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Monday, May 10, 1999

Putting "Mutual" into the Fund Biz

Reported by Sean Hanna, Editor in Chief

You have to admire a man who sticks by his guns. Last week John "Jack" Bogle, senior chairman and founder of Vanguard, used the opportunity of accepting an award from the National Investment Company Service Association (NICSA) as an opportunity to preach reform to the fund industry. The message isn't new, but we wonder whether he really expects anyone in the audience to hear the message. After all, it is the people in the audience benefiting from practices that Bogle was decrying.

Bogle was picking the Robert L. Gould Award for outstanding achievement within the mutual fund industry. Bogle is not the first challenger to the fund industry establishment to win the award. Last year Chuck Schwab won the honor.

Bogle surprised no one with the content of his prepared remarks. He alluded to a Greek parable, dubbing active managers and stock pickers "foxes" and indexers as "hedge hogs".

The foxes, he said, see the investing world as a complicated arena in which individuals must use a portfolio manager and a manager to pick the manager.

Hedgehogs, on the other hand, follow the precept that investment success and business success are based on simplicity, Bogle argued.

Bogle then pointed out that the costs of most funds virtually guarantee that investors in active funds are going to trail the market, and trail it badly.

"Fees are almost always so high as to consume the long-term value added by the fund manager," said Bogle. He added that over the past sixteen years actively managed funds returned just 85% of their benchmark on average.

Altogether, Bogle guessed that the cost of active funds runs 3-5% of assets; 1.5% for management fees, 1% in trading costs, and 0.5% to 1% in commissions.

Extrapolated over fifty years, these costs will eat 68% of all of the returns in a fund for investors, Bogle claims. He pointed out that investors put up 100% of the capital, take 100% of the risk, and earn 32% of the return.

Managers put up 0% of the capital, take 0% of the risk, and claim 68% of the return.

Bogle likened fund managers to the croupier at the casino who takes a slice of the action.

He then laid out a strategy that he believes will be the basis for long-term success in the investment management business. Firms must focus on communications, advanced technology and operational control, and client service.

He called for a return to prudent management and fiduciary responsibility. Firms must take a client services approach to human beings, rather than just gathering assets. On the investment side they need to take a long-term buy and hold approach rather than a short-term speculative approach.

"Lower fees, lower costs, lower turnover, and higher tax-efficiency," was Bogle's unsurprising mantra. He even went so far as to suggest that more companies adopt a mutual management structure (Vanguard is the only current fund company owned by its shareholders in this way).

"Funds that once required financial support have now reached their maturity," he said.

"Managers that react promptly may avoid nasty confrontations with the directors," he told the crowd. They may also avoid these same confrontations with their regulators and their shareholders, he said.

His message to hedgehogs, or those practicing what Bogle preaches, was to "stick with you investment style", "Don't get complacent", and "reduce your fees."

Both the foxes and the hedgehogs need to find a way to reduce the turnover in their shareholders, he said. One way to do this is to add a redemption fee, he said. Lest anyone doubt that he was backing away from his shareholder centric outlook, he added that any fee should be paid to the fund and not the management company.

After Bogle made his remarks, he stuck around to sign copies of his newest book. Interestingly, no one in attendance called Bogle on his admonishment to the industry to change its practices (and its economics).

Oh yes, when Bogle signed this reporter's copy of the $18 book, I took advantage of the opportunity to ask whether it would be possible to download the content of the book to read for free on the Internet. Doing this would cut out the costly middlemen, inefficient distribution, and money spent on marketing hype typical in the publishing industry. The similarity of the two industries' situations seemed lost on Bogle, whose most interesting response was; "I'm not going to cut my own throat!"

He did point out that all revenues from the book are earmarked for his foundation. Still, there must be a more cost effective way to donate money. 

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