10

MUTUAL FUNDS: THE PARADOX OF LIGHT AND DARKNESS

Distinguished Speaker Series
The Houston Club
Houston, Texas
January 14, 1998

MY 1993 BOOK on mutual funds concludes with what I describe as “Twelve Pillars of Wisdom” for investors. The final chapter begins with this lofty quote from Ecclesiastes: “Wisdom excelleth ignorance as far as light excelleth darkness.” That book is described as a “how-to-invest guide,” but as I considered my mandate to speak in this respected forum for airing the ideas of so many distinguished speakers over the years, it occurred to me that the theme of light and darkness might also profitably be used to accommodate a rather different approach.

My remarks today, while I hope they will stimulate your investment thinking, will focus, not on the use of mutual funds in your own investment and savings programs, but on the diverse factors—some widely known, some less so—that have fostered the growth of the mutual fund industry, as funds have replaced, first savings deposits, then life insurance, and then pension plans to become the investment of choice for America's families. If we have ever had a clear case of “creative destruction”—the phrase the economist Joseph Schumpeter chose to describe the process by which one industry strikes at the heart of another by providing a novel solution to society's needs—surely this industry's rise to preeminence is its apotheosis.

But, as the laws of physics tell us, a strong action engenders an equal and opposite strong reaction, and I shall also discuss some of the problems created by our industry's growth. These issues are rarely discussed, even (and perhaps especially) within industry circles. But I do not hesitate to do so before this distinguished forum. I have come here neither to promote our industry's interests nor to heap additional encomia on its good works. Rather, I want to offer a broad perspective from the viewpoint of one who thinks we can do a much better—and surely a much more responsible—job of serving investors than we have in the past.

By way of full disclosure, I freely acknowledge that I speak from the perspective of a unique mutual fund enterprise that was created to lead the way, to be “in the vanguard” of a new and better industry. Our very structure—based upon having mutual funds owned and controlled by their own shareholders and not upon existing as mere products (an unfortunate term used in our industry to denote mutual funds) of an investment adviser—shapes our focus on the primacy of the interest of the shareholder, not the interest of the adviser.

Since our inception 23 years ago, we have become the second largest firm in this burgeoning industry. Yet, ironically enough, not a single follower has appeared on the horizon. Our innovative structure has yet to be copied. Nonetheless, if this industry hardly needed (or wanted) Vanguard as such, I believe that it did need a Vanguard, a firm to offer a second and perhaps better way to serve investors—an alternative to the traditional structure. It's only fair, I think, to warn you in advance that you'll see some of this contrarian spirit—missionary zeal, if you will—in my comments today.

The Biggest Star: The Bull Market

In this industry's rapid ascent to public acceptance and even acclaim, many stars have shone their light on us. The greatest star of them all is the most remarkable bull market in U.S. history. The longest advance in the prices of common stocks, now more than 15 years of age; the steadiest, with just a handful of brief and quickly recouped declines; and by all odds the strongest, with the Dow Jones Industrial Average rising tenfold, from less than 800 to more than 8000 (when I prepared this speech!), an astonishing rate of total return (including dividends) of 19% per year. I assure you that there has never been another bull market—in anything, as far as I know—that has approached the sheer power of this one.

Since August 1982, when the bull market began, fund industry assets have risen 17 times over, from $260 billion to $4.3 trillion, a compound annual growth rate of more than 20%. Assets of equity mutual funds alone have risen from less than $40 billion to $2.5 trillion, a starkly faster 32% growth rate—an incredible rate that doubles assets every two-and-one-half years. This growth has taken mutual funds from cottage industry to financial behemoth in just 15 years—perhaps the most powerful force in U.S. financial markets today.

Fifteen years ago, funds owned but 3% of the value of all stocks; today, funds own 22%, and, adding in other accounts supervised by fund managers, fully 33% of all stocks. Our investment accounts likely are responsible for 60% or more of all equity market transactions. Our latent ownership power has helped to encourage U.S. corporations to focus on operating efficiency, restructuring, and the creation of economic value, which in turn have contributed to unprecedented corporate earnings growth. At the same time, of course, the massive capital flows into funds has created new demand for stocks which has helped to drive stock prices to today's lofty levels, simultaneously making funds a prime beneficiary of the market boom. The great bull market, then, has been the first and brightest of the stars that have shone on this most-favored industry, as we have ridden the crest of the market wave.

Three More Stars: Taxes, Technology, and Innovation

But the bull market has by no means been our only shining star. There are at least three others. A second star, surprising as it may seem, is the Federal tax code. In 1976, it was amended to enable municipal bond funds to exist; in 1980, it was amended to enable individual investors to open tax-deferred IRAs; and in 1984, it was interpreted as enabling the establishment of tax-deferred 401(k) thrift plans. These three salutary tax changes helped cause wide shifts in individual savings preferences and brought new focus on personal saving for retirement. Mutual funds had at the ready the investment programs to meet the needs of this diverse and ever-more-knowledgeable public. Together, municipal bond funds and investor-directed savings programs account for a truly remarkable $2 trillion of fund assets today—nearly one-half of the industry total.

And we can't ignore a third star that has shone on us. The technology revolution. The computer has provided us with communications technology, transaction technology, and record-keeping technology without which today's mutual fund simply could not exist. Imagine a mutual fund without an 800 number. Without daily asset valuations for retirement plan investments. Without the ability to handle huge daily cash flows. Without seemingly instantaneous liquidity (for our investors, as well as our portfolios). Without exchanges among funds. In a real sense, technology has shaped the character and development of what we know as the modern mutual fund industry.

Finally, there is a fourth star. While we can hardly take credit for the benefits bestowed on us by the other stars, we can claim this star as our own creation. I shall call it creative innovation. This industry has not only quickly capitalized on an environment of radical change—in the stock market, in the tax code, in the technology transfiguration—but has fostered a transformation of its own. During the past 15 years, the number of mutual funds has increased from 700 to 7,000. The industry has greatly broadened its historical dependence on equities to include bonds (which have enjoyed a bull market of their own, as inflation rates have tumbled and interest rates have followed suit) and short-term investments (causing the very cream of the savings market to desert banks in favor of money market mutual funds).

At the same time, we've vastly expanded our equity fund offerings, and we now include not only funds with the industry's traditional focus on U.S. blue chip stocks, but also funds emphasizing small-cap stocks, international stocks, and stocks in particular industries. It is probably safe to say that whenever the investor marketplace has demanded a “product” (again using the industry lingo)—or whenever we have sensed a demand for one—we have promptly created it, offered it, and marketed it. “A fund for every investor, a fund for every purpose under Heaven” could serve as an accurate slogan for the modern mutual fund industry.

And we've created the “fund family” to replace “the fund” as the preferred mode of doing business. Compared to supervising perhaps a dozen funds in 1982, a major fund family now manages an astonishing array of 150 individual funds, sometimes even more. There are a score of fund families with assets at the level of $50 billion or above. These 20 industry powerhouses account for about $2.5 trillion of the industry's $4.2 trillion of assets. And, in another amazing change, the two largest firms, and eight of the top 20—together holding $1.2 trillion of assets—have taken “the road less traveled by” 15 years ago: we offer principally no-load funds—purchased directly, without sales commissions, by investors. It could well be said “that has made all the difference” in bringing Main Street to Wall Street.

The Dark Side of the Bull Market

But, even as “all that glitters is not gold,” each of the four stars that have shone so brightly on mutual funds has a dark side. If a “black hole” scenario might be too strong a phrase to describe the reaction to the powerful forward action we've enjoyed in this industry, it would nonetheless be unwise to ignore the reaction potential created by the dark side of the stars that I've just described.

Let's begin with our first star, the stock market. First, with a simple question: Have fund investors shared adequately in the rewards of the great bull market? Alas, while our asset upsurge places us at the very crest of the market wave, the investment returns we have delivered to our shareholders leave us trailing in the market's wake. Compared to the annual return of 17.5% for the Standard & Poor's 500 Stock Index during the past 15 years, the average equity fund has returned far less: 14.1%. Result: $10,000 invested at year-end 1982 in an unmanaged market index would have been worth $112,000 as 1998 began; if invested in the average fund (ignoring initial sales commissions, if any) it would be worth $72,000—less than two-thirds of the unmanaged index. The typical fund investor has $40,000 less than he might have expected, a tangible manifestation of the reality that fund managers as a group have not measured up to the task at hand: they have failed to provide an excess return sufficient to overcome their heavy cost handicap of some 2% per year. It has been an expensive failure for fund shareholders.

The record is clear, then, that in the past these investment professionals have fallen well short of earning their keep. But what of the future? With fund costs now running at the highest levels in history, it would be unrealistic to expect future relative returns to improve very much. Nor would it seem realistic to expect that in a highly efficient market with prices set largely by fund transactions, funds owning one-third of all stocks could somehow outpace the returns of investors owning the other two-thirds.

To make matters even more difficult for the funds, long-run absolute returns are, at least in my view, likely to regress to the long-term mean of about 11%—and probably even below it. Why? It is much more than the simple rationale of believing that “trees don't grow to the sky.” (After the incredible performance of the stock market during the past three years, I may be alone in continuing to believe that ancient aphorism!) Rather, it is that in today's stock market, corporate stocks are valued far more highly than when the great bull run began 15 years ago. Then, stocks were valued at seven times actual earnings; today valuations are at 23 times earnings. Then, stocks sold at book value; today, at four times book. Then, stocks yielded 5.5%; today, just 1.6%. Of course, Wall Street says that dividend yields don't matter any more, but I remind you that, over the past century, the dividend yield has accounted for 40% of the total return on stocks. If—if—that relationship were to prevail in the coming decade, stocks would return but 4% annually, a far cry indeed from the 19% annual return that this flourishing bull market has lavished on them.

The Dark Side of Taxes, Technology, and Innovation

If our stock market star may dim, what of the tax star that has shone so brightly? Ever the pragmatist, I don't expect to see further major changes in the tax code that will favor us. But I fear that the industry faces a major challenge to its far-less-than-benign neglect of the tax issue in the past. Simply put, the fact of the matter is that fund managers in general run their portfolios without regard to tax considerations. It is not without evidence that I suggest that, in their drive to attract tax-deferred assets—now more than one-half of industry cash inflow—funds have flatly ignored the interests of the taxable investors that constituted the traditional backbone of this industry. Fund portfolio turnover now averages some 90% per year, meaning essentially that only 10% of the stocks in a given portfolio at the start of the year remain there at the end of the year. Imagine! The performance record of mutual funds that I cited earlier offers no suggestion that such turnover enhances industry-wide returns. Indeed, with funds largely buying and selling stocks among one another, turnover cannot reasonably be expected to do so.

And while high turnover fails to enhance the normally stated pre-tax fund returns, it has a powerful negative impact on after-tax returns. Indeed, the lag of three percentage points per year in pre-tax fund returns that I have already demonstrated would have increased to more than four percentage points on an after-tax basis. As a result, more than 20% of the market's total annual return would have been sliced away, largely by fund expenses and taxes. I estimate that funds realized and distributed $150 billion of capital gains during 1997, which will cost taxable shareholders some $22 billion when the tax bill comes due on April 15, 1998.

In the coming year, no matter what the stock market does, still more realized gains are certain to come pouring out. Given the industry's casual approach to taxes, some capital gains will be short-term, taxed up to the 40% maximum on ordinary income, some at 28%, with only some—perhaps even the smallest portion—taxed at the newly lowered 20% long term rate. Yet, with this newer rate, capital gains have become more attractive relative to dividend income than at any time since World War II. Perversely, this industry seems intent “on making the least of it” by virtually ignoring the colossal benefit of deferring the realization of gains to the maximum extent possible.

And what's the problem with the computer revolution star? “The law of unintended consequences” strikes again. For all the remarkable business assets technology has given us, it has given us some considerable business liabilities. First, all of that information has seemed to bring with it powerful little wisdom. But, even as seemingly infinite information about fund records permeates the marketplace, the simple truth—that the past records of top-performing funds are rarely, if ever, repeated in the future—seems to be lost. Yet the financial section of the newspaper reports fund performance each day, and the mere punch of a computer button can bring us a Morningstar analysis of the returns, risks, portfolio characteristics of any fund we select—with statistics of unimaginable detail—all on a single page. But when investors select a fund, it is predominantly on the basis of its past performance.

And there is an even more serious problem: instant communications and fast-as-lightning transaction facilities have enabled us to effectively turn mutual funds into proxies for individual common stocks. Since the early 1980s, the average holding period for a mutual fund share has dropped from more than ten years to less than three years. Whether or not this increase in investor share turnover is engendered by the same forces that have energized the soaring turnover in mutual fund portfolios I described a moment ago, it is simply another form of what I call casino capitalism. And it flies in the face of intelligent investing.

I ask simply: to what avail? To what avail have we converted the finest medium for long-term investing ever devised into a device for trading on market swings, for buying and selling funds on the basis of recent performance, for giving “hot” funds an apparently cost-free entry (although it is anything but that) into the investor marketplace, often based on little more than an idea and a short-term record of uncertain provenance. Yet as an industry we too often fail to adequately inform the investing public of the risks and costs involved in our funds, and indeed actively promote, not our typical offerings—and most assuredly not our offerings with inferior performance (and no firm is bereft of them!)—but the hottest-performing funds we have.

And that brings us to the star of creativity, our fourth star. Its dark side is that we have turned our remarkable record of innovation away from seeking creative ways to enhance the investment results that we provide to our shareholders, and toward the rather less lofty task of bringing more assets into our fund families. The marketing of mutual funds has become highly aggressive, far too much so for an industry which I conceive of, not as a modern-day collection of Procter & Gambles, Budweisers, and Coca-Colas, hawking “consumer products” for their “franchise brands,” but primarily as a trustee for other people's money. In this business, investing is becoming the poor relation of marketing. We appeal far too much (for me at least) to the desire to accumulate substantial wealth with ease, the apparent certainty of doing so through equity funds, and the ease of picking super-funds based on their past performance. The message is becoming the medium.

Marketing and distribution, of course, are highly expensive. So, “money is no object” seems to have become our industry's tacit watchword in the search for the holy grail of market share. Yet it is the fund shareholder whose money is no object, but the fund manager who reaps the benefits of the money spent on marketing, earning rising fees as the assets roll in. At the outset of the growth curve, some beneficial economies of scale may accrue to a fund's shareholders. Then shareholders neither gain nor lose, and the benefits of growth accrue to the manager, who enjoys rising fees without commensurately rising costs. Finally, as the fund grows to an extremely large size, fees continue to soar but asset growth may lead to excessive portfolio diversification, limited liquidity, and rising transaction costs, all negatively impacting returns to shareholders. Shareholders have paid to foster the fund's growth, yet they have suffered in return.

In part because of soaring marketing expenses, fund expense ratios have risen sharply. Fifteen years ago, the expense ratio of the average equity mutual fund was 1% of assets. Despite the enormous 65-fold (!) growth in assets since then, today's equity fund expense ratio has increased by half again to 1.55%—although only about one-tenth of the revenues generated by funds are expended on investment advisory services. Obviously, huge economies of scale now exist in this business, but it is the fund manager, not the fund shareholder, who has been the beneficiary.

Where Do We Go from Here?

If you believe in capitalism and free markets—and I can assure you that I hold their value to be self-evident—what must happen to resolve the deeply troubling issues that I've laid before you today? The fundamental, but I think only preliminary, response must be to let the problems work themselves out in the marketplace. For most competitive industries, that is clearly the sole recourse.

If this industry is to be reshaped by its investors, by supply and demand if you will, present and potential mutual fund investors will have to become much better informed. “Trial and error” is one answer, and investors who get badly burned by a long period of underperformance, or even (and much more memorably) a short-term bear market in stocks, will not soon return to our fold. Investors buying hot funds, experimenting with market timing, and shopping and swapping funds with untoward frequency in the supermarket casinos will one day learn by painful experience that these short-term approaches have been not only unproductive, but counterproductive.

More optimistically, the promulgation of better investor information may gradually turn the tide. Investors have clearly learned that costs matter. In the money market fund arena, they entrust far more of their savings to the lowest cost, and therefore highest yielding, funds at the expense of the highest cost, and therefore lowest-yielding, funds. A similar trend, if one of lesser degree, is evident in the bond fund arena. And there are at least hints of a similar pattern in the stock fund arena, most notably in the increasing attention being given to market index funds, which are making their mark solely through capitalizing on the simple values of extremely low cost and broad diversification. Fostered by corporate benefits executives who are responsible for selecting funds for tax-deferred employee stock plans with assets now approaching $1 trillion, by self-motivated investors with substantial assets, by the SEC tentatively mounting “the bully pulpit” to take up the cost versus performance issue, and by the increasingly sophisticated financial media, the mantra of costs matter will finally take hold. But all of that will take time, and—as long as present excessive costs persist—time is not running in favor of the fund shareholder.

As investors come to “vote with their feet”—learning to favor long-term investing over short-term and low cost over high cost—fund managers will finally get the picture. A focus on long-term portfolio strategy will supplant the frenetic—and costly—trading of portfolio securities today. Funds will more clearly define their investment objectives, describe their performance standards, report far more candidly on how their results compare with their expectations. The implicit promise of equity fund managers is “we can do better” than the market—or, in this tough world in which beating a broad market index sometimes seems beyond hope—at least bettering the results of their peers with similar objectives and strategies. So managers would seem to have an obligation to describe how they'll meet that goal, and then to disclose regularly the extent to which they are meeting it.

Corporate managers have become well aware that the creation of economic value—to earn a return on invested assets in excess of the cost of capital—is a “do or die” responsibility, with the price of failure the loss of their jobs, or even their corporations. Why shouldn't mutual fund managers who fail to provide shareholder returns in excess of those provided by the stock market be subject to the same discipline? Surely it is a fair question.

And investors should demand that industry creativity turn away from costly marketing efforts and expensive media advertising. What is really the point of selling past performance that is almost surely unrepeatable? Or the value, as one senior industry marketer stated approvingly, citing perfume as analogy, of selling hope? Rather, we should be focused on better solutions to investor needs. It shouldn't take too much curiosity for an investor to learn that the shortest, simplest route to top-quartile performance is bottom-quartile expenses. And it shouldn't take much more to figure out that the taxable investors in this industry—more than half of our shareholders—are being ill-served by the baneful tax and trading cost impact of high portfolio turnover.

This all may sound both dubious to achieve and too idealistic to prevail. But, without apology for my idealism (or, given the Vanguard shareholder-owned structure I described briefly at the outset, for my vested interest), I offer a simple solution. It comes from my conviction that strategy follows structure. And a structure in which fund shareholders are in working control of a fund—as distinct from one in which fund advisers are in control—will lead perforce to meeting nearly every important requirement in the litany that I have just recited. Once the industry's sole focus turns to serving investors as productively as possible, some critical things happen. Funds—at least large fund families—will run themselves. They will be “mutualized,” having their own officers and staff, and the huge profits earned by their external managers will be diverted to their shareholders. They won't waste money on costly marketing campaigns designed to bring in new investors at the expense of existing investors. With lower costs, they will produce higher returns and/or assume lower risks. They will improve their disclosure, and report to their shareholder-owners with greater candor. They might even see the merit of market index funds. It's quite an imposing bundle of improvements.

In preparing these remarks, I found it easy to identify with the prisoner in The Republic. In his “Allegory of the Cave,” Plato describes men living in a cave, shackled to the same spot, eyes covered with blinders so that they can see not the fire burning behind them at a higher elevation, but only the shadows cast in front of them by the fire:

Clearly, leaving the darkness of the cave—the safety and comfort of the place one has known—is difficult, unpleasant, and challenging. But Plato's allegory is a powerful symbol of the need for change. And as mutual fund shareholders come to see the light—and realize that “light excelleth darkness,” as in my citation from Ecclesiastes at the outset—and recognize the realities I have described today, they will demand a change in industry focus, a change that, in my view, can be best accomplished by a change in industry structure.

A truly mutual mutual fund industry would be structured precisely like every other corporate enterprise in America—management that serves solely the shareholders, and creates economic value, or else. I wish that I could be sure that this brave new world of mutual funds will begin to emerge during my remaining span of years. Alas, I fear not. But someday, somehow, just as 1997 inevitably rolled into 1998 two weeks ago, we will ring out the old structure for operating mutual funds, and ring in the new.