by John C. Bogle, President of Bogle Financial Markets Research Center, founder and past chairman of The Vanguard Group

January 28, 2001

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 watchdog—a word almost universally used to describe the role of the independent director—simply doesn't bark.

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 investing—the stewardship of shareholder assets—to the business of marketing—gathering 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 funds—more 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 incalculable—but significant—diminution 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 directors—whose legal duty is clearly to the shareholders who elected them—can be absolved of responsibility for the harmful trends that beset the industry.

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 Table 1.)

Table 1

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 Directors

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 liquidity—a 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 chairman—a 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 board chairman.

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 spent—the 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 2.)

Table 2

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 million—with 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.

Return to Speeches in the Bogle Research Center

©2010 Bogle Financial Center. All Rights Reserved.