Remarks by John C. Bogle, Founder and Senior Chairman,
The Vanguard Group
On Receiving the Adam Smith Distinguished Leadership
Award Before the Pennsylvania Partnership for Economic Education
June 17, 1999
I am deeply honored by your selecting me as the 1999 recipient of the
Adam Smith Distinguished Leadership Award. Surely Adam Smith, with all of
his worldly wisdom about how things work and what makes people's hearts beat,
would have understood my feeling. As he expressed it in The
Wealth of Nations, "honor makes a great part of the reward of all
My entire career has been dedicated to what I believe Adam Smith would
consider an honorable profession: to help the citizens of the United States
of America put aside part of today's earnings for tomorrow, and invest those
savings in the most productive manner possible. The role of mutual funds as
a repository for the savings of American families was a prime theme of the
senior thesis that I wrote at Princeton University nearly 50 years agoit
was entitled "The Economic Role of the Investment Company"and I have
worked in this industry ever since my graduation. Since I hardly possess Adam
Smith's gift for words, I'll use his words to express the fundamental propensity
to save that's part of our human nature:
The principle which prompts to save is the desire of bettering our condition,
a desire which comes with us from the womb and never leaves us till we grow
into the grave. In the whole interval which separates those two moments, there
is scarce a single instant in which any man is
with his situation. An augmentation of fortune is the means by which men propose
to better their condition. The most likely way is to save and accumulate some
part of what they acquire. The principle of frugality not only seems to predominate,
but to predominate very greatly.
Later on in his book, he put it even more bluntly: "A man must be perfectly
crazy who does not employ the (capital) stock he commands in some way."
My thesis put forth the proposition that the best way for individuals
to employ their capital stock was in owning mutual funds. After graduating
from Princeton in 1951, I put my career where my words were"my money
where my mouth was" is the conventional formulationand, given my first
break by legendary Wellington Fund founder Walter L. Morgan, joined the mutual
fund industry, then described by Fortune magazine as "tiny but contentious." For 23 years, I plied my trade at Wellington,
before my career took a surprising turn. A midcareer change, when it happens,
is not always fun, but I set my new course first to build a better fund company, and then to build a better fund industry.
To give you some sense of the new direction that I mapped in midcareer,
let me give you just a few sentences from a serial white paper that I prepared
early in 1974 for our mutual fund Board of Directors. The paper was entitled "The Future Structure of The Vanguard Group of Investment Companies,"Actually,
I expected to use the name "The Wellington Group of Investment Companies."
But as fate would have it, I would have to choose a new name, and decided
that "Vanguard" would do the job.and it took the position that
our mutual funds should have:
an appropriate amount of corporate and economic independence,
the highest quality of services, consistently superior performance, optimum
cost effectiveness, and a structure that is consistent with 'consumerism'
and new standards of business ethics.
The whole idea was to make the Vanguard funds independent of an external
manager/distributor with its own interests and agenda, high on which was earning
a generous return for its own set of stockholders. In this prototypical industry
structure, it goes without saying that seeking to serve the interests of two
sets of stockholdersin this case, the owners of the funds and the owners
of the companies that manage theminvolves serious conflicts. It also
must go without saying that, if the owners of the management companies control
the fund/manager relationship, it would be patently absurd to expect them
to resolve this conflict in a manner opposed to their own interests. The Apostle
Matthew said it well: "No man can serve two masters."
So, it came to pass that Vanguard was organized under a new mutual fund
structure, unique then as now. The fund shareholder alone would be served
through a Board of Directors unaffiliated with any external investment manager.
The funds would employ their own staff, responsible for administration, distribution,
and investment management, contracting with outside advisers only when it
was advantageous to do so, and then only with contracts negotiated competitively
and at arm's length.
Our bet on the future was a gamble that, by moving in a new direction,
our enterprise would be able not only to survive but to grow and prosper.
We would leave the traditional seller-driven distribution system, in which
the marketing/sales organization is king, to a new buyer-driven distribution
system, in which the consumer is king. The "Future Structure" white paper
was based on a few simple (and, I would argue, patently obvious in 1974, even
to one totally bereft of foresight) economic trends: (1) the aging of the
American population, a certainty after the post-World War II explosion of
births; (2) the growing income and wealth of the population, a simple extrapolation
of past trends; (3) a vast and growing reserve of savings generated by these
trends, savings which almost certainly would be employed to meet future retirement
needs; and (4) with these savings available, a far greater public interest
in economic and financial knowledge. After all, with all they would have at
stake, these new investors would not only want to, but need to, understand
our system of capital formation and how to most effectively and efficiently
invest their resources.
The mission of the Pennsylvania Partnership for Economic Education surely
both echoes and reinforces these goals. As you salute me today, so I salute
you for your accomplishments in increasing and improving the understanding
of the American economic system. Of course, this must begin in our primary
and secondary schools, for it is never too early to teach our citizens about
the management of financial resources, the role of entrepreneurship, and the
advantages of being (to quote the words used by Governor Ridge in informing
me that I was to be honored with this award) "more productive workforce members,
knowledgeable consumers, prudent savers, and competent decision makers."
From our inception nearly 25 years ago to this very day, Vanguard has
focused heavily on investor education. We begin with clarity,
for communication is only impeded by tortuous sentences that sometimes seem
almost designed to obfuscate. (We are in the vanguard, as it were, of the "plain English" mandate issued to the securities industry by the Securities
and Exchange Commission.) We emphasize candor,
stressing the risks of investing every bit as heavily as the rewards, a stance
that is hardly characteristic of this industry which is engaged not only in
preening, pheasantlike, about performance, but in hyping past performance
beyond reason. The simple fact, however, is this: The
past performance of a mutual fund has no predictive value. To the
contrary, reversion to the mean, in which top-performing funds come down to
earth and bottom-performing funds come up to (or at least toward) earth is
the rule of life. In my new book, I call this powerful tendency, "Sir Isaac
Newton's Revenge on Wall Street." In all this hyperbole that plays on the
notion that the past must be prologue, there is money to be made by fund managers. But there is none to be made by fund investors.
We also believe in full disclosure
of all of the facts a prudent investor might need to come to an intelligent
decision about investment choices. I'll grant that the industry too has traditionally
honored this principle. But with one notable exception: cost disclosure. It
is not that mutual funds conceal the direct costs of fund investing as such.
For the investor who looks long and hard enough, the disclosure of fund management
fees, expenses ratios, and sales charges can be found in each fund's prospectus.
But there is virtually no disclosure of another major cost of fund ownership: the brokerage commissions and market-impact costs
of the fund's portfolio transactions. The fact that the combination of direct
and indirect fund expenses may reduce the gross returns of the average equity
mutual fund by as much as 2.5% per year is nowhere to be found. But one need
only look at a compound interest chart with two lines extended over time at
7.5% and 10% respectively to see that the lower annual return provides only
47%less than one-half!of the cumulative value of the initial
investment after 30 years. Earning less than half of the stock market's long-term
return simply isn't good enough. To state the obvious: Cost
With costs so high, it is in the industry's interest to ignore that
self-evident fact, lest investor knowledge become investor power. Price competition
has thus yet to pervade the mutual fund industry. The question may be fairly
raised: Where is the invisible hand that Adam Smith relied on? Hear his famous
Every individual intends only his own security; by directing his industry
in such a manner as to produce its greatest value, he intends only his own
gain but is led by an invisible hand to promote an end which was no part of
promoting the interests of the society more effectively
than when he really intends to promote it.
But that invisible hand is, well, invisible in the mutual fund industry.
The interests of our society have not been promoted effectively; the interests
of investors have been ill-served. Why has Adam Smith's thesis that competition
works to produce the greatest value failed to work in the fund industry? Then-future
Nobel Laureate Paul Samuelson, writing in the first edition of Economics:
An Introductory Analysisthe classic text that provided my
own introduction to economics at Princeton in 1948, and hence to my senior
thesis on mutual fundshad the answer:
The praise of perfect competition is beside the mark
might say of free competition what George Bernard Shaw once said of Christianity:
"The only trouble with it is that it has never been tried."
It is clear that price competition has yet to be tried in the mutual
fund industry. The expense ratio of the average mutual fund has risen from
1.10% to 1.54% since 1980, a 40% rise in the face of a 7,300%(!) increase
in equity fund assets. The profits earned by fund managers have grown at a
rate so far beyond the profits earned by mutual fund shareholderseven
during this great bull marketthat they brook no serious comparison.
It has been the managers, not the fund investors, who have been the largest
beneficiaries of the bull market, as is clearly illustrated by even a superficial
comparison of the returns earned by the owners of mutual fund management companies
and the returns earned by the owners of the very mutual funds they manage.
When the history of this era is one day written, I believe that Vanguard's
principles of clarity, candor, and disclosureespecially cost disclosurewill
stand as a major factor in helping to at last bring Adam Smith's invisible
hand of price competition into the mutual fund industry. During our early
years, I often described the enterprise in which we were engaged as "the Vanguard
experiment"a test of whether a fund organizational structure that honored
the interests of fund shareholders over the interest of fund managers could
be made to work. Of course, it was easy to foresee it would work well for
investors. But would it work in the dog-eat-dog competitive world of mutual
funds? Could a business based on these principles sustain itself and grow?
Especially in this era of aggressive fund marketing, powerful salesmanship,
hot short-term performance, and sleight-of-hand dealing with the facts? Absent
the drive of sellers, would buyers respond? Put another way, "if we built
it, would they come?"
Now, of course, we know the answer. It is with decidedly mixed emotions
that I report to you that the Vanguard Experiment is over. For a quarter of
a century now, we have grown at a rapid but remarkably steady rate. The assets
we manage have grown from $1.4 billion to nearly $500 billion. We have built
a pretty good mousetrap, and investors have beaten a path to our door. We
have proven, I think, that sound economics and sound investment principles
can carry the day.
Adam Smith has today become the icon of the conservative side of the
political spectrum, a result of his zealous belief in the free market. As
he put it, "it is not from the benevolence of the butcher, the brewer, or
the baker, that we expect our dinner, but from regard to their own interest." But he was not opposed to government intervention when it would be beneficial
and not undermine the essentially free characteristics of the system. Students
should not forget that part of Adam Smith.
Permit me to close by moving briefly to a higher plane that transcends
economics, a message that I particularly send to the young men and women who
are gaining so much valuable economic education through the efforts of the
Pennsylvania Partnership. Even before venturing into economics in The Wealth of Nations, Adam Smith unveiled his credentials
as a philosopher. In The Theory of Moral Sentiments,
he expressed this thought, which I hope every budding entrepreneur-capitalist-businessman
will heed, suggesting as it does, that promoting one's own interests must
never engage the whole person:
It is reason, principle, conscience, the inhabitant of the breast, the
man within, the great judge and arbitrator of our conduct
us the propriety of generosity, of reining in the greatest interests of our
own for yet the greater interests of others, the love of what is honorable
and noble, of the dignity of our own characters.
With that final wisdom from Adam Smith, I thank you again for the honor
you bestow on me today.
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