U.S. index fund founder blasts mutual fund shift from stewardship to marketing

(January 15, 2003) John Bogle, founder of Vanguard Group, one of the largest U.S. mutual fund companies and a pioneer in index investing, thinks the fund industry has changed for the worse since he first began following it in 1949. Most notably, he feels that U.S. mutual funds have moved from stewardship to salesmanship, with a focus on short-term performance and generating profits for fund company owners that ill serves investors.

Bogle, who was speaking yesterday before the Boston Security Analysts Society, ticked off a number of areas that have changed in the past half-century. Above all, he sees a tide of entrepreneuralism that dates back to the mid-1950s, when investment management companies were allowed to go public.

Other aspects of that trend include rising fund management fees and a profusion of funds that follow investment fashions. As a result, where from 1950 to 1970 mutual funds delivered 87% of the returns of the market indexes to investors, they now deliver only 76%, a decline Bogle attributes largely to higher fund operating and trading costs.

Average investor earns only 2%

While funds are capturing less of the market gains, individual investors are less likely to do as well as the funds they own because their attention, too, has been diverted to short-term profits. They buy when funds are performing, investing too much when stocks are in favour, and contrariwise, investing too little when stocks represent good values. Thus, the average fund has earned 10% annually over the past two decades, compared to an S&P 500 return of 13%, but the average investor has only earned 2%.

Since he began tracking the mutual fund industry in 1949, Bogle notes that the number of funds has risen from 137 to 8,300, far more funds than there are stocks on the New York Stock Exchange. Instead of being diversified blue-chip funds, most funds now focus on a specific investment style or economic sector, a trend that has also extended to index funds, "the antithesis of their diversified forebears," Bogle says. Investors have more choice than they need.

Another trend that has altered the investment industry for the worse, Bogle says, is the replacement of "stodgy, consensus-oriented" investment committees with star portfolio managers. While some managers did become enduring stock pickers, "most proved to be comets, illuminating the fund firmament for a moment in time and then flaming out, their ashes floating gently down to earth," Bogle says.

Turnover now more than 100%

The emphasis on star managers taking more risks to bolster short-term performance has been reflected in much higher portfolio turnover. Until the mid-1960s, Bogle notes, "it was a rare year when fund portfolio turnover much exceeded 16%, meaning that the average fund held its average stock for an average of about six years." Now, he suggests, the holding period has dwindled to 11 months, with annual turnover at 110%. As a result, the mutual fund industry "has moved from investment to speculation," Bogle says, and "mutual fund managers are no longer stock owners. They are stock traders, as far away as we can possibly be from investing for investment icon Warren Buffet’s favourite holding period: Forever."

With such short holding periods, Bogle adds, it’s virtually impossible for funds to assert any kind of critical role in holding company management to account, even though they now own a much larger share of corporate America than they did in the 1950s. Consequently, "they bear no small share of the responsibility for the failures in corporate governance and accounting oversight that were among the major forces creating the recent stock market bubble and the bear market that followed."

Investors follow industry’s lead into short-termism In the 1950s, Bogle says, investors were likely to hold their shares for 16 years. "Like the managers of the funds they held, fund owners were investing for the long pull," he explains. The holding period is now less than two years, a trend abetted by fund companies that make it easier to switch among funds. While those trades appear to be free, Bogle argues that the costs actually come out of the management fees.

Management fees are a major Bogle target. Though the industry says fees have come down, Bogle argues that there are hidden fees, such as portfolio transaction costs, trailer fees and opportunity costs that stem from not being fully invested. Moreover, the incentive for entrepreneurial companies is to increase fees by increasing market share by adding new funds. While investors might seem fickle, the industry has contributed by rolling out sector funds in response to the tech bubble. "Many of the most respected firms in the industry," Bogle says, "abandoned their investment discipline, formed speculative funds, and offered them to their clients."

By advertising high-performing funds — Bogle mentions that in one issue of Money magazine, the 44 funds advertised had an average return of 85% — the fund companies brought in lots of new money. But performance has proven a double-edged sword, since most investors bought too late to capture the gains a fund might have registered over the full market cycle. The result, says Bogle, "is not irrational exuberance, but rational disenchantment that permeates the community of fund owners, many of whom, unaware that the great party was almost over and that a sobering hangover lay ahead, imbibed far too heavily at the punch bowl."

Fund mortality

Those tech funds now have a very high rate of attrition. "Fund deaths began to match, and will surely soon exceed fund births," Bogle argues, because, unlike the funds of the 1950s, these were not "built to last." Then, 99% of funds were around from one year to the next, and 90% from one decade to the next. Now, the failure rate for funds that are discontinued or merged is 50%.

"We have put aside our professional judgment and formed new funds when the investing public demanded them, and, when they outlive their usefulness or lose their performance luster, we give them a decent burial," Bogle says.

With both investors and fund companies suffering from the aftermath of the bubble, Bogle says it’s time "to put mutual fund shareholders back in the driver’s seat."

"We must return to our focus on broadly diversified funds with sound policies, sensible strategies, long-term horizons and minimal costs," he adds. To do that would require fund companies to reduce management fees and sales commissions, "to increase the portion of the stock market’s return earned by our funds."

But it would also mean "taking our foot off the marketing pedal and pressing our foot down firmly on the stewardship pedal, giving the investor better information about asset allocation, fund selection, risks, potential returns and costs, all with complete candour." That, he says, might "enhance the share of our fund returns earned by our own shareholders."

---

Is Bogle right on the money with his assessment of the changes in the mutual fund industry over the past 50+ years? Should mutual funds change their approach back, in your opinion? Share your views in the “Mutual Funds and Other Products” forum of the Talvest Town Hall on Advisor.ca.

Filed by Scot Blythe, Advisor.ca, sblythe@advisor.ca.

(01/15/03)