broader diversification and vast capacity,
when compared with most active managers and funds.
One of the things I like about Jack is that we can remain
friends when we disagree; it clearly helps that we’re in
agreement on 80 percent of the things we think matter.
He’s a bit like the wise and curmudgeonly uncle, usually
right and always insightful; we may find we occasionally
differ, to the consternation of the uncle, but we would be
fools to dismiss his insights without careful reflection.
www.journalofindexes.com March / April 2012 27

JoI: What do you think John Bogle’s lasting impact will
be on investing and investors?
Arnott: Jack has shaped the indexing world more than
anyone else. He has put the well-being of the end-customer
squarely at the top of the food chain—no investment professional
should prosper unless their customers are doing
well. More broadly, he has correctly challenged the notion
that active management is anything more than a zero-sum
game—indeed, a negative-sum game net of costs. If we
depart from cap-weighted indexation, we do well to recognize
that we can “beat the market” only if someone on the
other side of our trades is a willing loser. We do well to ask
who is losing, and why they are willing to lose. Without a satisfying
answer to that question, we shouldn’t stray from the
buy-and-hold index-based investing that Jack pioneered.
Steve Galbraith, Partner,
Maverick Capital
JoI: What impact has John Bogle had on you
as an investor and financial professional?
Galbraith: We have a Harold and Maude
relationship—he is probably my best friend in the business
despite the fact he is my father’s peer and I (like his son!)
practice active management.
JoI: What is your current long-term market outlook? Do
you think traditional buy-and-hold index-based investing
has a place in that market scenario?
Galbraith: I actually do not necessarily totally equate index
investing with buy-and-hold; to me, it is more about the fee
structure (witness the crazy trading in index ETFs). As to
markets, the relative expected returns to stocks has not been
better in the past 30 years. This may be damning with faint
praise, given alternatives are near nil, but after 13-plus years
of zero returns for stocks, it is getting interesting again.
JoI: What do you think John Bogle has gotten wrong?
Galbraith: Well, Yale and Tufts are clearly superior to
Princeton, but not a lot beyond that.
JoI: What do you think John Bogle’s lasting impact will be
on investing and investors?
Galbraith: He has democratized investing. There is no
question he is the most important investment figure of
the past century.
Ted Aronson, Managing Principal,
Aronson Johnson Ortiz
JoI: What impact has John Bogle had on you
as an investor and financial professional?
Aronson: Jack Bogle single-handedly
democratized investing by making capital market returns
achievable to the entire investing public. His impact on the
investing world cannot be overstated.
Jack’s other influence is as a clear and articulate voice of
reason, balance, prudence and sensible investing. He will go
down in history as one of the architects of modern finance.
Successful investing hinges on three things: taking risk
intelligently, diversifying and keeping costs to a minimum.
The Vanguard Group, Jack’s creation, provides the opportunity
to achieve all three. As such, he drowns out the
cacophony that is Wall Street’s self-serving, costly drivel.
JoI: What is your current long-term market outlook? Do
you think traditional buy-and-hold index-based investing
has a place in that market scenario?
Aronson: My current long-term investment outlook calls
for premium returns from emerging markets (after all, the
operative word is emerging), below-historic returns from
developed equities (after all, “developed” is in the past
tense) and disastrously bad returns from long Treasurys.
Buy-and-hold index-based investing holds a dominant
position in all environments!
JoI: What do you think John Bogle has gotten wrong?
Aronson: My only criticism of Jack Bogle’s investment philosophy
is a historic bias against international diversification.
It is dangerous to disagree with Jack, but on this topic,
I would allocate more to the international arena. (This
criticism might seem akin to inside baseball, because our
disagreements are a matter of degree.)
Stephen Davis, Executive Director
Millstein Center for Corporate
Governance & Performance,
Yale School of Management
JoI: What impact has John Bogle had on you
as an investor and financial professional?
Davis: While I have a hat as an investor, I’m really more a sort
of governance expert, as it were, in the field. But I also have a
hat on as a nonexecutive director at Hermes in London.
I think what Bogle has done is … give the world an
insider view as to how the mutual fund industry really
operates. In many ways, it has operated—as Bogle himself
would argue—to the benefit of many investors, but
not without risks and without negative factors. Very few
people outside the industry would have been so perceptive,
insightful and knowledgeable in giving a clear,
unvarnished picture of what this industry amounts to.
JoI: What is your current long-term market outlook? Do
you think traditional buy-and-hold index-based investing
has a place in that market scenario?
Davis: [Market outlooks are] not my thing. I run a corporate
governance center at Yale—I’m not running money. [But…] I
think that the way the industry has evolved is increasingly diverging
from the norms that we expect within market institutions in
terms of governance and transparency. We have a system where
most people know very little about their mutual funds other than
some performance figures that may or may not be accurate. But
they have very little say, for example, in who the boards are, in
who the directors—who represent their interests as opposed to
the shareholders in the mutual fund companies themselves—
28
March / April 2012

are. They don’t really know that. There are occasional votes for
those boards, but there’s very little attention paid to who’s on
those boards and what they are meant to do. How do they really
represent grass-roots investors? I think that’s a problem.
From the point of view of systemic risk, we have a big problem
in that mutual funds have only reluctantly acted as owners.
They tend to turn stocks, for one thing, much too quickly.
And as a result, they don’t own shares for all that much time.
But when they do, they tend as owners to almost reflexively
support management in many cases. It’s less true today than
it was before votes were made public. ... But they need to do
a lot more. They need to demonstrate a lot more that they are
responsible owners; that their ownership responsibilities are
really and truly in line with the interests of their grass-roots
investors; and that those votes are integrated fully in the investment
process rather than simply a rote compliance exercise.
The people that invest in mutual funds are not quite as
long term as [a Warren Buffett]. But they are for the most
part long term. The problem is the agents of the mutual
funds act as if they’re very short term. There’s a misalignment
between the time horizons of the ultimate beneficiaries
or ultimate investors and their mutual fund agents.
JoI: What do you think John Bogle has gotten wrong?
Davis: That’s a tough one, because I think I almost always
agree with him. This isn’t what he’s gotten wrong, but I
think his argument that there should be a fiduciary duty
standard set out in a clear way has taken a long time to take
hold. And I don’t entirely know why that is, but I think it
would benefit investors if it were perhaps fleshed out more,
and if there were a way in which to really galvanize the
grass-roots shareholders of the United States. He’s done
more than almost anybody to mobilize grass-roots investors,
and so I’m very loath to criticize in this regard. But
somehow we still have a situation where there are tens of
millions of Americans who invest through the stock market,
many of them through mutual funds—and they’re still
continued on page 31
The Foreword to “Bogle on Mutual Funds: New Perspectives for the Intelligent Investor” (1993)
The same surgeon general who required cigarette
packages to say: “Warning, this product may be dangerous
to your health” ought to require that 99 out of
100 books written on personal finance carry that same
label. 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.
I do not speak for myself. What is one person’s opinion
worth? It is the statistical evidences of economic history
that I speak for. Over half a century, professors of finance
have studied various strategies for prudent investing. A
jury of economists is never unanimous—how could it
be in such an inexact science?—but on these lessons of
experience there is a remarkable degree of agreement.
1. Diversification does reduce, but not eliminate, risk.
Buying many stocks, critics say, is “settling for mediocrity.”
When I was a trustee on the finance committee of
the largest private pension equity fund in the world—
which handled the old-age savings of the whole university
community—we had 30 billion reasons to look into
this critique alleging mediocrity. We discovered that
the hundreds of money managers who believe in putting
only a few eggs in one basket and then “watching
fiercely those eggs,” alas, produce long-term investment
returns that are significantly below those of diversified
portfolios. No exceptions? Yes, a few; but a changing
group, hard to identify in advance, and prone to regress
toward the mean even before you can spot them.
2. For those not in the millionaire class, the need
to diversify implies that the sensible and cost-efficient
strategy is not to handle personally investments needed
for those future days of retirement, of home purchases,
and of sending offspring to college. “Leave the driving to
Greyhound” is not counsel of cowardice and modesty.
It’s just plain good sense when you reckon the facts
about brokerage commissions and the need to keep tax
records. All this applies even if you will not go all the way
toward “index investing,” my next topic.
3. The most efficient way to diversify a stock portfolio
is with a low-fee index fund. Statistically, a broadly
based stock index fund will outperform most actively
managed equity portfolios. A thousand money managers
all look about equally good or bad. Each expects
to do 3% or better than the mob. Each puts together a
convincing story after the fact. Hardly ten of one thousand
perform in a way that convinces a jury of experts
that a long-term edge over indexing is likely. (For bond
and money market portfolios, the canny investor will
select among funds with high quality and lean costs.)
4. Enough said about the testimony of economic
science. Where John Bogle has added a new note is
in connection with his emphasis upon low-cost, noload
investing. I have no association with The Vanguard
Group of funds other than as a charter member investor,
along with numerous children and innumerable grandchildren.
So, 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.
May I add a personal finding? Investing sensibly,
besides being remunerative, can still be fun.
Paul A. Samuelson
Institute Professor Emeritus
Cambridge, Massachusetts
Published in 1993 by the McGraw Hill Companies
www.journalofindexes.com March / April 2012 29

Bogle’s Corner
Ideas Vs.
Implementation
A sneak peek at Bogle’s next book
By John Bogle
The following will appear in John Bogle’s forthcoming book
“The Clash of the Cultures: Investment vs. Speculation,”
which John Wiley & Sons will publish in July of this year.
Ideas are a dime a dozen; implementation is everything.
I’ve expressed that mantra all through my career, and
it surely applied to the creation of the world’s first
index mutual fund.
It was way back in 1951 that I first developed at least a
vague idea of the index fund. After examining the statistics
on equity fund returns relative to various market indexes,
I concluded in my Princeton University senior thesis that
mutual funds “should make no claim to superiority over
the market averages.” Others have interpreted that thought
as a precursor of my later interest in matching the market
with an index fund. Honestly, I don’t know whether it was
or not. Nonetheless, if I had to name the moment when the
seed was planted that germinated into my proposal to the
Vanguard Board in 1975 that we form the first index mutual
fund (based on the S&P 500 Index), that would be it.
By the late 1960s, lots of analysts and academics had
begun to seriously pursue the indexing idea. In 1969-1971,
Wells Fargo Bank, working from complex mathematical
models, developed the principles and techniques leading
to its version of index investing. John A. McQuown, William
L. Fouse, and James Vertin pioneered the bank’s effort. As
McQuown said, “Before we had computers, data, and good
models, we didn’t know which procedures were right and
which were wrong. We missed a lot, but we did come out
with some clear ideas.” Their work led to the construction
of a $6 million index account for the pension fund of
Samsonite Corporation in 1971.
The idea was solid, but the implementation was (by one
description) “a nightmare.” For the strategy was based on an
equal-weighted index of New York Stock Exchange equities,
creating “cumbersome record-keeping and bean-counting,
and requiring day-to-day management.” That strategy
failed, and was finally abandoned in 1976, replaced with a
market-cap-weighted strategy—now using the market-capweighted
S&P 500 Index, selected a year earlier as the standard
for Vanguard’s new offering—for accounts run by Wells
Fargo for its own pension fund and for Illinois Bell.
In 1971, Batterymarch Financial Management of Boston
independently decided to offer the idea of index investing
to its advisory clients. The developers were Jeremy
Grantham and Dean LeBaron, two of the founders of the
firm. Grantham described the idea at a Harvard Business
School seminar in 1971, but found no takers until 1973. For
its efforts, Batterymarch won the “Dubious Achievement
Award” from Pensions & Investments magazine in 1972.
It was two years later, in December 1974, before the firm
finally attracted its first client.
By the time the American National Bank in Chicago
created a common trust fund—also modeled on the S&P
500 Index—in 1974 (requiring a minimum investment of
$100,000), the idea had begun to spread from academia—
and these three firms that were the first professional advocates—to
a public forum.
Two other contributors to the development of the
index fund concept should also be noted. In 2002, former
American Express executive George Miller sent me a note
enclosing a copy of a preliminary “red-herring” prospectus
filed with the SEC on February 22, 1974, by American
Express for “The Index Fund of America.” The fund was
“loosely modeled” on the S&P 500, and carried a minimum
investment requirement of $1,000,000. But before the year
30
March / April 2012

was out, American Express senior management lost heart
for the challenge. The offering was withdrawn and the
project was abandoned.
In September 2011, The Wall Street Journal published a
letter to the editor written by Mr. Miller briefly describing
this history, at which point, yet another voice of creation
chimed in. An executive of TIAA-CREF reported that
way back in 1971, the firm received a letter from Nobel
Laureate economist Milton Friedman (who served on
the CREF Board) in which he proposed that the CREF
variable annuity should eliminate all investment analysis
and “adopt a mechanical formula whereby CREF simply
bought into a Standard & Poor’s 500 Index.” This idea also
fell by the wayside, never to reach fruition.
This multi-layered history of the development of the indexing
concept confirms my thesis that it is not the idea itself, but
its actual implementation, that ultimately wins the day. In all
of these forays into indexing: idea A+; implementation F.
Roundtable continued from page 29
not a political force. As a result, they lose when the issues
come up in Congress, for instance, or before regulators.
This isn’t a criticism of what he’s done; it’s really a question
and a challenge for those who agree with him to turn
those views into political power.
JoI: What do you think John Bogle’s lasting impact will be
on investing and investors?
Davis: There’s almost no one who can give a clear, independent
view of the mutual fund industry as well as Jack
Bogle. I think he’s opened a lot of eyes to the drawbacks
within this field, and I think that has a lasting impact. If he
hadn’t been out there throwing light on various practices,
then I think lots of people would still have their eyes closed
and they’d be losing more money than they are.
Ed Haldeman, CEO, Freddie Mac
JoI: What impact has John Bogle had on you
as an investor and financial professional?
Haldeman: Jack has impacted me in
many ways. As an investor, he has obviously
made me more aware of the significance of fees
and trading expenses on long-term performance. In
addition, he has provided a simple and useful framework
to allow me to think about the long-term expected return
from equities (yield plus expected earnings growth plus
change in P/E ratio). But more importantly, Jack has
impacted me by challenging me on the inherent conflict
between serving as a fiduciary and being an owner of
an asset management enterprise. Finally, through his
book “Enough,” he has impacted me by causing me to
re-evaluate my personal value system.
JoI: What is your current long-term market outlook? Do
you think traditional buy-and-hold index-based investing
has a place in that market scenario?
Haldeman: My long-term market outlook is for U.S. equities
to return 7 percent per year; non-U.S. equities to return 8-9
percent per year; and diversified bond portfolios to return 4
percent. I definitely think traditional buy-and-hold should
play a major role in any portfolio. Some might argue that the
extreme volatility and low returns of the past five years means
that a buy-and-hold strategy doesn’t work any longer. I don’t
agree with that view. There is a difference between getting the
opportunity to time markets and being successful in timing
markets. We know that the extreme volatility of the markets
provided a huge opportunity to time the market, but this does
not mean that investors in aggregate who practiced market
timing outperformed the buy-and-hold strategy.
JoI: What do you think John Bogle has gotten wrong?
Haldeman: I am not so bold as to say Jack Bogle has gotten
something wrong. I will offer three areas where I have
had conversations with Jack in which I challenged his
views. First, I have questioned him on his long-held view
that non-U.S. equities should be only a small weighting in
the portfolio of a U.S. investor. To me, holding less than
a market-cap weighting in non-U.S. securities is logically
inconsistent. It is akin to holding less than a market-cap
weighting of financial stocks in an S&P 500 Index fund.
Second, I don’t think it is morally wrong to seek to outperform
the market. The possibility of outperformance
may be a low-probability event, but if an investor wants to
hire a fund manager in the hope that he might be one of the
few outperformers, I don’t think either the investor or the
fund manager has an ethical or moral problem. Sometimes
Jack’s language suggests he sees a moral problem.
Third, I have questioned Jack on why he focuses exclusively
on fees, when I believe investors in funds are hurt much more
by the gap between a fund’s return and the average investor’s
return in the fund. The differential in fees costs the typical
investor about 75 basis points per year. However, some of the
things funds do to encourage investors to mis-time their flows
in and out of funds costs investors 300-500 basis points per year.
JoI: What do you think John Bogle’s lasting impact will be
on investing and investors?
Haldeman: Jack Bogle will have many lasting impacts that
are incredibly significant. Certainly, Vanguard and the
benefits it brings to investors because of its focus on low
costs and passive management will have a lasting impact.
But his impact goes much beyond Vanguard. What would
be the market share of passively managed money without
Jack Bogle? What would be the average fee level of
actively managed money without Jack Bogle? Think how
much more net worth savers have because of the popularity
of index funds and the pressure on actively managed
fees because of index funds. The legacy of Jack Bogle will
endure and benefit millions of investors.
continued on page 49
www.journalofindexes.com March / April 2012 31

Lessons Learned From SPIVA
10 observations drawn from a decade of data
By Srikant Dash
32
March / April 2012

There is nothing novel about the index versus active
debate. It has been around for decades, and there
are a few strong believers on both sides, with the vast
majority of investors falling somewhere in between. 2012 is
the 10th anniversary of the widely followed SPIVA (S&P Index
Versus Active) Scorecard, and over the past decade of serving
as the de facto scorekeeper of the active versus passive
debate, I have heard passionate arguments from believers in
both camps when the headline numbers do not turn out to
conform with their beliefs. But beyond the headline numbers
of SPIVA is a rich data set addressing issues of measurement
techniques, universe composition and fund survivorship that
are far less discussed, but which I have always found more
fascinating. In the spirit of celebrating 10 years of SPIVA, this
article is a reminiscence of 10 things I have learned.
1. Indexing Almost Always Works Over
A Five-Year Horizon
Short-term results, such as those over 12 months or
even three years, often swing between favoring indexes
or active funds. There is no consistent way to divine in
advance whether the subsequent year would favor passive
or active. But there is remarkable consistency over
five-year periods. Every SPIVA report shows that during
a five-year market cycle, a majority of active funds in
most categories fail to outperform indexes. Therefore,
if an investing horizon is five years or longer, a passive
approach may be preferable. (See Figure 1.)
Figure 1
% Of Active Funds Outperformed By Indexes Over A 5-Year Period
Category
Comparison Index
6/06-
6/11
6/01-
6/06
Large-Cap Growth Funds S&P 500 Growth 80.40 54.30
Large-Cap Core Funds S&P 500 62.50 69.75
Large-Cap Value Funds S&P 500 Value 35.32 87.15
Mid-Cap Growth Funds S&P MidCap 400 Growth 88.02 95.20
Mid-Cap Core Funds S&P MidCap 400 84.00 82.09
Mid-Cap Value Funds S&P MidCap 400 Value 66.67 78.89
Small-Cap Growth Funds S&P SmallCap 600 Growth 74.59 93.63
Small-Cap Core Funds S&P SmallCap 600 59.38 81.36
Small-Cap Value Funds S&P SmallCap 600 Value 47.67 59.87
Source: U.S. SPIVA Scorecards dated July 19, 2006 and August 24, 2011.
Note: A historical archive of SPIVA reports and Persistence Scorecards can be found at
www.spiva.standardandpoors.com.
2. Bear Markets Do Not Necessarily Favor
Active Investing
Bears markets should favor active managers. Instead
of being 100 percent invested in a market that is turning
south, active managers have the opportunity to move to
cash, or seek more defensive positions. Unfortunately, that
opportunity does not translate to reality. In the two bear
markets we have seen over the last decade, most active
managers failed to beat benchmarks. (See Figure 2.)
Figure 2
% Of Active Funds Outperformed By
Benchmarks In Bear Markets
2008
Source: U.S. SPIVA Scorecards dated April 20, 2009
2000 to 2002
All Large-Cap Funds 54.3 53.5
All Mid-Cap Funds 74.7 77.3
All Small-Cap Funds 83.8 71.6
Large Growth 90.0 49.4
Large Core 52.0 53.4
Large Value 22.2 36.5
Mid Growth 89.0 82.4
Mid Core 62.3 70.2
Mid Value 67.1 82.8
Small Growth 95.5 87.5
Small Core 82.5 70.8
Small Value 72.6 58.3
3. Consistency In Performance Exists . . .
But In The Wrong Quartile
The SPIVA Scorecard presents results on average for the
fund industry, and in the years following its launch, some
investment gatekeepers told us that it is not necessarily relevant
since they do not put their clients’ money in an “average”
fund. When a decision has been made to invest actively,
these gatekeepers go through a screening process that typically
screens the universe for top-quartile or top-half funds,
and then narrows down to the final choice by researching
factors like investment philosophy, fees, downside risk,
Sharpe ratio, etc. This was a valid argument, and we created
the S&P Persistence Scorecard as a companion to SPIVA in
2005 to evaluate the consistency of performance of active
managers. Since then, every single report we have published
shows that the chances of finding a top-quartile fund for the
future by using historical top-quartile performance is similar
or less than random expectations. There is consistency in
performance—but in the wrong quartile. Funds that have
delivered bottom-quartile performance in the previous three
or five years have a consistently high chance of being merged
or liquidated. Clearly, asset management companies go
through a regular spring cleaning process to make their slate
of funds look good. The Persistence Scorecard points investors
in an interesting direction: Instead of screening for topquartile
funds, you may be better off screening out bottomquartile
funds. (See Figures 3a and 3b.)
4. Municipal Bond Funds Have A Particularly
Tough Time Beating Benchmarks
SPIVA scorecards track more than two dozen asset
classes across stocks and bonds. The category that almost
always sees the most one-sided results is municipal bonds.
Almost all municipal bond funds have trouble beating the
S&P National AMT-Free Municipal Bond Index. To be
fair, municipal bond benchmarks are not fully replicable.
www.journalofindexes.com March / April 2012 33

Figure 3a
% Of Funds With Top-Quartile Performance For 5 Years
Figure 5a
% Of Active Small-Cap Funds Beating S&P SmallCap 600
30%
40%
39%
25%
25.00%
35%
20%
15%
10%
12.23%
20.22%
30%
25%
20%
15%
21%
5%
3.08%
10%
5%
0%
Large Cap
Mid Cap Small Cap Random Probability
0%
6/01 to 6/06
6/06 to 6/11
Source: S&P Persistence Scorecard, November 2011
Source: U.S. SPIVA Scorecards dated July 19, 2006 and August 24, 2011
Figure 3b
Figure 5b
50%
45%
% Of Funds Closing Or Merging
After 5 Years Of Bottom-Quartile Performance
49%
46%
4.0%
3.5%
Average Small-Cap Active Gap
4.0%
40%
35%
30%
25%
38%
3.0%
2.5%
2.0%
20%
1.5%
15%
10%
5%
0%
Large Cap
Mid Cap
Small Cap
1.0%
0.5%
0.0%
6/01 to 6/06
0.4%
6/06 to 6/11
Source: S&P Persistence Scorecard, November 2011
There are no index funds in this category, and the indexbased
ETFs available are rather heavily optimized, with
occasionally high tracking errors. But still, the breadth of
underperformance of active managers that is seen consistently
in this category is remarkable. (See Figure 4.)
Source: U.S. SPIVA Scorecards dated July 19, 2006 and August 24, 2011
5. Passive Works In Small-Caps
It is not uncommon to hear a statement such as this:
“Large-caps are an efficient market and should be indexed;
small-caps are an inefficient market and should be active.”
This market orthodoxy has stood the test of time—the penetration
of indexing in U.S large-caps is much more than U.S.
small-caps. However, over the last decade, SPIVA has consistently
shown that indexing works as much for small caps
as it does for large caps. The degree of underperformance
may vary with time, but it does exist. However, it should
be noted that as information and analytics have become
more broadly available beyond large-caps over the last few
decades, the frontier of inefficiency may have shifted further
out into micro-caps (but of course, purists will argue that the
“arithmetic of active management” has nothing to do with
market efficiency!). (See Figures 5a and 5b.)
Figure 4
Municipal Bond Fund Performance Over 5 Years
Average Active Gap (%)
Category Trading
3-Month % Of Funds Average Beating
Benchmark
Symbol
Daily Benchmark
Volume
Equal Weighted Asset Weighted
General Municipal Debt Funds S&P National AMT-Free Municipal Bond 9 1.06 1.08
California Municipal Debt Funds S&P California AMT-Free Municipal Bond 0 1.33 1.37
New York Municipal Debt Funds S&P New York AMT-Free Municipal Bond 0 0.92 1.36
Source: U.S. SPIVA Scorecards dated August 24, 2011
34
March / April 2012

Figure 6a
Figure 7a
6%
5%
4%
3%
2%
1%
0%
Mid- And Small-Cap Funds Vs. Russell Benchmarks
5.32%
Active MidCap
Funds
5.30%
4.26%
Russell MidCap Active SmallCap Russell 2000
Funds
Sources: U.S. SPIVA Scorecards dated August 24, 2011; Bloomberg
Figure 6b
Mid- And Small-Cap Funds Vs. S&P Benchmarks
4.08%
20%
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
Fund Death Rate Over 3 Years
Sources: U.S. SPIVA Scorecards dated August 24, 2011; Bloomberg
Figure 7b
16%
18%
17%
10%
Large Cap Mid Cap Small Cap General
Muni. Debt
17% 17%
California
Muni. Debt
New York
Muni. Debt
% Of Large-Cap Funds Beating Benchmarks Over 5 Years
7%
6%
5%
4%
5.32%
6.59%
4.26%
4.61%
90%
80%
70%
60%
50%
51.9%
64.7%
81.3%
3%
2%
1%
40%
30%
20%
10%
19.6%
30.0%
37.5%
0%
Active Mid-Cap
Funds
S&P MidCap 400 Active Small-Cap S&P SmallCap 600
Funds
0%
LC Growth Funds LC Blend Funds
■ All Funds ■ Surviving Funds
LC Value Funds
Sources: U.S. SPIVA Scorecards dated August 24, 2011; Bloomberg
6. Benchmark Choice Matters In The Active-
Passive Debate
Beyond the world of indexing and index-linked products,
benchmark choice is not exactly at the forefront of
most investors’ minds. That’s unfortunate, because no two
benchmarks are alike, and the outcome of an investment
decision process that employs benchmark returns as an
input can be dramatically different depending upon the
benchmark choice. For example, Figures 6a and 6b show
that one can get very different answers with regard to the
question of whether indexing works for midcaps and smallcaps
simply based on whether one is using S&P or Russell
benchmarks. There is no guarantee one benchmark will
perform better than another over any time horizon, but it is
fairly certain that indexes from different providers that measure
the same asset class can exhibit very different returns.
7. Survivorship Bias Is Too Big To Ignore
Mergers and liquidations are a fact of life for the fund
management industry. But the scale of fund deaths is
stunning—over three years, it is not surprising to see
SPIVA scorecards showing 10 to 20 percent of funds disappearing.
Over five years, the rate occasionally jumps
Sources: U.S. SPIVA Scorecards dated August 24, 2011; Bloomberg
Figure 7c
80%
70%
60%
50%
40%
30%
20%
10%
0%
% Of Small-Cap Funds Beating Benchmarks Over 5 Years
25.4%
35.1%
SC Growth Funds
40.6%
48.7%
SC Blend Funds
■ All Funds ■ Surviving Funds
Sources: U.S. SPIVA Scorecards dated August 24, 2011; Bloomberg
52.3%
67.2%
SC Value Funds
to a quarter or more. At the beginning of the investment
horizon, these funds that subsequently die are part of the
investment opportunity set. Not including those in the
opportunity set may paint a far more favorable picture
continued on page 62
www.journalofindexes.com March / April 2012 35

The Case For Indexing
Revisiting the foundations of passive investment
By Christopher Philips
36
March / April 2012

An index is a theoretical “basket” of securities
designed to represent a broad market or a portion
of the market. By reflecting the performance
of a particular market, an index provides investors with
a benchmark for that market’s performance. Because
indexes are, by definition, intended to mirror the market,
they are constructed to be market capitalization
weighted. An indexed investment strategy such as an
index mutual fund or an index-based exchange-traded
fund seeks to track the performance of an index by
assembling a portfolio that invests in the same group of
securities, or a sampling of the securities, that compose
the index. By investing in a product designed to replicate
the performance of a broad market such as the U.S. stock
market, an investor can participate, at low cost, in the
aggregate performance of that market at all times. By the
same token, investing in products designed to replicate
the performance of indexes with a narrower focus, such
as European stocks or long-term bonds, allows an investor
to participate in the purest exposure to a specific
market segment within a low-cost framework. As a result
of these features, indexing has gained in popularity over
time. Estimates of index fund assets, including ETFs,
are as high as $2.008 trillion, or 16.9 percent of the total
assets managed by registered investment companies. 1
Historically over time, an indexing investment strategy
has performed favorably in relation to actively managed
investment strategies, as a result of indexing’s low costs,
broad diversification, minimal cash drag, and, for taxable
investors, the potential for tax efficiency. Combined,
these factors represent a significant hurdle that an active
manager must overcome just to break even with a lowcost
index strategy over time, in any market. Of course,
skilled active managers who have overcome these hurdles
do exist, but as our research and other empirical evidence
suggest, the likelihood of outperformance by a majority
of managers dwindles over time as the compounding of
costs becomes more difficult to surmount.
This paper explores both the theory underlying
index investing and evidence to support its advantages.
We first examine investing as a “zero-sum game”
and relate it to the “index funds versus active funds”
debate. We emphasize the importance of costs in investment
management and their impact on index and active
strategies. We then offer a broader perspective on relative
performance, including subasset classes, market
cyclicality, and benchmark differences. We discuss, as
well, excess returns as an alternate perspective on relative
success. Finally, we address common myths regarding
indexing as an investment strategy.
quantitative risk-control techniques that seek to replicate
the benchmark’s return with minimal expected tracking
error (and, by extension, with no expected alpha, or excess
return versus the benchmark). 2 In fact, the best index is not
necessarily the one that provides the highest return, but
the one that most accurately measures the performance of
the investing style strategy or market it is intended to track.
Before considering the particulars of one investment
strategy versus another, it is instructive to consider the market
as a whole, where outperformance is often referred to as
a “zero-sum game.” The concept of a zero-sum game starts
with the understanding that at any given point in time, the
holdings of all investors in a particular market, such as the
U.S. stock or bond market, aggregate to form that market
(Sharpe, 1991). Because all investors’ holdings are represented,
if one investor’s dollars outperform the aggregate
market over a particular time period, another investor’s
dollars must underperform, such that the dollar-weighted
performance of all investors sums to equal the performance
of the market. 3 Of course, this holds for any market, such as
foreign stock and bond markets, or even specialized markets
such as commodities or real estate. The aggregation of
all investors’ returns can be thought of as a bell curve (see
Figure 1), with the market return as the mean. In Figure 1,
the market is represented by the tan curve, with the market
return as the red vertical dashed line.
Over any given period, the dollar-weighted excess
performance to the right of the market return in Figure
1 equals the inverse of the dollar-weighted excess performance
to the left of the market return, such that the
sum of the two equals the market return. However, in
reality, investors are exposed to costs such as commissions,
management fees, bid/ask spreads, administrative
costs, market impact 4 and, where applicable, taxes—all of
which combine to reduce realized returns over time. The
aggregate result of these costs shifts the curve in Figure
1 to the left. We represent the adjustment for costs with
a dark-blue curve. Although a portion of the after-cost
dollar-weighted performance continues to lie to the right
of the market return, represented by the light-blue region
in Figure 1, a much larger portion is now to the left of
Figure 1
Impact Of Cost On Distribution Of Market Returns
Costs Shift The Investor’s
Actual Return Distribution
Market Return
Understanding The Zero-Sum Game
An investment in conventional or exchange-traded
index funds (hereafter, “index funds”) seeks to track the
returns of that market or market segment by assembling a
portfolio that invests in the same group of securities, or a
sampling of the securities, that compose the market with
weights proportionate to their market value. Indexing uses
Source: Vanguard
After Costs, Less Value Is
Delivered To The Investors
www.journalofindexes.com March / April 2012 37

Figure 2
Annualized Excess Returns Versus U.S. Stock Market: As Of December 31, 2011
After-Cost Distribution Of Actively Managed U.S. Equity Mutual Funds
3000
2500
10-Year: 5,236 Worse (64%)
15-Year: 2,676 Worse (59%)
20-Year: 3,777 Worse (84%)
Dow Jones U.S. Total
Stock Market Index
10-Year: 2,989 Better (36%)
15-Year: 1,845 Better (41%)
20-Year: 744 Better (16%)
2000
1500
1000
500
0
Liquidated/Merged
Less than -11%
Between -11% and -10%
Between -10% and -9%
Between -9% and -8%
Between -8% and -7%
Between -7% and -6%
Between -6% and -5%
Between -5% and -4%
Between -4% and -3%
Between -3% and -2%
Between -2% and -1%
Between -1% and 0%
Between 0% and 1%
Between 1% and 2%
■ 10-Year ■ 15-Year ■ 20-Year
Between 2% and 3%
Between 3% and 4%
Between 4% and 5%
Between 5% and 6%
Between 6% and 7%
Between 7% and 8%
Between 8% and 9%
Between 9% and 10%
Between 10% and 11%
Greater than 11%
Notes: Includes multiple share classes where available. “U.S. equity mutual funds” refers to all funds, including those focused on a particular style or market capitalization such as
large growth or small value. However, we excluded sector funds, specialty funds such as bear market funds, and real estate funds. For this comparison, we evaluated active funds
after cost against a costless market benchmark. When implementing with an index fund or ETF, transaction costs, expense ratios and tracking error must be accounted for.
Sources: Vanguard calculations, using data from Dow Jones and Morningstar, Inc.
Figure 3
After-Cost Distribution Of Actively Managed U.S. Fixed-Income Mutual Funds
Annualized Excess Returns Versus U.S. Stock Market: As Of December 31, 2011
800
700
10-Year: 2,266 Worse (69%)
15-Year: 2,223 Worse (88%)
20-Year: 1,208 Worse (85%)
Barclays Capital
U.S. Aggregate Bond Index
10-Year: 727 Better (34%)
15-Year: 253 Better (24%)
20-Year: 116 Better (34%)
600
500
400
300
200
100
0
Liquidated/
Merged
Less than -4% Between -4%
and -3%
Between -3%
and -2%
Between -2%
and -1%
Between -1%
and 0%
Between 0%
and 1%
Between 1%
and 2%
Between 2%
and 3%
Between 3%
and 4%
Greater
than 4%
■ 10-Year ■ 15-Year
■ 20-Year
Notes: Includes multiple share classes where available. “U.S. fixed-income mutual funds” refers to all funds, including those focused on a particular style or market capitalization
as short-term government or long-term corporate. However, we excluded municipal funds, money market funds and any specialty funds. For this comparison, we evaluated
active funds after cost against a costless market benchmark. When implementing with an index fund or ETF, transaction costs, expense ratios and tracking error must be
accounted for.
Sources: Vanguard calculations, using data from Barclays Capital and Morningstar, Inc.
the dashed line, meaning that after costs, most of the
dollar-weighted performance of investors falls short of
the aggregate market return. By minimizing costs, therefore,
investors can help ensure that their return is closer
to the market return on average, giving them a greater
chance of outperforming investors who incur higher
costs. For example, investors whose fund has a 0.20 percent
expense ratio—a cost hurdle substantially below
the average mutual fund’s expense ratio (see Figure
4)—stand a greater chance of outperforming a majority
38
March / April 2012

of the dollar-weighted, higher-cost investors. This principle
is just as relevant in markets often thought to be less
“efficient,” such as small-cap or international equities
(Waring and Siegel, 2005). We further explore this aspect
of indexing in a later section of this paper.
Applying The Zero-Sum Game
To Mutual Fund Performance
The zero-sum framework refers to broad markets, but
may also be loosely applied to long-term mutual fund
performance. Although mutual funds account for only a
portion of the global equity and fixed-income markets,
we can still show a result similar to that of Figure 1, where
the long-term net returns of the aggregate diversified
actively managed mutual fund universe shift to the left
of the market benchmark over longer periods (see Figure
2). However, it’s instructive to note that even using net
returns, a wide distribution of active managers exists.
Several factors contribute to this wide performance distribution,
in addition to differences in cost and any skill
the managers may exhibit: The time period analyzed, the
benchmark used and the type of funds included can all
affect the return distribution and the conclusions drawn.
It is noteworthy that although the raw statistics show
that returns of actively managed funds have been nearly
evenly distributed around the benchmark, after accounting
for survivorship bias, the percentage of funds that
have underperformed the broad market has increased
substantially. This fact, together with market dynamics
that are discussed later in this paper, suggests that investors
in actively managed funds have found it difficult to
outperform the market consistently, after cost. By extension,
investors in a low-cost, market-tracking index fund
would expect to outperform a majority of higher-cost
active managers over similar time periods. 5
Overall, we expect the magnitude of dispersion in equity
returns to be much greater than that of fixed-income
securities. For example, the performance distribution in
Figure 2 is more than twice as broad as that in Figure 3. As
is typical, performance for funds focused on fixed income
is concentrated in the middle bars. The cost advantage
of indexing means that an indexed vehicle again had an
edge versus active funds in long-term performance. This
advantage exists because the relatively narrow range of
returns between the best and worst performers in this
asset class magnifies the benefits of a low-cost strategy.
This narrow distribution occurs because a large portion
of bond returns is determined by interest rate fluctuations,
movements of the yield curve and changes in credit
quality, as well as by an active manager’s positioning of a
fund relative to its peers and benchmarks. These factors
represent the primary differences between the relative
performance of actively managed bond funds and their
benchmarks. This is in contrast to the equity markets,
where return dispersion is much wider and risk-factor
differentials such as size and style under- or overweights
to peers and benchmarks amplify return dispersion. The
equity universe also has a much wider security distribution,
in which returns are unique to company and sector,
which can further affect relative performance.
Although active management in the fixed-income
arena is significantly affected by costs, indexing with
bonds may not be as straightforward as indexing with
equities. Unlike equities, bonds do not trade on exchanges
that are liquid and efficient. Instead, the bond market is
dominated by bond brokers, leading to relative illiquidity
and higher costs. As a result, bond index funds may incur
a larger performance drag relative to equity index funds.
The Indexing Cost Advantage
A shareholder’s net return equals the gross return less
the expense ratio and transaction costs. The lower the cost
drag, the greater the net return. Over time, lower costs
can mean outperformance relative to similar higher-cost
funds. Compared with index funds, actively managed
mutual funds typically have higher management fees
coupled with higher transaction costs. The higher fees
often result from a portion of the management fee that
must cover the research process. Higher transaction costs
are attributable to the generally higher turnover associated
with active management’s attempt to outperform
the market. Figure 4 shows the average dollar-weighted
expense ratios for actively managed equity and bond
mutual funds. For example, as of Dec. 31, 2011, investors
in actively managed large-cap equity mutual funds were
paying an average of approximately 0.87 percent annually,
and those in actively managed government bond
funds were paying 0.52 percent annually, versus 0.17
percent and 0.21 percent for the respective index funds.
Index funds generally operate with lower costs,
regardless of asset class or subasset class. Index funds
derive their low-cost structure from their low management
fees and low turnover. Turnover—the buying and
selling of securities within a fund—results in transaction
costs such as commissions, bid/ask spreads, market
Figure 4
Asset-Weighted Expense Ratios Of Active And Index Mutual Funds
(As Of December 31, 2011)
Actively
Managed
Funds (bps)
Index Funds
(bps)
Notes: bps = basis points
Sources: Vanguard calculations, using data from Morningstar, Inc.
Discrepancies due to rounding.
Difference
(bps)
Large Cap US 0.87 0.17 0.70
Mid Cap US 1.02 0.34 0.68
Small Cap US 1.12 0.39 0.74
US Sector 1.00 0.87 0.13
US Real Estate 1.05 0.26 0.79
International Developed 0.97 0.24 0.74
International Emerging 1.22 0.35 0.87
US Corp Bond 0.55 0.20 0.36
US Gov Bond 0.52 0.21 0.31
www.journalofindexes.com March / April 2012 39

Figure 5
Inverse Relationship Between Expenses And Excess Returns: Ten Years Ended December 31, 2011
10 Yr Annualized Excess Return (Scale From -15% To 15%)*
Small
Mid
Large
Value
Blend
Growth
10 Yr Annualized Excess Return (Scale From -5% To 5%)*
Intermediate
Short
Government Credit High-Yield
Expense Ratio (Scale From 0% To 3%)
Expense Ratio (Scale From 0% To 3%)
*Scales were standardized to show the relationship
in the slopes relative to each other; some funds’
expense ratios and returns go beyond the scales.
Notes: Each plotted point represents a fund within the specific size, style and asset group. The funds are plotted to represent the relationship of their expense ratio (x-axis) vs.
the 10-year annualized excess return relative to their style benchmark (y-axis). The straight line represents the linear regression, or the best-fit trend line, showing the general
relationship of expenses to returns within each asset group. The scales are standardized to show the slopes’ relationships to each other, with expenses ranging from 0 to 3%, and
returns ranging from –15 to 15%. Some funds’ expense ratios and returns go beyond the scales and are not shown.
Style benchmarks represented by the following indexes: Large core—S&P 500 Index, 1/2002 through 11/2002, and MSCI US Prime Market 750 Index thereafter; Large
value—S&P 500 Value Index, 1/2002 through 11/2002, and MSCI US Prime Market 750 Value Index thereafter; Large growth—S&P 500 Growth Index, 1/2002 through 11/2002,
and MSCI US Prime Market 750 Growth Index thereafter; Mid core—S&P MidCap 400 Index, 1/2002 through 11/2002, and MSCI US Mid Cap 450 Index thereafter; Mid
value—S&P MidCap 400 Value Index, 1/2002 through 11/2002, and MSCI US Mid Cap 450 Value Index thereafter; Mid growth—S&P MidCap 400 Growth Index, 1/2002 through
11/2002, and MSCI US Mid Cap 450 Growth Index thereafter; Small core—S&P SmallCap 600 Index, 1/2002 through 11/2002, and MSCI US Small Cap 1750 Index thereafter;
Small value—S&P SmallCap 600 Value Index, 1/2002 through 11/2002, and MSCI US Small Cap 1750 Value Index thereafter; Small growth—S&P SmallCap 600 Growth Index,
1/2002 through 11/2002, and MSCI US Small Cap 1750 Growth Index thereafter; Short-term bond—Barclays Capital U.S. 1–5 Year Credit Bond Index; Short-term U.S. government
bond—Barclays Capital U.S. 1–5 Year Treasury Bond Index; Intermediate-term bond—Barclays Capital U.S. 5–10 Year Credit Bond Index; Intermediate-term U.S. government
bond—Barclays Capital U.S. 5–10 Year Treasury Bond Index; High-yield bond—Barclays Capital U.S. Corporate High Yield Bond Index.
Sources: Vanguard calculations, using data from Standard & Poor’s, MSCI, Barclays Capital, and Morningstar, Inc.
impact and opportunity cost. These costs, although
incurred by every fund, are generally opaque, but do
detract from net returns. A mutual fund with abnormally
high turnover would thus likely incur large trading costs.
All else equal, the impact of these costs would reduce
total returns realized by the investors in the fund. A
mutual fund’s expense ratio, however, is visible and represents
shareholder payments to fund managers.
Because costs eat into returns, reported expenses
may be a valuable tool when evaluating fund returns.
Research bears this out. For example, Financial Research
Corporation evaluated the predictive value of different
fund metrics, including a fund’s past performance,
Morningstar rating, alpha and beta. In the study, a fund’s
expense ratio was the most reliable predictor of its future
performance, with low-cost funds delivering above-average
performances in all of the periods examined. A
fund’s expense ratio is a valuable tool for selecting an
investment because the expense ratio is one of the few
performance factors that are known in advance. Figure
5 provides evidence for the inverse relationship between
investment performance and cost within the mutual
fund universe. Specifically, the figure shows the 10-year
annualized excess return of each fund relative to its style
benchmark. To demonstrate the impact of costs, we show
a fund’s excess return relative to its expense ratio. The red
line in each style box represents a trend line that plots the
overall relationship between expenses and excess returns
for the funds in that style box. This analysis makes clear
that higher costs have historically tended to lead to lower
relative returns. For investors, the clear implication is that
by focusing on low-cost funds, the probability of outperforming
higher-cost portfolios increased.
Impact Of Cost On Mutual Fund Performance
As shown in Figure 5, over the long term, the cost drag
for actively managed mutual funds can detract significantly
from actual performance relative to a benchmark.
Although cost is important in the long run, at any given
point in time, relative cost differentials may have less of
an impact on a fund’s or category’s relative performance,
since active funds’ returns vary widely. Depending on the
dispersion of returns of active managers, costs may be a
small factor over shorter time frames such as one, three
or five years. As time goes by, however, costs become
more important. The relative cost advantages of indexing
compound and, when combined with tighter distributions
and a lack of strong manager persistence, these
40
March / April 2012

advantages become more stable, with an edge toward
relative net outperformance. For example, Figure 3 shows
that active fixed-income managers experience narrower
return dispersion relative to equity managers.
We would therefore expect costs to play a more
important role over both the short term and long term
for fixed-income managers and less so for equity managers.
But as the time period extends, Figures 2 and 5
show that costs become a primary determinant of relative
performance for equity funds as well.
To help quantify the impact of costs in the short term,
Figure 6 shows the one-year excess returns for large-cap
value and large-cap growth funds. Excess returns were
used here to better correlate with costs, which detract
directly from returns. As we would expect, costs compound
consistently through time, while in the short term
there is much greater volatility. Of course, this does not
indicate that active management is more likely to win
in the short term—only that portfolio construction decisions
play a much greater role in short-term relative performance.
For example, the outperformance of specific
market segments may lead to active manager outperformance,
as these managers may then outpace the index.
In a market with wide return dispersion, such managers
benefit directly from the segments’ outperformance, far
overshadowing the potential cost disadvantage.
Deepening The Discussion
Of Relative Outperformance
Relative Performance Over Time
Traditionally, to illustrate the relative performance of
indexing and active strategies, point-in-time statistics
(referring to one specific time period) such as those presented
in Figures 2 and 3 are used. However, alternative
analyses can enhance the discussion, potentially leading
to a more robust answer regarding relative performance.
Over time, the actual percentage of active funds underperforming
a particular index will vary, but historically,
the long-term return distribution of active managers has
been skewed toward underperformance of the broad
market, largely owing to the cumulative effect of costs.
For example, Figure 7 shows the percentage of managers
underperforming the U.S. stock market over a rolling
10-year window. The figure also inherently suggests how
the 10-year distribution in Figure 2 changes over time.
Although most actively managed portfolios are shown
to underperform the broad market historically, Figure
7 also depicts the volatility associated with the reported
group of outperformers. In fact, although we would
Figure 6
30.00%
20.00%
10.00%
0.00%
-10.00%
Manager Costs Matter Less In Short-Term Outperformance
-20.00%
1986 1990 1994 1998
— 1-Year Large-Value Excess Returns
— 1-Year Large-Growth Excess Returns
2002 2006 2010
Sources: Vanguard calculations, using data from Morningstar, Inc., Standard & Poor’s,
and MSCI. Indexes used include: S&P 500 Growth Index and S&P 500 Value Index,
1986 through 11/2002; MSCI US Prime Market 750 Growth Index and MSCI US Prime
Market 750 Value Index thereafter.
Figure 7
Comparison Of Active Managers To A Broad-Market Benchmark Can Be Volatile Over Time
Rolling 10-year relative performance of active fund versus broad-market benchmark
Percentage Of Active Managers
Underperforming Market
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Dec.
1997
Dec.
1999
Dec.
2001
Dec.
2003
10 Years Ended ...
Dec.
2005
Dec.
2007
Dec.
2009
Dec.
2011
Funds with ten-year track record
Number of funds in 1998
Small Value 19
Small Growth 39
}
12%
Small Blend 15
Mid-Cap Value 16
Mid-Cap Growth 78
}
19%
Mid-Cap Blend 21
Large Value 124
Large Growth 158
}
69%
Large Blend 144
Number of funds in 2011
Small Value 142
Small Growth 364
}
22%
Small Blend 258
Mid-Cap Value 143
Mid-Cap Growth 411
}
21%
Mid-Cap Blend 165
Large Value 566
Large Growth 782
}
57%
Large Blend 651
Sources: Vanguard calculations using data from Morningstar, Inc., and Dow Jones. Broad market represented by Dow Jones U.S. Total Stock Market Index.
www.journalofindexes.com March / April 2012 41

Figure 8
Shorter Time Periods And Market Segmentation Can Be Highly Cyclical
Percentage Of Funds Underperforming Style Benchmark
Five Years Ended…
1997
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Large Value 94% 86% 94% 83% 54% 40% 39% 31% 32% 71% 78% 71% 51% 51% 83%
Large Blend 84% 94% 90% 74% 67% 58% 49% 44% 57% 66% 71% 65% 62% 67% 77%
Large Growth 86% 99% 90% 62% 67% 55% 38% 49% 70% 63% 46% 57% 65% 76% 46%
Mid Value 74% 81% 65% 79% 82% 82% 70% 80% 94% 97% 79% 77% 65% 51% 51%
Mid Blend 69% 83% 70% 80% 81% 72% 62% 66% 69% 82% 81% 75% 69% 65% 41%
Mid Growth 57% 87% 68% 89% 95% 89% 80% 79% 84% 85% 76% 46% 52% 47% 17%
Small Value 90% 83% 82% 89% 83% 44% 43% 51% 34% 52% 70% 57% 48% 44% 33%
Small Blend 49% 63% 68% 58% 54% 55% 51% 45% 61% 72% 83% 60% 65% 69% 37%
Small Growth 29% 31% 21% 28% 35% 56% 64% 81% 86% 90% 81% 74% 80% 81% 25%
Notes: Style benchmarks represented by the following indexes: Large blend—S&P 500 Index, 1/1997 through 11/2002, and MSCI US Prime Market 750 Index thereafter; Large
value—S&P 500 Value Index, 1/1997 through 11/2002, and MSCI US Prime Market 750 Value Index thereafter; Large growth—S&P 500 Growth Index, 1/1997 through 11/2002,
and MSCI US Prime Market 750 Growth Index thereafter; Mid blend—S&P MidCap 400 Index, 1/1997 through 11/2002, and MSCI US Mid Cap 450 Index thereafter; Mid value—
S&P MidCap 400 Value Index, 1/1997 through 11/2002, and MSCI US Mid Cap 450 Value Index thereafter; Mid growth—S&P MidCap 400 Growth Index, 1/1997 through 11/2002,
and MSCI US Mid Cap 450 Growth Index thereafter; Small blend—S&P SmallCap 600 Index, 1/1997 through 11/2002, and MSCI US Small Cap 1750 Index thereafter; Small value—
S&P SmallCap 600 Value Index, 1/1997 through 11/2002, and MSCI US Small Cap 1750 Value Index thereafter; Small growth—S&P SmallCap 600 Growth Index, 1/1997 through
11/2002, and MSCI US Small Cap 1750 Growth Index thereafter.
Sources: Vanguard calculations, using data from Morningstar, Inc., MSCI and Standard & Poor’s.
expect a zero-sum game in the long term, even 10-year
periods may be considered short enough for certain
market cycles to affect the distribution.
Of course, this figure does not account for survivorship
bias, which would shift the reported results, possibly
significantly. The volatility observed in Figure 7 occurs
primarily because of the broad definition of outperformance,
where the results of all active funds are compared
with that of the broad market and where each active
manager is given the same weight and importance in
determining relative out- or underperformance versus
the market. For example, there were many more smallcap
funds with a 10-year history in 2011 than in the 1990s.
As a result of their significant outperformance relative to
large-cap funds since 2000, small-cap funds play a much
greater role in the aggregate outperformance numbers
versus a broad-market benchmark, which is marketcap
weighted. If and when market leadership changes
to large-cap, we would expect the overall percentage of
active managers outperformed to increase to levels closer
to those observed during the late 1990s. On the other
hand, if market leadership does not change, and smallcap
stocks continue to outperform large-caps, we would
expect the percentage of managers outperformed to fall.
Examining Market Segments And Benchmark Choice
Traditionally, the percentage of the universe of active
managers outperforming a broad benchmark has been
the most common measure of the effectiveness of indexing
or active management over time. However, evaluating
the success of active managers based simply on this percentage
assumes that funds are identical and disregards
both market and style cyclicality.
Evaluating each fund as identical does not address
the cyclicality of the markets or the distribution of fund
count. Figure 7 touches on this cyclicality, but Figure 8
digs deeper, in two ways. First, instead of comparing all
funds to the same broad benchmark, it compares funds
to style benchmarks. Thus, the performance of smallcap
value managers, for instance, can be compared with
that of a small-cap value benchmark, while results of
large-cap blend managers can be compared with returns
of a large-cap blend benchmark. The use of a style-box
approach in Figure 8 addresses the fund-distribution
concern. The second point is that current statistics (as
exhibited in the figure’s highlighted 2011 results) may
not be representative of all time periods. As the figure
demonstrates, even within style boxes, market cyclicality
is an important factor in determining the relative success
of indexing or active management.
Market cyclicality is more obvious in short (three- or
five-year) periods, because as the time lengthens, market
cycles tend to wash out and costs become the primary
factor affecting relative performance. To illustrate market
cyclicality within the style boxes, we focused on periods of
five-year performance. Even within this time frame, Figure
8 shows how the percentage of managers that a particular
style index outperforms can change substantially over time.
In fact, in most style boxes, the range of outperformance by
the benchmark indexes shifts rather significantly.
Style-box cyclicality is further influenced by the
relative performance of one style benchmark versus
42
March / April 2012

Figure 9
Extent Of Index Outperformance Depends On Which Index Is Used
Russell Benchmarks
MSCI Benchmarks
5-year
return
Percentage
of managers
underperforming
benchmark
5-year
return
Percentage
of managers
underperforming
benchmark
Russell 1000 -0.02 71%
Russell 1000 Growth 2.50 80%
Russell 1000 Value -2.64 40%
Russell Mid Cap 1.41 72%
Russell Mid Cap Growth 2.44 55%
Russell Mid Cap Value 0.04 52%
Russell 2000 0.15 48%
Russell 2000 Growth 2.09 63%
Russell 2000 Value -1.87 19%
Standard & Poor’s Benchmarks
MSCI US Prime Market 750 0.16 74%
MSCI US Prime Market Growth 2.59 81%
MSCI US Prime Market Value -2.32 46%
MSCI US Mid Cap 450 1.37 71%
MSCI US Mid Cap Growth 2.06 50%
MSCI US Mid Cap Value 0.36 58%
MSCI US Small Cap 1750 1.79 70%
MSCI US Small Cap Growth 3.73 83%
MSCI US Small Cap Value -0.25 40%
Wilshire Benchmarks
5-year
return
Percentage
of managers
underperforming
benchmark
5-year
return
Percentage
of managers
underperforming
benchmark
S&P 500 -0.25 68%
S&P 500 Growth 2.38 79%
S&P 500 Value -2.96 36%
S&P MidCap 400 3.32 88%
S&P MidCap 400 Growth 5.26 88%
S&P MidCap 400 Value 1.38 76%
S&P SmallCap 600 1.94 73%
S&P SmallCap 600 Growth 3.81 84%
S&P SmallCap 600 Value 0.12 45%
Wilshire US Large -0.03 71%
Wilshire US Large Growth 1.64 68%
Wilshire US Large Value -1.80 56%
Wilshire US Mid 2.77 87%
Wilshire US Mid Growth 4.42 79%
Wilshire US Mid Value 0.91 68%
Wilshire US Small 2.29 78%
Wilshire US Small Growth 3.68 83%
Wilshire US Small Value 0.88 59%
Notes: Data as of Dec. 31, 2011
Sources: Vanguard calculations, using data from Morningstar, Inc., MSCI, Standard & Poor’s, Wilshire and Russell
another. First, because many managers have holdings
that fall within other boxes, when there is large return
dispersion across all nine style boxes, managers in the
lower-performing boxes can be expected to stand a
greater chance of outperforming their respective style
box. For example, if midcap value outperforms largecap
value by 300 basis points, and midcap value stocks
constitute 20 percent of a large-cap value manager’s
portfolio, the large-cap manager would realize 60 basis
points of excess return relative to the large-cap value
benchmark, which could result in that manager outperforming
the large-cap value benchmark.
Second, the effect of holdings that fall outside the
style box combined with cash drag means that, on
average, active managers have a beta of less than 1
relative to their style box. Since the style box necessarily
has a beta of 1, during strong performance within
that style, the index will tend to outperform a greater
percentage of managers within that style box, and vice
versa. For example, large-cap growth managers fared
poorly during the growth-dominated bull market of
the late 1990s, small-cap managers underperformed
their benchmark during the small-cap bull market
of the 2000s, and Asia-Pacific managers lagged their
benchmark during the Japan-led bull market in international
equities in the mid-1980s.
It’s also important to note the vital role of benchmark
selection in gauging the success of certain market segments
(Sauter, 2002). Figure 9 uses the same universe
of active managers covering the five-year period ended
Dec. 31, 2011, and demonstrates that the perception of
active manager success can vary substantially, depending
upon which benchmark is used. Although midcap
performance stands out for the period, different benchmarks
led to changes in relative outperformance across
the board. This is because different benchmarks cover
varying ranges of stocks, have different selection criteria
for growth vs. value, and are even maintained and rebalanced
differently (Philips, 2010b). The point is significant,
because selecting one benchmark over another can mean
the difference between an outperforming manager and
an underperforming manager.
www.journalofindexes.com March / April 2012
43

Figure 10
Excess Returns Help Quantify Relative Performance Of Active Managers
15-year annualized as of 12/31/2011
Value Blend Growth
Government Corporate GNMA
High-Yield
Large
25% / 57% 69% / 84% 55% / 75%
0.90% -0.70%
-0.26%
Short
89% / 96% 98% / 99% 100% / 100%
-0.87% -1.50%
-0.91%
90% / 93%
-1.35%
Mid
100% / 100% 93% / 96% 94% / 97%
-2.73% -3.00%
-3.73%
Intermediate
67% / 84% 80% / 90%
-0.19% -0.67%
Small
54% / 70% 91% / 95% 61% / 78%
-0.29% -2.15%
-0.68%
n Percentage of funds underperforming benchmark /
Percentage underperforming, adjusted for survivorship bias
n Median fund excess return
Notes: Long government and long corporate funds were excluded owing to a small sample size and a duration mismatch with available long-term bond benchmarks. Because
duration is the dominant return factor, small differences in duration between a fund (or group of funds) and an index can lead to significant out- or underperformance, independent
of cost differentials. Any discrepancies in underperformance figures are due to rounding.
Equity benchmarks represented by the following indexes: Large blend—S&P 500 Index, 1/1997 through 11/2002, and MSCI US Prime Market 750 Index thereafter; Large value—
S&P 500 Value Index, 1/1997 through 11/2002, and MSCI US Prime Market 750 Value Index thereafter; Large growth—S&P 500 Growth Index, 1/1997 through 11/2002, and
MSCI US Prime Market 750 Growth Index thereafter; Mid blend—S&P MidCap 400 Index, 1/1997 through 11/2002, and MSCI US Mid Cap 450 Index thereafter; Mid value—S&P
MidCap 400 Value Index, 1/1997 through 11/2002, and MSCI US Mid Cap 450 Value Index thereafter; Mid growth—S&P MidCap 400 Growth Index, 1/1997 through 11/2002, and
MSCI US Mid Cap 450 Growth Index thereafter; Small blend—S&P SmallCap 600 Index, 1/1997 through 11/2002, and MSCI US Small Cap 1750 Index thereafter; Small value—
S&P SmallCap 600 Value Index, 1/1997 through 11/2002, and MSCI US Small Cap 1750 Value Index thereafter; Small growth—S&P SmallCap 600 Growth Index, 1/1997 through
11/2002, and MSCI US Small Cap 1750 Growth Index thereafter. Bond benchmarks represented by the following Barclays Capital indexes: U.S. 1–5 Year Government Bond Index,
U.S. 1–5 Year Credit Bond Index, U.S. Intermediate Government Bond Index, U.S. Intermediate Credit Bond Index, U.S. GNMA Bond Index, U.S. Corporate High Yield Bond Index.
Sources: Vanguard calculations, using data from Morningstar, Inc., MSCI, Standard & Poor’s and Barclays Capital.
Excess Returns And Survivorship Bias
Provide Additional Insight
Evaluating managers using the percentage who simply
outperform an index assumes that a manager who
outperforms a benchmark by 0.01 percent has achieved a
result as significant as one who outperforms a benchmark
by 10 percent. In other words, there is no information on
the magnitude of out- or underperformance.
To account for the magnitude of performance, we can
look at average excess returns of active managers versus a
benchmark. Such a statistic provides investors with a sense
of how active management has performed on average—
whether delivering positive or negative excess returns and
how much. Figure 10 calculates the average excess returns
for active managers in both equity and fixed-income segments.
For example, it shows that the average active largecap
growth fund underperformed the benchmark by 26
basis points, whereas midcap value funds underperformed
by 273 basis points. Even small-cap managers, on average,
underperformed their benchmark in terms of excess returns.
Although excess returns add additional perspective,
it bears emphasizing that as the time period lengthens,
excess returns should converge closer to the average cost
drag of active managers. For example, midcap value funds
would not be expected to underperform a midcap value
benchmark by 273 basis points or more (see Figure 10) for
an extended period. Most likely, the performance gap is
cyclical and will tend to narrow in the future. Similarly, we
would not expect such a narrow gap as reported by largecap
value funds to last indefinitely.
Figure 10 also shows the impact of survivorship bias across
equity and fixed-income sectors. In addition to market cyclicality,
benchmark selection, cost and excess return analysis,
investors must also be aware of the possibility that an active
fund could close owing to poor performance. Accounting for
this risk further shifts the analysis in favor of indexing.
Benefits Of Indexing In Portfolio Makeup
Although active managers must manage a portfolio
in ways that are different from a benchmark if they are
to try to outperform it, investors primarily interested
in obtaining the market return or in reducing a fund’s
volatility around a benchmark should strongly consider
indexing. Historically, broad diversification and style
consistency have helped to provide more predictable
returns relative to the targeted benchmark. As a result,
index funds and ETFs play an important role in the
portfolio construction process. An indexed mandate
also allows greater control of the risks in a portfolio. For
example, filling a recommended equity allocation with a
concentrated portfolio would result in an allocation that
will likely differ at any given point in time from the riskand-return
characteristics of the equity market.
Diversification
Index funds typically are more diversified than actively
managed funds, a byproduct of the way indexes are constructed.
Except for index funds that track narrow market
segments, most index funds must hold a broad range of
securities to accurately track their target benchmarks,
whether by replicating them outright or by a sampling
method. The broad range of securities dampens the risk
associated with specific securities and removes a component
of return volatility. Actively managed funds, on
the other hand, tend to hold fewer securities with varying
degrees of return correlation.
44
March / April 2012

Figure 11
Indexing Has Been Effective Across Asset Classes And Subasset Classes
International equity: 15-year annualized as of 12/31/2011
Large
Developed Global Emerging
35% / 61%
0.65%
34% / 64%
0.84%
56% / 75%
-0.17%
n Percentage of funds underperforming benchmark /
Percentage underperforming, adjusted for survivorship bias
n Median fund excess return
Notes: Benchmarks include the following MSCI indexes: All Country World Index, EAFE
Index, and Emerging Markets Index.
Sources: Vanguard calculations, using data from Morningstar, Inc. and MSCI.
Style Consistency
An index fund maintains its style consistency by attempting
to closely track the characteristics of the index. An investor
who desires exposure to a particular market and selects
an index fund that tracks that market is assured of a consistent
allocation. An active manager may have a broader
mandate, causing the fund to be a “moving target” from
a style point of view. Many active managers can choose to
vary their investments among small-, medium- or large-cap
stocks, betting on whichever segment is expected to perform
best. Even if a manager has a well-defined mandate,
the decision to hold more or less of a security than the index
will lead to performance differences.
The Tax Advantage
From an after-tax perspective, broad index funds and ETFs
may provide an additional advantage over actively managed
funds. Because of the way index funds are managed, they
rarely realize and distribute capital gains to shareholders.
According to Bergstresser and Poterba (2002), the typical
mutual fund distributed, on average, 50 percent of its
annual price appreciation in the form of capital gains. It
should be noted that very few conventional broad index
funds or broad ETFs have distributed capital gains in past
bull or bear market cycles. Historically, approximately
one-third of the distributions from actively managed
funds have been in the form of short-term gains and twothirds
in the form of long-term gains. Index funds, on the
other hand, distribute far less (an estimated 0.50 percent)
as long-term gains, primarily because selling occurs
only when the composition of the market index changes.
This can result in return advantages over the long term
because the majority of the investment compounds over
time instead of being lost to taxes.
Debunking Some Misconceptions
Regarding Indexing
Although the indexing strategy has proven to be successful
over time, indexing has also been continually criticized.
These criticisms have given rise to a number of misconceptions,
which persist despite research that has refuted them
and despite the historical performance of index mutual funds.
The first myth regarding the viability of indexing is that
indexing only works in markets traditionally viewed as highly
efficient. For example, the U.S. government bond market is
considered one of the most efficient markets, meaning there
is not a great deal of room for active managers to add value.
In such a market, it would be expected that an overwhelming
majority of active managers would fail to beat a benchmark.
On the flip side, markets such as high-yield bonds or international
markets are often viewed as much less efficient.
Investors tend to view these markets as better suited for
active management. In this view, indexing would be expected
to underperform a large majority of active managers.
Figure 11 addresses these arguments by showing the
percentage of active managers that beat a relevant benchmark
over the 15 years ended Dec. 31, 2011. After adjusting
for survivorship bias, funds focused on the global and
regional markets underperformed their benchmarks, on
average. Especially notable has been the relative underperformance
of emerging markets. In addition, Figure 10
shows that managers in both small-cap U.S. equity and
high-yield U.S. bond funds underperformed significantly,
even though these are thought to be areas of opportunity
for active managers. Further, in a parallel study of offshore-domiciled
funds (Philips, 2010a), we found that the
average manager significantly underperformed the benchmark.
These results held across investment mandates,
including U.S., Europe, global, eurozone and emerging
markets. Similar to the findings in this paper, these numbers
will change over time and across benchmarks; however,
the case for indexing across asset classes and subasset
classes remains robust. Further, as more funds enter the
arena, both results are likely to become more robust.
A second misconception about indexing is that actively
managed funds will outperform index funds in a bear
market. This belief is based on the idea that active managers
can accurately time market declines and upturns.
Relatively efficient markets, however, make it difficult to
consistently time market movements with accuracy.
Many investors believe that managers of active funds can
shift fund assets out of stocks in time to curb portfolio losses
during market downturns. In reality, the probability that
these managers will move fund assets to defensive stocks or
cash at just the right time is very low. Most events that result
in major changes in market direction are unanticipated. To
succeed, an active manager would have to not only time
the market but also do so at a cost that was less than the
benefit provided. Figure 12 illustrates how hard it has been
for active fund managers to outperform the Dow Jones U.S.
Total Stock Market Index. In four of seven bear markets
since January 1973, and seven of the eight bull markets,
the average mutual fund underperformed the index. These
results are particularly noteworthy, given that most bear
markets are relatively brief, while the indexing cost advantage
grows in magnitude over 5-, 10- and 20-year periods.
Similarly, Lipper studied active managers’ performances
in bear markets (defined as a drop of 10 percent
or more in the equity markets). 6 Lipper found that active
managers underperformed the S&P 500 Index in the six
continued on page 63
www.journalofindexes.com March / April 2012
45

Indexes In Perspective
The Index Industry’s
Changing Landscape
A call to action for index providers
By Rolf Agather
We have reached a turning point in the history of
indexes. Their influence on investors and on the
markets has expanded greatly in recent decades,
as these tools have gone beyond the task of measuring
active managers to serving as the foundation for investment
strategies. The market for index-based investment
strategies, which began in 1975 with the introduction of the
first index-based mutual fund by John Bogle and Vanguard,
has accelerated and taken on new shape in recent years.
Through a number of product innovations over the last
decade, index-based investment strategies have emerged
as essential building blocks for multi-asset portfolios. For
this reason, I believe that indexing is probably at its greatest
inflection point since the introduction of the Vanguard
Index Trust. Indexes play a more vital role in helping investors
invest today than at any point in their history.
Healthy Self-Examination
Indexes are enjoying strong growth as assets rapidly flow
into index-based investment vehicles such as exchangetraded
funds. It is an exciting time to be an index provider,
as investor demand continues to fuel product innovation.
However, this growth makes it critically important to consider
the tough questions being asked about our industry. It
is important to encourage an open dialogue in the interest of
index users and take responsibility as stewards of the indexes.
Have indexes gone too far in pushing beyond marketcapitalization-based
indexes into so-called “strategy” or
“alternative beta” approaches? Have index and ETF providers
together diced and sliced the market in so many
ways that they have lost sight of the original role of the
index? Has the relatively recent introduction of ETFs into
the equation made it too easy and quick to move money in
and out of the markets, producing a product that is of more
interest to short-term traders than to long-term investors?
These are all questions that John Bogle has raised in
one form or another over the years, and rightly so. A truly
healthy industry regularly analyzes the value it brings
to clients and asks itself the tough questions to ensure it
is taking the right steps to remain healthy in the future.
Thanks in large part to the innovation started by John
Bogle in 1975, index-based products are alive and well and
continue to enjoy great popularity among investors. To
continue to thrive going forward, however, I believe index
providers must remain focused on innovation while staying
true to the core principles of indexing.
From Passive To Active: The New Frontier
Before Russell significantly expanded the spectrum of
market-capitalization indexes in 1984, the index industry
was significantly smaller than it is today. Indexed assets were
still a small proportion of investor portfolios. Institutional
investors with specialist equity mandates generally used the
S&P 500 in every case. And while the S&P 500 is still a widely
used benchmark, the scope and scale of index products has
increased exponentially over the last three decades (see
Figure 1). In the 1980s and the first half of the1990s, this took
the form primarily of product expansion into investment
size and style (large-cap, small-cap, growth and value),
economic sectors and expanded global markets coverage.
Indexes covering fixed income were introduced as well.
Mutual funds tracking these indexes were popular and grew
quickly, contributing to this expansion.
Exchange-traded funds could not have existed without
indexes when they entered the picture in the mid-1990s.
As ETFs grew in popularity, the industry quickly licensed
46
March / April 2012

the most widely known broad market indexes, sometimes
with multiple ETF providers basing products on the same
indexes. By the early 2000s, there were fewer new market
indexes left to build into new ETFs and the industry looked
for new types of indexes to continue fueling its growth.
Innovation once again played a hand. When PowerShares
Capital Management (now Invesco PowerShares) introduced
its two new ETFs, the Dynamic Market Portfolio
(NYSE Arca: PWC) and the Dynamic OTC Portfolio (NYSE
Arca: PWO), in 2003, the most recent wave of innovation for
indexes began. The new PowerShares products were based
on the “Intellidex” index, which uses quantitative models
to weight constituents using a modified equal-weighting
methodology. This was a significant turning point, because
it was the first time that an active management strategy was
replicated through an index methodology and made available
to investors through an ETF.
Today most index providers devote some of their efforts
to developing indexes that capture active or alternative
beta strategies. An industry that grew up with a very clearly
drawn line between active and passive strategies is now
bridging that gap on a daily basis, with ETFs and other
index-related products accelerating the process. Index
providers have expanded their offerings beyond broad
market exposures to more specific rules-based strategies
that provide more targeted and narrow exposure to segments
of the market or particular investment strategies.
Remembering Our Core Principles
The movement of indexes closer to the active end of
the investment spectrum should be viewed with a positive
yet critical eye. Innovation has driven more index-based
investment alternatives for financial advisors and consumers.
Investors continue to have access to cheaper and more
efficient market exposure across a fuller spectrum of asset
classes, investment disciplines and styles. Yet we must be
careful not to innovate just for the sake of selling more
products. Innovation must be supported by a clear market
need and suitability for investors.
As index-based strategies evolve toward more quasiactive
approaches, we must retain many of the traditional
features of indexes, but at the same time we should hold
those newer index strategies to similar standards that we
have historically applied to active managers. For example,
an index must have a clearly defined objective, methodology
and investment opportunity set. The index must seek
to deliver some well-defined exposure, whether to an asset
class, an investment style or a certain risk factor. And just
as investors require due diligence on active managers, so
too should they require due diligence on index strategies
being offered in an investable product.
New indexes have emerged in recent years that have
compelling performance characteristics and potential outcomes
that are very different than the broad market indexes
of the past. These new indexes offer attractive choices for
investors, but consistent with our expectations of active
managers, the creators of these strategies need to provide
credible evidence that supports their approach. Just as
Figure 1
1,200,000
1,000,000
800,000
600,000
400,000
200,000
0
Total Net Assets: Index Mutual Funds & Index ETFs
1993-2011 YTD (In $ millions)
1993 1998 2003 2008 2011 YTD
— Index-Based Mutal Funds
— Index-Based ETFs
Sources: Investment Company Institute and Strategic Insight Simfund.
Data as of November 2011. ETF asset figures are for 1940 Act, index-based ETFs.
active managers must demonstrate that they have the judgment
and skill to beat the market, an index provider must
demonstrate more than just backtested performance for
investors to form an expectation of future excess return. It is
incumbent on the index provider to explain the factors that
drive an index strategy’s performance and provide a compelling
case as to why these conditions can reasonably be
expected to continue in the future. Many providers of popular
index strategies have provided considerable research to
support their investment thesis, but unfortunately, not all
of them have done so. Ultimately, the investor is responsible
for forming a view on what will drive performance and
choosing the index that best implements this view. But as
providers, we are responsible for giving the investor credible
information on which to base their decision.
It is not that these issues haven’t existed before, when
investors were limited to broad market exposures. In the past,
investors could efficiently express a view that large-cap stocks
would outperform small-cap stocks or that value would outperform
growth using index-related products. What is different
now is that an investor can go much further. There are a
wide variety of exposures and strategies available that enable
an almost infinite range of views to be expressed.
Indexes are still primarily building blocks to implement
an investment strategy. The difference now is that there are
more index-based strategies for investors to express a more
varied set of market views. This growing influence has raised
the importance of the index provider’s role. As indexes can
no longer be considered truly passive, index providers can
no longer be considered passive participants in the investment
arena. The growing role of indexes as the basis of ETFs
and other investment strategies requires more thoughtful
consideration of our contribution as client educators.
Turning A Corner
It is extremely important that we make sure our products
are understandable to our clients. For instance, there
is a lot of work that index providers can do together to
provide education and context on the new breed of altercontinued
on page 56
www.journalofindexes.com March / April 2012 47

Talking Indexes
Keeping It Simple
And Making It Work
Using financial theory in real-world investing
By David Blitzer
Investing is the practical manifestation of the science
of financial economics. Since the publication
of Harry Markowitz’s “Portfolio Selection” paper in
the Journal of Finance in 1952, the practice of investment
has borrowed heavily from theoretical advances found
in academic journals. The theoreticians have returned
the favor by expanding the ideas that seek to explain
how financial markets work. Practical ways to price
options came from the theory, while explanation of when
futures are in contango or backwardation emerged from
analyses of commodities trading. Although this joining of
investment art and financial science is mostly successful,
there are occasional disastrous moments. Recent examples
include the events of 2008 when Lehman Brothers
collapsed and AIG had to be deluged with money lest
it bring down the rest of the financial infrastructure.
At times investing practice becomes too enraptured
with the mathematical complexity and pyrotechnics of
finance while the fundamentals are forgotten.
As Markowitz’s work on portfolios and William Sharpe’s
capital asset pricing model gained increased attention
from financial economists in the 1960s, the theoretical
idea of investing in the whole market began to attract interest.
However, it was Jack Bogle who made whole-market
investing a reality for investors with the introduction of the
first index mutual fund in 1976. Among his many contributions
to modern investing, the other that stands out is the
founding of The Vanguard Group. These two achievements
alone are enough to establish him among the leading
investors of the last half century.
Among the many practitioners mining financial theory
and economic science for investment ideas, Jack Bogle
and a few others kept their feet on the ground and avoided
many of the recent manias. The efficient market hypothesis
(EMH)—which posits that markets are informationally efficient
and therefore investors cannot consistently beat the
market—underlies many of the ideas about how stocks are
valued, priced and traded, as well as recent debates over
why the market has suffered two 50 percent bear markets
in the last decade. Many believers in index investing argue
that the EMH is why indexing works. Lately, the theory has
been the subject of much debate caused by bear markets
and suggestions that prices aren’t always as random or
unpredictable as the EMH seems to hold. However, as Jack
Bogle has pointed out, the success of index investing does
not depend on the EMH, but rather on his own alternative
hypothesis—the cost matters hypothesis (CMH). Simply
put, CMH holds that indexing is cheap and index investors
keep more of their own money than investors who use
active managers. The proof is in the low-fee index funds
pioneered under Bogle’s leadership.
Keeping the cost of investing down depends on more
than just using indexes. Investors who rush into the newest
“perfect” strategy by abandoning their last sure bet
end up spending too much on trading and taxes (if there
were any gains to be taxed) while keeping far too little.
Other investors devote a lot of time to debating which
parts of the market will be the hot spots. Bogle’s answer
was to suggest buying a total market index fund and never
selling. While this approach should keep the transaction
costs of investing down, in recent years it has been open
to arguments that buy-and-hold investing no longer
works. With the last record high on the S&P 500 some 300
points above and more than four years distant from its
2011 year-end level, defending the buy-and-hold concept
may seem difficult indeed.
48
March / April 2012

But no one ever promised that investing with indexes
guaranteed outsized or even merely positive returns. Indeed,
the only claim by those espousing index investing was that
the costs would probably be lower and diversification would
probably be greater with index investing than by attempting
to buy only the stocks that are supposed to rise. The idea
behind indexing as an investment strategy is that over the
long run, the market rises as the economy grows and the
costs of participating in economic growth can be quite modest.
Does buy-and-hold always work? No. No investment
strategy always works. Although there are promises of strategies
that can be replicated and that consistently outperform
buy-and-hold, few if any have succeeded. In investing (and
in many other pursuits), there are no sure things.
Finally, having worked at S&P on indexes for several
years, I can’t write about Jack Bogle without acknowledging
a debt to Jack’s daring idea to launch a retail index mutual
fund and basing the fund on the S&P 500. Since the S&P
500 took its current form in 1957, it has been part of many
investing innovations, including index mutual funds, ETFs,
and index futures and options. The Vanguard mutual fund
stands out among investment and financial history as one
of the first and most successful examples of borrowing from
financial science for investing results.
Roundtable continued from page 31
From the Foreword to “John Bogle on Investing: The First 50 Years” (2001)
If a modern day Rip van Winkle were to wake up
after a sleep of 50 years, he’d have a lot of trouble
understanding today’s financial markets or recognizing
the names of the major participants. But if Rip happened
to be, say, a Princeton professor who had monitored
or read John Bogle’s senior thesis, he wouldn’t
be at all surprised about one of the most significant
developments in the world of the stock market and
money management.
John Bogle didn’t invent the business of mutual investment
funds. They had started before he went to college,
but were barely visible. His curiosity about the business
was piqued by an article in a magazine as he was ruminating
about a thesis topic. That bit of serendipity led not
only to an honors thesis but to a lifelong vocation.
Today, mutual funds are the dominant investment
medium for American families. They directly own a
large fraction of all traded stock and a sizable share of
bonds and liquid assets as well.
The success of the industry is built on a solid
base—the demonstrable value of diversifying risk and
spreading costs by collective investment. Those were
concepts intuitively recognized and emphasized by the
Princeton senior.
John Bogle has not, of course, been alone in seeing
the basic merit of mutual funds, now counted in the
thousands. His great contribution—his single-minded
mission—has been to insist that those funds should be
managed, first and foremost, in a way truly to serve the
interests of the investing public.
That has meant strong emphasis on minimizing conflicts
of interest and operating at the lowest possible cost.
To those ends, the family of funds which John Bogle
established a quarter of a century ago---The Vanguard
Group—has remained independent of ties to other businesses.
It has long led the industry in operating without
sales charges and with minimal operating costs.
Early in its life, Vanguard established the industry’s
first index fund. Over time, the stress on the value of index
funds responded to the clear logic—a logic fully supported
by the plain evidence—that most “active” money
managers most of the time will not be able to “beat” the
market. These days, after all, mutual funds largely are the
market. On the average, they couldn’t do better, even if
they had no costs, operated with perfect efficiency, and
incurred no taxes. With those hurdles to jump, very few
funds can consistently outperform the averages.
That’s not an easy conclusion for money managers
to accept. John Bogle has not won many popularity
contests among his professional colleagues. Moreover,
he himself would readily confess that the unique
form of governance and style of management that he
instilled in Vanguard is not easy to replicate.
But from a distance, I along with many others have
enormously admired the force and eloquence with
which he has set forth his thinking. It is thinking that I
find fully persuasive as an analytic matter and entirely
consistent with the public interest. John Bogle’s basic
conviction that the mutual fund investor is entitled, in
his words, to a “fair shake” should serve as the motto of
every mutual fund.
All of us dependent on mutual funds or other collective
investment institutions to manage our savings,
and that is most of us, owe thanks to John Bogle for
insisting that our interests be placed front and center.
Even more broadly, the strong sense of fiduciary
responsibility, the objectivity of analysis, and the willingness
to take a stand—qualities that permeate all his
writings—set high standards for all those concerned
with the growth and integrity of our open and competitive
financial system.
Paul A. Volcker
Published in 2001 by the McGraw-Hill Companies
www.journalofindexes.com March / April 2012 49

News
Index Providers To
Form Trade Body
MSCI, S&P Indices and FTSE have
held preliminary discussions about
the establishment of a trade body to
represent the index industry, the three
companies have announced. The
body will also aim to advance the
interests of clients and investors, the
index providers said.
The planned trade body will be open
to other index firms, a representative of
FTSE told IndexUniverse.eu. Discussions
about the trade association’s makeup
and objectives are still at a preliminary
stage, the representative added.
Index-based investing continues to
gain in popularity worldwide. According
to Morningstar, U.S.-based index-tracking
mutual and exchange-traded funds
held $2.3 trillion in assets at the end of
June this year, and are gaining ground
on the $7.3 trillion held in actively managed
funds. For year-end June 2011,
said Morningstar, passive funds, including
ETFs, took in more than $183 billion
in new inflows, while actively managed
funds collected only $138 billion.
Within the global ETF industry,
MSCI, S&P and FTSE currently rank
first, second and sixth in a table of
benchmark providers used by these
funds, according to BlackRock’s end-
June ETF Landscape publication.
LSE Acquiring
Remainder Of FTSE
A mid-December announcement
said that the London Stock
Exchange (LSE) is acquiring full
control of index provider FTSE in a
deal worth £450 million.
The LSE is buying the 50 percent
of shares in FTSE International
Limited it doesn’t already own from
publishing house Pearson in a cash
deal that is expected to close in the
first quarter of 2012.
FTSE says it plans to accelerate
its growth plans post-acquisition in
regions outside Europe, notably the
U.S. The LSE says it intends to diversify
its business activities further
into indexes, derivatives, and market
data products and services. Pearson
explains its sale of its FTSE stake by its
desire to move away from data provision
and toward further development
of its subscription-based publishing
model. The firm sold its stake in
Interactive Data last year for $2 billion.
Research Affiliates Files Suit
Against WisdomTree
Research Affiliates, the fundamental
indexing firm founded by
Rob Arnott, filed a lawsuit against
WisdomTree Investments in early
December. The patent infringement
lawsuit was filed in the U.S.
District Court for the Central District
of California, and alleges that
WisdomTree developed financial
products using proprietary information,
Arnott’s firm said in a press
release. Also named in the lawsuit
were Mellon Capital Management
Corp. and ALPS Distributors.
The London Stock Exchange
is acquiring full
control of index
provider FTSE in
a deal worth
£450 million.
Research Affiliates’ system screens
companies for four different qualities
before they can be included in a so-called
RAFI index. Those parameters are book
value, cash flow, sales and dividends.
The dividend screen may have
outsized importance in the suit, as
WisdomTree’s take on fundamental
indexing also involves screening
companies for their histories of paying
dividends. WisdomTree’s lineup
also includes indexes weighted and
screened based on earnings.
At issue in the lawsuit are the following
patents:
• U.S. Patent No. 7,747,502, titled “Using
Accounting Data Based Indexing to
Create a Portfolio of Assets”
• U.S. Patent No. 7,792,719, titled
“Valuation Indifferent Non-
Capitalization Weighted Index and
Portfolio”
• U.S. Patent No. 8,005,740, titled
“Using Accounting Data Based
Indexing to Create a Portfolio of
Financial Objects”
Officials at New York-based
WisdomTree weren’t immediately
available to comment.
50
March / April 2012

S&P Case-Shiller Indexes
See October Fall
U.S. home prices across much of
the country dropped again in October
after drifting lower the month before,
as the market continues to struggle
with economic uncertainty, the
December S&P/Case-Shiller home
price report showed.
Signs of a recovery, such as the temporary
strength during the summer
months, have proven to be seasonal,
and housing values remain pressured
by large inventories at a time when
housing starts are at near-record lows,
the report said.
The 10-City and 20-City Composite
Home Price Indexes in October
dropped 1.1 percent and 1.2 percent,
respectively, from their September
readings. Year-over-year, prices are
lower, but appeared to be slowly
climbing back toward parity. Still, both
indexes remained about a third lower
than their peak levels in mid-2006.
October saw prices slide relative to
September in all but one city surveyed,
and, again, home values nationally are
still below where they were a year ago.
Prices remain the lowest they’ve been
since mid-2003.
Both the 10-City and the 20-City
composites improved slightly on an
annual basis. The latest report pegs
the 10-City composite at -3.0 percent
from its October 2010 reading, with the
20-City sitting at -3.4 percent on the year.
What’s more, of the 20 cities surveyed,
14 showed improvement in the
12 months ended in October, even if
only two of those cities are not in the red.
But the flip side is that five cities saw
prices sink on an annual basis, with
Atlanta now leading the pack of worstperforming
markets. Home prices there
in October were 11.7 percent lower than
they were in the year-earlier survey.
Miami was the only market where
prices were unchanged year-over-year.
Arnott, Citi Team Up
On Bond Indexes
In late January, Research Affiliates
the firm founded by Rob Arnott—and
Citigroup rolled out a roster of bond
indexes that apply Arnott’s fundamentally
weighted index methodology known
as RAFI to the sovereign debt space.
The Citi RAFI Bond Index Series
minimizes exposure to “aging and
debt-laden” economies such as the
United States and Japan, while focusing
on resource-rich, younger markets
such as Australia and Canada.
The indexes weight countries by their
“economic footprint,” the Newport
Beach, Calif.-based company said in
a press release. The series covers both
developed and emerging markets.
The methodology is a departure
from most existing bond benchmarks,
which typically weight securities
based on market capitalization,
meaning investors make their biggest
bets on the biggest debtors.
According to the press release,
country weights are based on “gross
domestic product, energy consumption,
population and rescaled land
area,” with the intention of reflecting
which countries are best able to manage
and repay their debts.
The Citi RAFI Sovereign Debt
Developed Markets Bond Index allocates
21.7 percent to the United States,
with Japan coming second, at nearly
9 percent, followed by allocations to
Canada, Germany and Australia, hovering
around the 7 percent mark.
By contrast, the press release indicated,
similar sovereign developedmarkets
capitalization-weighted indexes
would have Japan representing as
much as a third of the portfolio, with the
U.S. coming in second, with a 27.6 percent
allocation. France, Germany and
the United Kingdom would round out
the top five holdings, according to the
press release.
Another Citi-RAFI bond index, this
one focused on the developed-markets
corporate bond space, will be
released in the spring, the statement
said. All of the RAFI bond indexes are
“available for licensing,” it added.
INDEXING DEVELOPMENTS
Stoxx Debuts
Expected Dividend Index
Index provider Stoxx launched
an index focused on the expected
dividend payout from large-capitalization
European companies in
early December.
The Stoxx Europe Maximum
Dividend 40 Index selects its constituents
from the index provider’s broad
European equity benchmark, the
Stoxx Europe 600.
The Maximum Dividend 40 Index
includes those companies with the
highest-expected dividend yield in
the upcoming quarter. The expected
dividend yield is determined by the
announced or estimated dividend
amount and the closing price of the
stock at the time of selection.
To be eligible for inclusion in the
index, a company must pay a dividend
in the upcoming quarter, have a freefloat
market capitalization of at least
€1 billion and an average daily trading
volume of at least €4 million over the
previous three months.
The higher a company’s dividend
yield and the more liquid it is, the
higher its weight in the index, says
Stoxx, subject to a maximum individual
component weight of 10 percent.
FTSE, Tobam Roll Out
Index Lineup
The FTSE Group released details in
November of the new family of indexes
it has been developing in partnership
with French asset manager Tobam.
The index provider first announced
the joint venture back in July, and said
www.journalofindexes.com March / April 2012 51

News
the pair would work on developing a
series based on helping investors avoid
the concentration risks associated with
market-capitalization weighting.
The resulting FTSE Tobam Maximum
Diversification Index Series
instead uses a methodology devised
by Tobam, which calculates each
stock’s weighting so that each effective
risk factor contributes equally to
the risk of the portfolio.
The new index family consists of
eight indexes—five regional developed-market
benchmarks and three
single-country indexes covering the
U.S., Japan and the U.K.
Van Eck Acquires Indexes
In late 2011, New York-based asset
manager Van Eck Global announced
the acquisition of the indexes that
bear the same Market Vectors name
as its line of ETFs from Germanybased
4asset-management. Terms
weren’t disclosed.
The acquisition is being carried
out by a new wholly owned Van Eck
unit, Market Vectors Index Solutions.
The 15 indexes involved in the transaction
underlie 15 U.S.-listed Market
Vectors ETFs that together command
$4 billion in assets.
The pre-existing indexes with the
Market Vectors name on them were
owned by 4asset-management. SEC
regulations have historically been stringent
in assuring that index providers
and ETF providers have critical separation
so that their respective missions
aren’t clouded by the other’s priorities.
However, Van Eck was granted
self-indexing relief from the SEC rules
after it filed regulatory paperwork
outlining a plan to establish a firewall
between its subsidiary Market Vector
Index Solutions and its New Yorkbased
ETF operation.
Qatar, UAE To Remain
‘Frontier’ Markets At MSCI
Qatar and the United Arab Emirates
will remain for now classified as frontier
countries in MSCI’s classification
system, according to a December
announcement. But the index provider
said they are still under consideration
for reclassification as emerging markets
as part of the index provider’s 2012
annual classification review next June.
At the time of its annual classification
in June 2011, MSCI had said it
would revisit the status of the UAE and
Qatar in December. At that time, it
decided that South Korea and Taiwan
would remain emerging market countries,
and that it would reconsider the
two Asian countries for reclassification
as developed countries as part of
its June 2012 annual review.
Explaining its decision on Qatar and
the UAE, MSCI said in a press release
that market participants need additional
time to assess the effectiveness
of “delivery versus payment” models
on the Qatar Exchange, the Dubai
Financial Market and the Abu Dhabi
Securities Exchange. It also said regulators
and stock exchanges need more
time to address remaining concerns of
international institutional investors.
BarCap Adds To
Fiscal Strength Indexes
Barclays Capital rolled out some
additions to its family of fiscal-strengthweighted
indexes in January. The newest
benchmarks track covered bonds;
such bonds are generally backed by
pools of assets usually consisting of
mortgages or public sector loans and
have become an increasingly popular
source of low-cost funding and liquidity
for banks in the eurozone.
The new Barclays benchmark indexes
use measures of fiscal sustainability
to adjust country weights within covered-bond
benchmarks as opposed to
existing market-weighted indexes the
company already offers, which allocate
about 40 percent of assets to Europe.
The three new indexes include:
• Global Fiscal Strength Weighted
Covered Bond Index
• Pan Euro Fiscal Strength Weighted
Covered Bond Index
• Euro Fiscal Strength Weighted
Covered Bond Index
All three of the new indexes are alternatives
to the Barclays Global Covered
Bond Index that was launched in 2000,
and track fixed-rate investment-grade
covered bonds from 22 countries
denominated in 11 currencies. The
three new indexes impose an overlay
of ratings by credit agencies, debt-to-
GDP ratios and deficit-to-GDP ratios
to reweight the countries contained
within the Global Covered Bond Index
based upon their fiscal health.
DJ Indexes Debuts
2-4-6 Commodity Index
Dow Jones Indexes rolled out the
Dow Jones-UBS Commodity Index 2-4-6
Forward Blend in December, according
to a statement from the index provider.
The new benchmark equally
weights the two-month, four-month
and six-month forward versions of
the DJ-UBS Commodity Index, resetting
their weights to one-third of the
index’s total weight on a monthly
basis, the press release said.
The original DJ-UBS Commodity
Index tracks front-month contracts,
but by combining the three forwardmonth
versions of the index, the 2-4-6
index provides exposure to a variety
of time points further out on the commodities
futures curve, which could
mitigate the effects of contango when
it manifests.
DJ RBP Index Family Expands
Dow Jones Indexes debuted the
Dow Jones RBP U.S. Small-Cap Index
at the end of November, according to
a press release from Dow Jones.
The Dow Jones RBP methodology
was developed jointly with analytics
provider Transparent Value LLC,
whose proprietary Required Business
Performance metric is designed to
help evaluate whether a company’s
business activities and expected future
profits justify its current stock price.
The DJ RBP U.S. Small-Cap Index
draws its components from the DJ
U.S. Small-Cap Total Stock Market
Index, selecting them based on return
on equity, free cash-flow yield, asset
growth and RBP probabilities, the
press release said. The chosen components
are weighted by their RBP
probabilities, the statement noted.
52
March / April 2012

The new index is the latest addition
to a wide-ranging family of RBP-based
benchmarks offered by DJ Indexes.
S&P Debuts Latin America
ADR Index
In mid-December, S&P launched
the S&P Latin America ADR Index, the
company said in a press release.
The index covers 25 issues, but is
not limited to American depositary
receipts—it can also include global
depositary receipts and primary stock
listings by Latin American companies
on U.S. exchanges. The index’s components
are selected based on liquidity
and weighted by market capitalization
subject to caps on the weighting
of individual companies and countries,
the release said.
At launch, the index’s top components
included ADRs for Petrobras SA,
America Movil and Vale SA, according
to a fact sheet provided by S&P.
The press release also noted that
S&P had launched several additional
“risk control” indexes based on the
new benchmark that aim for volatility
levels of 8, 10, 12, 15 and 18 percent.
S&P Teams With AFE On Index
S&P kicked off December with the
launch of the S&P AFE 40 Index, a
press release said. The benchmark was
developed with the Arab Federation of
Exchanges and draws its components
from the AFE’s member exchanges.
The index’s 40 holdings can be
selected from Bahrain, Egypt, Jordan,
Kuwait, Lebanon, Morocco, Oman,
Palestine, Qatar, Saudi Arabia,
Tunisia and the United Arab Emirates.
Generally, they are selected based on
market capitalization, but components
must meet a minimum value
traded threshold. Also, no single
country can be represented by more
than 10 stocks, and each country in
the AFE must be represented by at
least one stock, the press release said.
Individual countries are capped at
a weight of 35 percent, with individual
stocks capped at 10 percent. Shortly
before launch, the largest three countries
in the index included Kuwait,
Qatar and Saudi Arabia, according to
the press release.
Russell And Axioma Add
To Index Series
In early November, Russell Investments
and Axioma Inc. announced
the addition of five new benchmarks
to the factor-based index family jointly
developed by the two companies.
All of the new benchmarks are subsets
of the Russell Developed ex-U.S.
Large Cap Index.
The series is designed to offer
exposure to individual risk factors—beta,
volatility and momentum—according
to the press release.
Originally the series consisted of
U.S.-focused indexes, but the new
indexes provide exposure to non-
U.S. developed markets.
The additions to the Russell-
Axioma index roster include:
• Russell-Axioma Developed ex-U.S.
Large Cap Low Volatility Index
• Russell-Axioma Developed ex-U.S.
Low Beta Index
• Russell-Axioma Developed ex-U.S.
High Momentum Index
• Russell-Axioma Developed ex-U.S
High Volatility Index
• Russell-Axioma Developed ex-U.S.
High Beta Index
NYSE Euronext, Bloomberg
Launch Clean Energy Indexes
In late November, NYSE Euronext
and Bloomberg New Energy Finance
rolled out the first members of a new
family of clean energy indexes, a press
release said. The main indexes target
geographic regions and include
the NYSE-BNEF Asia Oceania Clean
Energy Index, the NYSE-BNEF Europe,
Middle East and Africa Clean Energy
Index and the NYSE-BNEF Americas
Clean Energy Index.
According to the press release,
each of the three indexes covers from
125 to 325 companies that have business
operations in the area of clean
energy. Components are drawn from
a universe of more than 1,000 such
companies, which are evaluated by
Bloomberg analysts and derive at least
10 percent of their business from clean
energy activities.
Additional indexes are expected to
launch in the coming months and will
cover industry- and activity-focused
subsets of the clean energy space, such
as solar, wind, energy efficiency and
electric vehicles, the press release said.
AROUND THE WORLD OF ETFS
Van Eck Repackages 6 HOLDRS
Dec. 21 saw the debut of six Market
Vectors sector ETFs from Van Eck—
however, the products themselves
are not exactly brand new. Just the
day before, their existing assets were
invested in Merrill Lynch HOLDRs,
trading under the same tickers and
with similar sector focuses. Merrill
Lynch, meanwhile, has shut down its
entire line of HOLDRS, which were
similar to traditional exchange-traded
funds but have static portfolios. Van
Eck transformed some of the most successful
HOLDRS into regular ETFs tied
to indexes. The new funds include:
• Market Vectors Biotech ETF
(NYSE Arca: BBH)
• Market Vectors Bank and Brokerage
ETF (NYSE Arca: RKH)
• Market Vectors Oil Services ETF
(NYSE Arca: OIH)
• Market Vectors Pharmaceutical ETF
(NYSE Arca: PPH)
• Market Vectors Retail ETF
(NYSE Arca: RTH)
• Market Vectors Semiconductor ETF
(NYSE Arca: SMH)
Each charges a net expense ratio of
0.35 percent.
iShares Debuts Regional EM ETFs
In January, BlackRock’s iShares
unit unveiled two new regional
emerging markets ETFs. The iShares
MSCI Emerging Markets Latin
America (NasdaqGM: EEML) and
the iShares MSCI Emerging Markets
EMEA Index Fund (NasdaqGM:
EEME). Both track MSCI indexes and
have primary listings on Nasdaq.
While EEME tracks an index
that covers companies in the Czech
Republic, Egypt, Hungary, Morocco,
Poland, Russia, South Africa and
www.journalofindexes.com March / April 2012 53

News
Turkey, EEML mimics an index that
includes issues from Brazil, Chile,
Colombia, Mexico and Peru.
Both funds come with annual
expense ratios of 0.49 percent.
Vanguard Slashes
Sector Fund Fees
A recent move to slash the fees on its
sector funds has resulted in Vanguard
undercutting the fees on most of the
competing SPDR ETFs from State
Street Global Advisors. The fees on
each of the following funds have been
reduced to 0.19 percent, which is one
basis point less than the fee charged by
the Select Sector SPDRs:
• Vanguard Consumer Discretionary
ETF (NYSE Arca: VCR)
• Vanguard Consumer Staples ETF
(NYSE Arca: VDC)
• Vanguard Energy ETF
(NYSE Arca: VDE)
• Vanguard Health Care ETF
(NYSE Arca: VHT)
• Vanguard Industrials ETF
(NYSE Arca: VIS)
• Vanguard Information Technology
ETF (NYSE Arca: VGT)
• Vanguard Materials ETF
(NYSE Arca: VAW)
• Vanguard Telecommunication
Services ETF (NYSE Arca: VOX)
• Vanguard Utilities ETF
(NYSE Arca: VPU)
The Vanguard Financials ETF (NYSE
Arca: VFH), meanwhile, has seen its
price cut to 0.23 percent from 0.27 percent.
That’s still more expensive than
the SPDR Financials Select Sector ETF.
Global X Launches Greece ETF
In early December, Global X Funds
launched the market’s first ETF that
focuses solely on Greece.
The Global X FTSE Greece 20 ETF
(NYSE Arca: GREK) tracks the FTSE/
ATHEX 20 Capped Index, which
consists of the top 20 companies by
market capitalization listed on the
Athens Exchange. The fund costs a net
expense ratio of 0.69 percent.
Prior to the launch of GREK, investors
looking to tap into Greek equities
could only do so via broader
European-focused ETFs such as the
iShares S&P Europe 350 (NYSE Arca:
IEV) or the $6.8 billion Vanguard MSCI
European ETF (NYSE Arca: VGK). But
these funds’ allocation to Greece is
minimal, if not negligible.
Direxion Debuts
Insider Sentiment Funds
Direxion rolled out the Direxion
Large Cap Insider Sentiment Shares
(NYSE Arca: INSD) and the Direxion
All Cap Insider Sentiment (NYSE Arca:
KNOW) in early December. The funds
track indexes from Sabrient that are
screened subsets of the S&P 500 and
S&P 1500 indexes, respectively, and are
designed to select the companies with
the most positive insider sentiment.
Each fund’s underlying index contains
100 stocks selected from the
parent benchmark based on public
company filings and increases in
holdings by company insiders, as
well as positive earnings analyses.
The indexes are “quant weighted,”
with the top 50 holdings weighted
exponentially and the bottom 50
holdings equally weighted.
Both of the funds charge an annual
expense ratio of 0.69 percent; however,
Direxion is waiving 4 basis points
of that fee through Dec. 1, 2012.
PowerShares Rolls Out
Int’l Low-Volatility ETFs
In mid-January, PowerShares
debuted two more low-volatility
ETFs that join its highly successful
PowerShares S&P 500 Low Volatility
Portfolio ETF (NYSE Arca: SPLV); the
new products target foreign stocks.
The PowerShares S&P Emerging
Markets Low Volatility Portfolio
(NYSE Arca: EELV) and PowerShares
S&P International Developed Low
Volatility Portfolio (NYSE Arca: IDLV)
track indexes derived from broader
benchmarks that have been screened
to exclude high-volatility components.
EELV tracks a low-volatility
version of the S&P Emerging BMI Plus
Large Mid Cap Index, while IDLV is
tied to a screened version of the S&P
Developed ex. US and South Korea
Large Mid Cap BMI Index.
PowerShares has applied a fee
waiver to the expense ratio, and both
funds will charge net expense ratios
of 0.25 percent through April 20, 2013.
SSgA Launches
Small-Cap EM Asia SPDR
State Street Global Advisors rolled
out a small-cap version of its broader
SPDR S&P Emerging Asia Pacific ETF
(NYSE Arca: GMFS) in January. The
SPDR S&P Small Cap Emerging Asia
Pacific ETF (NYSE Arca: GMFS) charges
an expense ratio of 0.65 percent,
versus GMFS’ price tag of 0.59 percent.
The new fund uses a sampling
strategy to track the S&P Asia Pacific
Emerging Under USD 2 Billion Index,
which has roughly 1,300 components.
Countries are eligible for inclusion
in the index if they are classified as
developing or as emerging. Country
classification is renewed annually,
according to the fund’s prospectus.
Fidelity Files For
Dramatic ETF Expansion
Financial services giant Fidelity
Investments filed papers with the
Securities and Exchange Commission
on Dec. 1, laying the groundwork for
the company to expand its limited presence
in the world of ETFs. The compa-
54 March / April 2012

ny launched its only ETF, the Fidelity
Nasdaq Composite Index Tracking ETF
(NYSE Arca: ONEQ), in 2003.
Fidelity is now seeking to offer
equity and fixed-income ETFs, covering
U.S. as well as international
markets. The filing it submitted to the
SEC only contemplates index-based
investments, although it is broad
enough to permit 130/30 funds and
other long/short products.
In an interesting twist, the filing
asks for permission to create a “master-feeder”
structure, whereby ETFs
would invest solely in a “master fund”
portfolio. That portfolio, in turn, could
serve as the basis for other ETFs as
well as other investment vehicles,
such as traditional mutual funds.
ETF Securities Up For Sale
ETF Securities, the firm known for
its heavy presence in the world of
precious metals, is up for sale and
has retained Goldman Sachs to solicit
bids, according to a report in the
Financial Times. The report cites an
asking price of around $1.6 billion.
The company, headed by Graham
Tuckwell, had assets of $28.2 billion
at the end of November. Almost twothirds
of that is in precious metals
products. Its U.S.-based assets were
almost $4 billion as of Dec. 2, according
to data compiled by IndexUniverse.
BACK TO THE FUTURES
NYSE Liffe US
Launches Repo Futures
NYSE Liffe U.S. kicked off 2012 with a
press release detailing its plans to launch
futures contracts on the DTCC GCF
Repo Index early in the year. The futures
exchange has exclusive rights to use the
benchmark to underlie futures contracts.
The underlying index is calculated
by the Depository Trust and Clearing
Corporation and covers the general
collateral finance market. Repos are
generally very-short-term loans involving
the sale and repurchase of government-
or agency-backed securities; the
DTCC GCF Repo Index tracks the interest
rate associated with these transactions,
the press release said.
CME Group Sees
Volume Increase In 2011
CME Group saw its overall average
daily volume increase in 2011, despite
a decrease in the fourth quarter.
The exchange group’s average daily
volume for the year was 13.4 million
contracts, a 10 percent increase from
the prior year’s average of 12.2 million
contracts, according to a press release.
Equity index contracts helped boost
volumes, with an 11 percent increase
in average daily volume.
Volume for the entire year was
up 11.7 percent on the group’s most
actively traded index futures contract,
the e-mini S&P 500, according
to CME Group data; however, volumes
were down on the exchange’s
two other most highly traded index
futures contracts: The Mini $5 Dow
contract saw its total volume for 2011
fall 4.6 percent from 2010, while the
e-mini Nasdaq-100 contract volume
was down 5.6 percent.
Interestingly, although the
exchange saw its average daily volume
in the fourth quarter fall by 2
percent, equity index contracts saw
their average daily volumes increase
by an impressive 24 percent, the
press release said.
KNOW YOUR OPTIONS
CBOE Options
Volumes Up In 2011
CBOE Holdings’ average daily
options volume grew by 8 percent
from 4.44 million contracts in 2010
to 4.78 million contracts in 2011, the
company said in a press release.
Index options saw their average
daily volume grow by 10 percent
during the year, while the average
daily volume for options on ETFs
grew by 21 percent. The two groups
combined represented approximately
59 percent of the exchange’s
total average daily volume.
CBOE To Trade Volatility
Options Based On EM ETF
A press release from the Chicago
Board Options Exchange said it
would list options on the CBOE
Emerging Markets ETF Volatility
Index on Jan. 31.
The underlying index applies the
methodology of the CBOE Volatility
Index to the iShares MSCI Emerging
Markets Index Fund (NYSE Arca:
EEM), the press release said. The
CBOE has listed similar options products
based on the SPDR Gold Shares
(NYSE Arca: GLD), the United States
Oil Fund (NYSE Arca: USO) and the
iShares FTSE China 25 Index Fund
(NYSE Arca: FXI), among other large
and widely traded ETFs.
Earlier in January, the CBOE
Futures Exchange launched futures
contracts on the same index.
ON THE MOVE
Russell Hires Gallucci
For Sales Role
In early December, Russell
Investments announced in a press
release the addition of Michael
Gallucci to its indexes team in the role
of regional director for U.S. structured
products and sell-side firms.
Gallucci joined Russell after 16years
at Standard & Poor’s, where he held
several sales positions. He was the
senior sales director for S&P’s index
group when he left the company, the
press release said.
In his current role, Gallucci operates
out of Russell’s New York offices,
reporting to Mark Sutter, who heads
up Russell Indexes’ U.S. sales efforts,
the release noted.
Fuhr Not Joining BofA After All
A January announcement from
Bank of America Merrill Lynch indicated
that Deborah Fuhr, formerly the
head of ETF research at BlackRock,
won’t be joining BofA after all. She
had been slated to take over its Delta
One equity derivatives business, a
move that had been discussed since
her departure from BlackRock in July.
The company said that due to
organizational changes, the position
Fuhr was to hold no longer
exists. It is not yet clear if BofA is
exiting or scaling back its involvement
in Delta One trading.
www.journalofindexes.com March / April 2012
55

Russell continued from page 47
native index approaches through broad-based education
programs. Confusion about these new products in the marketplace
should concern us as businesspeople. By banding
together as an industry to provide an educating force, we
can make a difference going forward.
I believe we can do more as an industry to provide better
education and context around index-based products and
investing strategies. Index providers must deliver transparent,
straightforward information on our index products and
how they are constructed so financial advisors and consumers
can better understand how they work. Information
on index products, methodology, composition and performance
must be readily available to consumers online.
And this information must be accompanied by education
and context. Indexes are tools, and the strategic decision is
always with the end-investor, but we should provide more
context on how institutional and retail investors, plan sponsors
and financial advisors can best use these tools.
Another way to advance an educational agenda is through
an index industry trade body, which is currently being considered
by major industry players. This will provide a more
powerful industry platform to create client-friendly initiatives
and develop broad-based educational campaigns on
various aspects of the index world. By banding together as
an industry, we can show a unified commitment to consistent
standards and work to build more education and
awareness on a number of important issues.
A good starting place may be to develop education programs
for financial advisors and investors. These programs
can explain new types of alternative index strategies, providing
perspective on various approaches such as factor
indexes, equal weight, fundamental, investment discipline
and various index-related topics such as optimization and
rebalancing, and how to evaluate whether an index-based
John Bogle taught us that there is always a better way to approach
investing and the markets. By making it possible for individuals to invest
in an index, he unleashed a democratizing force within the market.
approach makes sense for you or your client.
John Bogle taught us that there is always a better way to
approach investing and the markets. By making it possible
for individuals to invest in an index, he unleashed a democratizing
force within the market. “Bogle’s folly” accelerated
the widespread acceptance of the indexing approach, and
consumers have greatly benefited as a result. While Bogle
and others feel that the industry may have gone too far, as
indexes have gone beyond market-capitalization approaches
to investment style and other alternative beta approaches,
I believe we have just begun our journey.
Announcing the new
ETF Education Center
Reading
Qualifies for 1 hour of CFP CE Credit
Visit the ETF Education Center at:
www.indexuniverse.com/education
56
March / April 2012

Global Index Data
www.journalofindexes.com March / April 2012
57

Index Funds
58
March / April 2012

Morningstar U.S. Style Overview Jan. 1 - Dec. 31, 2011
Trailing Returns %
3-Month YTD 1-Yr 3-Yr 5-Yr 10-Yr
Morningstar Indexes
US Market 3.52 1.58 1.58 15.09 0.33 3.65
Large Cap 4.16 2.61 2.61 13.25 –0.24 2.49
Mid Cap 1.41 –0.81 –0.81 19.89 1.54 6.55
Small Cap 2.77 –2.57 –2.57 19.90 1.81 6.73
US Value 4.49 0.92 0.92 11.57 –2.65 4.35
US Core 4.77 2.67 2.67 14.73 1.46 4.38
US Growth 1.18 0.74 0.74 19.06 1.95 1.59
Morningstar Market Barometer YTD Return %
Large Cap
US Market
1.58
2.61
Value
0.92
Core
2.67
Growth
0.74
2.23 3.40 1.56
Large Value 4.92 2.23 2.23 9.31 –3.64 3.18
Large Core 5.25 3.40 3.40 12.39 1.10 3.22
Large Growth 2.13 1.56 1.56 18.32 1.57 0.33
Mid Cap
–0.81
–2.60 2.22 –2.29
Mid Value 2.64 –2.60 –2.60 16.93 –0.66 6.90
Mid Core 4.33 2.22 2.22 21.58 2.32 7.43
Mid Growth –2.78 –2.29 –2.29 21.03 2.64 4.71
Small Cap
–2.57
–1.84 –4.74 –1.04
Small Value 5.53 –1.84 –1.84 20.17 1.71 8.81
Small Core 0.49 –4.74 –4.74 19.42 0.54 7.19
Small Growth 2.53 –1.04 –1.04 20.00 2.88 3.91
–8.00 –4.00 0.00 +4.00 +8.00
Sector Index YTD Return %
Utilities 18.46
Consumer 13.39
Industry Leaders & Laggards YTD Return %
Oil & Gas Midstream 41.23
Tobacco 36.18
Biggest Influence on Style Index Performance
Best Performing Index
YTD
Return %
Large Core 3.40
Constituent
Weight %
Healthcare 11.90
Real Estate 6.94
Energy 5.05
Consumer Cyclical 4.06
Communication 0.64
–0.38 Technology
–0.71 Industrials
–14.12 Basic Materials
–16.51 Financial Services
Broadcasting - TV 35.11
Credit Services 34.74
Restaurants 32.53
Industrial Distribution 30.89
–36.82 Copper
–37.45 Auto Manufacturers
–38.05 Capital Markets
–41.75 Aluminum
–48.94 Coal
–72.40 Solar
International Business Machines Corp. 27.42 4.99
Philip Morris International Inc. 39.75 2.94
McDonald's Corp. 34.66 2.24
Intel Corp. 19.33 3.20
Bristol-Myers Squibb Co. 39.43 1.24
Worst Performing Index
Small Core –4.74
Hecla Mining Co. –53.41 0.95
WMS Industries Inc. –54.64 0.87
Triquint Semiconductor Inc. –58.34 0.60
OmniVision Technologies Inc. –58.68 0.52
Veeco Instruments Inc. –51.58 0.57
1-Year
3-Year
5-Year
Value
Core
Growth
Value
Core
Growth
Value
Core
Growth
Large Cap
2.23
3.40
1.56
Large Cap
9.31
12.39
18.32
Large Cap
–3.64
1.10
1.57
Mid Cap
–2.60
2.22 –2.29
Mid Cap
16.93
21.58 21.03
Mid Cap
–0.66
2.32 2.64
Small Cap
–1.84
–4.74 –1.04
Small Cap
20.17
19.42 20.00
Small Cap
1.71
0.54 2.88
–20 –10 0 +10 +20
–20 –10 0 +10 +20
–20 –10 0 +10 +20
Source: Morningstar. Data as of Dec. 31, 2011
Source: Morningstar. Data as of 2/29/08
Notes and Disclaimer: ©2011 Morningstar, Inc. All Rights Reserved. Unless otherwise noted, all data is as of most recent month end. Multi-year returns are annualized. NA: Not Available. Biggest Influence on Index Performance lists
are calculated by multiplying stock returns for the period by their respective weights in the index as of the start of the period. Sector and Industry Indexes are based on Morningstar's proprietary sector classifications. The information ?
contained herein is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.
www.journalofindexes.com
March / April 2012
59

Dow Jones U.S. Industry Review
Performance
Index Name Weight 1-Month 3-Month YTD 1-Year 3-Year 5-Year 10-Year
Dow Jones U.S. Index 100.00% 0.82% 11.96% 1.34% 1.34% 15.04% 0.28% 3.59%
Dow Jones U.S. Basic Materials Index 3.39% -3.56% 15.17% -14.72% -14.72% 22.97% 3.97% 7.75%
Dow Jones U.S. Consumer Goods Index 10.99% 1.46% 9.85% 8.80% 8.80% 17.21% 5.59% 7.49%
Dow Jones U.S. Consumer Services Index 12.32% 1.45% 12.06% 7.14% 7.14% 21.01% 2.62% 3.41%
Dow Jones U.S. Financials Index 15.02% 2.34% 12.06% -12.84% -12.84% 4.78% -14.02% -2.39%
Dow Jones U.S. Health Care Index 11.15% 2.95% 10.09% 11.75% 11.75% 12.44% 3.52% 3.13%
Dow Jones U.S. Industrials Index 12.46% 0.58% 16.51% -0.79% -0.79% 16.38% 1.59% 4.15%
Dow Jones U.S. Oil & Gas Index 11.44% -1.23% 18.17% 4.11% 4.11% 13.48% 4.82% 11.61%
Dow Jones U.S. Technology Index 16.22% -1.32% 8.24% 0.16% 0.16% 22.86% 4.16% 2.77%
Dow Jones U.S. Telecommunications Index 2.86% 3.68% 7.40% 3.97% 3.97% 10.38% -0.15% 0.84%
Dow Jones U.S. Utilities Index 4.14% 3.23% 9.07% 19.15% 19.15% 13.08% 3.50% 7.33%
Risk-Return
25%
Technology
Basic Materials
3-Year Annualized Return
20%
15%
10%
5%
Consumer Goods
Utilities
Health Care
Telecommunications
Composite
Consumer Services
Oil & Gas
Industrials
Financials
0%
10% 15% 20% 25% 30% 35%
3-Year Annualized Risk
Industry Weights Relative to Global ex-U.S.
Asset Class Performance
Basic Materials
-8.18%
U.S. [152.26] Global ex-U.S. [136.51] Commodities [120.42]
REITs [179.93] Infrastructure [171.72]
Consumer Goods
-2.59%
200
Consumer Services
4.49%
180
Financials
-7.26%
160
Health Care
4.57%
140
Industrials
-0.46%
120
Oil & Gas
0.47%
100
Technology
11.32%
80
Telecommunications
-2.46%
60
Utilities
0.08%
40
-15% -10% -5% 0% 5% 10% 15%
Underweight Overweight
20
12/08 3/09 6/09 9/09 12/09 3/10 6/10 9/10 12/10 3/11 6/11 9/11 12/11
Chart compares industry weights within the Dow Jones U.S. Index to industry weights within the Dow Jones U.S. = Dow Jones U.S. Index | Global ex-U.S. = Dow Jones Global ex-U.S. Index
Global ex-U.S. Index
Commodities = Dow Jones-UBS Commodity Index | REITs = Dow Jones U.S. Select REIT Index
Infrastructure = Dow Jones Brookfield Global Infrastructure Index
© CME Group Index Services LLC 2012. All rights reserved. The "Dow Jones U.S. Index" and "Dow Jones U.S. Industry Indexes" referenced in this piece are products of Dow Jones Indexes, the marketing name and a licensed trademark of CME Group Index Services LLC (“CME Indexes”). “Dow
Jones®”, “Dow Jones Indexes” and the names identifying the Dow Jones Indexes referenced herein are service marks of Dow Jones Trademark Holdings, LLC (“Dow Jones”), and have been licensed for use by CME Indexes. “CME” is a trademark of Chicago Mercantile Exchange Inc.
The Dow Jones U.S. Index and the Dow Jones U.S. Industry Indexes were first published in February 2000. To the extent this document includes information for the index for the period prior to its initial publication date, such information is back-tested (i.e., calculations of how the index might have
performed during that time period if the index had existed). Any comparisons, assertions and conclusions regarding the performance of the Index during the time period prior to launch will be based on back-testing. Back-tested information is purely hypotheticaland is provided solely for informational
purposes. Back-tested performance does not represent actual performance and should not be interpreted as an indication of actual performance. Past performance is also not indicative of future results.
All information in these materials is provided “as is”. CME Indexes and its affiliates do not make any representationregarding the accuracy or completeness of these materials, the content of which may change without notice, and each of CME Indexes and its affiliates disclaim liability related to these
materials. All information provided by CME Indexes is impersonal and not tailored to the needs of any person, entity or group of persons. Dow Jones, its affiliates and CME Indexes do not sponsor, endorse, sell, promote or manage any investment fund or other vehicle that is offered by third parties
and that seeks to providean investmentreturn based on the returns of any index. CME Indexes is not an investmentadvisor, and CME Indexes makes no representationregarding the advisabilityof investing in any investment fund or other vehicle. Inclusion of a security or instrument in an index is not a
recommendationby Dow Jones, CME Indexes or their affiliates to buy, sell, or hold such security or instrument, nor is it considered to be investmentadvice. Exposure to an asset class is availablethrough investableinstruments based on an index. It is not possible to invest directly in an index. There is
no assurance that investment products based on the index will accurately track index performance or provide positive investment returns.
Data as of December 30, 2011
Source: Dow Jones Indexes Analytics & Research
For more information, please visit the Dow Jones Indexes Web site at www.djindexes.com.
60
March / April 2012

Exchange-Traded Funds Corner
www.journalofindexes.com March / April 2012
61

Dash continued from page 35
of active management, as the examples of large-cap and
small-cap funds in Figures 7a-7c show.
8. Averaging Schemes Matter
Equal-weight averages, where a $10 million fund’s
returns are given as much weight as a $1 billion fund’s
returns, are a good measure of average manager performance.
On the other hand, the average invested dollar’s
performance is better measured through asset-weighted
averages, where the $1 billion fund gets 100 times as
much weight as the $10 million fund. These two averaging
schemes produce different results, which can alter the
conclusion of an index versus active debate. For example,
Figure 8, showing returns of small-cap funds, could be
interpreted as favoring active or passive depending upon
which average is chosen. SPIVA reports both, leaving
investors to draw their own conclusions.
These averages can also be used in a different way to
gauge whether funds with more assets are doing better or
poorly versus funds with small assets. If equal-weight average
returns are higher than asset-weighted averages, then
smaller funds did better than larger funds, and vice versa.
This is a fascinating way to see how the efficiencies of scale
Figure 8
5.0%
4.8%
4.6%
4.4%
4.2%
4.0%
3.8%
Average Small-Cap Fund Returns Over 5 Years
Source: U.S. SPIVA Scorecards dated August 24, 2011
Figure 9
80%
70%
60%
50%
40%
30%
20%
10%
0%
4.26%
Active Small-Cap Funds
(Equal Weighted)
4.62%
S&P SmallCap 600
4.97%
Active Small-Cap Funds
(Asset Weighted)
% Of Funds Beating Benchmarks Over 5 Years
66.7%
EM Debt Funds
Source: U.S. SPIVA Scorecards dated August 24, 2011
76.1%
International Smallcap Funds
Figure 10
Percent Of Funds That Survived And Maintained
The Same Style Over 3 Years
From 6/08
to 6/11
From 6/05
to 6/08
From 6/02
to 6/05
Large-Cap Growth Funds 69 67 58
Large-Cap Blend Funds 70 55 34
Large-Cap Value Funds 70 81 61
Mid-Cap Growth Funds 52 78 60
Mid-Cap Blend Funds 53 66 35
Mid-Cap Value Funds 43 71 49
Small Cap Growth Funds 62 78 60
Small Cap Blend Funds 68 75 42
Small Cap Value Funds 47 79 70
Source: U.S. SPIVA Scorecards dated August 24, 2011, July 15 2005 and November 12, 2008
of larger funds compete versus the nimbleness of smaller
funds. SPIVA shows no consistent pattern to reach any
long-term conclusions, but it is interesting by itself.
9. Active Funds Have Delivered Long-Term
Outperfor-mance In Some Categories
Over short time horizons, a majority of active managers
can, and often do, outperform benchmarks across
all fund categories. However, there are a handful of
categories where SPIVA scorecards demonstrate active
funds doing well versus benchmarks with fairly consistent
regularity over a five-year horizon. These include
emerging market debt and international small-caps. I
have not been able to conclusively ascertain whether
this is because of the relative inefficiency of these markets;
issues with benchmarking; or higher cross-sectional
dispersion that presents more active opportunities that
are capitalized. But the fact remains that there are some
categories in which a majority of active managers have
delivered long-term outperformance. (See Figure 9.)
10. Style-Box Investing May Not Always Work
Because Of Style Inconsistency
The nine-style box is a ubiquitous part of the equity
investing landscape. Very often one finds client portfolios
or plan lineups being allocated across style boxes,
with manager searches being commissioned to fill those
style-box allocations. The underlying assumption behind
this process is that styles stay consistent. In other words,
a small value fund picked for its performance in its peer
group today stays a small value fund over the course of the
investment horizon. However, SPIVA scorecards show that
over a three-year horizon, only half to three-quarters of
funds survive and stay in their original style box. There is
nothing wrong in creeping across style boxes in search of
investment opportunities, and in fact, there is a growing
school of thought that advocates style-box-unconstrained
investing, but such style creeps do not work well with a
style-box-driven asset allocation model. (See Figure 10.)
62
March / April 2012

Philips continued from page 45
Figure 12
Percentage Of Managers Outperforming Market
During Bull And Bear Cycles
U.S. funds vs. Dow Jones U.S. Total Stock Market Index
80%
70%
60%
50%
40%
30%
20%
10%
0%
Jan. 1971 - Dec. 1972
Jan. 1973 - Sep. 1974
Oct. 1974 - Nov. 1980
Dec. 1980 - Jul. 1982
Aug. 1982 - Aug. 1987
Sep. 1987 - Nov. 1987
Dec. 1987 - May 1990
■ Bull Market
Sources: Vanguard calculations, using data from Morningstar, Inc., and Dow Jones
market corrections occurring between Aug. 31, 1978 and
Oct. 11, 1990. For example, the average loss for the S&P
in these episodes was 15.1 percent, versus a 17.0 percent
average loss for large-cap growth funds.
Another common misconception about equity index
funds is that their managers will be forced to sell fund holdings,
and thus realize substantial capital gains, because
of investors’ increased redemptions during bear markets.
There are two errors in this argument. The first error
assumes that market downturns necessarily cause money
Jun. 1990 - Oct. 1990
Nov. 1990 - Jun. 1998
Jul. 1998 - Aug. 1998
Sep. 1998 - Aug. 2000
■ Bear Market
Sep. 2000 - Feb. 2003
Mar. 2003 - Oct. 2007
Nov. 2007 - Feb. 2009
Mar. 2009 - Dec. 2011
to flow out of index funds. Net cash flows for broad equity
index funds in aggregate actually remained positive during
the 2000-2002 bear market. According to the Investment
Company Institute, from 2000 through 2002, over $62
billion in new cash flow went into equity index funds.
Similarly, in 2008, $31 billion went into equity index funds.
The second error in this myth is that embedded capital gains
distributions for equity index mutual funds (expressed as a
percentage of their average net asset values) decreased during
the 2000–2002 bear market in lock step with the market decline.
Because cash flows of equity index funds have been largely
positive over time, index fund managers purchase stocks
across a wide range of prices. When redemptions result in
net cash outflows, the managers can sell cost lots that they
purchased at high prices and realize losses that can then be
stockpiled to offset gains elsewhere in the portfolio.
A well-managed index fund will use its high-cost lots to
accommodate redemption requests. In reality, redemptions
in a bear market can help an index fund to remain
tax efficient, creating losses, not gains, for tax purposes.
Conclusion
Since its beginnings in the early 1970s, indexing has
grown rapidly because it provides a simplified, efficient
investment vehicle with the potential to increase shareholder
wealth across a broad range of asset classes and
subasset classes. Primarily because of their low-cost
structure, indexed investments have generally offered
long-term outperformance relative to a majority of actively
managed funds. In fact, if broadly diversified active
funds were able to minimize fees and turnover on a par
with index funds, much of the indexing advantage would
be eliminated. The reality of active management, however,
is that costs are generally higher, giving index funds
a significant head start in relative performance.
References
“Active Equity Management: Examining the Differences Between Fundamental and Quantitative Strategies,” 2007. Valley Forge, Pa.: The Vanguard Group.
Barber, Brad M., and Terrance Odean, 1999. “The Courage of Misguided Convictions: The Trading Behavior of Individual Investors.” Financial Analysts Journal 55(6): 41–55.
Baron, Jonathan, 2000. “Thinking and Deciding.” New York: Cambridge University Press.
Bergstresser, Daniel, and James Poterba, 2002. “Do After-Tax Returns Affect Mutual Fund Inflows?” Journal of Financial Economics 63: 381–414.
Ennis, Richard M., and Michael D. Sebastian, 2002. “The Small-Cap Alpha Myth.” Journal of Portfolio Management 28(3): 11–16.
Evans, Richard E., and Burton G. Malkiel, 1999. “Earn More (Sleep Better): The Index Fund Solution.” New York: Simon & Schuster.
Financial Research Corporation, 2002. “Predicting Mutual Fund Performance II: After the Bear.” Boston: Financial Research Corporation.
Investment Company Institute, 2001. “Frequently Asked Questions About Shareholder Response to Market Volatility.” Washington, D.C.: Investment Company Institute,
Sept. 18; http://www.ici.org.
Investment Company Institute, 2010. “2010 Investment Company Factbook,” 50th ed. Washington, D.C.: Investment Company Institute.
Malkiel, Burton G., 2004. “Can Predictable Patterns in Market Returns Be Exploited Using Real Money?” Journal of Portfolio Management (30th Anniversary Issue): 131– 41.
Malkiel, Burton G., 1995. “Returns From Investing in Equity Mutual Funds,” 1971 to 1991. Journal of Finance 50 (2, June): 549–72.
Malkiel, Burton G., and Aleksander Radisich, 2001. “The Growth of Index Funds and the Pricing of Equity Securities.” Journal of Portfolio Management 27(2): 9–21.
Philips, Christopher B., 2010a. “The Case for Indexing: European and Offshore-Domiciled Funds.” Valley Forge, Pa.: The Vanguard Group.
Philips, Christopher B., 2010b. “Determining the Appropriate Benchmark: A Review of Major Market Indexes.” Valley Forge, Pa.: The Vanguard Group.
Philips, Christopher B., and Francis M. Kinniry Jr., 2009. “The Active-Passive Debate: Market Cyclicality and Leadership Volatility.” Valley Forge, Pa.: The Vanguard Group.
Sauter, Gus, 2002. “Index Rex: The Ideal Index Construction.” Journal of Indexes, 2d. quarter; http:// www.journalofindexes.com/contents.php?id=12.
Sharpe, William F., 1991. “The Arithmetic of Active Management.” Financial Analysts Journal 47(1): 7–9.
Waring, M. Barton, and Laurence B. Siegel, 2005. “Debunking Some Myths of Active Management.” Journal of Investing (Summer): 20–28.
Endnotes
1. Source for index fund and industry assets: Investment Company Institute (2010).
2. For more on management styles, see Active Equity Management (2007).
3. Dollar weighting gives proportional weight to each holding, based on its market capitalization. Compared to equal weighting, which helps ensure against any one fund
dominating the results but also implicitly makes relatively large bets on smaller constituents, dollar weighting more accurately reflects the aggregate equity and bond markets.
4. In this context, “market impact” refers to the effect of a market participant’s actions—that is, buying or selling—on a stock’s price.
5. For example, if we reduce the market return by 0.10 percent annually to approximate the total costs of a broad-market index fund or ETF, the percentages in Figure 2
do not change meaningfully.
6. As cited in Evans and Malkiel (1999).
63
March / April 2012

Test Your Skills
A True Industry Vanguard
ACROSS
1 2 3 4 5 6 7
How much do you
know about the
origins of index-based
investing?
By Bruce Greig
1. Proponent of the
efficient market
hypothesis, and
major influence on
37 across
10. ___ drop of a hat
11. Investment fund
viewed skeptically
by 37 across
12. One of the “Greeks”
in options trading
13. Pioneer cell phone co.
14. Not a liability
17. Accord maker
19. Grove, ex-CEO
of Intel
21. Type of “equity”
23. Chart often used
to show asset
percentages
24. It was spent in Athens
26. Money-back deal
28. Sharpe, P/E or
dividend yield
30. Shell alternative
33. Unit of markettraded
shares
34. Bring together
36. Oft-traded beans
37. Puzzle’s theme,
John ___
38. First American to win
Economics Nobel
Prize, and major
influence of 37 across
DOWN
2. Bull market chart
pattern
8 9
10 11 12
13 14 15 16 17 18
19 20 21 22
23
24 25 26 27
28 29 30 31 32 33
34 35 36 37
38
3. See 12 across
4. Necessities
5. Justice Dept. division
6. Retirement plan for the
self-employed
7. Chicago-to-Pittsburgh
direction (abbr.)
8. Investment company
founded by 37 across
9. 37 across prefers it to
be low
15. Spotted
16. Old-time Wall Street
machine
18. Magic and Wizards org.
20. Biblical verb ending
22. NY Exchange for trading
Russell index futures
23. One source of oil
25. One-time competitor of
13 across
26. Financial ratio, similar to
rate of return
27. Fast, in music
29. Investor’s Business
Daily founder, William ___
31. Louisiana waterway
32. Motown, Atlantic or
Columbia
35. Retirement vehicle
championed by 37 across
36. Loan-granting Fed.
agency
Solution
Across: 1. Burton Malkiel; 10. At the; 11. ETF; 12. Omega; 13. GTE; 14. Asset; 17. Honda; 19. Andrew;
21. Private; 23. Pie; 24. Drachma; 26. Rebate; 28. Ratio; 30. Mobil; 33. Lot; 34. Unite; 36. Soy; 37. Bogle;
38. Paul Samuelson
Down: 2. Uptrend; 3. Theta; 4. Needs; 5. ATF; 6. Keogh; 7. ESE; 8. Vanguard Group; 9. Management fee;
15. Saw; 16. Tape; 18. NBA; 20. Eth; 22. ICE; 23. Palm; 25. AT&T; 26. ROI; 27. Allegro; 29. O’Neil; 31. Bayou;
32. Label; 35. IRA; 36. SBA
64
March / April 2012

Go in with an
exit strategy.
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