by John C. Bogle, President of Bogle Financial Markets Research
Center, founder and past chairman of The Vanguard Group
Investigating the slaying of a racehorse
in Silver Blaze,* Sherlock
Holmes mentions "the curious incident of the dog in the nighttime."
Watson, surprised, responds, "But the dog did nothing in the nighttime."
"That was the curious incident," Holmes replies. He is able to identify
the culprit simply because the watchdog did not bark. Why?
Because the culprit was the dog's master.
There is a moral here for the mutual fund industry.
The Investment Company Act of 1940 specifically states that the
interests of fund shareholders must be placed ahead of the interests
of fund managers and distributors. The Act places this responsibility
in the hands of fund directors, a majority of whom must be independent
of the fund manager. But the master of the funds turns out to be
the fund manager, and the watchdoga word almost universally
used to describe the role of the independent directorsimply
What's the Crime?
If the fund manager is the culprit, what is
the crime? For me, it is the change in the central ethic of the
mutual fund industry from the profession of investingthe
stewardship of shareholder assetsto the business of marketinggathering
assets and creating whatever "products" it takes to do so. The impact
of this change can be easily measured:
1. Soaring Turnover Among Mutual Funds.
Fifty years ago, there were 126 equity mutual funds, most with
prudent long-term investment objectives. Today there are 4,800
equity funds, less than half of which, by my count, meet that
standard. Mutual funds, increasingly created to capitalize on
hot stock styles and hot money managers, come and go at an unparalleled
rate. Started opportunistically, they fail frequently, their goals
largely unfulfilled. During the 1960s, 14% of all funds failed
to survive the decade. During the 1990's, 55% of fundsmore
than one half!failed to survive. This diminution of our
traditional long-term focus has ill-served fund investors.
2. Soaring Fund Portfolio Turnover.
Portfolio turnover has leaped from 17% annually during the 1950s
to 108% in 2000. With this change from long-term investing (a
six-year holding period for the average stock) to short-term speculation
(an 11-month holding period) has come higher transaction
costs and far higher tax costs to fund investors. Part of the
increase reflects a shift from conservative, even staid, investment
committees to individual portfolio managers, who themselves last
for an average of but five years. Neither of these changes has
produced an observable improvement in fund performance.
3. Soaring Turnover of Fund Shares.
As if learning from their managers, fund shareholders are turning
over their own shares at unprecedented rates. In the 1950s, share
redemptions averaged 6% of assets, an effective 16-year holding
period. By 2000, the rate had leaped to nearly 40%, a 2½ year
holding period. All of this shuffling around in the chase for
performance has resulted in an incalculablebut significantdiminution
of shareholder returns.
4. Soaring Fund Expense Ratios. In
1950, fund expenses averaged just 0.77% of tiny assets of $2½
billion. By 2000, despite a 1600-fold leap in equity fund assets
to a gargantuan $4 trillion, the expense ratio had more than doubled,
to 1.60%. It is fund managers who have enjoyed the staggering
economies of scale available in investment management. The fund
shareholders, clearly, have not. As a result, they have not received
their fair share of the stock market's bountiful rewards.
These trends clearly illustrate that the interests
of fund managers are being placed ahead of the interests of fund
shareholders, precisely what the 1940 Act was aimed at preventing.
Taken together, soaring investment activity and soaring costs have
had a powerful negative impact on the returns earned by shareholders.
Unless reversed, these trends will continue to harm mutual fund
investors in the years ahead. Indeed, in the coming era of likely
lower equity returns, the damage will be even more pronounced.
Who's the Culprit?
If crimes they are, the culprit is clearly the
fund manager. For whether privately-held, publicly-owned, or a subsidiary
of a global financial conglomerate, it is the manager who runs the
show. Yet the watchdogs do not bark. Fund directors are essential
participants in the creation of new funds and the dissolution of
those that don't work; they remain silent as portfolio turnover
soars and managers are shuffled like chessmen; they likely remain
uninformed, even today, about soaring shareholder turnover; and
they approve every management fee for a new fund and every fee increase
for an existing fund. There is simply no way that fund directorswhose
legal duty is clearly to the shareholders who elected themcan
be absolved of responsibility for the harmful trends that beset
Why do the watchdogs remain silent? One reason
may well be that the directors of large mutual funds are so well
paid that the line has blurred between a "disinterested" role (the
word the Investment Company Act of 1940 uses to describe independent
directors) and an "interested" role (the word used to describe directors
who are paid employees of the fund's investment manager). A 1996
study showed that the annual fee for an independent director of
the ten highest-paying fund complexes averaged $150,000, nearly
double the $77,000 directors' fee paid by the ten highest-paying
Fortune 500 companies.
Fund directors fees are even higher today. In
a curious paradox, it is hardly unusual for independent fund
directors to be paid far higher fees than those paid to the independent
directors of the very corporations that manage the funds. Five of
the highest-paid mutual fund directors, in fact, receive fees averaging
$386,000 annually (in two cases, supplemented by $100,000-plus annual
pensions!), compared to just $47,000 for their management company
counterparts, directors of the companies (often large financial
conglomerates), whose business includes operating the funds. (See
Management Company vs. Mutual Fund
|Giant Bank (1)
|Giant Brokerage Firm
|Large Fund Manager
|Giant Investment Banker
|Insurance Holding Co.
1- Parent of Fund Manager
2- Plus annual pension of $157,500 for 10 years.
3- Plus annual pension of $115,000.
Responsibility: Corporate Directors vs. Fund
What could possibly explain this huge differential?
Could these fund directors possibly be shouldering eight times
the responsibility shouldered by their corporate counterparts? Consider
the facts: A corporate director is responsible for approving the
corporation's policies and business objectives; selecting the chief
executive officer; approving often-enormous expenditures on plant
and equipment; determining an appropriate capital structure, dividend
policy, and stock repurchase program; and, typically, approving
a mission statement focused on the creation of long-term economic
value for the corporation's shareholders, measured by returns that
are higher than the corporation's cost of capital.
Mutual fund directors are responsible for none
of these decisions. Rather, in the industry's own parlance, they
are "watchdogs" for (usually) each of the 100-300 funds managed
in the large fund complexes, approving (and rarely, if ever, disapproving)
each fund's advisory and distribution contracts, custodian agreements,
and pricing and valuation procedures; and monitoring investments
and portfolio quality and liquiditya seemingly imposing list
of 40 duties, but duties that, in the real world, are perfunctory.
None of these duties, however, relate to a fund's mission and its
obligation to create economic value and earn its cost of capital.
Further, those approvals and that monitoring
take place under the direction of the fund's chairmana chairman
who is, almost without exception, also the chairman (or a high official)
of the fund's management company. While it is said that "no man
can serve two masters" the independent directors not only serve
two masters, but are dominated by one: The management company. Experience
clearly confirms that as watchdogs, fund directors are, in Warren
Buffett's words, "cocker spaniels, not dobermans."
It will be no mean task to change director conduct.
Directors are typically invited on the board by the chairman, and
the chairman and other officers of the manager control the board
agenda and dominate the discussions. Most independent directors,
I'm confident, do their best to be fair, but the pervasive nature
of this domination, when added to the director's self-interest in
receiving fees (which obviously grows stronger as fees rise), makes
it easy for even the best of directors to justify a collegial acceptance
of the status quo.
Avenues of Change
But change is nonetheless possible. I suggest
beginning with these four changes.
1. An independent director should serve as
2. Independent directors should select their
own successors, without management participation.
3. No more than one management company director
should serve on the board.
4. The board's legal counsel should be completely
independent of the management company.
I would also urge mutual fund directors to review
not only expense ratios, as is the industry custom, but to
require the manager to provide an accounting for the dollars
of the fund assets that are spentthe sources of those dollars
(investment advisory fees, 12-b fees, etc.), and their uses (investment
management, distribution, operation, manager's profits, taxes, etc.)for
each fund and for the entire complex. Somehow, absurd as it may
seem, studies prepared for directors by fund consultants focus all
of their attention on ratios and none on dollars.
Following the Money
What might this examination of sources and uses
show? Let's follow the money in a $61 billion group of money market
funds managed by a large financial conglomerate. In 2000, the funds
paid some $254 million in management fees, $64 million in distribution
fees, and $71 million in shareholder service fees and operating
costs. Total: $389 million, equal to 0.62% of assets. (See Table
Money Market Fund Expenses
For a Major Fund Complex
Total Assets: $61 Billion
The fees spent on distribution and shareholder
services probably cover the cost of those services. What about the
amount spent on investment management? Consider a good-sized money
market fund, regularly rolling over short-term U.S. Treasury bills
and high-grade commercial paper. It might take as many as
a dozen people, performing tasks that are substantive but not taxing.
With office space, computers and other services, it might
be possible to get the investment management costs for these money
funds to $5 millionwith a generous dollop of indirect overhead,
perhaps even to $10 million.
Now let's do the subtraction: $254 million in
management fees, minus, say, $10 million of cost. Result: a net
profit of $244 million to the manager. In the money market field,
where it is virtually impossible for even the best manager to add
even the smallest value, and where each million dollars paid to
the manager reduces by one million dollars the return of the shareholder,
such a huge diversion of returns would be obvious. But only if
the watchdogs are watching. Despite the collegial atmosphere
and self-interest involved, when the watchdogs finally get the numbers
and follow the money they'll be compelled to take action that brings
fund fees down to realistic levels.
When fund directors examine the apportionment
of fund returns between managers and shareholders; when directors
consider the baneful trends that have developed in investment activity
and fund costs; when the bright spotlight of public attention is
focused on directors' fees that are grossly disproportionate to
the time commitments involved and the responsibilities assumed;
when board leadership devolves to independent directors served by
independent counsel; and when the watchdog has no master but the
investors he is duty bound to serve; then we shall at last
hear the barking dog, the strong watchdog that will lead the way
in giving the fund investor a fair shake.
* by Sir Arthur
Conan Doyle Return
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
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