John Bogle figured that cheap mutual funds, which just mirrored indices with little tracking error, would be a useful vehicle for wealth creation, recalls Devangshu Datta.
Retail investors should pay homage to John Bogle (1929-2019) who passed away recently.
About 45 years ago, Bogle introduced and popularised index funds and thereby revolutionised investing.
Bogle's insights seem simple enough in hindsight.
He built on the Efficient Market Hypothesis.
The EMH states it is hard to outperform consistently, in a market where information dissemination is efficient, and a large number of participants have equal access to info and trading platforms.
Most stock pickers in efficient markets fail to match index returns consistently.
Very few money managers beat indices consistently even three years in a row, and just a handful of stock pickers have beaten indices over longer-term periods.
Another Bogle insight was also simple: In the long run, equities outperform other assets.
By the 1970s, when he launched Vanguard, there was more than enough data to show that the US was an efficient market and US equities had outperformed bonds, gold, etc over 75 years.
Bogle had a well-developed moral compass, which is unusual in the financial services industry.
He figured that cheap mutual funds, which just mirrored indices with little tracking error, would be a useful vehicle for wealth creation.
Vanguard pioneered that model and became the largest global player in that space.
Passive investing -- buy, hold, match the index and pay as little brokerage as possible -- was pooh-poohed by many active players when it was launched.
It took a while to catch on.
But it transformed wealth creation for middle-class folks.
Bogle offered a guesstimate of long-term index returns, using a formula that added historical dividend yield to a long-term compounded annual growth rate (CAGR) of earnings growth and the change (maybe negative) of price-to-earning (PE) over a fairly long period.
For example, the Nifty has a five-year dividend yield of 1.3 per cent.
The five-year compounded earnings per share (EPS) growth rate since Jan 2014 is 3.9 per cent.
The PE change is 7.5 with the index PE rising from 18.5 in Jan 2014 to PE 26 in Jan 2019.
Add up the numbers (7.5+1.3+3.9) and an investor could expect the index to return around 12.8 per cent CAGR over the next five years.
The Nifty has returned 12.9 per cent CAGR since Jan 2014 with 11.6 per cent capital gain and 1.3 per cent dividend yield.
You may note that the returns have come mainly from re-rating of the index, with PE rising by 40 per cent.
The five-year EPS growth rate is pathetic and EPS growth has fallen from a poor 5.9 per cent in 2016, to less than 4 per cent now.
Obviously there will be errors with this "formula".
It isn't rocket science to understand that it just assumes returns will stay roughly within the same ballpark over long periods.
But making this rough estimate allows the investor to compare the assumed return to other assets like debt.
That helps a retail investor, who can, right or wrong, look at her life-cycle and future needs, and make allocations to different assets.
There are a couple of things Bogle followers need to understand about India.
In one way, India is a huge outlier as capital markets go.
It's a large market with easy trading access for many persons.
But a very large number of active Indian funds consistently beat the index returns and have done so for many years.
There are some possible explanations.
One is that the index construction is flawed.
Another, more likely reason, is that India is simply not an efficient market in terms of information dissemination.
Some people have better access to information than others.
However, even with this caveat, index investing is not a bad option in India.
A Nifty index fund or exchange-traded fund gave a return of 11.6 per cent (ex-dividend) in the past five years.
That beats the returns available from debt and it beats gold as well, across the same period.
If markets become more efficient in terms of information dissemination (this is not very likely but it's possible), fewer active stockpickers will outperform.
But the index return should still beat other assets.
Passive investing in low-cost funds, using systematic investment plans may seem like a no-brainer nowadays.
It wasn't, when Bogle started evangelising.
He created more wealth for more people than any other individual in history.
The next time you buy a mutual fund, offer up thanks in his memory.