John C. Bogle, founder of the Vanguard Group, spoke before the United States Senate Governmental Affairs Subcommittee on Financial Management, the Budget and International Security on November 3, 2003.
In a speech I delivered in the autumn of 1996, I warned that the "spirit of trusteeship, professional competence and discipline, and a focus on the long term, are rapidly losing their role of the driving force-in the long run, the life force of this industry." Today, the three principal points I made seem almost prescient:
- "The industry's traditional focus on trusteeship, implying placing the interest of fund shareholders as our highest priority and charging a reasonable price for our services, is being supplanted by a focus on asset-gathering-on distribution-as we worship at the shrine of the Great God Market Share, the exorbitant cost of which is borne by our own fund shareholders.
- "The industry's traditional focus on professional competence and discipline has moved from long-term investment to what is really speculation, with rapid turnover in our investment portfolios (averaging almost 100% per year!), funds concentrating on ever- narrowing segments of the stock market, and far too many gunslinger portfolio managers.
- "And the industry's traditional focus on the eminent suitability of mutual funds for long-term investors is quickly becoming a focus on investing in fund portfolios for the short-term (a second level of speculation) and, even more baneful, a focus on enticing fund shareholders to use their mutual funds as vehicles for rapid switching, either for the purpose of market timing or for the purpose of jumping on the bandwagon of the latest hot fund (and that's called speculation, too)."
What we now know, of course, is that the consequences of these three baneful trends have come home to roost in the most painful sort of way: in damage done to the pocketbooks of the shareholders who placed their trust in mutual funds.
The recent market timing scandals are but a midget manifestation of the problem. But the industry's response can be best characterized by a classic line spoken by the police chief in the film Casablanca, Claude Rains: "I am shocked, shocked to find (timing) going on here." We've already been told that the misdeeds are akin to "parking at a meter and not paying. Nobody is being bankrupted by this." And we'll doubtless be told (if we haven't already been told) that these breaches of fiduciary duty are attributable to only "a few bad apples." Although as these scandals continue to come to light, we may need to liberalize our definition of "few."
Even as the spotlight that shined on the specific acts that brought notoriety to corporate America's bad apples-the Ken Lays, the Dennis Kozlowskis, the Sam Waksals, the Jack Welches, the Richard Scrushys, to name just a few-illuminated all the nibbling around the edges of proper and ethical conduct that, absent the intrusive spotlight, could otherwise have persisted for another decade or more, so does the spotlight that shines on the scandals perpetuated by the bad apples of the mutual fund industry reflect the frequent willingness-nay, the eagerness-of fund managers to build their own profits at the expense of the fund owners whom they are honor bound to serve.
"It's an ill wind that blows no good." By illuminating the inherent conflict of interest between fund managers and fund investors, these scandals will ultimately prove a blessing for fund owners. This conflict is hardly a secret. Indeed in that very 1996 speech, I urged this industry to move to a system in which "the focus of mutual fund governance and control is shifted . . . to the directors and shareholders of the mutual funds themselves, and away from the executives and owners of mutual fund management companies (where it almost universally reposes today), who seek good fund performance to be sure, but also seek enormous personal gain."
If such a shift of control and governance had taken place, the market-timing scandals detailed in the Spitzer-Canary settlement may well never have occurred. The Attorney General's seemingly airtight case was built, not only on covertpractices, but on open motivations-on the receipt of payola, for the want of a better word. The managers received that payola in the form of side banking deals, lending money at high interest rates; large investments in other funds on which the manager earns high fees ("sticky assets" in the vernacular of the trade); and the like.
One manager's e-mail could hardly have made the motivation clearer. "I have no interest in building a business around market timers, but at the same time I do not want to turn away $10-$20m[illion]!" (Yes, the exclamation point was there.) The writer emphasized that allowing the timing trades would be in the manager's "best interests." Lest his colleagues be complete nincompoops and fail to get the point, he explained in a parenthetical aside what that meant: "increased profitability to the firm." Another e-mail (God bless e-mail!) also told the truth: "Market timers are a big problem . . . it's very disruptive to the operation of the funds. (But) obviously, your call from the sales side."
A Study In Corporate Incest
It can be little surprise that the mutual fund industry has not escaped the same kinds of scandals that have faced Wall Street and Corporate America. For in no other line of business endeavor is the conflict between owners capitalism and managers capitalism more institutionalized, and therefore more widely accepted. Yet by its very structure this industry, for all its protestations about its dedication to Main Streetinvestors, seems almost preordained to give the managers total control over the fund shareowners.
Consider how the typical fund organization operates. Even when their assets are valued in the scores of billions of dollars, fund complexes do not manage themselves. They hire an external management company-with its own separate set of shareholders-to manage their affairs. The management company runs the fund's operations, distributes its shares and supervises and directs its investment portfolio. It decides when to create new funds, and it decides what kinds of funds they will be. When the funds are badly run, the company replaces the portfolio manager . . . but with one of its own employees. And when a fund outlives its usefulness, it is the management company that decides how to dispatch it to its well-deserved reward: simply liquidating it, or, much more likely, merging it into another fund with a better past record . . . but a fund that it also just happens to manage.
What's more, this typical management company graciously provides all of the fund's officers, who are employees of the company, not the fund. And while the executives of the manager usually have a miniscule investment in the funds they run, they select themselves for the fund board, and until recent years also selected most of the funds' "independent" directors, who by law must now compose at least a majority of the board. In the typical case, furthermore, the chairman of the board of the management company also serves as, you guessed it, the chairman of the board of the mutual funds.
Given the Gordian knot on the rope that binds the fund and the manager together, it is impossible to imagine that at one of the fund's four annual board meetings the less-well-informed independent directors can stand up to the steeped-in-the business management company minority. Small wonder that an early law review article about this industry's structure was, as I recall, entitled: "Mutual Funds: A Study in Corporate Incest."
The Emperor's Clothes
How can it be that the industry takes this bizarre governance structure as the natural order of things? How is it that its leaders couldn't see that this structure was an accident waiting to happen? It must have something to do with what Hans Christian Andersen wrote about in 1837 in The Emperor's Clothes:
"When the little child said 'But he has nothing on,' and the whole people agreed, the emperor shivered, for they were right. But he thought 'I must go through with this procession.' And he carried himself still more proudly, and the chamberlain held on tighter than ever, and carried the train, which did not exist at all."
But the ability to ignore the reality of our industry's existence goes back even further than that. Hear Descartes in 1650: "A man is incapable of comprehending any argument that interferes with his revenue." And even 1,000 years before that, in 350 B.C., hear Demosthenes: "Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true."
The fund industry, in the vernacular of the day, "just doesn't get it." So I urge you not to be persuaded by the self-aggrandizing comments offered by the Investment Company Institute's president to the audience at this year's General Membership Meeting: "Your unshakable commitment to putting mutual fund shareholder interests first has served our shareholders and our companies well. In a nutshell, we have succeeded because the interests of those who manage funds are well aligned with the interests of those who invest in mutual funds."
But the interests are not well aligned. And to ignore-indeed, to deny-the obvious and profound conflicts that are manifest in this industry is hardly the beginning of wisdom. The fact is that whatever alignments of interest may exist are far outweighed by the misalignments. Consider just four of the major areas in which what is good for the managers is bad for the shareholders:
1) Market timing, which brings in temporary assets that provide higher fees to managers, but only at the cost of dilution in the returns for fund owners.
2) Management fees, which are-unarguably-inversely related to fund performance. The higher a fund's management fees and expenses. the lower the returns earned by its shareowners.
3) Growth in a fund's assets to elephantine size, which enriches managers but destroys the fund's ability to repeat the performance success that engendered that very growth. The bigger the fund, the bigger the fee, and the more likely the fund's reversion to the market mean.
4) The industry's marketing focus, which seems inevitably to demand the creation of new and often highly specialized funds to meet the heated investment passions of the day, creating huge capital inflows, huge fees for managers, and-far more often than not-huge losses to investors.
The preamble to the Investment Company Act of 1940 stated that investment
companies are affected by a national public interest. Some 63 years later,
that public interest is staggeringly large. Today, some 95 million
Americans own mutual funds. The interests of those investors have indeed
been 'adversely affected' by the fund industry's structure and the behavior
of its managers, precisely what the 1940 Act was designed to preclude. It
is high time to put investors in the driver's seat of fund governance, and
give them a fair shake.