Acquired
01:16:15 · David Rosenthal, Ben Gilbert
[01:16:15] S1: funny. Anyway, so, yeah, a couple people had tried to make this idea work on the institutional side before. Most prominently, the pension management division of Wells Fargo, so, like, the division of Wells Fargo that would manage and administer pensions for large corporations. They had actually created an index fund for the pension fund of the Samsonite Luggage Corporation a few years earlier. Amazing. Incredible. But it had failed. They couldn't make it work because, actually, this was a deceptively hard problem. In order to do this, to create a fund that continuously tracked something like the S and P 500 index, you needed a lot of software. You had to have automation. Humans could not do this. [01:17:10] S0: Right. The point of the S and P 500 is to create a subset of the total market that has essentially the same returns but with a smaller set of companies. So you don't need the thousands of companies. You just need this 500. But even setting up the systems to track 500 companies' movements day to day, sophisticated. Yeah. The other thing that makes it challenging is it's kind of expensive to buy, especially in whole share denominated amounts, a representative correctly weighted set of the entire S and P 500. Today, the minimum quantity of dollars you would need to do it on your own without buying into a fund is about 3 and a half million dollars to the sort of minimum efficient or or minimum representative S and P 500.
01:17:10 · Ben Gilbert, David Rosenthal
[01:17:10] S0: Right. The point of the S and P 500 is to create a subset of the total market that has essentially the same returns but with a smaller set of companies. So you don't need the thousands of companies. You just need this 500. But even setting up the systems to track 500 companies' movements day to day, sophisticated. Yeah. The other thing that makes it challenging is it's kind of expensive to buy, especially in whole share denominated amounts, a representative correctly weighted set of the entire S and P 500. Today, the minimum quantity of dollars you would need to do it on your own without buying into a fund is about 3 and a half million dollars to the sort of minimum efficient or or minimum representative S and P 500. [01:17:57] S1: So couple years after this, along come Jack and Vanguard in this unique moment where they they need something to make their model work, and computing and software is, like, just now starting to be capable of handling this. [01:18:14] S0: And Jack is reading the docs very carefully. He's having tight communication with his board of directors, and he realizes he's got a little bit of daylight here. [01:18:25] S1: He's got a loophole. [01:18:26] S0: Yep. Where he can say, I am not actively taking Vanguard and having it offer investment advice in any way here. But what we do wanna do is we wanna create this new fund that will require no investment advisory services, that will purely be this index of the S and P 500, and we can run it under Vanguard, and it's within our mandate. [01:18:50] S1: Yeah. We don't need to involve Wellington.
01:18:50 · David Rosenthal, Ben Gilbert
[01:18:50] S1: Yeah. We don't need to involve Wellington. [01:18:52] S0: His board agrees. Yeah. This is sort of the acid test. He goes, and this is what do you think? Is this what you've given me permission for? And they come back and say, yes. [01:18:59] S1: Yes. As Jack puts it in his memoir, you know, kinda like, you know, rendering a guilty verdict in a legal trial, He and early vanguard there had both the opportunity to commit the crime or, in this case, you know, create the first index fund, but also the motivation to do so because this was the way around this prohibition against active management. [01:19:22] S0: And the thing that Jack was starting to realize, which is the culmination of his senior thesis and the Paul Samuelson article, is that this could actually be very successful. [01:19:32] S1: Yep. [01:19:32] S0: He runs the numbers because he's Jack. The S and P index without the fees beat half the active managers. And over the full decade, it would beat 78% of them. So Jack realized, wait a minute. It's impossible to run an index at zero cost. But at scale, actually, you could approach zero cost. If you just own the S and P, then you could beat three quarters of the other mutual funds in the market. So there really could be something here.
01:19:32 · Ben Gilbert, David Rosenthal
[01:19:32] S0: He runs the numbers because he's Jack. The S and P index without the fees beat half the active managers. And over the full decade, it would beat 78% of them. So Jack realized, wait a minute. It's impossible to run an index at zero cost. But at scale, actually, you could approach zero cost. If you just own the S and P, then you could beat three quarters of the other mutual funds in the market. So there really could be something here. [01:20:01] S1: Yeah. This is a really important subtle point. If you are able to pull this off and just own the average of the market, but do it at significantly lower fees than all of the other managers in the market, you will actually have top tier performance. Because if your fee that you are charging your clients is lower than the average fee of the other managers in the market, well, now that delta between fund returns minus fees is much lower for you. So if you say, great. I'll just take the average, but I'm gonna actually get the average, you will do much better than most other people in the market. [01:20:40] S0: So here's the math to illustrate what a giant difference it is. You might hear, oh, 1% fee. That's that's not so bad. You know? And and at this point, it was actually higher than 1% fee. It was one and a half to two, but let's just say 1%. But that's 1% of the total assets. So if the stock market were to return 7%, but you owe 1% in fees, that's actually one seventh of your gains [01:21:03] S1: Yeah.
01:21:03 · David Rosenthal, Ben Gilbert
[01:21:03] S1: Yeah. [01:21:04] S0: That you are giving up or around 15% of the returns. And so when that happens year after year after year, it really cuts out your returns at the knees. And I did a little spreadsheeting just to check the math on this. If you invested a $100,000 at age 25 and you got 7% market returns for forty years, you'd end up with $1,500,000. But if you paid a 1% management fee along the way each year, that's a 6% annual return. Instead of $1,500,000, you end up with $1,000,000. [01:21:33] S1: Yeah. [01:21:34] S0: That's an extra 50% for your retirement that you could make by not paying 1% in fees each year. I mean, the the long term impact is that people thought Bogle was sort of this zealot for indexing, and he hated active management, but that's not true. He was a zealot for low fees. He always believed that, hey. Active managers might be able to outperform the market. But like Samuelson observed, the durability of that is really, really hard to do and consistently outperform for decades. But what is really obvious is even with just a 1% fee, that's a 15% outperformance that every year you're starting with a disadvantage, and you gotta beat the market by 15% just to break even. [01:22:21] S1: Yeah. [01:22:22] S0: Gosh. I'd I'd rather not have that structural disadvantage. That's the thing that is really Bogle's legacy and what he was obsessed with.
01:22:22 · Ben Gilbert, David Rosenthal
[01:22:22] S0: Gosh. I'd I'd rather not have that structural disadvantage. That's the thing that is really Bogle's legacy and what he was obsessed with. [01:22:29] S1: Yeah. Later in life, Jack would come to, call this the cost matters hypothesis. And to your example there of an extra half $1,000,000 in a retirement account or a college fund or even just a savings account, That's why I said at the top of the show, millions and millions and millions of people completely had their lives changed by this. An extra $500,000 or, you know, whatever base you start with. That's the difference between needing to rely on your kids to support you in retirement and being self sufficient. That's the difference in educational outcomes for your family. That's so important just because of that 1% delta in fees. That's right. Another way to put [01:23:07] S0: it, active managers in aggregate mathematically cannot beat the market after fees. And the in aggregate is doing a lot of lifting there, but that's the point is the market is made up of active managers. They can't all beat themselves. Some will outperform in any given year and justify fees, but the median active manager will underperform by exactly the amount of their fees. [01:23:30] S1: Yes. [01:23:30] S0: And since [01:23:30] S1: you can't [01:23:31] S0: reliably identify the winners in advance, especially when your goal is to stay invested for decades, the expected value of active management with fees as a whole is a negative expected value compared to an index fund without fees.