STOCK IDEAS
Buffett and Index Trackers

By Bill Mann (TMF Otter)
September 3, 2001

Two of the most important figures in investing celebrated birthdays last week.

On Thursday, Warren Buffett -- a man not known for his willingness to take big risks in his business activities -- celebrated his 71st birthday by bungee-jumping into a giant vat of Cherry Coke. Dozens of Berkshire Hathaway (NYSE: BRK.A) shareholders were admitted into hospitals around the country, many complaining of heart palpitations doctors attributed to Warren Buffett's publicity stunt.

"We'd prefer you stick to tap dancing, Mr. Buffett," said one stricken shareholder.

As a fellow Berkshire shareholder, I'm awfully glad the words "Warren Buffett" and "publicity stunt" seem to assault the senses when in direct proximity to one another. I'm also happy that I was forced to make up the above event, because it is highly unlikely that Buffett would do such a thing. (Well, except the tap dancing. And maybe the vat of Cherry Coke wouldn't be such a stretch. But the bungee jumping... No sir.)

Happy Birthday, Mr. Buffett! May you enjoy your day, but not too much.

Another one of the great friends of individual investors celebrated a birthday on Friday. Yes, the Vanguard 500 Index Fund (VFINX) was launched 25 years ago, on August 31, 1976. Its premise, that indexing would provide returns that beat most managed portfolios, was simple. But oh, how the brickbats flew on the eve of the launch of the Vanguard fund, portfolio management experts calling the concept everything from "a negative approach," to "conceding defeat," to "un-American."

I like this last one especially, as it gives me the impression that certain financial planners were trying to color Vanguard founder John Bogle as a wild-eyed, patchouli-smelling, Timothy Leary type corrupting youth everywhere with stories of lower-risk portfolios outperforming actively managed ones. Craziness, man.

Trouble was, Bogle's story turned out to be a) convincing, and b) correct.

The Vanguard 500 Index Fund has grown to become the largest mutual fund of any kind, with $91 billion in assets. Brian Mattes, a principal at Vanguard Group, estimates that index products account for more than $400 billion in U.S. investor assets, or nearly $1 in every $10. More importantly, the Vanguard 500 Index has whipped the majority of managed funds since its establishment. If an investor had placed $10,000 in each of the largest mutual funds on the day the Vanguard 500 Index Fund started, only one of them -- the American Funds Investment Company of America Fund (AIVSX) -- would have outperformed it net of fees.

             Growth of $10,000     Current Fund
               from 12/31/1976       Assets
                  to 6/30/2001    (in billions)
----------------------------------------------- 
American Funds         
Investment Company    $297,952         $57  
of America

Vanguard 500 Index     248,243        90.6 

Lord Abbett            246,928        10.5 
Affiliated

Fidelity Puritan       231,563          21 

Vanguard Wellington    200,900        23.9 

MFS Mass Invest Trust  194,057         6.9 

T Rowe Price           177,506         5.5 
Growth Stock

AXP: Stock Fund        156,871         2.7 

Alliance Fund          150,459         774 million

Dreyfus Fund           143,209         2.1 

AXP: Mutual            109,331         1.9 

 Source: The Vanguard Group

I would not consider it hyperbole to call index funds the best thing ever to happen to the individual investor -- even better than Buffett, though he has managed to outperform the S&P 500 by a significant margin. I'll explain why in a bit.

Indexing simply means committing yourself to the average return of the stock market (or a subsection thereof). The most famous, and oldest, indexing fund product is Vanguard's 500 Index Fund. This one, as the name suggests, tracks the returns of the Standard & Poor's 500 Index, which is comprised of 500 of the largest companies in the United States. Between these 500 companies, nearly 80% of the entire market cap of publicly traded U.S.-based companies is represented. From an equity standpoint, it is as much diversification as most investors will ever need.

Why more people don't index
Interestingly, the rapid rise in assets being indexed has been trumped by those being actively managed, either in the form of managed mutual funds or by individuals managing their own investments. In 1976 the largest mutual fund held only $2 billion in assets, but today a similarly sized fund is considered quite small. Several dozen funds control 10 times that amount. More households than ever before, meanwhile, hold at least one individual equity. Mattes calls this "the eternal power of hope": the confidence in one's own abilities to choose either superior investments or a superior investment advisor.

This is, unfortunately, awfully hard to do. A recent study by Burt Malkiel, author of A Random Walk Down Wall Street, showed that selecting top performing mutual funds from one five-year period in no way assures market outperformance over the next five years. In fact, on average these funds dramatically underperformed. It is nearly impossible to tell in advance which fund is going to beat the average, and over time, due to expenses and taxes, the majority fail to do so.

And while many individuals remain determined to select their own stocks, the fact is that few people are truly emotionally and intellectually cut out to do so and still beat the market. If the last 18 months' market slide has highlighted anything, it is that no one can control what the market does. Even if we have chosen correctly with our equities, we must be willing to suffer through some dramatic downturns, something many people cannot do. Mattes put it simply: "We should be willing to take what the market offers. We cannot control market fluctuations, but we can control costs."

A plea for sanity
Taking what the market offers is what has made Buffett the best investor of our generation. Unfortunately, many investors are completely incapable of doing the same thing, as we are too willing to confuse the prevailing winds for absolute truth. This is the only way I can explain the slew of "Buffett has lost his touch" articles that came out as Berkshire Hathaway suffered through a slide of more than 50% in share price in 1999. As it happened, we were looking at one of the greatest buying opportunities in a generation.

Berkshire share ownership is not for everyone: Buffett himself says he is only looking for a certain type of shareholder, one who does not live and die by the need for consistent earnings growth. Most people are not this type of investor, which is why the index fund is so important. Jason Zweig, in a brilliant column on CNNfn, called index investing the way to invest without having to know -- or guess -- at what is coming next. He called it "I don't know, and I don't care."

Most people, sage analysts included, don't know either. The luxury of indexing is the "don't care" part. Throw in the part about significant long-term outperformance, and what you have in index funds is a superior way to invest for the majority of investors.

Happy Birthday, Vanguard 500. Here's hoping for 25 more years of the same.

Fool on!

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