Industry must return to stewardship model: Bogle

The investment industry should return to its roots and abandon salesmanship for stewardship, according to an esteemed panel of two at the recent CFA Institute conference in Boston.

Putting clients first should be an obvious first step said Jack Bogle, founder of the Vanguard Group and Christopher Davis, chairman of Davis Selected Advisers.

While the timing of entry and the vicissitudes of equity markets have an obvious bearing on investor returns, subtle problems with the structure of the investment management industry also have a long-term impact on client returns.

When Bogle entered the industry, investment management firms were privately held partnerships, and held just a fraction of America’s corporate equity. At the time, individual shareholders held 92% of American stock, he said.

Today, management firms are either publicly traded companies, or owned by financial conglomerates. Although they control 70% of corporate equity, they don’t necessarily act in the best interests of their investors.

“If we can get the institutional managers that control 70% of the stock of every company out there to start serving their shareholders…that will get some of the agency problems out of the system,” he said, pointing to high executive compensation and mergers for the sake of size as examples. “If these owners don’t want it to happen, it will not happen.”

“Renting” vs. owning The focus of investing has shifted from owning a stock, to “renting” it for six months, Bogle pointed out. Speculation has long been a part of the stock market, but aside from increasing volatility, speculators diminish the value of companies because they have no interest in governance issues.

Corporate executives and boards pander to these temporary shareholders because they make up the largest base of voters. Ironically, though, they seldom exercise their voting power. If institutional managers were held to a fiduciary duty to their clients, they would vote for more responsible corporate governance, and increase the long-term viability of the company.

Over the past 60 years, portfolio turnover rates have skyrocketed— going from an average of 20% per year to 100%, according to Bogle. Speculation not only cheapens the true value of the companies they trade in and out of, but it also diminishes the returns to the fund holder, as heavy trading activity racks up transaction costs.

“If you’re buying a company to get the intrinsic value of the business’s discounted cash-flow, governance is everything,” said Bogle. “Governance comes down to ‘is this business being run in the interest of the shareholder?'”

He added that no mutual fund in the U.S. has ever put forward a shareholder resolution that was opposed by the corporation’s management.

“If we could make institutional managers subject to a federal standard of fiduciary duty, one of the things that would have to come out of that would be observing your corporate governance responsibilities.”

The average asset-weighted MER was 0.60%, but that has now risen to 0.90%, despite the massive cost efficiencies conveyed by technology and economies of scale. These MERs now consume 70% of the investment income—interest and dividends—generated by the portfolio, Bogle said, mostly limiting the investor’s upside to capital appreciation.

But some good news has come from the financial crisis: it may drive the industry to restructure along lines that are closer to its past. The industry used to be based on stewardhip, Bogle pointed out, but today it is far more focused on salesmanship.

Under today’s prevalent public ownership model, the manager is forced to serve two masters: their investors, and the investors in the parent company. Bogle and Davis agreed that the interests of the employer inevitably trump those of the client. If Congress wants to clean up the financial services industry, Bogle said, it should ban financial conglomerates from mutual fund management.

Business or service The language of business has “infected” the profession of money management, according to Davis. This may seem like a reasonable state of affairs, but he pointed out that a professional should always be concerned with client outcomes, not the profitability of the profession.

Leaving asset management aside for a moment, who would a client trust more: a surgeon concerned with the profit margin and quantity of procedures they complete, or one that is more concerned with the patient’s survival?

That is not to say that profitability is a bad thing, but by focusing on client outcomes, the professional should see an improvement in their own business outcomes.

At present, Incentives in the industry are asymmetrical, since the manager is playing with other people’s money. They are compensated based on the assets they manage, so there is an incentive to take on more risk in order to grow that asset base. But greed must be balanced with fear, Davis says, which is better accomplished through the private partnership model. When the portfolio includes all of the manager’s liquid assets, they will be more careful.

The first rule of business is to give the customer what they want, Davis points out. This is antithetical to the first rule of a profession, which is to give the client what they need. Just as a doctor should advise against smoking, even though the patient enjoys his nicotine addiction, the role of the asset manager is to advise clients against foolish investments that tickle their fancy.

“My grandfather told me throughout my whole career that bonds are certificates of confiscation—and then we had a 30-year bull market in bonds, ” Davis said. “Now, the money’s pouring in, after the money’s been made, and that’s a perfect example of pushing people the way they want to go. It looks like low, risk-free returns, but I think it’s very, very dangerous.”

Today, a portfolio of global large cap stocks—Coke, Nestle, Proctor and Gamble, for example—has an earnings yield of 7 to 8%, which Davis points out is somewhat inflation protected, and dividend yields of 3% to 4% . Meanwhile, bonds are yielding between 3% and 4%.

“What’s amazing is that you have the biggest inflows into bond funds ever in the history of all mutual funds, of all classes—more money went into bonds in the last 12 months than has ever gone into any single asset class. That is a terrifying idea.

“I think the only real bubble in the world is bonds. They might be great for the next year or two, there may be deflation, but when you look out over a 10-year period, people are going to get killed.”

At the end of Henry Paulson’s run as Secretary of the Treasury, he released an annual report modeled after an annual corporate report, with financial statements, MD&A, footnotes and an auditors report.

“What you do when you get an annual report like that, is go to the pension footnote,” Davis said. “The pension footnote for our government balance sheet, the present value of unfunded liabilities is $42 trillion. That looks exactly like how General Motors looked in 2000, relative to equity, earnings and so on.

“The idea of financing that enterprise at 3% seems crazy to me, when I can get a 7% or 8% earnings yield on Coca-Cola, for heaven’s sake.”

(06/10/10)