I am confident about the future of the U.S economy over the long term and bought one share in the Vanguard 500 Index Fund Investor Shares (VFINX) mutual fund to prove it. There are added benefits too. First, by purchasing VFINX I can now compare the performance of my portfolio of stocks to the performance of a passive strategy as represented by the mutual fund.
Second, the Oracle from Omaha had suggested the Vanguard 500 Index Fund mutual fund to be an adequate place to park savings and perhaps this is where my savings will go in a few years. Third, the fund’s historical return has been more than adequate.
In numbers: for every dollar invested in the mutual fund ten years ago, you would now have about two dollars, an average annual return of 7%. Most active mutual funds and hedge funds ,after fees, performed worse. But the overall long term positive growth trend was accompanied by short term hiccups. For example, at the end of 2008 the market value of the mutual fund had declined by about 40%.
While I knew why I had bought a share in VFINX, I was uncertain what companies the mutual fund actually owned. So I printed the fund’s 2016 prospectus and here is a recap of what I learned: the mutual fund aims to replicate the S&P 500 index which consists of largest companies in the U.S as measured by their market capitalization. To my understanding, managing the mutual fund requires little human enterprise and the decision how to replicate the S&P 500 index is mostly done by binary digits and computer language code (this is the main reason why the management fees are minimal, ranging from 16 to 24 basis points).
Summary of companies in the S&P 500 index
The fund’s managers had invested in 508 companies with a median market cap of $84.8 billion (read: very, very large companies). They paid an average earnings ratio of 23 times and the average price to book value ratio was 2.9 times according to the fund’s prospectus. The companies’ average return on equity was 17.7% alongside a 2.1% dividend yield which is likely to explain the expensive valuation.
The companies represented in the S&P 500 index operate in a vast line of businesses ranging from household brand names, such as Home Depot, Walt Disney and McDonald’s to esoteric companies such as Arconic Incorporated and Ameren Corporation. The former specializes in lightweight metals engineering and the latter company is a power company (and those are just examples of unfamiliar companies that start with the letter ‘A’).
While I didn’t realize it at the time of purchase, by explicitly buying a VFINX share, I am implicitly bought a share in companies that operate in the consumer discretionary, consumer staples and energy companies. The sum of the three segments represent almost half of the market value of the portfolio.
Perhaps you are like me and have no idea what consumer discretionary or staples companies do. So I bring to your attention a few examples: in consumer discretionary you will find companies such as Amazon, Nike and Starbucks (placing these companies under the same umbrella is similar to classifying classic cars, horses and running shoes).
In consumer staples, you will find companies such as Proctor and Gamble, Pepsi and Phillip Morris. Again, to me, there is a thin resemblance among the companies.
The confusion in passive investing
As I read about the motley number of companies that comprise the S&P 600 index, I wondered since when did we start using the word “passive” as a positive attribute? would you be proud of your children if they were passive in school? and when was the last time you enjoyed a lecture because the speaker was lethargic and passive? and do you ever go to bed at night wishing your life would be more passive than it is?
It is more than a peculiar use of the word. The term "passive investing" is misleading. John Bogle, Vanguard’s founder and retired chief executive would argue that there is nothing passive about passive investing. I heard him speak in March 2017 at the 70th CFA Institute Annual Conference that was held in Philadelphia. He noted that while the average common stock traded hands about once over a period of one year, in the case of passive investing, as demonstrated by Exchange Traded Funds (ETFs) traded over eight times during one year.
I am quite certain that Mr. Bogle would agree with me about the following statement: trading frequently and excessively is the action of a speculator and not of a passive investor.
Similar to our misuse of the term “hedge fund,” which rarely describes a company that hedges risks, the term “passive investing” has turned - de facto - into a modern way to actively speculate in the stock market.
Using the S&P index as a benchmark
Passive investing proved to be a reasonable investment vehicle over the past few decades. But I am uncertain what performance it will demonstrate in the future. In practice I enjoy (active) investing too much and would continue to invest as I please even if my future performance would lag the S&P 500 index. But I’m of the competitive nature. And had I bought a share in VFINX to prove to myself that I could do better than those “passive” tales out there.
I started the article with the statement that I am optimistic about the U.S. economy future. I am also an admirer of its past. And I developed a habit - as the tax season approaches - to read a few inspirational, great books about the United States and how admirable were its founders. It may sound silly to you, but it makes me somewhat proud to pay my taxes.
Read David McCullough’s collection of speeches if you need a refresher on the values and principles of this great country. His book, titled 1776, is a also wonderful read. And while a biography, not a history book per se, Walter Isaacson captures the ingenuity of the American spirit in Benjamin Franklin: An American Life. And finally, by one of my all-time favorite historians, Paul Johnson’s History of the American People is a wonderful read as well.