16

VANGUARD—CHILD OF FORTUNE

The Pennsylvania Partnership for Economic Education
Harrisburg, Pennsylvania
January 31, 2000

IT'S A THRILL both to be in the capital of this great Commonwealth and to address this distinguished group of business and government leaders. I'll focus this evening on Vanguard's role in the mutual fund world, especially our focus on the elemental principles of investing and economics.

In the 1999 annual reports of the Vanguard mutual funds, I began my message with one of my favorite passages, a quotation from the evocative poetry of Robert Frost:

Those few words tell, far better than I could, the story of Vanguard's founding more than 25 years ago. Indeed, we took, not merely a road less traveled by, but a road that no firm in this industry had ever taken before. The well-traveled road—then as now—was one on which mutual funds were managed by an external management company, in the business to make a profit for itself by charging a fee for its services. But the Vanguard funds—there were only 11 of them then—would be controlled by their own shareholders and operate solely in their financial interests. The outcome of our unprecedented decision was by no means certain. We described it then as “The Vanguard Experiment.”

Well, I guess it's fair to say it's an experiment no more. During the past 25 years, the assets we hold in stewardship for investors have grown from $1 billion to more than $500 billion, and I believe that our reputation for integrity, fair-dealing, and sound investment principles is second to none in this industry. Our staggering growth—which I never sought—has come in important part as a result of the simple investment ideas and basic human values that are the foundation of my personal philosophy. And I have every confidence that they will long endure at Vanguard, for they are the right ideas and right values, unshakable and eternal.

Fortune and Princeton

The Vanguard you know today—the largest pool of assets in the Commonwealth of Pennsylvania—exists only by remarkable chance. Hard as it is for me to imagine an investment world without Vanguard, we are here by the grace of the Lord. The first piece of good luck came 50 years ago, when I was determined to write my senior thesis at Princeton University on a subject which no previous thesis had ever tackled. (There went Adam Smith, Karl Marx, and John Maynard Keynes!) In December 1949, during my junior year, I stumbled across an article in Fortune magazine that described the mutual fund industry as “tiny but contentious.” I had never before even heard the term “mutual fund,” and I decided on the spot that this industry should be the topic of my thesis, which I entitled, “The Economic Role of the Investment Company.” And so my long journey in this industry began.

It seems problematical at best that my thesis, as some have generously alleged, laid out the design for what Vanguard would become. But whether that is true or not, many of the practices I specified then would, 50 years later, prove to lie at the very core of our success. “The principal function of mutual funds is the management of their investment portfolios. Everything else is incidental. … Future industry growth can be maximized by a reduction of sales loads and management fees…. Mutual funds can make no claim to superiority over the market averages.” And, with a final rhetorical flourish, funds should operate “in the most efficient, honest, and economical way possible.” Were these words an early design for a sound enterprise? Or merely callow, even sophomoric, idealism? I'll leave it to you to decide. But whatever was truly in my mind all those years ago, the thesis clearly put forth the proposition that mutual fund shareholders must be given a fair shake. Since our outset in 1974, that is what Vanguard has been all about. And, I can assure you, it works!

The next wonderful piece of good fortune came my way when fellow Princetonian Walter L. Morgan, who founded Wellington Management Company and Wellington Fund in Philadelphia in 1928, read my thesis. He was impressed enough to offer me a job after my graduation from Princeton in 1951. While I should have leapt at the chance offered to me by this great man, and my good friend until his death at age 100 in 1998, I agonized about the risks of going into what was then a tiny business. But, my courage strengthened by the conclusion in my thesis that the industry's future would be bright, I finally accepted the offer. And a good thing, too!

By 1965, Mr. Morgan had made it clear that I would be his successor. At that time, the company was lagging its peers, and he told me to do whatever it took to solve our problems. Young and headstrong (I was then but 36 years of age), I put together a merger with a highflying group of four “whiz kids” who had achieved an extraordinary record of investment performance over the preceding six years. (Such an approach—believing that past performance has the power to predict future performance—is, of course, antithetical to everything I believe today.) Together, we five whiz kids whizzed high for a few years, and then whizzed low. The speculative fever in the stock market during the “Go-Go Era” of the mid-1960s died, and was followed by a 50% market decline in the early 1970s. The once-happy partners had a falling out, and in January 1974 I was fired from what I had considered “my” company.

In the Business and Out

But without both the 1951 hiring, which providentially brought me into this industry, and the 1974 firing, which abruptly took me out of it, there would be no Vanguard today. Nonetheless, removed from my position as head of Wellington Management Company, I decided to pursue an unprecedented course of action. The Wellington Management Company directors who fired me comprised a minority of the Board of Wellington Fund itself, and I went to the Fund Board with a novel proposal: Have the Fund, and its then-ten associated funds, declare their independence from their manager. It wasn't exactly the Colonies telling King George III to get lost, as it were, in 1776. But fund independence—the right to operate in the interest of their own shareholders free of conflict and outside domination—was the heart of my proposal.

Thanks largely to the determination of a key Wellington Fund director named Charles D. Root, Jr., the Fund Board, after seven months of heated debate, accepted my proposal by the narrowest of margins. Perhaps because there are so few true leaders in our corporate society, such leadership by an independent director is rare in America today. I can assure you that it was even rarer all those years ago. But happen it did, yet another happy accident, and the new firm—a firm that would be owned, not by outsiders, but by the funds themselves—was incorporated on September 24, 1974.

Whether these events were fortuitous, or accidental, or Heavensent—I'll leave that for you to decide—another was about to happen. The new firm needed a name. In September, not a moment too soon, a dealer in antique prints came by my office with some small engravings from the Napoleonic War era, illustrating the military battles of the Duke of Wellington, for whom Mr. Morgan had named his first mutual fund all those years before. When I bought them, he offered me some companion prints of the British naval battles of the same era. Ever enticed by the sea and its timeless mystery, I bought them, too. Delighted, the dealer gave me the book from which they had been removed. After he left I browsed through it, even as I had browsed through Fortune 25 years earlier. I came to the saga of the historic Battle of the Nile (recently designated by The New York Times as the greatest naval battle of the millennium), where in 1798, Lord Nelson sank Napoleon's fleet. There, I paused, and noticed Nelson's triumphant dispatch “from the deck of HMS Vanguard,” his victorious flagship. The naval tradition of the name “Vanguard,” together with the leading-edge implication of the noun vanguard were more than I could resist. And two weeks later, on September 24, 1974, “The Vanguard Group, Inc.” was born—in a profound sense, the child of fortune.

The Character of Vanguard

But, truth told, there is more to Vanguard than this incredible series of happy accidents. So let me take you now to the character and nature of the company that had just come into existence. By having the mutual funds themselves responsible for their own governance and administration—after all, that's what independence was all about for the funds in 1974 even as it was for the colonies in 1776—we had broken new ground in the fund industry. Not only would we operate the funds at cost, but we would operate them at the lowest possible cost, disciplined and sparing in every expenditure, always asking ourselves: “Is this expenditure necessary?” Or, to put it another way: “If this were my own money rather than the shareholders’ money, would I spend it?” (Happily for our investors, I really hate to spend even my own money!)

In many businesses, all of this cost discipline could be merely an interesting observation, a harmless diversion. But in investing, cost matters. It doesn't stretch reality to point out that in most respects the stock market is a casino. A casino in which the investor-gamblers swap stocks with one another, a casino in which, inevitably, all investors as a group share the stock market's returns, no more, no less. But only until the rake of the croupiers descends. Then, what was a fruitless search by investors to beat the market before costs—a zero-sum game—becomes a negative-sum game after the costs of investing are deducted—a loser's game.

And the way the mutual fund game is played carries heavy costs and entails lots of croupiers, each wielding a wide rake. The cost of sales commissions when (most) funds are purchased. The opportunity cost when stock funds hold cash reserves in rising markets. The cost of fund management fees, marketing—all those television advertisements you see—and operations. The transaction costs expropriated by brokers and investment bankers when fund managers buy and sell the stocks in fund portfolios. The cost—and it is huge—of the excessive taxes to which fund shareholders are subjected unnecessarily, the result of the incessant, often mindless, turnover of fund portfolios—now nearly 100% per year. One can only be reminded of Pascal's words: “All human evil comes from this, man's inability to sit quietly in a room.”

How much do costs matter? Hugely! Taking into account sales charges, management fees, operating expenses, and portfolio turnover, the average mutual fund deducts about 2½% per year from investor returns. Assuming—an arbitrary assumption indeed—that the manager is able to match an annual stock market return of, say, 12½% before costs, the shareholder would receive a net return of 10% after costs. Result: 20% of the investor's return is consumed by costs in one year, 29% in a decade, and fully 45% of the return is consumed in a quarter century.

Nearly one-half of the cumulative return generated by the stock market has been confiscated by the costs incurred by the typical mutual fund. And that's before taxes. In a market returning 12½% annually, excess taxes could easily reach 2% per year, further slashing that 10% after-cost return to an 8% after-tax return. Now, the croupiers have consumed 36% of the investor's return in a year, with compounding it leaps to 48% in a decade and—I'm glad you're sitting down!—fully 68% in a quarter century. That leaves 32% of the market's return remaining for the investor, who put up 100% of the capital and took 100% of the risk. Yes, costs matter.

The First Index Fund

It was my conviction that costs are crucial that inevitably brought Vanguard to the two major mutual fund innovations with which I've been most closely identified—one very well known, the other barely known at all. Well known—indeed it seems almost folklore now—is our pioneering formation of the first index mutual fund. It was the very first step in the development of our corporate strategy. In mid-1975, only months after we began operations, I began to develop the rationale for the index fund. A quarter century earlier, the concept of an index fund had received at least tangential focus in my Princeton senior thesis. (Remember, “mutual funds can make no claim to superiority over the market averages.”) And by the mid-1970s, the academic financial journals had published several articles suggesting the development of index funds. In order to prove that the gambling casino theory I mentioned earlier worked in practice, I calculated by hand the annual returns generated by the average mutual fund during the previous 30 years, and then compared them with the returns of the Standard & Poor's 500 Index. The Index won by a 1½% annual pre-tax margin—virtually identical to the actual costs assessed by the mutual fund croupiers during that earlier era. Voilà! Practice confirmed theory. By December 30, 1975, we had incorporated the industry's first index fund.

Why was it Vanguard, rather than some other fund firm, that was the pioneer? Many financial firms must have recognized, just as easily as I did, the mathematics of the marketplace that define investment success by the apportionment of returns between investors and managers, even as between gamblers and croupiers. But external fund managers had a powerful vested interest in maintaining their own extraordinarily high profitability. We alone had an internally managed structure and a mission to be the lowest-cost provider of financial services in the world. So even if, at the same instant we did, 100 mutual fund firms had grasped the opportunity of a lifetime that indexing presented, 99 would have prayed that the cup of indexing pass quickly from their hands.

But, as fate would have it, as the evidence in favor of indexing mounted, one firm had just been formed that—like the suspect in a good murder mystery—had both the opportunity and the motive to seize the day, and take the first step that would one day re-landscape the financial firmament. After recognizing our opportunity, only force of will—persistence, patience, and determination, along with a healthy dollop of missionary zeal—were required. Implementation, after all, has always been far tougher than ideation! But we implemented with zeal, watching acceptance follow, and have seen indexing move from heresy to dogma.

The First Multi-Series Bond Fund

No comparable sea change was required in our second major innovation in mutual fund investment strategy—a new strategy for managing bond funds. It came less than a year after we formed our index fund, and had precisely the same basis—the knowledge that, in any given sector of the financial market, managers as a group must lose by the amount of the aggregate costs of the croupiers, along with the fact that we had both the mission to provide our services to investors at the lowest possible cost, and the structure to do exactly that. Again, opportunity and motive!

In June 1976, Congress had passed a law making it possible to offer municipal bond mutual funds. The first such funds were traditional actively managed bond funds, charging high costs. Ever the contrarian, I was deeply skeptical that any manager could consistently forecast interest rates with accuracy, and thus significantly outpace the famously efficient bond market over the long run. This situation presented Vanguard with the opportunity to change, not merely the structure of fixed-income management in mutual funds, but its very nature. Given our low operating expenses, we were in a position to offer a municipal bond fund that could deliver to our investors the highest net yields in the field, winning the performance derby not by genius, but by combining minimal cost with a less active approach to bond management.

But how would we deal with the question of managing bond maturities? The proverbial lightbulb went on: An idea so simple and so obvious as to defy description. We created, not a single “managed” municipal bond fund—as was the accepted custom of the day—but three separate series: A long-term fund; a short-term fund (essentially the first tax-exempt money market fund); and—you guessed it!—an intermediate-term fund. Each would own high-grade tax-exempt bonds, rigorously maintain a defined maturity range, employ professional managers, and minimize portfolio turnover. And the shareholders would be rewarded with top performance.

It is difficult to be very proud of such an elemental conception. Yet the simple notion of the three-tier bond fund is now firmly established as the industry norm, for tax-exempt and taxable bond funds alike. In its obviousness, its elemental simplicity, and its reliance on rock-bottom costs, the three-tier, fixed-income strategy we pioneered in 1976 had the same genesis as our 1975 pioneering of the index stock fund: The banal insight that it is the costs of investing that determine the gap between the returns the stock and bond markets provide and the returns investors as a group receive. Conclusion: To the victors—the shareholders of the lowest cost funds—belong the spoils.

It is Vanguard's stock indexing and bond management investment strategies—and the reputation we have earned for their efficient implementation—that have accounted for the lion's share of our growth. Of the $540 billion of assets we manage today, fully $370 billion—two-thirds of that total—is accounted for by funds following those two elemental strategies. Of course, success hardly came overnight. After a decade, for example, the assets of our first index fund (we now have 28 index funds, keyed to various stock and bond market indexes), totalled less than $500 million. But with our missionary zeal and our focus on simple investment strategies and investor education, we have, I think, begun to change the mutual fund industry, to make it a better place for investors to entrust their hard-earned dollars.

Education and Economics

Much of my career, in fact, has focused on educating investors about the elemental economics that drive this business and the simple economics of investing. Indeed, though it happened a half-century ago, it seems like only yesterday that I was writing my thesis on “The Economic Role of the Investment Company.” Amazing as it may seem, in recent years, I've used passages from that ancient document as the platform for talks about corporate governance, the sources of investment returns, fund performance, and the challenges confronting this industry. (Indeed, it may be some form of vindication that the thesis and a series of my speeches will be published by McGraw-Hill this autumn, the first volume of their planned series, Great Ideas in Finance.)

On this grand occasion, right here in the capital of our great home state—this remarkable American commonwealth that has been the source of fine governance, such fair taxation, such hospitality to business, and the home of such a splendid, motivated, and well-qualified labor force—it seems only fair to attribute considerable credit for our growth to being here in Pennsylvania, as well as to the kind of simplicity Pennsylvania's founder, William Penn, cherished when he came to his newly chartered lands in 1621. For Penn's own words come preciously close to describing the conduct of Vanguard's affairs:

And so, even as William Penn looked at Pennsylvania as his “Holy Experiment” for human rights and perfect freedom, I began Vanguard as an experiment—though hardly a holy one—to test whether a mutual fund enterprise of, by, and for the shareholders could succeed in a competitive, dog-eat-dog industry. With Quaker-like simplicity in our investment philosophy and with Penn's stubbornness, candor, and thrift in our business strategy, we've surely met the test so far.

My own role from the outset—and particularly in recent years—has been one of spreading the word. Speaking out all over America, not so much on Vanguard itself, but on the elementary principles that are embodied in the investment philosophy, strategies, and human values that I've inculcated into Vanguard, principles that are hardly proprietary, principles that any firm in this industry could adopt if only it has the wit and wisdom to do so.

In that context, I take this moment to applaud the Pennsylvania Partnership for Economic Education for the splendid work it is doing to raise the level of economic, financial, and investment understanding of our citizenry, and especially our youth. I know my trust is not misplaced that this mission will not lose sight of the fact that economics does not stand apart from idealism, that, quoting Woodrow Wilson, “There are other things besides material success with which one must supply our generation … we need men who care more for principles than for money, for the right adjustments of life than the gross accumulations of profit … for sober thoughtfulness and mere devotion as well as practical efficiency.”

My belief that the economic functioning of a business enterprise cannot be separated from the values it holds high has worked splendidly in practice. And at this stage of my life, I recognize more than ever the special meaning of William Penn's credo:

And so I will press on in my mission, comforted with some closing words of Robert Frost that parallel those describing the journey that I cited at the outset, a journey taken down a long road in a woods less traveled by: