The Wall Street rip off: fees and consequences.
An Interview with John Bogle
John Bogle is founder and retired CEO of the Vanguard Group--one of the two largest mutual funds in the world. Fortune magazine named him as one of the four "Investment Giants" of the 20th century; he was named one of the world's 100 most powerful and influential people by Time magazine; and Institutional Investor presented him with its Lifetime Achievement Award. He is the author of seven books, most recently Enough: True Measures of Money, Business, and Life.
Multinational Monitor: What's your complaint with the way the mutual fund industry operates?
John Bogle: It's a very simple complaint. Fund managers are in the business of gathering assets, all the better to maximize fees. It's a marketing business. It should not be a marketing business. It should be a business of stewardship. I've often said that we've let marketing triumph over management and salesmanship triumph over stewardship.
Stewardship means that the fund investor--not the manager--comes first, and that's not a principle we're really observing.
This is not to say that all fund managers are not trying to earn the best returns they can for their shareholders. Of course they are. But they're also trying to earn the best returns for other interests they represent, which is their management company.
Particularly in recent years, we've developed a whole new problem about management companies. Something like 40 of the largest 50 management companies are publicly held-either directly by the public or by giant financial conglomerates. And it doesn't take some leap of cynicism to realize that when a big international financial conglomerate buys a mutual fund management company for a couple billion dollars, they're interested in increasing the return on their capital, not the return on your capital. Those two interests are in direct conflict.
As a group, all investors inevitably capture the total market return. These investors are trading with one another--competing with one another--and if one wins, the other loses. So they all capture the market return before costs [fees and trading expenses] and lose the market return after costs.
To me, it is a tragedy that we can't recognize that taking cost out of the system is absolutely essential.
MM: What's the difference between the mutual fund and the management company? How do they interrelate?
Bogle: Typically, and this has not always been the case, an entrepreneur gets together some capital and starts a line of mutual funds. He picks their directors, he keeps them in compliance, and he gets paid an annual fee for doing that. Usually that fee is specified as a percentage of assets--maybe 1.5 percent of assets, maybe 0.75 percent of assets, sometimes the fee scales down as assets rise. At the outset of this industry, we had small asset management companies managed by professional investors and owned by private individuals.
This gradually developed into an industry where that same management company has been bought from its original owners, maybe by an international financial conglomerate, maybe a U.S. bank, maybe a Canadian insurance company. They're not investment professionals by and large; they are large institutions looking for high returns.
The problem is a very simple one, and it's written in the Holy Bible: No man can serve two masters. The directors of the funds are pretty much chosen by the management companies. They're trying to serve the interests of the fund shareholders--people who have invested in the mutual fund--but their prime interest is to serve the shareholders in the management company. They have a fiduciary duty to both of these groups. So which one has the high priority?
If the fees were reduced sharply, the beneficiary would be the mutual fund investor--the shareholder. If they were increased or left at too high levels, the beneficiary would be the public owners of that management company.
MM: Presumably the management company that's charging a high fee argues that they're bringing some high value added, that they've got some special insights into the way the market works, and they're going to give the mutual fund investors a greater return.
Bogle: Yes, and that's absurd when you examine the historical record. And it's absurd to think it could happen in the future even if it has happened in the past. We all think we're smarter than the average, we all think we're better drivers than the average, I've often observed that we probably all think we're better lovers than the average. But as a group, we're all average. And these managers are all average, until you take out their costs. If a manager has a little hot streak, he's going to claim, "I can beat the market." But the fact of the matter is, over time, mutual fund managers as a group lose to the market. And the other fact of the matter is, if you beat the market for a while, the odds are very powerful you'll revert to the market mean, less costs. So, you'll fall below the market.
We know--we know, we don't guess--that an index fund that invests in all stocks, let's say in this case all U.S. stocks, and holds them for ever, will have a huge advantage over the average actively managed fund largely because of costs. The index fund has maybe a tenth of 1 percent total costs. It has almost no transaction costs--it's not trading all the time like other mutual funds do. It is very cash efficient because it pays very little in the way of capital gains taxes because it's a non-trader. The actively managed funds, compared to that tenth of 1 percent, probably have an average fee of somewhere between 0.8 percent and 1.2 percent. Add to that transaction costs--hidden and undisclosed, but clearly existing--of somewhere between 0.5 percent and 1 percent a year, because they turn over fund portfolios almost 100 percent a year. And three, if you have a sales load in your mutual fund of 5 percent and investors hold it for five years, which is the average holding period for an equity fund investor, there's another 1 percent a year. And even if they hold it for 10 years, that's another 0.5 percent a year. So you can easily get costs in the range of 2.5 percent, compared to a no-load, low-cost, no-trading index fund of a tenth of 1 percent. That's 25 times as much cost. So, of course, the low cost funds win. In addition, the record shows quite clearly--we don't know so much about the future here, but we can measure the past--that actively managed mutual funds have about a 2 percent tax disadvantage relative to indexed funds.
MM: For people who are not investors, or even for people who are, you're saying the numbers are 10, 20 times more expensive, but they hear the number 2 percent and ask, what's the big deal? So, what is the big deal?
Bogle: The big deal is this: If you look at the issue short-term, 2.5 percent costs, in, say, a 7 percent market, is consuming one third of your return. And if the market is at 10 percent return, 2.5 will be consuming 25 percent of it.
What seems inconsequential over the short term becomes profoundly important over the long term. Let's assume we have a market return of 8 percent, and you reinvest all of your earnings. At the end of 50 years, the dollar you invested is worth $46.90. Now, let's assume we take 2.5 percent in fees out of the 8 percent return. Your return drops to 5.5 percent. At the end of 50 years that dollar grows to $14.54. So, if you can get costs out of the system, you can turn $14.54 into $46.90. Just imagine that. What we're talking about is with all of the expenses, you, the investor, put 100 percent of the capital up, you're taking 100 percent of the risk, and you're capturing, in very round numbers, 30 percent of the return. The financial system puts up none of the capital, takes none of the risk, and still captures 70 percent of the return that's there for the taking.
If everyone understood that, there would be an investment revolution in this country. It's a fact. There's no arguing it. We all know about the miracle of compounding returns. Just think of it: a dollar growing to $46.90. But none of us, or almost none of us unless they're Bogle-heads, are aware of the fact that the miracle of compounding returns over the long-term is overwhelmed by the tyranny of compounding cost over the long term. That's why that $46.90 dwindles down to $14.54.
It's short-term thinking, it's economic illiteracy, and it's also information asymmetry. This is an industry that depends on marketing and sales. We advertise high performing funds-this is really the disgraceful part that gets me angry just to think about it--knowing full well that the records we are advertising will not be repeated. That's a disgrace. We advertise, and we have a little footnote that says this may or may not be a reliable indicator of the future, or something like that, and we think we're relieved of responsibility for pumping up performance. But I don't believe that. I think it's unethical.
MM: You make a related point about the social consequences of speculation versus long-term investing.
Bogle: I'll give you a simple example to make it clear. There are 500 stocks in the S&P 500 today. Let's say that half of those stocks are held by investors who don't trade, and the other half of all those shares are held by speculators who trade, but inevitably trade only with each other. So the investors capture the market return as a group. The speculators capture the market return as a group because they own the same stocks, but they lose because they and their intermediaries are trading back and forth with one another. The speculators capture that S&P return less all those costs. So there is a social cost to that. It greatly damages the retirement savings of Americans. That's cost number one.
Cost number two is, when you have lower returns, the great temptation is to swing for the fences to get higher returns, which is one of the worst things you can do, because you're loading up on risk.
The third cost is the social costs of the mutual fund industry being a rent-a-stock industry rather than an own-a-stock industry. Because if you're renting a stock for a while--and that's one way to look at this speculative market--you don't care how the company is governed, you don't care what the directors are doing about executive compensation. If you're a speculator, you only care about short-term changes in the price of the stock.
If you're a long-term investor, you want to know what's going on in that company. You care about how it's governed, you want to be sure those directors are forcing the management of the companies to put the interests of the shareholders before their own personal and pecuniary interests. You're not in favor of some merger that will hike earnings over a short period of time, but hurt in the long run. You're not in favor of putting a lot less money in the pension plan so your earnings go up this year, leaving your successor in five or 10 years in a deep hole with an underfunded pension plan. You want to look at the investment as a long-term investment.
We all know, or should know, that there's one fundamental truth in investing: The value of any investment today is the discounted value of its cash flow in the future. Put another way: You may think a company is going to grow at 10 or 12 percent for a few years and gradually dwindle down for the rest of its existence, to maybe a 6 percent return on capital. You put that all in a formula and you discount it back to the current cost of capital, let's say 4 percent, and that's the value of the company. So, if you sell a stock, you sell because you want to capitalize on the value of that future cash flow. If you buy a stock, you want to own the right to that future cash flow. That's what securities markets are about: to enable those buyers and sellers to meet on reasonable terms. But future cash flow seems to be something we rarely look at, if ever, and that's a big oversight because we're so focused on the short term.
To make matters amusing, the speculators are not really first order speculators, they're second order speculators. If you see bad news in the market and the market tumbles, that's because a whole lot of speculators are selling. However, these early sellers aren't selling because they think the news will cause stocks to go down. They're selling because they think the news will cause other investors to think stocks will go down. They're trying to anticipate expectations.
Does all of this make you think about Las Vegas? With people swapping money back and forth and the house winning? Of course it does. Does it remind you of the race track where all that money comes in from the betters and goes out at the end of each race, except that the race track keeps itself a handle? Or does it remind you of a state lottery? The numbers are enormous if you win. The odds against winning are enormous. But the real winner is the state.
Wall Street has become casino capitalism in which the croupiers are getting too damn much money. Last time we calculated this, it's less now, the croupiers were taking something like $520 billion a year out of the financial markets with all this trading and money management. That's right out of our pocket.
MM: Is that the figure just from trading, or the overall financial sector profits?
Bogle: We actually didn't try and do it that way. What we did was make calculations based on the assets of mutual funds and the fee structure of mutual funds. Total expenses turn out to be around $75 billion or $85 billion. We then go to brokerage or trading firms--investment banking firms--and we look at their revenues. When you take out the interest they pay back and forth to each other, that turns out to be a number around $300 billion a year. And we take hedge fund managers, who are probably making about 4 percent on hedge funds, maybe 3 percent. If they're running around $4 trillion, just 3 percent of that would be $120 million. Annuities are another cost. We just aggregate those costs. It's not my job, I don't think, to do this scientifically. We should get some good academic to do it, but I haven't been able to find anyone to do it yet.
It's a good estimate of costs. I'd be happy if someone comes up with another estimate and says, "Look, Bogle, you're wrong. It's 'only' $400 billion." Costs are going down now. Fees are going down in this down market. We don't really know how much it will come down, but $520 billion or $530 billion is simply unsustainable.
Think about this: The stock market is valued now at about $9 trillion, down from $18 trillion. Let's say that expenses are $400 billion a year for the equity portion of the money management trading casino. Over 10 years, that's $4 trillion in expenses in a stock market that's worth $9 trillion. It's just plain shocking that that much wealth is confiscated by those who are taking advantage of those who are putting up the capital.
MM: You talked about finance being too big. What's your perspective on the size of the financial sector to the rest of the economy?
Bogle: In 2007, the financial industry's share of overall corporate profits rose to 27 percent, up from 5 percent 10 to 15 years earlier. It was much more than that because we didn't count the financial arms of General Motors, Ford and Chrysler, or General Electric, even though over half of General Electric's revenues came from its financial group. So it's easy to say in 2007 something around a third of the profitability of American business came out of finance, up from 5 percent or 6 percent a decade or 15 years before.
This business that detracts value from our society was the fastest growing and largest sector of our society. The financial sector made more than two of the most profitable sectors in our society together--healthcare and technology--and many times as much as our manufacturing companies.
MM: One of the chapters in your book is "Too much complexity, not enough simplicity." What does simplicity mean in the financial context and why is it important?
Bogle: With the example I gave you of half the people owning stocks and trading them, that would be a complexity. The half of the investors owning the total market in an index fund and not trading them represents simplicity--and it's quite clear that simplicity wins.
Part of the problem with complexity is it costs money, and part of the virtue of simplicity is it doesn't cost money.
Complexity also leads to uninformed investors because of information asymmetry. The seller always knows more than the buyer. Some fast-talking investment banker comes in with some new credit default swap, some new structured investment vehicle, some new way of breaking the link between borrower and lender, some securitization, some collateralized debt obligations, and he shows you how to get an extra return without any extra risk. First of all, anyone who believes you can get extra return without any extra risk is a damn fool because that's part of the package. But they don't need to tell you that and they don't tell you that. So, we have a much larger share of the market that can't understand what they're doing.
You might think as a logical person, they'd say, "If I can't understand it, I'm not going to buy it." In fact, that was my unfailing rule when I ran Vanguard. When people came in to propose all kinds of new types of funds to us, that was my definitive answer: If I can't understand it, we're not going to do it. Happily, I don't have a giant brain, so that means I've really got to focus on simplicity. I think that saved our shareholders an awful lot of money.
Sellers have a huge financial incentive to sell these new things because they get paid a lot of money. The buyer doesn't really know how much the seller is getting, but the seller sure does. If you combine a seller with an information advantage and a substantial financial incentive, you can see why selling pressure overwhelms the buyers' understanding. You might say people shouldn't accept that, but somehow they do.
Let me give you one example out of the Madoff case. There's a firm called Fairfield Greenwich. Apparently, without disclosing who was managing the money, Fairfield Greenwich put an awful lot of their clients' money into the Madoff Ponzi scheme. Between 2005 and 2008, Fairfield Greenwich was paid $400 million in fees for investing that money with Madoff. They pointed their finger and said, "You're money is going here," and that was worth $400 million. Nearly a half a billion dollars in a short period for just saying, "Let him do the work." How could they resist putting their money with Madoff?
MM: In light of this analysis, do you think that tighter restrictions on leverage--the use of borrowed money--are appropriate?
Bogle: Absolutely. Of course, we now mix banks and investment banks because of the stupid vote to repeal the Glass-Steagall Act. But investment banking firms were once private partnerships, and those partnerships were the ones who put up the capital; it was their money. They had unlimited personal liability, and believe me, they would make sure the quality of assets in their balance sheets was high. They wouldn't have a 40-to-1 leverage ratio because their own money was at stake. We've lost the link between investing people's money the way that one would invest one's own. You see the results everywhere.
MM: Do you have any thoughts about a new regulatory regime for financial derivatives?
Bogle: First, we have to have disclosure. We've got to have transaction disclosure, we've got to have counterparty disclosure, we've got to have volume disclosure, regulated by the SEC. How anyone can say that the S&P future has more in common with pork bellies [futures of which are regulated by the Commodities Futures Trading Commission] than it does with the S&P 500 index, has got to be the stupidest thing that you've ever heard. It turns out, by the way, at least by recent data, that while the value of the S&P is now $9 trillion, there are probably $18 trillion of S&P futures stocks that are outstanding. The tail is larger than the dog by a factor of two. Imagine how grotesque your pet would look.
MM: Besides transparency, do you think some of these instruments should be prohibited or require prior approval?
Bogle: I think we ought to go about that very carefully. I think there are some instruments that are so dangerous that their risks cannot be disclosed away. But failing that, I think sunlight is almost always the best remedy. I'm not an inherent believer in more regulation. I'm really a believer in less regulation, although we've got to have more regulation now. I never realized human behavior would be so bad. We do need some kind of limitations.
In our society and in our economy, we think of innovation as an almost unmixed blessing. Innovation brought us bar codes, EZ passes, the Internet, on and on. The unfettered price competition you get through the Internet has certainly been terrific for consumers. But in the financial field, I wonder if we haven't had enough innovation, because innovation takes place basically to benefit the innovator, not the buyer or user of the innovation. People make a lot of commission on CDSs, on CDOs, and other obscure financial instruments. And the users of them lost a lot of money. That strikes me as not a very good credential for an ethical system that ultimately has to be based on trust. We can't say, there will be no more innovation here. But we can say that it ought to be demonstrated somewhere along the way that this innovation will benefit the persons that use the innovation and not just the marketer of the innovation.
Warren Buffett has this wonderful saying that every new idea goes through three stages: first the innovator, second the imitator, and third the idiot. So this thing spreads like a virus around the land and the last people that get in really lose money.
MM: What do you think about a financial transactions tax to slow speculation?
Bogle: I love it. It's going to be very hard to get, but I love it. The financial institutions that control 75 percent of all stocks are tax free. Pension funds are tax free. Mutual funds are about half tax-deferred, but the other half is run by managers who pay no attention to taxes. So we've got these two giant industries basically operating without any frictional costs when they trade stocks back and forth. The tax costs to traders are basically zero, and the commission costs are half a penny a share or something like that. So we've taken the frictional costs out and that helps explain why we've had this orgy of speculation. No question about that.
So I like the idea of a transaction cost.
I also like the idea of a capital gains tax on very short-term capital gains, applied whether you're a tax exempt institution or not. In other words, a pension fund would be subject to that tax just like an individual investor.
In 1929, the turnover was about 145 percent in the stock exchange. It was about 25 percent, believe it or not, my first 15 or 20 years in this business. Last year, it was 350 percent. That's an orgy of speculation we've never seen before. If the idea of a transaction cost or a tax on short term capital gains is to cut back on that transaction volume, then it wouldn't produce much revenue, but it would succeed in its primary goal of reducing those costs.
When you think about it, we have an industry whose raison d'etre is to sic one investor on another and say, "You can take advantage of that guy." That's what the market is. If you sell, you're trying to take advantage of the buyer. You think you're smarter than he is and vice versa. By pitting one investor against another and having that croupier in the middle, which is apparently necessary for the transaction to take place, you ensure that investing is a loser's game. If investors acted in the community interest, that is, by owning the market, which they own anyway, and not trading, it would be a winner's game. So by doing what is best for society, our investors would end up being winners rather than losers.
MM: You talk at some length about executive compensation and how that's gone awry and creates wrong incentives. Do you feel that "say on pay" is an adequate solution or would you like to see a mandatory overall cap on executive compensation or maybe, especially in the financial sector, some requirement that incentive compensation be linked to long-term performance?
Bogle: The conversation about executive pay is just absurd. Going back to 1980 in five year increments, executives have been predicting earnings growth of 11 percent a year and delivering 6 percent. We know that executives as a group shouldn't get any incentives for failing. There has to be some accomplishment above average before you get paid a bonus. It has to be based on performance and not peers. We've been handed a real bill of goods by our compensation consultants who put everybody in quartiles. It's the nature of the system that the directors of companies whose executives are paid in the lowest quartile say that "our man or woman is good so we're going to move him or her up to the second quartile." And guess what happens? Somebody else falls into the fourth quartile. There's no way around it. So then the process goes on again.
What is value for shareholders? Let's start with what it is not: It is not the price of your stock. It may look like it, but over the long run your price of stock gets way ahead of the intrinsic value of the company--which is good for sellers and bad for buyers--or the price of the stock gets well below the intrinsic value of the company, which is good for buyers and bad for sellers. There's no way around that, just read the great Buffett on that point. It's just the totality again.
What matters for shareholders is creating intrinsic value over the long run. It's intrinsic value as compared to stock prices, and it's the long run instead of the short run. That kind of a rule--based on long-term accomplishment, if you leave the company you keep your shares, you don't get paid all at once every year, you don't get paid for short-term earnings--would help deliver real value for shareholders. Executives certainly should not get paid for stock prices--which is how every option plan in America is built. Stock prices are a terrible indication of corporate value in the short run, but as I mentioned, a perfect indicator of the long run, if you're around for the long run.
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|Title Annotation:||John Bogle|
|Date:||May 1, 2009|
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