Keynote Speech by John C. Bogle
Former Chairman and Founder, The Vanguard Group
Forrester Finance Forum
New York City, NY
June 11, 2001
In its February 2000 paper on "Overhauling Financial
Advice," the Forrester Report recalled "the vociferous attacks .
. . that greeted another rogue who challenged the status quo years
agoJohn Bogle of Vanguard." When we began in 1974, it was
said that the Vanguard mutual mutual fund structure would
fail. Since the funds owned the investment management company and
operated it on an "at-cost" basiswith the aim of improving
the bottom line of the clients, of all people!we couldn't
possibly generate the capital necessary to conduct our operations,
let alone become an industry leader in service and technology. And
our index fund, the world's first index mutual fund and the new
Vanguard organization's first creation, was not only offering guaranteed
mediocrity, it was downright unAmerican: "Bogle's Folly."
Now, nearly 27 years later, I'm still, I suppose,
a rogue. But those two supposed Achilles' heelslow costs and
indexinghave been, and remain, the driving force in our growth.
Our fixed-income funds and our index funds now account for nearly
$420 billion of our $580 billion asset base. What fixed-income and
index funds share is the direct link between the costs of fund operations
and the returns generated for investors. The lower the
costs, the higher the returns. These funds most obviously honor
the eternal, if eternally ignored, first principle of investing:
Investment success is defined by the allocation of financial
market returns between financial intermediaries and investors.
Put less kindly, the higher the croupiers' take, the less money
the gamblers take home. So, mixing the metaphor, my message is that
it is high time to drive the money changers out of the templeor
at least to reduce the benevolences that investors pay for their
A Reinvented Fund Industry
The fund industry has ignored that message. Indeed
the industry has reinvented itself over the past fifty years.
Traveling along a road that marks an unfortunate detour from their
historic principles, mutual funds have radically changedand
in ways that hardly serve investors. Despite the industry's staggering
growth (from $2½ billion 50 years ago to $7 trillion today),
the expense ratio of the average equity fund has doubled (to 1.6%
of assets). During the same period, fund portfolio turnover has
leaped from 15% to 100%, and the hidden cost of all that trading
now consumes at least 0.7% of fund assets each year. Adding in,
say, another 0.5% for the annualized impact of sales charges and
an opportunity cost of 0.5%, (since most equity funds are rarely
fully-invested in stocks), could bring costs to as much as 3.3%
annually. But let's conservatively assume an average equity fund
cost of 2½%.
Over the past 20 years, the stock market has provided
an annual return of about 15%. Deduct 2½% in fund costs for a pre-tax
return of 12½%. Deduct another 2½% for Federal taxes (forget,
for the moment, state and local taxes), and the croupiers have raked
off a total of at least 5%. Net to investor: 10%. Compounded at
10%, $10,000 invested in the average surviving mutual fund
grew by $57,000. Compounded at 15%, the same $10,000 merely invested
in the stock market itself increased by $153,000. Allocating just
37% of the market's return to the fund investorwho put up
100% of the capital and took 100% of the risksimply doesn't
seem like a fair shake.
Adding insult to injury, the industry's focus has
moved from management to marketing. New funds are created with no
investment rationale other than the fact investors are clamoring
for them. The result is just what you'd expect: Soaring fund failure
rates. While 12% of all equity funds didn't make it through the
1950s, 55% failed to survive the 1990s. Past performance of fund
winners is heavily promoted, never mind that it has no predictive
power. At the peak of the speculative boom in 1999-2000, 100 new
technology funds, including 31 internet funds, were formed. More
than 100% of the industry's record $270 billion cash inflow was
invested in tech funds and tech-stock-dominated growth funds-right
at the very worst moment. ($30 billion flowed out of value
funds, right before their long-awaited recovery.) What is more,
the heavy marketing costs of this pandering to the public taste
was financed by management and distribution fees paid by the fund
investors themselves. Yes, the mutual fund has been reinvented,
but it would be hard to argue that the reinvention has served investors
But it was the reinvention of the mutual fund that
helped pave the way for Vanguard's growth, from a $1.4 billion also-ran
to a $580 billion finalist. For we were reinventing the mutual fund,
too. Challenging convention, our reinvention went in precisely the
opposite direction from our peers. Slashing costs instead
of raising them. Resistingalbeit imperfectlythe temptation
to form funds responsive to the principles of modern marketing rather
than the principles of sound long-term investing. And staking our
future largely on index and index-like funds that virtually match
the returns of the stock market or the bond market (or precisely-defined
segments of each)a strategy that, for the investor, is just
as boring to observe as it is exciting to profit from. The contrast
between our strategy and that of our rivals could hardly be more
stark. Our unit costs are about 0.27% of assets. For our peers,
unit costs average 1.30%, five times as high. Our asset base
is 35% stock index, 33% fixed-income (including 4% bond index),
and 32% managed equity. For our peers, the figures are 1%, 22%,
and 77%. It is a remarkable contrast.
The Killer App
As peculiar (and, for that matter, as self-righteous)
as it may sound, indexing has proved to be "the Killer App." The
secret of investing, it turns out, is long-term compounding at minimal
cost. The index fund captures almost 100% of the market's pre-tax
annual return, while the average actively-managed fund captures
about 75% to 80%simply because of relative investment costs.
Right off the table of statistical probabilities, these are the
chances that an active equity fund manager has to beat the pre-tax
return of the stock market: One year, 37%; ten years, 15%; 25 years,
5%; 50 years, 1%. (The actual historical experience of mutual funds
is fully consistent with these data.) Those are not good odds.
The obvious upshot of the unarguable proposition that
investment success is defined by maximizing the investor's share
of market returns and minimizing the intermediary's share: Sooner
or later, intelligent investors will exhibit the kind of investment
behavior that serves their own best interests, and gradually force
the mutual fund business to offer more commodity-like funds, with
less deviation from financial market returns, much less shortfall,
and much lower costs. Former Citicorp Chairman John Reed
seemed to anticipate this trend a year ago, when he told Forrester
Research that the winner in online financial services, "won't be
a financial institutionit'll be a technology-based start up."
And in a certain sense, that's what Vanguard is.
Before you laugh, consider this: For our shareholders, by far the
most important aspect of Vanguard for our shareholders is their
trust in the simple, productive investment strategies that go hand
in hand with our low costs. But from a resource allocation standpoint,
we look far more like a technology-based start-up than a financial
institution. Last year we spent $1.2 billion of our $1.3 billion
operating budget on administration and operations, almost $600 million
of which was spent on technology. Contrast this total with the $30
million we spent on investment management. (The remaining $70 million
went for marketing and distribution.)
|Financial Institution or Technology-Based
|Vanguard's 2000 Budget
|Marketing & Distribution
It simply doesn't require legions of crewmembers to
manage index funds and fixed-income portfolios with rigorously-defined
investment strategies, high quality standards, and low turnover.
But it does require extraordinary technology
and a deep and dedicated crew to provide real-time information and
transaction capability for our 15 million owners. Half of our contacts
with them are now made through the Internet, and nearly all the
rest over the phone. Our only bow to bricks and mortar are the buildings
where our 11,500 crewmembers go to work each day. More than any
firm in our field, we have become a virtual company.
Technology and Mutual Funds
But whether we are a virtual company or not, technology
will clearly play an ever-growing role in the mutual fund industry.
In many respects it will be a blessing. But if the over-riding mission
of the industry is as I've described itto provide investors
with their fair share of financial market returnstechnology
in our business leaves much to be desired. Let's look at the pros
and cons in four key areas:
- Financial Market Technology.
Positive: The emergence of a financial system that has
enabled professional money managers to offer a whole new variety
of investment products, to enjoy remarkable liquidity for transactions,
in large volumes, around the globe, and at the speed of light.
Negative: Excessive trading, at lower unit costs but higher
total costs (good for the money-changers); development of funds
for marketing, not investment, purposes; focus on short-term strategies
at the expense of long-term goals.
- Information Technology. Positive:
The provision of an up-to-date information network that provides
data about mutual fund operations, portfolios, and past performance
so vast as to be beyond the ability of the human mind to absorb.
Negative: The data investors rely upon by far the most
are the past returns of funds, giving rise to "the star system,"
hot sectors, and hot funds. The siren song of past performance,
sung by fund managers and distributors and danced by investors,
has resulted in investment decisions that are unwise to a fault.
- Transaction Technology. Positive:
Ease of operations and transactions; reduction of frictional costs;
the availability of a communications network so efficient that
investors, without ever moving from their desktop computers, can
purchase and redeem fund shares almost instantaneously. (Even,
as recently announced, from their automobiles!) Negative:
Investors value their portfolios too frequently, and trade their
fund shares like stocks. These characteristics lead to foolish
- Financial Planning Technology. Positive:
The development of websites that not only provide fund shareholders
with real-time account valuations, but also financial planning
advice and recommendations that enable investors to plan their
financial futures with decimal-point precisionon paper.
Negative: Even the voguish Monte Carlo simulations that are
ascendant today require assumptions about the unknowable: Expected
market returns, inflation, and taxes; retirement age and Social
Security payments; the identification of superior managers and
styles, inevitably based largely on their past results. Yet
computers cannot predict the future. The single most important
attribute of investing remains what it has always been: Uncertainty.
The problem, then, is that the remarkable ability
of mutual fund websites to facilitate, expedite, and abet investment
activity is to a heavy extent counterproductive. We have a cornucopia
of information at our fingertips, but it seems rarely to
lead to knowledge. And in those rare cases when it does result
in knowledge, it seems more likely to increase investment activity
than to constrain it. For most investors, to put it bluntly, knowledge
is all too seldom translated into wisdom. And wisdom is what
investing is all about.
Educate, Inform, Implement
The fund industry's principal challenge, it seems
to me, is to use technology and web services to educate the investorto
help bring wisdom into a world where wisdom is such a rare commodityto
provide the financial information our investors need to make sound
decisions, and to facilitate the expeditious implementation of those
decisions. Educate-Inform-Implement must be our technology
mission. Index funds and bond index (or index-like funds) are a
major asset in each of those areas. First, simply because lower
costs must lead to higher returns, the strategies actually
work for the investor. (That's important, too!) Second, index
funds are risk-averse. All-market indexing, for example, substantially
eliminates three of the four risks of investing: (1) Individual
security risk, (2) style risk, and (3) manager risk. Only market
risk remains. For investors who seek to build their wealth,
there is no way around that risk. And returns that match the market
are virtually guaranteed.
|Educating the Investor
|A. Explain Stock Risk
|B. Explain Style Risk
|C. Explain Manager Risk
|D. Explain Market Risk
D. Explain Market Risk
Focusing on the financial markets themselves,
it turns out, is an extraordinary advantage in educating investors.
For when there is no need to tread the uncertain terrain of investment
styles and portfolio managers, an education platform
becomes the essence of simplicity. E-learning, e-meetings with clients,
web demonstrations, and "collaborative browsing" (integrating personal
contact with web services) become even more effective. The interesting,
but finally meaningless, reliance on style choice and manager selection
need not be central to the conversation. At that point, education
revolves around the relatively certain, not the inevitably speculative.
Call it, if you will, "The Joy of Indexing."
As Forrester Research correctly notes, advice is becoming
more widely available at lower cost, and life-strategy oversight
is becoming increasingly self-directed. Intimacy, the third side
of the triangle, remains, however. Most investors will come to value
most highly their fund provider's ability to customize their financial
interactions, another major role for efficient web technology. But
by eliminating many (but not all!) of the variables, investors still
need advice, and the market-focused approach works equally well
in this arena. The number of investment strategies, for example,
that are worse than a 50/50 bond index/stock index strategy
(with the ratio adjusted to each investor's particular circumstances)
is infinite. That being the case, it is worth considering that the
best investment advice may be not only priceless, but price-less.
Think about the implications of that!
The realities of investing, the majesty of simplicity,
the escalation in investor education, the great potential of the
web to do good rather than to wreak havocall point to the
need for a long-term approach to investor's needs and much
lower costs. Lower expense ratios, lower turnover costs, lower distribution
charges. That being the case, it is hard to take seriously the warning
I heard last month at the Investment Company Institute General Membership
Meeting: "The no-load business is dead." That prediction flies in
the face of the fact that it is the no-load fund that relies most
heavily on technology, and most closely approaches the virtual company.
Please don't hang by your thumbs waiting for the funeral.
The Mutual Fund Dinosaur?
While I'm confident that a bright future lies ahead
for firms that emulate Vanguard's reinventionthe Killer
App represented by our low-cost indexing and fixed-income strategiesI'm
not nearly as confident of the future of the industry's reinvention
that has brought us the modern mutual fund. The sins of this industryhigh
costs, low-tax efficiency, fad-following, hot products, marketing
hype, excessive opportunismhave created ample opportunities
for competitors to leap into the fray, offering better alternatives.
I see that as a positive development, however, for it should
accelerate the return of today's industry to its founding principles,
long abandoned. Let's briefly consider four of the alternative products
that seek to harvest the assets of fund investors.
Exchange-Traded Funds. ($70 billion) Standard
and Poor's Depository Receipts ("Spiders") are a beautifully designed
product, offering low cost and high tax-efficiency, just like
the best S&P 500 index funds. But Spiders are marketed toand
so far largely utilized byshort-term traders, and their
shares turn over at a spectacular 1300% annual rate. But the Spider
is apparently not speculative enough for traders, and the NASDAQ
100 "Qube" (now $23 billion) is almost as large as the Spider.
It turns over at a 3500% annual rate, a loser's game writ large.
I don't believe that the long-term investors who should be the
core of the mutual fund base will turn to ETFs. But if I'm wrong,
fund firms can easily create their own. (We just did!)
Folio-type Accounts. (Assets Unknown) Pioneered
by Folio/fn, customized portfolios ("baskets") of individual stocks
are now a reality. Except by Vanguard's standards, the cost is
truly rock-bottom ($295 per year, or 30 basis points on a $100,000
portfolio), and the idea of selecting, say, an equal-weighted
portfolio of 50 large growth stocks and holding them forever is
an intelligent strategy. (In 1998, I recommended we create mutual
funds that would do just that.) But I suspect that marketplace
acceptance will be very slow, that more short-term traders than
long-term investors will be attracted to these accounts, and that
folios will have more impact on the brokerage business than on
the fund industry.
Separate Accounts. ($125 billion) Brokerage
firms have had considerable success in offering these "fund-of-funds"
accounts, often using investment managers who do not manage large
funds. They offer the opportunity for individual attention and
potential tax-efficiency, but the cost (up to 1¾% of assets annually,
plus the costs of the underlying funds) is a monumental hurdle
to leap. Warren Buffett's partner Charlie Munger has said that
this sort of layering of advice reminds him of Bernie Cornfeld's
late but unlamented "Fund-of-Funds." I agree, and do not see separate
accounts as a major threat.
Managed Accounts. ($300 billion) Brokerage
firms are ever more active in this burgeoning area, working with
consultants and advisers to offer stock selection and asset management
services. The main advantage is said to be tax-efficiency, but
I'd be surprised if these accounts don't prove to be just anotherbecause
of technology, perhaps more efficientform of brokerage account.
Certainly the potential tax advantage exists, but I'm going to
guess it will be overwhelmed by the trading mentality that so
many investors and managers are unable to shake. The fees of the
intermediaries tend to run in the 1% range, 70% of which is, in
effect, a marketing cost and a dead weight to performance. So
I don't see managed accounts as a long-range threat to mutual
The End of Mutual Fund Dominance?
Forrester Research predicts "The End of Mutual Fund
Dominance." Is that correct? Despite the dominance of stock, bond
and money market funds in U.S. savings flows today, will this industry
gradually become marginalized? Answer: Yes, and no. Yes, we're history
if the industry fails to return to management rather than marketing
as our driving principle. Yes, we're gone if we fail to focus on
stewardship, and persist in our fad-following approach to marketing,
distribution, and advertising. Yes again, if we fail to reduce costs
and increase tax efficiency. But no, our future is bright if we
forthrightly recognize our failure to deliver a fair share of market
returns to our investors. No again, if we heed the powerful lessons
of the past, and if we focus on the power of long-term compounding.
And no, fund dominance will not end if we give fund shareholderslest
we forget, the owners of the fundstheir proper share
of the staggering economies of scale the industry has enjoyed. There
is no reason under the sun we can't accomplish these goals. The
task that lies ahead comes down to giving the investor a fair shake,
a fair shakethe whole spectrum of funds that cover the financial
marketsequity funds, bond funds, money market funds, too.
If we do that, mutual funds are certain to remain the investment
of choice for America's families.
Technology has a role to play in the outcome, and
technology can help. But the industry must re-examine its approach
to web services. Our responsibility is to push technology to the
highest and best use for our clientsto educate, to inform,
to implement. It is foolish and short-sighted for the fund industry
to adapt to the Internet. We've done too much of that already. Rather
than being the servant of the incredible technology that
rests in the palm of our hand, we must be its master. Our
long-run interest is hardly served by facilitating a focus on the
ephemeral and the short term, by laying out for investors a panoply
of funds that are born doomed to death at an early age, and by encouraging
investors to treat their funds as if they were individual stocks.
Believe me, there are eternal investment principles,
and technology doesn't alter them: Time is your friend. Impulse
is your enemy. Buy right and hold tight. Cost matters. If you aren't
sure, diversify. Invest for the long-term. Stay the course.
If we ignore these principlesas we as an industry are doing
todaythe mutual fund is indeed an endangered species. Not
because of the new technologies, but because, like Dr. Frankenstein,
we have created a monster. It is not that we must reinvent mutual
funds. Rather, we must unreinvent the investment practices
that we have developed in the industry's modern era. The sooner
we return to our founding principles, the better.
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
©2006 Bogle Financial Center. All Rights Reserved.