Roy Weitz, publisher of fundalarm.com, and Jack Bogle, founder, Vanguard Group, faced off last May on some of the problems the two outspoken critics have found rife in the industry (see inaugural issue of Money Management Executive 5/19/03).
Since then, of course, those problems have mushroomed into full-scale dilemmas, and their prescient views have rung truer than they could ever have imagined.
While unpopular (one fund executive called Bogle a Bolshevik at an ICI meeting in the mid-1990's), Bogle's and Weitz's viewpoints cannot be ignored. Bogle was called as a star witness at the House of Representatives' financial services committee hearing on mutual fund practices last winter (see MFMN 3/17/03), even before Spitzer began his investigations.
As we are more than likely to hear the official opinions of Bogle and Weitz in the year ahead, courtesy of the regulators and lawmakers, read on, in part one of a two-part interview, to find out what they see as some of the critical issues facing the mutual fund industry today - and how to fix the problems.
Weitz: So, back in May, when we did an interview for a special edition of Money Management Executive for the ICI General Membership Meeting, we were ahead of the curve.
Bogle: We talked about all of the problems before the scandals !
Weitz: Has the word vindicated crossed your mind?
Bogle: Actually, not. I don't think about life as being vindication. The mathematics have always supported my position. The obvious direction of the industry was there for anybody to see it.
I feel badly about the investors who have been hurt - and the investors whose trust has been betrayed. So, I don't think this is much of a time for gloating, except in the sense that out of this chaos will come order.
Weitz: When this scandal finally runs its course, what meaningful reform might it bring about, if any?
Bogle: We are going to accomplish a lot, and let me divide it into two categories. One is specific regulatory steps that can be taken to make sure these things don't happen again. And I would say, number one, the 2%, 30-day redemption fee that has been bandied around would actually be sufficient in a five-day period.
Number two, make the closing time, or else you face that terrible symbol of perdition: getting the next day's asset value [laughs], which 49.5% of the time is cheaper than the previous day's net asset value. So, this is a tempest in a teapot on that point.
Although, I happen to believe it would be far wiser to set a 2:30 p.m. cutoff time, so that the manager knows his cash flow for the day and, then, can invest at prices that reflect the closing asset value.
There is such a thing as accounting purity in all this, which is that cash flow and the investment purchases should meet at the same price. That's what we do at Vanguard in our index funds, although we don't do it for institutional purchases because they can't be done by 2:30 p.m. So, everybody has that problem.
Weitz: Do you think Spitzer & Co. have run amok in their arrests and charges?
Bogle: I wouldn't mind seeing some real penalties for violation of the law. If someone's really cheating, I don't see why going to prison shouldn't be a perfectly good alternative. After all, Jean Valjean, the protagonist of Les Miserables, only stole a loaf of bread. I wouldn't be that tough, but I'd be tough. And we may need other regulations.
I have to think that one unexplored area has been where all the buying power that mutual funds have had for IPOs. They ought to be looking into what they did with them. Did the managers use the hot IPO market to pump up funds that were small? Or did they use them as they should, for the funds whose buying power created the opportunity to own them?
Clearly, it [directing a hot IPO stock] is a drop in a bucket for the funds, but when you are talking about who owns the money, a drop in the bucket is important, and the money should go to the right place. I suspect an investigation of that will show some real problems.
Weitz: So, you think the investigation into market timing, late trading, compensation and fees might advance into yet other thorny areas?
Bogle: I think this industry is in such sad shape that just about everything, as the ICI is wont to say, is on the table.
For particular procedure issues, i.e. timing issues, pricing issues, regulation is the way to go. The broader issues affecting the industry by which the fraud and the betrayal pale in economic importance, are the setting of fees and the creating of funds that serve the manager rather the investor, the idea of going along with every fad that comes along.
You put numbers on those two things, you find that mutual fund investors are paying their money managers something like $130 billion a year, which I make to be about $70 billion in expense-ratio costs. Another $10 billion in sales charges. A few billion more in out-of-pocket fees, and another $30 billion to $40 billion in portfolio turnover costs.
That's a number that costs investors about 3% a year, and it's got to be cut to give investors who are getting between 9% and 12% a year, a fair shake at financial market returns. And the answer is: Lower management fees, lower fund operating expenses, lower marketing costs, lower portfolio transaction costs, lower turnover, and the like.
But the biggest number of all is the sensitivity of mutual fund distributors to bring out funds right at the peak of the market. Everybody knows, we brought out 496 New Economy funds in the two years up to the peak of the market. Five hundred billion dollars flowed into those New Economy funds, and investors, even today, even with the recent run up, have lost $250 billion.
So we need better fund governance to make sure the funds are governed, or, using the words of the 40 Act, to make sure the funds are organized, operated and managed in the interest of fund shareholders rather than in the interest of managers and distributors.
Weitz: Does it all come back to the directors?
Bogle: Yes. Envision, if you will, with me, a scale that says how the industry should be operated, and on the left-hand side are the fund managers, and on the right-hand side are the fund investors.
The law basically says that the right-hand side should be touching ground. The scale should be tilted way down to the right-hand side. The reality is that it is the managers' interest that is touching ground.
We aren't going to be able, I don't think, to get the fund investors' interest to touch the ground, but I think we ought to get that scale to be parallel to the ground - to be flat and even, in a free market.
Weitz: So, what you are saying is that you want to shake up the boards of directors?
Bogle: To me, that means a chairman of the board who is independent.
Read Part II of this two-part, special guest Q&A in the next issue.
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