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'Great Debate': Realist Bogle vs optimist Grant

Why "Wall Street should be thankful," or maybe not

If you have a good story to tell and tell it long enough, you can end up like Vanguard Group founder John C. "Jack" Bogle, once a radical in his business, and now its 85-year-old Establishment figure, one of the few true investment celebrities in America.

And if you can make a career of being consistently contrary, you can aspire to be like Jim Grant, publisher of the Grant's Interest Rate Observer newsletter of stock-picking and monetary policy, who hosted Bogle, amid a conference of Grant fans, in an ornate ballroom at New York's Plaza last week, for a "Great Debate" over how best to manage other people's money.

After an exchange of barbed letters (circulated to clients of Grant fans like Ted Aronson, who manages $25 billion at Philadelphia-based AJO + Partners), Bogle and Grant had pledged to argue whether "the cost of investing is the determining factor in the success of investing." The implication being, as Bogle maintains and Grant questions, that even the brightest securities pickers will in time see their returns regress to the median, as expressed by market indices like the Standard & Poor's 500, but reduced by the fees they pay investment pros, compounded annually.

That proposition has made low-fee index-fund specialist Vanguard the biggest mutual fund company, with $3 trillion in investor assets. Indexing has become so much the orthodox approach that when I posted Grant's objections recently three former Inquirer business columnists rushed to counter-post in Bogle's defense. Which only confirms Grant's first point: that every dominant assumption gets to where it is worth questioning.

"We are each talking our books: Jack and his trillions of dollars, I and my thousands of readers," Grant told his crowd.

Bogle peered out at the bargain-hunting stock-pickers and told them, in his ringing, folksy tones, "I suppose you're the enemy." He speculated about how many of them had quietly opened personal or client accounts in Vanguard index funds. "I don't dare ask for a show of hands," he added. "I know what would happen."

Bogle hit them with data, posted on wall screens: Index funds now account for nearly one-third of institutional and mutual fund stock investments, up from less than a quarter ten years ago. Indexed investments are a "Great Idea," Bogle maintained, comparable to electricity – automobiles -- air conditioning – computers -- the Internet.

That kind of talk makes indexing look like "a fad" – and fads eventually make investors' money disappear, Grant had said in the exchange leading up the debate.

"Is air conditioning a fad? Of course not," Bogle said onstage. "The idea of broad, low-cost portfolio management is not a fad, either."

Bogle didn't fight for every position. He questioned the use of exchange-traded index funds – a fast-growing chunk of Vanguard's business. "They're owned by speculators," he said, using the term for fast-trading owners like the negative epithet it is in the Bogle vocabulary. "They've taken (my idea), tied it in a plastic bag and turned it upside down."

Bogle also admitted he's "still trying to think of what to say" in defense of one of Vanguard's most popular product groups, bond index funds, which (unlike stock funds) can only sample widely-held government and corporate debt instruments; it's impractical to own more than a small percentage of all the bonds there are. And, Bogle noted, Vanguard's biggest bond index fund has only a "Silver" designation, not the top "Gold", from Morningstar Analyst ratings. (Revised) "That means there are 17 better," of 650 rated bond funds, he added.

Against Bogle's data, Grant's arguments leaned toward philosophy.

While the "average investor" might best index, the "accomplished investor" can do better, Grant insisted. Who wants to be held hostage, he asked darkly, by David Blitzer, head of Standard & Poro's stock index company-selection committee, or by Fed chair Janet Yellen and her doomed (as Grantians believe) cheap-money policies? "When you buy the whole market you are buying David's market and Janet Yellen's. Are you quite sure you want it all?" he asked the crowd.

It's a salesman's ploy: what American thinks of himself as average?

Then Grant opened up with his own data: Nearly 100 of the S&P 500 currently have short interest bets above 5 percent. Almost 150 are trading at price/earnings ratios above 25 times – which will only prove profitable if they boost earnings more rapidly than most analysts actually expect. There are times when the market is falling "when one ought to step back and think," sell selectively, and not go down with the index, Grant said.

"Yes, of course, some investors can win," said Bogle, affecting a lack of guile in his sunny tone, as he raised his knife. "A value-seeking, footnote-reading, neurologically and emotionally qualified manager. And where are they? We don't know."

High-fee genius-run hedge funds have badly trailed stock funds since the late recession, Bogle noted. He named a couple of long-term successful hedge fund managers – Seth Klarman, Michael Steinhardt. "Just give them a call and send them your money," Bogle mocked. "Tell Seth, 'I'm sending you $250 every month.' It's not gonna happen. Gurus (and) variable annuities are overrated. Mutual funds are the only option, for most investors." And, if mutual funds are a "penal system," smart investors "will do their time in an index fund."

Both sides cited Warren Buffett. Bogle noted Buffett has endorsed Vanguard index funds for his wife and small investors generally. Grant pointed out that Buffett has often endorsed the superiority of a few very successful investments over "owning the market."

"Stock picking is an illusion," Bogle insisted in his rebuttal. "If you accept my theory" that no one consistently beats the market, "we know we (at Vanguard) can do it cheaper than anyone else because there is no management profit in it."

Grant shot back: "Jack reminds me of a Debbie Downer little league coach who lines up the kids and says, 'I don't mean to sound discouraging, but in the big leagues the ball comes in at 93 miles and hour, and most guys wash out." But, Grant said, his readers are better than "company softball" whiffers.

"You have built a national monument," Grant told Bogle. "Wall Street should be thankful." But "it's a big financial world. We hear all day from people who go outside the market. There's arbitrage possibilities. There are workout opportunities. There's asset conversion."

Grant nearly pleaded: "We can't not have imagination,. We can't not seek knowledge." Yes, hedge funds have failed to beat stock indices. "But since when has the phrase 'has been' been a successful guide to thinking about the future?"

Afterward Bogle, whose sons John and Andrew watched the show, told a group of us what will happen when all the active managers shut down: Indexing "would collapse," he said. "We need activist investors" willing to challenge entrenched managers in underperforming companies – which he said even Vanguard and rival BlackRock, who each control about 5 percent of all U.S. stock, are unwilling to do in a meaningful way, because they won't risk annoying corporate retirement managers who hire the firms to manage their billions.

Grant left it to moderator Bill Baldwin, a longtime Forbes Magazine editor who said he was used to being browbeaten by Bogle on the futility of rating stock mutual funds, to ask the tough question about bond index investing. Grant also avoided mention of the IRS review of Vanguard's tax practices, a cloud on the horizon threatening the company's "no management profit" status, as Bogle called it. (Bogle has declined my requests to discuss his ex-employer's tax arrangements.)

Afterward, I told Grant I thought he'd pulled his punches. He answered like a true deep-value investor, or an old hand at putting down wiseguys: "So, how's the newspaper business doing, in Philadelphia?"