January 24, 2019
(This post originally appeared on my Patreon page.)
Last week, Jack Bogle, who founded Vanguard Funds, died at the age of 89. Bogle was widely praised in his obituaries (including by me) for starting Vanguard, which now has over $5 trillion in assets.
Bogle’s innovation was the recognition that most people lose money by trading. This is regardless of whether it is their own trading or they have an actively managed mutual fund. The fact is that the vast majority of people do not beat the market. This means that the money people spend in trading is essentially money thrown in the garbage.
The main asset offered by Vanguard is low-cost index funds. The idea is that investors buy an index fund that will closely track major market indexes like the S&P 500. By minimizing trading and other administrative expenses, people investing in Vanguard funds will maximize the returns on their investment.
The annual fees on many of Vanguard’s fund are in the neighborhood of 0.1 percent. By contrast, people often pay 1–2 percentage points of their assets, each year, in trading costs and fees for ordinary mutual funds. Simple arithmetic shows the enormous amount that Vanguard investors save. If we assume that alternative funds would charge 1.0 percentage point more than Vanguard, then Vanguard’s investors are saving over $50 billion a year compared to alternative funds.
The total savings would be considerably higher when we include the fact that other companies now also offer low-cost index funds in order to compete with Vanguard. It’s fair to say that Bogle has had a big impact on the ability of middle class people to save for their retirement.
It is also worth mentioning that Bogle organized Vanguard as a cooperative owned by its investors rather than as a traditional profit-making corporation. This helped keep costs low for its investors, but it also meant that Bogle would not get ridiculously rich from such a successful company.
According to press accounts, he had $80 million in assets when he died. This is certainly a substantial fortune that would allow him to live very comfortably, and place him well into the top 0.001 percent of the wealth distribution. But had he organized Vanguard as a standard corporation, he almost certainly would have had a fortune in the billions, if not tens of billions.
Anyhow, apart from being a rare hero in the financial industry who actually did something good for society, Bogle’s model also offers an important lesson about finance. Specifically, it offers insights into the benefits of a financial transactions tax, which Bogle supported.
The logic of a financial transactions tax (FTT) is to charge a small fee on trades of stocks, bonds, and derivative instruments. For example, a bill soon to be introduced by Senator Brian Schatz would impose a tax of 0.1 percent (10 cents on $100 of trades). The Congressional Budget Office projects that a tax of this size would raise roughly $100 billion a year or 0.5 percent of GDP.
This is a considerable amount of money from almost any perspective. It is close to two thirds of the size of the Trump tax cut. It could go far toward paying for progressive proposals like a Green New Deal or free college. But the really neat aspect of this tax is that it should barely touch normal investors, with virtually all the money coming out of the waste in the financial industry. This is the insight of Jack Bogle.
Standard estimates find that the volume of trading is very responsive to the cost of trading. In fact, most estimates indicate that trading volume is elastic, meaning that an increase in trading costs leads to an even larger percentage decline in trading volume. That could mean, for example, that a 25 percent increase in trading costs leads to a 30 percent decline in trading volume. In that story, the imposition of an FTT would actually mean that people spend less on trading, including the cost of the tax, than they did before the tax was put in place.
To take a simple example, suppose I had a 401(k) with $100,000 in assets. Suppose that the fund manager traded half of the assets each year, with an average cost of 0.4 percent on each trade. Since turnover means I buy new shares when I sell old shares, my total trades are twice as much, or equal to 100 percent of the value of my 401(k). This means that, if I combine what I buy and sell, it is equal to 100 percent of the value of my 401(k). With trading costs of 0.4 percent of the price of the stock, this means I will have total trading costs equal to 0.4 percent of my account, or $400 a year.
Now suppose the Schatz bill is approved by Congress and signed in to law by Donald Trump. (Hey, this is a hypothetical.) If we assume that the tax is split evenly between buyer and seller, this will add one twentieth of a percentage point (0.05 percent) to my trading costs, so that it now costs me 0.45 percent of the value of my stock to trade a share.
If my account manager traded just as much as before the tax, then I would be paying an additional $50 annually in trading cost, or $450 a year. But most research finds that the volume of trading is highly responsive to the cost. Since the tax was a 12.5 percent increase in the cost of trading (0.05/0.40 = 12.5 percent), we can assume that my fund manager will reduce the frequency of trading by more than 12.5 percent.
Let’s say that she reduces my trading by 15 percent. This means that instead of 50 percent of my account turning over each year, just 42.5 percent turns over (85 percent of 50 percent is 42.5 percent). Since each sale implies buying another share, my total trading is now equal to 85 percent of the value of my account. In this post-tax world, each trade now costs me 0.45 percent of the value of the stock, 0.40 percent goes to the financial industry and 0.05 percent goes to the government to pay the tax.
In this post-tax world, I am trading $85,000 worth of stock a year and paying $382.50 in trading costs, including the tax (0.45 * $85,000). This means that I am spending $17.50 a year less on trading costs with the tax than I was before the tax was in place. I am actually saving money because of the tax.
What’s the trick here? Let’s call it Jack Bogle magic.
I am paying less money because my account is trading less. If I had actually been making money on my trades, then I would be suffering because of the reduction in trading volume. But this was exactly Bogle’s key insight, the vast majority of us are not making money on our trades. Therefore, we should do less trading. Of course, we could have cut back trading without the tax, but we didn’t. So the tax is effectively getting to do something that we should have done anyhow. Think of it like a cigarette tax that gets us to give up smoking.
The losers in this story, just as the losers from the enormous growth of Vanguard, are the people who make money flipping stock and other assets in the financial industry. In my little 401(k) example here, they used to get $400 a year out of me. Now, I’m only paying $382.50 in trading costs, and $42.50 of that is going to the government to pay the tax. This means that they are only getting $340 a year in revenue on my account.
This is a really big deal if we add it up for all account holders across the country. It is an even bigger deal when we think about the hedge funds and high-frequency traders that may be flipping billions or tens of billions in assets every day. For them, an FTT is really bad news.
Just to be clear, the economy does benefit from having an active market in which people can buy and sell stock freely. But we had a very active market twenty or thirty years ago when trading volume was less than half its current level. The greater frequency of trading today is not helping the economy; it is just allowing a small number of people in the financial industry to get very rich at the expense of everyone else.
So we can think of an FTT as doing the same thing that Jack Bogle and Vanguard did. It will mean more money for investors and the government, to pay for things like universal pre-K or free college, and less money for the high rollers in the financial industry. That seems like a good deal all around.
 This assumes that 100 percent of the tax is passed on to investors in the form of higher trading costs. While most of the tax likely be passed on in higher trading costs, it will almost certainly be less than 100 percent of the costs.
 At the most basic level, the amount of money spent on trading has increased more than four-fold relative to the size of the economy over the last four decades, as trading costs have fallen sharply due to computerization.