Acquired
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.
01:23:31 · Ben Gilbert, David Rosenthal
[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. [01:23:45] S1: Yep. So back to 1975, 1976, and Jack and his merry crew And they do indeed call all employees at Vanguard crew members for many, many years because of the ship and the nautical theme, etcetera. It's perfect. Jack assigns one of the first employees, a guy named Jan Twardoski, to go write the software to do this, to create the first retail index fund. He goes off, writes it in the APL programming language on a time sharing computer in Philadelphia. Jack, meanwhile, goes off to Standard and Poor's headquarters and negotiates a licensing fee with them for the rights to use the S and P 500 index as the basis for this first index fund. There's a great story that Jack tells on a podcast interview about this. He was negotiating with whoever the head of the department that ran the 500 was at S and P. And, the guy was, basically, I don't know. Gosh. Should should you be paying us? Should we be paying you? This is gonna be great marketing for us. They eventually land on Vanguard paying S and P $25,000 per year that they sort of pull out of thin air as the transaction value for this, which is absolutely hilarious because now index fund licensing is basically the entire business of indices around the world, and it is extremely high margin.
01:25:12 · Ben Gilbert, David Rosenthal
[01:25:12] S0: I've got the numbers on this. People estimate that Vanguard pays S and P Global something like 3 to $400,000,000 per year and is their single largest licensing client. And the licensing segment of their business as a whole does $1,850,000,000 a year. And to your point, David, that is essentially all profit. Right. I mean, the whole world has agreed the S and P 500 is the standard brand for the market, and so they just get to take a rent of a $1,850,000,000 a year for anybody who wants to make an index fund. [01:25:48] S1: Great work if you can get it. Yep. Vanguard, BlackRock, Fidelity, State Street, all paying them a lot of money. [01:25:55] S0: And it's charged on a basis points of assets under management or AUM It's a management fee. Or trading volume basis. And so it scales depending on how valuable it is to you as a client. [01:26:09] S1: I did not know that. That is so deeply ironic. [01:26:11] S0: And I started looking too. Like, why doesn't Vanguard push their total market one stronger, or why doesn't someone come up with a sort of synthetic thing that looks a lot like the S and P 500 but isn't the S and P 500? Fidelity tried that. There is a 500 stock Fidelity fund that is not quite the S and P 500 or at least doesn't license the name, but people just don't flock to it. People want the standard. [01:26:37] S1: They want the brand. [01:26:38] S0: It's a good business if you can get it.