Remarks by John C. Bogle, Founder and Former Chairman,
The Vanguard Group
To the '40 Act Institute of PLI (Practising
New York, NY
May 15, 2000
As I was doing the research for
my Princeton thesis on the mutual fund industry in 1950, a mere
half-century ago, I discovered a report from the Securities and
Exchange Commission which described mutual funds as "the most
important financial development in the U.S. during the past 50 years."
Just how the SEC reached this powerful conclusion about an industry
which had but $2˝ billion of assets and represented only 1˝% of
the financial assets of American families was not at all clear to
me. But, by golly, they were right! Since then, the fund industry
has lived up to that early promise—and then some. Today, with assets
totaling $7.2 trillion, and accounting for a stunning 90% of the
net additions to family liquid savings over the past five years,
mutual funds have become the largest aggregation of financial assets
in the land.
But this industry
has lost its way. A half-century ago, it was far more an investment
business than a marketing business. Today, the reverse is
true. Measured not only by the fund industry’s very nature and focus,
but by its relative expenditures on each function, the industry
is primarily a marketing business. Then, funds were long-term investments,
fund managers were long-term investors, and fund shareholders held
their shares for an average of 15 years. Today funds come and go
at a remarkable pace: Each business day, three new mutual funds
are born and one existing fund dies, its performance usually poor,
its purpose passé.
Fifty years ago, fund costs were well within
the ambit of fairness. Now, despite the industry’s quantum 2900-fold
increase in assets, unit expenses of funds have risen by
one-third, giving rise to a far larger 4300-fold (!) increase in
the dollar amount of direct fund operating expenses—from $15 million
in 1950 to $65 billion in 1999.
Today I’m going
to present to you graphic evidence of these trends, which, I fear,
bode ill for this industry, and for the financial markets as well.
While I have been speaking out on these trends for more than a decade
now, they’ve only gotten worse. On the other hand, confession being
good for the soul, I acknowledge that there is little evidence of
their baneful effects on the stock market—so far at least.
Protecting the Interests of Those Whose Funds
They Command . . .
Nonetheless, these trends—the
focus on marketing, the soaring levels of fund investment activity,
and the huge increase in fund expenses—could combine to engender,
a year or two or three down the road, the kind of statement made
in 1934 by Justice Harlan Fiske Stone as he reviewed the events
that led to the Great Crash of 1929 and the Great Depression that
history of the financial era which has just drawn to a close
comes to be written, most of the mistakes and its major faults
will be ascribed to the failure to observe the fiduciary principle,
the precept as old as holy writ, that ‘a man cannot serve two
masters’ . . .
of the corporate structure so as to vest in small groups control
over the resources of great numbers of small and uninformed
investors, make imperative a fresh and active devotion to that
principle if the modern world of business is to perform its
Yet those who
serve nominally as trustees, but relieved, by clever legal devices,
from the obligation to protect whose who interests they purport
to represent . . . consider only last the interests of those
whose funds they command, suggest how far we have ignored the
necessary implications of that principle."
In this industry,
then as now, small groups "control the resources of great numbers
of investors," and it is fund managers who must accept the
lion’s share of the responsibilities for the baneful trends I will
discuss today. But fund directors—"those who serve nominally
as trustees—" must bear their share as well, given the responsibilities
they are assigned under Federal and State law. And it is a heavy
burden, given not only what they have done but what they have failed
to do. Whether affiliated with the fund management company or not,
they are serving two masters: The management company and the
fund shareholders, and that is the root cause of the problem. Yes,
we need entrepreneurs to start fund organizations, and, yes, they
have a right to make a profit. After all, that’s the American way.
But when that profit is excessive, it creates an unacceptable burden
on the returns earned by fund shareholders, who are, after all,
the owners of the fund.
I am not prepared
to argue that today’s fund directors have been, as were the trustee’s
of Justice Stone’s era, "relieved of their trusteeship obligation
by clever legal devices." Indeed, their trusteeship obligation
clearly exists; the problem is that it is given short shrift. There
is compelling evidence that the interests of the managers/marketers
are being placed first. To the extent that is true, it suggests
that fund directors today "consider only last the interests
of those whose funds they command . . . and whose interests they
purport to represent."
I’m going to develop
my analysis of recent industry trends by demythologizing, if you
will, the traditional attributes ascribed to mutual funds—attributes
that it would be impossible for anyone to seriously argue prevail
today. I’ll deal with five of them:
Myth 1. That
mutual funds are long-term investments.
Myth 2. That
mutual fund managers are long-term investors.
Myth 3. That
mutual fund shareholders are long-term owners.
Myth 4. That
mutual fund costs are declining.
Myth 5. That
mutual fund returns
are meeting the reasonable expectations of investors.
I’ll challenge these
myths by presenting the realities of how radically this industry
has changed over the years, especially in what we might consider
the "modern era" of funds, beginning in the mid-1980s,
when fund assets first crossed the $500 billion mark. Then, lest
I leave you with all problems and no solutions, I’ll conclude with
a Golden Rule and Ten Commandments for directors that would help
to begin the arduous process of putting the fund shareholders back
where they belong: In the driver’s seat of this critically important
Myth #1. Mutual Funds are Long-Term Investments
Once, mutual funds were considered
investments for a lifetime. The idea was to buy a mutual fund as
a complete, diversified investment program and hold it, well, forever—Warren
Buffett’s favorite holding period for a stock—much as wealthy families
use trust companies and private trustees. But over the years this
industry has moved from a focus on sound investment management to
the marketing of what have come to be known as "financial products"
(I don’t care for the choice of words, but the phrase surely hits
the nail on the head!). This trend means, as I recall one firm putting
it, "we’re in the ice cream business. We prefer vanilla and
chocolate, but if the customers want pistachio-maple-walnut, we’ll
give it to them."
This change in strategy
does much to explain the creation of the go-go funds of the 1960s,
those lamentable "Government-plus" funds and the global
short-term income funds of the 1980s (all of which came and now
are gone), and of the internet, technology, and so-called focus
(20-stock limit) funds of the turn of the century. During the past
five years, more than 2000 new equity funds have been formed, most
of them designed to capitalize on the public appetite to duplicate
in the future the fabulous returns captured in the past by stocks
in this so-called New Economy of technology, telecommunications,
and science. If history is any guide, few of these funds will be
with us a decade hence.
During the more
quiescent years of the 1960s, just 28 funds out of but 200 didn’t
survive the decade, an acceptable fund failure rate of 14% for the
decade. During the 1970s, in the inevitable hangover that followed
the wild spree of the earlier decade, 297 funds, including most
of the go-go funds, gave up the ghost, and the failure rate soared
to an astonishing 62%. Thus cleansed, the industry was more sedate
during the 1980s, and the rate receded to 21%. But despite the great
bull market, fund failures accelerated during the 1990s, to a surprising
55% for the decade. In the past two years alone, an estimated 450
funds have disappeared.
Clearly, too many
funds have been formed with the principal purpose of being sold
to investors. Often lacking durable investment principles and doomed
to performance failure, they were born simply to die. If in the
first decade of this century the failure rate of the last decade
of the previous century holds, more than, 2300 of today’s 4500 funds
won’t be around in 2010. Mutual fund directors, whether or not they
are aware of what is happening or aware of their fiduciary duties,
have presided over this change in the very nature of the mutual
fund—from being a sound long-term investment to a product offering
a short-term marketing opportunity; from providing stewardship for
a lifetime to the participating in the momentum of the marketplace.
Myth #2. Mutual Fund Managers are Long-Term
Equally depressing, at least
to me, is the baneful change in focus of mutual fund managers. I
mince no words: Fund managers, once long-term investors, have
become short-term speculators. From the time I wrote my Princeton
thesis until the mid-1960s, average fund portfolio turnover normally
ran in the 15%-20% range, a putative holding period of five to seven
years for the average stock fund. In recent years, turnover has
consistently run over 80%, and was 90% last year. Alas, in this
era of day traders—one-day traders—fund managers can be accurately
described as "406-day traders." If "speculator"
is too strong a word for the typical fund manager, it’s surely infinitely
closer to the mark than "long-term investor."
Their high turnover
rate, interestingly, is remarkably pervasive. It ranges from an
average of 146% for mid-cap growth funds to 62% for small-cap value
funds. And even the median large-cap fund turns its portfolio
over at 63% (excluding stock index funds, which turn over at only
about 9%). High turnover is not a statistical aberration; it is
almost as prevalent as the air we breathe.
Again, this industry’s
shift to a marketing ethos bears an important share of the responsibility
for soaring portfolio turnover. Only a few decades ago, it was the
investment committee that managed the fund and focused on
the long-term, but today it is the portfolio manager that
is in charge. Portfolio managers, focusing on the short-term,
can be "hot," and when there is heat, huge capital inflows
are not far behind. And larger assets mean larger fees. So, ever
since the mid-1960s, we’ve lionized our hot portfolio managers;
they became our stars, glamorous and glittering. "A star is
born" has become the watchword. Alas, as we now know, most
stars have proved to be comets, illuminating the financial
firmament for but a few moments in time and then burning out, their
ashes gently descending to earth.
Unlike those staid
old committees, the new breed of manager was lighting-quick on the
trigger. The portfolio managers just can’t seem to sit still for
very long, echoing Pascal’s maxim: "All human evil comes from
this, from man’s inability to sit quietly in a room." What
is more, the managers don’t hold their jobs for very long, and considerable
portfolio turnover arises simply from portfolio manager
turnover. The average manager of an equity fund with at least five
years of operations is but six short years, and when he or she moves
on—a failure, or such an ostensible success that the hedge fund
sirens beckon, or simply a reorganization of the investment department—the
broom of the new manager sweeps the portfolio clean.
What’s so evil about
this turnover frenzy? First, it cannot possibly serve fund investors
as a group, because as much as half of all turnover—perhaps even
more—takes place among mutual funds themselves. Second, it costs
money to trade securities—commissions, spreads, and market impact
costs—conservatively estimated at one-half to one percentage point
per year of return. Third, its tax impact is, well, devastating.
Capital gains, about one-third of which are realized on a short-term
basis and thus taxed as ordinary income—have resulted in a hit to
fund returns of almost three full percentage points of return each
year during this bull market.
Yes, as some naive
defenders of the present ethos argue, some 40% of equity fund assets
are held in tax-deferred accounts, so taxes don’t matter. But
there is no evidence whatsoever that all of this flailing around
enhances returns. Thus, the high turnover that is radically
diminishing the returns of 60% of fund shareholders does nothing
that benefits the remaining 40%. The shift from long-term investing
to short-term speculation, then, is hurting the very shareholders
that fund directors are duly-bound to serve.
Myth #3. Mutual Fund Shareholders are Long-Term
Like the "ILOVEYOU"
virus, the virus that has so adversely infected the duration of
the lives of mutual funds and the duration of the horizons
of fund portfolio managers seems to be wildly contagious.
Mutual fund shareholders are now suffering from the same malady—a
game of "follow the leader" that is, I am confident, utterly
unproductive. When I wrote my thesis, and for twenty years thereafter,
share redemptions by fund shareholders averaged about 7% per year,
suggesting an average holding period of slightly over 14 years.
(The reciprocal of the redemption rate is a crude, but reasonably
accurate, indicator of the holding period.) This figure gradually
drifted upward to the 15% range by the mid-1980s, a seven-year holding
But in the late
1970s, another source of shareholder activity began. As the concept
of the fund family took hold, the exchange privilege came
into wide use. Investors could redeem shares in, say, the family’s
value fund and buy its growth fund or, for that matter, its money
market fund—still clearly a redemption, but not "counted,"
as it were, in the official data, understating the true redemption
rate of fund investors by more than half. From the mid-1980s through
1997, regular redemptions of equity funds averaged some 17% of assets.
But exchange redemptions ran at an even higher 19% rate, bringing
the typical year’s all-in redemption rate to 36%, a holding period
of less than three years for the average shareholder, fully 80%
shorter than the 14 year average of the 1950-1975 era.
In 1987, with the
short-lived market crash and its aftermath, there was a rare departure
from this norm. Redemptions jumped to 20% of assets and exchange
redemptions (largely into money market funds) leaped to 42%, a combined
redemption rate of 62%. In October alone, the annualized rate soared
to 120%. (That’s right, a rate that, had it persisted for a year,
would have been larger than the entire equity fund asset base!)
That rate may well be a harbinger of what lies ahead if stock market
conditions move from unsettled, as they are today, to bearish. In
any event, the upward trend seems to be accelerating. The all-in
redemption rate rose to nearly 40% in 1999, and in the first three
months of 2000 has soared to 50%, reflecting an abandonment of value
funds, a surge in technology funds, and, to a small degree, a flight
to money market funds.
This sea change
in the character of fund owners, from long-term to short-term, violates
the most fundamental principle of investment success: Invest
for the long pull. I am confident that this frequent switching
causes investors to relinquish far more investment return than can
be explained by the high out-of-pocket transaction costs and taxes
they incur. Rapidly jumping from one fund to another is not
a formula for investment success. Yet these appalling figures of
aggregate redemptions are, as far as I know, almost never presented
to fund directors, who remain unaware of the shifting nature of
their constituency and the added risks and costs to which the funds
they serve are exposed.
Myth #4. Mutual Fund Costs are Declining
Back in 1950, when I was writing
my thesis, the expense ratio of the average equity fund was 0.77%.
It has been rising ever since, hitting 0.96% in 1980, 1.20% in 1987,
leveling off at about 1.40% through 1995, and then, with the rapid
formation of new—and higher-cost, always higher-cost—funds, rising
to 1.58% last year. In all, the expense ratio of the average equity
fund has risen by more than 100%—a doubling of unit costs.
Yet, sparked by
heavily-publicized industry data, a myth that fund costs are actually
declining has developed. Specifically, one industry study says,
using a thoroughly inaccurate formulation, that the "costs
of fund ownership" are declining. What it meant to
say is that the costs of purchasing funds is declining.
The industry study concedes that the average unit cost of
equity funds is now 1.93% (35% higher than even my 1.58%
figure). But it alleges that the average cost of purchasing
equity funds—when weighted by each fund’s sales volume—has declined
from 2.26% in 1980 to 1.35% in 1998.
The study leaves,
dare I say, much to be desired. Loading the dice by making sales
volume the basis of cost measurement, the study merely captures
the remarkable shift in investor choice from high-cost funds to
a relative handful of no-load funds, low-expense-ratio funds, and
minimal-cost index funds. But price competition is defined, not
by the actions of consumers, but by the actions of producers.
So the trend that this tortuous methodology measures is hardly evidence
of what is described as "vigorous price competition" in
the fund industry. Indeed, since few, if any, fund groups have slashed
their fees to take on the low-cost funds in the marketplace, price
competition is hardly intense; it is barely alive.
And the study has
still more weaknesses. It completely ignores a huge
cost of fund ownership, fund portfolio turnover. That would
add 0.50% to 1.00%-plus to the putative 1.35% total. It amortizes
sales loads based on 25-year old data, ignoring today’s infinitely
shorter (and therefore far costlier) holding period. It ignores
the opportunity cost that funds incur by their failure to
be fully invested in stocks—another 0.60% cost. And it no longer
even reports the fact, buried deep in the first of its two
studies, that the average expense ratio of the lowest cost decile
of funds has actually risen by 27% since 1980—from 0.71%
to 0.90% in 1997—perhaps up 35-40% if Vanguard were excluded. Even
the lowest cost funds will not be denied their fee increases. Since
fund costs have soared from $800 million to $65 billion over the
past two decades—increasing at an annual rate of 25%—it is clearer
that declining costs are just one more myth.
Position: Ownership cost of equity
funds down 40%. (1980 231 bps;1998 135 bps (Load 200 bps, no-load
by sales volume. Unweighted expense ratio up 64%—96 to 158 bps.
cost decile up 28% from 71 bps to 90 bps (1997).
hidden cost of portfolio turnover (50 to 125 bps).
opportunity cost (60bps).
fees on "wrap accounts."
of sales loads based on 25 year-old data. If updated, 1998 cost
up by 50 bps, to 185 bps (estimated).
Flaw: Price competition is (correctly)
defined by the actions of producers, not the actions of consumers.
Thus price competition is not "intense" in fund industry;
it is barely alive.
Myth #5. Mutual Funds are Meeting the Reasonable
Expectations of Investors.
Given the high fees and operating
costs, the short-term investment horizons, and the substantial transaction
and tax costs that go hand-in-hand with this rise in investment
activity, it is small wonder that mutual fund returns have lagged
so far behind the substantial returns generated by U.S. stocks during
this greatest of all bull markets. Assuming only that the expectation
of most fund investors is at least to enjoy a fair participation
in the long-term returns generated by common stocks—and that seems
a minimal assumption indeed—the idea that mutual funds have met
the reasonable expectations of investors proves to be yet another
I am speaking not
only of the failure of the average fund to match the returns of
the Standard & Poor’s 500 Stock Index. While that large-cap
index is not a bad comparison—after all, it represents 75%
of the stock market, and its return has been identical to
that of the total stock market over the past 30 years—it is a crude
comparison, given that nearly one-half of all equity funds today
focus principally on mid-cap and small-cap stocks. The net result
is that that the performance of the average fund was somewhat better
than it appeared during the surge in large-cap stocks from 1994
through 1998, even as it was worse than it appeared during
the small-cap outperformance of 1990-1993 and in the past 16 months.
But more sophisticated
comparisons are readily available. For example, we can compare large-cap
funds with a large-cap index (the S&P 500 is fair enough),
and compare mid- and small-cap funds with indexes of mid- and small-cap
stocks. Result: on a pre-tax basis, over the past 15 years, large
cap funds have lagged their benchmark by 2.9 percentage points per
year, mid-cap funds by 4.7 points, and small-cap funds by 2.0 points.
(Given the high failure rate of funds, I’ve tried to adjusted conservatively
for survivor bias, using an average of 1.2%, but—generously!—ignored
sales charges.) On an after-tax basis, as you might expect, the
lags increase substantially, to 4.5, 6.2, and 3.0 points respectively.
The brute fact: All-in fund costs have consumed about one-third
of the annual investment returns earned by their bogeys,
even after the benchmarks are adjusted for estimated index fund
expenses and taxes.
Alas for the fund
shareholder, that’s the least of it. Even as we have the famously
accretive magic of compounding of investment returns,
so we have subtly decretive tyranny of compounding investment
costs. Result: the cumulative investment returns earned by
mutual funds over the past 15 years have been a pale shadow of the
cumulative returns by comparable market indexes: Large-cap funds
have provided 51% of the cumulative after-tax profit generated by
the S&P 500 Index: Mid-cap funds have provided 37% of the profit
generated by the S&P 400 Mid-Cap Index. Small–cap fund have
provided 56% of return generated by the Russell 2000 Small Cap Index.
That’s just not good enough.
It is as hard to
imagine fund directors basking in the glory of this record of their
stewardship as it is easy to imagine their general concern, even
their embarrassment, although there is no evidence of either. So
it is easiest of all to imagine that the fund directors unaffiliated
with fund management are completely unaware of these facts. (To
be sure, their affiliated director counterparts must be all too
aware of them). Yes, I’m reasonably confident that nearly all directors
receive presentations showing returns on an annual basis and a cumulative
annualized basis, but I wonder how many boards are exposed to cumulative
after-tax returns on a comprehensive comparative basis.
Yet despite what
the data shows, we have virtually no examples of the termination
of contracts of fund managers primarily by reason of consistent
inferior performance. That strongly suggests that directors either
don’t know, or don’t care, or don’t think it is their role to take
action. If they don’t know, they are derelict in their duty. If
they don’t care, they are financially illiterate. And if they don’t
think their role is to take action, who else do they think will
fulfill that role?
Where Do We Go From Here?
Taken together, the shift of
industry focus from management to marketing; the rising rate of
fund failures; the incredibly short horizons of portfolio managers;
the increasing use of funds as vehicles for trading, not investment;
and the soaring costs and tax bills; together they have combined
to ill-serve fund shareholders and create a clear record of performance
inadequacy. What’s to be done? I suggest that independent directors
have a major role to play in the resolution of these seemingly intractable
problems. After all, who but fund directors are in a position to
bring funds into compliance with the clear mandate of the Investment
Company Act of 1940:
national public interest and the interest of investors are adversely
affected . . . when investment companies are organized, operated
and managed in the interest of investment advisers, rather than
in the interest of shareholders . . . or when investment companies
are not subjected to adequate independent scrutiny."
This Act’s preamble
clearly makes two demands: (1) That it is shareholders who come
first, with funds organized, operated, and managed with their
interests the highest priority; and (2) that it is independent directors
who have the responsibility for careful scrutiny that assures the
primacy of those interests.
The Ten Commandments
You don’t have to tell me how
tough a job it will be for this industry to reach that worthy goal.
I’ve been doing my best, even in the years before "The Vanguard
Experiment" began, but the tangible results are disappointingly
few. Vanguard began its thousand mile journey with a single step
in 1974, and lots more steps have followed. (Few of you know how
arduous and demanding each of those steps have been, and continue
to be.) But let me suggest some further steps along the way to meeting
the clear—and wholly desirable—mandate of the ‘40 Act. While I wish
we could take a giant step—establishing a federal standard of fiduciary
for fund directors would be my choice—the fact is that a series
of small but deliberate steps is more realistic. So I would propose
that we begin by setting down these Ten Commandments for independent
Shalt Retain Thy Own Independent Counsel.
Recommended by the Securities & Exchange
Commission, this step seems so obvious and so essential that
it is hard to imagine why it hasn’t been mandatory ever since
this industry began in 1924. Just imagine, in any other business,
the anomaly of a firm being represented, not by its own counsel,
but by counsel for its largest supplier of services, who depends
on it for its very existence. Yes, I read all the arguments
against independent counsel—there aren’t enough lawyers; they
won’t be as experienced; they won’t be the best; they won’t
have enough financial incentives; and believe it or not, in
the face of the failings I’ve described, the industry "is
not aware of any problems that have arisen as a result of current
practices." Although I have no doubt that the present proposal
can be sharpened, these make-weight arguments must be disregarded,
and the independent counsel proposal implemented.
- Thou Shalt Elect An Independent Director
As Thy Fund Chairman.
present fund chairman, by and large, is chairman or president
of the fund’s management company. But it must be clear that
the management company is a business corporation, and the primary
responsibility of its chairman is to keep the business running
soundly and to earn the largest possible profit for its owners.
The fund chairman’s primary responsibility is, in a sense,
precisely the same. . . but for a completely different
constituency: To keep the fund running soundly and
to earn the largest possible profit for its owners. The
two responsibilities directly conflict: the more the manager
charges in fees, the less remains for fund shareholders. Only
by separating these two distinct responsibilities can we possibly
begin the process of bringing management fees and profit margins
under control. After all, when the fund chairman negotiates
fees with the management company chairman, and they are
the same person, we can hardly expect shareholders to come first.
Warren Buffett put it perfectly: "Negotiating with oneself
rarely produces a barroom brawl."
Shalt Get The Facts About Performance. Demand
full, fair comparisons. Consider risks, peers, and appropriate
market indexes. Look at cumulative returns over extended
periods, and don’t forget after-tax returns.
- Thou Shalt Get The Facts About Costs.
For each fund you serve
as a director, "follow the money."
Review the adviser’s profit-and-loss statement.
How much did the fund pay?
How much was spent on investment management? How much on marketing,
and on administration? (Press hard on exactly how those expenditures
on advertising—directly or indirectly, through 12b-1 plans—benefit
the shareholder.) What was the manager’s pre-tax profit margin—before
and after marketing costs—on each fund you serve? On all funds
in the complex? This information should be readily accessible.
Indeed, 30 years ago, we regularly provided such information
to the directors of the mutual funds managed by Wellington Management
Company. You can’t intelligently consider fund fees without
knowing where the money goes. And, while
I’m on the subject of costs, let me reiterate my call for the
Securities & Exchange Commission to undertake a comprehensive
economic study of the mutual fund industry, first determining
and then publishing industry-wide data on where $65 billion
of fees and expenses paid by fund shareholders went last year.
and uses is the only way to follow the money.
the Dollar Fees Thy Fund Pays with Those of Competitors.
This industry has done a marvelous job at one thing:
Placing public focus on fee rates rather than fee dollars.
It brags that the cost of mutual fund ownership has fallen from
2.26% to 1.35% of assets since 1980. When the total dollar costs
paid by all funds (excluding sales charges) have soared from
$800 million in 1980 to $65 billion in 1999, it takes some kind
of brass to make that argument. Expense ratio comparisons
are fine as far as they go, but they don’t go far enough. It
is dollars that fund shareholders pay and dollars
that the managers extract. A 1.00% expense ratio may look
low—indeed is almost universally acclaimed as low—but
on a $25 billion fund, it produces $250 million for the manager
every year, $1 billion over four years. Make sure you know how
the dollars your fund spends compares with the dollars
spent by its peers.
shalt Challenge Thy Fee Consultants. Many
fund managers retain fund consultants to provide comparative
data to the Board. But like executive compensation consultants,
fund consultants know what their job is: To justify existing
compensation (fee) levels, and to provide a basis for compensation
(fee) increases. "Heaven forbid," they suggest, "that
your (sic) fund should be in the bottom quartile in expense
ratio." But let me assure you that when you’re down there,
it’s really good for shareholders. Honest! So demand
that the consultants calculate dollar fees as well as fee rates.
While you’re about it, demand that they include data for index
funds, and data for funds run by differently-structured (low
cost) fund organizations. I’m told that some consultants ignore
such funds and firms on the grounds that they’re "different,"
and somehow unworthy of inclusion. Yes, index funds and mutual
organizations are "different," but only if you see
the figures, can you be the judge of whether or not different
Shalt Keep an Eagle Eye on Portfolio Turnover. Consider
the level of fund turnover, and demand to see the attendant
costs of brokerage commissions and market impact, the amount
of gains realized, the extent of short-term gains, and the dollars
and cents burden in unnecessary federal, state, and local taxes
borne by shareholders. Find out how turnover affected performance:
Did it help? Did it hurt? By how much? Ask for a simple examination
of the results of the portfolio held at the year’s outset, assuming
that no changes been made all year. ("Static Portfolio
Analysis.") Ask for an explanation of the frequent rotation
of portfolio managers, and demand to know the extent and cost
of anticipated portfolio changes when a new manager is appointed.
- Thou Shalt Not Ignore
Incentive Fees. We
all—fund officers, directors, managers, shareholders—expect,
or at least hope for, outstanding performance. It is a consummation
devoutly to be wished, but, on the record, all too rarely achieved.
Don’t pay for expectations or hopes. Pay for achievement,
a standard easily accomplished by adopting a fee schedule that
awards premium fees for performance that exceeds agreed-upon
benchmarks, and assesses penalty fees for performance that falls
short. While the equity of such a system seems self-evident,
incentive fees have almost vanished from the mutual fund scene.
- Thou Shalt Consider Redemption Fees. One
of the easiest, and fairest, ways to mitigate the use of mutual
funds as speculative vehicles for short-term gains, and to return
them to their traditional use as investment vehicles for long-term
accumulation, is the imposition of reasonable redemption fees.
Today, equity fund redemptions are running at an astonishing
50% annualized rate. Yet largely as the result of a redemption
fee of 2% in the first year and 1% for the next four years,
the funds in the industry’s first tax-managed series, now in
their sixth year, have an annual redemption rate running at
just 5%. Surely there are lessons to be learned from this potential
90% reduction in redemption activity. (Alas, even as it effectively
excludes short-term investors, the redemption fee retards marketing.
So you serve the shareholders at the expense of the manager.)
Shalt Evaluate Thy Fund as If It Were Your Own Money
Bring this attitude to your work
as a director: Is this the way my money should
be run? Is my performance satisfactory? How about my tax-efficiency?
How about continuity of my portfolio management? How much would
I be willing to pay for this service? When performance
lags, how patient would I be? When would I terminate
my own fiduciary relationship and move to another? In all, behave
as if you were a large shareholder, and assume that the
assets were important to you. Better yet, actually own
shares of the funds you serve as trustee. The investment of
a significant portion of your own assets in the funds you serve
is the single most meaningful step you can take in demonstrating
both your commitment and your independence.
These are hardly
radical steps, and most require no new laws or regulations. A statement
of these principles by the Investment Company Institute, or by the
new Mutual Fund Directors Education Council, or by the SEC—or even
a speech by a senior SEC official—would start the ball rolling,
and it would not soon stop. It’s high time we begin the process.
The Golden Rule
There are 80 million mutual fund
shareholders out there. They need the support and commitment of
independent directors to make those five old myths about mutual
funds into five new realities—realities that recognize mutual funds
as long-term investments, with managers who are long-term investors
and shareholders who own their shares for an investment lifetime;
operated at reasonable—and therefore far lower—levels of cost and
far higher levels of tax-efficiency; providing shareholders with
returns that meet, and even exceed, their expectations for a fair
share of market returns.
So, before history
repeats itself, and Justice Stone’s words come to describe the of
this era and their causes, let’s make our philosophical anchor
the preamble of the Investment Company Act of 1940 that has served
this industry well in so many other arenas. Remember the Golden
Rule of the ’40 Act: Put fund shareholders first. If fund
directors will take seriously the Ten Commandments I’ve laid down
today, and guide managers toward their own enlightened self-interest
in serving investors "honestly, efficiently, and economically"—the
very words I used in my Princeton thesis a half-century ago—we can
avoid onerous and contentious regulation and legislation—and, for
that matter, litigation—and we’ll have come a long, long, way toward
finding our way back to our roots. It’s only common sense.
Note: The opinions expressed in this article do not necessarily represent the views of Vanguard's present management.
to Speeches in the Bogle Research Center
©2010 Bogle Financial Center. All Rights Reserved.