Saint Jack On The Attack John Bogle thinks the mutual fund industry has betrayed investors. That makes him mad.
(FORTUNE Magazine) – John Bogle is without question a titan of our age. He founded the investor-owned, ultra-cost-conscious Vanguard Group and built it into the second-largest mutual fund company in the land. He pioneered index mutual funds and was a leading force behind the triumph of no-load investing. He has written bestselling books of investment advice. His opinions are regularly sought by journalists and elected officials. He even spawned an army of "Bogleheads," small investors from around the country who communicate their admiration for the man on Internet message boards and gather for occasional jamborees.
But pay a visit to Bogle at Vanguard's sprawling headquarters outside Philadelphia, and the picture you see is not that of capitalist icon in repose. For one thing there's his office, just off the legal department and one floor down from the executive suite where he once reigned but is no longer really welcome. With its stacks of books and papers his office looks far more professorial than CEOish. There's also Bogle's less than grand choice of lunch venue--the Vanguard cafeteria--where, in deference to his transplanted heart, he sticks to the salad bar. Then there's the man's almost teenager-like enthusiasm about the people he gets to meet: Warren Buffett said something nice about him to Eliot Spitzer! He got to sit next to Paul Krugman at a dinner! As for Bogle's outfit of bright-yellow sweater and green-and-blue-plaid pants, well, let's just chalk it up to casual Friday and leave it at that.
What's most incongruous about Bogle, though, is how he spends his time. At 73, with a spectacular record of success behind him, with a pre-owned heart beating in his chest, he crunches data and churns out op-ed pieces, speeches, and journal articles ripping into the business he has spent his entire adult life building. "A lot of things have changed in this business, and we've moved in the wrong direction," Bogle says as he prepares to launch into a tirade he's polishing for a couple of mid-January speeches in Boston. "Let me count the ways."
So he does. First, Bogle says, fund managers now trade in and out of stocks way too much. "We used to be in the business of long-term investing, and now we're in the business of short-term speculation." Average annual portfolio turnover at equity mutual funds is more than 100% now, up from the mid-teens back when Bogle was starting in the business in the 1950s. High turnover, Bogle believes, is a recipe for high costs and disappointing long-term performance.
Second, "We've moved to making fund choice extremely difficult," he says. "Back then there were probably 200 funds, and now there are 5,000 equity funds, give or take." Instead of big diversified funds that offer investors a cheap, relatively safe entree into the market, the industry has come to focus on risky specialized funds that tend to get great returns for a few years and then crash.
Third, most funds are now run not by investment committees but by individual managers who are marketed to investors as "stars." Grumbles Bogle: "They're not stars but comets." And in fact, the tendency of fund managers to underperform market averages like the S&P 500 has only grown more pronounced over the decades.
Finally, and most dismayingly, the fees that mutual fund companies charge their investors have risen steadily, from an industry average of about 0.75% of assets each year back in the 1950s to almost 1.6% now. (Vanguard, as the accompanying chart shows, has been the great exception, with costs dropping steadily over the years.)
As a result, Bogle argues, investors in mutual funds have been almost criminally misserved. Encouraged by the industry's marketing techniques, investors now tend to hop in and out of funds. The average fund holding period has dropped from 16 years in the 1950s to 2 1/2 years now. And investors have done a pretty horrendous job of timing those hops. From 1984 through the end of 2001, when the S&P 500 advanced at a compound annual rate of 14.5% and the average equity mutual fund rose 11.5%, actual fund investors made just 4.2% a year, according to financial research firm Dalbar. Given how tough 2002 was for the market, the average investor return since 1984 will probably drop below 3%. That's less than the inflation rate over that time. Which means that over the past 18 years, the average mutual fund investor has gone nowhere, or maybe even a little bit backward.
"Other than that, this is a great industry," Bogle cracks.
The facts Bogle cites are, as he himself puts it, "irrefutable and undeniable." But despite the crisis of confidence that the fund industry is facing these days--with more money being pulled out of equity mutual funds than is flowing in for the first time in 14 years--nobody other than Bogle is really addressing them. After years of arguing with the man they sometimes sarcastically dub "Saint Jack," the rest of the fund industry has decided that the best policy is to ignore him. The current leaders of the Investment Company Institute declined to comment for this article. So did Jack Brennan, Bogle's successor at Vanguard. In fact, Bogle and Brennan have barely spoken since Bogle's reluctant departure from Vanguard's board when he hit the mandatory retirement age of 70 in 1999. (Vanguard does, however, continue to fund the Bogle Financial Markets Research Center, which consists of Bogle, an assistant, and a secretary.) The last time Vanguard's founder was invited to speak at an ICI event was in 1990, when another fund executive referred to him in a speech as not just a communist but a Bolshevik. Bogle responded that most of the people who worked for him considered him a fascist.
Bolshevik, communist, and fascist are all a bit strong. But when it comes to how mutual funds should be run, Bogle isn't exactly a capitalist either. His biggest complaint about the fund business, it turns out, is that it's run like a business--one that tries to maximize returns to its shareholders rather than to its customers.
Bogle traces this behavior back to a 1956 federal court ruling that allowed the firms that manage mutual funds to be bought, sold, or taken public. (The SEC had previously banned such sales.) "That opened the door to looking at this business as an entrepreneurial business, in which the focus was on making money for the entrepreneurs," he says. "That explains a lot. Once you change the investment profession into the financial services business, you put management in the back seat and marketing in front." Bogle ought to know. He was on the front lines of the transformation that he now bemoans.
Upon graduating from Princeton in 1951, the Montclair, N.J., native got a job--on the strength of his senior economics thesis about the mutual fund business, which we'll discuss later--at the Wellington Fund in Philadelphia. Founded in 1928, Wellington was the first balanced fund, one which mixed stocks and bonds. That conservative approach enabled Wellington to survive the 1929 Crash and the dismal 1930s. In the prosperous 1950s, though, it was starting to seem out-of-date.
Bogle rose quickly through the ranks at Wellington not as a money manager but as a marketer and administrator. By the late 1950s, he was the heir apparent to founder Walter Morgan. As he saw Wellington falling behind more aggressive rivals, he began pushing for change. At Bogle's urging, Wellington launched a second fund, the all-equity Windsor fund, which didn't take off until after the hiring of now legendary manager John Neff in 1964. Wellington Management Co. went public in 1960. More funds followed.
In the go-go 1960s that still didn't seem like enough, so in 1966 Bogle engineered the headline-making deal that would change everything for him. He merged Wellington with a Boston investment-counseling firm that managed the hottest fund of the moment, Ivest. "It was certainly the dumbest move of my career," Bogle says now. "I did something really stupid and paid a very steep price."
By the early 1970s the stock market had stopped go-going, and Bogle and the four young Bostonians who ran Ivest discovered they couldn't stand each other. The Bostonians, it turned out, could do something about it. The merger had given them 40% of Wellington Management's shares to Bogle's 28%, and in 1974 they were able to engineer a board vote to oust him. (Neff was the only dissenter.)
But while Bogle was out at Wellington Management, he was still chairman of the funds Wellington managed. Legally, mutual funds have always been organized as actual mutual enterprises in which the fund shareholders have final say. In reality, fund shareholders tend to be a pretty passive lot, and most funds were--and are--controlled by management companies like Wellington and Fidelity. But the boards of the funds managed by Wellington were still peopled with pre-merger Bogle loyalists, so the ousted CEO decided to stage an unheard-of revolt.
He first urged an outright takeover, in which the funds would simply buy Wellington Management and put him back at the helm. His fellow board members were too timid for that but agreed to a compromise: Wellington Management would keep managing and distributing the funds (distribution consisting of contracting with a sales force of load-charging brokers), while Bogle would handle "administration."
Bogle dubbed his rump organization Vanguard, after Nelson's flagship at the Battle of the Nile--thus keeping with the Napoleonic-wars theme set by "Wellington." And while Vanguard was at first in charge of nothing but keeping records and sending out statements to shareholders, Bogle quickly devised some sneaky ways to extend its reach. He got around the distribution compromise by switching the funds to no-load--selling shares directly without an up-front fee instead of going through the brokers controlled by Wellington. Then, in 1976, came the Vanguard Index Trust, which, because it simply aimed to track the S&P 500, got around the boards' decision to leave money "management" in the hands of Wellington. (Wellington Management is still around and still manages some Vanguard funds. But not many.) "It was one of the great acts of disingenuous opportunism defined by the mind of man," Bogle says now.
Thus was Vanguard, the only major mutual fund company controlled by the shareholders in its mutual funds, born. And thus was John Bogle reborn as a fearless crusader for small investors. If the Bostonians hadn't fired him, it might never have happened. "If I were still running Wellington Management, it wouldn't be no-load, and I would probably be rich as Croesus," Bogle says.
By the standards of the world at large and even those of FORTUNE readers, Bogle is in fact pretty well off. His holdings, built up by pouring his money into Wellington and then Vanguard mutual funds year after year after year, total almost $20 million. By the standards of the investment business, though, that's nothing. Abigail and Ned Johnson of Fidelity Investments, Vanguard's archrival, are worth a reported $10 billion.
That is why, barring another boardroom showdown like that at Wellington in 1974, it is highly unlikely that more mutual fund companies that truly are mutual will follow in Vanguard's wake. There's just not enough money in it. But that's not to say investors can't do a better job of choosing funds. And the way to do that, Bogle says, is to focus on that critical element of cost.
Always a number cruncher, even when he was running Vanguard, Bogle has now published two studies in the Journal of Portfolio Management showing that the lowest-cost quartile of funds consistently outperforms the highest-cost quartile. The margin of outperformance (2.2 percentage points over the ten years ending June 30, 2001) is substantially greater than the difference in costs (1.2 percentage points).
Bogle is happy to reel off the names of fund companies other than Vanguard that already--thanks to low expense ratios, limited fund offerings, low portfolio turnover, and modest advertising budgets--score high on his "stewardship" meter: Capital Group (which manages the American Funds family), Clipper, Dodge & Cox, Longleaf, TIAA-CREF. If the expense ratio were to replace those one-, three-, and five-year performance numbers as the most watched measure in the fund business, more would surely fall in line.
And then, just maybe, the mutual fund business could fulfill the promise that Bogle sketched out for it in that senior thesis of his back in 1951. Titled "The Economic Role of the Investment Company" and inspired by a December 1949 FORTUNE article on the then little-known mutual fund business, the thesis contained the germ of several ideas that were to become important decades later. (If you're really interested, it can be read in its entirety in the 2001 book Bogle on Investing: The First 50 Years.) The young Bogle observed that "funds can make no claim to superiority over the market averages." He concluded that mutual fund costs were too high. Most of all, though, he sounded hopeful: Mutual fund managers, because they possess "greater knowledge of finance and management than the average stockholder," could exert a healthy controlling influence on corporate behavior, Bogle argued. And citing John Maynard Keynes's depiction of financial markets as dens of irrational speculation, Bogle predicted that the rise of rationally managed, long-term-oriented mutual funds would change all that.
As Bogle puts it now, "Keynes one, Bogle nothing."
But don't count Bogle out. He certainly hasn't given up hope. "Of course there's hope," Bogle says. "There's a guarantee it will get better. People will not act contrary to their own economic interests forever." Now there's something both capitalists and Bolsheviks can agree on.