11

ECONOMICS 101: FOR MUTUAL FUND INVESTORS … FOR MUTUAL FUND MANAGERS

The Economic Club of Arizona
Phoenix, Arizona
April 20, 1999

IT'S A SPECIAL PRIVILEGE to be asked to speak to the Economic Club of Phoenix. For while this lovely city is a long way from the boundless seas that HMS Vanguard sailed centuries ago, it is the place we chose four years ago to develop Vanguard's first office space away from our home in Valley Forge, where I founded the firm. Given your Club's mission, I'm going to present some strong and perhaps controversial opinions about the nature of the economics of mutual funds—as they affect fund investors, and as they affect fund managers as well. As you will see, there is a difference. That difference has created serious flaws in the record of the mutual fund industry, flaws ignored during our era of incredible economic growth.

I've called the talk “Economics 101,” for what I intend to do is give a sort of basic college survey course explaining the nature of this industry, and its remarkable acceptance. For in the wink of an eye, mutual funds have at once become:

• The investment of choice among America's families, not only the dominant way in which we invest in stocks and bonds, but the dominant way we save our cash reserves.
• The largest institutional investor in common stocks, holding (when private accounts managed by fund advisers are included) fully one-third of all U.S. equities.
• The major force in the largest stock market in the world, accounting for almost two-thirds of all trading in U.S. stocks.
• Perhaps the most cost-efficient medium through which individuals can accumulate assets, even though the general level of costs charged by mutual funds are, in my view, grossly excessive.

In all, it is quite an imposing record. And it comes in an industry that, a mere 20 years ago, looked to be in the throes of a slow and painful death.

When we think of our enormous $5½ trillion industry today, it is hard to imagine that two short decades ago, assets were less than $50 billion, less than of today's size. In 1978, the industry was composed almost entirely of common stock funds, and in the aftermath of the 50% stock market crash in 1973–74, cash was flowing out of these stock mutual funds at a heavy rate. Steady outflows during 1974–1982 reached a cumulative total of $14 billion—a withdrawal of fully one-third of the industry's assets in mid-1974.

During those dog days, fund firms had begun, reflexively, to diversify their so-called product lines with bond funds, but there was not nearly sufficient investor interest to produce capital flows that would offset the equity fund bloodletting. Even so, hope sprang eternal in the industry's breast. I should know, for at the very bottom of the bear market, an odd series of events conspired to make September 24, 1974, the time for me to start The Vanguard Group, a new mutual fund organization with a unique mission. Our economics, as I'll explain later, were different from the economics of our peers.

Some 265 years ago, Alexander Pope warned mankind that, “hope springs eternal in the human breast. Man never is, but always to be blessed.” Our industry, however, defied his warning, and was indeed blessed by opportunity to create a new kind of fund, designed to capitalize on a peculiar inefficiency of the U.S. savings market. In an era of high (10% to 15%) short-term interest rates, the nation's savings institutions were limited by Federal Reserve regulations to paying but 5¼%.

The Leopard Changes Its Spots

The new mutual fund—the money market fund—owned short-term U.S. Treasury bills, certificates of deposit, and commercial paper, money market investments paying, of all things, money market rates, rates that were far higher than the regulated institutions could pay. Almost overnight, our industry, soon dominated by cash management funds, had changed its spots.

Assets still trickling out of stock funds were dwarfed by staggering inflows into money market funds. By the end of 1982, the mutual fund industry leopard, only shortly before spotted almost entirely with stock funds, was now spotted largely with money market funds. Measured by total dollars invested, in 1982 fully 76% of our leopard's spots represented the assets of money market funds, 8% bond funds, and barely 16% the stock fund segment that had comprised 90% of the spots only five years earlier. An amazing transformation! In less than a decade, industry assets had soared to $265 billion—a near eightfold increase from their 1974 low of $36 billion. We were blessed many-fold by the money market fund, for our industry's asset base—now with stock funds, bond funds, and money funds, essentially every form of liquid investment—became a virtual Rock of Gibraltar.

Perversely enough, then, just as equity funds touched their smallest-ever all-time share of the fund industry, the biggest bull market in history began. In August 1982, interest rates began to tumble from their all-time highs of 12% to 15% reached shortly before, falling from 12% to 9% in August alone. Bond prices soared, with stock prices not far behind. Over the following 16 years, to this very day, both bull markets have remained substantially intact, providing the best returns in the recorded history. Since 1982, stock fund assets have grown 50-fold, bond fund assets 40-fold, and even money market fund assets have grown sixfold from this huge base at the outset. Today, industry assets approach $6 trillion, and our leopard is covered 55% with stock spots, 18% bond spots, and 27% cash management spots. “Something for everyone” is a fair characterization of what the mutual fund industry is now offering investors.

The fund industry's share of savings flows has grown from nominal levels to levels that are now truly staggering. Last year, net additions to the savings of American families totaled $406 billion. Some $401 billion—nearly 99% of this huge amount—was represented by cash flows into stock, bond, and cash funds. Imagine that! A quarter century ago, the fund share was only slightly above 0.5%—$1 billion of $180 billion. Truly, we are seeing a stampede into mutual funds.

And total industry flows seem immune to fluctuations in the markets. Stock prices soar (and sometimes even drop), interest rates move bond prices up and down and alter yields on savings, but the industry's cash flows remain a pattern of steady growth: $10 billion a month in 1994, $20 billion in 1995, $30 billion in 1996–97, $40 billion in 1998. But yes, fund investors are market-sensitive to a fault; the stock fund portion can change radically. Stock fund flow, $20 billion a month before last summer's brief bear market, has tumbled $2 billion monthly since then—but money market and bond funds have consistently made up the shortfall.

It is fair to say that, for the moment at least, the mutual fund industry, with its diverse “product line” of stock, bond, and money funds, is meeting the perceived needs of America's investors and savers alike. Surely, our industry's position must be the envy of our rivals in the fields of insurance, savings, and even stock brokerage, to say nothing of the often-troubled financial institutions around the globe. Industry leaders, so often given—unwisely—to bragging, can fairly raise their arms and give the “V” symbol, and announce, as James Cameron, producer and director of Titanic did at Hollywood's Academy Award ceremony a year ago, “I'm the king of the world.”

I do not wish to be included among the braggarts. Yes, it would be easy to say that our extraordinary history over the past two decades has brought mutual funds to the point at which we are, as it were, bulletproof. But I hardly need tell the audience of economic club enthusiasts that nothing is quite so simple. In this rapidly changing world, it is fair to say that nothing is bulletproof. Indeed, with our industry's huge size have come potential flaws—and they are major flaws—concealed by the great dual bull markets in stocks and bonds, their impact almost unnoticed so far. But they do not, I assure you, escape the notice of this grizzled veteran of the mutual fund wars, who last December entered his 50^th year of involvement with mutual funds. I'm now going to discuss those flaws and the major challenges they have created for our industry.

The Flaw of Past Performance

First, the bull markets have served to conceal our performance inadequacies. If I may be permitted to mix a metaphor, while we have ridden the crest of the two bull market waves in one respect, we have trailed—badly—in their wake in another, and far more vital, respect. And it is a major shortcoming. In a stock market with record annual returns averaging 18.6% annually, since the bull market began in 1982, our industry's stock funds have earned an annual return averaging just 15.8% for their investors, an annual shortfall of 15%! Final result of $10,000 invested at the outset: stock market, $167,000; average stock fund: $113,000. With 85% of the annual return of the market, the total capital accumulated by the fund investor amounted to but 65% of the capital that would have been accumulated had he simply owned the market.

The bond fund story is little different: annual return of bond funds 9.1%, annual return of bond market 10.9%. Result: bond funds provided 83% of the market annual return, but only 76% of the market's accumulation during the full period. In both cases, the aggregate of annual shortfalls grows geometrically over time, a sort of “tyranny of compounding.” Over the long term, seemingly small annual lags in annual return grow to become yawning gaps in capital accumulation. “Little things mean a lot.” This failure to provide our shareholders with returns that can keep pace with the financial markets in which we invest is our first major flaw.

The Flaw of High Fund Costs

Our second flaw, rarely recognized, is that the high cost of investing in funds is principally—indeed overwhelmingly—the cause of this performance lag. The stock fund annual shortfall of 2.8% closely parallels the all-in costs of 2%-plus for equity funds—expense ratios that averaged some 1.3% and portfolio transaction costs of perhaps 1% annually during the period. (These cost and performance figures, moreover, ignore fund sales charges, costs which are paid by about two-thirds of fund investors.) In bond funds, the performance lag of 1.8% closely parallels all-in bond fund costs of 1.2%—about 1.0% expenses and 0.2% trading costs. (Again, sales charges would increase the fund shortfall.)

To make matters worse, fund expense ratios have steadily risen during the period. For stock funds, from about 1.1% to 1.6% or nearly 50%. For bond funds, from 0.9% to 1.1%, more than 20%. (Money fund ratios, however, declined from 0.7% to 0.6%.) These expense ratio increases, coming in the face of the quantum increase in fund assets from $265 billion in 1982 to $5½ trillion today, have raised industry revenues from about $2 billion annually to $60 billion annually (taking into account that fee rates tend to decline slightly for funds that attain large asset size). Clearly, this is a great business for the fund managers. The costs of fund managers have not risen nearly so fast as their revenues. Yet they have failed to adequately share the enormous economies of scale in fund management with their fund shareholders. They have effectively turned economies of operation into outright diseconomies in the costs that investors pay. High costs, then, represent our industry's second major flaw.

“Follow the Money”

I freely acknowledge that it costs money to operate a mutual fund. Let's examine how much. This year, on the operating side, the aggregate expenses paid by fund investors to fund managers this year will total about $50 billion—50 billion dollars. Where does this money go? We don't know exactly, but it looks to me that about one-tenth of that amount—up to $5 billion—is spent on portfolio management and investment research. (However vain the search for market-beating returns, that's presumably what investors expect their money to be used for.) About $8 billion of that total is spent on marketing fund shares; that is, on the effort to bring more money into the funds. (Of course, this expenditure adds nothing whatsoever to the funds’ returns; it reduces them by the amount of the expenditure … perhaps by even more, but that's another story.) About $17 billion, I think, is spent on services to fund shareholders, which is fine as far as it goes, although some of these “services” are thinly disguised marketing efforts; others are actually counterproductive for investors. That comes to a total of $30 billion.

But the total management fees and operating expenses paid by fund shareholders are actually $50 billion. Where, you may ask, is the other $20 billion? According to my rough estimates, $20 billion represents the aggregate pre-tax profit earned by the fund management companies—a rather handsome reward, considering the failure of fund managers to provide investors with the full returns earned by the market. By now the fundamental economics of the fund business itself are apparent. If we assume that the $5 billion spent on portfolio research and management is reasonable; that $2 billion could be spent, however counterproductively, on marketing; and that shareholder service expenses could be stripped down to say, $13 billion; then a total of $20 billion should be sufficient to operate this industry. Even if we conceded that managers are entitled to, say, $5 billion a year in profits, hardly an insubstantial sum, that would represent an annual savings to investors of $25 billion.

And now, a caution: I want to be clear that these figures should be considered only as informed estimates. The industry does not disclose such data, nor do I expect it to be voluntarily disclosed in the foreseeable future. But, in an environment of enlightened full disclosure, it ought to be disclosed. Indeed, I have recommended to the U.S. Securities and Exchange Commission that it undertake an economic study of the industry so that, one day, soon I hope, we shall all have a public awareness of, not good estimates of, the profitability of industry managers, but hard facts. The sunlight of full cost disclosure is the best remedy for awakening the awareness of where the shareholders’ $50 billion is being spent. It's high time, as was said in the Watergate scandal years ago, to “follow the money.”

The Flaw of Future Returns

Our third flaw comes in the fact that our two great bull markets seem unlikely to clone themselves in the next 16 years. The U.S. stock market began this bull run with a dividend yield of 6.2% and a price-earnings ratio of 7.7 times. Today, the yield is 1.3%, the price earnings-ratio 30 times. It is this increase in the price-earnings multiple—not in the fundamental factors of dividend yields and earnings growth—that has largely driven the bull market. For example, the Standard and Poor's 500 Index of stock prices was at 120 when the bull market began. It now reposes at 1300. But had the P/E ratio remained at 7.7 times, the Index would now repose, not at 1300, but at 320, almost 1000 points lower. But in the long run, it is dividend yields and earnings growth that are the fundamental driver of stock returns.

Now let's apply some elementary economics to the stock market. If we assume that today's 1.3% dividend yield is accompanied by future earnings growth of 8% (the long-term earnings growth rate is 6%), future stock returns based solely on our dividend yields and earnings growth would be 9.3%. Now let's make three different assumptions: (1) If today's price-earnings ratio valuation remains at 30 times a decade hence, this 9.3% would be the exact stock market return for the next decade. (2) If the price-earnings ratio fell to 18 times, the annual return on stocks would be but 4.3%. (3) If a future return of 16% were to be achieved, a price-earnings ratio of 57 times in 2009 would be required. I'd simply rule out #3. It seems inconceivable to me that a further substantial upward revaluation in multiples lies before us. So, I'd guess the best case for the future would rest between #1 and #2. Perhaps future stock market returns might lie in a 5% to 10% range. Because of their heavy operating and trading costs, then, equity funds would return as little as 2½% to 7½% over the next decade.

In the bond market, the case for lower future returns seems even clearer. The bond market began this great run in August 1982 with an 11% yield on long-term Treasury bonds, and subsequently delivered an average return of 10.9% annually. With a yield below 6% today, their most likely future return over the next decade would be, well, 6%. It would be unlikely, I think, for returns over the next decade to stray far outside a range of 4½% to 7½%. Future returns on bonds, really, cannot match those of the past 16 years—or come even close.

The high portion of fund returns confiscated by fund managers in our bull market era would rise even higher in markets in which returns were lower. For unit costs (the expenses paid on each dollar invested by shareholders)—are collected by managers as a percentage of assets, so, as market returns recede, the same asset charges consume a higher percentage of return. So, if we anticipate future returns in the 7½% range for common stocks and all-in stock fund costs of 2½% (due to ever-rising fund expenses), stock fund costs would consume, not 15% of the market's annual return as in the past, but fully 33%. Applied to a future bond market return of 6%, costs of 1.1% would result in bond funds providing, not 85% of the market's return, as in the past, but 81%. Under these conditions, fund investors would at last begin to recognize the extraordinarily baneful role that excessive fund costs play in the economics of mutual fund investing. Hidden in the current bull market, fund costs would truly be devastating in a less salubrious environment. When future market returns are lower, fund costs will have a far higher negative impact on investor returns, and that is the industry's third flaw.

The Flaw of Great Success

And now this fourth flaw: Fund industry growth. There is no longer any hope whatsoever that mutual funds can overcome the odds and beat the market in such a manner as to overcome their high cost handicap by a meaningful margin. That is because the funds are simply too large. Our industry's thesis of success has created its own antithesis. The lore is wrong: The truth is that “nothing fails like success.” As Warren Buffett puts it, “a fat wallet is the enemy of performance superiority.” Mutual fund managers, including the private accounts they oversee, now control one-third of America's $13 trillion of equities.

Even if it were arguable that the managers holding $4 trillion plus of stocks in our highly efficient markets could somehow, by dint of some superior skill, outpace the other professional and public investors holding the remaining $9 trillion by an amount sufficient to overcome the awesome burden of their heavy expenses, that hope would be quickly dashed by the fact that, with their stupefyingly high portfolio turnover rates—85% in 1997 alone, nearly twice the market's turnover—funds now account for almost two-thirds of all trading. The managers are clearly trading largely with one another, inevitably leaving fund investors as a group in a neutral position before costs. Relative to the stock market (and the bond and money markets, too) funds are playing a zero-sum game before management and trading costs, but a loser's game after the croupiers rake off their generous share of the wagers.

Even before funds grew to their current gargantuan presence in the market, funds had been unable to “beat the house”—the market. Indeed, way back in 1975, when I recommended to our directors that Vanguard form the first stock market index mutual fund, I presented data showing that over the previous 25 years, managed funds had experienced an annual shortfall of about 1½% to the S&P 500 Index. (The shortfall was smaller because fund costs were lower then.) Now, with a half-century of evidence of index superiority, it is high time for investment managers, brokers and financial planners, industry analysts, and the financial media to disavow, once and for all, the notion that “beating the market” is a realistic objective for the mutual fund industry.

The Industry Responds … Sort of … on Fund Performance

So far, the mutual fund industry has found little, if any, need to respond to the issues manifested in these four crucial flaws. The industry itself takes no position on the appropriate financial market indexes for comparing the performance of funds. When the SEC in 1993 required fund annual reports to include comparison with appropriate annualized market indexes—the Standard & Poor's 500 Stock Index, the Wilshire 5000 Equity Index of the total stock market, or the Lehman Aggregate Bond Index (covering the total investment-grade bond market), for example—the industry complained, but grudgingly complied, although most funds find few reasons to highlight the comparison and lots of reasons to bury it deep in the annual report. And, despite the SEC requirement to do so, substantive comments on the reasons a fund's return falls short (mostly) or exceeds (rarely) the return of the index are conspicuous by their absence.

But the fact is that even the most casual economic analysis suggests that if market indexes are almost impossible for managers to beat, the industry response should be to offer index funds. Why accept 85% or less of the market's annual return when an index fund can virtually guarantee 98%–99%? Indeed, long before he became a television celebrity, Fidelity's Peter Lynch was willing to concede that “most investors would be better off in an index fund.” And a former fund chairman has publicly said that investors ought to realize that “mutual funds can never beat the market” (italics added). Other fund executives, however, have a different view. One recently brushed aside the index comparison by scoffing, as quoted in Money magazine, “it's [the S&P 500 Index] a large-cap growth fund,” and defending his firm's managed funds by saying that they are “like everybody else. Our managed funds have done well over the long term but less well in recent years.”

Well, there are brute facts that can be brought to bear when statements like these are made. Fact 1: The S&P 500 Index is not a large-cap growth fund. A large-cap fund, yes, but, by common consensus, structured to include 50% growth stocks and 50% value stocks. Fact 2: As to “recent years,” the return of that executive's flagship growth fund trailed the S&P 500 by a cumulative total of 84 percentage points (+159% vs. +243% for the Index) during 1994–98. I guess “less well” is an acceptable, if rather generous, description of that shortfall. Fact 3. “Over the long term,” the annual return of this same flagship growth fund trailed the S&P 500 by 3 percentage points (+12% vs. +15%), meaning that $10,000 invested in the growth fund 25 years ago would presently be worth $160,000 vs. $324,000 for the same investment in the Index. That result surely pushes the definition of “done well” to some sort of world-class limit. People who live in glass houses, I think, shouldn't throw stones.

The Industry Response on Costs

There is no question that since 1980 the annual expense ratio of the average equity fund has risen by 40%—from 1.10% to 1.57% of fund assets. It has been documented, well, everywhere. But, the industry takes the position that the cost of fund ownership is declining. Or that's what the industry's Investment Company Institute says. What it means is that, according to its rather tortured and convoluted methodology, the cost of purchasing funds has, in fact, declined, from 2.25% annually in 1980 to 1.49% in 1997. The industry reaches this conclusion by including sales charges plus expense ratios, and then weights the results by the sales volume of each fund each year. High-cost funds that don't sell, in short, don't count. Virtually ignored in the ICI methodology, the managers of high-cost funds prosper and their shareholders suffer accordingly.

Given the dynamic combination of (a) the increasing importance of no-load funds (sold without commissions); (b) the rapid growth of low-cost market index funds; and (c) the remarkable rise in market share of the industry's sole mutual mutual fund complex—the unique structure adopted by a firm that operates its funds on an “at cost” basis (you'll recognize that firm as Vanguard)—the industry's claim, while rather pushy, may well even be valid, as far as it goes. However, it doesn't go nearly far enough. It ignores the fact that the heavy cost of portfolio transactions is a major “cost of fund ownership” which probably adds—the industry is tight-lipped on this subject—up to a full percentage point to fund costs, raising the total annual cost to as much as 2½%.

Even to the extent that the industry's overly generous appraisal of the data, along with its somewhat specious series of definitions, can be regarded as valid, however, what the data really show is that, quoting from the independent Morningstar Mutual Funds analysis, “the drop has been driven by investors, not by shareholder-friendly mutual fund companies,” and that a few fund families “deserve credit for keeping their expenses down, but one shouldn't credit the entire industry for the virtues of a few—and for the diligence of investors in seeking them out.” In any event, there's not a lot of point in arguing over the difference. The industry's 1.49% figure is hardly different from the 1.57% average expense ratio that is, I believe, a realistic figure.

The Industry Response on Price Competition

Finally, the issue comes down to the sharing of the economies of scale between fund managers and fund owners. The managers have grabbed the lion's share—that is, to be clear, almost all—of these economies. For this industry prices its wares at what the traffic will bear, not at what is fair to investors. Price competition—at least, competition to reduce prices (there is plenty of competition to increase prices)—is conspicuous by its absence in this mutual fund industry. To say the very least, the industry disagrees with that conclusion. The official position of the ICI: “Let there be no doubt in anyone's mind—mutual funds compete vigorously, based on price.”

Why, then do fund expense ratios remain so stubbornly high? Because they are virtually invisible, lost in the shuffle of fund performance during the greatest bull markets in all history. How many investors are aware that the gap between stock market returns and average equity fund returns have cost investors 35% of their capital potential during the bull market? How many are aware that the huge gap is explained largely by fund costs? How many investors realize that it is their market intermediaries—fund managers, promoters, and brokers—who rake in those revenues? While the fund shareholders put up 100% of the initial capital when they invest, and then assume 100% of the market risk, they receive only 65% of the stock market's long-run return. It is our capital market croupiers who, without providing any of the capital or assuming any of the risk, rake in the remaining 35% of the return. These economics hardly represent capitalism's finest hour.

Is There “Vigorous Price Competition”?

If there is vigorous price competition, how can the industry explain the fact—buried deep (and without comment) in the Investment Company Institute analysis of the costs of fund “ownership”—that the lowest cost 10% of funds have raised their expenses from 0.71% to 0.90% per year? A 27% cost increase.¹ (In fairness, the ICI report also calculated that the high-cost 10% of funds did experience a modest 9% decline in cost, from a confiscatory 3.45% to a marginally less confiscatory 3.15%. One wonders what the justification for those funds may be!) Again, if there is price competition, how can the industry possibly explain how the industry's sole VLCP (“very low cost provider,” if you will) has, in the past year, accounted for an eye-popping 90% of the cash flow into direct-marketed (no-load) stock and bond funds … without significant competitive response. (That's right: Vanguard cash flow, $49 billion; other direct marketers $5 billion.) In what other industry could a relative upstart capture a 90% market share and not have a single competitor imitate its strategy? How one can equate this picture with the allegation that mutual funds compete vigorously based on price is beyond my comprehension.

What would real price competition look like? The answer is as simple as it is obvious. Vanguard's philosophy is based on long-term investing at low cost. Competitors would have to plunge enthusiastically into the index fund fray. (A “kicking and screaming” entry won't do the job.) They would have to cut their management fees and the portfolio turnover of their managed stock funds. They would have to slash fees and raise the portfolio quality of their bond funds. These changes would make money for their investors. But it would slash profits for their managers and their shareholders. The simple economic truth is this: There is simply no increase in market share that would be adequate to maintain the managers’ present awesome levels of profitability. As long as today's awesome level of profitability is priority number one for the managers, fund shareholders will pay the price, and industry expense ratios will edge ever upward.

The fact is that price competition can not be proven by the admitted fact that one VLCP—Vanguard—exists in this industry. (Does the existence of Savings Bank Life Insurance prove that the life insurance industry is price competitive?) Since the low prices established by that single competitor are substantially ignored by other fund firms, there can hardly be said to be “vigorous competition.” Indeed such an allegation flies in the face of hornbook economics: Price competition is defined, not by the behavior of consumers, but by the behavior of producers.

Solutions: Unclear

If the aggressive entrepreneurship of fund managers, rather than fiduciary trusteeship, is the force that controls competition in the mutual fund industry—and believe me, it is—and if these managers, with their own management company shareholders to please before they please their fund shareholders, make more profits by relinquishing market share in favor of maintaining and increasing prices—as they do—how will the mutual fund industry ever give its shareholders the fair shake that they deserve?

So far, classical economics—the relationship between supply, demand, and price—shows but faint signs of being the agent of change. Not no sign, for the marketplace is demanding index funds; a few other firms are adopting index-like strategies (albeit at index-plus prices); at least one other bond fund manager with relatively low fees is building large assets; and, mirabile dictu, the hugely respected TIAA-CREF organization is adding low-cost mutual funds to its fixed—and equity—annuity base. May they flourish! Vanguard needs some high-quality, low-price competitors to hone our own competitive edge.

But if competition in the marketplace shows little sign of supplanting the serious, performance-penalizing economics of the financial markets for fund investors, there is another factor. The law of the land—The Investment Company Act of 1940—clearly intended to protect fund shareholders from the failure of competition to give them a fair shake. The Act doesn't even hint at allowing managers to charge what traffic will bear. Rather, it imposes on mutual fund directors the duty to place the interests of shareholders ahead of the interests of advisers. The SEC is evaluating whether independent directors are doing their job. Section 4 of my new book, Common Sense on Mutual Funds, will, I hope, provide the Commission with important information. (No less an investment icon than Warren Buffett has recommended, in writing, that section of the book to the SEC.) The House of Representatives has held hearings on “improving price competition,” and while the industry designees espoused the party line, at least one university professor and “The Motley Fool” were allowed to speak. And speak they did, bless them, endorsing my own iconoclastic views.

There is life, then, and there is hope, for fund shareholders. By building public awareness with groups like this one, and by writing another book—that, while primarily designed to help fund owners become more successful investors, also takes aim at improving industry values and structure—I'm trying my best to do my part.

“Show Me the Money”

This economic analysis of the fund industry I've presented today has, I fear, been a bit didactic and tedious, to say nothing of disillusioning, given the industry's remarkable growth over the past two decades. But I hope that my analysis has clearly revealed some of the important economic realities of investing, reflected both in the chinks in the armor of a potent industry and in the unlikelihood that this bull market is destined to last forever. I've been transfixed by the economics of this industry for nearly 50 years now—I began to write my senior thesis, entitled “The Economic Role of the Investment Company,” at Princeton University in December 1949—but I find these economics more interesting today than ever before, and certainly more challenging.

But never forget that the most important economic role of the mutual fund industry is to make it possible for investors—large and small, knowledgeable and naïve alike—to reach their financial goals in the most advantageous way possible, under the best terms, provisions, and, above all, costs. Yes, costs matter. And they'll matter even more when the financial markets at last revert to more normal returns, as seems to me inevitable. Two years ago, in a major mutual fund article, Newsweek magazine laid down a good rule for investors to consider in their mutual funds investments: “Your mantra as a low-cost investor: Show me the money.” Your money is at stake and it is high time you demanded it. Show me the money? Yes! And, since time is money, and compounding entails both magic and tyranny, the sooner investors recognize this simple fact, the better.