Part II
TAKING ON THE MUTUAL FUND INDUSTRY
OVER THE YEARS, I've become less and less constrained in speaking out with candor on what I perceive as serious shortcomings in the principles and practices followed by the mutual fund industry. While not all fund organizations are equally tarred by the broad brush with which I paint, a sufficiently large majority of firms is subject to these failings—high costs, excessive portfolio turnover, focus on marketing over management, delivery of inadequate long-term returns to shareholders, failure to hold stewardship as their defining characteristic—for me to comfortably take on “the industry.”
In this context, I'm reminded of what President Harry S. Truman said during his whistle-stop campaign aboard a train, a campaign that proved to be the key to his election in 1948. At each train stop, someone in the crowd would interrupt his scathing denunciation of “that do-nothing 80th Congress” and yell, “Give 'em hell, Harry.” He would respond, “I'm not giving them hell. I'm just telling the truth and they think it's hell.” Whether the industry thinks I'm giving it hell or not, I've yet to hear a single serious rebuttal to my criticisms of the fund industry. So I conclude that, because their veracity is self-evident, my words are accepted as truths.
The first speech (“Mutual Funds: The Paradox of Light and Darkness,” Chapter 10) describes the bright stars of the fund industry's growth, including the Great Bull Market, an increasingly favorable tax environment, the blessings of technology, and our industry's remarkable capacity for innovation. But I quickly note the paradox: Each of these stars has a dark side that may come back to bedevil us. I suggest that mutual funds must take off their blinders and see the industry as it really is, and then promptly get to work on improving today's imperfect model of mutual fund principles and practices. Plato's The Allegory of the Cave provides an apt metaphor from the classics: “The prisoner emerges from the dark cave and comes into the sunlight, dazzled by a new vision.” One day, so it will be for the mutual fund industry.
The next two chapters deal with the economics of the mutual fund industry, “Economics 101: For Mutual Fund Investors … For Mutual Fund Managers,” as Chapter 11 is entitled. There I contrast the extraordinary profitability of fund management companies with the lagging returns of fund shareholders relative to those provided in the financial markets. Because fund costs account for most of that shortfall, the contrast represents a definitional quid pro quo. I challenge the accuracy of the allegation by the industry's Investment Company Institute that fund industry costs are declining and present evidence that they are actually soaring. As a result, I urge the Securities and Exchange Commission to begin the process of bringing fund costs under control by undertaking an economic study of the mutual fund industry. (So far, alas, to no avail.) In the next chapter, I discuss the reasons that Vanguard's rivals have no interest in challenging our low-cost business model.
The final three chapters relate to fund governance issues. Both “Creating Shareholder Value” and “The Silence of the Funds” note that by abdicating their corporate governance responsibilities, mutual funds have failed to focus on creating shareholder value in the stocks they own. Funds have also failed to create shareholder value for their own investors, earning returns that fall well short of their cost of capital, the standard popularized by the phrase “economic value added” (EVA). The final chapter takes on the very independence of mutual fund “independent directors,” asking first, “Where are they?” and closing with, “I hope they'll be back soon.” I delivered that speech in 1991, almost a decade ago, but they haven't come back yet. But my hope—that directors will better honor their stewardship obligations to fund shareholders—springs eternal.