By John C. Bogle, Founder and Former Chairman,
The Vanguard Group
June 20, 2000
The following article was originally published in The Wall Street Journal on the Op-Ed page.
In a half-century, the mutual fund industry has gone from being a $2 ½ billion also-ran in the financial services industry to a $7 trillion titan. Funds now enjoy a position of leadership that is almost beyond challenge, accounting for 70% of the $2 trillion that American families have added to their savings during the past five years. But while mutual funds may be the best game in town at the moment, they are not playing nearly as good a game as they should.
In stock, bond and money markets alike, returns of fund shareholders have fallen far short of the returns available in each of those financial segments. A diminishing focus on stewardship, shrinking investment horizons, and soaring costs are largely responsible. The mutual fund industry has lost its way.
I've been studying mutual funds ever since 1949, when I began the research for my senior thesis at Princeton University. The change in industry direction and focus has been dramatic. Then, this was far more a management business than a marketing business; today the reverse is true. We have moved from treating funds as investment trusts designed to serve their owner/beneficiaries to treating funds as consumer products, designed to attract the largest possible assets. That change in direction has ill-served the interests of fund shareholders.
A dramatic decline in investment horizons has also changed the nature of the industry. In the 1950-1965 era, funds were long-term investments; fund managers were long-term investors; and fund shareholders held their shares for more than a decade. Costs were reasonable. And it could fairly be said that mutual fund performance was measuring up to the reasonable expectations of investors. Today, none of those statements accurately characterizes this industry.
Funds themselves, once investments for a lifetime, now come and go at a remarkable rate. Some vanish when they fail to achieve their investment objectives, liquidated or merged into other funds in the same family-maybe with similar goals, maybe not. Others, created to reflect the investment fads and fashions of the moment, disappear when the fad passes. The "go-go" funds of the late 1960s and the "government-plus" funds of the late 1980s are but two examples. It is easy to imagine that many of today's internet funds and technology funds will meet the same fate.
During the 1990s, 55% of all equity funds failed to survive the decade, almost four times the 14% failure rate of the 1960s. Should the recent failure rate hold during the coming decade, 2,500 of today's 4,500 equity funds won't be around in 2010, their owners not only the victims of inferior performance, but also subject either to paying unnecessary taxes when they liquidate their shares or forced to transfer to a new fund that they didn't bargain for.
Fund managers, once long-term investors, have become short-term investors—speculators, if you believe that holding stocks for an average of just 406 days has little to do with investing. Fund portfolio turnover, averaging about 17% annually during my first 15 years in this industry, rose to 90% last year.
The hyperactive trading atmosphere of the day is partly responsible. But the shift in investment control from investment committee to portfolio manager has also played a major role. For better or worse, the industry's dominant force has changed from consensus to impulse. What's more, portfolio managers themselves turn over at a rapid rate. The average manager lasts just six years, and, more often than not, the new broom that takes over sweeps the portfolio clean. It turns out that there are few stars in the mutual fund firmament, just many comets.
Since most fund trading takes place with other funds, the returns of fund investors as a group cannot possibly be enhanced by all of this turnover. Its heavy costs create benefits that go largely to those who execute the transactions. But the biggest beneficiary of all is the Federal government, which has reaped billions of dollars from taxes on long-term capital gains-not to mention the higher income taxes on the substantial short-term gains funds frequently realize. The premature realization of gains accounted for a major portion of the $30 billion of federal taxes paid by fund investors in 1999.
This contagious short-term virus has now spread to fund shareholders themselves. Share redemptions, which ran at about 8% of fund assets during the 1960s and 15% during the 1970s, leaped to 30% during the 1990s, and are running at an astonishing 47% rate so far in 2000, as shown in the chart nearby. This dramatic increase suggests that fund shares, once held by long-term investors for an average of 12 ½ years, are being held for an average of just over two years—a sad fate for an investment that was originally designed to be the perfect medium for the long-term investor.
The redemption rates shown in the chart are about twice as high as those published by the industry. Its data, for no apparent reason, exclude redemptions proceeds that are reinvested in funds of the same fund family. These exchange redemptions are about equal in amount to the regular redemptions that find their way into other funds, or individual stocks, or the bank, or to purchase a home or car.
All of these measures of mutual fund investment activity—funds that come and go, portfolio holdings that come and go, portfolio managers that come and go, and fund shareholders who come and go—frustrate the achievement of long-term investment objectives. Equally counterproductive is the heavy burden of mutual fund fees and expenses. When I studied the industry 50 years ago, expenses amounted to 0.77% of the assets of the average equity fund. This expense ratio has moved onward and upward ever since. In 1999, it reached 1.61%, an increase of more than 100%.
Given the staggering rise in fund assets, the surprising fact about the expense ratio is not that it has soared, but that it has failed to decline. There are huge economies of scale in mutual fund operations, but they are not being adequately shared with fund shareholders. Indeed, the Investment Company Institute reports that even the lowest cost decile of funds has raised prices by 27% since 1980.
Yes, as the Institute reports, the annual cost of purchasing equity funds (including expenses and sales charges) is "only" 1.32% when weighted by fund assets. But according to its data, mutual fund shareholders are now paying estimated annual fees, expenses, and sales charges of $75 billion. Adding in estimated portfolio turnover costs of some $45 billion, mutual funds are now generating returns of some $120 billion annually to their managers, marketers, and brokers—dollars that are diverted from the returns of the fund shareholders.
These costs, along with heavy taxes, are the principal culprits responsible for the inadequate returns funds have provided for their investors, returns that have fallen far behind those of the great bull market. During the past 15 years, equity funds—at least those that survived the period-provided a net return, after costs and taxes, of just 11.7%. By way of comparison, an index fund that owned the entire U.S. stock market—represented by the Wilshire 5000 Total U.S. Equity Index—would have earned a return, also adjusted for costs and taxes, of 16.1%. This advantage of 4.4% per year is, in fact, larger than it seems. Compounded over the period, the average equity fund rose 426%, compared to 839% for the index fund. The fund shareholder received barely one-half of what he or she might have reasonably expected.
Investment horizons that are too short and costs that are too high are the principal manifestations of the problems facing the mutual fund industry. When stocks come to generate lower returns, they will become far more visible. But the root cause of these problems is the industry's failure to focus on the primacy of the fund shareholder. It's called stewardship. The Investment Company Act of 1940 warns against organizing, operating, and managing funds in the interest of investment advisers rather than the interest of shareholders, but that warning is not adequately heeded today. It is high time that fund managers and independent directors, as well as public officials and the media, give these issues the attention they deserve.
While my voice has been a lonely one, I am not without some important support. In his insightful new book, On Money and Markets, Henry Kaufman writes, "basic fiduciary duty too often has been forgotten in the high-voltage, high-velocity financial environment that has emerged in recent decades . . . the notion of financial trusteeship is frequently lost in the shuffle." I hope that the mutual fund industry will find it, and will once again find its way.
Note: The opinions expressed in this article do not necessarily represent the views of Vanguard's present management.
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