John Bogle: High Court Fell Short With Fees Ruling

April 08, 2010

In an exclusive interview with IndexUniverse, indexing legend John Bogle examines the recent Supreme Court decision, the pros and cons of ETFs and the biggest successes and regrets of his career.

In an exclusive interview with IndexUniverse’s Managing Editor Olivier Ludwig, John Bogle, the former head of Vanguard and legend of the indexing and mutual fund industries, says the Supreme Court’s recent decision on mutual fund fees may help shareholders a bit, but adds that a continued lowering of costs is all but inevitable anyway. Still leery of ETFs, Bogle says there’s nothing wrong with them, but that they’re used for trading far too much, which can only hurt long-term returns. He’s proud of much of what he’s achieved, but wears his accomplishments with enough humility to acknowledge he’s made his share of mistakes along the way. What was your reaction to the Supreme Court decision on Jones v. Harris related to mutual fund fees?

Bogle: [T]he minimum result of the court’s decision on Jones v. Harris is that the door is now ajar [for shareholders to sue fund companies for excessive fees]. Not wide open at all, but it’s open a bit and maybe even more than ajar. So the opportunities are greater for shareholders, although I was deeply disappointed in a lot of the aspects of the decision, which seemed to me to be superficial, and in some senses, ill-thought out.

Life is about dollars in the mutual fund industry and not about rates. Boards negotiate rates, they don’t look at dollars, and that’s a terrible mistake. Can you elaborate on the superficiality?

Bogle: First off, the only way anyone’s going to ever understand the fee structure in the mutual fund business is to make a clear distinction between fees and fee rates. And that was the central point in my amicus brief to the court. You can look in Alito’s decision and he seems to go back and forth. He talks about fees with some frequency when he seems to mean fee rates. It’s a crucial distinction. All these decisions are about fees and not fee rates. To give an example: Fidelity Magellan Fund at $100 billion was getting a 1 percent fee. I don’t think that could “offend the conscience of the court,” a phrase that appears in the decision. But supposing you said the Magellan Fund was getting $1 billion. How could there be any question that that would shock the conscience of the court? But 1 percent is not going to shock anybody.

Life is about dollars in the mutual fund industry and not about rates. Boards negotiate rates, they don’t look at dollars, and that’s a terrible mistake. But eventually it’s going to be ironed out because it’s money that talks, not basis points.


Cachet is something we should be very careful of when we get into investing for a lifetime. The investors in those leveraged ETFs, as a group, are almost bound to lose. You’ve been negative on ETFs in the past, saying they can hurt investors, and I’m wondering if you still feel that way now?

Bogle: The ETF is fundamentally not a problematic investment. If you buy a Vanguard Total Stock Market ETF on the one hand, or the Vanguard Total Stock Market regular fund, how can I say the ETF is a bad thing? They’re the same thing. The ETF might be a little cheaper from Vanguard’s standpoint in terms of annual expense ratio, but you have to pay a commission more often than not and a spread to obtain it. If you’re going to put $1 million in it once and hold it forever, you’re probably better off going the ETF route, but if you’re putting in $100 a month, you’re much better going the regular route.

When you look at ETFs, there are two problems. There are around 800 of them. About 15 of them are all that I would call classic index funds: total U.S. stock market, S&P 500, total
bond market, developed international markets and perhaps emerging markets. The rest are narrower segments—it might be various industry sorts, it might be individual countries, it might be subindustry groups.

So one problem is that ETFs have departed so much from the sweeping broad nature of what classic indexing is about, which is owning markets and capturing market return. Then you’ve got people that enter the business like [Rob] Arnott [of Research Affiliates] and Jeremy Siegel [of WisdomTree] who are providing indexes that will “beat the market.”

The second problem is trading. We have some funds that will give you double or triple leverage on the upside, and if the market’s going down, you can bet on that and make a lot of money—double or triple. So there’s a lot of stuff being thrown around in ETF-land because ETFs are hot. If you want to start a line of funds, you start them in ETFs. And you capture the cachet of having a fund you can trade all day long.

Cachet is something we should be very careful of when we get into investing for a lifetime. The investors in those funds, as a group, are almost bound to lose. What about the tax efficiency of the ETF relative to the traditional mutual fund?

Bogle: ETFs have a theoretical advantage of tax efficiencies, but it’s never been proved out in terms of reality. First, there’s a lot of tax inefficiency when changes are made in the index, and there’s a lot of fooling around in these subsectors, and then changes made in the fund itself. It’s the trading in fund shares that doesn’t require you to realize capital gains. So there’s no evidence that the tax efficiency is very much different. I would also add that half the mutual fund equities are held in pension plans and 401(k)s, so it’s not a tax problem in the first place. I regard that as a claim that is technically good but doesn’t really exist. What do you think of the SEC’s decision to put a stop, for now, to actively managed or leveraged funds that use derivatives? Do you think the SEC is providing adequate oversight?

Bogle: I have an embedded dubiousness about the SEC being able to regulate in an intelligent way the kind of products that are being offered. But I agree with the decision. Not everybody knows that they promise returns for a day. If you hold them for a month, and the market goes up 20 percent, you might think it should go up 40, but it doesn’t happen. So they’re very subject to misunderstanding, and if they can’t be explained with examples, then they should not be able to be offered. What is your opinion regarding disclosure for ETFs and mutual funds?

Bogle: I’ve felt for a long time that mutual funds ought to report not only the returns the fund earns as such—what we call time-weighted returns, but also the returns actually earned by their shareholders—which are dollar-weighted returns or asset-weighted returns. The most recent data I looked at showed that ETFs that had comparable mutual funds—where you could buy a particular sector with either an ETF or a mutual fund—the time-weighted returns of the mutual fund and the ETF are pretty much the same, but the dollar-weighted returns were substantially different to the disadvantage of the ETF by as much as 3 or 4 percent a year. There’s much more opportunistic buying and selling going with on with ETFs because people think they can outguess the market, and that just can’t happen to investors as a group. Have ETFs been a net benefit or a net negative for the average investor?

Bogle: Definitely a net negative. If you look at investing as a lifetime affair, you want to invest in a broad market index fund or two in the stock market and the bond market and just hold them forever. But you get this trading mentality and it’s hard for me to imagine that at the end of an investment lifetime—we’re talking 50 years, probably 60 years now—that all this trading is going to do anything other than cost you a fortune. And ETFs are goading people into making that bad judgment, the way you see it?

Bogle: I think investors are basically trading these funds much too much. It’s hard for me to understand as an outsider how the Standard & Poor’s SPDR (NYSEArca: SPY) turns over 10,000 percent a year. Ten-thousand percent! The average stock is around 250 percent; the average mutual fund around 50 percent. That 10,000 percent is a staggering number. So they’re definitely used as trading vehicles, and I’m just very doubtful that that can pay off. What are your proudest achievements in your years at Vanguard?

Bogle: The achievements are four of the five innovations in this industry, say, in the past half century that have benefited fund investors. Those five innovations are: No. 1, the Vanguard structure that puts the investor first—shareholders over management. No. 2 is the index fund—a clear way to capture the long-term returns of the market with minimal cost. No. 3 was the defined-maturity bond fund. There were just a bunch of bond funds out there 30 or 40 years ago, and in 1977 we created the first series of bond funds—you had to choose between long, intermediate and short. They could have more income and more risk or less income and less risk. That was an important innovation. The fourth important innovation was the tax-managed fund. This has been an incredibly tax-inefficient industry, and we created, I think in about 1993, the first series of tax-managed funds in the industry’s history.

And the fifth one is the money market fund. That’s one we did not start. Was the money market fund a brilliant innovation? I think so, but we’re going through a critical time for money market funds, because their Achilles’ heel is promising everybody liquidity at a dollar per share. But like a commercial bank, you can’t give liquidity to everybody at a dollar a share on the same day. So money market funds, it seems to me, are going to come under new regulation, because if we’re going to, in effect, have a fixed asset value, we’re going to either have to insure them privately or pay to have some kind of government agency insure them. So the next chapter of the money market funds is yet to be written. On the other side of the ledger, is there anything you regret or might change about Vanguard?

Bogle: I was a little more aggressive in the ’80s, struggling to get this firm going and I was a little more focused on marketing than I ever should have been. We started sector funds, and we’ve gotten rid of most of them. And it’s a curious fact that while I regret that marketing-oriented decision, our healthcare fund and our energy fund have been two of the best-performing funds for shareholders in the industry’s history. So I don’t regret those two.

But I regret the other two or three or four or five that have come and gone. I started a group of funds called the Horizon Funds that had a little more distinctive and speculative flavor back in the early ‘90s. And they have come and gone. In the late ‘80s I was persuaded—but it was my decision so I have to take responsibility—to start real estate closed-end funds. That was in the halcyon days of real estate and people here persuaded me that real estate was a separate asset class. Well that may or may not be true, but when you put them into securitized form, it’s not a separate asset class. So those funds have come and gone.

So I come by my belief in simplicity not only by the innovations we created, but also by the regret about the times we departed from the straight and narrow and went into things I’m sorry to say were more marketing oriented than investment oriented.

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