Jack Bogle, founder of Vanguard, one of the most formidable mutual fund companies and investing approaches in the United States, is always a good man to check in with on weighty industry issues. Money Management Executive Editor Lee Barney spoke with Bogle last week, on the eve of the Sept. 3 two-year anniversary of the mutual fund trading scandal.
Money Management Executive: Do you believe that the reforms resulting from the trading scandal will make any significant difference to the way mutual funds are run - and, the burning question, will the trading scandal even go down in the history books?
Jack Bogle: I'm sure that we are at a defining moment in the history of mutual fund management.
While we clearly need to put meat on the bones of the Investment Company Act of 1940, precluding the need for even more regulation, perhaps a combination of better enforcement of the existing rules and some new ones will underscore the implicit fiduciary standard of the 1940 Act.
There are a lot of positive things in development now, although I fear that progress on these reforms will be painfully slow.
MME: Do you get a sense from investors that they are aware of or even care about the fund scandals?
Bogle: I spend much time speaking to executives and investors - meeting with corporate America, mutual fund America, and investor America - and my sense is that awareness of the scandals is small, and concern is largely lacking.
And awareness of the profound conflicts of interest between fund managers and fund shareholders - from which the scandals arose - is essentially zero.
MME: What needs to be done to prevent their recurrence?
Bogle: Let me remind you of the four requirements that I expressed in my testimony before Congress when the market-timing and late-trading scandals first broke three years ago.
First, there should be no more than one management company official serving on the fund board. Indeed, having any director associated with the investment management company sit on the board, let alone chair it, is odd to begin with. But the Securities and Exchange Commission rule requiring a super-majority of mutual fund directors - 75%-to be independent, although not quite what I wanted - comes pretty close.
Second, we need the chairman of the fund board to be an independent director, unaffiliated with the manager. The new SEC rule also requires this separation, and despite the recent United States Chamber of Commerce win at the U.S. Appeals Court, I believe the SEC rule will stand, as it should.
Third, the fund board must have independent advice on fund costs, performance and other matters. Again, the basic language of the SEC rule strongly encourages mutual fund directors to have their own staff or use outside consultants to provide such independent evaluation.
And fourth, we need a federal standard of fiduciary duty for fund directors and officers, which the SEC itself cannot provide, for it would involve preemption of state law. It will take federal legislation, and the sooner the better.
More broadly, we need fiduciary standards, not only in the mutual fund industry but also in society, to have a clear understanding of whom a financial adviser, director or other executive represents, along with clear standards for delivering on that duty. The law should help to clarify that difficult issue.
There is already a reality out there: The Investment Company Act of 1940 mandates that mutual funds should be "organized, operated and managed" in the interests of fund shareholders rather than in the interests of fund managers and distributors.
Arguably, the industry has been in violation of the letter of that law - and certainly its spirit. We must put a structure in place to get it right, and to give the shareholders a fair shake.
From the industry's and the Chamber of Commerce's point of view, there is a huge economic stake here, for the industry's huge profits come importantly at the direct cost of the returns earned by fund shareholders.
MME: What other lingering problems do you believe must be rectified?
Bogle: The driving force in this industry, once led by small, private investment counsel firms, now comes from giant, publicly or conglomerately owned enterprises. Marketing has replaced management as our highest value.
When the head of Bank of America demands that financial service revenues, now 7% of its total, grow to 15% in five years, it's hardly surprising that its financial service managers pull out all the stops to get there.
Among the investment managers in our industry, similar mandates were already a pervasive refrain. The trading scandals clearly reflect this pressure for asset growth and increased fee revenues, even at the expense of existing shareholders.
The scandals, then, are precisely what we should have expected when managers make unreasonable business and financial demands.
Fiduciary duty is the victim.
When I was head of Wellington Management Company, I gave a speech in 1971 on this very danger - the antithetical nature of public ownership and fiduciary duty. The danger continues as noxiously, if not more so, today.
That's largely why today we have all of these problems of conflicts of interest to repair. We have moved from a profession with elements of business into a business with elements of a profession.
We have the scandalmongers to thank for bringing this conflict to light. And our shareholders have paid the price. So, the rules, sanctions and criminal and civil cases so far are merely nipping around the bud.
MME: Where do the regulators fit in?
Bogle: Federal and state regulators keep opening up shocking new aspects to the fund scandal. The "pay-to-play" scandals came to light - brokers were selling the wrong (higher cost) class of shares.
Then, directed brokerage and even cash payments to brokers in return for favored treatment in offering funds.
In every one of these cases, the managers simply put their own interests ahead of the interests of the shareholders whom they were duty-bound to serve.
Were it not for Eliot Spitzer, none of this would have come to light. The investing public owes him a debt of gratitude.
While I am a great admirer of the SEC staff, they have listened a little too uncritically to industry leaders and the Investment Company Institute. There hasn't been enough introspection and skepticism at the SEC.
MME: Did the scandals surprise you?
Bogle: How could they? In a sense, the rapid trading of fund shares was public information. Annual reports and prospectuses contained information about market timing, and for that matter, at least hints about directed brokerage, revenue sharing, share class sales, breakpoint and other abuses. Anyone who opened a fund annual report could calculate its share redemption rate. One fund group had a redemption rate of some 400% a year - with $2 billion in assets and $8 billion in annual sales and redemptions alike, as was the case at Fred Alger Management.
Red flags should have been going up all over. But they weren't.
MME: What do you believe will be the biggest change coming out of all of this - and how will "Fundgate," as we have continued to dub this serious scandal, be remembered?
Bogle: Let me take the part on change first:
One, There will be a Federal statute on fiduciary duty
Two, Fund directors - to do their job correctly and honestly - will not stop at comparing their funds' expense ratios with those of other funds. They will start to focus not on mere basis points, but on actual dollars, and demand information on managers' costs and profitability.
It's a little like the mess regarding CEO compensation - comparing overpaid people with other people who are also overpaid. We really need to have someone take that issue on and have the fund directors stand up and be counted, focusing on shareholder interests.
While lofty, these are realistic outcomes that arise from the fund scandals and the profound conflicts of interest they revealed. All of this will take a long time, and it isn't likely to happen until fund investors become aptly involved and educated.
Investors must first be aware of what's going on, and understand how their managers have let them down. They must realize that the fund industry has put its own interests first, and theirs second.
Investors need to understand that the industry's excess costs come at their expense, and that it has become a tremendous marketing machine that has ill-served fund owners.
During the waning years of the Great Bull Market, for example, we brought out 496 "New Economy" funds that took in $520 billion from investors in just 2-1/2 years. Since then, they lost 60% of their money, all the while being charged with excessive fees.
MME: But when, if ever, will mutual fund consumers become educated?
Bogle: We have built an investment system in which activity and motion are the rules. The fund marketing system is about giving you advice to act, always to take action, ... "Don't just stand there, do something." Sell this fund; buy that fund," as it were.
Yet reality is that in most cases the best rule for the investor is, "Don't do something. Just stand there." Keeping emotions out of investing and keeping expenses down are the eternal verities of intelligent investing.
We need to help get investors to settle down, to get their asset allocation right, to hold diversified portfolios consisting largely of low-cost, tax efficient index funds. Because of the self-serving way the system is now working, this seemingly Utopian dream may take a long while, but we must get the underlying system right. The sooner the better, for time is indeed money in the pockets of fund investors.
Until we do fix what is so clearly broken, let me urge all in our industry to be straightforward, to be honest, and last but not least, to tell the whole truth about return, risk and cost. And engage in some realistic introspection of the errors and omissions that have plagued the fund field. Let's all of us in this industry strive to put our shareholders first. They are our ultimate customers, our owners, and the ultimate judges of the services we provide.
MME: Turning to more recent news, is it likely that the Chamber of Commerce will successfully overturn the SEC's independent chairman rule, now that the U.S. Court of Appeals granted the Chamber a stay on the rule through mid-November?
Bogle: I believe that the independent chairman rule should, must and will prevail, simply because of its inherent logic in giving fund boards the independence from managers that the 1940 Act demands, both in spirit and in letter.
Even if the industry - inspired by the Chamber of Commerce litigation -prevails in this case, the SEC will return to the fight on another day for what's right for the protection of fund investors. That, after all, is its legislative mandate.
And it will win.
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