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Whose Capital is It? Putting Owners Back in Control By John Bogle John Bogle founded the Vanguard Group in 1974 and is currently the President of the Bogle Financial Markets Research Center in Malvern, Pennsylvania. The Vanguard Group is one of the two largest mutual fund organizations in the world, comprising more than 100 mutual funds with current assets totaling about $950 billion. He was named by Time magazine in 2004 as one of the world’s 100 most powerful and influential people. In 1999, Fortune magazine designated him as one of the investment industry’s four giants of the 20th century and he is also a recipient of the Woodrow Wilson Award from Princeton University for Distinguished Achievement in the Nation’s Service.
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have been asked by NABE’s’ Financial Roundtable to talk about my new book, The Battle for the Soul of Capitalism, published last October by Yale University Press. It is a curious fact that it echoes in so many ways the principles I set forth in my senior thesis for my bachelor’s degree in economics at Princeton University. That thesis—and all that followed—depended on an incredible stroke of luck. A little over 56 years ago, I just happened to stroll into Firestone Library at Princeton, opened the December 1949 issue of Fortune magazine, and learned of the existence of something called “the mutual fund industry.” It was all there on page 116. When I saw the
industry described in the article as “tiny but contentious” (total industry assets were around $2 billion then), I knew immediately I found the topic for my senior thesis. I completed it in the spring of 1951 and entitled it, “The Economic Role of the Investment Company.” Curiously enough, a mere 50 years later that thesis was actually published in my third book, John Bogle on Investing: the First 50 Years—which proves, I think, that if you wait long enough, just about anything can get published. Considering I was only a year out of my teens, the thesis was probably not that bad; but I think if you were generous you would probably say it was workmanlike, perhaps even a bit callow. Moreover, if you read that thesis today, you would say it is shamelessly idealistic: on page after page the youthful enthusiasm of a college senior speaks out—actually yells out. In that thesis, I called again and again for the primacy of the mutual fund shareholder over the mutual fund manager: “The prime responsibility of fund managers must always be to their shareholders.” And the deal must be fair: “There is some indication that costs are too high” and that “future industry growth can be maximized by concentration on a reduction of sales charges and management fees.” Interestingly enough, after superficially analyzing fund performance, I concluded that “funds can make no claim to superiority over the market averages” —maybe, just maybe, an early harbinger of my decision to create, 25 years later, the world’s first index mutual fund. In the thesis conclusion, like the rest of it, I powerful-
ly reaffirm the conviction I hold to this day that the role of the mutual fund is “to serve the needs of both individual and institutional investors... to serve them in the most efficient, honest, and economical way possible. The principal function of investment companies is the management of their investment portfolios. Everything else is incidental.” All of this obviously gratuitous advice from a callow young college senior was, of course, totally ignored by the mutual fund industry; but the creation of Vanguard as a truly mutual mutual fund group, operated on an “at-cost” basis for the benefit of its owners rather than its managers, was my attempt to walk the walk that I had talked about all those years earlier. Today, my youthful idealism remains intact. Indeed, all these years later, the ideas in that thesis are shamelessly reflected not only in Vanguard but in The Battle for the Soul of Capitalism, which is an expression of my deep concern about American society today, an affirmation that our system of capital formation is essential to our economic growth and world leadership, and my acknowledgment that much has gone wrong in that system. There is a lot to be fixed. As I say in the book, “the business and ethical standards of corporate America, of investment America, and of mutual fund America (the three principal elements of the book) have been gravely compromised.” In each of those three arenas, I discuss what went wrong, why it went wrong, and how to go about fixing it. There is a very tough message in that book, bluntly delivered. I’m honest about
This paper is based on a NABE Financial Roundtable teleconference presentation delivered on January 24, 2006.
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that: the epigraph of my book contains this warning from St. Paul: “If the sound of the trumpet shall be uncertain, who shall prepare himself to the battle?” This is the battle for the soul of our capitalistic system. I hope that this book is the sound of the certain trumpet. The problem is that today’s capitalism has departed, not just in degree but in kind, from its proud traditional roots. Our free enterprise system— based on open markets and private ownership, on trusting and being trusted—has served us remarkably well, if imperfectly, for 200 years. Late in the 20th century, however, something went wrong. It was described by journalist William Pfaff (Praff, 2002, p. 8) as a “pathological mutation in capitalism.” The classic system—owners’ capitalism—had been based on a dedication to serving owners of the corporation and maximizing their return. But a new system developed—managers’ capitalism— in which, Mr. Pfaff wrote, “the corporation came to be run to profit its managers, in complicity if not conspiracy with accountants and with the managers of other corporations.” Why did it happen? “Because the markets had so diffused ownership that no responsible owner exists.” “This (managers’ capitalism) is morally unacceptable,” Mr. Pfaff writes, “but also a corruption of capitalism itself.” And so it is. What we have, of course, is a classic “agency problem.” Once we were an “ownership society,” where the direct owners held voting control over corporate America. Now, we have become an “agency society,” in which agents, who are primarily mutual fund managers and pension fund managers, control some 40 percent of all the common stock in America. The problem is that they have failed to represent their principals—pension beneficiaries and owners of mutual fund
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shares—properly. Therefore, a far too small portion of those returns have been delivered to the last-line investors—the bottom of the food chain if you will—who invested their capital and assumed all the risks. Let’s consider nine examples— three each from corporate America, investment America, and mutual fund America—that demonstrate the negative consequences of this change from owners’ capitalism to managers’ capitalism. What Went Wrong in Corporate America? In corporate America, obviously we begin with a staggering increase in managers’ compensation. CEO pay has risen from 42 times the compensation of the average worker in 1980 to 340 times currently. Long ago, Herbert Hoover, one of the few businessmen who ever served as President, put it very well: “The only trouble with capitalism is capitalists. They’re too darn greedy.” Imagine what he would say today. Peter Drucker, writing in 1974, thought that CEO compensation—then about 20 times the compensation of the average worker—might settle at ten times compensation of the average worker. Imagine what Peter Drucker would think about the situation today. After CEO compensation, and management compensation generally, a second consequence of the emergence of managers’ capitalism in corporate America is the rise of the financial engineering of corporate financial and earnings statements. It is common knowledge that corporate earnings are managed to meet the guidance that executives give to Wall Street quarter by quarter. One of the primary mechanisms of these earnings shenanigans is mergers that are made, as they often are, not with a sound business rationale but because of the consequent opportunity to
manage pro forma earnings by creating a veritable cookie jar, as Arthur Levitt called it, of reserves which are drawn in order to present a rosy but false picture of corporate growth. An even worse, but also commonplace, tactic was arbitrarily raising the assumptions for future returns on corporate pension plans, even as those prospective returns eroded. In 1981, when the long-term Treasury bond, believe it or not, yielded 13.9 percent, corporations projected their pension funds would earn seven percent per year—half the yield of the bond market. Currently, bond yields are at 4.7 percent, 65 percent lower than that; yet the average projected return on pension plans is 8.5 percent or 20 percent higher. What’s the likelihood that they’ll earn that projected 8.5 percent? Well, Morgan Stanley asked a group of CEOs what they expected the future return of the stock market to be, and the consensus was 6.4 percent. A 6.4 percent stock return, plus today’s bond yield of 4.7 percent (the correlation between current yields and future returns in the bond market is about 92 percent), produces an expected return on a 60 /40 (stock/bond) portfolio of 5.7 percent. After deducting pension fund costs of one percent, we can reasonably estimate the future return of corporate pension plan assets at 4.7 percent, versus the 8.5 percent they’re projecting. You can clearly see that the seeds of scandal exist. The inadequacy of pension assets to meet their payout liabilities to retirees will be our nation’s next financial scandal. A third consequence of the shift from owners’ capitalism to managers’ capitalism in corporate America is the terrible failure of gatekeepers to fulfill their responsibility. Auditors relaxed their traditional professional standards as they provided highly profitable consulting services to management—becoming partners, maybe
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even co-conspirators. That is not the way auditing is intended to work. Other traditional gatekeepers, our regulators and legislators, have much to answer for as well. In 1993 the Senate ignored the public interest and forced the SEC to back down on requiring options to be considered, of all things, a compensation expense and a deduction against earnings. And corporate directors should take some responsibility. They have failed to provide the adult supervision of those who manage companies. John Biggs, former CEO of TIAA-CREF, put it more harshly in a quotation I recall from a few years ago, “When we have strong managers, weak directors, and passive owners, don’t be surprised when the looting begins.” Of course, that is what we have seen in Enron, WorldCom, and in many ways in many other companies. What Went Wrong in Investment America? Turning to investment America, the vanishing ownership society has been almost unobserved but constitutes one of its fundamental problems. Direct holdings of stocks by individual investors have plummeted from 92 percent of all stocks in 1950 to only 32 percent today. Now, corporate control is in the hands of a relative handful of giant financial institutions— largely mutual funds and pension funds—whose ownership of corporate America has soared from eight percent to 68 percent over the past century, a virtual revolution in ownership. These agents are beset by conflicts of interest, and they fail to place front and center the interests of their principals—the owners of those mutual funds and the beneficiaries of those pensions. These agent/investors, on the other hand, passively ignore the need for good governance and allow corporate managers to look primarily to their own interests.
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Combined with this agency problem, we have the rise of short-termism—the second of the critical problems facing investment America. Institutional money management used to be an own-a-stock industry. During my first 15 years in this industry, the average annual turnover of mutual funds was 16 percent—a six year holding period. Now, institutional money management has become a rent-a-stock industry, with annual portfolio turnover of almost 100 percent, holding a typical stock for one year or even less. It must be obvious that as investors, owners must care—and care deeply—about the rights and responsibilities of corporate governance and exercise those rights and responsibilities. But, speculators, renters who merely trade stocks, could hardly care less about something like corporate governance, despite its profound importance in the long run. And why on earth should they care, when it’s unlikely they’ll even own the stock when the next annual meeting rolls around? The problem, as I put it in the book, is simple: “If the owners of corporate America don’t give a damn about the triumph of managers’ capitalism, who on earth should?” Of course, there are a few exceptions to this troubling trend. For example, TIAA-CREF is very active on governance issues, but they are far more the exception in today’s version of investment America than the rule. Third, in investment America we have the triumph of illusion over reality. Professional security analysts have come to focus far more heavily on illusion—the momentary precision of the price of the stock—and have increasingly ignored the reality of the inevitably vague, but eternally transcendent, intrinsic value of the corporation. Benjamin Graham said that “in the short run, the stock market is a voting machine; in the long
run, the stock market is a weighing machine.” In investment America, alas, we have far more voters than weighers. Sadly, too many security analysts measure up to Oscar Wilde’s wonderful definition of a cynic—one who “knows the price of everything, but the value of nothing.” When there is this gap between perception and reality, it is only a matter of time until the gap gets reconciled. It should come as no surprise that that reconciliation is always resolved in favor of reality. What Went Wrong in Mutual Fund America? One of my favorite subjects, of course, is mutual fund America. When I came into this business all those years ago, it was a profession with elements of business. Now it is just the opposite—a business with elements of a profession. We used to focus largely on stewardship. Now we have a new star—salesmanship. The predominant focus today is on marketing. The job of the manager is to increase fee revenues by building up assets under management—often by creating, promoting, and advertising speculative funds that meet the fads and fashions of the day. As I will illustrate, our fund investors have paid a terrible price for this shift. Second, much ignored, this industry has been taken over by conglomerates. When I came into this field, 100 percent of mutual fund management companies were privately-held, relatively small, firms that were managed by investment professionals. What is it like today? It has undergone its own pathological mutation. Forty-one of the 50 largest fund management companies today are publicly-held, including 35 that are owned by giant U.S. and global financial conglomerates, managed by businessmen without any financial training rather than by investment profes-
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sionals. These conglomerates and these businessmen are in the fund business to earn a return on their capital, not to earn a return on your capital as a fund investor. You cannot do justice to both: the record is very clear that the more the managers take, the less the investors make. In the fund industry, you don’t get what you pay for, you get precisely what you don’t pay for: gross return in the markets, minus cost, equals the net return actually delivered to shareholders. Third—the last of my nine little cameos—fund returns fall way short of market returns by almost the exact amount of all those fees, operating expenses, marketing charges, and hidden portfolio transaction costs the funds incur—something like 2.5 percent to 3 percent of costs per year. How could it be otherwise? Gross return minus cost equals net. Look at the past two decades. The annual return of the average equity mutual fund was ten percent, compared to 13 percent for the S&P 500, a three percentage point gap—almost entirely attributable to those pesky fund costs. To make matters worse, largely because of poor timing and poor fund selection, the return actually earned by the average fund investor lagged the average fund’s return by another three percentage points. So, instead of earning the market’s return of 13 percent per year, the average investor earned only seven percent a year, roughly 50 percent of the market’s annual return. An annual return of seven percent in a 13 percent market is a shocking gap, but it gets worse. When compounded over a 20 year period, and adjusted for inflation, investing $1,000 in a simple index fund mimicking the S&P 500 at the start of this period produced a profit after inflation of $5,490. For the average fund investor, the real profit came to just $910. The average investor, then,
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captured 16 percent of the market’s compounded real profit. Warren Buffett accurately describes the problem; “the principal enemies of the equity investor are expenses and emotions.” The fund industry has failed investors on both counts. No wonder David Swensen, that integrity-laden and remarkably successful manager of the Yale Endowment Fund, characterized such a shortfall as “the colossal failure of the mutual fund industry” (Swensen, 2005). The Surprising Lack of Public Discourse You would think that the business and financial leaders would be able to, or at least want to, face up to these failures—these nine failures—and other failures in the world of capitalism. Despite their contentious nature—broadly reflecting the powerful economic interests of the oligarchs of American business and finance over the interests of our nation’s 90 or 100 million investors—it is remarkable how little public discourse there has been on these issues. I have seen no defense whatsoever by the mutual fund industry of the inadequate returns delivered to investors. I have seen no defense of this industry’s truly bizarre and counterproductive ownership structure. I have never seen an attempt by institutions to explain why the rights of ownership that are implicit in holding shares of stock remain largely unexercised. There has been no serious criticism of the virtually unrecognized turn away from the once-conventional, pervasive strategies that relied on the wisdom of longterm investing toward strategies that rely on the folly of short-term speculation. Moreover, despite my urging for a full decade, no economic study of the mutual fund industry has been undertaken by the SEC. Surely, somebody must care about the economic structure of this $9 trillion business.
Until recent months, furthermore, there has been almost no discussion of the profound problems that are facing our system of our retirement plan funding. The Road Ahead I hope my book will open the door to corporate and financial leaders for some introspection. It does not seem like very much to ask, and it is long overdue. I hope my book will inspire an economic analysis of our financial system by academics and regulators. If we can get that, perhaps the changes that have been so badly needed will be hastened. We must return to the original values of capitalism that I talked about earlier—that virtuous circle of integrity, “trusting and being trusted.” The fact is that when ethical values go out the window and service to those whom we are duty-bound to serve is superseded by service to ourselves, the whole idea of capitalism as a moving force in the creation of our society’s abundance gets soured. Investors do not get their fair share of whatever returns our financial markets are generous enough to provide. My hope is that in the era that lies ahead, the paradigm will become the trusted businessman, the prudent fiduciary, the honest steward in American business and finance. This will be not be an easy task, but I think if we all work long enough and hard enough we can build out of that longgone ownership society and today’s failed agency society what I would describe as a new fiduciary society, one in which our citizen-investors receive the fair shake they deserve from our corporations, our investment system, and our mutual fund industry. The idea of values being intimately embedded in the practice of business is an important part of that idealistic message I made in my thesis 55 years ago. But I’m not alone in
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that idea of values. Consider Adam Smith’s The Theory of Moral Sentiments (1759, Part III, Chapter III), written long before he wrote The Wealth of Nations. He has a great quotation, calling for “reason, principle, conscience, the inhabitant of the breast,...the great judge and arbitrator of our conduct, who shows us the real littleness of ourselves,...the propriety of generosity, of reining in the greatest interests of our own for yet the greater interest of our others,... love of what is honourable and noble, of the grandeur, and dignity, and superiority of our own characters.” This is life-long stuff, but I believe it profoundly. I can only add that today we need a lot more of that grandeur and dignity. What Must Be Done I have scores of recommendations to get us closer to where we want to be. None of them are easy. Here, I will focus on my most sweeping recommendation, a call for a formation of a federal commission to recommend policies that respond to the failure of our agency society and take steps necessary to eliminate the frightening shortfall in the U.S. retirement system. This shortfall is not only in the defined-benefit private pension system, which is estimated to be $1.2 trillion under water in terms of present assets versus the future reserves that will be required. It is also the vast under-funding of investors themselves—the inadequate accumulations in their 401(k) thrift plans and IRAs and the implications of those shortfalls for our national savings. These two problems are directly related and can be best solved by the creation of a fiduciary society, established by a federal standard of fiduciary duty in which intermediaries truly represent the interests of the fund shareholders and the interests of the pension beneficiaries that they serve.
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I like the federal approach as a means of getting to an investor-oriented, not manager-oriented, fiduciary business. But even if that recommendation doesn’t come to pass (and it won’t come to pass for a long time), there is something that can be done, and it goes back to Adam Smith’s legendary invisible hand. There is no law that consigns us to be victims of today’s financial system; and America’s investors, by acting in their own self-interest, can gradually bring these changes about. If those of us who are investors simply have the wisdom to understand how our financial system works and to move our money where our common sense dictates, the current flawed system of financial intermediation will fail. We owe it to ourselves to look after our own economic interests. One way or another, via government fiat or via the invisible hand, the soul of capitalism—traditional owners’ capitalism—will be reclaimed. Since the first three rules of investing are diversify, diversify, diversify, those of us who rely on the productive wisdom of long-term investing, rather than having been lured into the counterproductive folly of short-term speculation, have been led to low-cost stock index funds. The goal is to find a broadly diversified, low cost way to participate in the growth of the American economy, with no sales charges and maximum tax efficiency. It’s really very simple. These principles have proven themselves since the beginning of time. I know that owning an index fund is about as fascinating as watching grass grow. But it seems a far wiser option than plunging headlong into a game rife with overpowering odds against success. Now as I mentioned earlier, I started the first index fund three decades ago—and it is now the largest fund in the world. Thus, it
would be reasonable to discount what I say about index funds. But don’t ignore Warren Buffett, who endorsed indexing decades ago, or Yale’s David Swensen (2005), who advises investors to “invest in low-turnover, passively managed index funds... and stay away from profit-driven investment management organizations.” Don’t ignore equally talented, Jack Meyer, former manager of Harvard’s endowment, who said, “The investment business is a giant scam. Most people should simply have index funds to keep their fees low and their tax down. No doubt about it.” (Quoted in Symonds, 2004.) If you don’t believe any of them, ask any Nobel laureate in Economics, beginning with the legendary Paul Samuelson, who recently likened the creation of that first index fund “as equal to the invention of the alphabet and the wheel.” Or, if you don’t like the financial world, then ask your college finance professors. They are probably doing the same thing: investing in index funds. In conclusion, while it is not going to be easy to return to a fiduciary society, the agency society is on the way out—whether forced to do so by law or regulation or by wisdom finally acquired by crowds of investors who are simply making intelligent investment decisions to further their own economic interests. That is my idealism, and it is still unshaken. Editor’s note: After his presentation, Mr. Bogle answered questions. The following question and its response were related directly to his presentation. What is preventing the shakeout of actively managed funds? First, the financial services business has historically been a system of supply push rather than demand pull. For example, the life insurance busi-
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ness has not grown by making life insurance cheaper and cheaper but by paying the salesmen more and more. Last year, I heard a lecture at the Investment Company Institute called “How to Succeed in a Multi-Channel, Multi-Product World.” It was a wonderful, horrifying presentation, in which the speaker went through all the different kinds of products and channels that mutual funds use. After an hour and a half he said, “If you get my point, the way to succeed in a multichannel, multi-product world is to pay the salesmen more money.” So there’s an economic incentive to keep the system going the way it is, and it is a powerful incentive. Speaking of agency problems, we can also talk about information asymmetry. Think about this: the salesman is always able to offer to customers a great “product,” a term I banned at Vanguard all those years ago because I don’t think mutual funds should be considered as “products.” With 4000 equity funds, there is always some fund, somewhere, that did wonderfully well. It might have been a technology fund back in the dotcom era, or a telecommunications fund, or—nowadays—it might be an energy fund or a value fund. There is always a story that, if you look at the short term or recent history, people will buy. Part of the problem is people have far too short a perspective, and the other part of it is, I think, a little bit about what Princeton Nobel laureate Danny Kahneman is writing about in behavioral economics: people all think they are above average investors and smarter than the rest of the market. However, whether we’re in Lake Wobegon or not, we have to come down to the overriding reality that, on average, we are, and must be, average as a group—and therefore below average after the deduction of the costs of investing. What’s more, there’s a lot of opti-
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mism in the system. There are many false numbers in the system. Some fund records—particularly during the dotcom era—and even earlier were just completely phony. Funds were loaded up with IPOs that they flipped over and over again, which artificially inflated the returns of what were, in many instances, tiny funds that weren’t even open to the public. The managers would then open these funds, promote the double-digit returns that they had “earned,” and the money would pour in. A few funds got caught doing this and paid a modest penalty, but it was far more prevalent than just those few. So the problem is basically the interest of the selling system over the interest of the investor. Just think about this for a minute: the whole Wall Street system depends on the principle “Don’t just stand there. Do something.” We trade over three billion shares of stock a day with one another, and if the system doesn’t trade, it comes to a complete halt. Yet it becomes clear, over and over again, that if we do nothing we capture the market’s entire return, simply because there are no costs to be deducted. So while the selling system depends on “Don’t just stand there. Do something,” the interests of the investor are favored by a diametrically opposed principle: “Don’t do something. Just stand there.” I can tell you from our own experience observing others that at Vanguard we would never advertise performance. But no advertising brings in money like performance advertising. So firms advertise their best performing funds, and when their returns slump (which they inevitably do), they advertise another best performing fund, a completely different one. There is much too much marketing in the fund business. ■
REFERENCES Pfaff, William. 2002. “A Pathological Mutation in Capitalism.” International Herald Tribune. September 9. Swensen, David. 2005. Unconventional Success. Free Press, Smith, Adam. 1759. The Theory of Moral Sentiments. Cambridge University Press. Also, http:/www.adamsmith.org/smith/tms/tmsindex.htm. Symonds, William C. 2004. “Online Extra: Husbanding that $27 Billion.” BusinessWeek. December 27, Available at: http://www.businessweek.com/@@kSYT7IYQ3 RdgsQYA/magazine/content/04_52/b391447 4.htm.
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