the “efficient market hypothesis” vs the “cost matters hypothesis”

David Henderson’s “A Nobel for the Random Walk of Stock Prices” (op-ed, Oct. 15) describes me as “one high-profile beneficiary of Mr. Fama’s insight,” allegedly inspiring my founding of the Vanguard 500 Index Fund in 1975.

This is untrue. Perhaps to my shame, I didn’t even learn of Eugene Fama’s “efficient market hypothesis” (EMH) until a decade after my creation of the 500 Index Fund. Rather, I was inspired by another Nobel laureate, economist Paul Samuelson, who in his 1974 essay in the Journal of Portfolio Management demanded “brute evidence” that active money managers could beat the market index. Such evidence has yet to be produced.

Numbers-crunching economists like Mr. Fama represent the “quantitative school” of indexing who came to believe in stock-market efficiency. In fact, he inspired the founding of Dimensional Fund Advisors (DFA), which follows, not an indexing strategy, but a strategy based on persistent undervaluations of various market segments. Mr. Fama continues to serve on the DFA board.

The “pragmatic school” of indexing, on the other hand, simply amassed vast statistical evidence showing that the returns earned by active managers seldom outpace the S&P 500 Index. Further analysis showed that the failure of active fund managers was a result of the costs they incurred. The average manager is average, but only before all these fund operating expenses, advisory fees, turnover costs and sales loads. After those costs, active management becomes a loser’s game. It is the “cost matters hypothesis” (CMH) that assures that investors in low-cost index funds win the battle for superior returns.

John C. Bogle, “Eugene Fama and Efficient Financial Market Theory“, letter to the Wall Street Journal, 19 October 2013.

There is more at the link, including a paragraph on another 2013 Nobel laureate, Robert Shiller.

John Bogle (born 1929) founded The Vanguard Group in 1974. Vanguard 500 was the first index fund that the general public was allowed to purchase. Mr Bogle is author of numerous books, including Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor (McGraw-Hill, 1999).

In light of Mr Bogle’s revelation, FT “undercover economist” Tim Harford was wrong to attribute to Eugene Fama ideas that “have helped popularise low-cost, diversified investment and discredit the idea that masters of the financial universe should be richly rewarded for their stockpicking ability”. Paul Samuelson was responsible for this insight and, much later, John Bogle and Robert Shiller for its popularisation.

To his credit, Canadian-born economist and blogger David Henderson apologized for his error.

Thanks for your correction, Mr. Bogle. My apologies for misrepresenting the source of your thinking. Also, thanks for setting up the fund. In my retirement investments, I’ve been a big beneficiary.

David Henderson, “Oops. My Apologies to John Bogle–and to Paul Samuelson“, EconLog, 19 October 2013.

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