Remarks by John C. Bogle
Founder and Former Chairman, The Vanguard Group
Before the 25th Annual Conference of
The Association of Investment Management Sales Executives
Boca Raton, FL
April 29, 2002
Some years ago, when I was trying to replace a side stay on my
yacht, the Blue Chip, an aging 14½-foot O'Day Javelin
sailboat, I struggled to find the manufacturer, a once fine firm
that had, sadly, been bought and sold several times. O'Day was hardly
in the pink, and when I finally found their number and spoke to
one of their staff, I learned they couldn't help me. When I expressed
my disappointment, the nice older lady with whom I spoke asked me
how long ago I had bought the boat. "25 years ago," I
answered. She responded simply: "Sir, a lot can happen in 25
years." Yes, a lot can happen in 25 years. And on your
25th anniversary, I hardly need remind you of that eternal wisdom.
Indeed it's almost unimaginable how much the world of investingespecially
the world of institutional investinghas changed during the
past quarter century.
- America has prospered beyond our fondest dreams,
with our GDP rising nearly six-fold, from $1.8 trillion to $10.2
trillion. Corporate earnings have grown almost as fast, from $100
billion to $500 billion.
- The stock market has soared, not merely proportionately
to those profits, but actually four times as fast. The
market value of U.S. stocks is up from $850 billion to $12.5 trillion,
and the Standard & Poor's 500 Index has risen from 100 (yes,
100!) to above 1100. The era began with pessimisman earnings
yield of 9% on the S&P 500 and a dividend yield of 4½%.
But, measured by the same numbers today, there is still optimism
in the aira 4% earnings yield and a dividend yield of but
- A once relatively unstructured institutional investing
industry has become a giant force. Institutional ownership of
U.S. stocks has grown from $330 billion to $8 trillionfrom
39% of all stocks to a dominant 60% ownership of corporate America.
- Active managers have watched asset non-managers
move to the fore. Passive market-indexing strategies now account
for more than 30% of total institutional assets, compared with
less than 0.1% at the end of 1976. Today, four of the eight largest
money managers focus primarily on indexing.
- Despite the increase in passive indexing strategies,
market activity has soared. Annual turnover in the U.S. stock
market was 23% in 1976; in 2001 it was 134%. Institutional investors
played a major role in this upsurge, with equity mutual fund turnover
rising from 30%long-term investmentto 110%short-term
- The very nature of retirement plan investing has
been turned on its head. We are at the culmination of a truly
seismic shift, a massive transfer of investment risk from the
corporation to the employee. Assets of defined benefit
(DB) plans, more than 70% of retirement plan assets back in 1976,
have declined to 45% of assets, and the end of that shrinkage
is not yet in sight.
- Then, investing was sort of an obscure mystery
to the public. There were said to be one million families owning
equities, and a quarter-page in The New York Times listed
about 300 mutual funds. Today, some fifty million families own
equities; there are dozens of investment magazines; CNN and CNBC
and others broadcast financial news all day long; and it takes
six pages of Sunday's The New York Times to list today's
8,346 mutual funds.
In his wonderful book, The Money Flood, Michael Clowes describes
the rise of institutional investing as "a revolution that has
reshaped the role of the federal government, the financial security
of individuals, corporations, and financial institutions, and the
capital markets (of the world) . . . yet a revolution that has occurred
quietly, without bloodshed and with minimal disruption of lives,
(one that has) gone largely unnoticed, a revolution of ideas that
swept away old thinking and old ways of doing things." And
What is more, much of what we accept as dogma today had barely
come into existence by 1976. As Clowes points out, the start of
this quarter-century era was virtually contemporaneous with a whole
host of related developments: The end of fixed commissions on the
New York Stock Exchange; the Employee Retirement Income and Security
Act (ERISA); and the birth of Pensions and Investments; the
Nobel Prize in Economics; and the emergence of Modern Portfolio
As it happens, also just moments before this quarter-century of
change began, I had the good fortune to start a new mutual fund
company. I named it Vanguard, after a British flagship that,
at the battle of the Nile in 1798, led a fleet that crushed Napoleon's
dreams of world conquest. Given our nautical heritage "stay
the course," and so onI use the term "sea change"radical
changeto describe what has since happened in the field of
institutional investing. While few of you were as fortunate as I
to be present at the creation of the new era of investing that began
in the mid-1970s, everyone here in this room today has witnessed
The Mutual Fund Industry
During this era the once-midget mutual fund industry became a
giant. Equity fund assets, $40 billion a quarter century ago and
12% of the institutional total, have grown to $4.1 trillion, holding
40% of all institutional holdings of U.S. stocks. But despite the
industry's colossal growth, the success of the firms that lead the
industry when the great boom began was hardly guaranteed. Consider
what happened to the top 15 mutual fund managers in 1976 over the
years that followed: (Ranked by equity fund assets only.)
As you can see, there is a lot of creative destruction going on
here. Among the 15 leaders in 1976 only seven remain in the top
echelon. Four firms, swallowed up by larger rivals, no longer exist.
Only three of the 15 (Vanguard, Fidelity and Capital Group) have
actually increased their market share. On the other hand, of the
eight new leaders, three did not even offer mutual funds in 1976,
and the remaining five then had aggregate assets of less
than $1.5 billion. Note too the staggering increases in equity fund
assets, even among the slower-growing firms. (I remind you
that a 25-fold gain equals a 14% compound annual growth rate!) Note
also the major increase in concentration: In 1976, the three largest
firms controlled 35% of the total assets of this elite group. By
2001, the three largest firms controlled almost 60% of the total.
There were, of course, a whole variety of factors that shaped
the relative success of these firms: The investment performance
of their funds, their marketing strategies, whether they were load
or no load; the extent to which they chose to embrace index funds,
even their cost structures. But one difference stands out: The
extent to which they sought and attracted institutional assets.
The fact is that the five largest equity fund managers just happen
to be the five largest providers of mutual funds to defined contribution
plans, and nine of the top ten firms appear on both lists. Those
managers alone account for $580 billion of DC assets, fully 70%
of the fund industry's $820 billion total. Defined benefit
plans also make up a significant portion of the asset bases of most
of these firms. A focus on the institutional ownership of
fund shares, then, has been one of the major forces that shaped
the widely varying fortunes of mutual fund firms, and is responsiblefor
better or worsefor the increasing concentration of industry
In 1983, when Vanguard made the decision to plunge full-force into
the brand new 401(k) arenaone of the first firms to do soour
reasoning was based on simple logic. Since we would be dealing with
savvy corporate financial and human resource managers, we believed
we had both the winning strategy and the winning structure: funds
with high performance predictability relative to their peers (including
the industry's only index fund), no sales commissions, and the exceptionally
low expense ratios that our mutual form of structure (shareholder-owned,
operated on an at-cost basis) facilitates. The decision to gear
up for this new business was really a strategic "no-brainer,"
although (as always!) I vastly underestimated the operating and
systems challenges we were to face. But we made the plunge into
the institutional arena, and it has obviously played a critical
role in our growth.
What's Next For the Financial Markets?
As I peer out into the next twenty-five years, there's not much
question that much will change in our field. Little of it is predictable,
although it's hard to imagine that institutional ownership won't
remain a major force in the fund industry. But in the coming era,
far more than in the past, mutual fund managers will have to focus
on two elements that have not yet appeared as consequential competitive
factors. One will be increasing recognition of the profoundly negative
impact of financial intermediation costs on retirement plan
investors; the other will be increased attention to asset allocation.
Both trends will be accelerated by the fact that, unless I miss
my guess, the financial markets will not repeat their remarkable
generosity of the past quarter-century.
Let's think about that issue for a moment. First, in the stock
market. We know that the annual return on U.S. common stocks during
the past 25 years has averaged a remarkable 13.7%, more than five
percentage points above the 8.4% rate over the prior 100 years.
I won't try to forecast the next 25 years at the end of which
I'll be 97, but my new heart (a major acquisition of 1996) will
be but 57!but I will look ahead to the coming decade. Before
I do, let me tell you how not to think about future returns:
(1) Do not believe that the stock market is an actuarial
table; (2) do not accept that the past is prologue; and (3)
do not succumb to Monte Carlo-itis, assuming that if you
throw all of those annual returns into something like a computerized
Waring blender, you'll establish the precise odds that a particular
return might be earned in the future.
I say that because I believe, with all due respect, that too many
quantifiers of the American stock market have failed to understand
the difference between risk and uncertainty. Risk
is not volatility; risk is not standard deviation;
risk is not beta. Risk represents the odds that a particular
outcome will occur in a known number of events, i.e., the
chance that you will flip heads in one toss of a coin is one out
of two; the chance that you will flip heads ten times in a row is
one out of 1024. Uncertainty, on the other hand, is simply not knowing
what lies ahead. Uncertainty is the possibility that you will lose
a lot of money just when you need it the most. Uncertainty is
the central maxim of investing.
Lord Keynes warned us: "It is dangerous . . . to apply to
the future inductive arguments based on past experience, unless
one can distinguish the broad reasons why past experience was what
it was." That warning suggests that if we can distinguish
the reasons why the past is what it was, we can apply that
very line of reasoning to the development of reasonable expectations
about what may lie ahead for stock prices. The reasons that
stock returns averaged 13.7% during the past 25 years are clear:
The average dividend yield on the S&P 500 Index was 3.6%, the
subsequent earnings growth was about 6.7%; the combined investment
return, then, was 10.3%. An additional 3.4% percentage points was
added from speculative return, a result of the tripling of
the price-earnings ratio from nine to 24. Result: a total return
of 13.7%. The math is not complicated!
But make no mistake about it: That speculative return loomed large
in the golden era in which institutional investing flourished. The
fact is that, based solely on investment return, $1 invested in
stocks at the outset would have grown to $11.73a handsome
near-twelve-fold enhancement. But the leap in the p/e multiple more
than doubled that investment return to $24.77nearly
twenty-five times over. Yes, we had literally never
had it so good.
So, let's look at these factors in the decade ahead. Today, the
S&P 500 Index yields not 3½% but 1½%, reducing
this key contributor to stock returns by two full percentage points.
Even if we assume a continued 6½% earnings growth, the annual
investment return on stocks would be just 8%. Will speculative
return add to or detract from this figure? It would be, I suggest,
absurd to expect today's P/E ratio of 24 (based on "normalized"
earnings at that), having risen at a 3%-plus annual rate during
the long bull market, to continue to rise at the same rate, which
would take it to 34 a decade from now. Indeed I'd expect it to decline
to perhaps 18 to 20 times.
No oneno onecan be confident about how much
investors will pay for a dollar of earnings ten years hence. But
if my expectation is reasonable, the resultant drop in the
P/E would create a negative speculative return of something
like 2% per year, reducing the annual return on stocks to about
6%. I'm not much for such precision, however, so let's assume a
wide range of, say, 3% to 8%. In any event, we'd best all count
on a coming era of lower returns in the stock market, and then hope
we're wrong. But I hardly need remind you: Relying on hope is
an unsound investment strategy.
In such an environment (and, I might add, even if the environment
proves more felicitous), mutual fund costs will be more important
than ever. During the past quarter-century, all-in equity fund costsmanagement
fees, operating expenses, portfolio transaction costs, sales charges
and cash dragaveraged slightly over 2% per year, consuming
something like 15% of the stock market's 14% return and leaving
fund investors with a return of less than 12%. Fund expense ratios
are now much higher, however, and the staggering increase in fund
portfolio turnover, despite much lower brokerage commissions, probably
increased transaction costs. If we assume 2½% in annual
costsand that may well be conservativethey would consume
more than 40% of a 6% stock market return. There are only two ways
to minimize such a confiscation: (1) Reduce fund transaction
costs by slashing portfolio turnover; that is, by investing
on the basis of long-term corporate value rather than speculating
on the basis of short-term stock price. (2) Reduce fund expense
ratios by operating more efficiently, and by cutting the level
of management fees.
The role that fund costs play in fund performance is substantial.
Indeed, an equity fund's expense ratio is the greatest single factor
in predicting its future relative performance. The Journal of
Portfolio Management has just published my study of the relationship
between fund performance and fund expense ratios over the decade
ended June 30, 2001. It is an eye-opening study, showing that while
the average equity fund provided an annual risk-adjusted
return of 12.5%, the average high-cost fund returned 10.8%1.7%
lowerand the average low-cost fund provided
a return of 13.8%1.3% higher, a spread of three percentage
points a year, representing a near-30% enhancement in return. Even
more impressively, compounded over the full ten-year period, each
dollar in the high-cost fund increased by $1.79, while each dollar
in the low cost fund increased by $2.64an enhancement to return
of nearly 50%, largely achieved merely by selecting low-cost funds
rather than high-cost funds and holding risk constant.
Importantly, the pattern for equity funds as a group held
constant for all nine distinctive styles of equity fund investing.
Morningstar data for each of the nine "style boxes" (large-cap
growth, mid-cap blend, small-cap value, etc.) confirmed the low-cost
advantage, not only in each case, but in remarkably consistent dimension.
While the high-cost/low-cost differential averaged 3.0% for all
funds, the spread was tighta high of 5.2% among small cap
value funds, and a low of 1.9% for both large-cap value funds and
mid-cap blend funds. What is more, in each case, the high-cost funds
provided significantly below-average returns, and the low-cost
funds provided significantly above-average returns18
independent demonstrations of a simple hypothesis: Costs matter.
And you can easily add a 19th: Low cost is what gives the index
fund its remarkable performance edge.
It is easy to understand why the average man-on-the-street is unaware
of the importance that cost plays in shaping fund returns: Cost
information, while available, is not exactly highlighted; the fractional
percentage point differences seem almost trivial; there are always
some high-cost funds that have provided good past returns, and some
low-cost funds that have failed to do so; and the impact of cost,
while compelling on a long-term basis, makes little impression on
a typical fund investor with a short-term focus.
But it is impossible for me to understand why plan trustees and
human resource and financial managers seem similarly oblivious to
the importance of cost. Individually, executives that supervise,
say, a $25 million pension plan or a $1 billion 401(k) plan have
a lot of clout, and they could surely exercise it collectivelyand
in the interest of their plan participantsif they wished to
do so. Indeed, knowingly or not, they did just that when they determined
that funds with sales charges would have to waive them. Today, every
major load fund firm has done exactly that, making their funds competitively-priced
with no-load funds for their large institutional clients. But I
predict that a decline in fund expense ratios for giant institutional
accountsperhaps by a separate series of funds, or perhaps
by clone fundsis one of the major changes that lies ahead.
The Coming Rise of Asset Allocation
I also predict that asset allocation will be given far more attention
in DC plans, and that bond funds will explode upward from their
present 3% share of the assets of retirement plan participants.
In the aftermath of the burst stock market bubble, investors are
coming to realize that all that glitters about the stock market
is not gold. And if I'm right that we are in for a time of lower
stock market returns, that will add to the already increasing focus
on the importance of asset allocation in intelligent retirement
So far, the pattern of asset allocation has been remarkably counterproductive.
In 1988, with stocks (as it turned out) at bargain-basement levels,
defined contribution plan participants had 43% of their investments
in equity funds and company stock, and 57% in fixed income investments
such as guaranteed insurance contracts (GICs) and bond funds. With
each ratcheting up of stock prices, up went the stock portion of
their plans55% in 1995, 72% in 1999, and by the end of 2000,
81%, including 62% equity funds and 19% company stock. That perverse
pattern meant that, just before the fall, the risk assumed by participants
was at an all-time high. Doubtless some of these investors are now
reconsidering their asset allocation strategy.
And it's at least possible that they're wise to do exactly that.
For I believe that future returns on bonds may well be competitive
with the returns on stocks. Indeed that 3% risk premium that existed
during the twentieth centuryand that we all accept
as holy writmay be far smaller in the coming decade, perhaps
even non-existent. If, following Keynes' advice, we have only the
wisdom to look to the reasons why past bond returns were what they
were, we see that the principal reason that bond returns averaged
9% over the past quarter-century is largely that at the outset the
yield on bonds was almost 8%.
The fact is that the best forecaster of long-term bond returns
is the known yield at the start of the period. Decade after
decade, the initial yield explains some 90% of the subsequent total
return of bonds. Currently, the Lehman Aggregate Bond Index yields
about 6%, almost guaranteeing substantially lower future
bond returns, perhaps in the range of 5% to 7%. At the low
end, of both and stock return ranges, then, bonds would provide
higher returns than equities, something that has happened
in one decade out of every five in U.S. history. At the high end
of both, the equity risk premium would be just 1%exactly what
it was during the nineteenth century!
As in the equity fund arena, of course, bond funds don't
earn the bond market return. While different maturities and
categories (government, corporate, municipal) don't lend themselves
to easy collective analysis, the patterns look the same no matter
which group we look at: Almost with each step up the cost ladder,
down goes the return-not only by the amount of the extra costs,
but by a slightly larger amount. Consider intermediate-term bond
funds. With an expense ratio of 1.4%(!), the highest cost decile
provided a return of 6.0% over the past decade; the middle two deciles,
with a cost of 0.8%, returned 6.7%; and the lowest-cost decile,
with a cost of 0.3%, returned 7.2%. Note that each decile earned
a gross return of about 7½%; the differences in net return
were engendered largely by cost differences, not by maturity
differences nor by quality differences nor by management skills.
The reality is that investment costs have a much greater short-term
relationship to bond fund returns than to equity fund returns, and
that clarity will not long be ignored by investors selecting bond
funds as a haven from volatile stock markets. I should add that
the net return on a bond index fundwhich carried the lowest
expense ratio in the groupwas 7.3%. Bond Indexing is an
idea whose time has come.
As retirement plan investors age and begin to gain some asset allocation
wisdomsadly, often through hard experiencethey will
come to understand both the need for bond funds and the critical
role of cost in their bond fund selections. Pressure will grow on
mutual fund managers to do exactly what the marketplace is apt to
require them to do in their equity offerings: One way or another,
to reduce expense ratios and turnover costs and give a fairer shake
to retirement plan participants.
Private Retirement Plans
In this final section of my remarks, I'd like to consider private
retirement plans in the perspective of the remarkable changes we've
witnessed. During the past 25 years, corporations have radically
shifted the investment risk of retirement savings from the firm
to the employee. Twenty-five years ago, there were nearly 30 million
participants in DB plans, today there are 22 millioneight
million fewer. Then, there were 10 million participants in DC plans;
today there are 58 million48 million more. This shift
has given corporations greater control of their pension costs, and
given participants greater control over their portfolios. Who could
argue against providing employees with the flexibility to establish
bond-stock allocations consistent with their own time-horizon and
risk tolerance? Further, the concept of a voluntary and remarkably
attractive means of saving on a tax-deferred basis with the plan
assets "traveling" with the employee, is a good one. But
the great experiment is not working as well as it should. There
are at least three problems: First, as the asset allocation choices
of DC participants show, overall risk exposure rose sharply, just
at the wrong time. Second, not enough employees are saving.
Fully 25% of eligible employees have not yet even begun to participate
in available DC plans, a heavy penalty when the magic of compounding
means that time is money.
Third, those who are saving are not saving enough. Some
18% of all employees are borrowing from their plans to meet current
living expenses, college tuition, and the like, mortgaging part
of their future to enjoy the present. While those who do
save are putting away about 10% of their salaries (including company
contributions), many will fail to reach their retirement savings
goals. A recent study reported that the typical employee in a DC
plan would earn retirement income, including social security,
equal to only 48% of previous income, compared with 60% for the
typical employee in a DB plan.
This under-saving would be less of a problem if future returns
on bonds and stocks are sustained at the generous levels of the
past. But, as I have argued, it is unlikely that will be the case.
Further, measured by equity exposure, not only has risk risen sharply,
but even more risky options are being introduced. In the name of
"choice," I fear many investment sins are being committed.
Funds with hot past performance are demanded by many plan sponsors;
separate accounts are gaining popularity; and a self-directed brokerage
account option is the newest gimmick. (Just imagine the likelihood
of success for an employee who engages in day-trading to build a
comfortable retirement nest egg!)
Thanks importantly to Enron, another flaw in the DC system has
come to light: A woeful lack of diversification. Almost a decade
ago, in Bogle on Mutual Funds, one of the twelve pillars
of wisdom I presented was, "Diversify, Diversify, Diversify."
And I know of no academic, or investment practitioner, or
financial adviser who wouldn't agree. Yet the shares of a single
company represent 20% of the assets of all DC plans,
and 48% of the assets of those plans that mandate the use of company
stock. When all goes well, of course, the employee prospers, both
in his career and in his retirement assets. But when things go wrong,
the employee can lose both. As the employees of Enron, Lucent, Rite-Aid,
and Global Crossingand doubtless many morewould agree,
company stock is not a panacea. Staggering portions of the value
of their retirement plans have gone up in smoke.
Given these problems of inadequate savings,
excessive risk exposure, and a bewildering array of investment choicesto
say nothing of the negative impact of the higher investment costs
incurred by DC plans relative to DB plansone commentator,
writing in Barron's, has described the extraordinary shift
from DB to DC plans as "a social and economic time bomb."1
And yet it seems to me that shifting of retirement plan risk from
employer to employee is unlikely to abate. Not only do DC plans
have the momentum, but the impact of DB plan costs on corporate
earnings is almost certain to rise dramatically in the years ahead.
Why? Because today companies are adding illusory billions of dollars
to their reported earnings by making highly aggressive assumptions
about future returns on their pension assets. The average future
pension fund return, as reported for 2001, is running about 9½%,
far higher than the stock and bond market returns that lie in prospect.
When the painful reality of tomorrow overrides the bright perception
of today, pension costs will rise and earnings will be penalized
(appropriately!) by those billions and more.
It's not too late to prevent the retirement plan time bomb from
exploding. While we can't change the pension funding situationtoday,
at leastwe can change other things. Institutional managers
and consultants can help by beginning to seriously consider the
issue of the proper balance between DC/DB plans, and discuss this
issue with their clients. At the same time, we all must work with
our clients to help educate their employees in the inherently simple
principles of investing, in understanding risk, and in the critical
role played by investment costs. (It's remarkably easy, for example,
to earn virtually 100% of the return of the stock market and the
bond market through index funds.) And we must work together to encourage
them to increase their savings in order to assure a comfortable
retirement. To keep our corporate retirement plan system from "riding
for a fall" (the headline on the Barron's article),
it's high time to focus on these issues.
Will History Repeat?
Well, we've all been part of a 25-year golden
era for institutional investing, and a lot has happened.
What will happen next? Although history does not repeat itself,
as Mark Twain said, sometimes it rhymes. Old weaknesses and
vulnerabilities appear, but in new garments. As Henry Kaufman2
has written, "(We) are unaware of or have forgotten about the
damaging effects of irresponsible behavior in the rush to 'innovate'
and profit." We're now paying the price for those excesses.
But some verities remain, and Dr. Kaufman did us all great service
when he reminded us of one of the simple basics: "People
in finance are entrusted with an extraordinary responsibility: other
people's money. This basic fiduciary duty too often has been
forgotten in the high-voltage, high-velocity financial environment
that has emerged in recent decades," indeed those very decades
in which the financial markets have become institutionalized. We
must learn from those mistakes in the next 25 years.
In such an era of growth, Dr. Kaufman added, "The notion
of financial trusteeship is frequently lost in the shuffle . . .
Financial institutions and markets must rest on a foundation of
trust. The large majority of ethical and responsible market participants
must not tolerate the transgressions of the few abusers . . . and
leaders of financial institutions must be the most diligent of all.
Why should current management of financial institutions be concerned
about distant events? After all, they will have retired long before
then. It will be someone else's problem." But we can't let
that happen. We must be concerned about distant events. Whether
we're talking about America's financial system, or the environment,
or for that matter, the very character of our society, we have a
moral obligation to leave our world better than we found itand
that includes the world of investment management.
The final sentence in Henry Kaufman's fine
book states our responsibilities to our clients, to ourselves, and
to our successors with crystal clarity: "Financial intermediaries
will need to be ever-more diligent, to balance their entrepreneurial
impulses with their fiduciary responsibilities." I close these
remarks by putting it more bluntly: We need more stewardship
and less salesmanship. We who offer financial services must
never forget that we are not merely in a business. We are in a profession.
In the next 25 years, of course, a lot canand will!
happen. But if we want the right things to happen, we must
never compromise our professional responsibilities in favor of the
tough demands of our highly competitive business. Only if we measure
up to that standard will our successors, 25 years from now, give
us credit for making the field of institutional investment management
live up to its high promise.
1. Barron's, November 28, 2001, "Riding
for a Fall," by William Bernstein. Back
Note: The opinions expressed in this article do not necessarily represent the views of Vanguard's present management.
2. Henry Kaufman, On Money and Markets, McGraw-Hill, 2000.
to Speeches in the Bogle Research Center
©2006 Bogle Financial Center. All Rights Reserved.