将互助精神带入共同基金

International Journal of Pension Management Effective Pension Governance: New Insights and Research Findings Table of Contents 1 Public Sector Pension Governance in the United States: Up to the Task? Global Thought Leadership Joel T. Harper 22 Roger L. Martin 3 Pension Governance in Australia: Why the World Needs this Journal An Anatomy and an Interpretation Keith Ambachtsheer 4 Wilson Sy 30 Effective Pension Governance: Making Pension Boards Work: The Ontario Teachers’ Story The Critical Role of Leadership Claude Lamoureux 6 Gordon L. Clark and Roger Urwin 38 The Conception of APG: Reorganizing Pension Collaboration: Strength in Numbers Pension Delivery in The Netherlands Danyelle Guyatt 46 Roderick Munsters 12 Bringing Mutuality to Mutual Funds The Pension Governance Deficit: John C. Bogle 54 Still With Us Keith Ambachtsheer, Ronald Capelle, The Pension Fund Advantage: Are Canadians and Hubert Lum 14 Overpaying their Mutual Funds? Rob Bauer and Luc Kicken 64 Volume 1 Issue 1 Fall 2008 Electronic Electroniccopy copyavailable availableat: at: http://ssrn.com/abstract=1290642 Rotman International Journal Volume 1 • Issue 1 of Pension Management Fall 2008 Bringing Mutuality to Mutual Funds John C. Bogle Jack Bogle is the This article is a condensed version of a lecture presented February 2008 at the 27th Founder and Former Annual Manuel F. Cohen Memorial Lecture at the George Washington University Chief Executive Officer Law School in the United States. of The Vanguard Group.

“… after all, that is where the money is, and despite the common use of the word mutual, the principal reason these Forty years ago, Manuel F. Cohen, then chairman In Whose Interest? funds are created and sold is to make money for the people of the United States Securities and Exchange Commission who sell them and those who manage them.” 3 (SEC), delivered a landmark address on the challenges facing the mutual fund industry. That speech, delivered at the 1968 Is there something improper or wrong, or even unethical about Federal Bar Conference on Mutual Funds, was entitled simply having funds operated with this purpose? Perhaps not. If this The ‘Mutual’ Fund 1, with emphasis on the quotation marks structure is not illegal, there seems to be something about the around the word mutual. Chairman Cohen’s main concern was way in which the industry has evolved that flies in the face of that the designation ‘mutual’ was inappropriate in view of the the provisions within the Investment Company Act of 1940 that changes the industry underwent in the 1960s that altered, for requires investment companies to be “organized, operated, and the worse, the industry’s character and mission. managed” 4 in the interests of their shareholders, “rather than in the interest of their managers and distributors.” 5 Interestingly, The fact is that even after 40 eventful years, the industry has the phrase ‘mutual funds’ does not appear in the statute. not just failed to respond to the challenging issues raised by Chairman Cohen, but has moved in the opposite direction.

Today, ‘mutual’ remains an inappropriate adjective to describe this business. The operation of almost all mutual funds is as An Exception to the Conventional far from the concept of mutuality as one can possibly imagine.

Chairman Cohen illustrates this point in his 1968 speech: Structure There is a single exception to the conventional external management structure. The creation of Vanguard, in 1974, “… the basic idea of a mutual fund is deceptively simple marked my attempt to create a family of mutual funds that … [but its] salient characteristics raise a serious question was truly mutual, mitigating to the maximum possible extent whether the word ‘mutual’ is an appropriate description.” 2 the obvious conflict of interest that exists between funds and their advisors. Under the Vanguard at-cost operating structure, While policyholders of mutual insurance companies and the profits that accrue to external managers are returned depositors in mutual savings banks were antiquatedly sharing directly to the fund shareholders. The 150 funds in the group in the profit of their institutions, mutual funds, Chairman Cohen actually own the manager, The Vanguard Group, Inc., roughly stated, were different. He noted that fund shareholders paid in proportion to their share of the Group’s aggregate assets, fees to their external managers, who were often corporations and share in the total expenses incurred by the funds in their in business to earn profits for their own shareholders, with a operations by approximately the same proportion. Vanguard’s completely different and often opposed set of interests. responsibilities include providing all of the fund’s administrative and marketing services and the largest portion of their investment Chairman Cohen observed that the resulting fee structure had management services. 6 provided a real opportunity for the exercise of the ingenuity for which fund managers had established an enviable The directors of the funds and their management company are reputation. identical. Eight of the nine directors are otherwise unaffiliated 54 Volume 1 • Issue 1 • Fall 2008 • 10.3138/rijpm.1.1.54 Electronic Electroniccopy copyavailable availableat: at: http://ssrn.com/abstract=1290642 Bringing Mutuality to Mutual Funds with the company. No director is permitted to be affiliated with to the Investment Company Act of 1940. Here is how he any of the funds’ external advisors, whose fees are vigorously opened the testimony at the hearings for the Act in 1939: negotiated and whose performance is monitored by Vanguard staff. Since the Vanguard funds essentially operate and manage “… the solution [to the industry’s] shocking record of themselves at cost, the fund shareowners garner the extraordinary malfeasance … was a group of expert trust managers who economies of scale that characterize investment management. It do not make their profits … distributing trust securities, is fair to describe Vanguard as the only truly mutual, mutual fund styled principally for their sales appeal, but from wise, complex. This shareholder-first structure has produced enormous careful management of the funds entrusted to them.” 9 growth in the assets of the Vanguard funds and enormous savings for investors. For example, in 2007, Vanguard’s composite “… [the Commissioners] were anxious to protect the fund expense ratio of 21 basis points (i.e., 0.21 percent) was 76 basis investor from the distorting impact of sales. Products 10 points below the 97-basis-point composite weighted average designed for their appeal to the market did not, and do not, expense ratio of its largest competitors. Within two years, necessarily make the best investments.” 11 cumulative fee savings for Vanguard fund owners will exceed U$100 billion. One might describe that total as real money. Legendary industry pioneer Paul Cabot, one of State Street’s founders and a major force in the drafting of the 1940 Act, agreed with the SEC on this point. Earlier, in 1928, he had described the abuses in the investment-trust movement of the day as: Whence ‘Mutual’?

If the word mutual did not appear in the Investment Company Act of 1940, when did it emerge? I’ve gone through old Investment “… dishonesty, inattention, inability, and greed. Even if a Companies manuals published by Arthur Wiesenberger & fund is honestly and ably run, it may be inadvisable to own Company back to its beginnings and not until the 1949 edition, it simply because there is nothing in it for you. All the profits a quarter-century after the industry began, do I find the first go to the promoters and managers.” 12 mention of mutual funds. But while the origin of the term remains a mystery, the paradoxical fact is that it first appeared While the derivation of the term mutual remains obscure, the only a short time before the industry began to abandon its early, prudent idealism behind the spirit of the industry when the mutual values. History confirms that from the inception of the 1940 Act was drafted arguably justified the use of the term. first United States mutual fund in 1924 until the late 1940s, the Yet the term mutual fund only came into being as the industry predominant focus of mutual fund management was on portfolio began to turn away from its original spirit of mutuality. From selection and investment advice, rather than on distribution and its early mission of stewardship of investor assets to its modern-marketing. In fact, the managers who founded Massachusetts day mission of salesmanship, a mission, as Chairman Cohen Investors Trust, State Street Research and Management seemed to be suggesting, that would make the use of the term Company, and Incorporated Investors, the original Big Three mutual something of a joke. of the fund industry, put themselves forth as the “twentieth-century embodiment of the old Boston trustee”. 7 During the industry’s early years, sales of fund shares were typically the responsibility of separate underwriting firms The Straw That Broke the Camel’s Back As with any major transformation, many factors were financed by distribution revenues from sales loads and responsible for the sea of change that gradually subverted predominately unaffiliated with fund managers. For example, the fund industry’s mission. For decades, the industry was the primary concern of the State Street Research and operated by a group of small firms that were privately-owned Management Company partners was not to be distracted by professional managers who provided advisory services by the sales effort. and focused on earning a return on the capital that investors had entrusted to them. The industry then morphed into a As they wrote to investors in 1933, group of very large firms that were mostly publicly-owned and controlled by corporate executives whose mission was “… it is our intention to turn over the active selling and the asset gathering and whose focus was on earning a return on the commissions to dealers … thereby leaving us free to devote capital of the owners of the management company. The straw … our entire time and effort to research and the study of the that broke the camel’s back of the traditional industry came problems of investment.” 8 when the owners of privately-held management companies gained the right to sell their ownership positions to outsiders, The same spirit was echoed by Judge Robert F. Healy, the SEC then to the public and finally to large financial conglomerates.

Commissioner primarily responsible for the legislation leading Volume 1 • Issue 1 • Fall 2008 55 Electronic Electroniccopy copyavailable availableat: at: http://ssrn.com/abstract=1290642 Rotman International Journal Volume 1 • Issue 1 of Pension Management Fall 2008 Paul Cabot did not approve of that change. For him, the private of shares in Insurance Securities, Incorporated (ISI), at a price ownership of fund managers was essential and represented equal to nearly 15 times its book value, did not constitute gross a moral imperative for him. He sharply criticized firms that misconduct or gross abuse of trust under Section 36 of the would sell out to insurance companies and other financial 1940 Act. The SEC had gone to court to oppose the sale on institutions. In 1971, he recalled the negotiations over the the grounds that the excess price represented a payment for Investment Company Act of 1940: succession to the advisor’s fiduciary office.

“… both the SEC and our industry committee agreed that the The Court agreed with the SEC that “a person occupying a management contract between the fund and the management fiduciary relationship with another will not be permitted to group was something that belonged … to the fund … and, exploit such relationship for personal gain.” 16 It weighed more therefore, the management group had no right to hypothecate heavily the fact that the value of the contract did not represent it, to sell it, to transfer it, or to make money on the disposition an asset of the trust fund, rather it reflected the business reality of this contract … the fiduciary does not have the right to sell that the manager received a profit for rendering services in his job to somebody else at a profit.” 13 return for stipulated fees that the fund had contracted to pay. Regardless of whether this decision by the Ninth Circuit 17 was Ironically, 11 years later in 1982, Paul Cabot’s successors, the considered either good or bad, the US Supreme Court refused partners of State Street Research and Management Company, to hear an appeal. That narrow legal decision, now almost a sold the firm to (paradoxically, then-mutual) Metropolitan Life half-century ago, played a definitive role in setting the industry Insurance Company for at that time an astonishing profit of on a new course. A course where manager entrepreneurship U$100 million. The Board’s reasoning was as follows: in the pursuit of personal profit would supersede manager stewardship in the interest of prudent investment returns for “… the affiliation of State Street with an organization having fund shareholders. the financial and marketing resources of Metropolitan Life will result in the development of new products and services Within a decade, many of the major firms in the fund industry which the fund may determine would be beneficial to its joined the public ownership bandwagon, including Dreyfus, [fund] shareholders.” 14 Franklin, Putnam, as well as Wellington. Over the next decade, T. Rowe Price and Keystone (now Evergreen) also went public.

Such new products and services would be beneficial not to the In the era that followed, financial conglomerates acquired Fund’s shareholders, but to the management company, which big firms such as Massachusetts Financial Services, Putnam, became a subsidiary of the insurance company. In fact, the American Century, Alliance, AIM, and many others. The original merger hurt the fund shareholders. “Performance lagged, and trickle of public ownership of fund management companies the manager’s position in the industry declined from tops to eventually became an ocean. Today, the tide of public ownership average.” 15 By 2002, Metropolitan Life abandoned the fund of fund management companies has subsided and private business, selling State Street Management and Research ownership is at an all time low. Among the 50 largest mutual Company to Blackrock Financial for an estimated U$375 fund management complexes, only nine have maintained their million. One of Blackrock’s first moves was to merge the original private structure including Fidelity, American Funds, industry’s third-oldest fund into another Blackrock fund, Dodge & Cox, Teachers Insurance and Annuity Association-putting State Street Management out of its misery. I still College Retirement Equities Fund (TIAA-CREF), and Vanguard. refer to this event as a death in the family. Of the 41 remaining firms on the list, nine are publicly-held and 32 are owned by banks, giant brokerage firms, and US and international conglomerates. As the data will shortly demonstrate in this article, the seemingly irresistible trend towards public and largely conglomerate ownership has The Floodgates Open The sale and resale of State Street Management exemplified the ill-served mutual fund shareholders. potential for trafficking in fund advisory contacts that greatly concerned the SEC during the drafting of the 1940 Act. While the SEC and the industry agreed that the management contract was an asset of the fund, the 1940 Act failed to explicitly Vanguard Goes the Other Way articulate this sound principle. It would only be a matter of Only a single firm swam against this epic tide and operated time until a sale of a contract would take place. That sale under a novel and unprecedented structure. The story of its opened the floodgates to public ownership of fund management creation is a story worth telling. 18 In 1960, my employer, companies. The date was April 7, 1958, when the United States Wellington Management Company, was among the firms to Court of Appeals for the Ninth Circuit ruled that the 1956 sale ride that early wave of industry Initial Public Offerings (IPOs).

56 Volume 1 • Issue 1 • Fall 2008 Bringing Mutuality to Mutual Funds In 1965, when I assumed leadership of the firm, I realized my recommendation that the funds terminate their distribution we had to deal with the challenges involved in serving two agreements with Wellington Management, eliminate all demanding masters whose interests were often in direct sales charges and abandon the broker-dealer network that had conflict. Obviously, we had a fiduciary duty both to our fund distributed Wellington shares for nearly half a century. Almost shareholders and to our management company shareholders. overnight, the firm moved from a seller-driven, load-fund When a privately-held management company becomes publicly- channel to a buyer-driven, no-load channel that is maintained held, this conflict is greatly exacerbated. today. Only 21 months after Vanguard began operations, the fledgling organization had been transformed into a fully-I soon went public with my concerns. Speaking at the annual functioning fund complex responsible for administration, meeting of my Wellington partners in 1971, I revealed an distribution and investment management. What we referred ancient prejudice of mine: to as the Vanguard Experiment in fund governance was about to begin in earnest.

“… all things considered, it is undesirable for professional enterprises to have public shareholders. Indeed it is possible to envision circumstances in which the pressure for earnings growth engendered by public ownership is antithetical to How it All Worked Out the responsible operation of a professional organization. Some 34 years have elapsed since Vanguard began operating Although the field of money management has elements of under its unique mutual structure, and 50 years since the Ninth both a business and a profession, any conflicts between the Circuit decision opened the floodgates to public ownership two must, finally, be reconciled in favor of the client.” of fund managers and the age of conglomeration that has overwhelmed the industry. Paradoxically, the philosophies It is a matter of fiduciary principle, as no man can serve two underlying these two events are diametrically opposite. Mutual masters. ownership views mutual funds as trust accounts, managed under the direction of prudent fiduciaries. Outside ownership, I explored some ideas about how a reconciliation might on the other hand, demands that investment funds be viewed be achieved including, a mutualization, whereby the funds as products that are manufactured and distributed with the acquire the management company. Within three years, I found objective of maximizing profits for the manager. It’s time to myself in a position where I would not only talk the talk about look at the record and compare the results of firms that follow mutualization, but would walk the walk. A series of dire events these opposing philosophies. in the stock market was enough to destroy the happy partnership formed by an unfortunate merger I implemented in 1966 I am fond of saying that in more than three decades, Vanguard and I was axed as the Chief Executive Office of Wellington has proven to be both a commercial success and an artistic Management Company on January 23, 1974. I remained success. A commercial success, because the firm’s structure Chairman of the mutual funds, with their largely separate has proven to be a superb business model. Fund assets under and independent Board of Directors. After a seven month management have grown from U$1.4 billion at its 1974 founding struggle, I persuaded the Board to establish the funds’ own to U$1.2 trillion today, now likely the largest firm in the fund administrative staff under the direction of its operating officers industry. Of course, the stock market boomed during most of and I would continue as Chairman and President. that period and the fund industry flourished. Nonetheless, Vanguard’s market share of industry assets has soared from a The Board allowed Wellington Management Company to retain mere 1.8 percent in 1980 to 10.6 percent today, without a single its name, so I had to create a name for the new firm. I proposed year of decline. If that share had remained at 1.8 percent, assets the name, Vanguard, and the directors approved it. We began of the Vanguard funds would be U$220 billion today. Almost operations on May 1, 1975. Over the next two years, we moved all U$1 trillion of our growth—80 percent of it—has come beyond our narrow administrative mandate to engage in fund from increased market share. portfolio management and share distribution services as well.

The first fund we formed was the world’s first index mutual How did Vanguard earn that commercial success? By the fund, modeled on the Standard & Poor’s 500 Stock Index. artistic success the firm had achieved, which I define as When its IPO was completed in August 1976, we had raised a providing superior investment returns to shareholders. The mere U$11 million. Despite that meager start, Vanguard 500 data indicates that the performance of the Vanguard funds Index Fund, with its several series, is now the largest mutual has indeed been superior, while the returns produced by the fund in the world. financial conglomerates that dominate this industry have been inferior. Let’s look at the record. While there are many ways Only a few months later, in February 1977, the Board accepted to measure fund performance, I’ll use one of the more sensible Volume 1 • Issue 1 • Fall 2008 57 Rotman International Journal Volume 1 • Issue 1 of Pension Management Fall 2008 methodologies, relying largely on the Morningstar system, in list is conglomerate-held, while only one of the firms among which the risk-adjusted returns of each fund are compared with the top ten can be similarly characterized.21 In the middle group, the risk-adjusted returns of its direct peers over a full decade. all producing average scores for their funds, is one publicly-Under this system, 10 percent of funds receive five stars (the held firm (Franklin, +9), one owned by a large investment top rating) and 10 percent one star (the bottom rating); 22.5 banker (Morgan Stanley, +2), one privately-held (Fidelity -3) percent receive four stars and 22.5 percent receive two stars; and three owned by conglomerates (all below par, with one the middle 35 percent receive the average grade of three stars. 19 rated at -4 and two at -14).

That deceptively simple methodology results in the calculation, Considering the high-performing, average-performing and for each fund complex, of the percentage of its funds ranked low-performing groups together, it becomes clear that the with four and five stars and subtracting from that total the only firm with a truly mutual structure, and the other three percentage of funds ranked with one and two stars. The result firms with privately-held structures, dominate the top group. is a segmentation between the funds that provided distinctly These firms have provided consistently superior returns for superior returns and those that provided distinctly inferior their fund shareholders, in sharp contrast with the inferior returns, with an industry-wide norm of zero percent. While scores that clearly characterize the funds managed by financial I’ve never seen this methodology used before, I believe that conglomerates. minimizing the funds in the one and two star categories provides an equally important benefit for fund shareholders.

We measured the returns achieved by 50 of the largest fund Table 1: Major Mutual Fund Managers: complexes, defined as the firms managing at least 40 individual Fund Performance funds excluding money market funds. Only one fund complex had assets of less than U$25 billion. This remarkably representative % of Funds Ranked list covers more than 8,800 funds with some U$7 trillion in Highest Lowest Highest fund assets, and 80 percent of the industry’s long-term asset (4 or 5 (1 or 2 Minus base. A summary of the results that show the scores of the top Manager Stars) Stars) Lowest six firms, the bottom six firms and six fairly well-known firms that achieved roughly average performance records for their 1 Vanguard 59% 5% 54% funds, is presented in Table 1. The top-ranking fund complex, 2 DFA 57 7 50 in terms of providing superior returns to its investors, was Highest 3 TIAA-CREF 54 4 50 Vanguard. With 59 percent of the Vanguard funds in the top Returns 4 T Rowe Price 53 9 44 group and less than five percent in the bottom group, the 5 Janus 54 16 38 firm’s performance rating is +54. 20 6 American Funds 46 20 26 Joining Vanguard among the top three are Dimensional Fund 7 Franklin Templeton 31 22 9 Advisors (DFA) and TIAA-CREF, both at +50. Coincidentally, 8 Morgan Stanley 32 30 2 all three firms are focused largely on index-like strategies. At Average 9 Fidelity 31 34 -3 number four is T. Rowe Price (+44), followed by Janus (+38) and Returns 10 Barclays Global 27 31 -4 American Funds (+26). I believe that most objective observers would agree that over the past decade, at least five of these six 11 AIM Investments 20 34 -14 firms have been conspicuous in delivering superior returns, a 12 Columbia Funds 23 38 -14 judgment that would confirm the validity of the methodology.

Again coincidently, this six-firm list is dominated by four 13 Goldman Sachs 15 55 -40 management companies (Vanguard, DFA, TIAA-CREF and 14 Dreyfus 12 53 -40 American) that are neither publicly-owned, nor controlled by Lowest 15 MainStay Funds 20 60 -40 a conglomerate.

Returns 16 John Hancock 17 60 -43 17 ING Investments 9 64 -55 On the other hand, each of the bottom six firms is a unit of a 18 Putnam 4 62 -58 large brokerage firm or a financial conglomerate. Their ratings range from -40 for Goldman Sachs to -58 for Putnam, the Source: Morningstar (December, 2007) (long-term funds only) lowest-ranking firm with only four percent of its funds in the top category and 62 percent in the bottom category. Strikingly, every single one of the 17 lowest-ranking firms on the 50-firm 58 Volume 1 • Issue 1 • Fall 2008 Bringing Mutuality to Mutual Funds U$50 billion of investor capital flowed into the funds. In the bear market that followed, the funds collapsed. As a result, Performance Evaluations from a Higher most Janus investors actually experienced dismal returns.

Authority While any performance methodology is inevitably imperfect, I believe that the methodology chosen here is not only reasonable, but a significant enhancement over most other methodologies.

Let’s not rely on statistics alone to evaluate fund performance, Table 2: Major Mutual Fund Managers: but find out how the fund shareholders themselves regard the Fund Performance and Shareholder Loyalty funds they own. Thanks to a survey done in 2007 by Cogent Research LLC, we now have measures of how fund shareholders % of Funds Ranked feel about the mutual fund firms that manage their money. In Highest Client short, shareholders are arguably the highest authority for the Minus Loyalty appraisal fund performance.

Manager Lowest Score The Cogent study 22 measured client loyalty, presenting 1 Vanguard 54% 44% investors with a scale representing the extent of their trust 2 DFA 50 n/a in their managers: ten points awarded for the highest rating Highest 3 TIAA-CREF 50 n/a (definitely recommend to other investors), one point for the Returns 4 T Rowe Price 44 21 lowest (definitely not recommend to other investors). Each 5 Janus 38 -30 firm was scored by subtracting the percentage of shareholders 6 American Funds 26 12 who rated the firms at five or below from the percentage who rated the firms at nine or ten. Only 11 of the 38 firms evaluated 7 Franklin Templeton 9 1 had positive loyalty scores. The average score was -12, a message about investor confidence in the fund industry that 8 Morgan Stanley 2 -18 would seem to be less than a rousing tribute.

Average 9 Fidelity -3 12 Returns 10 Barclays Global -4 n/a Simply put, fund shareholders seem to get it. In Table 2 we see 11 AIM Investments -14 -48 a remarkable, if hardly exact, correlation when we juxtapose 12 Columbia Funds -14 -47 these loyalty scores for each firm with its performance scores.

Vanguard’s performance score (+54) and loyalty score (+44) 13 Goldman Sachs -40 -32 were both the highest in the field. Putnam’s scores, also similar 14 Dreyfus -40 -45 (-58 and -54 respectively), were both the lowest in the field.

Lowest 15 MainStay Funds -40 n/a When disparities between the two scores exist, they seem to Returns 16 John Hancock -43 -10 arise because the performance ratings, presented in Table 1, 17 ING Investments -55 -11 reflect the returns reported by the mutual funds themselves.

18 Putnam -58 -54 These reported returns can vastly overstate the returns that fund investors have actually earned. That’s often the case in Source: Morningstar, Cogent Research (December, 2007) this business, for fund marketers have a seemingly irresistible impulse to promote shares of a fund only after the fund has During the decade, these Janus funds reported time-weighted achieved sterling performance, which results in an impulse to returns averaging 9.3 percent per year, a compound ten-year purchase the funds that also seems irresistible to fund investors. return of +157 percent. The Janus fund investors, on the Following such superior performance, such funds seem to have other hand, earned dollar-weighted returns averaging 2.7 an almost equally irresistible impulse to revert not only to the percent per year on the money invested, a compound return market mean, but even below it. of only 38 percent. This means that the returns earned by Janus shareholders for the decade fell 119 percentage points The most glaring gap between the performance rating (+38) behind the returns that the Janus funds reported. That truly and the loyalty rating (-30) appears for the Janus funds. Let’s astonishing gap surely accounts for the gross disparity examine their records. During the ten years ending December between the funds’ high scores in reported performance 31, 2007, the five largest Janus funds produced an average and their low loyalty scores, based on the actual investment annual return of 9.3 percent, a solid margin over the annual experience of Janus shareholders. return of 5.9 percent for the S&P 500 Index. During the first three years of that period, the Janus returns soared far above the Index return and, as the market rose to new heights, some Volume 1 • Issue 1 • Fall 2008 59 Rotman International Journal Volume 1 • Issue 1 of Pension Management Fall 2008 to maintain expense ratios that average 1.5 percent per year, five times as high?

Costs Rear Their (Usually Ugly) Head The data clearly shows that truly mutual investing has not only reaped rewards for its clients, but has also earned their loyalty. According to Brian Cartwright, general counsel of the SEC: Also apparent is that financial conglomerates have not only failed their investors, but have earned their state of disgrace. “… [there are many] signs the mutual fund marketplace may How do we account for these differences in return? Obviously, not be performing in a way one would expect in a satisfactorily there is a certain amount of luck, skill and timing in performance functioning competitive market … American investors may ratings, even though much of the impact of those variations be being deprived of the long-term returns they deserve.” 25 evens out over a period as long as a decade. Even more of the disparity is mitigated when the management firms run Clearly, price ought to be the talisman that drives investor choice, one hundred or more funds. forcing fund managers to reduce costs, but that is simply not happening. Yes, money flows are increasingly directed toward It turns out that there is one factor that plays a major role in the lower-cost funds. Vanguard has not only initiated that trend, the relative returns of peer funds. Fortunately, it is a factor but has been its prime beneficiary. Other fund complexes are not that persists over time: the costs that funds incur in delivering following the lead. 26 In short, if price competition is not defined returns to investors. Funds with similar objectives, managed by the action of consumers, but by the actions of producers, then by competent and experienced professionals and compared price competition is conspicuously absent in the mutual fund over an extended period of time, are likely to achieve similar industry. Why don’t fund managers compete on costs? To do so returns, but only before the costs of investing are factored in. would be antithetical to their vested financial interest in maximizing These costs come in many forms including the expense ratio the return on their own capital, which in turn is based on the (i.e., annual percentage of asset value consumed by management level of fees and the growth in assets under management. fees and operating expenses), sales loads that represent the cost to acquire fund shares, and transaction costs representing the expenses incurred in the execution of the investment decisions made by the fund’s portfolio managers. Since transaction costs Table 3: Major Mutual Fund Managers: Fund are not publicly available, the all-in expense ratios I’m using, Performance, Shareholder Loyalty and Costs including sales loads built into the B and C share classes, are the most satisfactory measure of the aggregate impact Funds Ranked of fund costs.

Highest Client Avg. Eq.

Minus Loyalty Fund Exp.

Table 3 adds a column to Table 2 that shows the expense ratios Manager Lowest Score Ratio of the equity funds in each group. 23 It shows that the three firms with the highest performance ratings are the same firms, in the 1 Vanguard 54% 44 0.23% same order, that have the lowest annual expense ratios. For the 2 DFA 50 n/a 0.33 top-performing group, in total, the average ratio is 0.69 percent.

Highest 3 TIAA-CREF 50 n/a 0.37 Expense ratios for the middle group average 1.24 percent, al-Returns 4 T Rowe Price 44 21 0.93 though that group is also populated with fairly costly funds. 24 5 Janus 38 -30 1.21 The bottom group of performers has the highest expense ratios, 6 American Funds 26 12 1.06 averaging 1.57 percent per year. This data shows that relative costs are a principal determinant of relative fund returns.

7 Franklin Templeton 9 1 1.48 Costs matter a great deal.

8 Morgan Stanley 2 -18 1.23 Average 9 Fidelity -3 12 1.31 Returns 10 Barclays Global -4 n/a 0.41 11 AIM Investments -14 -48 1.59 Price Competition?

Despite the powerful message in Table 3 about the importance 12 Columbia Funds -14 -47 1.41 of costs, price competition remains conspicuously absent in the mutual fund industry. Investors seem to be largely unaware of 13 Goldman Sachs -40 -32 1.59 the direct and causal relationship between fund costs and fund 14 Dreyfus -40 -45 1.65 returns. Table 3 shows that there are only three low-cost firms in Lowest 15 MainStay Funds -40 n/a 1.49 the industry and that these three firms dominate the performance Returns 16 John Hancock -43 -10 1.40 statistics. Yet together they constitute a mere 14 percent of 17 ING Investments -55 -11 1.72 industry assets. How can the remainder of the industry continue 18 Putnam -58 -54 1.56 Source: Morningstar, Cogent Research (December, 2007) 60 Volume 1 • Issue 1 • Fall 2008 Bringing Mutuality to Mutual Funds The Triumph of Conglomeration Yet the SEC was: The truly mutual model of the mutual fund has yet to be copied “… not prepared to recommend at this time the more drastic and domination of the industry by the conglomerate model statutory requirement of compulsory internalization of management remains. Early on, Chairman Cohen recognized the serious [i.e., mutualization]. [Rather, the SEC recommended the adoption problems that would be created by this conglomeration. In of a] statutory standard of reasonableness … a basic standard a 1966 speech, he spoke of: that would make clear that those who derive benefits from their fiduciary relationships with investment companies cannot charge “… new and more complex relationships … [between] institutional more for services than if they were dealing with them at arm’s managers and their beneficiaries, [and sought] a more adequate length.. [Under this standard, the measure would be] the costs scheme of regulation that ultimately will protect beneficiaries of management services provided to internally-managed funds from unwarranted action by their managers, and will realize and to pension funds and other non-fund clients. [If the standard the fullest benefits of their participation [in their funds]. [His of reasonableness does not] resolve the problems in management concern about] public ownership of investment advisors … and compensation that exist … then more sweeping steps might the beginning of a trend toward their acquisition by industrial deserve to be considered.” 30 companies, [which makes it] increasingly difficult to define the responsibilities of institutional managers, [who may] be With vigorous lobbying by the Investment Company Institute obligated to serve the business interests of the very companies (the self-anointed representative of fund shareholders that is in in which they invest.” fact the powerful voice of fund managers), the reasonableness standard was never enacted into law. Fund fees soared and That is exactly what has happened. conglomerates gradually acquired the overwhelming majority of large mutual fund managers. As a result, more sweeping The snowball effect that began with the onset of public ownership steps will now have to be considered. of management companies in 1958 took a while to gain speed.

During the 1980s and 1990s, it gathered strong momentum.

With this massive wave of conglomeration, the industry’s mantra gradually changed from the stewardship that characterized its What’s to be Done? early tradition to the salesmanship of today. Asset-gathering My idealism tells me to fight for compulsory internalization, 31 became the name of the game and with it came the wave of at long last making it possible to delete those quotation marks product proliferation that carried the number of mutual funds around the ‘mutual’ fund that reflected the prescient concerns from 560 in 1980 to some 12,000 today. expressed by Chairman Cohen in the speech he delivered 40 years ago. My pragmatism suggests otherwise. Powerful and well-financed lobbyists led by the Investment Company Institute, the fabulously profitable management companies and their conglomerate owners and the U.S. Chamber of Commerce, It’s Time for a Change Only two weeks after that 1966 speech by Chairman Cohen, the SEC sent Congress a massive report by its staff entitled would take up arms against such a seemingly radical proposal. Public Policy Implications of Investment Company Growth Their campaign would come with unbridled enthusiasm and (PPI). 27 In that report, the SEC noted the burgeoning level energy, and virtually unlimited financial firepower. Given of fund fees, then at an annual level of a mere U$134 million the dismal state of corporate governance among our nation’s versus more than U$100 billion today. It also noted the business corporations, the self-interested opposition would effective control that advisors held over their funds and: almost surely defeat the reform of our fund management corporations and fail to honor the public interest and the “… the absence of competitive pressures, the limitations of interest of investors, the very interests that the 1940 Act disclosure, the ineffectiveness of shareholder voting rights, and the was designed to protect. obstacles to more effective action by the independent directors.” 28 Hope is not completely lost. There is a way to honor the spirit The SEC also noted: and letter of the Act so that investment companies are organized, operated and managed in the interests of their shareholders “… the advisor-underwriter permeation of investment company rather than their managers and distributors. It would take a activities to an extent that makes rupture of existing relationships series of logical steps to achieve this goal; some already in the a difficult and complex step … [rendering] arm’s length work; some proposed by an earlier SEC and now seemingly in bargaining between the fund’s board and the managers … jeopardy. Some new steps would take us even further toward a wholly unrealistic alternative.” 29 that goal. One simple, if dramatic, organizational change that Volume 1 • Issue 1 • Fall 2008 61 Rotman International Journal Volume 1 • Issue 1 of Pension Management Fall 2008 would create enormous momentum toward fund operational independence from their advisors is the following: Two Powerful Endorsements This critical analysis of the mutual fund industry is not mine 1. Require that 100 percent of fund Directors be unaffiliated alone. Listen to Warren Buffett: with the management company. There is no point subjecting management company Officers to the “… fund independent directors … have been absolutely profound conflicts of interest of serving as fund pathetic. They follow a zombie-like process that makes a Directors as well. It’s time to honor the principle mockery of stewardship. Independent directors, over more that no man can serve two masters. than six decades, have failed miserably.”

2. Require that the Chairman of the Board be independent Then, hear this from another investor, one who has not only of the management company. Such a separation of produced one of the most impressive investment records of the powers, ordained for our federal government in the modern era, but who has an impeccable reputation for character Constitution, is not only a fundamental principle of and intellectual integrity, David F. Swensen, Chief Investment governance, but simple common sense. Officer of Yale University: 3. Require the retention by the funds of Legal Counsel “… the fundamental market failure in the mutual-fund industry independent of the Advisor and a Chief Compliance involves the interaction between sophisticated, profit-seeking Officer. Both have already been mandated by the providers of financial services and naïve, return-seeking SEC, but we must require them to be responsible consumers of investment products … Investors fare best with to the Fund Board, reporting to the independent funds managed by not-for-profit organizations, because such Fund Chairman. firms focus exclusively on serving investor interests…” 34 4. Require that Fund Boards retain Advisors and Experts I regard these two powerful endorsements of the positions necessary to carry out their duties, in order to provide I hold as a call for action. It’s time to make fund directors aware truly objective and independent information to the of their duty to serve the fund shareowners rather than the Board. In its 2004 recommendations, the SEC entrenched fund managers and to bring independent leadership recommended language authorizing such staff or to fund Boards. That is the purpose of the six changes I’ve consultants. It should be mandatory, but apply only delineated. I’m well aware that for some firms, these changes to fund complexes of a certain size and scope.32 may finally lead to the full mutualization that, in the only case study that exists, has served shareholders so well. It’s 5. A specific regulation that authorizes funds to assume also time to return to court and seek to overturn the ghastly responsibility for their own operations including legacy of the Ninth Circuit’s erroneous decision in 1958 that administration, accounting, financial controls, opened the floodgates first to public ownership and then to compliance, shareholder record-keeping and so conglomerate ownership. 35 It’s high time to return the industry on. Such a structure would cut the Gordian knot to its professional roots, with fiduciary duty at the fore. that has given fund managers de facto control over the funds they manage. 33 In short, it’s time for a new order. It’s time to go back to the future and honor the vision of trusteeship held by Paul Cabot, 6. Enact a federal standard of fiduciary duty for financial to the vision of SEC Commissioner Healy to protect investors institutions, one that would apply to fund directors. from the distorting impact of fund sales, to the wise and prescient The fact is that mutual fund managers and pension vision of SEC Chairman Manuel Cohen, who challenged us fund managers, public and private alike, face serious to build an industry that is worthy of deleting those quotation conflicts of interest in carrying out their duties. In marks that he placed around the word ‘mutual’ and at last today’s relatively new agency society, in which bringing true mutuality to the mutual fund industry. financial institutions control more than 70 percent of stock ownership, there has been a serious failure of these agents to serve their principals - largely fund shareholders and pension beneficiaries.

62 Volume 1 • Issue 1 • Fall 2008 Bringing Mutuality to Mutual Funds Endnotes 1 “The ‘Mutual’ Fund”, an address by Manuel F. Cohen before the 1968 from their returns. This method gives a more realistic picture of the Conference on Mutual Funds, Palm Springs, California, March 1, 1968. performance actually delivered to fund shareholders in all share classes. 2 Ibid. 20 Full disclosure: two much smaller firms have higher ratings; Dodge & 3 Ibid. Cox, with 4 funds, achieved a remarkable rating of +100; Royce and 4 Investment Company Act of 1940, 15 U.S.C. § 80a- 1(b)(2) (2000), Associates, with 31 funds, had a score of +65. available at http//www.sec.gov/about laws/ica40.pdf. 21 The success of Neuberger Berman, ranking #8 with a score of +19, was 5 In re: The Vanguard Group, Inc., S.E.C. Investment Company Act Release largely achieved before its 2003 sale to Lehman Brothers. No. 11,645, 22 SEC Docket 238 (Feb. 25, 1981). 22 The Wall Street Journal published the ratings for only eight of the firms 6 The investment advice for approximately 70 percent of Vanguard’s fund in the survey. The other ratings were made available for this essay. assets—largely index, bond, and money market funds—is provided Many of the firms in the performance survey were not included in the internally on an at-cost basis by Vanguard itself. The remaining 30 loyalty survey. percent of assets are in funds advised under contracts held by a score 23 Since the largest variations in fund expense ratios come in equity funds, of external advisors. I have excluded the expense ratios of bond funds—which are generally 7 Yogg (2006). lower—from this comparison. This practice also eliminates the distortion 8 Ibid. that would be created when firms manage different proportions of bond 9 Ibid. funds to stock funds.

10 I believe that referring to mutual funds as “products”—even worse, as 24 The funds managed by Barclays, with a ratio averaging 0.41 percent, “products manufactured by their advisers”—demeans the fiduciary spirit largely follow lower-cost index or index-like strategies. of the 1940 Act. Decades ago I banned the use of the term at Vanguard 25 Speech by Brian G. Cartwright, before the 2006 Securities Law and imposed a fine of $1.00 for each usage. Developments Conference, December 4, 2006.

11 Yogg (2006). 26 I’m often told that Vanguard’s demonstrably low costs—increasingly 12 Ibid. recognized in the marketplace—are responsible for setting an upper 13 Ibid. limit on prices among our competitors. But that level is still far too 14 Ibid. high for my taste.

15 Ibid. 27 U. S. Government Printing Office, December 3, 1966 16 Ibid. 28 Ibid.

17 A note in the Harvard Law Review of April 1959, Number 6, took issue 29 Ibid. with the Ninth Circuit’s decision, agreeing with me that the decision was 30 Ibid. ill-decided. “If (the Act) is construed to incorporate the basic principle 31 But not for all fund complexes, only for complexes that exceed certain that a fiduciary owes individual loyalty to the beneficiary and must avoid thresholds; for example, fund complexes that manage over $25 billion any conflict of interest, then a seller should not be allowed to transfer his in assets and more than 30 mutual funds. fiduciary office for personal gain . . .” page 180. 32 For example, complexes meeting the standards outlined in Endnote 31. 18 To prevent this extensive essay from being even longer, I have summarized In my darker moments, I’d consider applying this requirement only the story of Vanguard’s formation, including the tortuous path of negotiating to fund complexes in which a majority of the directors are unable to and the compelling economics of my proposal for fund shareholders actually name all of the funds on whose boards they serve. under which funds would acquire Wellington’s mutual fund business. 33 It is a curious fact that the operational function was ignored in the 1940 (Its counseling business would have been returned to the pre-merger Act, which refers solely to the other two functions of fund management, partners.) An expanded version of the story can be found in my lecture investment advice and share distribution (underwriting). “The Mutual Fund Industry, From Alpha to Omega,” at Boston College 34 Swensen (2005).

Law School on Februrary 20, 2003, available at 222.johncbogle.com. 35 Interestingly in light of my recommendations here, the note in the Harvard 19 By weighting the analysis by number of funds rather than by assets, Law Review cited in Endnote 17 concludes with this caveat. “However, this procedure has one strength not in evidence in other methodologies, the sellers might be allowed to sell control for any consideration if the which almost invariably ignore the impact of sales loads. My methodology fund had an independent board of directors … with control of the proxy captures the returns of “B” and “C” shares, usually smaller in assets but machinery and the power to select another adviser.” in which sales loads are built into their expense ratios and thus deducted References Manuel F. C., The ‘Mutual’ Fund”, an address by Manuel F. Cohen before the Bogle, J. (2003), “The Mutual Fund Industry, From Alpha to Omega,” 1968 Conference on Mutual Funds, Palm Springs, California, March 1, 1968. Lecture at Boston College Law School, 222.johncbogle.com.

Investment Company Act of 1940, 15 U.S.C. § 80a- 1(b)(2) (2000), available Cartwright, B. G. (2006), Speech before the 2006 Securities Law at http//www.sec.gov/about laws/ica40.pdf. Developments Conference.

Yogg, M. R. (2006), Passion for Reality, Xlibris. Swensen, D. F. (2005), Unconventional Success, Free Press.

Volume 1 • Issue 1 • Fall 2008 • 10.3138/rijpm.1.1.63 63 About Rotman International Centre Editorial Advisory Board for Pension Management The Netherlands Australia The mission of the Rotman International Jack Gray - Sydney University of Technology Rob Bauer - Maastricht University Centre for Pension Management (Rotman Wilson Sy - Australian Prudential Dirk Broeders - De Nederlandsche Bank ICPM) is to be a catalyst for improving the Regulation Authority Jean Frijns - BCBG Institute management of pensions around the world.

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