Keynote Speech by John C. Bogle
Founder and Former CEO, The Vanguard Group
Park Distinguished Lecture Series,
Before the Financial Planning Association 2002 Forum
New York, NY
April 25, 2002
Despite the title of my remarks, my purpose here today
is not to predict the demise of the mutual fund industry. In fact,
I've simply quoted the title of a report prepared last autumn by
the respected Forrester Research organization. It predicts that
by 2004right around the corner, reallymutual fund assets
will grow by 26%, while separate account assets will grow by 400%.
By then, they predict the end of mutual fund dominance will be well
"By 2006, large fund firms will emphasize separate
accounts at the expense of mutual funds . . . By 2010, assets
in separate accounts will exceed $2.6 trillion, at least 30% of
retail assets managed."
And that's not all. "The end of mutual fund dominance
will accelerate as fund families create their own separate account
products," 401(k) plans will jump on the bandwagon, and financial
advisers will construct their own client portfolios with stock baskets
Why will this happen? In Forrester's view, simply
because "separate accounts deliver what investors want: customized
money management." The alleged benefits: higher tax efficiency;
ability to structure investors' portfolios around large individual
holdings (e.g., company stock); real-time disclosure of portfolio
holdings; and the ability to avoid investments that have "moral
or sentimental importance" to them.
If we accept this reasoning, a dark era for the mutual
fund industry lies close at hand. Or does it? One need only
recall Mark Twain's famous comment, "the reports of my death
are greatly exaggerated." If it merely chooses to do so, the
mutual fund industry can continue its dominance on the balance sheets
of individual investors for as far ahead as the mind can imagine.
For America's families have spoken, and mutual funds have emerged
as their investment of choice to an astonishingand often unrecognizeddegree.
Consider our nation's historical savings flow patterns.
As the 1970s turned to the 1980s, our families were investing about
20% of their capital into mutual funds. By the turn to the 1990s,
the rate had risen to 25%. But by 1996 it had risen to 60%. And
by the turn of the millennium, it had soared to 82%. Yes, on average
during 1999-2001, our familiesthe very backbone of the U.S.
economysaved $385 billion per year . . . and placed $320 billion
of it in mutual funds.
No Longer an Equity Fund Industry
This powerful increase in market penetration says
something very simple about mutual funds: They are popular with
investors who use them. But it also says something else: Today's
fund dominance comes because of the remarkable flexibility of the
fund industry and the wide span of financial instruments that mutual
funds comprehend. Lest we forget, this industry includes not only
equity mutual funds (the apparent focus of the Forrester
study), but bond funds and money market funds. When
you think about it, mutual funds are the investment of choice in
each asset class, and will continue to growno matter what
the course of the financial markets, no matter what the emotional
state of the American investor.
In the soaring stock prices of 1999 and the first
half of 2000, for example, when fund cash flows from individual
investors were $400 billion, the mix was 90% stock funds and 20%
money market funds, with 10% actually withdrawn from bond
funds. Then, when the stock market reversed course over the next
year and one-half, industry cash flows remained strong at $290 billion,
but the mix was 30% bond funds, 30% money market funds, and only
40% equity funds.
Clearly, mutual funds have successfully made the transition
from the old equity-oriented industry that we knew from 1924 (when
the first U.S. fund was formed) right up to 1975, when the money
market fund was introduced. Shortly thereafter, in that seemingly
ancient era of the early 1980s when yields were at double digit
levels and investors wanted, of all things, income, from
their investments, money market funds dominated the industry, with
bond funds not far behind. (In a 1992 speech, I described bond funds
as "the third mutual fund industry.")
Consider some of the extremes. At their peak in 1972,
equity-oriented funds comprised 93% of fund industry assets. By
1974, a 50% stock market decline and net liquidations of fund shares
had reduced total industry assets from $60 billion to $36
billion, a cool 40% decline. Then came the rise of money market
funds, bailing out our shaken industry and producing a remarkable
$270 billion of assets by 1982. At that point, money funds constituted
an amazing 80% of industry assets, leaving equity funds with a residual
share of 14%. Then, as long term interest rates moved well ahead
of short-term money market rates, it was the bond fund segment
that was the industry's fastest-growing component. At the close
of 1986, Bond fund assets of $240 billion actually exceeded equity
fund assets of $180 billion.
The 33% stock market crash of September-October 1987
contributed to the dimunition in equity fund share. But despite
the fact that the full year 1987 saw the market rise, equity
flows were negative in 1988, and didn't return to 1986 levels until
1991, five years in which stocks were at bargain-basement levels.
But with each acceleration in the great bull market, the equity
fund share of industry assets increased apacefrom 30% in 1991
to 40% in 1993, to 50% in 1995. As the cash began to roll in, the
equity fund share leaped to 67% in 1998, and by the time March 2000
rolled around, equity-oriented funds laid claim to 72% of the assets
of this then-$7 trillion dollar industry.
Where Else Can An Investor Go?
This capsule history of the mutual fund industry's
asset mix is, if nothing else, a confirmation of our fundamental
character: We are a market-sensitive industry. But it also
validates the fact that in all three of the pieces of the basic
asset allocation piecash, bonds, and stocksmutual funds
are formidable competitors. Just think about it. Where else can
an investor go?
- For cash, the money market fund puts bank savings
accounts to shame. By leaving the traditionaland expensiveactive
checking accounts to the banks and focusing on large account balances
with infrequent transactions, and eliminating all that costly
"bricks and mortar," we provide substantially higher
yields. And if you're worried about the lack of Federal deposit
insurance, isn't it possible that a U.S. Treasury Money Market
fund is even safer than a bank deposit?
- For bonds, there is no viable substitute for the
bond fund. A choice of taxable or tax-exempt funds; a quality
level to suit every taste (U.S. Treasury, investment-grade, high-yield);
a maturity level to fit every risk profile; and the ability to
acquire extraordinary diversification without being nickled and
dimed (and dollared) to death in buying and selling small lots
of individual bonds.
- And for stocks, it's hard to imagine a better concept
than a broadly diversified equity fund, holding one hundred or
more stocks in every imaginable industry; minimizing individual
stock risk; and either retaining experienced professional managers
to select and supervise the portfolio or, maybe even better, just
owning the entire stock market in a single fund; and operating
with remarkable efficiency. Truth told, the only other choices
are to pick stocks yourself, or, if you're in the six-figure or
seven-figure or eight-figure wealth category, to hire such managers
to pick stocks for you.
So there are solid conceptual reasons why American
families continue to pour half of their hard-earned dollars into
mutual funds. And yet a moment's reflection on the industry trends
that I've shown you presents a perverse riddle that, for whatever
reason, has made mutual fund investing far less productive than
it ought to have been. The obvious "market sensitivity"
exhibited by fund investors has not helped them. It has hurt
The Perversity of Asset Exposure
Think again about the figures I mentioned earlier.
The industry's peak exposure to equities came in 1972 (94%) and
in March of 2000 (72%). On the first occasion, a 50% stock market
decline was about to begin; on the second occasion, a 40% decline
was soon to follow. Despite the nice recovery from the September
21, 2001 low, stocks today remain 30% below their 2000 high. And
it is not at all clear, to me at least, that those earlier lows
will not be surpassed.
So, too, when investors had the chance to lock-in
bond fund yields at an attractive 9% in the late 1980s and early
1990s, investors were deserting bond funds in droves. And with yields
averaging 6% in 1998 and 2001, bond fund cash inflows were higher
than almost ever before in history.
In the money market fund segment, of course, current
yields have no necessary relationship to past or future yieldsdon't
forget that it is impossible to have both a fixed income
payment and a fixed principal valuethe capital flows
(at least ever since this segment reached maturity in the mid-1980s)
seem to represent a residual figure, with money coming into
the funds because it is coming out of stock and bond funds,
and vice versa.
The Tragic Flaw
But the tragic flaw of this industry is that mutual
funds have failed to give our investors an adequate share of the
returns actually generated in the stock market, the bond market,
and the money market. During the two decades ending December 31,
1999, these returns were at the highest levels in U.S. history:
18% per year for stocks, 10% for bonds, 7% for the money markets.
As a result, despite relative returns that significantly
lagged those of the markets in which they invested, fund investors
enjoyed good absolute returns.
In buoyant markets, that lag mayMAY!have
been a tolerable flaw. After all, in that 18% stock market, the
average equity fund did provide a 15% return. But when the financial
markets generate significantly lower returns, such a lag will become
intolerable. And, in my judgment, it's precisely such an era that
we have entered. The mathematics of the stock markettoday's
low dividend yield plus nominal earnings growthsuggests an
investment return averaging about 6½% over the coming
decade. And it seems inconceivable that the huge boost that investment
returns received from the 1979 - 1999 increase in the price-earnings
ratio from 7x to 30xa speculative return of more than 7% per
year!can possibly recur. Indeed, it is reasonable to predict
that p/e ratios, having added so much to previous
stock returns, will now begin to subtract from them. That
is, having seen the bright upside of speculative return,
we are now seeing its dark downside. Reversion to the mean
Current bond yields of 6% set the stage for average
bond returns at a roughly similar level over the next decade. And
while today's money market yields of about 2% can and will change,
perhaps substantially, it would take some leap of faith to forecast
a return to the earlier average. So, while I'm the first to admit
that even the most reasonable expectations for future financial
market returns may be wide of the markeither way!it
seems sensible for both investment professionals and investors themselves
to plan for an era of lower financial market returns. Not 18% for
stocks, but perhaps 4% to 8%. Not 10% for bonds, but perhaps 5%
to 7%. Not 7% for the money markets, but perhaps 3% or 4%. Maybe
we'll be surprised on the upside. I hope so!
Taking the Toll 1: Fund Costs
But whatever the returns in those markets turn out
to be, the returns of comparable mutual funds will be significantly
lower. The reason for the lag, of course, is costs. And we know
pretty much what those costs are: management fees, operating expenses,
sales charges, portfolio turnover costs, out-of-pocket fees, and
cash drag. (Most stock and bond funds hold a small percentage of
their assets in cash.) All-in costs for the average stock fund come
to something like 2½% per year; for the average bond fund,
1 1/3%; for the average money market fund, 7/10 of 1%. In the new
era I foresee (I hope I'm wrong!), equity fund costs would consume
between 30% and 60% of stock market returns. Bond fund costs would
consume from 20% to 25% of bond market returns. And money fund costs
would consume about 25% of money market returns.
Taking The Toll 2: Market Timing
Further, while the average equity fund provided
returns of 15% during the great bull market, please don't make the
mistake of thinking that the average equity fund investor
earned 15%. No, recent data suggest that such an investor earned
about 6%. Just 6%! Less than regularly rolling over a bank
three-year certificate of deposit during the two decades. How can
that possibly be? The answers are not very complicated. One reason
for that remarkable shortfall is that fund investors, to an appreciable
degree, were engaging in a sort of "market timing" exercise.
With the Dow Jones Industrial Average below 1300 from
1982 to 1984, for example, American savers placed just 2% of their
annual savings in equity funds. Even during the early 1990s, with
the Dow below 4000, the equity fund flow represented only 20% of
savings. But during the twelve months ended March 31, 2000, with
the Dow often over 11,000, investors invested an incredible 120%
of their savings into equity funds. And, when the inevitable bear
market came, investors virtually ceased their equity fund purchases.
During 2001, cash flow into equity funds plummeted to just 11% of
savings for the year. Sitting on the sidelines when stocks are low
and plunging into the market when stocks are high, clearly, is not
a formula for investment success.
Taking The Toll 3: Fund Selection
And investors are also hurt in another perverse way.
They have a deep-seated tendency to buy on the basis of past performance,
pouring their money into exactly the wrong funds at precisely
the wrong time. For example, during the twelve months ended March
2000, when the great technology-age market bubble was inflating
to its very bursting point, investors poured $240 billion dollars
in technology funds and tech-oriented growth funds at their peak
levels, funding some of those purchases by actually withdrawing
$40 billion from the value funds that had failed to participate
in the great boom. In the aftermath, the asset values of the most
popular growth funds declined by an average of 63% from high to
low, while the most unpopular value funds actually rose in value
by 3%. Combined with the toll taken by fund costs and the toll taken
by market timing, this penalty for adverse selection is the third
leg of the unfortunate triumvirate of tolls that has left mutual
fund investors in the backwater of the returns earned by the financial
markets. If financial advisors do no more than keep your client
from paying these unnecessary tolls, you've made a great start on
serving them well!
Of course, stock market booms and speculative manias
are merely a reflection of the public mood. Tuplipmania, the South
Seas Bubble, the Crash of 1929, it is often argued "just happen."
And in the recent bubble, the information age, globalization, "the
long boom," and the turn of the millennium simply combined
to create an era of unreasonable expectations. Investors, it is
said, have no one to blame but themselves.
Please don't believe that. To do so is to ignore
the role of the professional investorsand professional marketerswho
helped create the aura of omnipotence that enveloped the financial
community. Just like those Wall Street security analysts who gave
us the "research" that inspired the internet stock craze,
as well as Enron, Global Crossing, and scores of other watered stocksall
in the name of capturing more investment banking clientsalong
with those corporate insiders who purchased stocks through low-cost
options and quickly sold them at inflated prices; so too many mutual
fund managers accepted uncritically the hyped-up growth projections
for technology, medical, and telecommunication stocks, and piled
them into the funds they manage.
And that's not all that the mutual fund industry must
answer for. We have to accept our responsibility for jumping on
the new era bandwagon, forming 116 new technology fundsincluding
40 internet funds, and a dozen NASDAQ qube fundsand 378 new
growth and aggressive growth funds during the final years of the
mania, all designed to bring in public money into our coffers rather
than to help investors achieve their long-term financial goals.
We also have to accept our responsibility for, right at the market
peak, promoting the living bejebbers out of our hottest performing
funds. The 44 equity funds that advertised their performance in
the March 2000 issue of MONEY magazine for example, reported an
average return of 85.6% during the previous year.
The End of Fund Dominance?
Well, if the mutual fund investors haven't come within
a country mile of capturing the returns of the financial markets,
and if they are predestined to fall short of whatever returns the
stock, bond, and money markets are generous enough to provide in
the future, why doesn't this era of mutual fund dominance
deserve to come to an end? Why shouldn't separate
accounts move to center stage? Forrester Research is hardly alone
in suggesting that these accountsindividually-managed, customized
investment accounts that can take into consideration each investor's
objectives, tax-status, and personal predilections, all the while
providing real time reports of portfolio holdingswill do exactly
that. Well, I, for one, doubt it. For it is not at all clear the
SMAs (separately-managed accounts) have significant advantages over
- First of all, while fund costs may be our Achilles
heel, the costs of the SMA are even higher: 2% to 3% per
year (plus transaction costs) is the going rate. Fee-based compensation,
the Forrester report asserts, could raise payouts to brokers by
50%, and it is the client who will bear these costs.
- Second, the tax-efficiency benefit is dubious.
Who says that SMA's necessarily provide greater efficiency? And
even if it exists, won't the value of such a benefit be far lower
in an era of subdued equity returns. (Today, equity funds as a
group may well have unrealized losses on their books.)
Further, taxes are not a particular issue for bond and money market
fundsnow 40% of industry assetsand some one-half of
all equity fund assets are in tax-deferred plans. Finally, regular
index funds and tax-managed mutual funds offer readily available
- Third, I don't believe that SMAs offer investment
advantages, and they may be disadvantageous to investors. There
is no arguing against the notion that the essential mission of
the investor is to capture as close as possible to 100% of the
returns provided by the financial markets in which they invest.
While we know that mission can be accomplished by owning
the market through a low-cost index fund, we know next to nothing
about the records of SMA Managers.
- Fourth, the challenges of operating SMAs is substantial.
Few registered advisers and brokers are satisfied with today's
(largely) APL technology. And while tomorrow's technology will
surely be better, it's hard to imagine that it can ever be as
economical as the simple pooling of accounts that has been the
crux of mutual fund operational efficiency since the industry
A New Mutual Fund Industry
Nevertheless, if mutual funds fail to change,
our dominance will come to an end. We hold no permanent monopoly
on the good will of our owners; we must re-earn it every day. Fund
managements can no longer bask in the warm noonday sun and continue
to place their own needs ahead of the needs of their clients. During
the great bull market, many firms that trod the wrong path prospered.
Even where prudence, principles, and stewardship took a back seat
to marketing, the money rolled in. Hundreds of new aggressive funds
were formed and backed with more than a billion dollars of advertising.
"We'll focus on short-term rewards, momentum, and concept stocks,"
was the implicit strategy, "and don't worry about higher fees,
and portfolio transaction costs." In an era of exploding returns
on stocks, the sky seemed to be the only limit to excess.
Those strategies won't play well in the years ahead.
We must make speculation passé, and put stewardship in the
driver's seat. The counterproductive leap in fund portfolio turnoverwhich
rose six-fold (from 14% annually to an incredible 117%) from 1960
to 2001must be reversed, as we return at long last to our
original focus on middle-of-the-road funds, and on long-term investing
that emphasizes, not the price of the stock, but the value of the
corporation. And all of this foolishness about earnings "guidance,"
these forecasts of unsustainable growth rates for American corporations,
and the managed earnings that haunt our capitalistic system must
be replaced with realistic expectations and principled accounting
And fees will have to come down. So far, there's no
sign of a wave of fee reductions, but it must be obvious that investors
are sending the lion's share of their cash flow to fund firms that
have the highest stewardship quotient (SQ):
- The lowest fees on their equity funds
- The greatest index fund orientation (or at least
the broadest kind of diversification)
- The strongest (meaning lowest cost, highest quality)
bond and money market line-up
- The greatest reluctance to pander to the public
taste in their new fund offerings
- The lowest portfolio turnover
- The greatest tax-efficiency
- The longest holding periods by their own shareholders.
And most firms that have one of those high
SQ characteristics, have all of them. (Just check the record.)
But there aren't nearly enough high SQ firms, and even those that
do possess high SQs have room for improvement. That improvement
will come, day by day, week by week, year by year, as investors
turn to high SQ firms. And as they do, other firms will be compelled
to raise their own SQs, placing the mutual fund industry's dominance
on a far firmer foundation.
Back to Basic Principles
To make this transition requires only that investors
speak and managers listen. In order to solidify mutual fund dominance,
we need to develop the will to go back to basics like these:
- We must honor fundamental investment principles
such as asset allocation and diversification.
- We must recognize that intelligent long-term investing
means a focus on the value of the corporation rather than the
price of its stock.
- We must remind ourselves that the returns that
investors as a group receive are, by definition, the returns earned
by the financial markets, minus the costs of the intermediaries.
- We must give shareholders a higher share of market
returns, by slashing the frictional costs of fund investingmanagement
fees, sales charges, operating expenses, turnover costs.
- We must recognize that past financial market returns
can't be interpreted as actuarial tables and realize that uncertainty
is the ultimate reality of investing. In our great focus on emphasizing
the probabilities of reward, we must never let our investors ignore
the consequences of loss.
- And we must restore a proper balance between stewardship
Summing it all up, by managing their assets
in the most honest, efficient, and economical way possible, we must
give our clients a fair shake. If we do only that, the age of mutual
fund dominance is not only not over, it is just beginning.
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.