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By late 2016, Larry J. Puglia had been managing the $33 billion T. Rowe Price Blue Chip Growth Fund (Blue Chip Growth Fund) for more than 23 years. One of the fund's original managers, Puglia had been the sole manager of the open-ended mutual fund since 1997 and had generated superior returns on average for his investors over the life of the fund. 1 Since inception in mid-1993 through September 30, 2016, the fund had returned an average annual total return of 10.12%, outperforming the 9.12% return of the fund's benchmark, the Standard \& Poor's 500 Index (S\&P 500). 2 For most fund managers, beating the S&P500 in any single year was an accomplishment, yet Puglia had served his investors well by performing better than competitor funds both in bull markets, such as that of the late 1990s, as well as the bear markets, such as that of the first decade of the 2000s. Exhibit 1 presents a summary of the Blue Chip Growth Fund. Exhibits 2 and 3 show the fund's performance and annual return versus its benchmark and other funds in the large-eap growth category. While Puglia, working out of T. Rowe Price's Baltimore, Maryland, headquarters, rarely had the best overall performance in any given year, and other managers had beaten his results over short-term periods, his overall long-term performance relative to the index was truly impressive. He ranked 20th out of 558 U.S. stock mutual funds with a single portfolio manager, and Morningstar had awarded the Blue Chip Growth Fund its coveted five-star rating for the fund's five-year performance, placing it in the top 10\% of 1,285 mutual funds investing in large-capitalization growth stocks.'3 Puglia had also been nominated by Morningstar as one of five finalists for Domestic Fund Manager of the Year in 2013. The fund had been recognized as an IBD Best Mutual Funds 2016 Awards winner by Imestar's Busimess Daily (IBD), 4 In addition, Mong Magazime consistently named the fund to its annual selection of best funds, and Kiplinger's Personal Finance magazine included the fund on its list of 25 favorite funds. Puglia's results seemed to contradict conventional academic theories, which suggested that, in markets characterized by high competition, easy entry, and informational efficiency, it would be extremely difficult to beat the market on a sustained basis. Observers wondered what might explain such consistent outperformance by a fund manager and how it could be sustained. The Mutual-Fund Market 5 The global mutual-fund market represented \$37.2 trillion in worldwide assets at the end of 2015. Investment companies in the United States accounted for almost half the global market, with $18.1 trillion in assets; U.S. investment company assets first topped \$1 trillion in 1990, growing to $5.8 trillion in 1998 and \$18.1 trillion in 2015. Ninety-three million individuals and 44% of U.S. households owned mutual funds in 2015. In 2015, individual investors owned about 86% of the assets held by U.S. investment companies. Mutual funds provided several benefits for individual retail investors. First, they gave investors the ability to diversify their portfolios-that is, invest in many different securities simultaneously, thereby reducing the risks associated with owning any single stock. By purchasing shares in a mutual fund, investors without significant amounts of capital could efficiently diversify their portfolios, investing as if they had the sizable amount of capital usually necessary to achieve such efficiency. Mutual funds also offered scale cconomies in trading and transaction costs, economies unavailable to the typical individual investor. Second, mutual funds provided retail investors with professional management and expertise devoted to analysis of securities, which in theory could lead to higher-than-average returns. A third view was that the mutual-fund industry provided, according to one observer, "an insulating layer between the individual investor and the painful vicissitudes of the marketplace" =0 This service, after all, allows individuals to go about their daily lives without spending too much time on the aggravating subject of what to buy and sell and when, and it spares them the even greater aggravation of kicking themselves for making the wrong decision...Thus, the money management industry is really selling "more peace of mind" and "less worry," though it rarely bothers to say so." Between 1970 and 2015, the number of mutual funds offered in the United States grew from 361 to 9,520. This total included many different types of funds; each pursued a specific investment focus and could be classified in one of several categories, such as aggressive-growth, growth, growth-and-income, international, option, balanced, or a variety of bond or fixed-income funds." Funds could be further segmented by company size based on the market capitalization (market cap), calculated by multiplying the number of shares outstanding by share price. Investors could, for example, opt to invest in large-cap, mid-cap, or small-cap growth funds. Funds whose principal focus of investing was common stocks or equities represented the largest segment of the industry., The growth in the number and types of mutual funds reflected a major shift in retirement plans for U.S. workers. Prior to the 1980s, most workers were covered by traditional defined-benefit (DB) pension plans, which were funded by employers and managed by institutional money managers hired by the employers. Changes to the U.S. tax code in the 1970 set the stage for a major shift, which would have broad implications for the mutual-fund industry. First, the Employee Retirement Income Security Act of 1974 established the selfdirected Individual Retirement Account (IRA) through which workers could save and invest individually for their retirement on a tax-deferred basis. Second, large U.S. companies began to replace their DB pension plans with defined-contribution (DC) plans such as 401(k) and 403(b) plans. The new plans, named for the relevant sections of the U.S. tax code, shifted the burden and responsibility of saving and managing retirement assets from corporate employers to individual employees. Exhibit 4 shows the growth in retirement-plan assets over the period from 1975 to 2015 . By 2015,$7.1 trillion of IRA and DC plan assets were invested through mutual funds. 10 The shift into DC plans created a broader customer base for the mutual-fund industry, as well as a deeper penetration of the total market for financial services. With DC plans, each worker had an individual investment account that could hold multiple mutual funds, whereas a company's DB plan held the assets of tens of thousands of workers in a single investment account. Funds owned in an employee's name after a vesting period remained in the employee's name even if they switched employers. By 2015,44.1% or 54.9 million U.S. households owned mutual funds, up from 5.7% or 4.6 million U.S. houscholds in 1980.11 The breadth of mutual-fund alternatives tended to encourage fund switching, especially from one type of fund to another within a family of funds. The switching behavior reflected the increased participation of growing numbers of relatively inexperienced and unskilled retail investors; their interest in market-timingoriented investment strategies; and the greater range of mutual funds from which to choose, all of which increased volatility in the market. In short, as the mutual-fund industry grew and segmented, mutual-fund money became "hotter" (tended to turn over faster). 12 As a result of the growth in the industry, the institutional investors who managed mutual funds, pension funds, and hedge funds'3 on behalf of individual investors grew in power and influence. By 2015, mutual funds owned 31% of the outstanding stock of U.S. companies. 44 The power and influence of institutional asset managers was apparent in their trading musele-their ability, coupled with their willingness, to move huge sums of money in and out of securities. 15 The rising role of institutional investors investing on behalf of millions of individual account holders resulted in increases in trading volume, average-trade size, and block trading (a single trade of more than 10,000 shares) 16 When individuals invested in an open-ended mutual fund, their ownership was proportional to the number of shares purchased. The value of each share was called the fund's net asset value (NAV). The NAV, computed after market close each day, was the fund's total assets less liabilities divided by the number of mutual-fund shares outstanding, or: Net asset value ( NAV )= Market valuc of fund assets Liabilitics Fund shares outstanding The investment performance of a mutual fund was measured as the increase or decrease in NAV plus the fund's income distributions during the period (i.e., dividends and capital gains), expressed as a percentage of the fund's NAV at the beginning of the investment period, or: Annual total return =NAV(atthebeginningoftheperiod)ChangeinNAV+Dividends+Capital-gaindistributions Investors in mutual funds generally paid two types of fees for their investments: one-time transaction fees and ongoing management fees. A fund's transaction fee, or sales load, covered sales commissions paid to brokers for selling the fund. The sales load could be a front-end or back-end load. A front-end sales load shaved off as much as 6% of an individual's initial investment. A back-end load, in contrast, enabled investors to invest all of their money and defer paying the sales load until they redeemed the shares. Some companies eschewed the use of brokers and pursued a no-load strategy, selling funds directly to investors. In addition to any sales load imposed, investors paid fees for the ongoing management and operation of the mutual fund. Expenses included management fees for managing the investments, administrative costs, advertising and promotion expenses, and distribution and service fees. Expenses were calculated as a percentage of the fund's total assets (the expense ratio), and were charged to all sharcholders proportionally. Expense ratios ranged from as low as 0.2% to as high as 2.0%. As seen in Exhibit 5 , expense ratios were lower for index funds (funds designed to replicate the performance of a specific market index) than they were for actively managed funds which sought to outperform a market index. Because the expense ratio was regularly deducted from the portfolio, it reduced the fund's NAV, thereby lowering the fund's gross returns. Depending on the magnitude of the fund's expense ratio, the net effect of loads and expense ratios on shareholder returns could be substantial. 18 Another drag on shareholders' returns was the tendency to keep some portion of fund assets in cash either to invest in attractive investment opportunitics or to meet shareholder redemptions. As cconomist and industry observer Henry Kaufman warned in 1994, a sudden economy-wide shock from interest rates or commodity prices could spook investors into panic-style redemptions from mutual funds, which could force the funds themselves to liquidate investments, sending security prices into a tailspin. 19 Unlike the banking industry, which enjoyed the liquidity afforded by the U.S. Federal Reserve to respond to the effects of panic by depositors, the mutual-fund industry enjoyed no such government-backed reserve, and thus fund managers often carried a certain amount of cash to meet redemptions. 20 A final drag on sharcholders' returns was taxes. Mutual funds collected taxable dividends for the shares they held and generated taxable capital gains whenever they sold securities at a profit. Dividends received and capital gains and losses were reflected in the daily NAV. The funds could avoid paying corporate taxes on dividends carned and capital gains realized during the year if they distributed the investment income to sharcholders prior to year-end. The distribution shifted the tax liability from the investment company to individual shareholders. Mutual funds generally distributed the year's realized capital gains and dividend income to sharcholders in December. Dividends and capital gains had, of course, been collected and realized throughout the year, and were reflected in the daily NAV as they occurred. On the day of the distribution, the NAV was reduced by the amount of the distribution. As an example, imagine a mutual fund with an NAV of $10 per share that had realized capital gains of $1.12 per share during the year. In December, the mutual fund would distribute $1.12 per share to its investors and the new NAV would be $8.88. Thus an investor with 100 shares who chose to receive the distribution in cash would have $112 in cash plus 100 shares worth $888 for a total investment value of $1,000. An investor who held 100 shares with an NAV of $10 prior to a distribution that he chose to reinvest would hold the original 100 shares with a new NAV of $8.88 plus 12.612 new shares ( $1.12100 shares /8.88 per share), for a total of 112.612 shares worth $1,000($8.8812.612 shares ). When funds were held in taxable rather than tax-deferred accounts, capital gains distributions triggered both unexpected and unwanted tax liabilities for investors, and reduced the net returns to investors. Most mutual-fund managers relied on some variation of the two classic schools of securities analysis for choosing investments 21 : Techmical antabyis. This approach involved the identification of profitable investment opportunities based on trends in stock prices, volume, market sentiment, and the like. Fundamental analysis: This approach relied on insights afforded by an analysis of the economic fundamentals of a company and its industry: supply and demand, costs, growth prospects, and the like. While variations on those approaches produced above-average returns in eertain years, there was no guarantee that they would produce such returns consistently over time."2 Performance of the Mutual-Fund Industry The two most frequently used measures of mutual-fund performance were (1) the annual growth rate of NAV assuming reinvestment of all dividend and capital-gain distributions (the total return on investment) and (2) the absolute dollar value today of an investment made at some time in the past. Those measures were then compared with the performance of a benchmark portfolio such as the Russell 2000 Index or the S\&P 500 Composite Index, Exhibit 6 provides performance data on a range of mutual-fund categories. The Russell, S\&P 500, Dow Jones, and Value line indices offered benchmarks for the investment pefformance of hypothetical stock portfolios.21 Academicians criticized those performance measures for failing to adjust for the relative risk of the mutual fund. Over long periods, as Exhibit 7 shows, different types of securities yielded different levels of total return, and each type of security was associated with differing degrees of risk (measured as the standard deviation of returns). Thus the relationship between risk and return was reliable both on average and over time. For instance, it would be expected that a conservatively managed mutual fund would yield a lower return-precisely because it took fewer risks. 24 After adjusting for the risk of the fund, academic research indicated that mutual funds had the ability to perform up to the market on a gross-return basis, but when all expenses were factored in, the funds underperformed the market benchmarks, In a paper first published in 1968, Michael Jensen reported that gross risk-adjusted returns were 0.4% and that net risk-adjusted returns (i.e., net of expenses) were 1.1%, Later studies found that, in a sample of 70 mutual funds, net risk-adjusted returns were essentially zero, and some analysts attributed this general result to the average 1.3% expense ratio of mutual funds and their tendency to hold cash. 25 In his best-selling book, A Ramdom Walk Donw Wall Strut, a classic investment tome first published in 1973. Burton Malkiel, an academic researcher, concluded that a passive buy-and-hold strategy (of a large, diversified portfolio) would do as well for the investor as the average mutual fund. 23 Malkiel wrote: Even a dart-throwing chimpanzee can select a portfolio that performs as well as one carefully selected by the experts. This, in essence, is the practical application of the theory of efficient markets... The theory holds that the market appears to adjust so quickly to information about individual stocks and the economy as a whole, that no technique of selecting a portfolio-neither technical nor fundamental analysis-can consistently outperform a strategy of simply buying and holding a diversified group of securities such as those that make up the popular market averages.... [o]ne has to be impressed with the substantial volume of evidence suggesting that stock prices display a remarkable degree of efficiency.... If some degree of mispricing exists, it does not persist for long. "True value will always out" in the stock market. 27 Many scholars accepted and espoused Malkiel's view that the stock market followed a "random walk," where the price movements of the future were uncorrelated with the price movements of the past or present. This view denicd the possibility that there could be momentum in the movements of common stock prices. According to this view, technical analysis was the modern-day equivalent of alchemy, 2n Academics also dismissed the value and effectiveness of fundamental analysis. They argued that capital markets' information was efficient-that the data, information, and analytical conclusions available to any one market participant were bound to be reflected quickly in share prices.27 The belief that capital markets incorporated all the relevant information into existing securities' prices was known as the ffficient market byporbesis (EMH), and was widely, though not universally, accepted by financial cconomists, If EMH were correct and all current prices reflected the true value of the underlying securities, then arguably it would be impossible to beat the market with superior skill or intellect. 10 Economists defined three levels of market efficiency, which were distinguished by the degree of information believed to be reflected in current securities' prices. The avak form of efficiency maintained that all past prices for a stock were incorporated into today's price; prices today simply followed a random walk with no correlation with past patterns. Semistrong efficiency held that today's prices reflected not only all past prices, but also all publicly available information. Finally, the stromg form of market efficiency held that today's stock price reflected all the information that could be acquired through a close analysis of the company and the economy, "In such a market," as one economist said, "we would observe lucky and unlucky investors, but we wouldn't find any superior investment managers who can consistently beat the market." 12 Proponents of EMH were both skeptical and highly eritical of the services provided by active mutual-fund managers. Paul Samuelson, the Nobel Prize-winning economist, said: [E]xisting stock prices already have discounted in them an allowance for their future prospects. Hence,..one stock [is] about as good or bad a buy as another. To [the] passive investor, chance alone would be as good a method of selection as anything else. 33 Tests supported Samuclson's view. For example, in June 1967, Forbes magazine established an equally weighted portfolio of 28 stocks selected by throwing darts at a dartboard. By 1984, when the magazine retired the feature article, the initial $28,000 portfolio with $1,000 invested in cach stock was worth $131,698,99.5% compound rate of return. This beat the broad market averages and almost all mutual funds. Forbes concluded, "It would seem that a combination of luck and sloth beats brains." 4 Despite the teachings of EMH and the results of such tests, some moncy managers-such as I _arry Pugliahad significantly outperformed the market over long periods. In reply, Malkicl suggested that beating the market was much like participating in a coin-tossing contest where those who consistently flip heads are the winners. 15 In a coin-tossing game with 1,000 contestants, half will be eliminated on the first flip. On the second flip, half of those surviving contestants are eliminated. And so on, until, on the seventh flip, only eight contestants remain. 'To the naive observer, the ability to flip heads consistently looks like extraordinary skill. By analogy, Malkiel suggested that the suecess of a few superstar portfolio managers could be explained as luck. 10 Not surprisingly, the community of professional asset managers viewed those scholarly theorics with disdain. Dissension also grew in the ranks of academicians as research exposed anomalies inconsistent with the EMH. For example, evidence suggested that stocks with low price-to-carnings (P/E) multiples tended to outperform those with high P/E multiples. Other evidence indicated positive serial correlation (i.e., momentum) in stock returns from weck to weck or from month to month. The evidence of these anomalies was inconsistent with a random walk of prices and returns.17 The most vocal academic criticism came from the burgeoning ficld of "behavioral finance," which suggested that greed, fear, and panic could be much more significant factors in determining stock prices than mainstream theories would suggest. Critics of EMH argued that events such as the stock-market crash of October 1987 were inconsistent with the view of markets as fundamentally rational and efficient. Lawrence Summers, cconomist and past president of Harvard University, argued that the 1987 crash was a "clear gap with the theory. If anyone did seriously believe that price movements are determined by changes in information about economic fundamentals, they've got to be disabused of that notion by [the] 500 -point drop" which erased more than 22% of market value in a single day. " Following the 1987 crash, Yale University economist Robert Shiller concluded: "The efficient market hypothesis is the most remarkable error in the history of economic theory. This is just another nail in its coffin."? Market events such as the Internet bubble of the late 1990s and the global financial crisis of 2007-2009 further added to the belief that market participants were not always rational and the EMH was flawed. Yet, despite the mounting evidence of its shortcomings, the EMH remained the dominant model in the academic community.t The Rise of Passive Investing More than 20 years after graduating from Princeton University in 1951, where he wrote his senior thesis on "The Economic Role of the Investment Company," John C. Bogle founded the Vanguard Group and established a fund whose investment goal was to match-not beat the performance of a market index. Bogle's First Index Investment 'Trust launched on December 31, 1975, and was quickly dismissed as folly by many. Investors, critics proclaimed, would not be satisfied with receiving average returns. Over time, Bogle's fund, which tracked the S\&P 500, and was eventually renamed the Vanguard 500 Index Fund, proved critics wrong. Without expensive portfolio managers or research analysts to compensate, the fund charged a low expense ratio of 0.16%. Without portfolio managers trading in and out of securities, the fund's turnover rate was 3%, meaning that year-end capital-gains distributions were negligible, making the fund extremely tax efficient for taxable investors. At least some investors decided that the benefits of being average outweighed the costs of trying to be above average. From approximately $11 million in assets in 1975, the fund grew to $262.80 billion in assets on September 30, 2016," Vanguard also grew. By December 2015, the company employed 14,000 individuals and offered more than 300 U.S. and non-U.S. funds, serving more than 20 million investors from approximately 170 countries.,2 Vanguard's success was noticed. In particular, other investment companies developed and offered index funds, and by 2015, \$2.2 trillion was invested in index-based mutual funds. 43 Exhibit 8 shows the growing percentage of assets invested in equity index funds from 2000 to 2015, and Exhibit 9 shows how outflows from actively managed funds matched the inflows to passively managed investment funds from 2009 to 2015.4 Conclusion Judged from an historical perspective, Puglia's investment success seemed exceptional. His long-run, market-beating performance defied conventional academic theories, Investors, scholars, and market observers wondered about the sources of such superior performance and about its sustainability. At of the end of 2016, was it rational for an equity investor to buy shares in the Blue Chip Growth Fund, or for that matter any actively managed fund? Investors and other observers wondered whether and for how long Puglia could continue to outperform the market. In particular, they wondered whether he would be able to sustain his performance under the weight of having $30 billion in assets to invest. - How easy will it be to sustain Puglia's historical performance record into the future? What factors support your conclusions