EVENTS

Date:	Tuesday, May 9, 2006
Time:	9:30 AM -- 11:30 AM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

May 2006

The Bogle Critique of the Mutual Fund Industry

John Bogle is one of the pioneers of the mutual fund industry in the United States, a founder of the Vanguard Group, and an author of several books and innumerable articles about finance and investing. He is also one of the most outspoken critics of the mutual fund industry today. In his most recent book, The Battle for the Soul of Capitalism (Yale University Press, 2005), Bogle writes, “Using an organizational design that would amaze (and delight!) the oligarchs of corporate America, the managers of mutual funds have enjoyed virtually free rein to place their interests ahead of the interests of the owners of their funds.” This is characteristically strong language, but is it an accurate representation of an industry that now has over 90 million investors and almost $9 trillion in assets? And what organizational design does Mr. Bogle recommend? At a May 9 AEI conference, the ninth event in the series, “Is There a Better Way to Regulate Mutual Funds?” Mr. Bogle presented his views on the mutual fund industry, and other industry experts responded to his arguments.

Peter J. Wallison
AEI

In his latest book, The Battle for the Soul of Capitalism, John Bogle makes four policy prescriptions for the mutual fund industry: a fund board may have no more than one management company director; the board must have an independent chair; the fund must employ a staff that reports directly to the independent chair and is responsible for evaluating the investment performance and marketing results of the manager, the reasonableness of fund fees paid, and other relevant information; and that there be a federal statute of fiduciary duty for fund directors. Just recently, the D.C. Court of Appeals struck down an SEC rule that would have mandated that boards have independent chairs and a supermajority (75 percent) of independent directors. This would have essentially implemented two of Mr. Bogle’s recommendations, but the court struck it down because the SEC had not considered its effect on efficiency and competition. Mr. Wallison argued that in light of this recent court decision, Mr. Bogle should address how a supermajority of independent directors and an independent chair would increase efficiency and competition. In addition, since the SEC has not charged any directors with dereliction in connection with the late-trading and market timing scandals, it remains ambiguous how the rule, had it been in place, would have prevented the wrongful acts by the advisers from occurring. Furthermore, while Mr. Bogle argues that management fees have eaten up excessive amounts of investors’ profits, Mr. Wallison noted that he has not given concrete estimates on the effect that the additional staff he proposes will have on cost.

John C. Bogle
Bogle Financial Markets Research Center

The theme of The Battle for the Soul of Capitalism is that during the late twentieth century, capitalism underwent a change from its traditional form, owners’ capitalism, in which corporations were run for the benefit of their owners, to managers’ capitalism, in which corporations were run for the benefit of their managers. This shift was aided by the fact that corporate ownership has become dominated by institutions who serve as agents for the real owners [e.g. the beneficiaries of pension and 401(k) plans]. We have become an agency society in which few responsible owners remain.

The shift from owners’ to managers’ capitalism is most evident in the mutual fund industry. The industry’s predominant structure, in which mutual fund complexes are owned and operated by a group of outside shareholders, poses a basic conflict of interest, as higher fees increase the manager’s revenue to the direct dollar-for-dollar detriment of the returns earned by the fund investors. Even when trillion-dollar fund complexes could easily manage themselves, they find it necessary to be controlled and operated by separate outside managers who are in business to serve their own shareholders, not the fund investors.

Industry data suggest that mutual funds have failed to adequately serve their owner investors. Mr. Bogle illustrated this failure through six main points:

• Traditionally, stewardship was the raison d’etre of the mutual fund industry. Now, the emphasis is on marketing and increasing the amount of assets under management, thereby increasing fee revenue.
• The majority of the industry’s largest fund companies are owned by large financial conglomerates whose managers are looking to achieve a return on their capital, not on the investors’ capital.
• Hampered by excessive fees, mutual fund returns have fallen dramatically short of market benchmarks. Additionally, poor timing and fund selection have caused fund investors to underperform the market by an even greater margin.
• While one would expect an increase in assets to bring about the benefits of economies of scale, mutual fund expenses--with Vanguard’s assets being virtually the sole exception--have actually grown at a faster rate than assets over the past forty years.
• Mutual fund portfolio turnover has risen from 15 percent in the 1950s to over 100 percent currently, resulting in larger transaction costs, which further diminish investor returns.
• There has been an overall failure by mutual fund managers to honor the responsibilities of corporate ownership. There is a tremendous agency problem in the industry today that has not been resolved.

Recent efforts by the SEC to reform the industry, while well-intentioned, have too often been of a narrow and technical nature. To truly address the conflict of interest inherent in the industry’s current structure, Mr. Bogle advances several policy changes, which Mr. Wallison outlined in his introduction. These recommendations will allow independent directors to become ferocious advocates for the rights and interests of the fund shareholders they represent, at last assuming the fiduciary duty they are charged with under Investment Company Act of 1940. Another, more dramatic, step in curbing the current problems is the mutualization of at least part of the mutual fund industry. Under mutualization, large fund families would run themselves, and a greater share of the profits would be returned to investors.

Robert E. Litan
Brookings Institution

Mr. Litan began by clarifying Mr. Bogle’s comments on the mutualization of fund companies. Under the current structure, mutual funds hire a separate management company to manage the money in the fund. Thus, there is a conflict of interest, in that one company (the fund) hires another company (the management company), but the second company has hired the first one. Vanguard dealt with this conflict by internalizing the management company.

Mr. Litan asked Mr. Bogle why, if the Vanguard model is so good, haven’t other companies followed suit? Also, even before the SEC ruled that fund boards must be comprised of a majority of independent directors, many fund companies had already done so. However, these independent directors have apparently been unable to control the excess fees that Mr. Bogle criticizes. If majority independent boards have not been able to deal with the issue of high costs, why should we expect that boards that are 100 percent independent will fix the problem? Mr. Litan posed other questions regarding the consequences of additional litigation that could be brought on by the statutory changes Mr. Bogle suggests and about the lack of incentive that board members have to exercise their voices when they are supposed to be overseeing an index fund, which is essentially just buying the market.

Geoff Bobroff
Bobroff Consulting

Mr. Bobroff began by noting how the mutual fund industry as a whole--despite the recent scandals--still serves investors rather well, as evidenced by the continued net inflow of assets from investors. The fact that there is $10 trillion under management demonstrates that people consider mutual funds a good way to invest and are satisfied with the product. Also, investors are responsive to changes in the industry. They follow net return first and foremost, and since fees play a significant role in determining returns, it makes sense that investors are flocking to low-cost fund providers such as Vanguard, Fidelity, and American Funds. The industry remains highly competitive and diverse, with concentration in 2006 roughly the same as it was in 1991. Investors today have greater access to more investor services, funds, and individual account information via the Internet. Further, investors have access to more information on mutual funds than other forms of investment, and as investors are responsible for more of their retirement assets, they are increasingly going to outside investment advisers for guidance and/or advice.

In regard to the cost issue, data indicate that over the past few years, costs have been decreasing. Regarding corporate governance issues, as a consultant, Mr. Bobroff has been spending more of his time with mutual fund boards. Boards are becoming increasingly focused on the interests of investors, and have been hiring consultants and making use of their chief compliance officers, a position recently created by the SEC.

John D. Rea
Rea Consulting

Mr. Rea disagreed with Mr. Bogle’s critique that the mutual fund industry has “lost its way.” To argue that the industry has generally served investors well, he made two main arguments. First, the extraordinary growth in assets and ownership of mutual funds over the past fifty years suggests that investors are at least somewhat satisfied with what they receive from mutual funds. Second, the fund industry has a competitive market structure, and it is generally accepted that competition does not reduce consumer welfare.

In regard to the first point, since 1980, assets under management have grown from $135 billion to almost $10 trillion. Also, ownership has risen from fewer than five million households to fifty-four million households, or almost half of American households. Furthermore, most investors have investment advice in choosing funds. They either hire advisers or choose among the options of their employers’ 401(k) plans.

In regard to the second point, currently, 600 mutual fund companies offer approximately 8,000 funds. Moreover, the concentration of the top five, ten, and twenty-five companies over the past twenty-five years has been relatively stable, but the companies within those categories have changed substantially. Data indicates that mutual fund investors follow fund performance, and that the industry is responsive to investor demands. After all, fund companies need to attract investors and their assets in order to maintain a profit and stay in business. The industry has been continuously changing, offering different kinds of asset allocations, no-load funds, and different levels of advice. Due to the competitive, dynamic nature of the industry and the way in which it has changed to satisfy the needs and demands of investors, it is wrong to assert that the industry has somehow “lost its way.”

AEI staff assistant Dan Geary prepared this summary.