John C. Bogle is a titan of the mutual fund industry, identified most closely with steadfastly promoting the investing principles of slow and steady growth and truthful financial reporting.
Many disasters of the past decade-the dot-com crash, the Enron and WorldCom accounting frauds, and, most critically, the credit crisis and global recession, would have been averted if his advice was followed closely.
The founder and retired chairman and CEO of Vanguard still believes-passionately-in the strength of corporate America and the merits of investing in stocks. Since the last decade delivered zero returns in equities, Bogle reasons, it is inevitable that in the next 10 years, the pendulum will swing back and investors will once again be rewarded. Bogle even sees a silver lining to the Great Recession: more honest, realistic and sustainable growth.
Under his watch at Vanguard from 1974 to 1996, Vanguard became the second biggest mutual fund complex in the world. In 2008, Vanguard overtook Fidelity as the biggest mutual fund complex in the world. Today, assets stand at $1.43 trillion, beating out Fidelity by more than $200 billion.
Bogle predicts that Vanguard will remain No. 1 for the foreseeable future due to its unique, mutually owned structure that returns profits to shareholders, its emphasis on fiduciary responsibility and its fees, which are among the lowest in the industry.
"You have been such a voice for integrity and transparency in our markets," former Securities and Exchange CommissionChairman Arthur Levitt recently said to Bogle on CNBC. "Your every stand has been so principled, so honorable, so decent. You've given this market a better name than it would have had without Jack Bogle."
Money Management Executive recently met with Bogle at Vanguard's Malvern, Pa., headquarters. Here are his views on the state of America's financial future:
MME: In your new book, "Don't Count On It!" (John Wiley & Sons, November 2010) you note that you were worried about the mind-bogglingly complex and expensive credit default swaps and collateralized debt obligations, long before the credit crisis of 2008. Because these instruments are outside the realm of mutual fund portfolios, why did they become such a concern to you?
Bogle: We obviously depend on a financial system that operates effectively and at understood levels of risk, and the mutual fund industry is part of this larger financial system. We're all in this together.
The speech that I gave to the Philadelphia Federal Reserve in the autumn of 2007, "Can Financial Innovation Go Too Far?" stressed that, yes, financial innovation had already gone too far. Our financial system is operated for the benefit of Wall Street insiders, rather than for the benefit of investors.
Innovation might be a positive for consumer goods, but I would say that the financial system is not just another business. We are a fiduciary business, a business that must provide stewardship for clients and appeal to the "better angels of our nature," to quote Abraham Lincoln's inaugural address.
And that's where we departed from our mission. We put our service to self before the service to the community.
MME: When did that start happening?
Bogle: The tension between financial innovation, or buccaneership, and prudent investing, stewardship and fiduciary duty-that tension has been there forever.
When did the mutual fund industry start becoming more of a business than a profession? At the beginning of this industry, the two very first mutual funds, Massachusetts Investors' Trust and State Street, were run by the trustees and didn't even get involved in distribution.
At MIT, the trustees were paid a fee equal to 5%, which actually gave them more money than they could spend. By the time I wrote my thesis on mutual funds, in 1951, 25 years later, they had reduced their fee to 3.5% of income, which gave them an expense ratio of a mere 19 basis points. That's a fact. Today, expense ratios are around 1.5%. In the world of the Investment Company Institute, this is called "a good example of the way fees have come down in the mutual fund industry."
So we gradually moved from being a reasonably balanced profession of noble faith, to one that survived by focusing on revenue. In the industry's first 40 years, up until around 1976, fund companies were run as two separate companies, with investment management on the one hand and distribution on the other. It became less common to have that separation with each passing year, but it's always been the tension in the business.
And I would pretty much date the beginning of the decline to the go-go era of the 1960s, when even I forged a stupid merger at Wellington Management. I made a terrible error doing that merger and I paid a terrible price, my job. But if I hadn't been fired, I wouldn't have gone on to found Vanguard on the principles of low-cost, long-term investing that I laid out in my Princeton thesis.
Mutual fund managers want to make a fortune for the companies or public shareholders that own them. Of the 50 largest fund companies, 32 are owned by financial conglomerates and eight are publicly held.
MME: Many investors have been forever changed by two the market crashes of the past decade? Was that failed merger your dot-com, credit crisis lesson?
Bogle: Yes, it gave me a sense of realism about the business in which I find myself, and that is, it's like a great big pendulum. Sometimes it's way over here to the right, and sometimes it's way over there to the left. On average it's in the middle only for a moment.
It made me realize that there is no such thing as an eternally good money manager because that's not what really works for the market. I've seen examples of that over and over and over again all throughout my career.
It compelled me to realize there was a better way to run a mutual fund business than the way it was being run-going back to that initial trusteeship model.
I wanted to create a company where the shareholders actually owned it and to come down firmly on the side of the issue that no man can serve two masters. Rather than making money management the master, I decided that we would create a system where the directors of the fund shareholders are the masters. And the shareholders are going to own the funds.
Out of that structure comes a revolution in strategy because everything changes when you do that. Your idea about cost is to minimize costs for fund shareholders, where all of your rivals' idea on cost is to charge whatever markets will bear. You have a different attitude toward risk. You can get a higher, or least a competitive return, by taking much less risk because the extra return is generated by this fabulous cost advantage we have.
That's where index funds come in. Active managers hate index funds because they aren't revenue producers like equity funds are.
As one manager said to me once, "The problem with index funds is all the damn money goes to the investors."
MME: What is your overall impression of the Dodd-Frank bill and the government's response to the financial crisis?
Bogle: I don't think the bill is strong enough, number one. I would have separated investment banking and commercial and deposit banking. So I like the Volcker rule but I like a stronger Volcker rule; I'm not going to get it.
I would have liked some idea of fiduciary duty to come into that law. In its absence, there is a little study commissioned by the law to look at fiduciary duty in the sense of investment advisers versus brokers, that ongoing issue of whether a broker shouldbe a fiduciary? I don't see how, to be honest. There really is a difference between investment advisers and brokers. We should make this clear to investors by permitting investment advisor operating under a standard of fiduciary duty to be allowed to say so. And if you're not, maybe even require the broker to say that fiduciary duty has nothing to do with what they're doing. Just simply, "I'm trying to sell you stocks, and I think they'll go up."
MME: In 2008, Vanguard overtook Fidelity as the largest fund complex in the nation. How important is that to you-and how long can Vanguard remain there?
Bogle: We have actually been tying with Fidelity for about three years. Vanguard has $1.4 trillion in assets under management. We clearly are so far ahead of Fidelity. We're half a trillion dollars ahead of Fidelity in long-term funds, but if you count everything, including money market funds, we're $200 billion ahead.
What's good about our size is we're providing a very valuable service: low-cost, market-tracking mutual funds that guarantee your fair share of whatever market returns you want to pick, be it stocks, bonds, emerging markets, non-U.S. developed markets, value, large-cap value, small-cap growth. We will give you a cost advantage and your fair share of whatever those segments return.
And also-and I'm constantly saying this-that also means your fair share of the losses they incur when times are bad. It's a fair share deal.
If our assets continue to grow and bring these benefits to a lot more people, well, wonderful.
Vanguard's 12,000 crewmembers deeply believe we have the right mission, we're doing the right thing, and we're serving the shareholder first.
We are the low-cost provider by a wide margin, and no one else in the industry wants to compete on cost. Keep your honor high and your fiduciary principles intact and you really can't lose.
If Vanguard were an active manager, we couldn't seriously proclaim our ability to manage $1.4 trillion in assets. That is too big to differentiate.
MME: While you don't see much change in the industry's emphasis on profitability, what about shareholders? Could the financial crisis tamp down their expectations for growth, thereby bringing more stability to the market?
Bogle: It's a possibility. Let me just take you through the numbers. Think about the Eighties and the Nineties. The stock market delivered average annual returns of 17%. Mutual funds charged an average of 2.5%, including expense ratios of about 1% and turnover costs of about 1.25%. Add to that a 25 basis point sales load.
That 2.5% of the 17% returns represents nearly 15% of that figure.
Now let me look ahead. It looks to me like the market will see about a 7% return. Supposing the inflation rate is 3%. That's a 4% return. And now that 2.5% expense ratio constitutes 60% of the return, not 15%. It people would just be aware of that and look at real returns instead of nominal returns, in an era where reasonable expectations for the stock market would suggest somewhere between 6% and 8%, then they would be more more attuned to low-cost choices.
MME: Recently there's been a price war among exchange-traded funds, and the Department of Labor is going to require 401(k) plans to more clearly spell out their fees beginning in January. Do you think that this might possibly make investors more knowledgeable about fees?
Bogle: Yes, I think everything helps. I don't think it would change the shape of the world. Still, I read somewhere that ETFs have a 40% pretax margin.
MME: You were not very interested in ETFs when they first came out, but this year, Vanguard's ETFs are bringing in 39 cents of every dollar invested. Vanguard has introduced 16 new ETFs to the market. And Vanguard's ETF assets have increased by more than 72% over the past year, raising the firm's market share to 14.5% of industry assets, according to Morningstar. Have you changed your opinion of ETFs?
Bogle: Well first of all, to clarify, ETFs are mutual funds that you can trade all day long in real time-to which I would say: What kind of a nut would want to trade an ETF all day long in real time? There must be better things to do with your life than that. How about helping the kids do their homework? How about taking your wife out to dinner? How about playing golf? And if all else fails, how about reading a book?
What do I think of ETFs? I think ETFs are like the great Purdey shotgun, supposedly the greatest shotgun ever designed. They're great for big game hunting in Africa-or for suicide. It all depends on how you use them.
And while I like the idea of broad market ETFs covering the U.S., developed and emerging markets, and buying and holding them for the long term-I don't like some of the more creative permutations or the high turnover.
The SPDRs trade at 10,000% a year. And I think 30 % is too high. Long-term investing is a winner's game, and short-term investing, speculation, is a loser's game. And there's no way around the math.
MME: And you firmly believe this even after the May 6 Flash Crash and the disastrous 2008?
Bogle: Yes, because the stock market is a giant distraction to the business of investing. Investing is not buying stocks; investing is owning companies, owning corporations. Corporations have capital and they may earn a return on that capital, and they pay dividends and they reinvest when it's not paid out and they make their earnings grow.
So the long-term return on stocks is determined 100% by the returns earned by corporations. And if we have 2% dividend yield, that makes the math easy. Factor in a 2.3% or 2% dividend yield on 6% earnings growth, and you should be able to get an 8% return on stock.
If we just we look backward to a decade of zero returns in the market and the anomaly of the Flash Crash and ask, "How can you be bullish?," I would simply answer, it's precisely because we've just gone through a decade with zero returns in the market is how I can be bullish.
And we have this idea that the past is prologue. I don't buy that any past trend is permanent. That's my conviction.
MME: What about permanent changes in investors' risk appetite? Sixty percent of flows a year are going to bond funds and Strategic Insight does not expect this risk aversion to change anytime soon. What do you think? Do you think the pendulum will just simply swing back?
Bogle: No, in fact I would agree that the flows will stay about where we are now. The S&P will have to rise 40% or more from its current 1190 level to get people to put their money back into stock funds.
I call it the rowboat theory. When you're in the rowboat you know where you've been but you have no idea where you're going, pulling those oars. The bow is behind you, stern is in front of you. So, I don't see stock investors coming back anytime soon.
But when you take a closer look at the net liquidations of stock funds, you'll find that the index funds over the past three years have continued to be positive and the managed funds negative.
But I don't think there has been as big a flight out of equity funds as has been reported. I think what we simply have is normal redemption rates and lower purchase rate.
MME: Turning to retirement, how can the mutual fund industry do a better job of motivating investors rather than scaring them?
Bogle: The first thing the industry could do is lower expenses. Number two, get taxes down. Third, get turnover down. Mutual fund portfolio turnover averages 100 % a year. That's ridiculous. When I came into the business it was I think around 16 %, 18 %. Four, get transaction costs down.
Also, try and get investors to focus on the long term. And that illustrates a real problem in this industry. How do you get investors to invest for the long-term in an industry in which 40 % of the mutual funds that began in the last decade go out of business and the average portfolio manager lasts about five years?
The portfolio managers come and go. The funds come and go. Thus, the only way around that is to get a fund without a portfolio manager, i.e. an index fund, and the fund is going to last because it's never going to fail to give you the market returns.
And the most important thing is not brilliant asset managerial skills, but low costs.
We have to get investors to act sensibly. You know, not invest as a casino, but invest as a way of owning assets that deliver returns on those assets.
MME: But corporations need to be run better, too, and that includes removing the incentives for management to juice the numbers each quarter to increase their bonuses and earnings.
Bogle: You're absolutely right on that and that gets into this whole circularity thing. We as institutional investors are not particularly interested in forcing the corporations in our portfolios to put the interest of those shareholders first.
We've got to put the interest of long-term management first. We often do very unwise mergers; sometimes we get to vote on it and sometimes we don't. We often create huge stock options. If someone ever added up the total value of stock options in the last decade it would be stunning because an enormous share issuance came of out that. And then there were enormous share buybacks which were only to offset the option issuance. And this is very much true, almost dollar for dollar, in the non-tech side, the conventional business side of America.
The tech side issues huge amounts of options, and then they don't do nearly as many buybacks.
We're agents who need to care about corporate governance and have the power to effect change, since mutual funds and other institutional investors own 70% of the stocks in America. When I came into this business, institutional investors owned only 8%.
Mutual funds have got to realize we can do whatever we want. We can change the management of the corporation, but we have no unity, and there's no energy in doing this, partly because fund companies have the conflict of also running corporations' retirement plans. If you look at the top 50 institutional managers, you'll see that every one of them is both a pension manager and a mutual fund manager.
The people running these institutional management companies aren't stupid. They're quite able to figure out that if their voting patterns are very lenient on companies that they're running money for and very stiff on companies that are not, that will become conspicuous and evident, and they could be in for a lot of trouble. Studies have shown that fund companies circumvent this by not voting the stocks of our clients. So, we're smart that way; nobody can hang that bell on us.
And there's also the argument that why should you pay Vanguard to spend time and money trying to repair AT&T when we own 2 % of the stock, even if we are right. Ninety-eight percent of the benefit will go to someone else.
In 2002, I tried to form the Federation of Long-Term Investors to pool our resources to form a proxy advisory firm that would provide us with an independent view of how to bring about long-term change in coporations.
And at the end of the meeting the head of one of the biggest asset management firms said, "Look, Jack, we know what you're trying to do, but it's a big challenge. So why don't we just leave it to Adam Smith's Invisible Hand?"
And I looked at the man and I said, "For God's sake, don't you even understand that we are Adam Smith's Invisible Hand?"
But it didn't get anywhere. When you think about it, the mutual fund industry has become a great big marketing business.
Pooling proxy resources does cost a little money, but with all of the money asset management firms make-Fidelity earned $2.5 billion last year-there's plenty of money to do it.
MME: So let me ask about your optimism. Despite all of these problems inherent to capitalism, you say in your current book, "I believe that a quarter century from now the companies that will be leading the way in their industries will be those that make their earnings growth not the objective of their strategy but the consequence of their corporate performance."
Why are you so optimistic and what will bring about this change?
Bogle: Sooner or later corporations will have to part with their short-term focus and realism will set in.
There is a symbiotic relationship between fund managers and corporate managers, with one hand washing the other. Corporations want to meet their short-term guidance on earnings, and fund managers have been demanding it. They want to tell you that they can grow 12 % a year. They simply can't. No corporation can grow at 2-1/2 times the rate of the economy.
The fact of the matter is 75 years of data shows that corporate earnings grow at the rate of the economy. If we have 5 % growth, corporations are going to grow at 5 %. Corporate profit is almost never below 4 % and almost never above 8 %.
In the long run, the reality of enterprises is the reality of earnings through dividends; dividend yields and earnings growth. These more accurately determine investors' stock over the long term.
We need to get more accurate earnings reports. I believe we are not. I believe we have a lot of fiction out there in terms of short-term earnings. We have a tendency to lend great weight to numbers that are made up.
MME: You've been highly critical of lax accounting standards that make it possible to create pro forma earnings on paper and that motivates CEOs to meet their numbers in order to drive up their stock prices and sell their options. Are you optimistic, perhaps, that moving away from the enormous latitude accorded by Generally Accepted Accounting Principles to International Financial Reporting Standards will remedy that?
Bogle: Reconciling GAAP and IFRS will not be easy, but the bottom line is they must be reconciled because we are in one world now.
But there will always be room for manipulation.
MME: Are you optimistic that emerging markets will become the major driver of the global economic growth, or does this growth concern you with regards to America's dominance on the world stage?
Bogle: It's only a matter of time until China's economy is going to be bigger than ours. But I see serious risks in China since their economy has been very heavily driven by an overcapacity of construction. That can't go on.
Still, my fundamental believe is that emerging markets will grow more rapidly than the U.S. They can hardly avoid it, as they get to a more developed stage.
Looking 10 years out, I foresee emerging markets and the U.S. and other developed markets producing about the same returns for stockholders. But I would recommend limiting international markets, both developed and emerging, to 20% of your portfolio.
That said, 45 % of all the profits of U.S. corporations come from abroad. So if you buy the S&P 500 or the U.S. stock market, you're already investing internationally to a huge extent.
MME: Are there any others in the industry who you believe share your same ideals, or who you admire?
Bogle:Warren Buffett. Southeastern Asset Management is a nice fund group that is well intentioned. Jean-Marie Eveillard, senior investment advisor to the First Eagle Funds, is a very realistic investor. I like the people that run Dodge & Cox. They're primarily long-term investment managers and not marketers.
