The Vanguard Group
"Mutual Funds: Trading Practices and Abuses that Harm Investors"
Selected excerpts from testimony to The Senate Committee on Governmental Affairs

The Senate Committee on Governmental Affairs
Hearing on
"Mutual Funds: Trading Practices and Abuses that Harm Investors"
November 3, 2003

Selected excerpts from testimony


Senate Subcommittee members in attendance:

Peter G. Fitzgerald, Subcommittee Chairman (R-IL)
Susan M. Collins, Committee Chairman (R-ME)
Daniel K. Akaka, (D-HI)

Panelists:

John C. Bogle, Founder and Former CEO, The Vanguard Group
Matthew P. Fink, President, Investment Company Institute
Mercer E. Bullard, Founder and President, Fund Democracy


Statement of Senator Peter G. Fitzgerald

Today we are conducting an oversight hearing on the mutual fund and investment advisory industry. We are here to investigate the breadth and the extent of the illicit trading practices that have come to light in recent months and to examine the impact that the abusive practices have had on ordinary mutual fund investors. We are also here to re-examine mutual fund management and governance and, specifically, to identify statutory and/or regulatory reforms that should be enacted in order to prevent a recurrence of the abuses and to better protect fund shareholders.

Just two decades ago, the mutual fund industry was relatively small, but today it’s enormous. In 1980, only a small percentage of Americans invested in mutual funds and the assets of the industry were only $115 billion. Today, roughly 95 million Americans own shares in mutual funds and the assets of all the funds combined are now more than $7 trillion.

As John Bogle, who will testify later this morning, has observed, the coming to light of the "market timing" and "late trading" scandals is a blessing in disguise. The growth of the mutual fund industry has been so rapid during the past 20 years that the industry has managed to escape the sort of thorough review and oversight that it merits. The current scandal prods both Congress and regulators to catch up with the industry and to re-examine its whole set up. Given that mutual funds are now the repository of such a large share of so many Americans’ savings, few issues we confront are as important as protecting the money invested in mutual funds.

But our current focus on particular types of trading abuses must not prevent us from seeing the big picture. It’s time for a wholesale re-examination of how mutual funds are organized and managed. As several of our witnesses will testify today, the governance structure of a typical mutual fund is a study in institutionalized conflict of interest. Until we eliminate the conflicts, lots of mutual funds will continue to engage in behavior that benefits fund managers at the expense of fund shareholders.

Mutual funds typically have a board of directors but no staff. The board outsources all investment functions to an outside investment advisory firm which charges the fund a management fee. Almost always, many of the directors of the mutual fund, including the Chairman, are also insiders of the investment advisory firm. Surprisingly, federal law not only allows this incestuous relationship, but codifies it. The law apparently places faith in the false conceit that fund directors can bargain at arm’s-length with themselves.

Because of the incestuous relationship between mutual fund directors and their investment advisors, investment management and other fees charged to most mutual funds are far too high. As Eliot Spitzer will testify, in 2002, mutual funds paid advisory fees of more than $50 billion and other management fees of nearly $20 billion, not to mention tens of billions that the funds spend on trading costs.

In most industries, there are economies of scale. One would think that as mutual fund assets increase, advisory fees would decrease. But in fact the reverse is true. It appears that as mutual fund assets rise, advisory fees rise even more. As Mr. Bogle and Mr. Spitzer will point out, between 1980 and 2000, mutual fund assets grew by 60 times, but the funds’ fees and expenses grew by 90 times.

America’s mutual fund industry has enabled millions of Americans, who otherwise would have been unable, to invest in debt and equity securities. It has contributed substantially to keeping our country’s capital formation system the best in the world. But its institutionalized conflicts of interest have cost Americans dearly. The recent industry scandals merely highlight that in trying to serve two masters, many fund directors have all too often preferred the investment advisory firms with which they are associated over the mutual fund shareholders whom they should theoretically be trying to protect.

"Late trading" and "market timing" abuses cost fund investors a bundle, but management fees, distribution fees, sales charges on purchases (loads), purchase fees, deferred sales charges (deferred loads), account fees and other charges cost investors many times more. Even small differences in these fees can translate into large differences in returns over time.

The combination of opaque fees, abusive trading practices and government policies which channel investor money into mutual funds has transformed this once sleepy industry into a monster. The mutual fund industry is now the world’s largest skimming operation – a $7 trillion trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the nation’s household, college and retirement savings.

We may only be talking about a skim of a basis point here and a basis point there, but when the skim is multiplied by $7 trillion and then compounded over 10, 20, 30 or more years, pretty soon we’re talking about real money.

But because no one has to write a check for these costs – and because it makes so much sense to have a tax sheltered retirement or college savings account – relatively few have questioned the industry’s practices or fees, let alone its bizarre governance structure. And, unfortunately, too few have listened to industry reformers like John Bogle, who has been sounding the alarm for years. Until now that is.

The current scandal gives us the opportunity to re-think the whole mutual fund industry. In my judgment, in addition to the obvious tightening to prevent "market timing" and "late trading," we must do at least the following:

(1) Require that at least 75% of the fund’s directors, including the chairman, be independent, and tighten the definition of independent director.

(2) Clarify the fiduciary duty a fund director owes to fund shareholders and make that duty pre-empt any conflicting duties that a director may owe to any vendor to the fund.

(3) Require mutual funds to competitively bid out all investment advisory contracts.

(4) Substantially tighten the fee disclosure requirements for mutual funds.

(5) Require brokers who steer customers into a particular fund to disclose in writing to the customer the compensation that the broker will receive due to the transaction.

(6) Finally, we ought to consider facilitating the creation of more mutual funds that are truly mutual – ones where, like Vanguard, the funds actually own the firm.

Senator Fitzgerald: Mr. Bogle, we may begin with you, and I mentioned in my opening remarks that Vanguard, as I understand it, is the only fund company in the country that is set up in a truly mutual way in which the fund owns Vanguard. In all other instances of mutual funds, you have a separate advisory firm typically that, I gather, sets up the funds, and you set up Vanguard so that the interests of the operators of Vanguard were more aligned with the funds. Could you address that structure that you have just at the outset? I think it is a very important point.

Mr. Bogle: Yes, I am happy to do that. We created an organization in which the mutual funds actually own all of the common stock of Vanguard Group, Incorporated, which is our manager. We operate at cost, and each fund picks up its own share of that cost—there is no profit to any outside organization. When we employ external investment managers, we negotiate with them very vigorously on behalf of our funds. And, in fact, in some cases we get the fees down to less than one basis point—not 10 basis points, Mr. Chairman, one basis point. So we not only have the ability to run at cost, we have the ability to negotiate at arm’s-length.

Senator Fitzgerald: You get the fees for investment management down to one basis point?

Mr. Bogle: Yes. I will confess that the fees on our larger equity funds sometimes run as high as 10 or even 15 basis points.

Senator Fitzgerald: Okay. Not one point. We are talking basis points. One basis point.

Mr. Bogle: Yes. Our Ginnie Mae fund, which is a managed mortgage-backed securities fund, has a fee of 9/10ths of a basis point.

Senator Fitzgerald: What kind of a fee does that fund pay?

Mr. Bogle:

Well, just 0.9 basis points generates a staggeringly large fee—I think it is about $3 million a year. How could anybody possibly spend that much on that kind of management? Just think about it for a minute. So we ought to all be looking, by the way, Mr. Chairman, at dollar amounts of fees and not only fee rates. You know, it is almost as if there was a conspiracy many years ago, and this industry said, what is the biggest number we can think of to relate our management fees to? And someone said, how about we use all the assets of the fund? So we get this 1.5 or 2 percent or 1 percent fee, which looks very small, but we do not say that 3 percent all-in costs—counting trading costs for equity funds—is 30 percent of a 10 percent stock market return and actually 100 percent of the equity premium—that is to say, stocks usually yield about 3 percentage points more than bonds. And at a 3 percent cost in an equity fund, you might just as well own a bond fund as a stock fund. It is a staggeringly large cost.

Now, if I may move on to my opening statement, first of all, I obviously deeply appreciate your incisive and insightful opening statements, and I have to say, Mr. Chairman, I am deeply humbled by your comments because the only thing I have ever had to offer this industry or this world is common sense—I am not a big brain—and some sense of trust—a responsibility for other people’s money. It is interesting that my extreme statements of yesterday seem almost overnight, as I heard in your earlier remarks, to be statements of great moderation, and that which was once heresy in now dogma.

I began my involvement with this industry in 1949, when I began to write my senior thesis at Princeton University. In 1951, I went to work with industry pioneer Wellington Management Company and headed that company from 1965 to 1974. For two years in that period, I was also the Chairman of the Board of Governors of the Investment Company Institute. It was in 1974 when I founded this new mutual fund organization called the Vanguard Group of Investment Companies.

It is peculiar but true that Vanguard represented my attempt to create a firm that would measure up to the goals I set forth for the mutual fund industry in that original senior thesis: to place the interests of fund shareholders as the highest priority; to reduce management fees and sales charges explicitly; to make no claim of ability to beat the stock market; and to manage funds—and this is a direct quote form that ancient thesis—“in the most honest, efficient, and economical way possible.” And through Vanguard, we have done our best of meet those goals. As a result, Vanguard has become the lowest-cost provider of financial services simply by delivering to our investors the staggering economies of scale that exist in the money management business. In fact, Vanguard’s unit costs are down about 60 percent since we began, and the industry’s unit costs are up about 60 percent. That is quite a contrast. Because many investors now understand the importance of costs, that low-cost theory has enabled us to become one of the two largest firms in this field, with $650 billion of assets.

After giving up my position as Vanguard’s senior chairman, I have been engaged in writing, researching, and speaking about investing in the fund industry and, for that matter, corporate America, including writing half-a-dozen op-ed pieces for the New York Times and the Wall Street Journal—one of which castigated the fund industry for taking the position that we should not even tell our own owners how we are voting their shares—as well as several additional books, now four in all, all presenting strong and, I hope, well-reasoned views of this industry’s imperative need to better serve its shareholders.

But I am sorry to tell you, Mr. Chairman, the fund industry has yet to measure up to those idealistic yet wholly realistic goals that I urged upon the industry back in 1951.

Disgusting—disgusting—as they are to someone like me, who has made fund management his life’s work, the recent market timing scandals, as you observed yourself, sir, have a good side. They call attention to the profound conflicts of interest that exist between fund managers and fund shareholders, conflicts that arise from an inherently flawed governance structure in which fund owners in practice have little, if any, voice. The trading scandals are just the small tip of an enormous iceberg of conflict.

While the costs of international time zone trading have been estimated at about $5 billion, the costs of managing the industry’s nearly $7 trillion of assets in stock, bond, and money market funds came to some $130 billion, counting trading costs, in 2002 alone, a cost that is largely—think about this for a minute, sir—largely, indeed almost entirely, responsible for the lag by which mutual fund returns fell short of the returns available in the financial markets. Gross return minus cost equals net return. It is inescapable and, yes, sir, costs matter.

If the management fees that represent the major portion of those costs were subject to arm’s-length negotiation between funds and their managers, it is doubtless tens of billions of dollars could be saved and added to investor returns, year after year after year.

The kind of stewardship that demands that fund directors effectively represent the shareholders who elected them and to whom they are responsible under the law is rarely found in this industry. Rather, managers focus on salesmanship, their agendas dominated by a desire to bring in assets under management. That marketing agenda led us, as you know, sir, to create hundreds of risky “new economy” funds during the stock market bubble, not because we thought that they were prudent investments, but simply because we thought the public would be eager to buy them. And in the ensuing market crash, those very funds cost our shareholders hundreds of billions of dollars, even as fund managers were reaping tens of billions of dollars in extra advisory fees.

The conflicts of interest that engendered these unhappy and costly outcomes for fund shareholders must be resolved, and must be resolved in favor of fund owners, and not fund managers.

My formal statement sets forth a series of governance reforms that I believe are required to set the balance straight, and I strongly urge you to consider them.

In closing, let me say very briefly that I love the mutual fund industry. I have loved it ever since we first met in 1949. But we have lost our way, and we must return to our proud heritage. It is the recent scandals that give us the opportunity to build a fund industry that is worthy of that heritage, one that does what I have been trying to get it to do for a long time—sometimes I think I have been working on it forever: Give the mutual fund industry’s 95 million investors a fair shake.

Thank you, sir.

Senator Fitzgerald: Thank you very much, Mr. Bogle.

Why is it that Vanguard is able to negotiate lower fees with its investment advisers than virtually—does any other mutual fund have lower fees from their investment advisers than Vanguard?

Mr. Bogle: I think it is fair to say as a categorical that no other funds—other than a single isolated fee here or there—pay lower advisory fees than Vanguard.

Senator Fitzgerald: And you have set up Vanguard so that you have eliminated those conflicts between the director of the funds and vendors to the fund.

Mr. Bogle: Right.

Senator Fitzgerald: Well, why is it that not one of the other 8,600 mutual funds in this country is able to negotiate the kind of fees that Mr. Bogle’s firm has?

Mr. Fink: Well, I think Mr. Bogle put his finger on it. You have got to remember—and Jack can correct me—Vanguard was created with a lot of money in existing funds that reorganized themselves to do this. And as Jack said, there is no profit motive, so it would not pay Senator Fitzgerald or Matt Fink to go out and start a fund company that way because we would not make any money at it. So you kind . . .

Senator Fitzgerald: Mr. Bogle, would you care to respond?

Mr. Bogle: Yes. First, let me say that Vanguard started with an existing asset base of around $1 billion, $1.4 billion, and so we had an asset base on which to build this mutual structure. And I will say, Mr. Chairman, I do not expect anybody to start a mutual mutual fund group, except someone like me, without an idea of an entrepreneurial profit. But that should not go on forever. You know, a child becomes an adult, and when we leave the billion-dollar level and have scores of fund organizations that are running $10 and $20 and $100 billion and more, they ought to grow up and think about having an internally managed structure. It almost offends common sense to think a $200 billion aggregation of assets has to hire another company to run it. What sense does that make?

Senator Fitzgerald: Well, let me ask you this: You would not envision any other truly mutual mutual funds. Vanguard is the only one. We do have mutual savings banks. We have credit unions. They are organized. They are not-for-profit. Theoretically, they should have better interest rates that they offer to the customers. I think what has happened in practice is they have not been able to run banks or savings and loans out of town because their service is not as good, probably because there is not the profit motive there.

But what would be wrong if the Government created a means to encourage the formation of more truly mutual mutual funds?

Mr. Bogle: I think public policy should work in the direction of requiring consideration of mutualization after a fund gets to a certain size. You know, one way this industry has changed over the long span I have been in it is, when I entered, all management companies were private companies. They were private partnerships or private corporations owned by the investment advisers, and the SEC successfully kept firms from going public and capitalizing on their fiduciary office. The SEC lost a case in court in 1958. We now have many public companies. And we also have what is really harmful to the industry and to the shareholders: that is, 36 of the 50 largest fund organizations are owned by giant financial conglomerates. And when a big conglomerate buys a mutual fund business for $2 billion, it says to whomever they get to run it for them, we want $240 million a year of profit—that is a 12 percent return on its capital—and if you cannot get it, we will hire somebody who can get it.

So that conglomeratization has moved the management away from this original closely held group out into this distant financial colossus. At that stage, fund complexes, if they have an independent board and an independent staff, will be able to say, look we are going to mutualize.

Mr. Bullard: Mr. Chairman, it is important to remember that while Vanguard is the leader on cost, there are fund companies that are competing directly with Vanguard on cost, and in some cases doing it very successfully. TIAA-CREF, USAA.

Senator Fitzgerald: Does any for-profit firm compete closely on cost?

Mr. Bullard: Yes, sir. In fact, the biggest threat to Vanguard right now are exchange-traded funds, which are consistently offered by for-profit entities, and most people believe Vanguard missed a great opportunity to reduce its expense ratios that are now being undercut by those funds being offered by firms such as Barclay’s.

And I also might add, the largest fund complexes generally correlate fairly consistently with lower costs, with Fidelity, Vanguard, American Funds, T. Rowe Price.

Senator Fitzgerald: Vanguard offers an exchange-traded fund.

Mr. Bogle: We do. Let me be clear on this. First, nobody competes with us on cost, Mr. Bullard notwithstanding. I mean, TIAA’s costs are about 10 or 15 percent higher; USAA’s are probably 100 percent higher; Fidelity’s are 200 to 300 percent higher. So no one competes with Vanguard by providing really rock-bottom costs.

The trick of the ETFs, the exchange-traded funds, is that the costs of administration are basically thrown over to the marketplace, so people pay for them with their brokerage commissions and things of that nature. We have an ETF owning the total stock market index. We can run that fund for—I believe the number is 12 basis points, where the fund itself we run is 15 to 20 basis points. So the differences are small but they are there. So we are in the business. No one is going to take that business away from us.

Senator Fitzgerald: Mr. Bogle, would you like to address what fees are not disclosed in the required disclosures that the SEC mandates in the prospectuses?

Mr. Bogle: Yes, I would like to at least make this one comment. The SEC and the ICI seem to have come to agreement that you can multiply $10,000 by the fund’s expense ratio to get the amount of dollars that would be involved. But they do not seem to be able to multiply the actual value of your account times that expense ratio.

I find that absolutely astonishing in this technological age. It is a simple multiplication by the computer that would give you the dollar-cost number you want. So I do not understand what is going on over in this negotiation.

Senator Fitzgerald: Does the expense ratio encompass all expenses?

Mr. Bogle: No. That is just the fund expenses, which are essentially management fees and other operating expenses. I would like . . .

Senator Fitzgerald: What are the other expenses?

Mr. Bogle: The other expenses are—well, they are quite numerous. One is portfolio turnover costs, which I have a very low estimate of, much lower than most people. I put that in at about eight-tenths of 1 percent. So you would add that, for example, to the 1.6 percent average expense ratio, and that would get you to 2.4 percent.

Most funds have sales charges. If you amortize them over time, it is probably another 40 basis points, something like that. There are out-of-pocket costs. There are opportunity costs. Most funds are not fully invested so you pay an opportunity cost, that being the difference between long-term stock market returns and, say, money market returns, which comes to around another 30 basis points.

So if one wants to think that mutual funds cost around 3 percent a year, one wouldn’t not be far off. The fact is, Mr. Chairman, that we have a study of fund performance since 1984, and the average fund has turned in a 9.3 percent annual return while the stock market has turned in a 12.2 percent annual return. That happens to be a 2.9 percentage point difference.

And if I may expand on that, we have also found out the average fund investor during that period has earned a return of just 2.6 percent, which I believe to be substantially overstated. That is for another day.

Senator Fitzgerald: So we are missing 7 percent somewhere.

Mr. Bogle: Yes, somewhere along the way.

Senator Fitzgerald: Is that part of what I referred to in my opening statement as the skim? Was that all skimmed off?

Mr. Bogle: Well, actually, that is not the skim. That is the net result of an industry that used to sell what we made becoming an industry that makes what will sell. We market funds—for example, technology funds—right at the high of the market. The money pours into them, and then it starts to pour out when the market goes down. At the height of the market, the money is pouring out of value funds, let’s call them “old economy” funds, into “new economy” funds. And investors have paid a huge penalty for that, partly, in fairness, their own fault, their own greed, probably their own jealousy of their neighbor. But the industry brings out those funds, promotes them, advertises them. If you look at the March 2000 issue of Money Magazine, 44 mutual funds were advertising their performance there, and they were offering to the investment public, believe this or not, Mr. Chairman, an average return over the previous year of plus 85.6 percent—come and get it. But, of course, nobody got it. The market went down and they lost their money.

Senator Akaka: Mr. Bogle, what is your evaluation of mutual fund advertising? And do you believe that it is misleading to investors? What needs to be done to prevent investors from being misled by advertisement?

Mr. Bogle: The first thing—and I did not always feel this way, but we live and learn—is that I believe that mutual fund performance advertising is inherently misleading on the face of it. We get this free shot. When times are good, we advertise very high returns. When times are bad, we either advertise nothing or we advertise our bond funds. The record is very clear on that. It is opportunistic, it is overly zealous, and it is inherently misleading.

So I would say you cannot show performance numbers. When I started Vanguard, I said we will never advertise a performance number, nor ever have we. So that is what should not be shown.

What should investors think about? Investors should simply understand that active management is in many respects a charade, that nearly all mutual fund active managers end up being average—before costs. How could it be otherwise? And, therefore, they lose to the market by the amount of their costs. So investors ought to think first about how diversified their fund is, and whether or not they should just own the entire stock market rather than trying to pick a manager who can beat it.

Second, it is so important that they understand to importance of costs— that is right up there after diversification.

Third, they ought to look at fund portfolio turnover. There is direct correlation not only between cost and investment returns, but between the level of turnover and investment returns. I mean, it cannot be more obvious, and if you look in my written statement, you will see that if you combine operating costs and turnover costs, the low-cost quartile of funds wins by 3.5 percentage points per year. And it’s true in every one of the nine Morningstar boxes. The pattern is unmistakable. The higher the turnover, the higher the costs, the worse the returns investors get. If we could talk investors out of looking at past performance, that would be a good thing.

Likewise, if we could also talk them out of buying specialty funds and sector funds—which they always buy after the funds have a run of good performance. Investing is actually a matter of great simplicity. Get the diversification as wide as you can, get the cost as low as you can, and then close your eyes and hold on for the rough ride that common stocks have been giving investors since the beginning of time. So my first rule is: Don’t do something, just stand there. And my second rule is: Don’t peek. Never look. And when you retire you’ll be fine if you follow those rules.

Senator Fitzgerald: I want to thank Mr. Bogle for coming here today. He has honored us by his presence. We thank you for the good work you have done over your illustrious career, and I hope to stay in touch with you as we work through some reforms that you have been arguing for for years. Thank you so much for being here.

Mr. Bogle: I would be glad to help, Mr. Chairman, in any way that is within my power. Thank you, sir.

Note: The opinions expressed in this speech do not necessarily represent the views of Vanguard’s present management.

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