Bogle's Corner

May 01, 2006

The mutual fund industry has been transformed in the past generation from a profession with elements of a business to a business with elements of a profession. When I joined the industry in 1951, it was composed of relatively small, privately held firms run by investment professionals; today it is dominated by giant, publicly held firms run by corporate managers. These firms are in business primarily to earn a return on their capital, not to earn a return on the capital of fund investors.

The change from private ownership to public ownership in the mutual fund field depended on a single landmark legal case, now long-forgotten, except perhaps by those (like me) who witnessed it. In 1956, the owners of Insurance Securities Incorporated (ISI), manager of the ISI Trust Fund-a mutual fund investing largely in the stocks of insurance companies-sold their controlling shareholdings in the management company to a new purchasing group for 15 times the firm's book value. (While the book value of ISI was $300,000, the shares were sold for $4,300,000. In those days, this industry was much smaller and the dollar was much bigger!)

Following management's recommendation in the proxy statement, the Trust Fund owners approved the transfer. The Securities and Exchange Commission (SEC) challenged the deal, arguing that the sale of a fiduciary office was a "gross abuse of trust" under Section 36 of the 1940 Act. Since "the value attached to the (management) contract is an asset of the fund," its sale to others violated "general equitable principles." The SEC also argued, prophetically, that when an excess value is paid, it might "prompt the new owners to pursue a hazardous or doubtful policy in an effort to recoup the purchase price."

The SEC arguments failed to carry the day. The lower court ruled in favor of allowing the sale. Appealed to the Court of Appeals in the Ninth Circuit, the ruling was upheld in April 1958, and the U.S. Supreme Court declined to review the decision. The die was cast, and the floodgates opened. A rush of public offerings of fund management companies followed, and by the mid-1960s, a score of fund managers had become publicly held, including industry leaders like Wellington, Vance Sanders, Dreyfus and Putnam.

But public ownership was only the beginning. Over the decades that followed, in yet another pathological mutation, ownership of most of the industry's major management firms were acquired by giant financial conglomerates, largely U.S. and international bank holding companies that included Bank of America, JPMorganChase, Deutsche Bank, AXA and UBS. This era also marked the entry of major investment banking and brokerage firms-including Merrill Lynch, Morgan Stanley and Goldman Sachs-into the field of fund management and distribution. The fund business became big business, another "profit-center" much sought after for its predictable and growing asset-based revenue stream.

Today, among the 30 largest mutual fund companies (listed in order of assets managed at year-end 2005) controlling 74 percent of the industry's assets, only four firms remain privately held, including fund-shareholder-owned Vanguard. Of the remaining 26 firms, 19 are owned by financial conglomerates and seven are owned by public investors. It is high time that we focus on the change in the very nature of mutual fund management wrought by this remarkable change in the control of the assets of our nation's funds, and ask whether these changes have served the interests of fund investors. I fear that they have not.

While it is not possible to precisely associate cause with effect, some things are clear: The fund industry, once a field focused largely on professional management, has indeed become a business of product marketing. Like all successful marketers, fund distributors watch the actions of consumers like a hawk, and rush to respond to-even to foment-demand by investors for the investment fads and fashions of the day. Once satisfied to sell what we made, we became an industry that makes whatever will sell. (During the market bubble, for example, we created 494 "new economy" funds-technology and telecommunications funds, and aggressive growth funds dominated by these sectors.)

I don't want to suggest that the conglomerates and the other publicly held firms bear the sole responsibility for this change. The three giant private firms hardly ignored the marketplace, and must accept their share of the responsibility too. But the pressures of outside ownership-the need to serve two very distinct masters, if you will-surely played the major role in the transformation that has ill-served mutual fund investors.

Fund advertisements, once limited to "tombstones" in black-and-white on the financial pages, now appear in living color on our television sets and in magazines, often focused on once-prohibited quasi-endorsements (most recently from Paul McCartney and Lance Armstrong), and buttressed by sophisticated measurement techniques. And when a fund's performance fades and it loses its appeal in the marketplace, it is given a hasty burial.

The investment process, too, is affected by this change. The reliance on investment judgment by those small professional firms gradually became institutionalized and process-oriented. As marketing efforts produce burgeoning cash inflows from new investors, fund assets grow to levels that jeopardize the ability to generate superior returns. The investment management function is redefined as "manufacturing." Gradually, marketing replaces management as the talisman, and ethical standards are compromised. (Is it an accident that all six of the largest public- or conglomerate-owned firms-and none of the four major private firms-were implicated in the mutual fund market-timing scandals?)

And when, in a miasma of faltering fund performance, new corporate management, or rethought strategy, the utility of the fund management company fades, its owner does the obvious: It sells to a new owner, who does what new owners traditionally do-"rightsize," reshape the product line, increase the marketing budget, and raise existing fees and/or add new fees, all with a view toward earning a higher return on the capital it has invested. Salesmanship replaces stewardship, and fund management companies change hands over and over again.

Let's look at the relative performance of the funds run by private managers versus funds run by public managers, using a study prepared for Fidelity a few years ago, in which each fund manager is given a ten-year percentile rank compared to its peers (i.e., its large-cap-value equity fund vs. its peers, its long-term municipal bond fund vs. its peers, etc.) (Figure 1). No comparison is perfect, but this peer-based, decade-long approach is probably about as fair as it gets. This record shows, unequivocally, that funds operated under the aegis of the largest financial conglomerates have provided distinctly inferior returns to the shareholders of their funds compared to those provided by the private companies.

On average, the funds run by the 13 private firms provided near top-quartile performance (29th percentile), while the funds run by the 34 conglomerates were third quartile (55th percentile) performers. In fact, all seven top performers-and eight of the top nine-were private firms, with only two represented among the bottom 34 firms.

Increasingly, investors appear to understand what's happening. Because just as conglomerate-management has failed investors, it also appears to be failing as a business strategy. Since the end of 1999, investor cash flows have dried up for conglomerates, even as the private firms have enjoyed enormous inflows. Since the stock market peaked near the end of 1999, there has been $940 billion of cash inflow into long-term mutual funds managed by just seven firms: very low-cost Vanguard and Barclays, low-cost Dodge & Cox and PIMCO (largely in its bond funds), and below-average-cost Capital Group, Fidelity and T. Rowe Price. At the same time, the ten giant conglomerates who run the higher-cost funds-Putnam, Merrill Lynch, American Century, Scudder, MFS, JP Morgan, Dreyfus, Morgan Stanley, AIM, and Columbia (Bank of America's new brand)-have gone essentially nowhere. In the aggregate they have actually experienced $170 billion of cash outflow from their long-term funds. To state the abundantly obvious, the fund investor is sending us a message: Cost matters.

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