That John C. Bogle, the founder and former CEO of
the Vanguard Group speaks his mind – and is a fervent believer in index funds – comes as a surprise to no one on Wall Street. But that Jack, who now sports the title of President of Vanguard's Bogle Financial Research Center, has chosen to spend his "golden years" hopping from speaking platform to speaking platform, Congressional Hearing Rooms
most definitely included, to excoriate his industry, corporate managements and the Street for enriching and entrenching themselves while treating investors shabbily in the extreme, is-face it-a mite unsettling. Rocking the boat just isn't good form. Yet there's Jack, forcefully advocating things like making mutual funds prominently disclose not only performance stats and proxy votes, but expense ratios, sales charges, portfolio transaction costs and other expenses – in terms their investors can understand and on a regular basis. Not to mention a federal statute spelling out a fund management's fiduciary duty to its shareholders. I drove down to the outskirts of Philly last week, to hear firsthand, what's on Jack's mind. Hint: Plenty.
-KMW
Even a casual perusal of your recent speeches on the Vanguard Website makes it clear you're on something of a crusade, Jack – I don't know that I'd call it that. But we've created quite a mess in the corporate and financial worlds over the last few years, and I've been pointing out some important – and largely unrecognized – themes that I think go a long way toward explaining how we got into this position, and suggesting ways out. But our problems are complicated, and I don't claim to have all the answers. They don't all stem just from criminal elements. It wasn't just a few bad apples. It wasn't just the accountants. Or stock options. It wasn't just the short-term fixation of the markets. Or the mania. It wasn't just the failure of directors to do their duties and the failure of owners to exercise their responsibilities. It wasn't even just greedy managements. It was kind of all those things, coalescing together. We've been through a financial perfect storm? As I heard a wise man say not long ago, when you have strong managers, weak directors, cooperative accountants and passive owners, don't be surprised when the looting begins. We had some of that, and we had a lot of stuff that was not technically looting, but certainly was a betrayal of trust. And I think a lot of the blame can be laid on a transformation – or pathological mutation, it's been called – in the nature of capitalism in this country since the end of WWII, from owners' capitalism to managers' capitalism. The former was based on a dedication to serving the interests of the corporation's owners, maximizing the return on their capital investment. But a new system slowly developed in which the corporation came to be run to profit its managers, in complicity if not conspiracy with accountants and the managers of other companies. Phew. But why blame mutual funds? Isn't it really the institutionalization of the market that's at fault? Probably. But the fund industry grew enormously over that time – and played a critical role as its focus gradually shifted -from management to marketing, from stewardship to salesmanship, and – just as in the case of corporate America – from owners' capitalism to managers' capitalism. At this point, the mutual fund business is an industry without even a pretense of price competition – unless you want to argue that the competition in the mutual fund industry is to raise prices, which I would not argue with! Isn't that bound to change, if investment returns stay more modest than we've been accustomed to for quite a while? Well, there are two elements to that. It is amazing how much the world has changed and how everybody is now talking about costs. Not a lot of people are doing anything about them – like the proverbial weather – but even the academics now realize that getting costs out of the equation is our No. 1 job in the industry. Anyone who doesn't – put it this way: If you look back 30 years, you'll see that half of the funds that existed back then are gone now. And that was in a stable mutual fund industry. Not to mention, a bull market. But at least half of today's mutual funds will be gone in 10 years. You give them that long? This industry acts very slowly when its own economic interests are at stake. Price competition will come, but investors will have to be the driving force behind it. Brokerage firms, for example, have no interest in lowering their charges. They're marketing information. That great Wall Street selling machine depends on selling – and salesmen depend on commissions. That has always been the case and it is still the case today. That is not necessarily bad although there is a tremendous amount of abuse in the system. But as investors figure it out, it will change. How so? Visualize this: In Year 1 there is a fund that has $100 million in sales volume and a 2 percent expense ratio. But the day that year ends, all investors wake up and buy index funds. They buy $100 million in the index funds at .18. The Investment Company Institute would describe that as a 90 percent cost reduction in the mutual fund industry. But real price competition is not defined by the actions of consumers. It is defined by the action of producers. Competition will eventually come. But it will come at a glacial pace because there is always somebody out there who beat the index last year. Actually, in any year, about one out of three managers do it, and over five years it is probably one out of five and over 10 years it is probably one out of seven or eight, if you take into account survivor bias. But there is always somebody, so there is always a salesman. This is still very much a business that requires human interface – and that face that is interfacing with you is going to get paid. Indexing only "works" under special circumstances: When most investors aren't doing it – and in bull markets. As much as I love John Neff, if you look at his Windsor Fund record, you will find that counting three or four extraordinary years, he just about equals the index after taxes. Portfolio turnover is a big drag, even with Vanguard's cost structure which is very unusual and unusually low – and which was a big benefit to John. He would be the first to tell you that. And when you take taxes out, it is not easy. Now, Legg Mason Value Trust's Bill Miller is a wonderful manager. He has been for 12 years. Does anybody really think he is going to be for the next 12? Well, probably everybody. But I don't know. It is going to be a bigger fund. He may decide to retire. A couple of facts: The average mutual fund investor owns approximately four equity funds. The average mutual fund manager lasts for five years. That means in 10 years, you have eight managers. In 20 years, you have got 16 managers. In 30 years, 24 managers have taken roughly three percent a year out of your return. You are going to probably pick those managers based on their past performance, another big mistake. So the probability that the average fund investor is going to beat an unmanaged index over 30 years is zero. Wait a minute. The indexes aren't managed? Their components are massaged all the time. Stocks go in and out of the indexes, yes. But based on the University of Chicago data, we know what the return of the stock market has been since 1928. The S&P has actually done a little better, which is a statistical aberration because they picked up a little performance in 1933 and '34. But the correlation is .97. It is a myth that the S&P 500, which is of course 80 percent of the market anyway, is not going to give you the market's return. How could the other 20 percent be that different? And it does in fact give you the market return. And the most powerful part of stock price returns are based on what the market does. You can't really get that much differentiation. So yes, I am a dyed-in-the-wool indexer. The problem is, you've attracted too much company. You mean, what happens if everybody indexes? Well, if everybody indexes, we have no financial markets because there is no trading. Exactly. Something akin to that played no small part in the bursting of the stock market bubble in early 2000. It wasn't just the index funds that were indexing, but virtually every professional investor was "closet indexing." Eventually, we hit a tipping point, and the market couldn't keep levitating. I am going to say two things: 1) A lot of my intuition tells me that you are exactly right. There was a lot of "closet indexing" – although there was no real uniformity in what that meant. But just look at how brokers make recommendations now. They don't say buy and sell, they say overweight, underweight. They are closet indexers. And that does make indexing bigger. But 2), that said, you have to ask yourself what that closet indexing meant to the market. Because if the index is the S&P 500, you could argue that the S&P 500 was actually driven way above the return of the market and then sold way below it in the ensuing crash. But that did not happen. The S&P tracked the total stock market or the rest of the stock market very closely on the way up – and very closely on the way down. Which implies to me that closet indexing didn't play the role you're talking about. Clearly, I'm not going to convince you not to index. Let's get back to what ails the fund industry. Why hasn't competition from the likes of Vanguard already forced rivals to bring their costs down? There are a lot of people who argue that Vanguard's cost structure, merely by its existence, has kept costs from going up further. I am going to guess that is true – but the industry's costs should be much lower. You have an average unweighted equity fund expense ratio of 1.6 percent. The weighted average is 1.2 percent. The average turnover cost I use is about 0.8 percent and [Aronson + Johnson + Ortiz LP's] Ted Aronson uses a number that is probably double that, but I think that I am right and he is wrong. In my view, a cost is anything that comes out of an investor's pocket and so detracts from the market return. But I don't buy the idea of opportunity costs on the trading side. I don't buy delay costs. Ted can show how they detract from a portfolio's investment returns every which way. Yes, but what I do is look at costs to the system. If I buy 100,000 shares of, say, Intel and pay $21 a share, instead of $20, because of a delay, well, somebody else sold it for $21 instead of $20. In other words, it is a closed system. I am trying to look at the costs that the system extracts. Ted's methodology is perfectly intelligible and correct for a fund, but I am looking at out-of pocket costs for all mutual fund investors. It takes money to administer 401-Ks, money to buy and sell stocks. It takes money to print statements, all those kinds of things. Even that didn't matter terribly when the average investor was getting a fat double-digit return. But things are very different in a subdued return environment. Three percent out of 6 percent is 50 percent. It doesn't take a genius. And that is especially obvious in the money market fund field, where costs and returns are simply opposite sides of the same coin. Investors lag the market by the amount of the system costs every day. When investors finally see that, they will eventually have to think about what's happening in their equity funds, too. In fact, it is high time we had a government-sponsored economic study that "follows the money" in the mutual fund industry. The Investment Company Act of 1940 says absolutely nothing like, "You are able to charge what the traffic will bear." Nor does it say that what the competition is charging is a good guide for a fair cost for mutual funds. The Investment Company Act of 1940 says unequivocally, right in the preamble, that the interests of mutual fund shareholders must be placed ahead of the interests of mutual fund managers and distributors. What it says specifically is that mutual funds must be organized, operated and managed in the interests of shareholders rather than in the interests of managers and distributors. But there is not a human being in America today who believes that is the way this industry is being run. I am glad you said that. Next you're going to be talking about quaint notions like fiduciary duty. As I said, this business of stewardship has been turned into a business of salesmanship. A transformation, your tone leaves no doubt, you were happy not to be in the vanguard of. I can take some consolation in the fact that the Vanguard Group's market share has increased for 20 years in a row. Without big sales charges, without doing the face-to-face to the ultimate buyer. We have succeeded in driving almost every major firm out of the no-load mutual fund business. Think about that. Scudder is gone. Dreyfus is half-gone or three-quarters gone. Fidelity is emphasizing advisor funds that they sell through brokers. They have actually taken the loads off a couple of their big funds, like Magellan, but they're not selling any, so that's not much of a difference. Costs are going to come down for a whole lot of reasons. I haven't gotten into disclosure of soft-dollar arrangements, but of course they should be disclosed and payments to dealers for sales should be disclosed, too. But we don't do those things at Vanguard, so I have not really gotten into that fray. Has the mutual fund industry peaked? Look at the enormous growth of hedge funds and alternative investment vehicles – Well, when the record is written, I don't think hedge funds, or separately managed accounts, will produce returns any better – and probably worse, given their costs – than the average index fund. It is hard to beat the market. That is how the hedge funds justify their enormous fees. By claiming they can – and do. Funny, I read somewhere that around 700 of them went out of business last year. But let's get back to mutual funds. We definitely want to get rid of this Gordian knot that gives the managers such control over the funds. I also want to establish a federal statute of fiduciary duty, clearly stating that directors have a fiduciary duty to place the interests of shareholders ahead of the interests of managers, directors, officers and distributors of the fund. That is what the act implies now. But a federal fiduciary statute would be a big step forward. There hasn't been a lot of response from the committee members, I admit. But I would hope the SEC would play a much more active role in all this. The fact is that mutual funds need a change of heart – no pun intended. Heart? What heart? Here I'm reaching all the way back to an article that appeared in Fortune Magazine way back in December, 1949, on trusteeship, in mutual funds – and which inspired me to write my senior thesis at Princeton on the industry. Fund trustees were groups of investment professionals, by and large, back then. The funds were run by those committees, not by individual managers. Very often, the managers of the funds had nothing to do with the funds' distribution. Separate companies were set up to handle the distribution, and made their money on a sales charge, a nice little business. Portfolio turnover was around 16 percent a year – for a very long time. In other words, portfolios turned over about every six years. It didn't get over 16 percent until 1965. Now it averages something like 110 percent – meaning the typical holding period is 11 months. The difference is stunning, especially in its implications for costs borne by investors. Back then, you had trustees interfacing with independent directors. Now the same thing supposedly happens – except that the directors aren't independent in many cases. The funds are no longer run by private little companies whose owners feel duty-bound to restrain their greed. In 1951, the average expense ratio for the 25 largest funds, with aggregate assets of but $2.2 billion, was only 0.64 percent. What a difference five decades makes! Despite the truly staggering economies of scale in mutual fund management, fund investors have not only not shared in these economies. They have been victims of far higher costs. Why? Other than fraud, waste, greed and stupidity, that is? I believe that the most powerful force behind the change was that mutual fund management emerged in the post-war era as one of the nation's most profitable businesses. Up until 1958, a trustee could make a tidy profit by managing money, but could not capitalize that profit by selling shares of the management company to outside investors. The SEC held that the sale of a management company represented payment for the sale of a fiduciary office, an illegal appropriation of fund assets. If such sales were allowed, the SEC feared, it would lead to "trafficking" in advisory contracts, leading to a gross abuse of the trust of fund shareholders. Gee, you mean the SEC was prescient? A California management company challenged the SEC's position and won in court. After that came a rush of IPOs as management companies were quickly brought to market. But that was just the beginning. Giant banks and insurance companies bought up even privately held management companies, paying lofty premiums averaging 10 times book value to get into the burgeoning business. "Trafficking" wasn't far off the mark; there have been at least 40 acquisitions during the past decade. Today, only six of the 50 largest fund managers are privately-held, in addition to mutually-owned Vanguard. Only seven are publicly held. The rest are owned by giant U.S. and foreign financial conglomerates. The upshot is that as you get the economic ownership attenuated out to the shareholders of Deutsche Bank, just to pick an example, the independent fund directors aren't going to feel the same responsibility towards shareholders, it seems to me. I also think the structure of mutual funds will have to be streamlined, though it won't happen rapidly. Isn't it peculiar that these $100 billion fund complexes need another company to run them? Think about that. At that kind of asset level you can run the company yourself. I'm the kind of guy who dug out the March 2000 issue of Money magazine recently, to look at all the fund returns in the ads. There were 44 mutual funds advertising their returns for the preceding year in that issue – and the average return advertised was 85.6 percent. The industry was saying, "Come and get these new age funds." Of course, the industry is going to object, "We didn't say that at all." That was clearly the message. If not the words used. But are you arguing for some sort of restraint on free speech or commerce? Remember, you couldn't give away boring old value funds, for instance, at that point. Let me answer this way: Is it possible to believe that those 496 funds were organized in the interests of investors rather than in the interests of managers? Not on your life. What's wrong with expecting a certain amount of discipline from fiduciaries? Just think about what has happened to a manager who sold those funds. His face is red. He has hurt his business in the long run. But which is the chicken and which is the egg? It seems that not just mutual funds, but investors of every stripe, as well as most companies are all afflicted with ADD [attention deficit disorder]. There is no question that is the problem of the age. A short-term focus is at the root of many of the governance problems, for example. We hear this called a rent-a-stock industry – and it is. Renting and owning are two very different things. If you own a stock you care about how the company is governed. If you're just renting short-term performance, you couldn't care less how a company is governed. This fund industry, with its short-term focus, bears huge responsibility for both the bubble and it aftermath. We have gotten almost no blame for it at all – but we should have. We've hurt a lot of investors very badly and hurt a lot of other people, employees of corporations, by allowing ill-considered mergers to be approved, we improved excessive compensation to managers. Fact is, while a fund that owns stocks has little choice but to regard proper corporate governance as of surpassing long-term importance, a fund that rents stocks could hardly care less. Thanks, Jack.
Kathryn M. Welling is the editor and publisher of welling@weeden, an independent research service of Weeden & Co. L.P., Greenwich, Conn. http://welling.weedenco.com
