Vanguard Chairman Recommends Internalizing Fund Management
April 12, 1999
In his second book, John C. Bogle, senior chairman and founder of The Vanguard Group, reiterates much of what he has said in frequent speeches and in a previous book.
His new book, "Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor," (John Wiley & Sons, 1999), however, goes beyond his previous book with a significant section devoted to issues related to the management of mutual fund companies. His previous book was devoted to his thoughts on investing.
One of the most provocative suggestions Bogle makes is that mutual fund management should be internalized. By managing their funds themselves and abandoning the practice of hiring investment management companies to do so, fund complexes and shareholders would save a good deal of money, Bogle says. It would also eliminate the fiction of "independent directors," he said.
Currently, independent directors who are selected by a fund's manager and paid handsomely by that fund are not objective, Bogle says. The fact that expense ratios have soared in the past 15 years and marketing and advertising budgets have ballooned is proof of "languid oversight" by mutual fund boards, he says.
The notion of internalizing fund management harkens back to the time before passage of the Investment Company Act of 1940. That act mandated that fund complexes be managed by independent companies.
Other points Bogle makes will sound familiar.
He says fees are far too high and that marketing and advertising campaigns are largely a waste of money that only create unrealistic expectations for returns.
Bogle also decries the fact that equity mutual funds are now traded as if they were disposable consumer goods, rather than being held as long-term investments. Today's mutual fund industry has taken on the character of a gambling casino, he writes.
On average, the annual equity fund expense ratio rose 50 percent in 16 years, from 0.97 percent of assets in 1981 to 1.55 percent in 1997, "even as assets have exploded," Bogle writes. These costs are essentially hidden to investors, buried deep in mutual fund annual reports, he says. Since consumers would not tolerate a sudden increase in the price of automobiles, Bogle questions why they should let this go unnoticed in the mutual fund industry.
Meanwhile, pretax profit margins for mutual funds are 40 percent, he says.
"Because there are staggering economies of scale in portfolio management and research, expense ratios should have substantially declined, and savings should have been enhanced by even more billions," Bogle wrote. Instead, the really big winners have been the directors and managers of mutual fund companies, he said.
Bogle also says that performance figures are misleading. Dollar-weighted and time-weighted returns are realistic measures but rarely used by the industry, he says. Returns are usually inflated, he says.
Marketing campaigns distract fund managers from their "fiduciary responsibility" of acting as stewards of shareholders' hard-earned investments, Bogle says.
"Investment principles take a back seat when marketing takes precedence over management," he writes.
Bogle finds the current climate of selling mutual funds as though they were packaged consumer goods distasteful.
"Mutual funds are not selling skin care lotions or exotic vacations," Bogle writes. "We ought not to be selling hope, dreams, youth or fitness. . . .We should not be hawking consumer products or imitating their naturally aggressive product marketing programs. Mutual funds are or at least should be first and foremost stewards of investors' savings."
The extra assets that a marketing or advertising campaign attracts only serves to make the portfolio "muscle-bound," and less able to agilely respond to the market, he says. Bogle estimates that mutual funds spend more than $10 billion a year on promotions, and another $6 billion in 12b-1 fees for distribution.
Even if mutual funds were restructured and adopted internalized management, the industry has been irrevocably changed by the day trading that the Internet has wrought, Bogle says.
Today, "mutual funds are evaluated as stocks, purchased as stocks, traded as stocks and discussed as stocks in the corridors of commerce and at cocktail parties," Bogle writes. Currently, the average holding period of a mutual fund is only three years whereas 20 years ago, it was 11, Bogle says.
There is, however, some hope that investors and mutual fund managers will return to the fundamentals of investing once the bull market ends, Bogle says. The end of the bull market could also precipitate changes in the industry, he said.
Only ignorance is preventing investors from staging a revolution against abuses in the industry now, he says. But eventually, as the bull market wanes, disappointed investors will become more critical and demand full fee disclosure, lower fees and truly independent directors who will keep their interests at heart, he said.
"Some 50 million faceless and voiceless shareholders have been entranced by receiving the magnificent blessings of the long bull market without realizing they have received far less than their fair share of these blessings," Bogle writes. "They deserve better from the directors they have elected to represent them."