Challenge to Judgement

In 1974, Paul Samuelson writes an article in the Journal of Portfolio Management titled “Challenge to Judgement.” The article questioned the concept of active management and hinted at the origin of the first index fund. The article is a short read but can be summed up with a quick quote from Paul:

“At the least, some large foundation should set up an in-house portfolio that tracks the S&P 500 Index – if only for the purpose of setting up a naive model against which their in-house gunslingers can measure their prowess.”

Jack Bogle, at the time, was the lead manager at the Wellington Fund. While reading this article, Jack decided the idea was solid and should be advanced. What developed from this article is today a firm called Vanguard, managing over 5 trillion in assets globally!

Recently, I listened to a podcast between AQR co-founder Cliff Asness and Vanguard’s Jack Bogle. Pairing up a titan of active management against the father of passive investing. You would expect to hear bickering back and forth debating who has the best investment strategy for all of mankind. Instead, what we see is a lot of agreement between both Cliff and Jack.

Let’s start with the invention of the index fund. Most people assume index funds were created based upon the theory of the Efficient Market Hypothesis. In a nutshell, EMH assumes markets are efficient and all information is known, therefore earning excess returns above a benchmark is impossible. To put this another way, if the S&P 500 is your benchmark, EMH assumes no managers can beat this benchmark because all information is already priced into a security.

Bogle’s response to creating the index fund actually had nothing to do with the Efficient Market Hypothesis but instead something much simpler. Index funds, per Bogle, were created simply to alleviate the need for cost within a portfolio. Some managers are going to try to outperform the benchmark and will succeed in doing so. While other managers will attempt this same outperformance, only to fail. For every outperforming fund within an industry, there is a corresponding underperforming fund. So why pay for the chance to outperform when you can simply accept the average return for virtually nothing.

Charging more cannot beat an average that’s charging less. – Cliff Asness

Imagine you have $100,000 invested. If the account earned 6% a year for the next 25 years and had no costs or fees, you’d end up with about $430,000.

If, on the other hand, you paid 2% a year in costs, after 25 years you’d only have about $260,000.

A bar chart showing that 2% costs can eat away at money you've saved
Source: Vanguard – Cost’s Eat Away Your Returns

So when evaluating index funds, your expectations need to be set to match exactly what they are intended to do. Your goal when purchasing an index fund is simply receiving an average return of the markets returns over time. Price discovery (aka Active Management) will still exist, and some fund will actually outperform these index every year. The thing we have to focus on is that it probably will not be the same manager outperforming each and every year.

Cliff Asness actually believes we could see the amount of indexing double or even triple as a percentage of the entire stock market. This doesn’t mean active management is going away, but instead, it’s becoming more competitive.

In the past, it was everyone in one giant ring fighting against each other for the best investment returns. Your grandparents invested against every hedge fund manager, portfolio manager, endowment, and pension for their returns.

In the future, however, it may end up being a large portion of the world’s assets indexed to receive the average return. The remaining 15-20% of assets might remain a hyper-competitive active management showdown. Your children, on the other hand, may simply accept average returns. Leaving hedge fund managers, portfolio managers, endowments, and pensions to fight amongst themselves for returns!

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