Keynote Speech by John C. Bogle
Founder and Former Chairman, The Vanguard Group
Annual Interchange Conference of the Society of Information Management
The Loews Philadelphia Hotel
October 22, 2001
The marriage of information
technology and investing has changed our nation'sand the world'sfinancial
system, and its wedding vows reverberate all through the mutual
fund industry. Given the tumultuous geopolitical, economic, and
market era in which we are now living, and with the unprecedented
terrorist attack on the heart of the U.S. financial system, an economy
in recession, and the most severe bear market in more than a quarter-century,
adding the phrase "for richer or poorer" to my theme could
hardly be more timely. We are in a New Era in which America is being
challenged on her own shores, even as the New Era of information
technology shapes nearly everything we do.
Just as we were taught in our college economics
classes, however, competition remains the iron rule of capitalism.
The Internet, for all of its mind-boggling complexity, speed, accessibility,
and entrepreneurial innovation, has proven to be just what we should
have expected: Not only a superb medium for human communication,
but the greatest medium for unfettered price competition ever designed
by the mind of mana priceless asset to consumers, but an enormous
challenge to the profitability of producers. We live in a New Era
in our economy, but the winners and losers are still being sorted
But, as we now know, we are not in a
New Era in the stock market. After rising from $3.7 trillion at
the end of 1994 to $16.2 trillion in March of 2000, the total value
of U.S. stocks declined to $10.6 trillion as the stock market tumbled
40% to its late September lows, before recovering some of the lost
ground. But the dichotomy between the returns of the information
technology stocks of what became known as the New Economy (always
capitalized!), and the traditional basic industry stocks of the
Old Economy was stark.
From the start of 1998 through the first quarter
of 2000, the NASDAQ Index, home of the New Economy, rose by 200%.
During the same period the New York Stock Exchange Index, largely
Old Economy issues, rose just 26%. (The difference between the two
indexes is not inconsequential: A NYSE listing requires a company
to have at least three years of operating earnings; the NASDAQ requires
no earnings history.) And then the bubble burst. In fits and starts,
the NASDAQ Index plunged. At its low following the terrorist attack,
it was down 72% from its earlier peak. The NYSE Index, by contrast,
was off just 2% during the same period. From 1998 to date, the net
return: NASDAQ +9%, NYSE +8%.
In the aftermath of this boom and bust cyclejust
one more such cycle in the annals of American financethis
conference presents a wonderful opportunity for this veteran participant
in the rapidly-changing world of investing to meet with this group
of information technology professionals from all across the nation.
I want to discuss the role of technology in changing the financial
marketplace, its impact on the mutual fund industry, and how Vanguard
has responded. I'll conclude with some investment advice that I
believe will help you become richer rather than poorer as you pursue
your personal goal of long-term wealth accumulation.
Does Technology Help us to Better Serve Fund
As I observe the changing world of information
technology, with all its glamour, excitement, gadgetry, and drudgery,
and the truly staggering allocation of the resources of financial
intermediaries that are now devoted to it, I'd like to step back
and ask the only question that really needs to be asked: Does
the marriage of information technology and investing help mutual
fund firms to better serve our clients? The answer is multi-faceted,
for as we adjust to the information age technology is playing many
roles in the financial business.
Here are the seven questions that I'll consider
- Does technology enhance the returns of mutual
- Does technology help us to create better
- Does technology afford our investors better
- Does technology help us to provide better
- Does technology help us to provide better
- Does technology offer our clients better
- Does technology give us a better cost structure?
As I focus on these issues, I am reminded of
the timeless message of Vanguard's long-time Chief Technology Officer,
Robert A. DiStefano, whose inspired leadership, mastery of the IT
field, and compassionate human values brought us into the Information
Age with flying colors. His death last summer, at far too early
an age, only magnifies that message: "How we do technology
is far less challenging than deciding what we do. We must
be clear on our objectives and our strategies, and allocate our
resources accordingly. We must set intelligent priorities and
have clear business objectives for each project we undertake, and
serving our clients must be at the heart of all we do."
The Economist of London said pretty
much the same thing: "Durable client relationships are only
partly about clever technology, however imaginatively used. Mainly
they require relentless attention to detail: good products, prompt
service, well-trained staff with the power to do a little extra
when they judge it right to do so. No wonder firms that send you
away with a smile on your face are so rare." So now let's see
the extent to which mutual fund firms are using technology to send
clients away with a smile, with better performance, better products,
better information, better communications, better services, better
advice, and a better cost structure.
1. Better Investment Performance?
Technology has changed the financial markets,
and for the better. Markets are cheaper, faster, more transparent,
and more automated. They are truly global in nature, executing at
the speed of light giant transactions in complex financial instruments
that would have been inconceivable in an earlier age, and operating
at volume levels undreamed of in an earlier era. For example, shares
of U.S. stocks (NASDAQ and NYSE combined) turned over at 135% last
year, three and one-half times the 40% rate of two decades
earlier. Importantly, without electronic systems and the dispersal
of market activity and back-up communications networks that they
facilitated, the rapid reopening of our financial markets after
the September 11 terrorist attacks would have been impossible.
What is more, money managers today have seemingly
infinite information at their fingertips. Corporations observe the
rules of full disclosure, and a vast community of investment professionals
analyze each firm's financial statements in intimate detail. Soaring
transaction volumes, liquidity and information availabilityspread
among market participants almost simultaneouslyhave made the
markets even more efficient, arguably making it more difficult for
skilled managers to ply their trade. Money managers canand
docompare their portfolio holdings with those of their peers,
and their weightings with those of the stock market indexes which
the marketplace uses to evaluate them, and fiduciaries canand
doregularly evaluate their managers on the same basis. And
whether we like it or not, benchmark riskhow the manager
performs relative to the chosen standardhas replaced, well,
real riskhow much the client can loseas the relevant
In these more liquid, volatile markets, electronic
technology has sharply reduced the costs of each transaction. Despite
these lower unit trading costs, however, total trading
costs have actually risen because transaction volume has soared
by an even larger magnitude. The stodgy investment committees of
an earlier age have been replaced by mercurial portfolio managers,
and a star system not unlike Hollywood's has emerged, with the brightest
stars attracting the largest cash flows from investors.
Doubtless some managers have used this New
Era of infinite information to their advantage. After all, the new
Compaq 700 has 5000 times(!) the power of a 1985 IBM PC.
But it is in the nature of markets that for each winner there must
be a loser. Beating the market is a zero-sum game. The average
fund manager can't win. When asked if the average manager could
win, Columbia University's legendary Benjamin Graham, mentor to
the even more legendary Warren Buffett, said: "No. That would
mean that the stock market experts as a whole could beat themselvesa
logical contradiction." Which quickly leads to the second truth:
While all investors as a group share the market's gross return,
their net return is reduced, dollar for dollar, by the costs of
financial intermediaries. After costs, beating the market
is a loser's game.
Yet in the New Era, the relative returns earned
by mutual fund investors have not merely stayed the same; they have
gotten worse. Why? Because the costs paid by mutual fund investors
have risen. Result: the share of market return earned by fund investors
has declined even further. How much have costs risen? In the Old
Industry, the average equity fund carried an expense ratio of about
0.75% of assets per year; in the New Industry, the average is more
than 1.6%an increase of more than 100%. Including the costs
of soaring portfolio turnoverup from about 20% to nearly 100%
annuallyand sales charges, fund all-in annual costs now could
well reach as much as 3.3% per year. But even at 2½% of assets per
year, fully 25% of an assumed 10% stock market return would go to
the intermediaries rather than the investors.
The industry's shortfall to the stock market
during the past three decades appears, not surprisingly, to be a
directly comparableand largely causal2.9%, double the
1.5% shortfall that I calculated by hand in 1975 from old industry
by manuals during the pre-information age. Those rising costs are
the principal reason that fund performance in the Information Age
is not far better. It is far worse.
And, yes, costs do matter. Just compare an
assumed market return of 10% with a mutual fund return of 7½%10%
gross stock market return minus even 2½% expensesfor a tax-deferred
retirement plan in which $5,000 per year is invested over 40 years:
Final value of the actively-managed mutual fund investment, $1.1
million. Final value of the passive stock market investment, $2.2
million. Two to one. While investment technology, as Ben
Graham knew intuitively, could not possibly enhance fund returns
relative to the market, it is high time that fund costs be reduced.
That vast $1.1 million chasm in the amount of capital accumulatedoccasioned
primarily by investment costsreminds us that we need to use
technology to help us get there.
2. Better Investment Products?
Thanks in part to technology, the fund industry
certainly has a lot more products8,341 funds today, compared
to 564 funds in 1980. The incredible power of the computer has not
only enabled the development of innovative and complex financial
market instruments, but the creation of new kinds of mutual funds"new
products," as the industry refers to them. Technology enables
us to backtest with remarkable facility the results of any kind
of fund; a fund that invests on the basis of a stock's price momentum,
for example, or a fund that invests in companies sending positive
signals to Wall Street by beating the earnings estimates with which
it has conditioned the marketplace. Alas, however, backtesting proves
to have little predictive power.
Technology has also facilitated the development
of so-called quantitative funds, relentlessly using modern portfolio
theory to search the market for winning stocks through computer
models that calculate risk factors, size factors, industry factors,
financial structure factors and the like. The result: A diversified
portfolio that, if all works well, will consistently outpace
the market. Alas, the slips 'twixt cup and lip seem as eternal ever,
and there's no evidence that any of these new types of funds have
provided better returns than their traditionally managed kinfolk.
But for very different reasons, the New Era
of technology has given fund owners not only worse returns, but
much worse returns. The boom in technology stocks during
the late 1990s resulted in the creation of 678(!) risky new fundsInternet
funds, telecom funds, technology funds, and technology-oriented
growth fundslargely designed to attract fund investors eager
to participate in the great NASDAQ boom. The industry's resultant
hyping and promotion of these "New Economy" funds rapidly
increased the industry's risk profile, which reached its most dangerous
exposure in mid-March 2000, at the very moment that the bubble,
having reached its point of maximum inflation, was about to pop.
Together these aggressive funds gathered the
staggering total of $237 billion of additional investor assets during
the year and one-quarter immediately preceding the market peak,
withdrawing $23 billion from their value funds during the same period,
precisely the reverse of what they should have done. At the market
high, $2.1 trillion of assets of fund shareholders was invested
in the New Economy aggressive growth funds, nearly twice
as much as the $1.1 trillion of investor assets in value-oriented
Old Economy funds. Since then, the former group has dropped by an
average of 40%, while the latter group is off just 4%.
No, it wasn't the fault of technology that
the superficial investment appeal of technology stocks lured millions
of investors into these new funds. Rather, the mutual fund industry
bears the responsibility for doing the luringcreating the
aggressive new funds, promoting them to the skies, and then watching
them self-destruct. The idea of making what will sell rather than
selling what we make, always lingering in the industry's background,
lurched to the fore during the great bull market, and the investing
public paid the price.
Happily, there was at least one area in which
technology helped to improve the lot of some investors. Given the
inevitable mathematics of the stock market that I described at the
outset, the industry began to develop passive, low-cost mutual funds
that assured a market-like performance, and thus virtually guaranteed
superiority over peer funds. The index fund could merely
buy all of the stocks in the market and hold them forever, paying
no advisory fees, engaging in no costly portfolio trading, holding
administrative and marketing costs to rock-bottom levels, and charging
no sales loads. While its concept is simplebuying American
industry and holding it foreverhowever, its implementation
is not. The data-crunching power of technology is required to keep
an index fund portfolio rigidly in line with its target index, to
promptly adjust for any changes in the index, to value its portfolio
accurately and promptly, to coordinate daily cash flows with portfolio
activity, and to create the market-like baskets of stocks that have
proved so useful in managing its portfolio.
Overall, then, technology has not resulted
in the creation of better products. Through no fault of its own,
it has facilitated the creation of worse products especially
the New Economy funds that represented one of the great crazes in
mutual fund history, making fund investors poorer by scores of billions
of dollars. But on the plus side, technology has helped the index
funds to track the market even more efficiently, enriching investors
simply by assuring them of their fair share of financial market
3. Better Information for Investors?
Hardly surprisingly, it is in the area of investor
information that the Information Age has shone its brightest. Through
fund evaluation services such as Morningstar, Value Line, Strategic
Insight, and the like, open networks provide data about mutual fund
portfolios and performance so vast as to be beyond the ability of
the human mind to absorb. Never again will mutual fund investors
lack the ability to make fully-informed investment decisions. From
that standpoint, mutual fund investors are among the greatest beneficiaries
of the information revolution.
Fund information is surely rife, and accessible at a moment's notice.
Consider Morningstar Mutual Funds, which provides "everything
you ever wanted to know about your fund, but were afraid to ask,"
and on a single page at that: Historical asset values and dividends;
total returns on a quarterly basis, absolute and relative to market
indexes and peers; fund expense ratios and sales charges; tax efficiency;
risk analysis; the 25 largest stock holdings; the average price-earnings
ratio, earnings growth rate, and market capitalization; industry
weightings; and, if you're into Modern Portfolio Theory, alphas,
betas, and R-squareds. And there's still room left on the page for
a two-paragraph editorial comment! All topped-off by the fund's
rating: one-star, worst; five-star, best.
I fear, however, that fund investors pay little attention to this
plethora of information on fund risks, costs, and portfolio construction.
Rather, they select funds that have had hot past performance and
five-star ratings. But since past performance has rarely proven
prologue to the future, "stars" cannotand
do notgive investors the power to select future winners.
A portfolio of Morningstar five-star funds, for example, has provided
far lower returns than the stock market itself, all the while carrying
significantly higher risk. So while technology has enriched investors
by giving them better information, but investors have impoverished
their potential returns by using the information to make worse decisions.
They are acting as shoppers rather than long-term shareholders,
and we in the industry haven't fulfilled our responsibility to educate
investors as to what information matters and what doesn't. The Book
of Proverbs had it right: "Get wisdom, get insight."
In addition to public networks that provide information on fund
returns, risks, costs, and portfolios, nearly all of the major fund
families have built proprietary networks that provide their shareholders
with timely, accurate, and complete information about their investment
accounts. If you go to Vanguard's website, for example, and check
the value of your fund accountsall of your family accounts
are at a single site, and one click will get you there after you
identify yourselfand you'll see the value of your account
at the close of the previous day, any changes you've made in your
holdings, and your balance among stock funds, bond funds, and money
market funds. You can check your purchase dates and your tax basis.
You can also quickly learn about pending distributions of realized
capital gains, as well as each fund's unrealized gains or losses.
It wasn't too many years ago when there were no consolidated
fund statements (each fund was treated like an individual stock),
and when information came by mail, usually a month or more after
the quarter ended. Thanks to technology, we've come a long way in
a short time, and fund investors now receive better information,
better organized, and available in what amounts to real time. But,
like the wealth of publicly-available fund information, this wealth
of proprietary account information has only a tenuous relationship
to improving the returns of investors.
To whatever avail, it's easy to see how important, timely, and comprehensive
information is to investors who are moving money from one fund to
another, to investors who are paranoid about performance, and to
investors with short-term horizons. But to what avail is this plethora
of comprehensive, up-to-the-minute information to true long-term
investorsthe kind of investors whom Vanguard has soughtwho
are putting their money to work in middle-of-the-road funds (even
index funds!), who are allocating their assets intelligently between
bond funds and stock funds, and who are carefully planning to accumulate
wealth for a retirement plan that they expect to call on, say, 30
years hence? Wouldn't they be as well servedor better servedby
buying right, holding tight, and checking on their account once
a year or so? That kind of discipline will pay off in the long run.
Knowledge may be power, but the fact that fund investors are receiving
better information than ever before has been largely offset by their
using that information for the wrong purposes. The bandwidth of
the human mind, I fear, has been overwhelmed by the staggering bandwidth
of information now presented to useven thrust on us. What
should make fund investing better may well be making it worse.
The trick is to convey the vast array of information available to
fund investors in a sensible but focused way, so as to provide perspectivenot
merely on a one-way information highway, but through a two-way
4. Better Communications with Owners?
To better communicate with our Vanguard shareholders, in recent
years we have begun to use technology to enhance the services we
provide. Today, fully one-third of our individual assets are held
by shareholders registered on our website. And nearly 50% of our
client service interactions take place over the web. Our goal is
to give our clients the closest thing to personal service that is
possible without actual face-to-face, person-to-person interaction,
which, truth told is, as a practical matter, impossible. After all,
the median holding of a mutual shareholder is less than $5,000 and
an account of that size would generate about only $80 in annual
revenues for the average fund manager, and, given our low costs,
a minuscule $12.50 for Vanguard. Clearly, those revenues couldn't
possibly justify a substantial commitment to personal service for
the typical investor.
But we do make an effort to provide special
services designed to expand and deepen our relationships with our
investors, and technology has played a major role in accessing our
account database. As in all businesses, a relatively small number
of relatively large clients are responsible for a high portion of
our business, and our most desirable clients are those with the
largest investment balances and the longest and strongest relationships
with us. While our objective is old-fashionedusing enhanced
services to retain clients, all the while keeping costs under controlthe
technology used in this pursuit is new. Electronic wizardry has
allowed us both to mine our shareholder database for those clients
and then to more effectively manage those relationships.
The special services we provide to our client
households with $250,000 to $1,000,000 or more invested at Vanguard
include a designated and experienced phone representative (or team)
who provides continuity, account familiarity, and (in the words
of The Economist article that I cited earlier) an ability
to do "a little extra when they judge it right to do so."
While the 400,000 households that qualify represent only about 5%
of our investor population, they hold nearly $200 billion of our
sharesfully 60% of our $320 billion of shares held by individuals.
(We categorize the remaining $230 billion as institutional,
fund shares largely owned through retirement and thrift plans.)
These Flagship and Voyager investors are among our
most loyal and satisfied owners.
We push technology as far as we can to personalize
these services. We hold e-meetings, and send e-mail which discusses
changing markets and changing investment expectations. We have begun
a program of collaborative browsing, in which both client
and Vanguard representative have the same data before them on the
computer screen. They can readily discuss the status of the accounts,
consider the implications of changing fund holdings, and provide
some reassurance, when appropriate, about staying the course.
Technology has also enabled us to create more
favorable prices for our largest and most durable clients. Nearly
a decade ago, we created an Admiral series of funds with
a $50,000 minimum holding requirement and lower fees reflecting
our economies of scale. In 2000, we began to expand this service
to all of our funds, creating, in effect, two classes of shares:
the low-cost class for regular investors and a very low-cost
class for substantial investors with long holding periods. The Admiral
class already totals more than $50 billion.
Our goal is both to retain the loyalty of our
clients through appropriate pricing, and to bring personalized interactions
as close to personal meetings as possible. The shareholders truly
care about the personal touch, a point driven home to me last summer
when a group of nearly 50 shareholders who knew each other only
through the Internetthe Morningstar Vanguard Diehards
website, where they call themselves "Bogleheads"came
at their own expense to visit us at our Valley Forge headquarters.
In a wonderful interaction of Internet technology and human values,
the message was clear: Even in this world of electronic communications,
human contact remains the desideratum. Information technology
will be for the better only as it provides better communicationcommunication
that educates as well as informs, that reminds us of our obligation
to serve the needs of honest-to-God, down-to-earth human beings,
who have entrusted their hard-earned assets to our care, each with
their own hopes, fears, and investment goals.
5. Better Services for Shareholders?
There can be no question but that technology
has brought to mutual fund shareholders a level of service that
is not only better, but better almost beyond imagination. What began
with the revolution in telecommunications more than a decade agoimagine
the financial service industry without the 800 number! now
encompasses the round-the-clock ability to buy and sell stocks by
the minuteand buy and sell funds by the daily close of businesselectronically,
simply by pressing a computer button and watching the trade, the
clearing, and the settlement take place almost automatically, right
before your eyes.
What is more, without technology there is no
way we could effectively administer shareholder accounts holding
a variety of funds; IRA accounts with small monthly deposits; 401-K
corporate savings plans with almost infinite fund choice (even self-directed
brokerage accounts) and loan provisions; variable annuities; and
withdrawal plans that automatically meet the minimum distribution
requirements of the Internal Revenue Service-and do all of that
almost flawlessly, if not yet at a Six Sigma level. At the same
time, we have given investors almost unlimited choice of funds,
plans, and programs, and the ability to change their portfolios
at a moment's notice.
But all of these miracles of technology are
not only for better; they are also for worse. There is no iron law
that says that higher investor returns will result from a wider
range of investment choice, nor from greater frequency in changing
funds, nor from rapid swings in asset allocation. To the contrary,
the limited evidence we have suggests that quite the reverse is
true. As investors, we have met the enemy, and he is us. It is not
that technology hasn't wrought miracles in creating new tools; it
has done exactly that. But the fund industry has offered these tools
to investors without providing the education required to assure
the productive use, not the counterproductive abuse, of the system.
And so redemptions of fund shares have soared.
So have exchanges within fund families from one fund to another.
Together they now run to nearly 40% of fund assets compared to 7%
in 1961. Put another way, the holding period of the average fund
investor has dropped from 14 years during the 1960s and 1970s to
about 2½ years currently. Investors in mutual fundsas well
as fund managers and direct investors in common stocksseem
enthralled by the new gadgetry and are ready, willing, and able
to use it. But the result is that shareholders are increasingly
using mutual funds for short-term speculation, sharply vitiating
the value of the best medium even designed for long-term investing.
I believe that trading mutual funds shares and trying to time the
market are, finally, loser's games. The marvelous new services that
technology has enabled our investors to use are all too often being
used counterproductively, and they will be poorer, not richer, as
6. Better Financial Advice?
Amidst all the information and commentary that
is available on Internet websites, I find myself particularly concerned
by the application of technology in financial planning advice. Yes,
the advice is voluminous and comprehensive, giving us the apparent
ability to better plan our financial futures. We can do so with
decimal-point precision, and we can manipulate the data to our hearts'
content, raising and lowering our expected retirement plan contributions,
our allocations to stocks and bonds, and our assumptions about tax
rates and inflation rates, retirement age, and future returns in
the financial markets. But, at bottom, the data that is provided
tacitly ignores the most fundamental single characteristic of investing:
I go quickly to first principles: The stock market is not an
actuarial table. Yet the projections provided by financial advice
websites seem to me to cast an aura of predictabilityif not
certainty, surely high relative assuranceon the numbers that
pop up on our computer screens. But, as ever, the output is highly
sensitive to the input. Consider, for example, a retirement plan
for a 30-year old investor, investing 6% of a $50,000 incomewith
a 3% company matchin a 401(k) plan, salary growing at 5% per
year until planned retirement at age 65, when he began to draw upon
his nest-egg to meet expenses. If he believes that the stock market's
annual return will be 12%, at his actuarial life expectancy of 90
years the accumulated capital would be $2,827,101. (Note the precision!)
If, on the other hand, the market return turns out to be 9%, he
runs out of money at age 81a zero balance, and nine years
too soon at that. But believe me, no one in the world knows whether
the future return on stocks will be 12%, 9%, 5%, or anything else.
So, pauperhood at that age is just as likely as a $2.8 million nest-egg.
The craze of the moment is the Monte Carlo simulation, not merely
calculating the sequential returns of asset classes, but mixing
up the annual returns in a sort of Waring blender approach that
shows ranges of possibilities. But even the most exotic technology
can't help us to predict which mutual funds will win, and it often
produces fund selections that are truly bizarre. Further, history
tells us little about future market returns because, as September
11 so poignantly reminds us, low-probability, high-impact events
occur unpredictably in investing as well as in life. When the fund
industry uses information technology to present investors with hypothetical
information clothed in the mantle of precision, we mislead them.
We would be giving better advice to long-term investors if, instead
of offering complex advice that implicitly encourages investors
to try to outguess the unguessable and to try to select winning
stock funds based on their past returns, we offered a simple, basic
asset allocation plan balanced between a stock index fund and a
bond index fund. Despite its patent simplicity, such an investment
strategy, it seems to me, is the ultimate killer app.
7. A Better Cost Structure?
With all of the enhancements in mutual fund
operations, communications, services, and infrastructure that have
been made possible through technology, its important to ask whether
it has made this industry more cost-effective. In short, has our
technology initiative made our cost structure better or worse?
There is no industry wide data on cost-effectiveness1,
so I can use only Vanguard as my model. The cost of information
technology is our largest single cost, last year accounting for
some $450 million of our $1.3 billion dollar operating budgetsome
40% of the total, vs. 18% a decade earlier. Technology, obviously,
doesn't come cheap! Indeed, our tech expenditure is more than six
times the $70 million we spend on marketing, and 15 times the $30
million we spend on the in-house portfolio management of our index,
quantitative, and fixed-income funds. We have become, perhaps more
than any other firm in our field, a virtual company.
The huge commitment to technology we've made
over the past 15 years has given our shareholders many more services,
much more information, greater speed and reliability, and enhanced
record-keeping security. But there is no evidence that it has increased
our productivity. In 1995, with our assets at $140 billion (after
adjusting for market appreciation) we had over 3,900 crewmembers,
or 27.2 per $1 billion of assets. With assets at $560 billion today$400
billion if we adjust for market appreciationand 11,000 crewmembers,
we still have 27.6 crewmembers per $1 billion. In fairness, if we
adjust for the improvement in our service qualitythe sort
of hedonic adjustment that government statisticians use to
calculate the true value of, for example, computerswe probably
have become slightly more cost-efficient.
While we know that e-accounts and e-prospectuses,
as well as automated telecommunications are, unit by unit, 50% to
95% cheaper than the traditional means of providing information,
those gains seem to have been countered by the substantial ongoing
development costs of offering the Next New Thing that great
breakthrough in service enhancement that may lie just beyond the
horizon. So while technology, overall has not given us a better
cost structure, our huge tech expenditures have not given us a worse
For Better or Worse
In sum, information technology in the mutual
fund industry has clearly given us the opportunity to better serve
investors, if not in investment performance which simply isn't
a realistic possibilitythen in better products, better information,
better communications, better services, better financial advice,
and a better cost structure. But in too many cases we have abused
the opportunity, and in each of these areas have made some things
worse. On balance, I fear, by focusing on mechanical service improvements
rather than on education and human needs, that the marriage of technology
and mutual funds has made more investors poorer then it has made
richer. So far, then, it has not been a productive union.
But there is no reason we can't make it a happy
marriage. To achieve that goal, we must 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
at birth are doomed to death at an early age, and by encouraging
investors to treat their funds as if they were individual stocks.
Our interests are best served when we finally force technology to
deliver the substantial economies of scale we must achieve, and
pass those economies along to our shareholders.
To do these things, the fund industry must change.
We must return to the fundamental principle that mutual funds are
best used as long-term investments. We cannot allow the kind of
casino capitalism that has run amok in recent years to be a permanent
fixture of the industry. Trading in fund shares is not only a loser's
game for shareholders, it places roadblocks in the way of the implementation
of sound strategy by fund managers. Technology, for all its gee-whiz
wonder, is both bane and blessing, and I hope that this industry
gives far more thoughtful consideration to curbing the powerful
monster we have created. Fund executives and information technology
leaders must keep in mind not only information, speed, cost, and
efficiency, but common sense, foresight, and wisdom, for our prime
responsibility is to help the human beings who have entrusted their
hard earned dollars to us to a more secure financial future.
A Word of Advice for Technology Professionals
I'll close these remarks by delivering on my
promise to offer some advice as to how you technology professionals
might best invest their own savings in the years to come. Let me
be frank, and give you three "do's," and three
"don'ts." First, if you want to at once save your
time and effort, avoid sleepless nights, enjoy whatever returns
the financial markets are generous enough to provide, and dedicate
the lion's share of your energies to your careers in the exciting,
challenging, and rapidly-changing profession in which you ply your
trade, do invest in low-cost stock index funds and low cost
bond index funds, in whatever proportion fits your needs, circumstances,
and risk tolerance.
Second, do start your thinking with a
baseline balance of 50/50 between stocks and bonds, and then adjust
the stock portion upward as: 1) you have more earning years
ahead of you; 2) smaller assets at stake; 3) less need for investment
income; and 4) greater courage to ride out the inevitableand
likely extremeswings in stock prices. Conversely, as these
considerations are reversed, adjust the 50% stock ratio downward.
Third, do prepare yourself for financial
market returns that are considerably lower than most of you have
seen in your lifetimes. The annual rate of return over the past
20 years (through 2000) has averaged 6% for money market investments,
9% for bonds, and 17½ % for stocks. (The typical mutual fund, I
reiterate, has earned about 75% of those returns, say, 5%, 7%, and
13%, respectively.) But today money market instruments yield about
2½%not 6%and bonds less than 6%not 9%so
the handwriting is on the wall.
In stocks, of course, the handwriting on the
wall is harder to read, but the math is less than mysterious. Stocks
are likely to provide earnings growth that will parallel
the growth of our economy, most likelybut never certainly6%
in nominal terms. Add to that figure the current dividend yielda
measly 1½% and the future investment return on stocks would
average 7½% per year. Speculative returnwhether investors
will pay more or less for $1 of earnings (i.e., the price-earnings
ratio)may increase or reduce that total. But with stocks selling
at a (normalized) 22 times earnings today, I believe the P/E is
more likely to go down than up.
A drop to 18 to 20 times, for example, would
reduce the investment return over the next decade by one or two
percentage points, taking the market return to 6½% or even 5½%.
(If the P/E risesunlikely in my viewthe return could
be 8½% or 9½%). If that tentative range seems wrong to you, you
can use my simple methodology to calculate future stock returns
for yourself. Just insert your own idea of earnings growth, and
of the P/E ratio in 2011. But don't get carried away! And always
hold some stocks, for no one, least of all I, can predict
future returns with accuracy.
Components of Stock Market Return
|Initial Dividend Yield
Calculated Market Return
|Initial P/E Ratio
|Final P/E Ratio
* Impact of P/E Change
And now to the don'ts. First, don't
use those mathematics to predict the future of technology stocks.
While the methodology is the samedividend yield plus earnings
growth plus change in P/Ethe confidence level is minuscule
in such an explosive field. While we forgot it during the great
tech bubble, the value of a technology stock, like any stockand
any stock marketis simply the discounted value of its
future cash flow. No, the market value of a stock is not
about concepts; not revenue growth, nor price-to-sales, nor site
visits, nor eyeballs, nor the growth rate in the exciting early
years of a new venture. Whether we're talking about the New Economy
or the Old Economy, the market value of a stock is about moneytomorrow's
earnings capitalized in today's dollars.
Second, don't make an excessive commitment
to any individual stock (especially employer stock) or to
technology stocks as a group. If the past year and a half haven't
taught you that lesson, then you either aren't paying attention,
or you are truly brilliant (or lucky!). Technology is a competitive
business, changing at exponential speed, and rapid future growth
is hardly assured for any company.
You should be aware that the technology sector
of the market has provided a steady 12% to 16% of the market's earnings
during recent years, meaning that earnings growth has been no more
than average. But the tech sector began the decade at 8% of the
market's value, rose to 35% (!) at the market high in March
2000, before tumbling to 15% currently, a figure more in keeping
with its earning potential. Even though that relationship looks
a lot more like fair value, the tech share of earnings this year
is crumbling and its earnings visibility is close to zero. That
means very high risk, as well as high return potential. That stock
index fund I recommended to you earlier, obviously, also has 15%
in technology stocks today. In an uncertain world, that's enough
concentration for any investor, especially for you who earn your
Finally, if you are concentrated in technology
stocks today, don't stay the course. The broadest possible
diversification is the best possible diversification, and you'd
best get on with an all-market index strategy right away. Just because
you may have done the wrong things in the past doesn't require that
you be wrong forever. Start today to alter your portfolio gradually.
Begin with 25% of your equity holdings, and over, say, the next
year or two, make the full conversion of your individual holdings
to whatever index-based asset allocation fits your circumstances.
Then, when you complete your program, get investing
as far out of your mind as you can. Look at your portfolio no more
often than once a year, but don't change it, except to reduce the
stock allocation a bit every five years or so. I can't predict how
much you will have in your account when you reach retirement, but
I can predictwith as much certainty as is possible in the
uncertain world in which we livethat it will be, not only
considerably larger than the account of anyone you know who has
put the same amount of money to work in a different fashion, but
far less time-consuming and worrisome.
Yes, you will be one of those fortunate souls
who has been well served by this industry, and you will look at
the wealth you have accumulated with a smile on your face. So, just
go out and do it. And while you're about it, if you work in the
mutual fund industry, use your knowledge and your common sense to
help us make the marriage between technology and mutual funds better,
not worse, so that fund investors will be richer,
not poorer in the years ahead.
1. By offering its services
on an at-cost basis, Vanguard is unique in the industry. Other fund
complexes are operated by external management companies with their
shareholders, in return for a fee that averages about 1.2% per year,
including money market, bond funds, and stock funds. The largest
single portion of fund cost is the manager's pre-tax profits, accounting
for at least 40% of the fee they receive. Back
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.