Remarks by John C.
Founder and Former Chairman, The Vanguard Group
Subcommittee on Government Before the Subcommittee on Government
U.S. House of Representatives
New York, NY
April 20, 2004
Good morning, Chairman Platts, Ranking Member Towns,
and sub-committee members.
Thank you for inviting me to speak with you today.
I hope that my experience in the mutual fund industry will be helpful
in considering the issues before you regarding resource allocation
and strategic planning at the Securities and Exchange Commission.
I have been involved with the mutual fund industry
ever since I began to write my senior thesis at Princeton University
in 1949. In 1951, I went to work for industry pioneer Wellington
Management Company, heading the company from 1965 to 1974. In 1974,
I founded a new mutual fund organization, which I named The Vanguard
Group of Investment Companies.
Vanguard represented my attempt to create a firm that
would measure up to the goals I set forth for the fund industry
in my thesis, all those years ago:
- To place the interests of fund shareholders as the highest priority;
- To reduce management fees and sales charges;
- To make no claim to performance superiority over the stock market
- And to manage mutual funds, “in the most honest, efficient,
and economical way possible.”
These goals proved to be closely aligned, not only
with what I regarded as the spirit of the Investment Company
Act of 1940, but with its letter: to insure that mutual
funds are “organized, operated, and managed” in the interest of
shareowners, rather than of managers and distributors. We’ve done
our best to achieve those goals, and today Vanguard is both the
world’s lowest-cost provider of financial services and, with some
$730 billion of assets under management, one of its two largest
mutual fund firms.
Since relinquishing my position as Vanguard’s senior
chairman in 1999, I have been engaged in researching, writing, and
speaking about investing and the mutual fund industry. I have also
written a half-dozen op-ed pieces for The New York Times
and The Wall Street Journal on these matters, as well as
several additional books, all presenting strong views of this industry’s
need to better serve its shareholders. But I am sorry to tell you
that the fund industry has yet to measure up to the idealistic,
yet wholly realistic, goals I urged upon it way back in 1951, indeed
the goals so clearly articulated in the 1940 Act.
Disgusting as they are to someone like me who has
made fund management his life’s work, the recent market timing scandals
have a good side. They call attention to the profound conflicts
of interest that exist between mutual fund managers and mutual
fund shareholders—conflicts that arise from an inherently
flawed governance structure in which fund owners, in practice, have
The trading scandals are but the small tip of a very
large iceberg of conflicts. One academic estimate of the cost of
international time-zone trading came to $5 billion per year. By
contrast, in 2003 alone, the total cost of managing the industry’s
$7.0 trillion of assets in stock, bond, and money market funds may
have come to more than the $100 billion, a cost that is largely—indeed,
almost entirely—responsible for the shortfall of mutual fund returns
to the returns available in those markets themselves. If the management
fees that represent the major portion of those costs were subject
to arms-length negotiation between the funds and their managers,
tens of billions of dollars could be saved and added to investor
returns, year after year.
The kind of stewardship that demands that fund
directors effectively represent the shareholders who elect them
and to whom they are responsible under the law is rarely found in
this industry. Rather, managers have focused on salesmanship,
their agendas dominated by the desire to bring in assets under management.
That marketing agenda led us to create hundreds of risky “new economy”
funds during the stock market bubble, not because they were prudent
investments, but simply because we saw that the public was eager
to buy them. In the ensuing market crash, these very funds cost
their shareholders hundreds of billions of dollars.
The conflicts of interest that engendered these unhappy
and costly outcomes for fund shareholders must be resolved in favor
of fund owners, not fund managers. The recent scandals
give us the opportunity to at last build a fund industry that is
worthy of its early heritage, one that does what I have long—sometimes,
I think, forever—suggested: Give this industry’s 95 million
investors a fair shake.
The Role of the SEC
Achieving this goal, finally, must come from the industry
itself. But it cannot be accomplished without an active, energetic,
dedicated, fully staffed Securities and Exchange Commission. During
my long career, both before and after the market bubble and the
corporate and mutual fund scandals, I have had frequent occasion
to work with members of the Commission and its staff. It is without
hesitation that I report to the Subcommittee that, virtually without
exception, I have found these individuals to measure up to the highest
standards of public service—integrity, expertise, education, intellectual
curiosity, and willingness to listen and make reasoned decisions.
I salute them.
The Commission’s oversight and examinations cover
tens of thousands of corporations, exchanges, accounting firms,
broker-dealers, investment advisers, and mutual funds. As the activities
in each of those fields exploded in a frenzy during the late market
bubble, the Commission’s workload soared accordingly. So did the
SEC fees paid by these entities, from $750 million in 1996 to $1.8
billion in 1998 to $2.3 billion in 2000.¹
Had those fees flowed directly to the Commission,
it might have had a fighting chance to hire, retain, and motivate
a staff sufficient in number and talent not only to deal with the
cascading flow of paperwork from new offerings of securities, new
and complex financial instruments, and new mutual funds, but to
increase its investigation, overview and probe more deeply into
the emerging issues of the era. However, the SEC fees collected
each year do not represent the funds actually appropriated
for SEC operations. In fact, the Commission’s appropriation was
just $300 million in 1996 (only 40% of the fees), $315 million in
1998 (20% of the fees), and $370 million in 2000 (16%).
It is hard to imagine that the Commission would not
have been far more able to handle the added regulatory responsibilities
engendered by the bubble had its funding grown apace with its responsibilities.
But even in 2003 (when SEC fees had fallen to $1 billion), it was
appropriated only $600 million in funding. I am pleased that a
substantial increase in funding lies ahead, for a Commission starved
in resources and plagued by huge staff turnover is a Commission
unable to fulfill its mission of overseeing our nation’s vital system
of financial markets.
That said, I do not want to appear to excuse, solely
on the basis of limited resources, the Commission’s failures in
its oversight of issues, markets, and funds. Economics, after all,
is about the allocation of limited resources in a world where need
is essentially unlimited. Neither private enterprise nor public
agency ever succeeds in getting its resource allocation precisely
right. (I can assure you that in running two different fund management
companies, I certainly didn’t!) But we must acknowledge our mistakes,
learn from them, and use that wisdom to do a better job in the future.
My sense is that the Commission has done, and is doing,
exactly that. I am impressed with the leaders of both the Division
of Enforcement and the Division of Investment Management as they
respond to the clear evidence of unethical, and in some cases illegal,
behavior that have been uncovered among a score of mutual fund managers,
including some once considered industry leaders. I am also impressed
with Chairman Donaldson’s vigorous leadership in reforming how the
Commission operates, as outlined in his testimony to the Senate
Committee on Banking, Housing, and Urban Affairs on April 8, 2004.
His initiation of a new Office of Risk Assessment and Strategic
Planning is directly and positively responsive, of course, to the
subject of your hearing today.
As I am most familiar with the Commission’s Division
of Investment Management, I will take the liberty of commenting
on a few of the issues that are receiving attention today, and some
that seem to have received, for whatever reason, inadequate attention
in the past:
- Mutual Fund Market Timing. The so-called “time-zone” trading in international funds has been going
on for at least a decade, although it seemed to accelerate in
recent years. Most industry participants were aware of it, and
its frequency could be easily measured, or at least suggested,
by the daily purchases and liquidations in each fund’s shares;
these data, indeed, are published in each fund’s annual and semi-annual
reports. In funds where the most frequent timing was going on,
shares purchased and redeemed each year were three or four times—or
more—the fund’s total assets. In some cases, the sources of these
flows were difficult to detect, but far too few fund managers
seemed willing to stem the tide by such obvious means as stiff
redemption fees, mandatory holding periods, or “fair-value” pricing.
- Hedge Funds.
The activity of hedge funds in this illicit market timing activity
also was hardly a secret. Indeed, an article by four New York
University professors, published in The Financial Analysts
Journal² in 2002, noted
that there were thirty hedge funds that identified “mutual fund
market timing” as their investment strategy. The article not
only described how to implement timing maneuvers and the returns
achieved by timers, but also bluntly pointed out that such schemes
worked against the interests of the other shareholders in the
funds and urged fund managers to take corrective action. (For
this and other reasons, I share Chairman Donaldson’s view that
hedge funds must be brought under the Commission’s purview.)
- Portfolio Manager Disclosure. Having full and fair disclosure has been—and should always be—the
hallmark of our system of financial regulation. But we should
not forget that the reason disclosure works is only in part that
it informs the investing public. Even more important, in my view,
is that disclosure modifies behavior. In essence, if an
action has to be disclosed, we’ll think twice before we do something
questionable. I would hope the Commission would dedicate some
resources to the issue of disclosing the compensation of mutual
fund executives, often veiled by the fact that they are employed
by a management company that is either privately-held or part
of a financial conglomerate. The Commission is now considering
a proposed rule that would require, among other things, disclosure
of how (but not how much) portfolio managers are
compensated. It must be obvious that such a limited disclosure
is essentially no disclosure. The Commission should require
disclosure of the dollar amount of each manager’s compensation
(including his or her share of the profits of the management company
itself). Comparable disclosure should also be required for the
five highest-paid executives of the company. There is no rational
reason for exempting fund executives from the spotlight of public
disclosure applicable to their counterparts in regular corporations.
- Pension Accounts Managed
By Fund Managers.
Among the 100 largest fund managers, 13 are state and local pension funds.
Of the 87 private managers, fully 77 manage both mutual
funds and pension funds. This issue is worthy of Commission
focus for two reasons: First, to understand how fund managers
handle potential conflicts between the two classes of clients,
such as allocations of portfolio transactions and new issues.
Second, and even more important, to assess the reasons for the
wide disparity in fees paid by pension fund and mutual fund clients.
The California Public Employees’ Retirement System, for example,
often pays advisory fees of a mere one-hundredth of the
fees paid by the mutual fund controlled by the adviser, both portfolios
presumably owning similar portfolio securities. Calpers typically
demands, and receives, low base-fee rates, with incentive fees
for superior returns, but the adviser doesn’t agree to similar
arrangements with its mutual fund. There may be reasons for the
differences, but the Commission—to say nothing of the fund’s board
of directors—ought to understand them.
Recent press reports have reported clandestine payments from fund
mangers to pension clients, often in the form of rebates. The
relationship between administrative costs paid by these plans,
the costs assumed by the fund sponsor and their relationship to
the advisory fees the assets generate, the amounts borne by the
company, the amounts shifted to the plan participants, and the
sources of compensation to pension consultants all deserve prompt
and careful study. Most 401-k plan arrangements are unregulated,
and guidelines for fair practice do not seem to exist. This area
should be a high strategic priority.
Until 1958, fund management companies were privately-held
organizations, owned largely by the fund managers themselves.
Then, despite Commission opposition, the Supreme Court held that
such companies could go public. As a result, public ownership
and ownership by fund conglomerates has gradually become the industry’s
modus operanti. Of the 50 largest fund managers, only
seven privately-held firms remain (including Vanguard, owned by
our fund shareholders). Seven are publicly-held, and 36
are owned by large U.S. and foreign financial conglomerates, banks,
brokerage firms, and insurance companies. These businesses purchase
fund companies in order to earn a return on their capital;
yet the 1940 Act makes earning a return on the fund shareholder’s
capital the over-riding priority. This rarely acknowledged conflict
of interest cries out for study.
- An Economic Study of
the Mutual Fund Industry. While I have been calling for such a study for at least eight years, my voice
has fallen on deaf ears. Such a study must be an essential
focus of the Commission’s strategic planning efforts. It
would evaluate the role of mutual funds and their managers in
the context of our national economy, and facilitate an understanding
of how the fund industry actually works. We need, in short, to
“follow the money”—to account for the sources of industry’s direct
revenues (administrative fees, distribution fees, sales loads,
out-of-pocket fees, etc.), operating expenses paid by shareholders,
and indirect revenues utilized by fund managers, including brokerage
commissions. We also need to account for the uses of these revenues—for
administration, for marketing and distribution, for investment
management, and for other major cost centers (including soft dollars).
Without this information, regulation must, in essence, operate
in the dark—in an information vacuum. (Be clear, please, that
I am not in favor of fee regulation.)
Having laid out this litany of priorities for strategic
study by an SEC whose resources are already stretched, I fully recognize
that the job before the Commission is large and its resources, while
larger now, are limited. But these tasks are not only worthwhile,
but essential, for the protection of investors. However, I would
like to offer a final recommendation that could, in the long run,
actually reduce the Commission’s regulatory responsibilities.
Just think about it: One of the principal reasons for existing
regulations, the additional regulations now being considered, and
the areas for study that I’ve noted above is the need to deal with
the profound and obvious conflicts of interests that exist between
mutual funds and their shareholders on the one hand, and
management companies and their shareholders on the other.
The timing and late trading scandals are obvious examples of this
conflict. The setting of appropriate fees is an equally obvious
conflict, and has an economic impact many times the magnitude of
the scandals. And the fund industry’s focus on asset-gathering
through huge sales and marketing expenses and new and exotic “products”
clearly manifests another conflict of interest, also of huge dimension.
Yet, as I noted at the outset, the Investment Company
Act of 1940 provides that funds must be “organized, operated,
and managed” in the interests of their shareholders, rather than
their advisers and distributors. Metaphorically speaking, the
law of the land—our Constitution, if you will—puts the fund in the
driver’s seat and the management company in the rumble seat. (Indeed,
a narrow reading of the Act would not even allow the management
company in the car!) But the fact is—I think beyond argument—that
it is the management company that is driving the car. If funds
were truly organized, operated, and managed solely in the interest
of their shareholders, many, indeed most, of today’s regulatory
issues would vanish. The funds themselves would protect their
shareholders—with their own rules against market timing and
late trading; with advisory fees that were set at arms-length and
with failed managers not necessarily being replaced by managers
from the same company; and with funds organized not merely because
they can be sold, but with service to investors and prudent investment
principles as their foundation.
How can we achieve, or at least approach, this goal?
Now there is a good question for the use of SEC strategic
resources! For an industry that operates, as the 1940 Act says,
“in the national public interest and the interest of investors,”
public policy must move in the direction of an industry structure
focused on the interests of its share owners, just as the existing
law both intends and expresses.
How to begin?
A federal standard of fiduciary
duty for fund directors.
- An independent
chairman of the fund board.
- No more than a
single affiliated director.
- A staff (or consultants)
to provide the fund with objective information with which to evaluate
the management and marketing performance of the advisor, as well
as the appropriate compensation for its services.
We need these long overdue reforms in fund governance,
and we need them now. Some steps may require only Commission
action; some (notably the fiduciary duty standard) doubtless would
require legislation. High on the Commission’s list of strategic
priorities and its allocation of resources should be the decision
as to where regulation will suffice and where legislation is required,
and it should be a vigorous proponent of such legislation.
These reforms are hardly a panacea that will bring the
fund industry into compliance with the spirit of the 1940 Act.
But “a journey of a thousand miles begins with a single step.”
Thank you for hearing me out.
1. All figures
are approximate. back
2. “Stale Prices
and Strategies for Trading Mutual Funds,” July/August 2002,
by Jacob Boudoukh, Matthew Richardson, Marti Subrahmanyam, and
Robert F. Whitelaw. back
Note: The opinions expressed
in this speech do not necessarily represent the views of Vanguard’s