12

HONING THE COMPETITIVE EDGE IN MUTUAL FUNDS

The Smithsonian Forum
Washington, D.C.
March 23, 1999

IN A RECENT ARTICLE, Forbes magazine raised the question of the competitive edge in the mutual fund industry, beginning with these words: “How common is it for a relatively unadvertised brand without any mass sales force to be a top name in a mass marketed industry?” Forbes’ answer: “Freakish … unusual … very unusual …maybe even unique.” So why has that very situation happened in the mutual fund industry? Again, Forbes’ answer: “Maybe that strange business called Vanguard isn't a business at all. It's a religion.”

Well, as you can imagine, these words—though far more objective observers than I will have to judge their accuracy—provide considerable reaffirmation to the faith that Vanguard's founder has had in our mission since I started the firm on September 24, 1974, just short of a quarter century ago. But the objective facts surely support Vanguard's rise to industry leadership. Beginning as an also-ran with $1 billion-plus in assets, our firm has grown to become the second largest mutual fund firm in the world. We now manage $460 billion of assets, now growing by about $6 billion per month of net cash inflow.

The 30% annual growth rate that we have enjoyed during our history is the highest of any firm in our industry, and our competitive edge has enabled us to move from a rank of #12 in our industry to #2 today. Our market share of assets among directly marketed U.S. funds (those sold without sales charges) has grown from 8% to 28%, and our market share of net cash flow has grown from zero (!) to 60%. In other words, six out of every ten dollars now flowing into no-load mutual funds are invested in Vanguard funds. It may surprise you—it surely surprises even me!—that this substantial market share is being earned by a firm whose marketing philosophy is based on these two basic rules I set out early in our history: (1) Market share is a measure, not an objective; (2) market share must be earned, not bought.

We honor these two rules. Yet Vanguard's market share is rising. Why? I can only presume it is rising because we are earning the confidence of mutual fund investors by providing them with superior returns. Indeed, the very same issue of Forbes that described Vanguard in such generous terms suggests that is the case. In the magazine's regular listing of “Best Buys in Mutual Funds,” fully 30 of 86 funds—more than one-third—were Vanguard Funds. The next six fund firms together had but 29 “Best Buys,” one less than the Vanguard total. The magazine's selections tell us something important about Vanguard's investment philosophy: Our stock market index funds constitute one-half of the “best buy” index funds (2 of 4), our bond funds almost one-half of the “best buy” bond funds (18 of 41), and our actively managed stock funds about one-fourth of the “best buy” stock funds (10 of 42). Clearly, Forbes sees Vanguard's index and bond funds as our principal strengths. And so our market share suggests. We enjoy more than 70% of industry cash flows in each of these sectors.

Index Funds and Managed Funds

It is in the index and bond fund arenas that cost plays the principal role in determining investment success. Index funds invest in a list of stocks determined by a stock market index; for example, all 500 stocks in the Standard & Poor's 500 Composite Stock Price Index, weighted according to their market capitalizations. So, the difference between the market index return and the index fund return is determined largely by the expense ratio of the index fund. Result: a low-cost index fund produces 98% to 99% of the return earned by the market index. For example, in a market with a 12% annual return, an index fund with a cost of 0.2% per year should provide a return of 11.8%, or 98.4% of the market return.

As it happens, few—very few—actively managed stock funds perform with such effectiveness. In fact, over the past 15 years, only 12 of the 289 stock mutual funds in business throughout the period—one in 24—outpaced the return of the Standard & Poor's 500 Index. And only two did so by a statistically significant margin (that is, their annual margins of advantage were reasonably stable). As a result, despite the fact that relatively few fund organizations offer index funds, such funds now claim more than 60% of all of the cash flowing into equity mutual funds during recent months. It is not that index funds are so good—they have not beaten, and never will beat, the market—but that most mutual funds are not very good. I recently read an apt phrase about the Pulitzer Prize for fiction: “It takes dead aim on mediocrity, and almost never misses.” So too the same thing might be said about mutual funds. Except, of course, that “mediocrity” means, roughly stated, “neither good nor bad,” and this industry's record relative to the market has to be characterized as … well, I really don't need to characterize the record. Let the figures speak for themselves.

What the figures tell us is that, during the past 15 years, the S&P 500 Index has earned an annual rate of return of 17.9% per year. The average equity fund (including only those that survived the period, and eliminating those poorer performers that did not) provided a return of 13.7%. This represents a shortfall of 4.2 percentage points per year. In fairness, however, the S&P 500 Index is dominated by giant corporations with huge market capitalizations, which fared considerably better than mid-size and small stocks during the period. The mutual fund industry has an investment profile more akin to the profile of the Wilshire 5000 Equity Index, which represents substantially the entire U.S. stock market. The return of the Wilshire 5000 averaged 16.7% annually during the past 15 years, so the industry shortfall was a smaller, but a still impressive (in its own perverse way) 3.0 percentage points per year. Net result: funds delivered just 82% of the return earned by the total U.S. stock market—when 98%-plus was there for the taking for investors, by the simple expedient of owning a low cost, all-market index, mutual fund.

The Powerful Relationship between Costs and Returns

But the decision as to whether to characterize the industry's record as mediocre—“neither good nor bad”—shouldn't end there. For when these returns are totaled up for an investor who put $10,000 to work at the beginning of the 15-year period, the fund investment (even ignoring sales charges that must be paid at the outset to purchase shares of most managed funds) would have grown to $68,600, while a similar investment in the market would have grown to $101,400. The capital appreciation earned on the $10,000 invested by the fund buyer, through the magic of compounding—or was it the tyranny of compounding?—represented only 64% (not 82%) of the accumulated appreciation of the investment in the stock market. The industry, as far as I know, has not attempted to characterize the outcome of its labors. But I believe that nearly all investors would characterize it, not as “mediocre,” but as “bad.”

The severe shortfall of equity mutual funds to the stock market is easily explained. It arises largely from the (I would argue, excessively high) costs incurred by fund managers. As a group, these managers, it turns out, have stock-picking skills that are about average, not in any demonstrable way superior to the man on the street, nor, for that matter, to throwing darts randomly at a wall of stock listings. With average skills, fund managers generate average returns before costs, and then lose to the market by the amount of their costs. (Obviously, all investors as a group must do precisely the same thing.) During the past 15 years, the average fund has had an annual operating expense ratio of about 1.3% (it's even higher now), and incurred portfolio transaction costs that can be fairly estimated at perhaps another 1.0%, bringing the total cost of doing business to 2.3%, or nearly 80% of the 3.0 percentage point shortfall. (The remainder is attributable largely to fund holdings of cash reserves, with a consequent loss of market appreciation on that portion of equity fund assets.)

The issue of mutual fund cost applies, too, in bond funds. Last year, for example, the average general bond mutual fund provided a return of 7.5%, compared to 8.7% for the Lehman Aggregate Bond Index, which is of roughly comparable quality and maturity. That difference of 1.2 percentage points was largely caused by the all-in (expense ratio and turnover) costs of 1.1% annually for the average bond fund. Result: the 1998 annual return of the typical bond fund investor was 86% of the return of the bond market. What if we assume that these returns were to prevail over the next 15 years? (Given the 6% +/− level of interest rates today, that assumption would be optimistic.) The cumulative appreciation earned by the investor who put $10,000 to work at the start of the 15-year period would be just 79% of the appreciation (including reinvested interest income) earned by the same investment in the bond market.

For money market funds, the same fundamental things in life apply as time goes by. It is in money market funds of course, that the causal nexus between cost and return should be most obvious and most immediate. It is. After all, how could one expect any manager—limited as he must be to investing 100% of assets at all times in U.S. Treasury bills and top-quality bank CDs and commercial paper, all with average maturities of less than 60 or 70 days—to find substantial extra value hidden deeply within these highly efficient markets that are dominated by professional investors? Or to out-guess Federal Reserve Chairman Greenspan as to whether short-term rates will rise or fall?

Well, even if it could conceivably happen, it hasn't happened. Over the past 15 years, each one of the 73 money market funds in business throughout the period has earned a return of about 6.7% per year before costs. After costs, which averaged 0.7%, the average net return was 6.0%. But the net returns of the individual funds ranged from 5.3% (gross return of 6.7% less expenses of 1.4%) to 6.4% (gross return of 6.7%, less expenses of 0.3%). Cost was all that truly mattered. Compounded over 15 years, $10,000 grew to $23,900 in the average fund, compared to $26,400 in the money market itself. Net result: Money funds earned 89% of the money market's annual return, and 85% of the cumulative appreciation.

Vanguard vs. the Competition

So, whether we evaluate stock funds, bond funds, or money market funds, the record is clear: Cost is the culprit. And here is where a powerful part of Vanguard's competitive edge comes into play. From the figures that I have presented, it is easy to see how important it is to maintain the lowest possible level of operating expenses so that the fund investor receives the highest possible proportion of market returns. And Vanguard's unique structure—without parallel in the industry—gives it not only the willingness, but the desire, to maintain the lowest possible level of expenses, and the ability to attain that goal.

Other mutual fund organizations lack the willingness and desire, and the ability as well. Why? Because they are operated by external organizations, privately held management companies which seek to earn high returns for fund investors, to be sure, but seek at the same time to earn the highest possible returns for themselves. Some of these companies are publicly held, in which case their shares are held by investors who own their shares for the same reason that investors own Microsoft or General Motors: To make money for themselves. These public investors, as compared to the fund managers, have little reason to be much concerned about the earnings of the investors in the funds the company manages. This conflict of interest between fund shareholders and fund advisers lies in the very structure of the mutual fund industry. And with the managers controlling both fund affairs and management company affairs, there is a powerful tendency, borne out by the figures you have seen today, for managers to resolve this conflict in their own favor.

Now let's sum up where we are. It is clear that, in the long run, investment success has been based on the apportionment of market returns between fund investors on the one hand and investment managers on the other hand. What would happen in a mutual fund structure in which that conflict was resolved entirely in favor of the fund shareholders? This was the nature of what I called the Vanguard experiment when it began a quarter century ago. Rather than being structured like other fund organizations—operated by an externally owned manager—the Vanguard Funds literally own The Vanguard Group, our management company, and operate it under a joint cost-sharing agreement with the Funds. We operate at cost, and the Funds control how much we spend on administration, on marketing, and on investment management. Net result: our operating costs average about 0.25% of assets annually vs. about 1.25% for the average mutual fund (including stock, bond, and money market funds). Savings: 1.0% per year. That may not sound like much, but 1% of $460 billion dollars is $4.6 billion—and per year, at that—representing a tangible and material enhancement of the investment returns our shareholders receive. Less of the market return to managers, more to investors.

It's More Than the Expense Ratio

I don't want to leave you with the thought that the expense ratio advantage of an internally owned fund management organization is the only advantage of a structure that, in effect, creates mutual mutual funds. From this structural difference, a whole new system of corporate values can flourish. Of course, the key advantage is that the truly mutual firm, without an incentive to earn highly superior returns on the capital of external entrepreneurs or profit-seeking public investors, is in business solely to create superior returns for its fund shareholders. The entire corporate strategy of such a firm is shaped by its structure. “Strategy follows structure,” as it were. For example:

• Lower prices. There is a big difference between cost-based pricing and charging investors the highest prices that traffic will bear.
• Extra emphasis on high-quality investor services. A truly mutual enterprise treats its fund clients as its owners, because they are its owners.
• Reduced tolerance for risk. If a mutually oriented fund can hold risk constant with its peers, and provide extra return simply by virtue of its lower cost, why would it seek extra return by assuming extra risk? It need not. It does not. (This advantage is especially critical in bond and money market funds.)
• Minimal marketing expenditures. The enormous marketing budgets that permeate this industry cost fund investors hundreds of millions of dollars each year, but benefit only the fund managers. Why would a truly mutual firm spend, well, anything on marketing? It wouldn't. Or at least it wouldn't spend much.
• Developing mutual funds. The structure of the conventional fund firm calls for offering whatever funds—however speculative or opportunistic—the marketplace demands. (That's how advisers earn fees.) The structure of the shareholder-owned firm calls for offering funds that offer the highest value—and, by definition, the lowest cost—to investors. Index funds, for example, do not fit the first example; they fit the second. That, in fact, is why we started the first index fund 24 years ago. (It took nearly a decade before our first index competitor joined the fray.)

At this point, I want to add a further thought about managers and index funds. In the conventional firm, managers and index funds clearly threaten one another's existence. Allocating substantially all of the market's return to fund investors doesn't help managers to earn high profits for themselves. In the mutual firm, however, index funds do not threaten the firm's existence. Every fund is operated at cost. Think about that. And index funds represent the closest approximation we can find for emulating the success of America's most successful investor, Warren E. Buffett. Mr. Buffett rails against “short-term trading of pieces of paper.” Instead, he prefers “long-term ownership in businesses.” He's right. Mr. Buffet doesn't succumb to the wiles of “Mr. Market,” who bids for his properties each day. But few mutual funds maintain such discipline. With a staggering average portfolio turnover rate of 85% per year, generating billions of dollars of extra transaction costs, this industry has aligned itself with the short-term traders. We can call that speculation. But an index fund is clearly a long-term owner of businesses. We can call that investment. Investment is better.

Mr. Buffett says his favorite holding period for a stock is “forever.” I say that owning an all-market index fund is owning every publicly held business in America … forever. No wonder Mr. Buffett repeatedly endorses the index fund: “By investing in an index fund, the know-nothing investor can actually outperform the professionals.” There is a sharp difference—both in cost and in investment philosophy—between a conventionally managed mutual fund and an index fund, and therein lies a difference, not merely in degree, but in kind. In my bolder moments, I believe that the index fund will, by its crystal-clear example of the causal link between cost and return, finally prove to be the vehicle that will not only change the focus of the mutual fund industry, but its very structure.

Revolutionary Words

A change in the structure—indeed the entire modus operandi—of this industry is imperative. Yet change seems nowhere in sight. Costs must be cut, simply because all those expenditures incurred by mutual funds—on management fees and operating expenses, on marketing fees and sales charges, and on the execution of portfolio transactions—have consumed at least a quarter of the stock market's annual return, more than 4 percentage points per year, not even counting taxes, during the long bull market. When market returns fall back to more normal levels—as they will—the diminution will be cataclysmic.

Those words may sound rather idealistic and fiery—even revolutionary—so I quickly confess that they are neither new, nor mine. They are the words—right down to the italics—of my great-grandfather Philander B. Armstrong, who conceived the idea of mutual insurance in the property field, and formed the Phoenix Mutual Fire Insurance Company in 1875. A decade later, he spoke those words to his fellow leaders of the insurance industry in St. Louis, Missouri. The fact that my own career in the mutual fund industry, and my own convictions as well, so closely resemble his must stand as a monument to the fact that even the apple's apple's apple's apple doesn't fall very far from the tree.

The fact is that costs still matter, today as in 1875. They matter in insurance and in mutual funds, and in all financial service industries. And they matter most where they are at once very large, compounded over time, and easily measurable relative to the value of the services provided. The confluence of those three factors is vividly etched in the investment record of the mutual fund industry. And it is high time that fund costs, after rising for decades, begin a long cycle of decline.

Four Generations—Two Authors—One Idea

Bringing fund costs down to proper levels will take a long time. I know that, if only because of the experience of Great Grandpa Armstrong, an insider taking on the property insurance industry in the 1880s and 1890s. According to his biography, “His methods were original and diametrically opposed to almost every recognized underwriter in the country.” Perhaps frustrated by the failure of his ideas to catch hold in the fire insurance industry, by the turn of the century he had turned his critical gaze to the life insurance industry. He wrote a classic, if rather intemperate, book entitled, “A License to Steal,” subtitled, “Life Insurance, The Swindle of Swindles. How Our Laws Rob Our Own People of Billions,” published in 1917. His concluding words were these:

When Great Grandpa Armstrong wrote those words, he was the same age as the apple of his apple's apple when my own new book, Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor, was published two months ago. While my book about mutual funds is rather more temperate than his about life insurance, it makes the same point: “… the industry has embraced practices that seriously diminish its shareholders’ chances of successful long-term investing. … Mutual funds should provide the greatest sum of investor returns with the least management expense, (but) the natural order has been turned on its head. The result not only defies nature, it offends common sense. … Common sense demands that funds be governed in the interests of those who own them.”

Common Sense on Mutual Funds

On that note, let me add just a few comments on my new book. It aims, not only to help its readers become more successful mutual fund investors, but to chart a course for change in the mutual fund industry. While it is designed to be read sequentially, just as a typical book, it is in fact a series of 22 essays, each of which can be read independently. The first three parts of the book are purely about investment issues, encompassing (1) investment strategy, including the nature of financial market returns and asset allocation; (2) investment choices, including index funds, investment styles, and stock, bond, and global funds; and (3) investment performance, including the powerful role reversion to the mean plays in the financial markets, tax-efficiency (and tax-inefficiency), and the effect of time on return, risk, and cost.

The next two parts of the book turn to critical industry issues that have played a key role in the disappointing past records of mutual funds of all types. Part four, “On Fund Management” describes the industry's deviation from its original principles, discusses the ascendancy of marketing over management as our talisman, rails at the failure of fund directors to uphold shareholder interests, and suggests the positive implications of the change in industry structure that I discussed a few moments ago. This subject matter, of course, is unusual stuff for a book on fund investing, but the subject of part five, “On Spirit,” is even more unusual. Here, I conclude that a mutual structure, as helpful to shareholders as it may be, is not enough. Irrespective of their structure, the firms in this industry need a mutual attitude toward serving investors, an attitude conspicuous only by its virtual absence today. So in part five, I take the liberty of describing the mutual values and spirit that, as Vanguard's founder and leader, I have endeavored to inculcate in our enterprise.

“Common Sense” is the theme that suffuses each of the book's subjects. Not only common sense as you and I understand it today, but “Common Sense” as Thomas Paine used it in his pamphlets some 225 years ago, presenting sentiments to the citizens of the Colonies “not yet sufficiently fashionable to procure their general favor … offering nothing more than simple facts and plain arguments,” and asking the reader to “generously enlarge his views beyond the present day.” I present similar sentiments to fund investors in my book.

Except for the final section, the book is not about Vanguard. It is largely about my deeply held convictions on how to invest successfully. Vanguard's growth, which I described at the outset, seems to reflect an improving, indeed burgeoning, acceptance of the investment ideas, policies, and principles that I urge fund investors to adopt. And it is primarily by these means that we have established whatever competitive edge it is that we have, an edge that has enabled us to establish the structure and spirit that Forbes found to so clearly differentiate us from our rivals.

The Competitive Edge

Given what we observe in most competitive industries—and the mutual fund industry is ferociously competitive in all respects save one, the setting of prices—we might expect our competitive edge to be challenged. In an industry with perhaps 30 major competitors, how many firms would you expect to challenge a leader who captures a 60% share of cash flow? Five firms? Ten? All 30 firms? The answer, however, is: None. No fund leader, as far as I can tell, has called a meeting of his senior officers and said: “These guys are eating our lunch! Let's take them on, toe to toe! Now!” That hasn't happened. Why? Because taking on Vanguard would require aggressively challenging us with low-cost index funds, low-cost bond and money market funds, and low-cost conservative stock funds focused on long-term investing. The fact is that the returns of the clients of our rivals—their fund shareholders—would be markedly enhanced, but the returns of their own management firms would be slashed—no matter how much their market share improved. In the face of the competitive edge we have created, the industry's silence has been, well, deafening. There's no money for fund managers, or so it seems, in giving their clients—the owners of their funds—a fair shake.

Despite our competitive edge, honestly, I worry about the bright outlook for Vanguard's future growth. Huge size, at our awesome levels even today, is a mixed blessing. And we won't be any smaller tomorrow, or a year hence, or a decade from now. Investing money doesn't get easier as you get bigger, though the minimal turnover strategies of our index and bond funds greatly vitiate the challenge. But neither does managing an enterprise get any easier. Our crew (we don't have “employees”) has burgeoned from the 28 human beings on board when we began to 9,000 human beings today. Bureaucracy looms. Technology supplants more and more human interaction. Judgment battles to hold its own against process. Our managers and crewmembers today are mounting a superb offense, but merely holding the line to maintain our spirit and values remains a challenge. With an admittedly far more unremitting opponent than asset size, King Canute failed, as was inevitable, to hold back the onrushing tide.

But maintaining the competitive edge we now hold at Vanguard will remain a challenge. Curiously perhaps, it is a challenge I recall first facing up to when our assets were but $8 billion, only about one-sixtieth of our size today. As far back as 1984, I spoke to our entire crew (then, there were just 350 crewmembers) on the subject of “Two Axioms.” One was “nothing succeeds like success.” The other was “nothing fails like success.” I warned our crewmembers that our success—even in those ancient days—could easily lead to failure, pointing out that “countless business enterprises, at the very moment of their greatest triumph, were planting the seeds of their own destruction.”

Turning to the incipient competitive edge that we were even then establishing in 1984, I warned the crew that when a company is doing as well as we were, “the danger is to think it can do no wrong.” I also pointed out that “when an institution goes down, one condition may always be found: it forgot where it came from.” It forgot where it came from. Today, I think it is fair to say that our competitive edge has been established. But now, even as in 1984, “whether we can keep it is up to us.” If we continue to give each of our shareholders a fair shake, hold to our long established values, continue to do the right things in just the right way, remember where we came from, and hone our competitive edge to an ever-finer point, we will meet the challenge. Of that I have no doubt. But it would be a lot easier to keep our competitive edge sharply honed if at least a few mutual fund firms would seriously compete with Vanguard on our terms. With that expectant hope, I welcome all comers.