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The Battle for the Soul of Capitalism.

The Battle For The Soul Of Capitalism

By John C. Bogle. 2005. New Haven, CT, and London: Yale University Press. Pp. 260, $25, hardcover.

John Bogle is the ultimate critie of the U.S. business scene. The long-time CEO of the Vanguard Group, third-largest U.S. institutional money manager with holdings in excess of $400 billion, has all the credentials, contacts, and honors anybody would desire while enjoying retirement in his 70s. Yet, here he is telling us that capitalism has lost its way during the past generation and setting out to offer corrective steps that will not endear him to his colleagues.

His criticism comes under three main headings. First, control of capital has changed from owners to managers, whose interest is their own aggrandizement rather than the enhancement of owners' equity. Total pay of the average CEO has jumped from 42 times the average worker's pay in 1980 to 280 times in 2004. The invention of earnings "guidance and management" has led to accounting manipulations and outright fraud as regulators, and above all boards of directors, have failed in their supervisory and control duties.

Second, the investment process has been altered and distorted by institutionalization of equity ownership. In just 15 years, 1990 to 2004, the institutional holdings of equities have risen from 53 to 66 percent while direct individual holdings have declined correspondingly. The top 100 managers alone now hold 52 percent of the outstanding equities. (These facts are of course compatible with the rise of individual share ownership, which now stands at about 50 percent of the population in the periodic asset surveys of the Federal Reserve. Individuals are credited with indirect holdings through mutual funds and defined-contribution pension plans.)

The problems in the investment process described in Chapters 4-6 basically relate to the passivity of institutions toward the management of the enterprises they own in a fiduciary capacity.
 With very few exceptions, the only sound we've heard from our
 investment institutions in response to ... ethical and financial
 aberrations is the sound of silence (pp. 76).

The silence in turn is caused by the prevalence of conflicts of interest among institutional stockholders. Thus, investment banks often exaggerate the attractiveness of additional public offerings of companies whose securities they hold in their asset management departments. Objective evaluation of stocks and bonds held on behalf of pension and mutual fund clients is suppressed.

The third major section deals with John Bogle's home territory, mutual funds. During 1985-2004, the annual return on the S & P 500 averaged 13.2 percent, but only 10.4 percent for mutual funds as a group. The 2.8 percentage point difference is accounted for by fund charges. There is an almost perfect negative correlation between costs and net yields. Furthermore, the almost universal catering to changing fads in the timing and selection of new funds creates double jeopardy for investors, as "new economy " stocks are far more risky than established equities. The average return to actual mutual fund investors is even less than what can be explained by costs.

The fault lies with the emphasis on managers' earnings rather than shareholder return in mutual fund administration. Fees rise as assets grow so that enlargement of the funds through salesmanship becomes more important than the return flowing through to the owners. The hiring of outside managers to run funds reinforces the misplaced emphasis on administrators' and salesmen's income. In all of this, the stark contrast between the average mutual fund and Vanguard's low-cost offerings helps illustrate what's wrong. The possibility, since a court decision in the late 1950s, to buy and sell the stock of fund management companies--and the subsequent boom in such stocks--shows where money is made.

Throughout this recital, John Bogle cites the numerous illustrations of capitalism gone astray that have become apparent in recent years. If you haven't heard enough yet of Ken Lay and Jeffrey Skilling of Enron, Bernard Ebbers of World Com, Bill Esrey of Sprint, Dennis Kozlowski of Tyco, and more of their ilk, Bogle will treat you to a succinct summary of their sins. The flaws in the investment process are highlighted by the tales of Henry Blodget of Merrill Lynch, Jack Grubman of Salomon Smith Barney, and Frank Quattrone of Credit Suisse First Boston. As to mutual funds, their "governance structure ... is a study of institutionalized conflict of interest" (pp.194, approvingly quoted by Bogle from a statement by Senator Peter Fitzgerald of Illinois).

To his great credit, Bogle does not shy away from corrective suggestions. Their essence is simply a return to basics. Regarding corporations, the Report in 2002 of the Conference Board's Commission on Public Trust and Private Enterprise is endorsed--emphasize long-term performance in executive compensation; the directors' nominating/governance committee should be independent of management; audit standards should be tightened. (Bogle adds recommendations on options and on strengthening board supervision of management.) The main recommendation on the investment side is the mobilization of institutional shareholders in demands on management--divide board chairman and CEO duties, vote against dilutive stock options plans, endorse SEC proposals to ease the exercise of shareholder rights in director elections. As to mutual funds, a return to the principles of the Investment Company Act of 1940 will do. The fiduciary standards of the Act should have ruled out, from the beginning, the abuses of late trading, soft-dollar handouts, and excessive management fees.

This brief summary cannot do justice to John Bogle's mastery of financial intricacies, his detailed prescriptions, and, above all, his realistic idealism, so unusual for a "member of the establishment." To be sure, he is too ready to generalize from specific misdeeds, and his prescriptions cannot cure avarice and disregard of ethical and legal limits. Yet he speaks loudly and clearly to our fears regarding the deterioration of the cultural and social climate in our financial markets. This book is must reading.

Francis H. Schott


Ridgewood, NJ
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Author:Schott, Francis H.
Publication:Business Economics
Article Type:Book review
Date:Apr 1, 2006
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