Remarks by John C.
Founder and Former Chairman, The Vanguard Group
Financial Analysts Journal;
CFA Institute's "Bold Thinking on Investment Management: The FAJ 60th Anniversary Anthology,"; 2005
During the glorious financial excesses of the recent era, we in
the investment community basked in the sunlight of prosperity
that is almost unimaginable. But in this environment, our
community developed a vested interest in ignoring the obvious
realities of financial market returns. It's been said—I think
by my detractors—that all I have going for me is "an uncanny
ability to recognize the obvious." But as we look ahead to a
far less forgiving investment environment, we all must face
This problem is not new. Two and a half millennia ago,
Demosthenes warned, "What each man wishes, he also
believes to be true." More recently, and certainly more pungently,
Upton Sinclair marveled, "It's amazing how difficult it
is for a man to understand something if he's paid a small
fortune not to understand it."
But we all must understand the realities of our investment
system, for they are central to the operation of the system of
financial intermediation that underlies the collective wealth of
our citizenry and the accumulation of assets in our retirement
systems. While the Bush administration defines our system as
the "ownership society," I call it the "investment society." But
whatever words we use, the future of capitalism depends
importantly on our understanding the realities of our system.
The Cost Matters Hypothesis
The overarching reality is simple: Gross returns in the financial
markets minus the costs of financial intermediation equal the net
returns actually delivered to investors. Although truly staggering
amounts of investment literature have been devoted to the
widely understood EMH (the efficient market hypothesis),
precious little has been devoted to what I call the CMH (the cost matters hypothesis). To explain
the dire odds that investors face in their quest to beat the market, however, we don't need the
EMH; we need only the CMH. No matter how efficient or inefficient markets may be, the returns
earned by investors as a group must fall short of the market returns by precisely the amount of
the aggregate costs they incur. It is the central fact of investing.
Nonetheless, the pages of our financial journals are filled with statistical studies of rates of
market returns that are neither achievable nor achieved. How can we talk about "creating positive
alpha" without realizing that after intermediation costs are deducted, the system as a whole has
negative alpha? Of what use is speculation about the amount of the equity risk premium when
100 percent of the return on the 10-year U.S. Treasury note (or T-bill, if that's what you prefer) is
there for the taking while as much as 50 percent or more of the real return on stocks can be
consumed by the costs of our financial system?* How can we ignore the fact that, unlike those
children in Garrison Keillor's fictional Lake Wobegon, we investors are, as a group, average before
costs but below average after our costs are deducted?
The idea that investors as a group must be average goes back more than a century, expressed
by Louis Bachelier in his PhD thesis at the Sorbonne in 1900: "Past, present, and even discounted
future events are [all] reflected in market price." That's essentially what the EMH says. Nearly half
a century later, when Nobel Laureate Paul Samuelson discovered Bachelier's long-forgotten thesis,
he confessed that he oscillated between regarding it as trivially obvious and regarding it as
remarkably sweeping. Of course, Bachelier was right. However, when he went on to conclude that
"the mathematical expectation of the speculator is zero," Bachelier was wrong. He didn't go far
enough. For the fact is that the mathematical expectation of the speculator and the long-term
investor alike is not zero. It is zero minus the cost of playing the game, a shortfall to the stock
market's return that is precisely equal to the sum total of all those advisory fees, marketing
expenditures, sales loads, brokerage commissions, legal and transaction costs, custody fees, and
security-processing expenses. And that is the essential message of the CMH.
Relentless Rules That Are Eternal
With that background, let me now turn to the quotation that inspired the title of this essay. In Other
People's Money (1914), Louis D. Brandeis, who later became one of the most influential jurists on
the U.S. Supreme Court, railed against the oligarchs who a century ago controlled both investment
America and corporate America. He described their self-serving financial management and
interlocking interests as "trampling with impunity on laws human and divine, obsessed with the
delusion that two plus two make five." He predicted (accurately, as it turned out) that the
widespread speculation of that era would collapse—"a victim of the relentless rules of humble
arithmetic." He then added this unattributed warning (perhaps from Sophocles): "Remember, O
Stranger, arithmetic is the first of the sciences, and the mother of safety."
As it is said, the more things change, the more they remain the same. The history of the era
that Brandeis described may not be repeating itself exactly today, but (paraphrasing Mark Twain)
it rhymes. America's investment system—our government retirement programs, private retirement
programs, and indeed all of the securities owned by stockowners as a group—is plagued by
the relentless rules of humble arithmetic. Because the returns investors receive come only after the
deduction of the costs of our system of financial intermediation—as a gambler's winnings come
only from what remains after the croupier's rake descends—those relentless rules devastate the
long-term returns of investors. Applying Brandeis's formulation to these contemporary issues, we
seem obsessed with the delusion that a 7 percent market return, minus 2.5 percentage points for
costs, still equals a 7 percent investor return.
No one knows the precise amount of the intermediation costs of our financial system.1
However, we do have data for some of the major cost centers. During 2004, revenues of investment
bankers and brokers came to an estimated $220 billion; direct mutual fund costs came to about $70
billion; pension management fees, $15 billion; annuity commissions, some $15 billion; hedge fund
fees, about $25 billion; fees paid to personal financial advisors, maybe another $5 billion. These
financial intermediation costs alone—even without including the investment services provided
by banks and insurance companies—came to approximately $350 billion, directly deducted from
the returns that the financial markets generated for investors.
Moreover, the price of intermediation has soared. In 1985, the annual revenues of these cost
centers were in the $50 billion range. In the bubble and postbubble era (since 1996) alone, the
aggregate costs of financial intermediation may well have exceeded $2.5 trillion, all dutifully paid
by our stockowners and stock traders. Of course, some of these costs create value (for example,
liquidity). But, by definition, those costs cannot create above-market returns. To the contrary, they
are the direct cause of below-market returns, a dead weight on the amount earned by investors as
a group. In investing, all investors together get precisely what they don't pay for. So, it is up to all
of us in the financial community to develop a more efficient way to provide investment services
to our clients.
The Mutual Fund Industry
The largest of all U.S. financial intermediaries is the mutual fund industry. In my article (Bogle
2005) about the fund industry, in which I've now spent 56 years, I examined the changes that have
taken place during this long period and asked whether these changes are for better or for worse.
I regret to report that the answer to the question is "for worse."
Consider this summary:**
• We have created a mind-boggling number of new and often speculative funds that demand
unnecessarily complex choices by investors.
• We've moved from investment committees focused on the wisdom of long-term investing to
portfolio manager "stars" engaged in the folly of short-term speculation.
• We've enjoyed an enormous growth in our ownership position in corporate America along
with a paradoxical and discouraging diminution of our willingness to exercise that ownership
position responsibly, if at all.
• We've imposed soaring costs on our investors that belie the enormous economies of scale in
• Our reputation for integrity, sadly, has been tarred by the brush of a broad-ranging series of
• Among the larger management companies that dominate the field, we've moved away from
private ownership in favor of public ownership, and then to ownership by financial conglomerates.
• We've changed from a profession with aspects of a business to a business with aspects of a
The evidence clearly supports the conclusion that the mutual fund industry has moved from
stewardship to salesmanship. To this dispiriting analysis of the past, I would add a warning about
the future: Unless we return to our traditional role as trustees of other people's money, the mutual
fund industry will falter and finally fail—a victim of, yes, the relentless rules of humble arithmetic.
I love this industry too much to remain silent and let that happen without putting up a fight.
The record of the past two decades indicates that the humble arithmetic I have
described—Gross Return minus Cost equals Net Return—has proven dangerous to the wealth of
the families who have entrusted their hard-earned wealth to mutual funds. In fact, it has destroyed
their wealth in almost precisely the measure that the CMH suggests. Investors have learned, and
learned the hard way, that in mutual funds, it's not that "you get what you pay for" but that "you
get what you don't pay for."
Table 1 shows that over the past 20 years, a simple low-cost, no-load stock market index fund
that replicated the Standard & Poor's 500 Index delivered an annual return of 12.8 percent—just
a hair short of the 13.0 percent return of the market itself. During the same period, the average
equity mutual fund delivered a return of 10.0 percent, a shortfall to the index fund of 2.8 percentage
points a year and less than 80 percent of the market's annual return. Compounded over that period,
each $1 invested in the index fund grew by $10.12—the beneficiary of the magic of compounding
returns—whereas each $1 in the average fund grew by just $5.73, a shriveled-up 57 percent of the
index fund's cumulative return—the victim of the tyranny of compounding costs.
These data are before taxes. When after-tax data are used, the annual gap between the equity
fund and the index fund soars far higher, rising from 2.8 percentage points to 4.1 percentage points
a year. The average fund deferred almost no gains during this period; the index fund deferred
nearly all. (Deferred taxes may be the ultimate example of how you get what you don't pay for.)
Cumulatively, the average equity fund produced, not 57 percent of the market's after-tax return,
but only 41 percent.
In fairness, however, the wealth accumulated in the index fund and the average equity fund
should be measured not only in nominal dollars but also in real dollars. As Table 1 shows, the real
annual return for the index fund drops to 8.9 percent and for the equity fund, to 4.8 percent,
obviously the same gap of 4.1 percentage points. But when we reduce both returns by the identical
3.0 percentage points a year for inflation, it will hardly surprise those who know their humble
arithmetic that the compounding of those lower annual returns further widens the cumulative
gap. Over the past 20 years, the cumulative profit on each $1 initially invested in the equity fund
after costs, taxes, and inflation comes to just $1.55 in real terms—only 34 percent of the index fund
real profit of $4.50.
A casual look at the stock market over the past two decades, then, reflects a 13 percent annual
return that produced a profit of $10.52 on each dollar initially invested. But the underlying reality
reflects an outcome almost light years away. After investment costs and taxes are deducted each
year in nominal dollars, and after the erosion of inflation, the annual return for the average equity
fund tumbles to 4.8 percent, with an accumulated real profit of just $1.55, only one-seventh the
amount of the apparent profit on the market portfolio.
Fund Returns vs. Investor Returns
To make matters worse, the stark reality is that the
return of the average equity fund greatly overstates the return earned by the average equity fund
investor. When we consider what fund investors actually earn, as shown in Table 2, the shortfall
to the market return worsens dramatically.
As this industry came to focus more and more on marketing and less and less on management,
we deluged investors with a plethora of enticing new funds, at ever-rising costs. Our marketing
experts responded with alacrity to the waxing and waning of market fads and fashions, most
obviously with the "new economy" funds of the late market bubble. Aided and abetted by the
fund industry, investors not only poured hundreds of billions of dollars into equity funds as the
stock market soared to its high but also characteristically selected the wrong funds. In addition to
the wealth-depleting penalty of fund costs, then, fund investors paid one substantial penalty for
the counterproductive timing of their investments and another large penalty for the unfortunate
selection of the mutual funds they chose to own.
Intuition suggests that these costs were large, and the data we have, although not precise,
confirm that hypothesis. The asset-weighted returns of mutual funds—which are easy to estimate
by examining each fund's quarterly cash flows—lag the standard time-weighted returns by fully
3.7 percentage points a year. Adding that shortfall to the 2.8 percentage point annual lag of timeweighted
returns of the average equity fund relative to the S&P 500 Index fund over the past two
decades, we see that the asset-weighted returns of the average equity fund stockholder fell behind
the index fund by a total of 6.5 percentage points a year. Average annual pretax nominal returns
for the period: index fund, 12.8 percent; equity fund investor, 6.3 percent—less than one-half of
the stock market's annual return.
Applying the tyranny of compounding not only to the actual costs of fund operations but also
to the even larger costs of, well, fund ownership, we find that each $1 invested at the outset by the
average fund investor, before taxes and inflation, grew by only $2.39 over the full period, compared
with the growth of $10.12 that came from simply owning the low-cost index fund. That is, investors
received only 24 percent of the wealth that might easily have been accumulated simply by holding
a low-cost, unmanaged stock market portfolio.
Much of this extra lag came from the specialized (usually speculative) funds that the industry
created and promoted. For example, as Table 3 shows, during the bull and bear markets we
experienced in 1998–2003, the asset-weighted returns of the industry's six largest broadly diversified
funds lagged their time-weighted annual returns by an average of less than a single
percentage point. The asset-weighted returns of the six largest specialized funds, in contrast,
lagged their time-weighted returns by an average of more than 11 percentage points.
Compounded during the six-year period that included the bubble and its aftermath, the gap in
returns was astonishing. The specialized funds produced a positive time-weighted annual return of
6.6 percent but lost a cumulative 25 percent of client wealth. Despite a slightly lower time-weighted
annual return of 5.4 percent in the broadly diversified large funds, client wealth was enhanced by
30 percent during the period—an additional 55 percentage points in wealth accumulation.
The "Marketingization" of the Fund Industry
The stark arithmetic that illustrates the huge
sacrifices of wealth incurred by fund investors has been driven by two costly and counterproductive
trends. One is the marketingization of the mutual fund industry, in which most major firms
have come to create and market whatever funds will sell.
One reasonable proxy—obviously an imperfect one—for differentiating a marketing firm from
a management firm is the number of funds it offers. The data, which come from a Fidelity
Investments study of the 54 largest firms managing about 85 percent of the industry's long-term
assets, clearly support the proposition that fund firms that have avoided being dominated by a
marketing ethic have provided distinctly superior performance.
On the one hand, as shown in Table 4, the 9 firms that each operate fewer than 15 mutual
funds clearly dominate the upper reaches of the rankings, holding six of the seven top spots. The
firms focused on few funds outpaced almost 80 percent of all their common rivals (i.e., their largecap
growth fund versus other large-cap growth funds, their balanced fund versus other balanced
funds, etc.) during the 10-year period studied (1994–2003). On the other hand, the 45 firms with
more than 15 funds (averaging 52 funds each) focused on offering a broad line of fund "products"
to the public, outpaced only about 48 percent of their peers and hold 36 of the 37 lowest ranks.
Marketing focus, apparently, comes at the expense of management success.
"Conglomeratization" of the Fund Industry
The other trend that has ill served investor
interest is the conglomeratization of the fund industry, in which giant international financial
institutions, eager to get a piece of the action for themselves—a share of the huge profits made in
money management—have gone on a buying binge. (The trend toward conglomerated public
ownership, while little noted, has been dramatic. Until 1958, all fund management firms were
Again, a powerful pattern prevails, with funds operated by privately held management
companies holding an impressive edge in investors' returns over funds owned and operated by
financial conglomerates. Table 5 compares the relative returns of the funds managed by the 13
private companies that remain today and the funds managed by the 41 public companies—those
that are held either directly by public investors (7 firms) or indirectly by publicly owned financial
conglomerates (34 firms).
The funds managed by the 13 firms under private ownership (averaging 34 funds and totaling
$1.3 trillion in assets) outpaced 71 percent of their peers and held eight of the top nine spots.*** The
34 fund managers under the aegis of conglomerates (averaging 47 funds and totaling $1.6 trillion
in assets) outperformed only 45 percent. The other 7 publicly held firms (averaging 55 funds each
and with $0.6 trillion in assets) outperformed 60 percent. In all, public firms held 32 of the 34 bottom
spots on the list.
From these compelling data, it seems reasonable to assume that publicly held firms run by farremoved
managers who may well have never looked a fund independent director in the eye are
in the fund business primarily to gather assets, build revenues, and enhance their brand names.
Such a firm is, with some logic, likely to be far more concerned about the return on its capital than
the return on the capital entrusted to it by its mutual fund owners. (We saw something of that
syndrome in the recent scandals, in which the largest offenders were owned by conglomerates.)
Of course, the conglomerate's managers have a clear fiduciary duty to the conglomerate's
owners as well as to the owners of its funds. But the record suggests that when fund fee schedules
are considered and new fund "products" created, the conglomerate resolves these dilemmas in
favor of its own public owners, ignoring the invocation in the Investment Company Act of 1940
that funds must be organized, operated, and managed in the interests of their shareholders.
Despite the problems I have described, fund investors (at least those investors
who didn't jump on the bull market bandwagon late in the game) seem satisfied with earning
the decidedly modest positive returns achieved by their funds during the bull market of the past
two decades. They seem willing to ignore the generally hidden costs of fund investing, oblivious
to the tax inefficiency, happy to think in terms of their returns in nominal rather than real dollars,
and comfortable in assuming that the responsibility for the mistakes made in fund timing and
fund selection are theirs alone.
But suppose we are entering an era of lower returns. What are the implications of these findings
for long-term wealth accumulation? Let's measure what might be the typical experience in terms
of the investment horizon of a young investor of today. Assume the investor has just joined the
workforce and is looking forward to 45 years of employment until retirement and then to enjoying
the next 20 years in retirement that the actuaries promise—a total time horizon of 65 years.
If the stock market is kind enough to favor investors with a total return of 8 percent a year
over that period and if annual mutual fund costs are held to 2.5 percentage points, the return of
the fund investor will average 5.5 percent. By the end of the long period, a cost-free investment at
8 percent will carry an initial $1,000 investment to a final value of $148,800, a profit of $147,800.
However, as Figure 1 shows, the 5.5 percent net return will increase the investor's cumulative
wealth by only $31,500, bringing the final value of the investor's investment to $32,500. In effect,
the amount paid over to the financial system, also compounded, will come to $116,300.
In other words, the investor who put up 100 percent of the capital and assumed 100 percent
of the risk would receive only 21 percent of the return. The financial intermediaries, who put up
0 percent of the capital and assumed 0 percent of the risk, would enjoy a truly remarkable 79
percent of the return. Indeed, the cumulative return of our young capitalist saving for retirement
would fall behind the cumulative return taken by the financial croupiers after the 29th year, less
than halfway through the 65-year period. Devastating as is this diversion of the spoils of investing,
apparently few investors today have either the awareness of the relentless rules of humble
arithmetic that almost guarantee such a shortfall in their retirement savings or the wisdom to
understand the tyranny of compounding costs over the long term.
The Wealth of the Nation
If our system of retirement savings were not the backbone of the wealth of the nation and our
economic strength, perhaps this wealth-depleting arithmetic would not matter. But retirement
savings are the backbone, and the arithmetic does matter. Our corporate pension plans hold $1.8
trillion in stocks and bonds; our state and local pension plans, another $2.0 trillion. Private
noninsured pension reserves total $4.2 trillion; insured pension reserves, $1.9 trillion; government
pension reserves, $3.1 trillion; life insurance reserves, $1.0 trillion—for a total of $10.2 trillion, or
nearly one-half of total family assets (other than cash and savings deposits).
Since 1970, U.S. national policy has been to increase private savings for retirement by providing
tax-sheltered accounts, such as IRAs and defined-contribution pension, thrift, and savings programs
[usually 401(k) plans]. The present administration seems determined to extend the reach
of these tax-advantaged vehicles, together with the amount that each family may invest in them
each year. So, how do the relentless rules of arithmetic affect our investment society or, if you
prefer, our ownership society?
Certainly, the earlier data on relative returns show that the retirement savings of U.S. families
are too important to the wealth of the nation to be entrusted to the mutual fund industry. Moreover,
the system of tax incentives provided to investors clearly hasn't resulted in adequate wealth
accumulation. Only about 22 percent of our workers are using 401(k) savings plans, only about 10
percent have IRAs, and about 9 percent have both. Even after three decades of experience with
these tax-advantaged plans, the average 401(k) balance is now a modest $33,600, and the average
IRA $26,900—hardly the kind of capital with the potential to provide a comfortable retirement.
In addition, the massive shift that has taken place from defined-benefit plans to definedcontribution
plans does not seem to be working well from an investment standpoint. Not only
have DB plans produced higher returns than DC plans during the period 1990–2002 (144 percent
versus 125 percent), they have done so with far less volatility; in the recent down-market years,
DB plans fell only about half as much (–12 percent versus –22 percent). Part of the cumulative
shortfall over the 12-year period, of course, can be traced to the higher costs imposed on investors
in DC plans, dominated by mutual fund holdings.
The Humble Arithmetic of Pension Plans
Clearly, the nation's foray into DC plans is not doing the job it should in producing a solid base
for retirement savings. But our DB plans have done far worse, not because of the returns they have
earned, but because of the excessive returns they have projected. The financial statements of U.S.
corporations are rife with aggressive assumptions about future returns that have fostered substantial
underfunding of their pension plans. Even as interest rates tumbled and earnings yields
steadily declined during the past two decades, projections of future returns soared.
In 2000, for example, General Motors Corporation was projecting a 10 percent annual return
on its pension plan, compared with the 6 percent assumption it was using in 1975. Why? It based
the projection largely on "long-term historical returns." The higher the stock market rose and the
more interest rates tumbled, the higher the pension plan's expected returns rose, and not only in
the GM model. Amazingly, General Motors was essentially saying, "The more stocks have gone
up in the past, the more they'll rise in the future."
Corporate America's projections of pension fund returns are both a national scandal and an
accident waiting to happen. Consider from the standpoint of the relentless rules of humble
arithmetic what might today be reasonable in projecting future returns of pension plans. Table 6 provides the data for a conventional pension portfolio of 60 percent U.S. equities and 40 percent
U.S. bonds. The projected return of 7.5 percent for the stock portfolio is based on realistic
expectations—today's 2 percent dividend yield and historical earnings growth of about 5.5
percent—and assumes no change in the current P/E multiple of 21 times reported earnings.
The present yield on a conservative portfolio of U.S. Treasury and corporate bonds suggests
a projected bond return of about 4.5 percent, bringing the gross portfolio return to 6.3 percent.
Deducting estimated annual plan expenses (fees, turnover costs, etc.) of 1.1 percent from the gross
return, the arithmetic takes us to a net return of 5.2 percent, less than two-thirds of the 8.5 percent
total projected by the average large U.S. corporation. A company making that kind of projection
for its pension plan is either looking for trouble or trying to engineer upward the earnings it reports
to its shareholders.
General Motors currently uses that 8.5 percent assumption, which seems outlandish on the
face of it. When I pursued this issue with GM, I was told that the traditional policy portfolio of 60
percent stocks and 40 percent bonds is history; GM has added alternative investments, such as
venture capital, and "absolute return" investments, such as hedge funds. It's easy enough to
understand that change, so let's make some reasonable assumptions about what this new policy
portfolio might hold:#
• 30 percent in U.S. equities,
• 40 percent in U.S. bonds,
• 10 percent in venture capital,
• 20 percent in hedge funds.
Table 7 shows one example of the returns that would be required from each of these four asset
classes to reach that 8.5 percent target. The market returns for equities and bonds are unchanged,
so the equity managers would have to beat the stock market by 3.0 percentage points a year and
the bond managers would have to beat the bond market by 0.25 percentage point. Then, let's
generously assume that the venture capital market will return 12 percent, with smart managers
who earn almost 18 percent, and that hedge funds will earn an average 10 percent return, with
smart managers who earn 17 percent. Then, let's deduct investment costs, as we must. Voila! The
pension fund reaches its goal of 8.5 percent a year!
But now consider the possibility that these returns actually will be achieved. Equity managers
who can beat the market by 3 percentage points a year are conspicuous by their absence. (And the
quest for such outperformance presumes the assumption of considerable risk.) Consider too that
the assumed venture capital returns are far above even the historical norms that were inflated by
the speculative boom in IPOs during the market madness of the late 1990s. And consider not only
the high (10 percent) assumed average hedge fund return but the obviously staggering odds
against finding a group of so-called absolute-return managers who can consistently exceed that
return by 6–7 percentage points a year over a decade. Surely most investment professionals would
consider these Herculean assumptions absurd.
Of course, no one can really know what lies ahead. Assumptions are, after all, only assumptions.
But that is not my point. My point is that each corporation's annual report should present
to shareholders a simple table like Table 7 so that its shareowners can make a fair determination
of the reasonableness of the arithmetic on which the pension plan is relying to calculate its pension
fund return assumptions. Such a report should be placed high on the list of financial statement
disclosure priorities, and I would hope that serious analysts will take this issue directly to corporate
managers and challenge the reasonableness of any assumptions deemed excessive. Corporate
boards rarely touch this issue, but shareholders ought to force it to the fore.
The seemingly outlandish returns being assumed by corporations for their pension plans have
been a major factor in the growing negative gap between the assets and the liabilities of corporate
pension plans. The future of DB plans is fraught with challenges that can only be described as
awesome. A recent report by Morgan Stanley's respected accounting expert Trevor Harris (with
Richard Berner, 2005) put it well:
Years of mispriced pension costs, underfunding, and overly optimistic assumptions about
mortality and retirement have created economic mismatches between promises made and the
resources required to keep them. Corporate defined-benefit plans as a whole are as much as $400
billion underfunded. State and local plans, moreover, may be underfunded by three times that
amount. Those gaps will drain many plan sponsors' operating performance and threaten the
defined-benefit system itself, especially if markets fail to deliver high returns, or if interest rates
Excessive return assumptions, insufficient contributions, and the almost universal failure to
consider the profound long-term erosion of market returns engendered by investment costs have
combined to create this serious savings shortfall that pervades our nation's private pension system,
our government pension systems, our individual retirement plans, and our defined contribution
plans. Much of the responsibility for that failure can be laid to the unwillingness of the financial
community to recognize the relentless rules of humble arithmetic.##
Comparative Advantage or Community Advantage?
If we are to create greater wealth accumulation for investors, we in the investment profession must
focus on these broad issues. Yet we continue to focus nearly all of our attention on the search for
the Holy Grail of achieving superior performance for our own clients, seemingly ignoring the fact
that all market participants as a group earn average returns. Put another way, in terms of the returns
we earn for our clients, we in the investment community are, and must be, average.
Here, I want to make a point about the difference between "comparative advantage" and
"community advantage." Much—sometimes I think almost all—of what I read in the learned
journals of finance has to do with comparative advantage, such as picking winning stocks or
capitalizing on a market inefficiency that improves performance relative to the total market or
gaining an edge in return over professional rivals. Yet we ply our trade in what is essentially a
closed market system, and we can't change whatever returns the markets are generous enough to
bestow on us. So, each dollar of advantage one investor gains in the market comes only at the
direct disadvantage of other market participants as a group.
Of course, each of us believes that we ourselves are not average, that we can gain a sustained
edge over the market. But we can't all be right. A recent article in the New Yorker (Gawande 2004)
noted the great fear: "What if I turn out to be average? Yet, if the bell curve is a fact, then so is the
reality that most [investors] are going to be average." The article continued:
There's no shame in being one of them, right? Except, of course, there is. Somehow, what troubles
people isn't so much being average as settling for it. Averageness is, for most of us, our fate.
Alas, in the world of money management, the picture is even darker. For we are average only
before investment costs are deducted. After costs, we are losers to the market—that relentless rule
of humble arithmetic that we want to deny but cannot. Put another way, costs shift the entire bell
curve of variations in our individual performance to the left.
But it is a rule of life that none of us want to be average, and competition to be the best is, up
to a point at least, healthy. Our efforts to win, however fruitless in the aggregate, provide the
transaction volumes that are required for liquidity and market efficiency. Yet, paradoxically, the
closer we move to market efficiency, the closer we come to a world in which the EMH becomes
Of course, management fees and transaction costs also fatten the wallets of fund managers
and Wall Street's financial intermediaries. If the successful strategy of a given fund manager
remains undiscovered and sustained, that firm will attract more dollars under management,
diverting fees into its pockets from the pockets of its rivals. Such success may even allow the firm
to charge higher fees, thereby increasing (albeit only modestly, at least at first) its advisory fee
revenues. Yet, again paradoxically, when that happens, by definition, the net returns earned by
all investors as a group are commensurately reduced.
Realizing that the upshot of all our feverish investment activity is to advantage Peter at the
expense of Paul is doubtless vaguely painful to investment professionals. The dream that we can
all achieve success defies Immanuel Kant's categorical imperative that we must "act so that the
consequences of our actions can be generalized without self-contradiction." Yet our best and
brightest souls continue to compete—arguably, ever more vigorously—in this game of comparative
advantage that is inevitably a zero-sum game before costs and a loser's game after costs.
Warren Buffett's crusty but wise partner, Charlie Munger, shares my concern that in the field
of money management, as far as the interests of clients are concerned, there can be no net value
added, only value subtracted. Here's what he had to say about the commitment of so many
exceptional people to the field of investment management:
Most money-making activity contains profoundly antisocial effects . . . As high-cost modalities
become ever more popular . . . the activity exacerbates the current harmful trend in which ever
more of the nation's ethical young brain-power is attracted into lucrative money-management and
its attendant modern frictions, as distinguished from work providing much more value to others.###
Adam Smith's invisible hand may give a minority of money managers a competitive edge, but
it cannot improve the lot of investors as a group.
Yet we do have it within our power to do exactly that—to create a community advantage that
provides value to all investors. And that can be achieved only by slashing the costs of financial
intermediation and reducing the overcapacity present in our investment business today in the
form of, for example, the grossly excessive number of mutual funds and the staggering levels of
If capitalism is to flourish, enriching the returns of all investors as a group must be a vital goal
for our investment society. Yet the triumph of managers' capitalism over owners' capitalism in
corporate America has been paralleled by an even greater triumph of managers' capitalism over
owners' capitalism in investment America—the field of money management. So long as moneymaking
activity simply shifts returns from the pedestrian to the brilliant or from the unlucky to
the lucky or from those who naively trust the system to those who work at its margins, then of
course, it has "profoundly antisocial effects." If we vigorously work to reduce system costs, thereby
increasing investor returns while holding risk constant, wouldn't we be making capitalism work
better for all stockowners? And wouldn't that create, well, profoundly social effects that are the
diametrical opposite of the antisocial effects that so concern Munger?
Our Intermediation Society
Two powerful forces stand in the way of realizing the idealistic
goal of "beginning the world anew" in investment America. One of those forces is money. The
field of financial intermediation has become so awesomely profitable to its participants that the
vast sums of money we earn has become a narcotic. We have become addicted to enormous profits.
The second force may be even more powerful: the reliance of investors on financial intermediaries
to protect their interests. We may think we live in an ownership society—albeit one that has miles
to go before it achieves its promises—but each passing day brings fewer actual direct owners of
our wealth-generating corporations.
The fact is that we now live in an intermediation society, in which the last-line owners—
essentially, our mutual fund shareholders and the beneficiaries of our public and private pension
plans—have to rely on their trustees to act as their faithful fiduciaries. Yet largely because of the
dollar-for-dollar trade-off in the money management business (in which the more managers take,
the less investors make), there is far too little evidence of such stewardship today. But if our 100-
million-plus last-line stockowners and beneficiaries rise up, however, and demand that their
stewards provide them with, well, stewardship, then all will be well in investment America—or
at least far better for our clients than it is today.
We need to change not only the costs and the structure of our system of financial intermediation
but also the philosophy of its trustees. Way back in 1928, New York's Chief Justice Benjamin
N. Cardozo put it well:
Many forms of conduct permissible in a workaday world for those acting at arm's length are
forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals
of the marketplace . . . . As to this there has developed a tradition that is unbending and inveterate
. . . . Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of
behavior . . . . Only thus has the level of conduct for fiduciaries been kept at a level higher than that
trodden by the crowd.+
Yet somehow, in today's world of caveat emptor, of the marketplace as the ultimate arbiter of
what's right, and of "get while the getting's good," too large a portion of our financial community
seems to have lost sight of that standard.
The Next Frontier
In early 2005, as I approached the completion of my new book on today's
counterproductive form of capitalism (forthcoming 2005), I was reading the January/February
2005 issue of the Financial Analysts Journal, which included my history of how the mutual fund
industry has changed over the past 60 years. I was drawn to Keith Ambachtsheer's insightful essay
"Beyond Portfolio Theory: The Next Frontier."
His perceptive thesis questioned the conventional wisdom that the next frontier in investing
is about "engineering systems to create better financial outcomes for investors." He suggested that
we ought to be thinking more about information theory—knowledge about the costs of investing,
for example—and agency theory—the conflicting economic interests that manager/agents confront
when they make decisions on behalf of their investor/principals. He wrote of seeking "better
outcomes" for investors by virtue of a material reduction in intermediation costs and a "value for
money" philosophy in which the driving force is service to clients and beneficiaries. I can only
express my deep appreciation for his willingness, without any prior consultation with me, to stand
up and be counted on these issues that are at the core of the reflections I present here.
I have been fortunate to play a role in articulating these issues for a full half century,
culminating in the creation of The Vanguard Group as a truly mutual mutual fund complex all
those many (30-plus) years ago. "The Vanguard Experiment," as we called it in its early years, was
an effort to set the standard for a new kind of financial intermediation designed to give investors
their fair share of whatever returns our markets are kind enough to deliver. Had I not "walked
the walk" of truly mutual investing ever since, I would hardly be in a position to "talk the talk"
of this essay.
Walking the Walk
It has been a singular and wonderful walk, one that has enabled us to keep investor costs low and
investor performance commensurately high. As a result, Vanguard has arguably achieved not only
an artistic success but also a remarkable commercial success. Our share of mutual fund assets has
now risen for 23 consecutive years—going from 1.8 percent in 1981 to 11.0 percent in mid-2005, as
shown in Figure 2. It is a revelation to compare that trend with the market share of Massachusetts
Financial Services (MFS), our longtime rival of the 1950s and 1960s.
Ironically, MFS converted from its own original mutual structure to a typical public (and later
conglomerate) ownership in 1969, just before we did exactly the reverse five years later. Although
their conversion was hardly the sole cause of the sharp tumble in market share MFS experienced
(also shown in Figure 2) from 9 percent to 1 percent, it surely could not have helped. To the limited
extent exemplified in these two contrasting patterns, investors are speaking, and their voice is loud
and clear: They want their interests placed front and center.
I hope you will forgive the vested nature of this conclusion. It merely brings me full circle to
the early words in this essay about the importance of "recognizing the obvious." Surely Vanguard's
turning creed into deed is a validation of the words of famed entrepreneurial economist
Joseph A. Schumpeter, who asserted that "successful innovation is not an act of intellect, but of
will." The fund industry has yet to emulate the innovation that is Vanguard, but I guarantee you
that our pioneering outpost will not stand alone at the frontier forever. "The relentless rules of
humble arithmetic" that I've pounded home in this message and the attendant CMH and related
fiduciary concepts will, sooner or later, resonate with the investing public. That public will accept
nothing less than that we in the financial community live up to the responsibilities we are duty
bound to honor. Forewarned is forearmed.
Berner, Richard, and Trevor Harris. 2005. "Financial Market Implications of Pension Reform." Morgan Stanley Research,
Global Economic Forum (18 January): www.morganstanley.com/GEFdata/digests/20050118-tue.html.
*It's high time for someone (perhaps for CFA Institute) to conduct a careful study of the system and find out. back
**I recognize that there are fund organizations that are exceptions to these generalizations. The number, however, is surprisingly small. back
***Group averages have been adjusted for sales charges and B-class shares. back
#Possible variations on the new policy portfolio and its potential returns are myriad. back
##The rules of arithmetic apply also to Social Security and the issues surrounding privatization, but these are topics for another day. back
###Munger was speaking at a meeting of the Foundation Financial Officers Group in Santa Monica, California, 14 October 1998. back
+From the decision in Meinhard v. Salmon (1928). back
Ambachtsheer, Keith. 2005. "Beyond Portfolio Theory: The Next Frontier." Financial Analysts Journal, vol. 61, no. 1
Bogle, John C. 2005. "The Mutual Fund Industry 60 Years Later: For Better or Worse?" Financial Analysts
61, no. 1 (January/February):15–24.
———. Forthcoming 2005. The Battle for the Soul of Capitalism. New Haven, CT: Yale University Press.
Brandeis, Louis D. 1914. Other People's Money. New York: F.A. Stokes.
Gawande, Atul. 2004. "The Bell Curve." New Yorker (6 December):82–91. Available online at www.newyorker.com/