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30 for 30 Interviews: John Bogle

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Investment Advisor is celebrating its 30th anniversary. How would you say the mutual fund business has changed in that time period?

Mutual funds used to be kind of middle of the road more or less providing market like returns, this is back in the 1950s, more or less providing market like returns, mostly less, but tracking the market reasonably, very diversified. They kind of look like the Dow Jones 30, most portfolios, or the S&P 500 even. You would buy those securities and hold them for a long time and charge the investors reasonable amounts of money for our services. It was a good way to invest for a lifetime, the old mutual fund industry. The industry changed to becoming a much more speculative industry in two ways.

One way, is creating a lot more speculative funds, funds that have much more volatility than the market, funds that are much more concentrated than the market portfolio itself. Sector funds would be would be one example, technology funds, internet funds, all those kinds of funds that we now have to choose from that have very little to do with the market. Second, fund managers are much more attuned to speculation. What we know is in the 1950s portfolio turnover of mutual funds ran around 15-20% a year and it’s now running 100% a year. Fifteen to 20% a year is a decent statement of long term investing, 100% a year is an excellent statement of short-term speculation. If short-term speculation is folly and long-term investing is wisdom, we’ve moved down the road from wisdom to folly. And somehow that disease, if you will, has been communicated to mutual fund shareholders. The rate of redemption of fund shares in the 50s averaged probably around 6% a year, leaving an average holding period for the typical fund of 16 years. Today that redemption rate runs around 40% a year. That means that the average shareholder holding is about two and a half years.

And costs should have gone down. This industry has gone in that period from being a $2 billion industry to a $10 trillion plus industry and the economies of scale that have been realized are enormous. They’ve gone far more into the pockets of the fund managers than into the pockets of investors.

And the very structure of the industry changed. Back in the 40sand 50s mutual funds were run by either partnerships or by firms owned by their principals, and the people managing the money were the people that controlled the firm. So they had a much greater feeling of fiduciary duty to shareholders than mutual funds today. That whole structure–privately held firms, investing rather than speculating, owners of the firms were investment people. Now, of the 40 largest mutual fund complexes, 30 are publicly held; mostly by financial conglomerates. These financial conglomerates have bought into the mutual fund industry, I hope you’re sitting down for this revelation, have bought into the mutual fund industry in the hope of earning a return on their capital, which you do by building up assets under management essentially, rather than earning a high return on your capital, the mutual fund investor. So I see a different mutual fund industry and it’s probably fair to say, I’m not particularly keen on what I see.

Are mutual funds still the way to go for the average American?

Absolutely. The problem is that the investors are just getting this message. What is investing all about? Investing is all about putting money to work in businesses and enjoying the return that businesses earn on their capital. The stock market it turns out, particularly as represented by mutual funds, is a giant distraction to the business of investing. In the long run 100% of stock market returns are created by dividend yields when you buy in, it’s better to buy in at 6% than at 1%, obviously, and subsequent earnings growth.

The problem with the fund industry [is] it takes too much out of that return, as our financial institutions generally do. Just to give you an example, and this make the point very strongly in thinking about the long term rather than the short term: by common consensus, the all in cost–expense ratios, sales loads, portfolio turnover costs, which are hidden but exist–is around 2.5% a year. So let’s assume that we’re lucky enough to get an 8% return from the stock market. A dollar at 8% over fifty years, which is less than an investment lifetime, grows to $47. At 5.5%, which is what the fund investor would get from that market, the dollar grows to $14.50. So the investor puts up 100% of the capital, the investor takes 100% of the risk, and the investor gets roughly 30% of the 50-year return. The financial system, including the mutual fund system, puts up 0% of the capital, takes 0% of the risk and gets 70% of the long-term return. It just doesn’t seem like that works well for the investor.

What do we do about it?

What we should do is have much greater focus on index funds, I should underscore low-cost index funds, while we’re just speaking about stocks here for the moment, I do want to mention that everybody should have a bond position. I use a very rough, crude rule of thumb that a bond position should equal their age, plus or minus. At 50 you might want to be 40% bonds, or 30% bonds, and at any event, [you should have] more bonds as you get older.

To come back to how do you buy stocks? You buy them through an index fund. The magic of an index fund is simply that it guarantees and I quote the subtitle of one of my books: The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns.

We will own these companies in the index fund, every company in the United States, or every company in the world if you like to do it that way, and hold those stocks forever. There’ll be no turnover costs and the fee should not be more than 10 or 15 basis points as compared to 250 and the tax efficiency should be very high.

By the way, I didn’t even take taxes out form that cost of 2.5% [the difference between the 8% and 5.5% on mutual fund returns] before even though the mutual fund is basically the most tax inefficient investment vehicle ever designed by the mind of man. We turn our portfolios over now realize taxes but portfolio managers get paid on pre-tax returns, they don’t care about post-tax returns, but for equity fund investors who are taxable, it’s still one more big penalty.

But I digress, the index fund simply gives you the returns earned by American business and those returns are very similar to the growth of earnings in corporate America and are very similar, and this shouldn’t surprise anybody, to the growth of our GDP, the growth of the American economy. So in fact you’re getting a share in American business or a share in America when you buy an index fund. You can hold it forever. You don’t have to worry about the portfolio manager changing. This is a world where the portfolio manager changes every five years for mutual funds. So if you’re investing for a lifetime, and it’s very important to get this idea out there, and you have four mutual funds, that means you have four managers in five years, eight managers in 10 years, 16 managers in 20 years and 32 managers in 40 years. Anybody seriously put forth the proposition that you can beat the market when you have 40 managers in 50 years.

I would like to have a federal statute of fiduciary duty requiring managers to put the interests of their shareholders first. That would be pretty extreme. If you believe in the Biblical caveat that “no man can serve two masters” all these funds that are owned by conglomerates and the public are serving two masters and paradoxically those big financial conglomerates have a fiduciary duty, not only to the mutual funds but to their own public shareholders. So that can not go on, particularly since the duty to the public shareholders in the firm, the stockholders in the marketplace, takes a much higher priority than your putting the shareholder where he belongs, as your sole interest. So I’d like to have that federal standard of fiduciary duty saying shareholders come first, saying that fund managers have due diligence on security analysis, and also participate actively in corporate governance so we force our corporations to serve the interest of their shareholders, too.

That has to change. That’s not going to be easy to do. My god, if we can’t even get a consumer protection bureau, how you’re ever going to get a federal standard of fiduciary duty is something that most people would say is not entirely realistic. I’m idealistic enough to say that the more people tell me it’s not going to happen, the more I’m absolutely determined to fight on.

The other solution, let’s call that the ethical principles solution. The other is the Adam Smith principle solution and that is if investors would only look intelligently after their own interest, would only look after themselves, all of this would happen because they would buy index funds and in an 8% market shareholders are going to get 5.5%, there’s no way around that, so the index fund will give you 8% less 10 basis points, or maybe 15. So it will capture your fair share of the market returns. Investors have to be educated. You don’t have to trade index funds. The managers don’t trade anything. The investors can’t be disappointed in the managers because they’re just capturing the market returns. It’s the simplest solution in the world. It’s growing, but it’s still only up to about 20% of mutual equity fund assets. So we have a long, long way to go.

If investors march in that direction, other firms will have to consider: a. a structure like Vanguard’s in which the shareholders do come first because they own this firm, they’ll also have to consider if they don’t want to do the structure, of behaving more in a fiduciary mode and that is investing for the long term, having a portfolio…this industry was primarily run by investment committees, teams of trustees, and we seemed to do better back then than when we got into this wild age of the portfolio manager–here the name was not to do a good job for investors but to take big risks and if they pay off, god how the money will roll in.

Most people totally disagree with me, but I’d love to take somebody on and just challenge them on every sentence that I’ve just uttered. Is it true that gross returns in the market minus the cost of investing or the net returns investors receive as a group, if somebody wants to argue that position they’d be laughed off the stage. It’s not a good position to say that the mathematical reality does not exist.

How important is shareholder activism for index funds?

The old so-called Wall Street rule is if you don’t like the management, sell the stock, and it’s a pretty crummy rule anyway. It doesn’t stand the test of reason or analysis, but index funds cannot do that. So they have to say if we don’t like the management, change the management. This is not a revolutionary idea. Benjamin Graham talked about it, not from the mutual fund standpoint when funds were so small but from the standpoint of investors in corporations. He was doggedly pursuing greater activism by shareholders. Back in the first edition of The Intelligent Investor, back in 1949, probably 30%, certainly 25% of the book was dedicated to shareholder activism, now long forgotten. So to the extent that Benjamin Graham is the towering ideal of our age, and he remains that way to me, what I’m talking about is basic Benjamin Grahamism, not communism, or socialism, or revolution, although I do say investors of the world unite to get these things done in corporate America.

What do we need to do to prevent another crisis like the one we’ve just been through?

First there’s the fundamental nature of the crisis, which is too much debt at too low a quality, too much leverage, too much innovation. In the financial business innovation is designed to serve marketers and not investors. Let’s see what we can figure out here so we can sell something to somebody. You see it in the mutual fund industry, you see it in the credit default swaps; you see it in collateralized debt obligations. So we need less innovation, so we have to reward innovation less and part of it is we have to have less leverage. I think that as a matter of public policy we ought to be considering reducing and maybe even eliminating the tax deductibility of interest. One of the big underlying problems, which not a lot of people have talked about, is the extreme attractiveness of debt compared to equity, which led us into a lot of the problems with private equity, into a lot of the problems with hedge funds, a lot of the problems with investment banks–too much debt, too much leverage and poor quality in the balance sheets. The analysts, I think, the professional security analysts, the buy side analysts, ought to be thinking about doing a much better job. Someone like Peter Fisher from Black Rock, a man I greatly respect has suggested you need a special license to be an analyst of bank stocks. I don’t think that’s a bad idea, because that’s a complex piece of work. But we have to do a much better job of analysis and my god, the accountants have a lot to answer for in all of this, and the ratings agencies have a lot to answer for in all of this. At our fixed income meetings here years and years ago when we started the fixed income group, I would sit in on all the meetings and someone would say, these are rated AAA by Standard and Poor’s and Moody’s and I would say I don’t care what they’re rated by Standard and Poor’s and Moody’s, what do you rate them?

People seem to constantly do things that are illogical, or against what appears to be their best interests. Is that just human nature?

There’s a gambling mentality in all of this. They want investing to be fun and investing should not be fun. Investing should be boring. You should buy and hold a portfolio of stocks and bonds weighted in various ways and hold it for your investment lifetime. What I tell people is one of the best rules is don’t peek.

An index fund is going to give you that market return. America’s future particularly in this day and age, I want to be very clear about this, is not guaranteed, but it’s the best thing we have available to us out there, I think. A little international diversification, even though half of the revenues and profits of American companies come from abroad, a little international diversification in stocks that are headquartered outside the U.S. is not I think necessary, but it’s not a foolish thing to do, 20% of the equity portfolio could be in developed and emerging markets around the world, and you want to be very clear in your allocation. People that thought the market was an endless ride of 9% returns without any bumps made a big mistake, so they panicked and they should have been much more careful about their asset allocation, they should have been more cautious.

I’ve often said the best rule in investing is not, “just don’t stand there, do something,” because that’s the way the financial business works, that’s when your broker calls you up, or your mutual fund advisor calls you up, and says, “I guess you heard what happened yesterday, you better do something.” A better rule is “don’t do something, just stand there.”

We all think we’re smarter than average, better drivers than average, I’ve observed without factual verification that most people think they’re better lovers than average, and they think they’re better managers, because “I can pick good managers.” The record is bereft of a single scintilla of evidence that’s an easy thing to do. In fact French and Faema in their most recent publication juszt a few weeks ago said the chances that a mutual fund will beat the market over a long period of years is 3%. The odds are 97% that you’ll do worse than in an index fund. So I’d just like to bring common sense, reality and mathematical truth back into the world of investing. And don’t think I’m going to stop trying.

Do you have any advice for our audience?

The basic piece of advice is put the client first, not only in letter but in spirit. Look to the long term. Look to the wisdom of long term investing and as far as possible from the folly of short-term speculation. The idea is to capture the returns of the bond and stock markets. Don’t reach for yield. Don’t reach for performance. Those things generally have unhappy, even tragic outcomes. Invest the money of your clients’ the way you would invest your own. By the way I have a new convert to this philosophy and his name is Bernard Madoff. There was an article in the press somewhere that said all the convicts down in his prison are asking him for investment advice and he’s telling them all to buy index funds.


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