CAHPTER 6
THE COST-FEE NEXUS
At Boston Consulting Group in the 1960s, founder Bruce Henderson made a strong case for basing an organization’s long-term strategy on low costs, arguing that they would enable the firm to charge lower prices. In doing so, the firm would gain market share and increase volume so much that the combination of lower costs and higher volume would enable it to become profitable. Repeated in a virtuous cycle, lower and lower costs would make possible lower and lower prices—that would lead to higher market share and larger volume, enabling even lower prices because the cost per unit of production would be lower.
Low fees for investors, Vanguard’s central proposition, depend on low operating and fund management costs. Reducing, removing, and managing costs shows up over and over again as the company’s primary management focus.
Bogle earned a reputation for frugality and a relentless focus on lowering the cost of investing. Vanguard investors admired his drive to reduce costs, knowing they would benefit with higher returns. His friend, Princeton economics professor Burton Malkiel, told this story when introducing Bogle before the Newcomen Society in 1992:
Once Jack had to stay at New York’s expensive Plaza Hotel for a meeting. When his turn in the check-in line came up, he informed the desk clerk he wanted the cheapest room possible. The clerk suggested an economy single at $250, but Jack insisted that was way too high. After Jack rejected a number of other suggestions, the exasperated clerk indicated sarcastically that there was a windowless former broom closet next to the elevator shaft for $89. Jack quickly said, “I’ll take it.”
As the bewildered clerk was searching for a key, Jack turned to a gentleman waiting in line behind him and apologized for holding up the line. The gentleman, who turned out to be a Vanguard shareholder, said, “Oh, that’s perfectly okay. You’re Mr. Bogle aren’t you? Cheap! Right?”
Bogle not only insisted on cheap hotel rooms; he also flew coach, wore off-the-rack suits long after they were showing their years, avoided the social circuit, and drove cars of a certain age, all as part of the penny-pinching image he cultivated for himself and, by extension, for Vanguard. He established the importance of low cost and increasingly offered low fees at Vanguard long before anyone else in the industry thought low fees could be important.
Of all the many beliefs about the investment management business, at least until recently, the strongest and strangest has been that fees are not important. Fees are widely perceived to be low. So why would being “lower than low” make sense as a business strategy? Who would notice? Who would care? Superior performance was every investor’s obvious objective, and the relevant clichés were plentiful: “You get what you pay for.” “You wouldn’t choose a brain surgeon just because he charged less.” “Do you really want a manager who is less than the best?”
Bogle knew that conventional certainties can become seriously misleading over time as business changes compound. The new investor already had the assets, so the manager was providing only returns. If, say, the returns on a balanced fund averaged 7 percent, the fee described as “only 1 percent” of assets was actually a full 15 percent of returns; 15 percent is clearly not “only 1 percent.” Add another 1 percent of assets for transaction costs (commissions and market spreads between price to buy and price to sell), and an active manager must recover nearly 2 percent of assets—which means achieving nearly 30 percent higher returns than the market average. Could this be achieved repeatedly in a stock market dominated by equally well-informed competitors, equally well-armed with technology and talent, and all competing to identify and exploit any pricing error—making such opportunities remarkably difficult to find and quick to disappear? Bogle had studied the performance records of mutual funds and said: No!
Most fund management companies were increasing their management fees, particularly by adding on 12b-1 fees of 0.20 percent to 0.40 percent. Vanguard kept lowering its fees, attracting more attention and much more in assets. Yet for many years, Vanguard did not attract direct price competition because competitors were for-profit businesses, not “mutual” organizations. By 1995, Vanguard’s average expense ratio had been reduced to 0.30 percent while its average competitor’s had increased to 0.92 percent. The difference would matter.
Thanks to internal cost discipline—travel coach, stay in bargain hotel rooms, simple meals, no entertainment, moderate pay, little advertising—and tough fee negotiations with its external investment managers, Vanguard almost axiomatically had the lowest costs of operation. Cost consciousness is obvious in the spartan offices of senior managers. Simple, functional, and “standard issue,” they are all gray, modest in size, and surrounded by cubicles used by the managers’ direct reports. Vanguard was staking out a strategic corner of competitive advantage; for decades none of the other mutual fund companies would want to match its low fees.
From the point of view of the investor, if indexing can deliver almost all of the market’s return (minus just a few basis points) at no more risk than the market itself, what does the typical mutual fund based on active investing offer? While there are winners every year in the contest to beat the market, over a decade or longer the record is sharply different—and instructive.
Even though each fund is free to select the particular market segment in which it will specialize—large or small companies, growth or value focus, and dozens more—and is free to assemble the team it wants, to select the research resources it values most highly, to select the stocks it likes best and avoid those deemed less attractive, the grim reality is that over the past 15 years, a stunning 89 percent of actively managed mutual funds failed to keep up with their chosen target index. Managers who were in the winning 11 percent in one year were unlikely to stay there in succeeding years. Those funds that fail to match their benchmark lose far more than the few successful funds gain for shareholders. Adding insult to injury, investors in mutual funds notoriously do noticeably worse than the funds they invest in because they tend, as a group, to buy their funds high and sell them low.
Major long-term changes in the structure of the stock market and the overwhelming dominance of today’s market by professional investors and computers have slashed the odds of any active manager’s outperforming an index from high 60 years ago to low today. After the substantial costs of active management—over 1 percent of assets for fees and nearly 1 percent for transaction costs*—beating the market has gotten persistently harder in almost all the major markets around the world. (China, where stock market activity is still dominated by individual trades, continues to be an exception—until institutions inevitably begin to dominate.) The challenge isn’t to locate an excellent manager. There are now so many excellent active managers that the real challenge is to find an active manager who is significantly better than excellent. Today almost all buying comes from expert professionals and almost all selling is to expert professionals. This is extraordinarily different from past markets dominated by part-time individual amateurs and ponderous institutions. The “willing losers” are almost all gone.
The near-equality of excellent investment talent reflects the remarkably near-equality of excellent information. Large securities firms that might have had only a dozen analysts 50 years ago now have 500 or more industry and company analysts, economists, commodity experts, portfolio strategists, and others in regional offices all over the world, gathering insights and information they distribute via the internet to their institutional clients everywhere. Every professional has superb computer power, as well as Bloomberg terminals that enable users to organize any useful data in whatever way they like, on 345,000 desks worldwide. The SEC requires public companies to make diligent efforts, whenever giving any one investor significant information, to ensure that same information is simultaneously available to all investors. In sum, among the professionals, almost everyone knows almost everything at almost the same time.
What might an investor do to avoid the trap of costs exceeding benefits? Reduce costs! Index funds and ETFs are two ways to deliver cost-effective value. Another way is to carefully select active managers and contract with them to provide their investment services at unusually low fees. This win-win arrangement is now used to select managers for dozens of actively managed Vanguard funds.
Vanguard offers its active managers four major benefits: substantial assets will be accumulated if the manager performs; all shareholder services are provided by Vanguard; a Vanguard relationship allows managers to significantly diversify their business; and Vanguard investors’ assets are more persistent or stable than those of the average mutual fund. Vanguard is more than happy to pay a successful manager a handsome incentive for outstanding results. Of course, there are significant penalties for underperformance as well.
Vanguard strives to provide superior indexing and superior active management. Either way, it is focused on providing investors with low-cost access to long-term investment managers and on guiding clients toward sound investment policy planning and staying on plan for the long term.
Even individually small cost savings add up. Many fund companies report and pay dividends four times a year. To minimize costs, Vanguard has semiannual dividend distributions for some funds. Each reduction in distribution frequency can save $50,000 to $100,000. Similarly, after analyzing mailing costs, Vanguard cut an eighth of an inch off the form for voting proxies and saved $40,000 a year for its investor-owners.
The most pervasive cost consciousness at Vanguard is in the vigorous use of technology to reduce the number of people required to deliver good service to investors. But at least one source of significant savings involved little technology and more people. Years ago, instead of increasing the permanent service staff to handle peak call-volume days, Vanguard developed a flexible response capability that both increased service capacity in the near term and reduced costs over the long term. Conceived by Jack Brennan, then chief operating officer, and dubbed the “Swiss Army” by Bogle after the defensive force that has protected that small country’s independence for more than 500 years, the program was a successful response to a service failure.
Back in April 1987, with interest rates rising, the municipal bond market took an unexpected nosedive. Municipal bond markets are quite thin, so any rush by investors to buy or sell can quickly send prices up or down. Falling prices can provoke still more selling, which is what happened in 1987. Clients responded by suddenly wanting to switch from long-term municipal bond funds to short-term money market funds. While most fund managers charged a redemption fee, Vanguard (and Dreyfus) did not, so they got hit with almost all the anxiety selling. With some municipal bond prices off by as much as 20 percent, more than 27,000 calls poured into Vanguard’s 800 phone lines from worried investors.1 Bond manager Ian Mackinnon recalled, “It was like being in a traffic accident. Your mouth gets dry. You don’t feel pain because you’re in a state of shock.”2 Vanguard was not able to keep up with its standard of answering 90 percent of calls within 45 seconds.
Brennan was determined to prevent a recurrence and to do so cost-effectively. Call volumes vary for many reasons: market breaks, but also weather, tax season, and more. Peak to trough call volume generally varies 2 to 1. Brennan’s solution: cross-train hundreds of crew members—including himself; James H. Gately, head of the individual investor group; Gus Sauter, head of indexing; and Jack Bogle—to serve as an on-call ready reserve of trained people who could staff the phones whenever needed—but only when needed. The training consisted of two days in a classroom and five weeks on the phones, with a two-day annual refresher. The Swiss Army met three Vanguard objectives: minimize costs, maintain high client service standards and, importantly, keep senior leaders in touch with retail clients.
The hard test of Vanguard’s Swiss Army came just six months later, when the Dow Jones average dropped 22.6 percent in a single October day, the most before or since. Call volumes took off; the army was ready. Vanguard kept up with the surging demand for service, and smiles of satisfaction were everywhere among the crew. In times of investor anxiety, as Brennan has said, “First, you have to be there. Second, you have to provide good information, and third, you have to meet the client’s request.”3
One request during his service on the client phone lines tested Gus Sauter’s sense of humor. The investor calling in wanted an actively managed fund and opined that index funds could be managed by a monkey. Sauter replied amiably, “I guess you’re talking to the head of the monkeys.”4
While systematically reducing or eliminating costs, Vanguard has also found a way to augment returns in a conservative way. By lending securities, Vanguard earns cash that goes straight back to investors. Vanguard lends securities to carefully selected dealers that want to sell those securities short, usually for their own risk-mitigation purposes. The dealers must always put up more than 100 percent in high-grade collateral, so Vanguard incurs no risk. As Bill McNabb, then head of the 401(k) business, told the Financial Times, “Everything we do [in lending securities] is 100 percent collateralized with maturities shorter than our own money market fund. So [the program] is run very conservatively. The extra income can, on occasion with certain index funds, offset management fees entirely. In such cases, the net cost of skillful management to investors: zero.”
Another creative way to reduce cost is by changing service providers when one becomes unwilling to respond to business changes. Vanguard’s original deal with Standard & Poor’s was based on a fixed fee for the S&P 500 index fund. When that fund grew beyond all expectations, S&P realized it had made a big mistake and wanted more money. Vanguard refused to change the contract terms. Then Gus Sauter introduced an ETF version of the S&P fund. S&P claimed the ETF was a different customer, so it had a right to a higher fee. When Vanguard again refused, S&P’s then parent company, McGraw-Hill, sued and won. But that was not the end of the story.
Sauter had earned his MBA at the University of Chicago, a flourishing academic center for quantitative analysis of investment markets. As a leading alumnus, he had been asked to serve on the Chicago business school’s board of advisers. He knew that, decades before, Merrill Lynch had offered $50,000 to support what would become the school’s Center for Research in Security Prices, or CRSP (pronounced crisp). Merrill Lynch had wanted contemporary proof that stocks were better long-term investments than bonds. That was then still a contentious proposition, although it had been argued at least since Edgar Lawrence Smith’s 1924 book Common Stocks as Long-Term Investments, the bible of the 1920s roaring bull market.
Guided by corporate finance professor James H. Lorie, a gaggle of graduate students collected, organized, validated, and entered onto IBM punch cards the daily prices of more than 1,000 stocks over 8,650 days of trading—nearly 9 million entries. The center was successful at proving that stocks substantially outperformed bonds over time.* So Merrill Lynch got value for its money, and quantitative analysts found the data useful, particularly for research articles. But CRSP data was not marketable in the way Standard & Poor’s data was because it had not been converted into an index that could be tracked, minute by minute, throughout the trading day. Sauter had a win-win opportunity in mind.
CRSP was not at all known to individual investors, Vanguard’s main market. So before confronting S&P, Sauter did his homework. He commissioned a survey of investors to learn how much they cared that the index fund was tied to the S&P index. As he expected, most didn’t care at all. They valued Vanguard as a low-cost fund manager but felt that any reputable index was as good as any other.
Sauter’s proposal to Chicago’s Dean Ted Snyder was compelling. Vanguard would advance the school 100 percent of the cost of converting the CRSP data into a first-rate continuous index, with the work to be done by two faculty members at $750 a day each. To use the index as the Vanguard fund’s benchmark, Vanguard committed to paying an annual royalty that, while considerable, was low relative to those imposed by S&P and provided the Chicago business school with a substantial annuity.5
And that’s how the Vanguard S&P 500 Index Fund became the Vanguard 500 Index Fund.
Advertising was long one of the most obvious ways Vanguard minimized costs. It did almost no advertising—Fidelity spent more than 10 times as much on media ads. Jack Bogle had a personal solution for the advertising gap: get favorable newspaper, magazine, and cable TV stories about Vanguard, particularly in the New York Times, the Wall Street Journal, Money, Forbes, Barron’s, CNN, and CNBC.
The secret to Bogle’s success with the media was no secret at all. When many investment people avoided the press, he embraced it. Bogle was an active, skillful player, in the game every day. Financial reporters got to know that he answered phone calls and had facts to support his opinions about what was best for investors. He proclaimed that the investment management industry, highly profitable for insiders, all too often failed the individual investor by charging high fees while claiming but not actually delivering superior results: “Mutual funds charge fees that are too high.” “Sales charges are excessive.” “Managers are greedy and focus on the short term.” “Advertising is misleading.” “Somewhere along the road, the industry has lost its way.” Reporters cited Bogle as a maverick, the conscience of the mutual fund business, an iconoclast. Some chided him for his love affair with controversy. As part of his persistent campaign, Bogle would offer, in several books and many articles and speeches, not only a tough critique of shoddy procedures, but also basic guidelines for success that every investor could understand and use.
Bogle’s status as an industry icon was good for Vanguard’s business. It also made Jack Bogle impervious to anyone else’s management or control. Call by call, article by article, and quote by quote, he built a personal brand, one of the best in the business. In Jack Brennan’s view, Bogle’s press coverage was “worth millions” to Vanguard every year. Few people in business achieve name recognition and admiration that make them public celebrities—and in finance, very few. Jack Bogle made himself one. He loved it and defended it. When the Washington Post cited both Bogle and Warren Buffett as leaders who had set high standards of faithful services to investors, Bogle protested that the Post had mentioned Buffett more.
Whether others always liked it or not, Bogle had always been the most visible and recognizable spokesperson for Vanguard. That personalized and differentiated the firm, especially in the early stages. He complained in retirement, “They won’t use me.” That bothered Bogle on three levels: he would work without cost to Vanguard; he would have loved to do it; and he knew that Vanguard knew that. He felt they were hurting him and the firm he had founded by denying him the opportunity. What he could not, or would not, see was that his need to be independent and outspoken had tarred him as a loose cannon with opinions that were often in opposition to those of Vanguard’s senior management. He had decried ETFs as temptations to trade too much. He went public with “concern” about index funds becoming market dominating and somehow causing harm. (See Chapter 18 for a discussion of these issues.)
Jack Bogle became one of the most widely recognized people in American business. He enjoyed the whole process. No matter how his wife might plead that he retire at 70 or 75 or even 80 or 85, he pressed on regardless. The focus of his unrelenting drive became perfecting his public reputation as the centurion of the everyday investor. He was consistent and plain spoken. In a fearless, curmudgeonly style, he held the attention of large audiences who delighted in anticipating what he might say and enjoyed hearing him out. Time and again, his audiences learned from him and learned to trust him. As more and more reporters paid attention to Bogle, he compiled and, every few weeks, mailed out to reporters and others packages of his recent speeches and articles with a page or so of Xeroxed handwritten commentary reinforcing his key points and correcting any errors he had seen in articles about him. Eventually, Bogle no longer needed to be CEO or even at Vanguard to be widely recognized and respected as an insightful observer to be reckoned with.
As the stock market plunged in 2008, financial firms terminated tens of thousands of employees to cut costs. Not Vanguard; while shaving millions of dollars from its cost structure, it terminated not one crew member (as its employees are known).
How did this retention fit with cost management? The need for crew did not drop comparably with the market. Clients still needed lots of service, maybe even more. Moreover, Vanguard senior management believed loyalty down would win loyalty up. Layoffs were averted by redeploying crew to other duties and project work. The result: unusually low turnover, unusually high morale, and continued dedication to serve clients.
Jack Brennan said, “Low cost is not the same as cheap. Our leaders understand that a focus on cost does not mean don’t spend. It means spend wisely. We must be comfortable being—no, we must relish the opportunity to be—the lowest-cost, highest-value provider of investment services in the world.”6
Lower pricing is more important in absolute dollars to larger investors. Larger investors are also less costly to serve per dollar invested. That’s why owners of Vanguard’s Admiral shares (and recently, all index fund shareholders) enjoy lower expense ratios. To the extent that it attracts larger investors, Vanguard gains advantages of scale, allowing it to reduce overall expense ratios, benefiting investors of all asset sizes.
“You define yourself more by why you do things than by what you do,” said CEO Tim Buckley. “We try to look at every decision in terms of what we should do and what we should not do. We are always asking, ‘How could each new idea work to reduce cost or increase service value or both?’ We seek efficiency to increase our effectiveness in serving clients. For example, a bill-paying service that Jack Brennan loved as a personal convenience attracted only 4,000 customers. This was not an adequate number of users to achieve significant scale advantages, so it was terminated.”
Pressing too hard on any one dimension can, of course, have unintended negative consequences and even do serious harm. Both speed of response and accuracy can fall short when Vanguard is growing so rapidly. Finding the right balance between minimizing cost and optimizing service is a perpetual challenge. Response time and errors are both tracked. Customer complaints are taken seriously.
With Jack Bogle’s focus on not spending, unintended but serious consequences emerged years ago in two all-important areas: computer-based technology and compensation. In both areas, as we shall see, Jack Brennan and his management team took the lead in changing the course.
Senior managers and members of the Vanguard crew, aware that one of the major advantages of being in the investment industry was above-average compensation, were wondering. They liked the Vanguard mission of serving everyday investors with good service at low cost. They respected Bogle for “walking the talk” and being so personally committed to Vanguard’s being the low-cost industry leader. They were fine with small, plain offices. They liked eating meals in the Galley, Vanguard-speak for the company cafeteria: simple food, plenty of variety, quick, and low cost.
Brennan liked to tell job candidates, “If knowing you’ll never have extraordinary wealth would bother you, don’t come to Vanguard. If you do come to Vanguard and do well here, you’ll earn a very good income versus your peers and friends in other areas of our economy.”7 Still, increasing numbers of Vanguard people were concerned that they were not being paid all that well. Some worried that they were not only servicing investors (which they liked) but also somehow subsidizing the organization (which did not feel right). They wondered whether they were accepting less than they might earn in other investment organizations. Should they stay at Vanguard, potentially for their whole careers, as Brennan was always urging? Were they making a mistake? Brennan listened carefully, particularly in his “skip level” lunches with younger managers who reported to the senior managers who reported to him (see Chapter 10).
“I’m always glad to steal any good idea from anyone at any time,” Brennan said with a big smile as he reflected on a great idea he saw first at S.C. Johnson, maker of Johnson Wax at Racine, Wisconsin. Invited to be the CEO’s personal assistant when he graduated from Harvard Business School, Brennan saw firsthand something he really liked: the Johnson family was sharing part of the earnings of their company with the people who worked there, and that generosity attracted the better workers in the area to make their careers with S.C. Johnson.8
Brennan worked out the mechanics and made a compelling case for how profit sharing could be made to work for a mutual organization like Vanguard. Bogle quickly approved, and on December 21, 1984, sent a memo to all employees describing the Vanguard Partnership Plan.
Since inception, Partnership Plan units awarded to crew members have increased in value at a brisk pace, averaging over 15 percent a year, including declines in 2002 and 2008. This has significantly increased many crew members’ compensation. By further aligning the interests of crew, company, and clients, the Vanguard Partnership has measurably intensified loyalty. Turnover always increases cost, so expenditures that reduce turnover are best understood as wise investments. At Vanguard, there’s practically no turnover among senior managers.
* Almost entirely the spread between bid and ask prices, which can be particularly large when surprising positive or negative information provokes many investment managers to take sudden action.
* Ironically, the University of Chicago, generously endowed by John D. Rockefeller, had put most of its own endowment into bonds. As a result, the endowment underperformed its peers, dropping from second to tenth in assets.