六十年后的共同基金行业：更好还是更糟？

The Mutual Fund Industry 60 Years Later:

For Better or Worse?

John C. Bogle

Over the course of the past 60 years, the mutual fund industry has undergone tremendous change. In 1945, it was a tiny industry offering a relative handful of funds—largely diversified equity and balanced funds. As 2005 begins, it is a multi-trillion-dollar titan offering thousands of funds with a dizzying array of investment policies and strategies. I have been actively engaged in this field since 1949—fully 55 years of the Financial Analyst Journal’s 60-year existence—when I researched and wrote my Princeton University senior thesis about mutual funds. In the aggregate, I have spent my entire career in the mutual fund industry. The staggering increase in the size of the industry and the huge expansion in the number and types of funds are but the obvious the fundamental manifestations of the radical changes in the mutual fund industry. It has also undergone a multifaceted change in character. In 1945, it was changes in the an industry engaged primarily in the profession of serving investors and striving to meet the standards of the recently enacted Investment mutual fund Company Act of 1940, which established the policy that funds must be “organized, operated, and managed” in the interests of their shareholders rather than in the interests of their managers and distributors. industry during the It was an industry that focused primarily on stewardship. Today, in contrast, the industry is a vast and highly successful marketing busipast 60 years have ness, an industry focused primarily on salesmanship. As countless independent commentators have observed, asset gathering has benefited mutual become the fund industry’s driving force. Beneath the surface of this broad change lie numerous specific fund managers, not developments. This essay reviews 10 of the major changes that have taken place in the mutual fund industry during the past 60 years, and then evaluates the impact of those changes, not only on the returns mutual fund earned by the mutual funds themselves, but on the returns earned by their investors. investors. 1. Bigger, More Varied, and More Numerous The mutual fund industry has become a giant. 1 From a base of $882 million at the beginning of 1945, fund assets soared to $7.5 trillion in 2004, a compound annual growth rate of 16 percent. If the industry had merely matched the 7 percent nominal growth rate of our economy, assets would be only $50 billion today. (Such is the magic of

John C. Bogle is president of the Vanguard Group’s Bogle Financial Markets Research Center. Editor’s Note: Mr. Bogle, whose Princeton University thesis was titled “The Economic Role of the Investment Company,” joined Wellington Management Company in 1951 and led it from 1965 until 1974. He founded The Vanguard Group in 1974 and served as its CEO until 1996 and as senior chairman until 2000. The opinions expressed in this article do not necessarily represent the views of Vanguard’s present management.

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compounding!) In 1945, 90 percent of industry only directly by investors but also in individual assets were represented by stock funds and stock- retirement accounts and in profit-sharing and oriented balanced funds. Today, such funds com- employee savings plans. Assets in these taxpose about 57 percent of industry assets. Bond funds deferred plans today total $2.7 trillion, or nearly 40 now represent 17 percent of assets, and money mar- percent of industry assets. 2 ket funds—dating back only to 1970—constitute the remaining 26 percent. So, what was once an equity 2. Stock Funds: To the Four fund industry now spans all three broad categories Corners of the Earth of marketable securities—stocks, bonds, and money market instruments. This change has been a boon to Stock funds remain the industry’s backbone and fund investors as well as to fund managers. driving force and are the principal focus of this As Table 1 shows, the number of funds has historical review. As their number soared, so did also exploded. The 68 mutual funds of yesteryear the variety of objectives and policies they follow. As have multiplied to today’s nearly 8,200 total, and Table 2 shows, in 1945, the stock fund sector was they offer investment objectives and policies dominated by funds that invested largely in highly designed to meet almost any imaginable invest- diversified portfolios of U.S. corporations with large market capitalizations and with volatility ment goal. As funds have become, overwhelm- roughly commensurate with that of the stock maringly, the investment of choice for our nation’s ket itself. Today, such middle-of-the-road funds are families, fund choice, fund selection, and asset allo- a distinct minority, and most other categories entail cation have become the watchwords of today’s higher risks. Only 579 of the 4,200 stock funds mutual fund industry. measured by Morningstar now closely resemble The vehicles through which mutual funds are their widely diversified blue-chip ancestors. 3 purchased have also changed. Funds are the under- What’s more, the industry now also boasts 455 lying securities in variable annuities and, thanks to specialized funds focused on narrow industry favorable federal tax legislation, are now held not segments—from technology to telecommunications

Table 1. The Mutual Fund Industry: Growth in Funds and Assets 1945 2004 Number Assets Number Assets Type of Fund of funds (millions) a of funds (billions) Stock/hybrid funds 49 $794.0 5,100 $4,266.9 Bond funds 19 88.0 2,100 1,246.8 Money market funds 0 — 970 1,962.2 Total 68 $882.0 8,170 $7,475.9 a Total assets of stock funds in 1945 estimated as 90 percent of industry total. Source: Wiesenberger and Investment Company Institute.

Table 2. Stock Funds: Number and Type 1945 2004 a Category No. of Funds % of Total No. of Funds % of Total U.S. large-cap blend 38 77% 579 14% Other U.S. diversified equity 0 — 2,484 59 Specialized 11 23 455 11 International 0 — 686 16 Total 49 100% 4,204 100% a Includes all equity funds covered by Morningstar. Source: Wiesenberger and Morningstar.

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(these two groups were particular favorites during the late stock market bubble). Some 686 international funds run the gamut from diversified funds owning shares of companies all over the globe to highly specialized funds focusing on particular nations, such as China, Russia, or Israel. Sixty years ago, an investor could have thrown a dart at a broad listing of stock funds and had three chances out of four of picking a fund whose return was apt to closely parallel that of the U.S. stock market. Today, that investor has just one chance out of seven. For better or worse, the selection of mutual funds has become an art form. Indeed, it is fair to say that choosing a mutual fund has come to require the same assiduous analysis as selecting an individual common stock. Indeed, most investors now hold portfolios of funds rather than yesteryear’s portfolios of stocks. 4 One curious counterpoint to this trend is worth noting. Unmanaged index funds essentially representing the entire U.S. stock market (through the Wilshire Total Stock Market Index or the S&P Composite Stock Price Index) did not enter the field until 1975, but they have accounted for more than onethird of equity fund cash inflow since 2000 and now represent fully one-seventh of equity fund assets. 5 Such funds may be said to provide the nth degree of diversification.

3. Investment Committee to Portfolio Manager The vast changes in fund objectives and policies have been accompanied by equally vast changes in how mutual funds are managed. In 1945, the major funds were managed almost entirely by investment committees. But the demonstrated wisdom of the collective was soon overwhelmed by the perceived brilliance of the individual. The Go-Go Era of the mid-1960s and the recent so-called New Economy bubble brought us hundreds of ferociously aggressive “performance funds,” and the new game seemed to call for free-wheeling individual talent. The term “investment committee” virtually vanished, and the “portfolio manager” gradually became the industry standard, the model for some 3,387 of the 4,194 stock funds currently listed in Morningstar, as Table 3 reports. (“Management teams,” often portfolios overseen by multiple managers, are said to run the other 807 funds.) The coming of the age of the portfolio manager, whose tenure lasted only as long as the individual

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Table 3. Equity Fund Management Modes Type 1945 2004 Committee 47 0 Single portfolio manager 2 3,387 Management team 0 807 Total 50 4,194 Note: No management form was listed for 10 funds in 2004. Source: Wiesenberger and Morningstar.

produced superior performance, moved fund management from the stodgy old consensus-oriented investment committee to a more entrepreneurial, free-form, aggressive (and less risk-averse) investment approach. Before long, moreover, the managers with the hottest short-term records were publicized by their firms and, with the cooperation of the media, turned into “stars.” A full-fledged star system gradually came to pass. A few portfolio managers actually were stars—Fidelity Investment’s Peter Lynch, Vanguard’s John Neff, Legg Mason’s Bill Miller, for example—but most proved to be comets, illuminating the fund firmament for but a moment before flaming out. Even after the devastation of the recent bear market and the stunning fact that the average manager now lasts for only five years, the portfolio manager system remains largely intact. The continuity provided by the earlier investment committee is but a memory.

4. Investment or Speculation? Together, the coming of more aggressive funds, the burgeoning emphasis on short-term performance, and the move from investment committee to portfolio manager had a profound impact on mutual fund investment strategies, most obviously in soaring portfolio turnover—as shown in Table 4. In 1945, mutual fund managers did not talk about long-term investing; they simply did it. That’s what trusteeship is all about. But over the next 60 years, that basic tenet was turned on its head and shortterm speculation became the order of the day. Not that the long-term focus did not resist change. Indeed, between 1945 and 1965, annual portfolio turnover averaged a steady 17 percent, suggesting that the average fund held its average stock for about six years. But turnover then rose steadily; fund managers now turn their portfolios over at an average rate of 110 percent annually. Result: Compared with the six-year standard that

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Table 4. Equity Fund Portfolio Turnover Rates Year Rate 1945 24% (est.) 1950 25 1955 14 1960 14 1965 20 1970 39 1975 36 1980 51 1985 83 1990 90 1995 77 2000 108 2003 110 2004 a 112% Note: Turnover is the lesser of portfolio sources or sales as a percentage of fund assets. a 2004 data are for all funds that had reported as of 31 October. Sources: For 1945–1987, Investment Company Institute, based on industry aggregates. For 1988–2004, Morningstar, based on turnover of average equity fund.

prevailed for some two decades, the average stock is now held by the average fund for an average of only 11 months. Moreover, turnover rates do not tell the full story of the role of mutual funds in the financial markets. The dollars involved are enormous. For example, at a 100 percent rate, today’s managers of $4 trillion in equity assets would sell $4 trillion of stocks in a single year and then reinvest that $4 trillion in other stocks, $8 trillion in all. Even though more competitive (and increasingly electronic) markets have slashed unit transaction costs, it is difficult to imagine that such turnover levels, in which trades often take place between two competing funds, can result in a net gain to fund shareholders collectively. If a six-year holding period can be characterized as long-term investment, and if an 11-month holding period can be characterized as short-term speculation, mutual fund managers today are not investors. They are speculators. I do not use the word “speculation” lightly. Nearly 70 years ago, John Maynard Keynes contrasted speculation (“forecasting the psychology of the market”) with enterprise (“forecasting the prospective yield of an asset”) and predicted that the influence of speculation among professional investors would rise as they emulated the uninformed public—that is,

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seeking to anticipate changes in public opinion rather than focusing on earnings, dividends, and book values. In my 1951 thesis on the mutual fund industry, I was bold enough to disagree with Keynes’ baleful prediction. As funds grew, I opined, they would move away from speculation and move toward enterprise by focusing, not on the momentary, short-term price of the share, but on the long-term intrinsic value of the corporation. As a result, I concluded, fund managers would supply the stock market “with a demand for securities that is steady, sophisticated, enlightened, and analytic.” I could not have been more wrong. Mutual funds, once stock owners, became stock traders and moved far away from what Warren Buffett describes as his favorite holding period: Forever.

5. America’s Largest Shareholders In 1945, as Table 5 shows, funds owned only slightly more than 1 percent of the shares of all U.S. corporations. Today, they own nearly 25 percent. They could wield a potent “big stick” but, with a few exceptions, have failed to do so. With their long record of passivity and lassitude about corporate governance issues, fund managers must accept a large share of the responsibility for the ethical failures in corporate governance and

Table 5. Mutual Fund Ownership of U.S. Stocks Percent of Year Equities Owned 1945 1.4% 1950 3.1 1955 3.3 1960 4.8 1965 5.7 1970 6.2 1975 4.9 1980 3.0 1985 5.2 1990 8.1 1995 16.0 2000 22.4 2003 23.1 2004 a 24.9% a 2004 data are as of 30 June. Source: NYSE, Wilshire Associates, and Federal Reserve Flow of Funds Report.

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accounting oversight that were among the major forces creating the recent stock market bubble and the bear market that followed. It was not always this way. In the old days, when mutual funds were responsible owners, the December 1949 Fortune article that inspired my ancient thesis described them as the ideal champion of . . . the small stockholder in conversations with corporate management, needling corporations on dividend policies, blocking mergers, and pitching in on proxy fights. (p. 118) Indeed, in 1940, the U.S. SEC called on mutual funds to serve as the useful role of representatives of the great number of inarticulate and ineffective individual investors in corporations in which funds are interested. (“Investment Trusts and Investment Companies,” part 2, p. 371) It was not to be. Once an own-a-stock industry, funds became a rent-a-stock industry. The change in the industry’s focus from investment to speculation can hardly be unrelated to its failure to observe the responsibilities of corporate citizenship. A fund that acts as a trader, focusing on the price of a share and holding a stock for less than a year, may not even own a company’s shares when the time comes to vote them at the corporation’s next annual meeting. In contrast, a fund that acts as an owner, focusing on the long-term value of the enterprise, has little choice but to regard the governance of the corporation as of surpassing importance.

6. Compressed Investor Holding Periods The change in the mutual fund industry’s character has radically affected the behavior of the mutual fund shareholder. Sixty years ago, shareholders bought shares in broadly diversified funds and held them. As Table 6 shows, in the 1950s and for a dozen years thereafter, fund redemptions (liquidations of fund shares) averaged 6 percent of assets annually, which suggests that the average fund investor held his or her shares for 16 years. Like the managers of the funds they owned, shareholders were investing for the long pull. But as the industry introduced new funds that were more and more performance oriented, often speculative, specialized, and concentrated—funds that behaved increasingly like individual stocks— it attracted more and more investors for whom the

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long term didn’t seem to be relevant. By 2002, the redemption rate had soared to 41 percent of assets, an average holding period of slightly more than three years. The time horizon for the typical fund investor had tumbled by fully 80 percent. Much of this reduction in investor holding periods, we now know, resulted from investors’ pervasive use of timing strategies based on such aspects as time-zone trading. Following the timing scandals that were revealed late in 2003, however, fund managers tightened up their controls designed to preclude excessive trading in fund shares, and the shareholder redemption rate has tumbled to about 25 percent; nonetheless, the resulting average holding period is just four years. As the old buy-and-hold mantra turned to “pick and choose,” freedom of choice became the industry watchword, and “fund supermarkets” with their “open architecture” made moving quickly from one fund to another easy. The cost of these transactions was hidden in the form of access fees for the shelf space offered by these supermarkets. Access fees are paid by the funds themselves, so swapping funds seems to be free, which tacitly encourages shareholders to trade from one fund to another. But although picking tomorrow’s winners based on yesterday’s performance is attractive in theory, there are no data that suggest the strategy works in practice. Quite the contrary!

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7. New Funds Appear, Old Funds course, poured into those winners of yesteryear Vanish after they led the market upward. They would also soon lead the market on its subsequent downward Part of the astonishing telescoping of holding peri- leg, with their shareholders suffering losses of hunods can be traced to opportunistic, gullible, and dreds of billions of dollars. emotional fund investors as well as the change in After the fall, the formation of opportunistic the character of our financial markets (especially in new funds began to unwind and a record number the boom and bust of the stock market bubble of funds went out of business, usually merging into during 1997–2002). But by departing from the other, better-performing funds in the same family. industry’s time-honored tenet of “we sell what we During 1994–2003, fully 1,900 funds vanished— make” and jumping on the “we make what will largely, the New Economy funds. The conservative sell” bandwagon—that is, creating new funds to equity funds of six decades ago were, as the saying match the market fads of the moment—this indus- goes, “built to last,” whereas their aggressive new try must also assume much responsibility for the cousins seemed “born to die.” The 10–20 percent soaring investment activity of fund investors. failure rates that characterized the decades of the As Table 7 reports, the 1990s were a banner 1950s to the 1980s (except for the 1970s, following decade for fund formation; 1,600 new general equity the 1973–74 bear market) reached 36 percent during funds alone came into existence, which was more the 1990s. Should present fund dissolution rates than twice the number of funds in existence at the continue, some 2,800 of today’s equity funds—more decade’s outset. And the new funds typically carried than one-half—will no longer exist a decade hence. higher risks than their predecessors. As New Economy stocks led the market upward in the latter part 8. Cost of Fund Ownership of the decade, mutual fund managers formed 494 new technology, telecom, and Internet funds and In 1945, as Table 8 shows, the average expense ratio aggressive growth funds favoring these sectors. 6 (total management fees and operating expenses as Not only did the industry create such funds, it a percentage of fund assets) for the largest 25 funds, marketed them with unprecedented vigor and with aggregate assets of but $700 million, was 0.76 enthusiasm, both through stockbrokers and percent, generating aggregate costs of $4.7 million through advertising. At the market’s peak in March for fund investors. Six decades later, in 2004, the 2000, the 44 mutual funds that advertised their assets of the equity funds managed by the 25 largest performance in Money magazine bragged about fund complexes had soared to $2.5 trillion, but the amazing returns averaging +85.6 percent during average expense ratio had soared by 105 percent to the previous 12 months. During 1998–2000, equity 1.56 percent, generating costs of $31 billion. 8 In other funds took in $650 billion of new money—well over words, while their assets were rising 3,600-fold, half a trillion dollars—overwhelmingly invested in costs were rising 6,600-fold. (The dollar amount of the new breed of speculative, high-performance, direct fund expenses borne by shareholders of all aggressive growth funds. 7 Most of the money, of equity funds has risen from an estimated $5 million

Table 7. Formation and Liquidation of Equity Funds No. of Fund No. of Fund Decade New Funds Creation Rate Dying Funds Failure Rate 1950s 28 (est.) 80% (est.) 10 (est.) 13% 1960s 211 88 37 21 1970s 123 34 202 61 1980s 534 110 78 17 1990s 1,604 125 462 36 2000s a 980 52% 1,045 56% Note: Creation and failure rates for each decade are summed annual rates. a Figures for the 2000 “decade” represent the first four years annualized. Source: CRSP database and author’s estimates.

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Table 8. Direct Costs of Fund Ownership: 25 Largest Fund Managers Measure 1945 2004 Change Total assets $0.7 billion $2,500 billion 3,600× Fees and operating expenses (est.) a $4.7 million $31 billion 6,600× Average expense ratio 0.76% 1.56% +105% a Excluding portfolio transaction costs, sales charges, and opportunity costs. Source: Wiesenberger and Strategic Insight.

annually in the 1940s to something like $35 billion in 2004, or 7,000-fold.) Despite the substantial economies of scale that exist in mutual fund management, fund investors have not only not shared in these economies, they have actually incurred higher costs of ownership. Some of that enormous rise in the average expense ratio is a result of the inclusion of marketing expenses paid for by the fees allowed under Rule 12-b(1) of the Investment Company Act of 1940 adopted in 1980. These distribution fees have, in part, replaced traditional front-end sales charges. And although reductions in management fees that fully reflect the economies of scale are virtually nonexistent, investors have increasingly chosen no-load funds and low-cost funds. When portfolio transaction costs—an inseparable part of owning most funds—are added to expense ratios and sales charges, however (plus fees paid to financial advisers to select funds, which have also partly replaced earlier front-end loads), the costs of mutual fund ownership remain a substantial impediment to the ability of equity funds and their shareholders to capture the returns generated by the stock market.

9. Rise of Fund Entrepreneurship Sixty years ago, the mutual fund industry placed its emphasis on fund management as a profession— the trusteeship of other people’s money. Today, there is much evidence that salesmanship has superseded trusteeship as our industry’s prime focus. What was it that caused this sea change? Perhaps trusteeship was essential for an industry whose birth in 1924 was quickly followed by tough times— the Depression and then World War II. Perhaps salesmanship became the winning strategy in the easy times thereafter, an era of almost unremitting economic prosperity. Probably, however, the most

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powerful force behind the change was that mutual fund management emerged as one of the most profitable businesses in our nation. Entrepreneurs could make big money managing mutual funds. In 1958, only 13 years after the inaugural issue of the FAJ, the whole dynamic of entrepreneurship in the fund industry changed. Until then, a trustee could make a tidy profit by managing money but could not capitalize that profit by selling shares of the management company to outside investors. The SEC held that the sale of a management company represented payment for the sale of a fiduciary office, an illegal appropriation of fund assets. If such sales were allowed, the SEC feared, it would lead to “trafficking” in advisory contracts, a gross abuse of the trust of fund shareholders. But a California management company challenged the regulatory agency’s position. The SEC went to court—and lost. Thus, as 1958 ended, the gates that had prevented public ownership since the industry began 34 years earlier came tumbling down. A rush of initial public offerings followed, with the shares of a dozen management companies quickly brought to market. Investors bought management company shares for the same reasons that they bought shares of Microsoft Corporation and IBM Corporation and, for that matter, Enron: Because they thought their earnings would grow and their stock prices would rise accordingly. The IPOs were just the beginning. Publicly held and even privately held management companies were acquired by giant banks and insurance companies that were eager to take the new opportunity to buy into the burgeoning fund business at a healthy premium (averaging 10 times book value or more). The term “trafficking” was not far off the mark; there have been at least 40 such acquisitions during the past decade alone, and the ownership of some fund firms has been transferred numerous times. Today, among the fifty largest fund managers, only eight remain privately held (plus mutually owned Vanguard). Six firms are publicly held, and the remaining thirty-five management companies are owned by giant financial conglomerates— twenty-two by banks and insurance companies, six by major brokerage firms, and seven by foreign financial institutions. Obviously, when a corporation buys a business, fund manager or not, it expects to earn a hurdle rate on its capital. So, if the cost of an acquisition is $1 billion, and the hurdle rate is 12 percent, the acquirer will require at least $120 million of

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annual earnings. In a bull market, that goal may be easy for a mutual fund firm to achieve. But when the bear comes, we can expect a combination of (1) cutting management costs, (2) adding new types of fees (distribution fees, for example), (3) maintaining, or even increasing, management fee rates, and even (4) getting the buyer’s capital back by selling the management firm to another owner (the SEC’s trafficking in advisory contracts” writ large). It would be surprising if this shift in control of the mutual fund industry from private to public hands, largely those of giant financial conglomerates, had not accelerated the industry’s change from profession to business. Such staggering aggregations of managed assets—often hundreds of billions of dollars under a single roof—surely serves both to facilitate the marketing of a fund complex’s brand name in the consumer goods market and to build its market share. Conglomeration does not seem likely to make the money management process more effective, however, nor to drive investor costs down, nor to enhance the industry’s original notion of stewardship and service.

10. Scandal For 78 years—from its start back in 1924 through 2002—the mutual fund industry was free of major taint or scandal. But as asset gathering became the name of the game, as return on managers’ capital challenged return on fund shareholders’ capital as the preeminent goal, as conglomeration became the dominant structure, and as stewardship took a backseat to salesmanship, many fund managers were not only all too willing to accept substantial investments from short-term investors and allow those investors to capitalize on price differentials in international time zones (as well as engage in other unrelated but profitable activities), they were also willing to abet and even institutionalize these practices. To improve their own earnings, managers put their own interests ahead of the interests of their fund shareholders. They allowed short-term traders in their funds to earn illicit higher returns at a direct, dollar-for-dollar cost to their fellow investors holding for the long term. Brought to light by New York Attorney General Eliot L. Spitzer in September 2003, the industry’s first major scandal went well beyond a few bad apples. More than a score of firms, managing a total $1.6 trillion of fund assets, including some of the oldest, largest, and once most respected firms in the industry, have

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been implicated in wrongdoing. This scandal exemplifies the extent to which salesmanship has triumphed over stewardship.

For Better or Worse? Clearly, the mutual fund industry of 2005 is different not only in degree but in kind from the industry of 60 years earlier—infinitely larger and more diverse, with more speculative funds focused on ever-shorter investment horizons. It is less aware of its responsibility for corporate citizenship; its funds are held by investors for shorter time periods; and it is far more focused on asset gathering and marketing. The fund industry is increasingly operated as a business rather than a profession and, despite the awesome increase in its asset base, has far higher unit costs. The culmination of these changes is a scandal that crystallizes the extent to which the interest of the managers has superseded the interest of fund shareholders. Way back in 1967, Nobel Laureate Paul Samuelson was smarter than he could have imagined when he concluded, there was only one place to make money in the mutual fund business—as there is only one place for a temperate man to be in a saloon, behind the bar and not in front of it . . . so I invested in a management company. (Notre Dame Lawyer, June 1969, p. 918) Determining how well the investor—the intemperate customer on the other side of the bar in that saloon—has been served by the old industry versus by the new—is a fairly simple statistical matter. Although equity fund shareholders have, of course, made substantial profits during the industry’s modern era, Table 9 shows that the profits have been but a small fraction of what they could have captured simply by buying and holding a low-cost all-U.S-equity index fund.

Table 9. Mutual Fund Returns vs. the Stock Market Measure 1945–1965 1983–2003 Stock market return a 14.9% 13.0% Average equity fund return 13.2% 10.3% Shortfall 1.7 pps 2.7 pps Fund share of market return 89% 79% Note: Fund return in the second period was reduced by 0.3 percentage points as a minimal estimate of survivorship bias. a S&P 500. Source: Lipper.

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• In 1945–1965, the average fund delivered 89 percent of the market’s annual return. The small shortfall that did exist between the annual rate of return of the average equity fund and that of the S&P 500 Index was doubtless largely accounted for by the moderate costs of fund ownership in those two decades. • In 1983–2003, with the shortfall at 2.7 percentage points, the average fund delivered only 79 percent of the market’s annual return. That a consistent gap exists between equity fund returns and stock market returns should not be a surprise, for in the long run, the record is clear: Equity mutual funds are commodities (and with relatively low survival rates, at that) that are differentiated largely by their costs. After all, with fund managers competing among themselves in selecting stocks, aggregate equity fund returns must inevitably parallel those of the equity market itself and thus fall short of those returns by the amount of their management, marketing, and turnover costs. Although the data are lacking to account with precision for the gap between stock market returns and equity fund returns, the 20-year differentials between the return of the average fund and the index in both the old era and the new—as well as the increase in the spread—appear to be largely, if not entirely, a result of fund costs. For example, in the 1945–65 period, equity fund expense ratios averaged about 0.8 percent and the cost of portfolio turnover (averaging about 16 percent a year) added perhaps another 0.8 percent, producing a 1.6 percent total, very close to the 1.7 pp lag shown in Table 9. In the 1983–2003 period, the average expense ratio was about 1.4 percent, portfolio turnover (90 percent annually on the average but at much lower unit trading costs than in the earlier period) added an estimated 1.0 percent, for a 2.4 percent cost, again very close to the 2.7 pp lag. (Because funds are rarely fully invested in stocks, opportunity costs may well account for the remaining differences between the cost and the shortfall. 9 ) So, it is largely the increase in fund costs that led to the substantial reduction shown in Table 9 in the share of the stock market’s return earned by the average equity fund. 10 But the average equity fund shareholder has fared far worse. Based on studies comparing traditional time-weighted (per share) returns and dollar-weighted (investor) returns over the past decade, the average fund investor earned an annual return fully 2.4 pps less than that of the average fund.

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The change in the industry’s character bears a heavy responsibility for the reduced earnings of the average fund shareholder. First, shareholders investing in equity funds have paid a heavy timing penalty: They invested too little of their savings in equity funds when stocks represented good values during the 1980s and early 1990s. Then, enticed by the great bull market and the wiles of mutual fund marketers as the bull market neared its peak, they invested too much of their savings in equity funds. Second, they have paid a selection penalty by pouring money into aggressive growth funds investing in the New Economy during the bubble while withdrawing money from value funds favoring the Old Economy. While the stock market was providing an annual return of 13 percent during the past 20 years and the average equity fund was earning an annual return of 10.3 percent, the average fund investor (assuming that the 2.4 pp shortfall prevailed for the full period) was earning only 7.9 percent a year. Compounded over two decades, the 2.7 percent penalty of costs was huge. But the penalty of character was almost as large—another 2.4 pps. Table 10 shows that $1.00 invested in the market and compounded at 13 percent grew to $11.50; the investor’s $1.00 grew to $4.57, at best a modest reward for assuming the risks of equity investing during a period in which the stock market was providing returns well above long-term norms.

Table 10. Comparison of Market Returns, Fund Returns, and Investor Returns, 1983–2003 Annual Growth of Measure Return $1.00 Stock market return 13.0% $11.50 Average equity fund return 10.3% $7.10 Gap between average fund and market 2.7 pps $4.40 Estimated equity fund investor return a 7.9% $4.57 Gap between average investor and average fund 2.4 pps $2.53 Total gap between average investor and market 5.1 pps $6.93 a Author’s calculation based on a comparison of time-weighted returns with the dollar-weighted returns earned by the fund investors for 600 general equity funds during 1993–2003.

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The point of this statistical examination of the returns earned by the stock market, the average fund, and the average fund owner is not precision, but direction. Whatever the precise data, the evidence is compelling that equity fund returns lag the stock market by a substantial amount, largely accounted for by cost, and that fund investor returns lag fund returns by a substantial amount, largely accounted for by counterproductive market timing and fund selection.

Where Do We Go from Here? In the aggregate, the tens of millions of our citizens who have entrusted their hard-earned trillions to the care of mutual fund managers have not been well served by the myriad changes that have taken place in mutual funds during the past 60 years. What about mutual funds yet to come? My answer should not surprise you: It is time to go back to our roots; to put mutual fund shareholders back in the driver’s seat, to return to the principles of the 1940 Investment Company Act and demand that funds be organized, operated, and managed in the interest of their shareholders rather than the interest of their managers and distributors. Some of the steps that must be taken would be relatively painless for fund managers—reducing turnover costs by, for example bringing turnover rates down to reasonable levels—and some would be rather painful—reducing management fees and sales commissions and cutting operating and marketing costs. Because there is no reason to expect that today’s $7.5 trillion fund industry can increase the portion of the market’s returns earned by their funds by suddenly finding the ability to provide

Notes

1. The term “mutual fund” refers to open-end investment companies, with redeemable shares, registered under the Investment Company Act of 1940 with the U.S. SEC. 2. These data are from the Investment Company Institute’s 2004 Mutual Fund Fact Book. 3. Today’s accepted terminology for equity funds reflects this change. We have come to accept a nine-box matrix of funds arranged by market capitalization (large, medium, or small) on one axis and by investment style (growth, value, or a blend of the two) on the other. Yesterday’s middle-of-theroad funds would today find themselves in the “large-cap blend” box, which now comprises only 14 percent of the equity funds in the Morningstar database. 4. Sign of the times: As the public interest moved from individual stocks to stock funds, the New York Times took appropriate action. On 30 June 1999, the daily mutual fund price listings were moved ahead of those of the NYSE and NAS-

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market-superior returns (after all, fund managers are essentially competing with one another), such cost reductions are the only realistic way to enhance the returns of the average fund. To enhance the share of fund returns earned by fund shareholders, the industry needs to reorder its product strategies to focus once again on broadly diversified funds with sound objectives, prudent policies, and long-term strategies. The industry needs to take its foot off the marketing pedal and press down firmly on the stewardship pedal. At the same time, the industry must give investors better information about asset allocation, fund selection, risks, potential returns, and costs—all with complete candor. To do otherwise will doom the industry to a dismal future. For whatever the profession, finally, the client must be served. Whatever the business, finally, the customer must be served. As an article in a recent issue of Fortune (January 2003) quoted me as saying: Of course there’s hope [the industry will change]. There’s a guarantee it will get better. Investors won’t act contrary to their own economic interests forever. (p. 113) The need for change is obvious; the steps that must be taken equally obvious. It is high time for the mutual fund industry to return funds present to funds past, to restore the industry to its original character of stewardship and prudence. If funds come to refocus on serving shareholders—serving them “in the most efficient, honest, and economical way possible,” as I wrote in my thesis 54 years ago—the future for this industry will be not simply bright but brilliant.

DAQ. Several years later, only the fund listings remained in the main financial section. 5. Strategic Insight Mutual Fund Research and Consulting. 6. Strategic Insight. 7. 2004 Mutual Fund Fact Book. 8. Asset-weighted expense ratios were used in calculating total costs. 9. If stock returns average 12 percent and U.S. T-bills average 4 percent, the 8 percent spread on an average 5 percent cash position represents an opportunity cost of 40 bps. In any event, the fund returns exclude the impact of front-end sales charges and thus are overstated in both comparisons. 10. Federal and state income taxes represent yet a further toll on the returns earned by taxable fund shareholders. High portfolio turnover generates considerable tax inefficiency; during the past 15 years, equity fund after-tax returns lagged pretax returns by 2.2 pps a year—an additional burden that nearly doubled the confiscatory impact of the other fund costs.

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