Befuddled By John Bogle's Advice

2014-04-02

by Eric D. Nelson, CFA

 

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I happened upon a recent interview with Vanguard founder John Bogle this week, which unfortunately repeats a lot of the inconsistencies in his message that I’ve come across lately.  For any other prominent investor, this wouldn’t be a big deal.  But Bogle has achieved a cult-like following that has hundreds of thousands of individual investors hanging on his every word and constructing investment portfolios based on his advice.  What’s our beef and what should you do about it?

 

#1 - Don’t Forget the Risk When “Reaching For Yield”

 

Bogle has long been a supporter of simple mutual funds known as “total market” indexes.  As a matter of fact, in the first line of the interview he repeats that position: “...by indexing, I mean all-market indexing and no trading.”  But that no longer seems to be the case.  

 

Because of record-low interest rates and the yield spread between government bonds and corporate bonds, he now suggests tactically shifting a total market fixed income portfolio exclusively to higher-risk bonds with pure credit exposure.  But that “higher-risk” part is my emphasis, not his.  Because whenever he brings up the idea of reaching for more yield in bonds, it’s couched in terms of higher returns, not higher risk in the pursuit of higher-expected returns.  

 

A discussion of possible write downs or defaults in corporate bonds (especially on the A and BBB rated bonds prominently held in corporate bond funds) is noticeably absent, as is the possibility that those happenings could eliminate any return advantage to riskier bonds.

 

Mentioning the fact that for over 80 years (since 1927), the realized return difference between higher-risk corporate bonds compared to lower-risk government bonds (Ibbotson Long-Term Bond Indexes) hasn’t even been 0.5% per year*?  No mention of that either.

 

And what about the tendency for corporate bonds to perform more poorly when stock markets decline?  In our most recent bear market, 2008, US government bonds earned a whopping +12.4% for the year, the aggregate bond market did +5.2%, but risker corporate bonds actually lost -3.1% (source: Barclay’s Indexes).  I imagine that is something the market-timing bond investor may want to be reminded of before they decide to reach for that extra 0.5% of potential return.

 

#2 - Still Stuck On Total Stock Indexes

 

So while Bogle pounds the table on (riskier) corporate bonds as opposed to the aggregate bond market or more defensive government bonds in what is generally considered the “safe” part of a diversified portfolio, his appetite for risk still doesn’t extend to stocks.  

 

Professor Eugene Fama was awarded a Nobel Prize in Economics for his research into the unique and higher-expected return dimensions of small cap and value stocks, yet Bogle still refuses to give this an ounce of credibility.  When asked about a set of “fundamental index” ETFs, relatively low cost and reasonably diversified indexes that at worst provide a less-than-optimal way to increase one’s exposure to the higher risk and expected-return dimensions of small cap and more value-oriented stocks, he writes them off completely.

 

But why?  Over the same period referenced above for government and corporate bonds, large cap value stocks exceeded the return on a total stock index by over 2% per year.  Same for small cap stocks.  And small value stocks, which combine value and small cap risk in one asset class package, earned over 5% per year more than the total stock index, all according to indexes complied by Fama and Professor Ken French**.  

 

Think that’s a US phenomenon?  The same patterns have existed in non-US developed markets since 1975 and emerging market since 1989.  

 

Think you need highly engineered institutional class mutual funds inspired by Fama to achieve those results?  $1 invested in Vanguard’s own Small Cap Value Index Fund (VISVX) since it’s inception in 1998 has grown to almost $4 vs. barely $2 for the Vanguard Total Stock Index fund (VTSMX).  

 

If taking additional corporate bond risk in pursuit of a few basis points of higher potential returns seems worth it, then certainly “tilting” a stock portfolio towards the higher expected returning dimensions of small cap and value companies seems infinitely more intelligent.  Here, of all places, however, Bogle decides the total market index is infallible.

 

#3 - Don’t Just Stand There, Do Something!

 

Finally, when it comes to the overall portfolio policy, things just get bizarre.  

 

Bogle’s never been a big fan of rebalancing, an almost universally accepted practice among long-term focused investment experts as a way to control portfolio risk.  But after a few years of good stock returns, he suggests that taking a full 15% out of your stock portfolio and replacing it with lower risk and expected return fixed income (but not that low - remember, we’ve been told to abandon total market indexing in fixed income for the added risk of lower-quality corporate bonds).  

 

A dramatic 15% shift goes well beyond rebalancing into the realm of tactical allocation—making sizable portfolio bets in reaction to past events or based on forecasts about the future.  If you know anything about John Bogle, you know he’s always been a devout supporter of “staying the course”.  Tactical portfolio changes are clearly a divergence from this long-held policy, and a dangerous one at that.  Sure, expected stock returns going forward are lower today than they were five years ago, but bond yields still hover around historical lows, and are far from a panacea.  And for what amounts to only a sliver of higher expected returns, lower-quality corporate bonds expose investors to some of the same risks as stocks.

 

If you are confused by John Bogle’s advice of late, we’re with you.  Once considered a compatriot in the battle for support of buy and hold long-term investment policies, he seems to have done an about-face.  

 

What can we learn from these troubling developments?  It’s simple: trust a philosophy, not a person.  We are all human, and can easily be swayed by prevailing market sentiments or the rush of higher potential returns while ignoring or downplaying the higher risks.  Instead of developing an investment portfolio and adhering to a philosophy based on Bogle’s books or interviews, incorporate those aspects of his council that best fit your circumstances into a personal investment policy statement (IPS).  When urges to make changes or follow the crowd present themselves, revisit your IPS and remember that your portfolio is based on your unique goals, objectives, and risk tolerance, not off-the-cuff comments or market-timing calls from prominent industry professionals.  

 

Your plan may not always be the most popular, and at times, your stay-the-course approach might seem completely out of step with the “just do something” crowd.  But more often than not, it will be the most rewarding approach for you.

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Source of data: DFA Returns Program 2.0

 

* 1927-2013 Annualized Returns: Ibbotson Long-Term Corporate Bond Index = +5.9%, Ibbotson Long-Term Government Bond Index = +5.5%

** 1927-2013 Annualized Returns: CRSP 1-10 Total Stock Index = +9.9%, Fama/French US Large Value Research Index = +12.0%, Fama/French US Small Cap Index = +12.1%, Fama/French US Small Value Index = +15.1%

 

Past performance is not a guarantee of future results.   You cannot invest directly in an index.  There are limitations inherent in index performance; it does not reflect trading in actual accounts and may not reflect the impact that economic and market factors may have had on an advisor’s decision-making if the advisor were managing actual client money.  Index returns are hypothetical and for illustrative purposes only.  Indexes performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses.  Servo advisory fees are 0.75% on the first $2M of investable assets, and 0.50% on amounts above $2M.  This content is provided for informational purposes and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.