If investors have learned one thing from the financial crisis, it is that, eventually, level heads and long-term investing will prevail. In that spirit, sister publication Investment Dealers' Digest recently spoke with a man known for having one of the most level heads in the industry, John Bogle, founder of Vanguard Investments, about what he sees for mutual funds and other investment firms in the years ahead.
IDD: How do you think the credit crisis will play out?
Bogle: The market can't bail itself out of this mess. Wall Street has a lot to answer for to Main Street, and yet Main Street, which is really where the tax base is, is going to have to bail out Wall Street for Wall Street's errors. And that is, of course, a tragedy-an economic tragedy. But I am persuaded because I respect people like Larry Summers. I certainly respect Ben Bernanke. I am not so sure about Hank Paulson. I suppose I respect him in a way, but his issue is that he is an investment banker. So it should come as no surprise to anybody that he looks at these things from an investment banker's perspective. How else can he look at them?
It [the bailout] has to happen. I think it is too bad it has to happen, but I think we ought to get ready for building a better financial system, which means building a smaller financial system because what is going on on Wall Street is a casino and our croupier has raked too much off of the table before we get paid.
IDD: When you say our financial system gets smaller, what do you mean by that?
Bogle: Revenues will be less for a whole bunch of reasons. First, they are never going to be allowed-with the government being part owners of them-to have 35-to-1 leverage.
Number two, we're going to have better disclosure about what is on that balance sheet. When you think about it, if you are leveraged 35 to 1 and all your assets are Treasury bills, I don't see that as much of a problem. The problem is that none of them are Treasury bills. They are toxic mortgages, and we need much better disclosure of that.
The third thing is that they are going to have to be content with less revenues.
IDD: You like the idea of keeping things simple in business and investments; what do you think about the credit default swaps market?
Bogle: It's a modern-day version of quantitative insanity-a completely obvious example of the way that speculation has over run financial investment in our financial markets.
An easy way to look at it is this. Suppose you have a house and you insure it against fire for $200,000. Now, suppose that you have 130 neighbors, 65 of whom are betting that it will burn down and 65 of whom are betting that it won't. And, that's approximately the ratio we have got here. It's supposed to be about $2 trillion debt instruments covered by CDS and $62 [trillion] or $65 trillion of credit default swaps. Half of them are in one side and half of them are in the other.
So, you could say, "Well, what's the matter with having your neighbors insuring or betting your house will burn down or betting it won't burn down?"
What's the matter is you have to keep a close eye out for arsonists. So, we have arsonists out there playing the CDS market, to sink your firm, make money for themselves and their hedge funds. They want those premiums to go way up. Playing games like that-we don't know how much because the market is totally opaque and volume is not recorded-these are the things that have to change.
IDD: Your observation that the stock market is a giant distraction to people is interesting.
Bogle: It is a giant distraction to the business of investing. And the word "business" was not lightly chosen. Investing is owning businesses and hanging on to them so they can earn a return on your capital.
IDD: Does this idea run counter to playing the CDS market short term?
Bogle: Absolutely.
IDD: In your recent book, "Enough: True Measures of Money, Business, and Life" (Wiley, 2008), you trace the history of the introduction of futures and options on stocks. Yet, they seem like another toy to tinker with, taking away from the true essence of buying into a business and its future.
Bogle: When you buy an option or a future, you are making a bet on the future price of the stock or the derivative or the index.
We do need speculators. The market might not trade every day. I'm not sure how bad that would be. That's another story. But if nothing traded, you would not have a way to value securities or anything else. The reality is not that speculation is inherently bad or investment is inherently good, but, rather, we have lost the balance.
If I had to guess, it would be my druthers that the market be 80% investment and 20% speculation, or something like that. That's really what it was when I came to this business. This year, the turnover of the market is an astonishing 345%, whereas it was 25% when I came into the game. In 1998, this turnover rate rose to above 100%, and last year it rose to 284%.]
IDD: What do you think about computer program trading?
Bogle: Any kind of algorithm or trading based on a single philosophy is only its worst enemy. I talk the same way about indexing based on earnings and revenues rather than indexing based on market cap. The problem with it is a very simple one. There will be periods of time where it does better and there will be periods of time where it does worse. The algorithm guys, the quants, are having a bad year this year.
IDD: What about prop desks active in equity and bond markets? Did you and your colleagues change the way you view Street firms because of this?
Bogle: The only thing I can say is there is a quote from Warren Buffett, and that is: "Any new idea goes through three phases: first the innovator, then the imitator and then the idiot." You know where Wall Street is on that scale.
Wall Street is late in the game. We always copy what's done well in the past, and I don't know how we can be so dumb, to be honest with you.
IDD: There is a number in your book that was interesting. In 2001 we had over 6,000 mutual funds, and by 2008, half of those are still around. What's the common denominator behind their fall, and could more mutual funds fold?
Bogle: It will accelerate, inevitably. If you have a fund that can't perform or doesn't beat the market, people forget about it pretty quickly. Or a fund that performs but can't beat the market. It won't get very big.
The economics of this business are such that a $10 million fund is not really worth running. So, with the combination of limited size and bad performance, the manager says, "It is just not working."
IDD: One of the suggestions you make in "Enough" is that investors should go for not-for-profits because their interests are aligned with the investors.
Bogle: Exactly. Just read David Swensen, chief investment officer of Yale University Endowment on that point. He is probably the most respected investor for his personal integrity, his unwillingness to get paid what he could earn somewhere else, his success up at Yale and doing all this hard work to improve the quality of education in New Haven, Conn., first, but also ultimately in America.
IDD: Where do you think the Standard & Poor's 500 Index ought to be? Do we have a further way to go down for the S&P 500 and the Dow Jones Industrial Average? Do you have an outlook on where they may be by year end, and when do we see a turnaround in either one of those indexes?
Bogle: I have absolutely no idea because the market is being driven by emotion. In the long run, stocks ought to be able to produce returns of 8% or 9% over the next decade, and I think the probability for that is good.
But where it will be by the end of the year has nothing to do fundamentals and reminds me-I think this phrase may be in the book-the daily moves in the market are like a tale told by an idiot full of sound and fury, signifying nothing. So, there is no point in predicting. If you are investing between now and the end of the year, I would say get out even though it may go up a lot.
Then again, who knows? Between now and the end of the year, what will drive the stock market is speculation. It is investment that drives the stock market, and speculation contributes zero to the long-term returns in the stock market.
IDD: What are your views on private equity firms and other investors who are not in it for the long term? Some of them have run into trouble because they leverage up their companies.
Bogle: I think David Swensen has in his book some data that shows they don't add much value. If they do, it is simply by leverage. If you put enough leverage on a moderately performing company, it becomes a high-performing company so long as times are good. I don't want to gamble on that.
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