The United States is at war. Unemployment is up. Economic growth is limping. The stock market remains in a deep slump. Americans are skeptical about corporate reporting. In such a perilous climate, what does one of the country’s best-known stock market experts advise investors to do?
Just stay the course, says John Bogle, founder and retired chairman and CEO of The Vanguard Group, the second largest mutual fund company in the U.S. and the leader in the index-style of investing that Bogle invented. “An investor who isn’t worried about what is going on in the world is a damn fool,” Bogle said in an April 2 interview with Knowledge@Wharton.
But that doesn’t mean, he added, that investors should do radical surgery on their portfolios. The war in Iraq, for example, probably won’t have any long-term effect on the stock market, though the wide price swings since fighting began demonstrate its emotional toll on investors. “Emotions lead to the exactly wrong conclusions,” he warned.
A long-time critic of his own industry and investment fads, Bogle sees plenty of problems in today’s financial markets. He believes, for example, that President Bush’s tax-cut proposal is ill timed and will do little to boost the economy. “When you’re running a huge budget deficit, you don’t want to cut taxes.”
Like many ordinary investors, Bogle is skeptical about the accuracy of corporate reporting and worries that too many managers and directors are putting their own interests ahead of shareholders.’ But he is not convinced new regulation is the solution.
“We’ve got to get the system to do a better job itself,” he said. That will require more activism from shareholders, including fund companies. Unfortunately, actively managed funds buy and sell stocks so fast that they have little long-term interest in corporate governance issues. According to Bogle, average portfolio turnover among managed funds is 110% a year.
In recent years, there has been an increase in shareholder resolutions, Bogle added, noting that most of the activity has come from labor unions. “Mutual funds are in the Dark Ages” when it comes to shareholder activism.
Bogle was a strong supporter of a recent Securities and Exchange Commission rule change requiring fund companies to publicly disclose their votes on proxy issues at companies in which their funds own stocks. Bogle felt shareholders have a right to know how their fund managers vote, and that opening the process would put pressure on managers to use their clout to improve corporate practices. Most of the fund industry, including Vanguard’s current management, opposed the SEC proposal.
It wasn’t unusual for Bogle to go against the current. Indeed, that has been the central theme of his career.
The foundation of his mutual fund philosophy was laid when, as a student at Princeton in the late 1940s, he stumbled across a Fortune magazine article on the then-tiny fund industry. The result was a thesis that set out the basic principles Bogle believed should be followed by a responsible fund: Sales charges and management fees should be stripped to the minimum, the fund should avoid extravagant promises about performance, effort should be focused on management rather than sales, and the company’s primary responsibility should be to shareholders, not its own managers.
After Princeton, Bogle went to work for the famous Wellington Management Company, which ran the actively managed Wellington Fund. By the early 1960s Bogle was in charge. He brought in partners who fired him in the wake of a disastrous period for the company when some of its funds trailed the market averages by wide margins. “I made a big error and I paid a big price,” he recalled in a recent speech to the Wharton School Investment Management Club.
In 1974 he founded The Vanguard Group in Malvern, Pa. The next year, he started the Vanguard 500 Index Fund. Rather than employ teams of stock pickers, the fund simply buys all the stocks in the Standard & Poor’s 500 index. Today, this is the largest fund in the world.
“I’m sure you think, ‘That’s a pretty stupid, banal idea,’” he told the students. “‘Somebody must have thought of that before.’ But nobody did think of it before.”
Up to that time, mutual funds typically relied on stockbrokers to generate sales. Bogle’s idea was to wait for investors to come directly to Vanguard, eliminating the fee, or “load,” charged to investors to pay the brokers. While most fund companies are publicly traded corporations or closely held companies, Vanguard has always been owned by its fund shareholders.
The heart of Bogle’s indexing philosophy is the belief, supported by much academic and fund-industry research, that few active managers can consistently beat stock market averages year after year. One study, he said, showed that 35% of managers beat the market in any single year. But the percentage falls to 25% over a 10-year period, 10% over 25 years and 5% over 50 years – an investor’s lifetime investing horizon. “You’ll all be in the 5%,” Bogle joked, drawing laughter from the Wharton students, many of whom aspire to careers as investment managers.
Since the odds of beating the market are so slim over the long term, the best results will be achieved by those funds that are content to match the market by owning all the major stocks in it, and that minimize the corrosive effect of costs, Bogle said.
Citing data from the fund-tracking company Lipper Inc., Bogle noted Vanguard’s expense ratios (generally, the annual fee paid to the fund’s managers) have fallen from an average of 0.73% of an investor’s holding in 1974 to 0.26% today. Over the same period, the entire industry’s average (including index funds) has risen from 0.91% to 1.32%.
In addition to expense ratios, which average 1.6% for managed funds, the typical managed fund must pay 0.8% for trading commissions and other transaction costs and 0.3% in sales charges. By holding 6% of funds assets aside for cash reserve, the typical managed fund passes up 0.2% in investment gains. Miscellaneous costs chew up another 0.2% of assets.
Hence, said Bogle, the total annual costs for the average managed fund is 3.1% of assets. If annual investment gains averaged 8%, these fees would devour 37% of each year’s return. By reducing annual returns from 8% to 5%, these costs would cut the 30-year return by 57%, so that each dollar invested would grow to $4.32 instead of $10.06.
The indexing approach seeks to dramatically reduce costs. “Low costs inevitably lead to higher returns,” Bogle said. A $10,000 investment in 1982 in an index fund matching the S&P 500 grew to $109,000 by the end of 2002, while an identical investment in the average managed stock fund would have grown to $63,600. The reason: While the S&P 500 returned 12.7% a year, costs reduced the average stock fund’s annual return to 9.7%.
While some investment experts labeled indexing “Bogle’s Folly” in the 1970s, his strategy’s merits have been clear to millions of investors. Today there are more than 350 index funds, up from one in 1976.
The strategy has also been good business for Vanguard, which controls 80% of the stock index fund market. With more than $550 billion under management, Vanguard is the second largest fund company, behind Boston’s Fidelity.
In an interview, Bogle insisted that the war, economic weakness and crisis of confidence that plague today’s market should not be a concern for the long-term index investor. Over the long run, he said, stock price gains track the growth of corporate earnings, which have recovered from all previous slumps. Also, index investors are so broadly diversified they need not worry about accounting shenanigans and other problems at individual companies.
For the students in his audience, Bogle offered some career tips drawn from his own experience: Be lucky, be ready to jump on an opportunity, find a good mentor, be observant and open to new ideas.
“Don’t be like me,” he concluded. “Be yourself. That’s the most important thing you can do in life.”