American Enterprise Institute

May 9, 2006

[Edited transcript from audio tapes]

9:15 a.m.	Registration
9:30	Introduction:	Peter J. Wallison, AEI
9:45	Presentation:	John C. Bogle, Bogle Financial Markets Research Center
	Discussants:	Geoff Bobroff, Bobroff Consulting, Inc.
		John D. Rea, Rea Consulting
	Moderators:	Robert E. Litan, Brookings Institution
		Peter J. Wallison, AEI
11:30	Adjournment

Proceedings:

Peter Wallison:  I want to welcome all of you today to what I think will be a very interesting program.  I’m Peter Wallison.  I’m a resident fellow here at the American Enterprise Institute, and my colleague, Bob Litan, who I want to introduce in a moment and I have been conducting a study of mutual fund regulation under the general rubric, “Is there a better way to regulate mutual funds?”  This is the ninth conference we have had on this subject.  There will be several more but this one promises to be I think one of the most interesting if not, controversial. 

Our guest and principal speaker today is Jack Bogle, a pioneer in the mutual fund industry and the founder of the very successful and innovative Vanguard Group.  I won’t go into detail concerning Mr. Bogle’s extraordinary career; that is outlined in the biography included in your materials. But suffice to say that he began looking at the benefits and cost of mutual funds with his senior thesis as a Princeton undergraduate and essentially never stopped.  His work as both an innovator and then a critic of the mutual fund industry has earned him in 2004 Time Magazine’s listing as one of the 100 “Most Influential Men in the World.” 

We were eager to bring Jack Bogle to this podium because his critique of the mutual fund industry has received wide circulation, not just through his books, but through his remarkable speaking schedule and abilities.  As the Washington Post once said, “He has the mind of an economist and the personality of a preacher.”  Any study of mutual fund regulation and the structure of the industry which is what Bob and I are engaged in here must take into account the Bogle critique and particularly his recommendations for change and certainly we will. 

In his latest book, The Battle for the Soul of Capitalism, which incidentally is on sale in the lobby, and you can get it after the program, or if you are leaving early you can get it then, Mr. Bogle outlines his prescription for reform.  He cites four elements in his reform agenda: no more than one management company director on a fund board; an independent chair; a fund staff reporting to the independent chair with responsibility for evaluating the investment performance and marketing results of the manager, the reasonableness of fund fees paid and other relevant information; and a federal statute of fiduciary duty for fund directors. 

We are eager to hear Mr. Bogle’s arguments in favor of these reforms for several reasons.  Clearly, this fits in with the kind of study that we have been doing.  First, the SEC’s 2004 regulation that would have required the chair and at least 75 percent of the directors of every fund to be independent of the investment adviser was recently struck down by the D.C. Court of Appeals because the SEC had failed to consider the effect of its rule on efficiency and competition in the mutual fund industry.  In the National Securities Markets Improvement Act of 1996, Congress required the SEC to consider these factors, that is, efficiency and competition, when it makes rules, and Bob and I, I think-- certainly I because I have written a lot about this--would really like to know how Mr. Bogle connects the independent share and the super majority of directors with efficiency and competition in the mutual fund industry. 

Secondly, the only significant scandals in the industry’s 66-year history were the recent market timing and late trading scandals.  Both were discussed extensively in Mr. Bogle’s book.  The SEC proposed its requirement for an independent chair and an independent supermajority of the board largely as a response to these scandals and thus essentially implemented two of Mr. Bogle’s major reforms.  I have been trying to figure out how these reforms, had it been in effect, would have prevented these scandals.  The SEC has never charged any directors independent or otherwise with dereliction in connection with the clearly wrongful acts by the fund’s advisers and has never suggested that the directors should have or even could have discovered the wrongdoing. 

So I have never been able to determine how increasing the number of independent directors from a majority to a super majority or making the chair independent of the investment manager would have been a remedy for the one serious scandal that has ever afflicted this industry.  Since it is an important part of his prescription for reform, I am hoping that Mr. Bogle will draw the connection between the reform and the wrongdoing. 

Third, in his book, Mr. Bogle argues that expenses imposed by investment managers have eaten up very large percentages of the returns that investors might have expected from the growth in the value of their funds.  Yet he recommends that the funds themselves have a paid staff to evaluate the work of the investment adviser.  Presumably, that would add even more cost that ultimately would reduce the yields that investors would get from appreciation of their portfolios. 

Mr. Bogle does not estimate what these cost could be but if we were to adopt his idea, I would like to get some sense of what he thinks these costs might be and how they would increase the returns for investors.  More generally like Jack Bogle, Bob and I are focusing our study on what reforms will improve the returns that investors will get from their mutual fund investments.  In looking at mutual funds today, we see an industry with nearly $9 trillion in assets, heavily regulated by the SEC and largely under the control at the board level of a majority of independent directors and in many cases a supermajority.  From this arrangement, investors obtained diversification that protects their nest eggs against the kinds of losses suffered by the non-diversified shareholders of we will say, Enron and WorldCom. 

But far from being dissatisfied with what this arrangement is costing them, there are indications that investors are willing to pay even more for investment advice.  If I understand the figures correctly, almost 60 percent of mutual fund investors use financial advisers.  Most of them are paid in whole or in part by the investors themselves or through 12b1 fees that are in effect paid by mutual fund shareholders.  And how else can one explain the growth of separately managed accounts in which investors pay advisers to set up special, customized, diversified portfolios? 

One of the alternatives we might consider in our study is the adoption of the reforms that Jack Bogle recommends.  But in order to do so, we would have to see how these reforms cure the problems Mr. Bogle cites or give investors more of what they seem to want.  We look forward to Mr. Bogle’s remarks as I’m sure you do and to the discussion that follows, and now I’m delighted to welcome to the podium, Jack Bogle.  I will introduce my colleague, Bob Litan and the other speakers after Jack is finished.  Please.

John Bogle:  [Long pause] Alright, I’m sorry about that.  I will repeat myself.  I’m not sure I have gotten it covered in my talk all of the items that Peter mentioned in his generous introduction.  But if we have not covered them in the talk we will certainly talk about them in the Q&A period, and I hope this will be a no holds barred session.  It is very rare for me to get any debate on these ideas I have which seemed to be as a wise man once said somewhat out of the mainstream and indeed they are. 

But I thank you for the nice introduction Peter, and it’s a real pleasure to be at AEI and be with some industry-savvy participants like John and Geoff and also these think-tank intellectuals at the same time like Peter and Bob.  It’s really a treat to be with you, and I love the challenge of that and I’m going to start off by just mentioning as a jumping off point the new book that I have, Battle for the Soul of Capitalism, published by Yale University Press just last November, and it relates directly to the themes I’ll talk about today. 

The theme of the book is that today’s capitalism has departed in many, many areas not just in degree but in kind from its traditional roots, a system that served us so well for so long.  This system worked or at least it did work.  And then late in the 20th century something went wrong.  A pathological mutation in capitalism as it is called in the book in which the traditional system, the classic system, owner’s capitalism, based on a dedication to serve in the interest of the corporation’s owners and maximizing the return in their investment morphed into a new system, manager’s capitalism, in which the corporation came to be run to profit the corporate area, its managers and complicity with accountants and the managers of other corporations.  This change came in large measure because the markets had so diffused corporate ownership that no responsible owner exists, a corruption of capitalism itself, quoting from the book. 

Once we ran ownership society not so long ago either in the whole span of time in which direct owners of stock held voting control over corporate America, and we turned in now an agency society and we are not going back to an ownership society.  This move has been massive and unrelenting as you all know roughly in 1950, 92 percent of all stock was held by individual investors and only 8 percent by institutions, and since then institutional ownership has soared to 68 percent from 8 percent.  But while we have replaced our traditional ownership structure dominated by individuals with a new agency structure dominated by institutions, we have yet to change the rules of the game. 

It is a curious fact that my new book echoes in fact Peter, in so many ways the principles that I set forth in that senior thesis at Princeton all those years ago completed in the spring of 1951, oh my God, 55 years ago.  It was entitled “The Economic Role of the Investment Company.”  Read today, I think you would find that the thesis may be a little bit more than workmanlike but not much.  Probably rather callow, but that powerfully as it happens, reaffirms the ideals that I hold to this very day. 

“The role of the mutual fund,” I’m quoting from the thesis now, “is to serve the needs of both individual and institutional investors, to serve them in the most efficient, honest and economical way possible.  The prime responsibility of fund managers must always be to their fund shareholders.  The primacy of the interest of the owners getting back to the theme of the book of fund shares over the interest of the fund’s managers.”  All of these gratuitous advice from a callow college senior who was, of course, totally ignored by the fund industry, and the 1974 creation of Vanguard however, as a truly mutual mutual fund group operated on the at-cost basis for the benefit of the community of owners rather than the private interest of its managers was my attempt, it turns out, to walk the walk that I had talked the talk about all those years earlier. 

Today, it might be evident in my comments this morning, my youthful idealism has not departed.  I think it is somewhat worse, shamelessly reflected not only in Vanguard but in the new book and certainly in the commentary you will hear from me this morning.  The pages of The Battle for the Soul of Capitalism are divided in three roughly equal sections: Corporate America, Investment America and Mutual Fund America.  But I’m going to focus today, of course, on the mutual fund part of that.  The funding industry is in fact the paradigm, the poster boy if you will of the triumph of manager’s capitalism over owner’s capitalism. 

Given as the book states, and as your invitation to this morning's session repeats, “an organizational design that would amaze and delight the oligarchs of corporate America under which the managers of mutual fund had enjoyed virtually free reign to place their interest ahead of the interest of the owners of their funds.”  Just think of that, just these two, and I could go way on beyond this to differentiate Mutual Fund America from Corporate America.  Fund complexes even when their assets exceed $100 billion or $1 trillion and they do could easily manage themselves.  Yet, they find it necessary to be controlled and operated by separate outside managers who are in a business to serve their own shareholders. 

And number two, another difference, mutual funds are owned almost entirely by investors of modest means, relatively modest means with very few of those potentially, potentially only at the moment, pesky giant institutional owners to be concerned with.  As a result, the sound national policy promulgated in the preamble to the Investment Company Act of 1940 that clearly ordains that funds must be organized, operated and managed, remember those three words – "In the interest of their shareholders” rather than the interest of their managers and distributors has been honored for far more in the breach than in the observance. 

It is the disregard of this principle that the interest of shareholders comes first that explains why mutual funds have as a group failed to adequately serve their owner investors.  It is not just theoretical.  The evidence is real, and the evidence is tangible.  Let me illustrate this point with six of the major areas that I see as problems. 

One, the mutual fund has changed from the time that I have been in it for the worse.  All those years ago as I saw it at least there was a profession with elements of a business and it has gradually become a business with elements and too few elements of a profession.  Our traditional guiding star of stewardship was largely replaced by a new star, salesmanship, focused on management.  When I wrote that Princeton thesis all those years ago, our predominant focus today is on marketing, the name of the game is increased fee revenues to managers by building up assets under management often by creating, promoting and advertising speculative funds that meet the fads and fashions of the day at a staggering cost to fund investors. 

Point two, this industry has been taken over by financial conglomerates.  When I entered this field all those years ago - first chart, virtually 100 percent of mutual fund management companies were privately held firms, relatively small firms and managed by investment professionals.  Today, the vast majority of our largest fund management companies are publicly held.  Look at that change.  Largely owned by giant financial conglomerates, they are managed by businessmen bereft of professional investment training. 

Think about it.  These conglomerates are in the fund business to earn a return on their capital, not a return on your capital as a fund investor.  That’s what the business is all about.  They cannot do justice to both because the more the managers take, the less the investors make. 

The record is very clear on this point.  Over the last decade using the figures that Geoff Bobroff had done but for Fidelity--we have made some cumulative change, I do not know how well you can read this, but the fund shown--this is ranking down the three columns, first column, second column, third column.  At performance rank, based on that percentile rank against competition across the board, the fairest way you can really to look at fund performance, and the yellow firms at the top of the list are privately held firms.  The white firms are conglomerate-owned firms and the gray firms are publicly held but not owned by conglomerates.  You can see that all seven of the top performing fund complexes were privately held and 32 of the bottom 34 performers were publicly held.  I do not know how to do a correlation on that chart but I do not think we need to bother. 

Three, mutual fund returns have fallen dramatically short of market returns, proving the validity of that take-make trade-off, the more we take the less you make, the gap comes to almost exactly the mutual fund returns from the market.  Exactly the amount of cost they incur.  All those management fees and operating expenses and front-end sales charges amortized for the purpose of these data over 10 years, 12b1 fees, hidden portfolio transaction costs, all-in cost that in fact come to something like 2.5 percent or even more per year. 

How could it be otherwise then?  In the past 25 years for example, the average equity fund has fallen short from the Standard and Poor’s index return by 2.5 percentage points a year just about the same as those costs and largely because of those pesky fund costs.  Gross return minus cost equals net return.  Please do not forget it.  Judge Brandeis gave me a great phrase for that, "The relentless rules of humble arithmetic" and they apply to the mutual fund industry as well as every other industry around.  A return of 10 percent in a 12.5 percent market is obviously a shocking gap but the reality is much, much, much worse than that. 

As a marketing business versus an investment profession, we bring out these new funds based on the choices of the day and draw in the investing public often at exactly the wrong time.  Call it the “timing penalty,” and I call it the “selection penalty.”  Together, the average fund investor lags the average fund by nearly another 3 percent--it’s actually 2.7 percent leaving the investor with a net return of just 7.3 percent a year compounded to 4,820 compared to 17,000 or 28 percent of the market’s return.  But do not forget that those are nominal returns.  They have to further reduce them to a real return of about four percent after we take a 3.3 percent inflation rate out.  When compounded over this grand 25-year era for investing, the average fund investor has captured 22 percent of the market’s real pre-tax return. 

I’m not kidding; you can see it in this chart, $1000 investing in a simple index fund that happens to be ours produced a net profit after inflation but before taxes of $7620, to which I say hurrah for the magic of compounding returns.  But for the average fund investor, the real profit came to $1,670, 1/5 as much, to which I say “boo” to the tyranny of compounding cost which overwhelms the magic of compounding returns.  If we adjusted those figures for taxes, and funds are horrendously tax-inefficient, it would get even worse. 

These are not mere abstractions.  These are the differences between a secure retirement and a need dependent on a social security system that is itself deeply troubled.  The opportunity cost that you see in that chart given up by fund owners are enormous and if future returns are not 12.5 percent, think about this for a minute, but more like 7.5 percent on equities and nominal terms and I think that’s not a bad number.  It seems to be at this time a sign of a consensus return, the after tax, real after cost, after tax, real returns of the typical mutual fund investor in that environment would be about zero.  Do the math.  I will not do it for you. 

Number four, soaring costs in this industry, fund asset have burgeoned during this great bull market the greatest bull market in history, cost worn by fund owners have incredibly increased at an even faster rate than assets have grown.  From 1980 to 2005, for example, as assets soared from $45 billion to over $4 trillion the expense ratio, the average equity fund actually rose.  From 0.94 of 1 percent to 156, 66 percent increase and a lot of people want to use an asset-weighted basis.  Fair enough.  We do that too.  It rose from 64 to 0.92 percent or by a mere 44 percent. 

The staggering economies that I have of all people know exist in the field of money management failed to materialize as total equity fund expenses rose in this period from $280 million a year to $37 billion a year, 129 times over.  How such a pattern could suggest there is price competition--other perhaps than the competition to raise prices--in the mutual fund field is simply beyond my comprehension.  But it was not always so, and this is an important point. 

Back in the old days when I attributed more of a professional cast to this industry, when industry assets rose four times over during the 1950s, my first decade essentially in the business, from 2.5 billion in assets to 10 billion, not very big numbers, the expense ratios of the eight largest funds actually dropped by 20 percent if you can see it in that chart in the first cycle there over at the left.  From 0.60 of one percent, think about 0.60 to 0.48 of one percent, and I do not think today you can find a single fund in the mutual fund industry outside of Vanguard that is lower than 48.  Well, you can probably find one or two stray little rabbits out there but not very many. 

Today, the expense ratios of that original group of funds - and this is a micro view instead of a macro view I think it is very helpful, average 1.02 percent excluding Vanguard's Wellington Fund there on the third yellow--the second yellow line whose ratio drop from 0.60 to 0.32 percent for the full period dropped by 32 percent from 1950, and it is worth thinking about what that extraordinary exception means, you ought to have that in your mind.  The expense ratio of the remaining funds averages 112 percent, 1.12 percent compared to 0.48 in 1960.  Even as fees paid to their managers have soared however, the managers continue to offer their services to non-mutual fund clients at a tiny, tiny fraction of what they charge to funds they control. 

Three large managers, these are the only data I have been able to come with but CalPERS report this, for example, charged CalPERS a total together of $1.7 million, and I think the year was 2003--it is not on there, the most recent data I could get.  A total of $1.7 million for managing $2.1 billion of assets or eight basis points while the manager's three funds with comfortable objectives paid $167 million for managing 36 billion, 61 basis points.  I'm not sure the dollar is on a much better measure when you get onto this area than basis points are by the way.  So that nearly eight-fold disparity in fee rates, and that gross 98-fold disparity in fee dollars hardly suggests as the Investment Company Institute is constantly assuring the world, "The interest of Mutual Fund Managers are well aligned with the interest of Mutual Fund owners." 

Number five:  The rise of Short-termism.  To make matters worse, institutional money management used to be what we call an owner's stock industry.  When I came into it, we held an average stock for six years during my first 15 years in this business never much more, never much less.  We became the rent-a-stock industry and we now hold stock for a single year or even less, leaving aside for the moment one:  The un-wisdom of that strategy, high turn over strategy.  Two:  The inevitable uncertainties surrounding the returns achieved by funds of such fragile investment bearings and three:  The tendency of short-term focus to increased risk portfolio of volatility. 

Such a strategy is expensive.  When high turnover costs are combined with the industries high fees and high operating costs, the achievement of superior returns is almost out of reach.  For example, take a look at the figures.  This just happens to be the last decade.  We have taken the fourth cross quart, equity fund cross quartiles and compared their gross returns, subtracted their costs including turnover cost to get the reported net return.  We have taken their risks, we gotten the risk adjusted return and looked at the growth of the dollar.

 Those numbers do not happen to include sales charges so the cost will be somewhat higher pretty much across the board.  The lower cost quartile outperformed the high cost quartile by 30 percent a year in net return and they assumed 34 percent less risk - think about that - and therefore delivered an annual advantage of almost 50 percent in risk adjusted annual return.  Compounded over a decade, the advantage to the funds with lower cost--a 207 percent profit versus the profit for 118 percent for the high cross quartile--came to an enhancement of capital of fully 75 percent.  You are talking almost about the difference between a double in your money at 118 and at triple at 207.  Note that before, interestingly enough, all of those costs, the manager's returns from quartile to quartile were very similar, more or less 12, 12.5 percent a year.  The relentless rules of humble arithmetic strike again. 

Six, and my last point, has resulted from the short-termism I think in part, the failure to honor the responsibilities of corporate ownership.  Even as direct holdings of stock by individuals were replaced by an institutional ownership, these agents—intermediaries--beset by conflicts of interest placed their own interest ahead of the interest of their principals--bad way to do it.  Whereas more of these agents where owners in names only, as investors, owners must honor the rights and exercise the responsibilities of corporate governance.  But as speculators, renders of merely trade stocks, they can hardly care less and you could argue properly so. 

But if the owners of corporate America do not give a damn about the triumph of manager's capitalism there, the question I raised in the book, "Who on earth should?” We have, as the economist would say, a very serious agency problem.  Led by the mutual fund industry, which now owns 28 percent of all stocks, by far the largest block, institutional owners have risen to the power over corporate America that is theoretically beyond challenge.  Even as these owners seem to ignore the gross excesses of corporate America in the recent era, including all that CEO compensation and all that financial engineering and all that flawed governance, just to begin the list, they have been virtually absent mutual fund managers from legal and regulatory processes aimed at reforming the following system. 

Consider this astonishing, truly astonishing lack of participation by fund managers.  No mutual fund firm as far as I know has ever sponsored a proxy resolution that was opposed by the board directors and managers.  No mutual fund manager testified before Congress about the most important piece of public company legislation in the last 50 years - Sarbanes-Oxley.  No large fund manager demanded more substantial access to corporate proxies when that SEC proposals came along and a few even argued for more stringent limitations on that proposed access but the vast majority did not even take the trouble to comment. 

No fund manager, as far as I know, urged the FASB to get some of the job of requiring stock options to be expensed.  No senior mutual fund executive, as far as I can tell, have spoken out on the subject of the rights and responsibilities of either corporate shareholders or mutual fund shareholders.  And the only fund manager comments submitted in the recent SEC proposals designed to enhance disclosure of executive compensation was made by a fund group controlled by a labor union and there you have it. 

What explains this silence?  Either our industry leaders have no opinions on these issues, which is hard to imagine, or they have opinions and will not express them.  After all, we do manage all that corporate pension and 401k money.  We deny there is any conflict.  Just for the record, there is no conflict therefore according to the industry.  You can decide on that for yourself.  But it is time I think for us to honor our own responsibilities and demand that fund managers exercise their corporate citizenship in the interest of the fund shareholders and interest for that matter in our economy and our society whom they are duty-bound to serve with the fund shareholder that are duty bound to serve. 

Obviously, I have expressed here serious concerns about the mutual fund industry on many levels by way of summary.  Industry structure, unsatisfactory investment results excessive cost, focus on speculation over investment, inadequate exercise of the rights and responsibilities of corporate governance.  But they all come down to that single principle I mentioned at the outset.  Mutual funds must be organized, operated and managed in the interest of the shareholders just as the 1940-Act requires.  If the national public, and I am quoting here from the preamble of the act, "The national public interest and the interest of investors, demands as it did in 1940 such a policy for a $450 million industry.  God knows that goal should not be compromised in 2006 when the industry oversees $10 trillion of other people's money." 

Within the industry, I know precious few leaders who agree with the critique I have given you this morning.  They do not disagree with it--I never heard any negative comments but they certainly do not agree with it.  And when we venture beyond our parochial confines, however, confines of the financial business and the mutual fund industry, some of the most objective, integrity laden, and successful investors in the world share my concern. 

David Swensen, Manager of the Yale Endowment Fund describes the colossal failure of the mutual fund industry resulting from its systematic exploitation of individual investors and David is no hellraiser.  As funds extract enormous sums in investors in exchange for providing a shocking disservice, excessive management fees take their toll and manager profits dominate fiduciary responsibility.  His conclusion - of course - invest in low turnover, passively managed index funds and stay away from profit-driven investment management organizations and this is a man with the nth degree of credibility. 

As is Jack Meyer, successful giant who tripled the Harvard Endowment Fund assets from 8 billion to 27 billion.  Most people think I'm quoting from Jack Meyer, "They can find managers who can outperform" but most people are wrong, 85 percent to 90 percent of managers fail to match their benchmarks.  Because managers have fees "incurred transaction cost" you know that in the aggregate they are the deleting value just what I showed you take versus make.  The investment business he concludes is a giant scam.  What to do?  Mr. Meyer says get diversified, keep your fees low, invest for the long term and avoid the most hyped and expensive funds in favor of low cost index funds, no doubt about it he concludes. 

What about Warren Buffet who needs no introduction here.  Fund management companies have followed policies that hurt the owners of funds they managed while simultaneously boosting the fees of the managers trampling the interest of fund shareholders in an appalling manner.  This is not Bogle--this is Buffet.  The blatant wrongdoing that has occurred has betrayed the trust of millions of fund shareholders.  Hundreds of them, and this is true, hundreds of industry insiders had to know what was going on.  All they had to do was read the redemption ratios reported by the Investment Company Institute, yet none publicly said a word.  We urge, closing the Buffet quote, "Fund directors to decide whether their job is to work for owners or for managers." 

And finally, we will go the conservative Wall Street Journal, Holman Jenkins: "Will fund customer keep supporting the enormous overhead required to sustain ineffectual, unproductive stock-picking across an array of thousands of individual funds devoted to every investing style and investor in the economic sector or regional subgroup that some marketing idiot can dream up?  Not likely.  A brutal shake out is coming" says Mr. Jenkins.  And one of its revelations concluding his quote would be that stock-picking is a grossly overrated piece of the puzzle, and that cost control is what distinguishes a competitive firm from an uncompetitive one. 

There is, of course, another point of view.  Recent paper, Federal Reserve economist, entitled "Mutual Funds: Temporary Problem or Permanent Morass."  The paper argues that despite the obvious conflicts of interest between fund owners and fund managers, there is, and I'm quoting this remarkable paper here, "One and only one reasonable objective for a fund manager, to maximize the managers own profit."  But think about that.  The record is clear that the achievement of profit maximization comes at the direct expense of the mutual fund shareholders presumably satisfied with this outcome, the author, Paula Tcak, now argues in a recent Wall Street Journal item, there is "at least reason to consider removing fund board oversights of this and even contemplate eliminating fund boards" - that sounds like a lot of progress. 

But if we are bound by the public interest and the interest of investors as the Act says, it is simply unacceptable that mutual funds should continued to be mired in any morass, let alone a permanent morass that puts the interest of managers ahead of the interest of shareholders even for a moment, let alone permanently.  It is time to resolve the profound conflicts of interest that suffuse this industry and resolve them in favor of the fund owners who have put their own capital at risk and expect their trustees to act exclusively in their interest.  Over the past two decades of course, the SEC has adopted many new regulations. 

But too many, indeed, I would argue well over the vast majority of them have been however, well-intended and however necessary focused on what I would call fairly narrow technical areas, money market fund valuations disclosure of director holdings or limited disclosure of director holdings and reporting of complex-wide director's fees.  But no regulations were on the books that could have ever precluded the more subtle forms of wrongdoing. 

As a result, we witnessed the industry stagger to serve investors.  In the market timing abuses, the performance advertising and aggressive marketing and highly speculative and narrowly focuses funds, the failure in many cases to provide volume discounts to eligible fund investors, all of these paid a place games surrounding brokerage commissions and the grossly excessive fees paid by fund managers to the funds they controlled.  The scandal it turns out is not what is illegal.  The scandal is what is legal.  And the mutual fund scandals were simply an eye into that.  They were not the most important part of it but great to get to the spot. 

Some of these problems of course are beyond regulation, but the fee issue is not.  I believe the SEC staff can be subject to criticism for what might be described as its benign neglect in this area.  Why do I say that?  As I turn the clock back exactly 40 years to review the commission's position in public policy implications of investment company growth in 1966, I believe we have one of its authors right here.  And when the SEC vigorously recommended legislative changes presently designed to restore a better balance of interest between shareholders and managers all those years ago, 40 years ago, after they considered the burgeoning level of fund fees, then at an annual rate of $134 million, the effective control that advisers hold over their funds and the absence of competitive pressure I'm quoting from the public PPI the limitations of disclosure, the ineffectiveness of shareholder voting rights and the obstacles to effective action by independent directors, the SEC recommended the adoption of "a statutory standard of reasonables, a basic fiduciary standard to make it clear that those who derived benefits from their fiduciary relationship with investment companies cannot charge more for their services than if they were dealing with them at arms length."  Such a standard "does not resolve the problems in management compensations that exist" the commission added then more sweeping steps might deserve to be considered. 

The industry, of course, fought that battle and as we now know won it against the reasonable standard, allowing fund expenses to soar to the astonishing levels that I had cited earlier and costing funds extra tens of billions of dollars year after year.  Today's annual fund operating expenses do not run to 134 million anymore, they run as you have seen to about 80 billion. 

Yet even now, four full decades later "more sweeping steps have yet to be considered."  I think it is now time for us to consider them, and I do hope the SEC will do exactly that.  I want to interject here a couple of points that I do not have in my written remarks and that is how can funds as a group do better for their investors. 

And I want you to think about this not just about equity funds, which are 99 percent of what gets written about the fund industry or 98, but about bond funds and particularly about money market funds.  Because identical principles apply in each case, just at different levels of obviousness and money market funds are crystal clear, and bond funds are very clear, and in equity funds they are clear over the long run and kind of muddy in the short run. 

There are two ways funds can do a better job for their shareholders.  One, all managers can get better.  All managers can move their performance up so instead of lagging in the market by 2.5 percent and if they all earn 2.5 percent more, their 2.5 percent charge will then leave the investors equal to the market instead of falling behind.  You all can decide for yourself whether we live in a Lake Woebegone, where all of our managers will be above average and well above average or not.  I guess my opinion is probably clear by the way I phrase it. 

There is one other way to improve the returns to fund investors, and that is to slash industry costs.  Reduce the take that managers and intermediaries and brokers, draw from the mutual fund industry and financial advisers, and then the investors will make more when we do that.  I think it is pretty obvious that only the latter one of those two things is even remotely possible and it is remotely possible.  So put me on the side of those, this will I'm sure astonish you - that believe that it is time for change in the mutual fund industry.  We have to re-balance that scale in which the respective interest of fund managers and fund shareholders are weighed.  Despite the express language of the statute that arguably calls for all the weight on that balance scale to be on the side of the fund shareholders, it is the manager's side of that scale that is practically touching the ground. 

So to get the preponderance of weight where it begins, where it belongs on the shareholder's side, we need the commission to press on its mission now at last under serious legal challenge by some firms in the industry at least to mandate an independent fund chairman, a super majority of fund directors.  And I want to say parenthetically that I do not know why we should not have even 100 percent of the fund directors be independent and management companies.  Why would they be entitled given their obvious conflict of interest to any representation and in fact at Vanguard, none of our external managers are represented without apparent harm to our fund shareholders? 

And three, the empowerment of an implicit encouragement. 

Four, fund boards to retain a staff for independent consultants to provide objective information to the board just as Peter outlined earlier my idea on that.  We need Congress also to take action and legislate a federal standard that requires that "fund directors have fiduciary duty to assure that" going to now that present formulation "that funds are organized, operated, and managed with the interest of their shareholders rather than the interest of their advisers and distributors."  This principle should be fortified with appropriate language that establishes clear guidelines for care, oversight and loyalty by directors. 

Taken together, these changes would at last allow independent directors to become ferocious advocates for the rights and interest of fund shareholders they represent, at last becoming the fiduciaries that they are supposed to be under traditional laws of trust leadership.  Alternatively, and perhaps even more desirably, investors must at last consider more sweeping steps. 

One step could call for a radical restructuring, resulting in a mutualization of at least part of the mutual fund industry in which the large fund families would run themselves and huge profits now earned by external managers will be returned to the fund shareholders.  Such truly mutual firms would not need to waste money on costly marketing and campaigns designed to bring in new investors at the expense of existing investors and with lower cost, they could either produce higher returns or assume lower risks or some combination of the two.  The benefits available to fund shareholders through such a mutual structure are not only obvious but they have in fact been demonstrated in the real world by the industry's loan mutual firm. 

Please forgive me for the bragging that is about to follow but the record happens to be crystal clear.  Soon to complete our 32nd year, Vanguard is consistently - remember the standards of the act, organize solid funds, operated them at rock bottom cost and manages them to achieve superior shareholder returns.  Those are the three standards of the act and have earned asset growth that has brought the firm to the very top of the mutual fund industry. 

Look at this chart.  The Vanguard market share has increased by 9.2 percent, Capital’s has increased by 7.5, Fidelity’s is by 3.4, and very few other firms have a positive increase in market share, and the negatives go right down the chart.  It is amazing to see that.  Despite that success on the terms that I have mentioned, solid funds, rock bottom cost, and with superior returns, we have yet to fund our first follower and what makes that tragic is when I chose the name “Vanguard,” I chose it because it ment leader in a new trend. 

So it is pretty pathetic we have yet to find our first follower 32 years later.  You might all ask yourself why and we can talk about that in the question period.  But if Congress on the other hand acts to impose on fund directors the fiduciary duties that many of us believe they have always held rarely exercise, I am not sure that full mutualization could be mandated by law for the large companies.  I'm not talking about the smaller companies.  As long as advisory firms are owned by managers who act responsibly and put the shareholder's interest first, who make manifest their dedication to that proposition and their actions, for example, limiting assets size, limiting fees, limiting market activities, focusing on long-term investment strategies, providing superior service to their shareholders, mutualization does not need to be required. 

On the other hand, when a fund complex reaches a certain size or a certain age when it has become more business than profession, it is high time to demand that mutualization at least be placed on the board agenda and honestly and objectively considered.  It won’t easily be done, of course, and there is literally no one in this entire industry who knows how difficult it is to do and the obstacles it must be overcome to reach that goal as I am, but if there is a will, there will, I can assure you be a way.  One way to begin to strengthen the power fund directors is the funds employ their own officers.  Today, of course, they are generally filled and paid by management company executives and assumed full responsibility. 

This is an interesting thought that I have not seen, broached anywhere else, take the responsibility for all their administrative activities, fund accounting, shareholder record keeping, legal and regulatory fund compliance, all these sort of very vaguely boring things that must be done well but still leave to the external manager, today's mutual fund manager, full responsibility for all investment management and marketing and distribution activities.  Under this structure, the funds would then have at last the real, as compared the illusory freedom, to deal with their adviser and distributor at arms-length, fund by fund basis with a small operation staff to provide independent and objective information on the performance and cost of those marketing and management services. 

It may surprise you to know that this was precisely the basis on which Vanguard began just that little administrative function all those years ago, 1974-1975.  We did take over desk distribution, and then we converted it from load to no load a few years later.  But to this day, it works and we continue to use external advisers for nearly all of our actively managed equity funds.  So do not disregard that step and the power transmitted to the board, regardless of what structure we decide on it, a truly mutual form or an improved conventional form or this kind of hybrid form I have just described.  Public policy must move in the direction of assuring that funds are operating on the basis of assures that the interest of fund shareholders holds interest sway over the interest of fund managers just as the 40 act demands.  But that's not the only reason. 

The fact is that such a change will at last enable the industry to enhance economic value for its 95 million shareholders, striving to earn for them their fair share no more or less than whatever returns our financial markets are generous enough to deliver in the years ahead.  Standards applicable to mutual fund management stewardship must never, I repeat, never be confused with standards applicable of the provision of ordinary products and services using some of the ones that are listed in this tax article in the Wall Street Journal, jewelry, toothpaste, beer, oil changing and plumbing and those are not the standards for the mutual fund industry.  Go out and buy whatever you want there. 

Enhancing shareholder value for fund investors is a direction that this industry must at last move.  It is not a radical idea.  It is a logical development that returns us to traditional notions of trusteeship and fiduciary duty that have their basis in English Common Law going back centuries.  A body of law that suggests, I do not know if you are going to beat that, that the prudent investment of other people's money is a sacred trust, and so it is.  Thank you. 

Peter Wallison:  Well, I think now you can see why the Bogle Critique is something that has to be taken seriously by any group that is looking at the regulation of mutual funds and the structure of the industry.  We are going to have a very interesting discussion here and to lead it off will be my colleague, Bob Litan.  As many of you know, Bob is the vice-president for research and policy at the Kauffman Foundation in Kansas City and a senior fellow in Economic Studies at the Brookings Institution.  He was formerly vice-president and director of Economic Studies at Brookings and is currently co-director of the AEI-Brookings Joint Center on Regulatory Studies.  He is an economist and an attorney.  He has practiced law and he has taught banking at the Yale Law School. 

Bob is the author and co-author of numerous books and he has written many articles on financial institutions.  He and I had actually have collaborated on a couple of those.  He is formerly the associate director of the Office of Management and Budget, Deputy Assistant Attorney General in the Anti-Trust Division of the Justice Department and a Regulatory Specialist for the President's Council of Economic Advisors.  It is really a pleasure to welcome Bob. 

After Bob talks I am going introduce Geoff Bobroff.  I am going to introduce John Rea.  They will have a chance to talk then all of you will have an opportunity, we hope, to ask questions of Jack Bogle or any of the other speakers and I hope you will take notes on what you are thinking about in the way of questions so that you will have plenty of them when we open this discussion, thanks, Robert.

Robert Litan:  Thank you Peter.  First, I want to thank Jack for an outstanding talk, and we are privileged that he made time to come and talk to us, so we want to thank you.  Now, I am going to introduce several questions probably more in the nature of piling on, and Jack I do not expect you to answer every single one of these, you may not have time.  But I am going to be advancing these questions largely from what I will call a devil's advocate point of view because both Peter and I are legitimately in the mode of trying to inquire about what is the best approach for regulating mutual funds and assuring investors that they can cost effectively diversify their assets, and we do not have answers to these questions, and so do not take these questions as represented of my views, they are just questions. 

So the first question actually proceeds from a premise that I want to make clear.  A lot of you here and maybe in the television audience may not understand the basic premise of what Jack was talking about, and frankly to be honest with you, I did not neither until about a couple of years ago, and that is the mutual fund industry is very unusual. 

You have funds that you invest in.  Whether you buy Vanguard, or whether you buy Fidelity or any of the other names on that list, and you are a shareholder in that fund, there is a separate management company that the fund hires to manage the money that is in the fund.  There is an overlap and this is why Jack has been so critical in the industry, there is an overlap between the people who run the fund company and the people who are on the management company.  In fact, traditionally, the people in the management company organize the funds and so if you have an identity of people on both sides of the fence, Jack has long raised in his writings, do you not have an inherent conflict of interest with essentially one company hiring another but the other created the first company?  That is what has led to Vanguard saying, "We will resolve this paradox or this conflict by internalizing the functions of a management company." 

So essentially the story of Vanguard is a story where Vanguard took over the management company, it took them many years to do it but eventually Jack was able to do this; he mutualized the management company.  In essence the management company reports to Vanguard.  So Jack has raise this in his comments.  They are the only company that has done this; and so my first question to Jack is, why has not anybody else done this in all these years?  The market and we have got lots of $9 trillion out there with people voting with their feet has moved in another direction; and unless you assume that $9 trillion of people are vastly stupid, why have they gone to this other funds and not adopted the Vanguard model? 

There is an analogue in the insurance industry by the way.  We have insurers who are mutuals, who are owned by their policy holders and we have insurers that are for profit stock companies.  They exist side by side.  We have an industry in mutual funds which is parallel to that, except we only have one company that is a mutual fund, why the exception? 

Second question, the question is really if there is such assuming there is such an over charge or excess fees that Jack has persuasively laid out, why is it that the independent directors already have not been able to make some dent in this problem?  It is only recently for example that the SEC has talked about moving toward more independent directors but in fact, as I understand, a number of funds, many funds have already moved to an independent director model.  Many of them in fact have the majority of their directors are independent and yet we have this persistence of these so called excess fees that Jack has talked about, why has this situation not been corrected?  And if it has not been corrected by independent directors, then why do you believe that moving to 100 percent independent directors is going to solve the problem? 

Third question, there has been a lot of criticism in the mutual fund industry for the way in which fees are disclosed.  For the average investor, to be perfectly honest with you, it is very complicated.  I mean, we had mentioned here earlier of something called 12b-1 fees which frankly I suspect not many people understand what they are; they are expenses that are incurred for distributing funds which are paid out of the fund corpus; actually, an idea that I learned that essentially Vanguard pioneered.  Vanguard went to the SEC as I understand it and asked for an exemption that created 12b1 that apparently led to the monster that Jack has later criticized.  We have an industry now that relies heavily on 12b-1.  But in any event, the fee structure in this industry is complicated, and so why is not a solution to a lot of these problems a vastly simplified set of disclosures related to fees, maybe an all lump-sum one fee structure so that people can easily compare them, and then as in other industries let the market decide where the money goes?  So why is not simplified disclosure an answer to this problem? 

Fourth issue, Jack talked about having a congressional change, a new statute that would impose a fiduciary duty on the fund directors as I take it to act in the interest of their shareholders.  Though my understanding is existing law already requires that and in fact we have, again on my understanding, a lot of litigation under what is called 36b of the act where essentially we have litigants who are claiming the directors are not living up to their fiduciary duties as they are under current law.  This litigation is expensive.  So the question is, why do we need an additional statute, and if we do have an additional statute that somehow goes beyond existing law, are you not concerned that in essence we are going to have judicial intrusion into not only setting fees but also management styles.  I mean, I can envision lots of litigation or broadly worded statute that basically has judges deciding what kinds of investment philosophies funds ought to be performing. 

And my final question; Peter, and I am going to observe the time limit, my final question is, Jack has a long critique about the failures of mutual fund companies to vote their proxies.  In other words, they are not exercising voice.  They are just simply staying quiet.  And yet he has argued and I think very persuasively because I follow this advice for my own personal affairs, I have gone to indexing, alright.  But if investors go to indexing there is no incentive for a fund, an index fund to talk up because an index fund--you’re just buying the market--so why should we expect the directors or the officers have an index fund which is just buying the market to essentially voice their views and all this proxy proposals and the essence, it is not their business, their are just buying in the market?  So hopefully that's food for thought. 

Jack I do not expect you to answer every question, but at least that gets a few of the issues out of the table.  Again, thank you very much.

Peter Wallison:  Alright, our first commentator will be Geoff Bobroff.  Geoff has held a number of positions in the investment management industry spanning three decades.  Before establishing his consulting business which is called Bobroff Consulting which he did in October 1993, he served as senior vice-president of Lipper Analytical Services overseeing their Denver office and before that, he helped physicians as executive vice-president of Integrated Resources where he was responsible for money management, broker-dealer activities and other operations of the firm.  And he was the executive vice-president also of J&W Seligman and Co., where he was responsible also for operations and financial affairs.  Geoff, do you want to speak from there? 

Geoff Bobroff:  Yes.

Peter Wallison:  Okay, that's fine.  We will remove the podium then.  Please welcome Geoff Bobroff.

Geoff Bobroff:  Thank you.  I am not going to try in any way to address all the different issues that Jack raised in his presentation but just raise some issues that I think are general concerns for some of the discussion that I heard this morning and read in his book.  And from a practical standpoint, I believe that as an industry we have gotten a bum-rap in a variety of ways, and I am not here to sit and defend the industry but to tell you very candidly, market scandal or the late trading and market timing issues seemingly has swept up so many issues as being scandal related.  And it troubles me as a practitioner in the business to see all of the things that are somehow, should I say, draped with this concern that somehow this industry has lost its way

And as a generalization, yes, we have had problems and as a generalization, yes people have engaged in conduct that is inappropriate.  But at the same time there are significant numbers in this industry, members of the industry that have not strayed and it delivered on their promise to investors.  So, it just troubles me to hear the generalization that this industry has lost its way that this industry has been consumed by the excesses of the 1990s.  That's not to say that certain members have or have been affected by it but the rest of the industry as a whole, I believe, can stand tall and show that it has delivered on its promise to investors.  Investor returns are quite good across the industry. 

Mutual funds, if they were not a choice investment by individuals, would not be at the position that Jack indicated earlier today at $10 trillion.  From a business standpoint, that is a recognition that investors have found that they are getting value in their returns.  Now, one might argue that they may not fully understand what it is that they are doing, but point being is that as an industry this is an industry that has responded to change. 

It is a highly competitive industry.  Back in the 1950s as Jack described the inception, the industry was very simple.  It had basically two products.  We had a domestic equity fund, and we had a bond fund.  The domestic equity fund what I would call as a go anywhere fund.  It basically could go large, mid, small to the extent that they existed.  International to the extent that they could engage in such activity and the same thing is true about fixed income.  But as time went on, this industry decided to embark upon some variations on the theme and today it is an industry that consist of, and I do not recall what the actual number is, but well in excess of 10,000 individual mutual funds that expand every category imaginable from an investment standpoint. 

I was amazed that there is a big push, Jack, right now by several groups to do, should I say leveraged index funds, I mean we have taken the basic index concept and taken it to an extreme.  That's not to say that the core of the industry, the heart of the industry still is very focused on providing quality investment returns to investors.  What we have also seen in recent periods is an explosion of a concept called fund-to-funds.  Vanguard being a leader here, when they went and got their exemptions through the SEC to allow them to create what is called Vanguard Star Funds. 

Today the Star Funds or the asset allocation funds and balance funds are the largest single category of investment choice within our industry and that to me is an amazing concept of what transition has occurred as a basic business.  We have been living with transparency issues for the last 30 years.  We have had this debate and discussion about full disclosure of fees and expenses.  If we go back and look at the history, this little table that appears in the front of the prospectus, this fee and expense table has gone through many evolutions or revisions by the SEC, and each time it gets enhanced. 

I would tell you that I think bottom line, though, investors are most interested in one thing--net return to the investor--which does take into account what those expenses are, and investors are driven by the net return, not necessarily whether or not this fund is expensive or not.  They are focusing on what the return historically has been.  Since as an industry we cannot speak in terms of future returns, we can only speak in terms of historical returns.  Transparency has been expended over the years in a variety of ways and Jack has enumerated some of them in his earlier discussion.  Whether or not they are necessarily as far reaching as some people would like, I would say to you today of almost any investment that is out there, our mutual fund shareholder gets more information than they get from any other investment that they maybe making today. 

But all that aside, this is an industry that is still driven by net return.  And if you go back and look at that chart, the top three organizations Vanguard, American Funds and Fidelity have surprisingly among the lowest expenses in the industry; Vanguard being probably the lowest and Fidelity and American Funds not far behind.  What does that tells us?  It tells us that return is influenced by net expenses and obviously investors are driven or follow or seek return. 

So, if there is a message that the industry should be listening to and looking to is, where is the money going?  Those three organizations today have 30 percent of the industry's assets.  That is a remarkable thought because if you go back as Jack did to 1981, those three organizations had 12 percent of the industry's assets.  So, what we have seen is a transition that has occurred in a robust return environment to a return environment that is clearly less than robust from what it was in the 1990s.  However, it is interesting to me in tracking this industry--and I am a student of it and have been involved since 1969--is the fact that things evolve and change but in reality we have not seen significance. 

This is an entrepreneurial business.  When you look at the business in 1991, some 15 years ago, the top 30 fund companies had 72 percent of the industry's assets.  Today, the top 30 companies have 75 percent of the industry's assets.  Now mind you, the industry has grown from about a trillion plus in 1991 to the $10 trillion today.  What does that tell me?  What does it show?  It is a diverse industry.  You would expect in a maturing industry the concentration would bring all the assets to the top.  It has not.  It has allowed people to come in to this business that were not in the business before, and that to me is a marvelous aspect of it.  This is a unique business that allows things to occur in a variety of different ways. 

The other element is that mutual funds cross individual portfolios of all net-worths.  Recent analysis that I have done with another consultants shows that mutual funds play a significant part in the retail, the affluent and the high net worth market place.  What does that tell me?  It tells me that mutual funds are serving and satisfying the need of investors.  Clearly those that are in the high net worth market place have a lot of choices available to them.  Those are in the affluent market place--mutual funds still play a significant part. 

If we look at individual asset holdings, exclusive of the defying contribution market today, over 52 percent of the $10 trillion, not the mutual fund industry, but the $10 trillion that is owned by individual's holdings of securities and mutual funds not in their retirement plans.  Fifty two percent is in mutual funds.  Again that gives you a sense of the breadth and cross-section of the acceptance of mutual funds as a concept.  I mentioned earlier that this interesting evolution to the balanced and asset allocation concept.  It is the largest singled category today of investments selected by individuals.  One can blame it on the bear market.  One can blame it on a variety of factors or see the roots of it. 

But in the practical terms, we have clearly seen the change.  This is an industry that has been accepted and embraced in a retirement plan market place.  Strategic Insights published a data point, I guess it was last year, which show that in terms of the period 1997 through 2004, this seven years, in domestic equity funds, 73 percent of the net inflow came from retirement related plans, and 61 percent of the industry's assets in those funds is retirement related.  And when I say retirement related I am referring to these define contribution plans as well as individual retirement accounts. 

So, it is an industry that has clearly been benefited by the retirement aspects of our industry.  As I mentioned earlier, it is highly competitive.  Information is so available to investors whether it is through the internet, whether is to the newspapers, whether is to magazines.  This is not an issue in which we are playing the three-card Monte in New York where you are trying to find the queen and trying to figure it out.  It is there. 

Now, granted investors may need some time to do it, but what is interesting is, I think as mentioned by Peter, is that the overwhelming majority today of investors are now seeking guidance and advice from someone, where they are relying upon a professional to bring to them--one can question that judgment but that is reality--the best investment choices that is available to that professional to provide to that customer.  So from a business stand point, we have seen a change and emphasize.  Investors are no longer self-directed in the numbers that they were in the 1990s.  They clearly are seeking guidance and advice. 

Again, you can blame it all to on bear market.  But to go back to a couple of points that were raised in terms of the concept of expanding the board, or should I say making the board more independent.  My consulting business over the last two years or three years has change markedly.  Today, over 50 percent, and in reality this year it probably will be 75 percent of my time will be spent in the boardroom with boards.  Jack has indicated that the board should be seeking a staff of its own. 

Well, the SEC mandated a chief compliance officer requirement which is the beginning of the staff of its own.  In addition, the SEC is promulgating some rules on disclosure has indicated and urged boards to hire their own independent consultants to assist them and I will tell you that based on my own experience, boards are doing that.  Boards are looking at a variety of issues.  One of the questions is raised again in Jack's numbers in terms of the expense component, Lipper, which does tabulations of the industry, shows that in 2003 roughly 300 classes--because they just did not break it down by funds--So, it is hard to determine but roughly 300 had there fees lowered in 2003.  In 2004 over 1,700 had there fees lowered by there board or by managements' own desires or by the regulators’ being the era of Mr. Spitzer, and in 2005, the preliminary number was about 1600. 

So, we clearly have seen a directional change.  I will be the first to admit that if we go back and look it the period preceding 2000, what we saw was an upward bias for variety of reasons in terms of expenses.  First, new funds being created in categories that did not exist before in which people sought and obtained higher fees based on what was perceived to be the relative market value of those services.  But clearly there has been a sea-change, and in my experience with boards, whether or not they are using an independent chair or they have a lead independent director or clearly seeing a shift and emphasis and a focus that is very much along the lines that Jack has indicated, which I think has clearly been historically in variety of organizations, it is focused on the interest of shareholders. 

So, from a business standpoint, I think this industry is evolving.  It may not be evolving as rapidly as Jack and other commentators might believe but clearly a sea-change is on the way.  Thank you.

Peter Wallison:  Thanks very much Geoff.  Our next commentator discussing is John Rea.  John is a consultant specializing in the mutual fund business.  From 1994 to 2004, he served as the Chief Economist of the Investment Company Institute (ICI).  Before joining ICI, he was an assistant director and chief of the capital market section at the Federal Reserve Board.  Before that, he was a professor of Economics and chair of the Economics Department at Oklahoma State University and a financial consultant to the Federal Reserve Bank of Kansas City.  John, welcome to the podium.

John Rea:  Alright, thank you Peter.  I appreciate you inviting me here today.  I think Jack's, I may not appreciate it as much later on but Jack is a very tough act to follow and in fact I find very interesting that his stature has now increased to the point were we all have to do is refer to the Bogle Critique and you really do not have to say anything else Jack.  We are quite aware of what all that means.

John Bogle:  In 40 minutes. 

John Rea:  Well, I wish it had been a little shorter myself.  But I do want to say that I'm glad to have an opportunity to comment on it.  Jack's long and distinguished career in the mutual fund business, which does include founding one of the most innovative and most respected names in the business, does require us to pay close attention to his views on the mutual fund industry. 

This morning, I would like to begin with a brief summary of Jack's assessment of the fund industry, based upon my reading of his new book, The Battle for the Soul of Capitalism.  I will follow that with the discussion of two short comings in his analysis.  To be specific, I will argue that his analysis provides no explanation for the growth of the fund industry and that his analysis is inconsistent with the industry's competitive market structure. 

In summarizing Jack's view the fund business, I think it is fair to say that he does not like what he sees.  One of his favorite phrases is, “the industry has lost its way” not just recently but over the past 50 years.  By this, Jack means that fund advisers or fund management companies have turned their backs on fund shareholders in favor of their own interest.  As a result, Jack concludes that mutual funds are overpriced, under-performing investments that serve mutual fund owners poorly while in enriching advisers and management companies. 

The root of the problem in Jack's view is a flawed business organization coupled with weak cooperate governance.  Shareholders in a mutual fund do not directly or indirectly own their fund’s advisory or management company.  Thus, the adviser is not answerable the fund shareholders or rather to the others of the advisory company.  To make matter worse, advisers dominate mutual fund boards, which consequently have been ineffective in enforcing advisers the play shareholder's interest before their own.  To elevate shareholder's interest to the top priority, Jack supports empowering independent directors by requiring a super majority of independent directors and by requiring fund board to be chaired by an independent director.  In addition, Jack has called for federal legislation, making fund directors fiduciaries and would like to see fund board retain its own staff. 

For two reasons, I do not agree with Jack that the fund industry has lost its way or that it has generally harmed fund shareholders.  One reason is that the extraordinary growth in assets and ownership of mutual funds over the past 50 years suggests that fund investors have to be receiving something of value from their investments. 

The second reason is that the fund industry has a competitive market structure and is well known that competition does not reduce consumer welfare.  Let me elaborate on these two problems with Jack's analysis starting with the growth of the industry.  Mutual funds have become a large and significant industry with over nine trillion in assets, the fund industry is today just a shade smaller than the banking sector which is the largest group of financial institutions in the U.S.  For comparison fund assets in 1980 were a mere $135 billion or just 1.5 percent of there current level. 

In 1980, less than five million households owned mutual funds.  Today, 54 million households--nearly one out of every two U.S. households--owns mutual funds and these 54 million households contain 91 million individual investors.  It is hard to believe that this expansion and assets and ownership could have occurred if mutual funds are in fact the decidedly inferior service that Jack says they are.  Mutual funds, after all, are not a necessity nor are they the only means that individuals have invest in stocks or bonds.  Individuals can buy them directly or through separately managed accounts or in personal portfolio programs.  Other alternatives for investors include bank deposits, deferred annuities, saving funds, life insurance, writs, common trust, exchange rated funds and hedge funds and fine contribution plans.  Employers can use collective trusts, guaranteed investment contracts, bank deposits and separate accounts instead of mutual funds. 

As the availability of these substitutes suggests the use of mutual funds is voluntary, and this means that the growth of the fund industry itself has been the result of voluntary transactions; not coercion, government mandate are a necessity.  Investing in funds does not take place in the dark as information on them is widely available.  In addition, shareholders receive regular reports on the performance for their funds and they can terminate the relationship with their mutual funds at anytime and for any reason by redeeming their shares.  The individuals who have chosen to purchase and own mutual funds typically do not go it alone, but rather invest with the help of third parties or intermediaries.  Sixty percent of all fund owners primarily buy funds through their employers, which select a small number of funds and other investments in which participants in defined contributions plan may invest.  Of those who principally buy funds outside retirement funds, nearly 75 percent use financial advisers or brokers when investing in mutual funds. 

Although a large number of fund owners or of modest means, mutual funds are not just for the small investors, the vast majority of wealthy households own funds, and their holdings account for well over half of all the fund assets held by households.  I could describe other characteristics in mutual fund owners but my point should evident.  Shareholder characteristics, combined with voluntary decisions to invest in mutual funds, do not suggest the population that would willingly purchase and hold funds, if as Jack asserts, they are virtually of no value. 

Indeed, if Jack were right, it would imply that millions of individuals or financial advisers and their employers would have been making investment decision for decades that were inimical to their welfare.  And Jack's framework, the willingness of anyone to own mutual funds--much less 91 million individuals--is baffling in mysterious.  Let me now turn to my second topic competition.  The fund industry has a competitive market structure which one would therefore expect to enhance investor welfare.  Nonetheless, one important implication of Jack's assessment of the fund industry, is that competition hurt investors. 

Let me briefly review the structure of the industry. Reflecting low barriers to entry and exit, 600 mutual funds currently all for about--600 mutual fund companies currently all for about 8000 mutual funds to the public.  Asset concentration among these companies is low.  The big three, Fidelity, Vanguard and Capital Research, account for about 1/3 of industry assets.  Concentration ratio for the top 5, 10 and 25 fund companies had been relatively stable over the past 25 years, although the companies within these categories have changed substantially.  Outside the fund industry, there are large numbers of potential entrants that include non-fund money managers and domestic and foreign financial institutions as well as numerous portfolio managers with existing fund companies. 

As noted above, mutual funds have many close substitutes and information on virtually every aspect of mutual fund performance is readily available at low cost from mutual funds, regulatory filings, vendors, financial advisers and the media.  Finally, showing cost sensitivity and investing behavior, mutual fund investors have concentrated their purchases and holdings in low cost funds.  In competitive markets, prices reflect the inner play of supply and demand. Competitive markets ensure that resources are allocated efficiently, that funds are responsive to consumer taste and preferences, and that long-run profit are not excessive. 

From this perspective, recent research has shown that the performance of the mutual fund market reflects its competitive nature.  For example, several researchers have found that the asset share of fund companies is highly and negatively related to expense ratios.  That is, expenses increase and expense ratios reduce the funds family share of industry assets.

 Researchers also found that market shares are affected by investment performance in other services.  This evidence suggests a competition in the fund market is consistent with enhancing investor welfare, not reducing it as Jack maintains.  It is important to know that in making his case that the mutual fund industry has adversely affected investors, Jack does not rely or point to traditional sources of market failure such as externalities, natural monopoly or collusion.  Rather he attributes the adverse effects to the profit maximizing behavior of fund companies.  That is, in Jack's framework, the pursuit of profits leads fund companies to ignore the demands of their customers.  His analysis, however, conflicts with the conventional theory of competition, in which the profit maximizing behavior of producers is part of the process leading to positive outcome for customers. 

Let me explain how this might work with mutual funds, fund investors want good performance from their fund investments which for better or worse, investors evaluate using past returns, net fund expenses and other costs.  As has been widely documented, past performance drives new investments to funds.  For their part, fund companies want large and increasing levels of assets because their revenues are tied to assets under management, to attract and retain assets fund companies strive to achieve high net returns.  Thus, the interplay of investor behavior and fund company objectives serves to lie in the interest of these two groups. 

In these competitive setting, fund expense ratios are rationalized and constrained as Jack and countless academics have found, net returns are negatively related to expense ratios of fund company that might seek to increase revenues, by raising fund expense ratios without restraint would adversely effect fund performance and lose assets.  Beyond performance, fund investors want a high level of services such as a variety of fund types, broad distribution, advice packaged with the purchase of fund shares, no-load funds, and access to customers services and representatives, just to name a few. 

Fund companies that pursue strategy of accommodating these service demands also gain assets.  Thus, from a competitive perspective, the changes that have occurred in the fund industry over the past 50 years are not a mystery or an indication of a failed industry.  Rather the changes reflect the responses of competitive industry to individual's demands for stocks and bonds that can be satisfied through mutual funds.  Indeed if the fund industry had not changed or had remained as it were in 1950 or even 1980, then I would say it would be fair to wonder if the industry had indeed lost its way. 

In closing, I want to add that it is not my intention to suggest that mutual funds constitute an industry that can do no wrong.  The market timing and late trading scandal is sufficient to make that point, but one could expand the list to cover other misdeeds.  In this regard, the industry would have been well-served to pay attention to Jack's concern about this slippage and ethical and financial standards. 

Furthermore, I do not want to imply that the competitive marketplace eliminates the needs for fund boards and independent directors.  Boards are necessary to help resolve and mitigate conflicts of interests between advisers and funds.  Nonetheless, these qualifications do not imply that the fund industry has poorly served its customers for the past 50 years.  On the contrary, the industry has responded to the changes in marketing conditions as one would have expected with competitive industry, and in the process it has met its costumers' demands.

Peter Wallison:  Great, thank you, John.  We have had a number of questions for you Jack, and I would like to give you an opportunity now to respond to all those and then we will ask the other members of the panel if they want to respond to what Jack has said and then we will go to questions from the audience, so Jack?

 John Bogle:  Okay.  Let me try as many of them--I have been making a lot of notes here--and I kind of wished each time I think in very round numbers about 50 things have been said up here that I totally disagree with, and even Bogle can’t respond to all 50 in any reasonable way.  Let me just reflect on a few things. 

One, we must be dated – I will paraphrase John's thoughts and this is maybe a little bit an edgy way to paraphrase them but I think it is pretty clear.  We must be doing something right.  We have $10 trillion of other people's money.  Well, wait a minute.  We grew up in the greatest, longest, and strongest bull market in the recorded history of the human race, 18 percent a year, an equity fund environment in which $10,000 would grow.  If there were not very many people in the mutual fund industry at the beginning of the period but when you look back, in which $10,000 would grow to I think the number is $162,000.  You can look back and say that we were lucky to be in that kind of environment.  I would.  But the idea that growth in an unprecedented and not-to-be-repeated stock market is not a very strong read on which to rely for the years ahead.  So it is not going to happen. 

Number two, and this is more on Geoff's point, returns have been good across the industry.  Please.  Where would that come from?  I mean, you saw the data.  The average common stock fund has lagged the market by 2.5 percent a year.  The average common stock fund investor has lagged the market by 5.2 percent is the number, 2.5, plus the 2.7 that bad timing and bad selection brings about.  I do not see good across the board.  But again, as I have said in my talk, think for a minute about the nature of the fund industry.  It is not just an equity industry. 

And let me start with money market funds.  It is in the cards that money market funds cost will take about 30 percent of the return available to you in the money market, away from you at kind of existing interest rate levels.  It could go higher; it is a little bit less at the bottom.  Some money market funds were quite literally yielding so little that the managers waived the fees so they could produce the half of one percent return or something like that, and a probably 1.5 or two percent market.  So money market funds, you are giving up in round numbers 30 percent of your returns. 

In the bond area, this is all in the record.  The average bond fund lags the bond market by about 20 percent per year.  You lose 20 percent of your returns and that does not count the fact that when you buy a load fund, which is the most common way to buy a bond fund is through a load fund, I am going to make a point around that in a second, but I have not even taken account of the fact that your first year’s income is eliminated by buying that bond fund.  You pay a five percent sales charge and get round numbers while you get about a four percent yield from the average bond fund because in the five percent market, the average bond fund delivers - guess what? - four percent in the five percent market. 

And then you are talking about the equity market.  Well, sure, in a 12.5 percent market that was the return for the last 25 years because we had the bad years that followed those great years, 2.5 percent is, I guess, 20 percent of the return goes away.  But we are not going to have another 12 percent market.  There is no point in looking back and talking about the past in terms of what is going to be consumed.  If you look at a 7.5 percent market, it might be reasonable.  Funds will consume about, at present levels, about 30 percent of that return and then if you have the ill-grace to look not at that nominal return but at the real return, the capture of fund of the equity market real returns under those circumstances would be about 60 percent of a 4.5 percent net return. 

So we have the social fabric of our society here, and if you add bad selections to that number, it gets even worse.  So, the numbers just do not support.  The results have been good if everyone in the audience would agree that good has something to do with approaching the returns in the market.  Independent studies, academic studies--not Bogle's--suggest that over an investment lifetime, you have about a five percent chance of beating the stock market.  Not this year, not next year, not 25 years but over your investment lifetime, which for young people today is 65 year. 

So when the stock market return is there for the taking, why in God's name would anybody fool around with it?  So why are the customers so "dumb?"  Well, first of all, the customers of most fund companies who are not investors; they are brokers and financial advisers.  Think about it.  Think about the variable annuity business, the best possible example of the conflict I am speaking of.  Look at the ads that say, I have got a great variable annuity for you.  How do I know it is great?  Because you make 50 percent of the first year’s commissions and then a trail of 10 percent a year.  They are appealing to the seller and not to the buyer.  We have a seller-dominated industry and we therefore have – I love to use economic phrases - we therefore have information asymmetry.  That is a nice way of saying that the seller knows what is going on and the buyer does not.  The buyer is very short term-oriented.  You can always find a fund that has in the past three, four or five years done twice as well as the stock market.  You can find I'm sure a few that have done three times as well and you can also find the other side of that coin because on average, we are all average but the brokers focus on what has worked. 

We know the fund industry.  John does not ignore customer demand, we love customer demand.  Why on earth do you think we created 494 new economy funds, telecommunications, technology, internet funds at the peak of the stock market and took $600 billion into those funds and lost even to this day $300 billion of those investors money?  We love to meet demand, but we do not meet demand in the right way.  We meet demand on short term market impact and we have gotten a lot out of that.  So I am bothered with that kind of analysis, greatly bothered with it because I think it a) looks backward, and b) really ignores some of the things when you get through looking at how fund investors have been compared to how fund investors did. 

Let me come to the question that Bob raised about where are the other Vanguards?  Well, this is an industry that certainly began on entrepreneurial kind of people started a fund group and let us put the best possible face on.  They thought of themselves as trustees, and I know a lot of these people.  I actually new people like Merrill Griswold and Walter Morgan and some of the old… Mr. Johnson senior.  They basically thought of themselves as trustees and in many cases in those days, did not even have a distribution company of their own.  The distribution was done by a completely different firm, eliminating the conflict between marketing and management that I have spoken of so often.  So it is an industry that started to work that way and fell away from that. 

And now the question is, should a structure that seemed eminently reasonable at the beginning be supplanted by a new structure better-fitted for the needs of today's investors?  The conglomeratization, and I do not think anybody in this room would argue with that 70 percent ownership of the mutual funders by conglomerates, those firms and it is spelled very clearly out of the performance data I showed you, are in business to make money for themselves.  That is what people do.  I mean, read what they say when they come in to the fund business.  “We are not getting enough fee-related business,” says the Bank of America and so they say, “Go out and get fee-related income here from 7 percent to 15 percent,” and guess what happens? 

The investment management division knows exactly what to do.  They bring in assets.  They bring in Canary funds.  They offer side deals.  They do hedge fund trading.  They allow market timing at the expense of their long term shareholders to enrich these short-term hedge funds, which I am told hedge funds trafficking in mutual fund shares reached a total of 400 hedge funds trafficking in mutual fund market timing.  That is an awful lot.  That is the number that came out of at least I read it in the Wall Street Journal quoting the SEC. 

And the conglomerate, I want to add this about – we do not know a lot.  When I was testifying down at the SEC about the separation, I was of course testifying in favor of the separation when Chairman Levitt was trying to separate consulting from auditing services, separate the consultants from the auditing and conflict of interest there, and one of the commissioners said, "Well, where is the smoking gun.  Where is the evidence that this combination of auditing and consulting services has done any harm?"  This was of course pre-Enron and even at Enron we do not have real smoking gun as far as I can tell.  The whole case has now been reversed, so I guess we do not have a smoking gun.  But I said there are some times when statistics do not prove what common sense does, and so we are talking about some body of people looking after the interest of the funds. 

It is interesting in the case of the market scandals and this is one of the subtle things about a better structure.  I just took a look at the 25 largest mutual fund firms and 10 of them, 40 percent of them, not this little tiny thing the industry talks about, 40 percent of those major firms were involved in the mutual fund scandals.  Five of the 20 were privately held.  Not one was involved in the scandals.  The remaining 20 were publicly held and conglomerate-owned and 10 of them were involved in the scandal, 50 percent versus zero.  That is a statistic that does not necessarily prove anything but gosh, you got to think about whether their interests are the good of the business and the good of the manager or the good of the fund share holder.  And we freely can see, of course everybody is doing the best for their fund shareholders. 

Why would they do otherwise?  We are all out there slugging it out to try and get a better performance everyday.  But on average, we are all average.  I mean, get a life.  I mean we are all average before cost and below average by the amount of the cost.  So we have to recognize that by taking huge amount of cost not only out of the mutual fund system and we ultimately will.  It's fees, and trading, and sales commissions and so on.  We just have to come out of the system. 

Let me just see if I can pick up maybe one more and then I will ask you to focus on maybe your favorite criticisms that I might not have addressed.  Let me talk about the independent staff.  I think you raised this in the information.  First, the cost of an independent staff would be trivial, a couple of people there, maybe bright, young business school grads or something like that have a way with numbers.  Think of what real information would do. 

Let me give you one simple example.  From the beginning of my career, we always talked at our board meetings about redemption rates which I call an index of shareholder satisfaction.  And in the early years of this business, the typical redemption rate for the average fund was around seven percent a year.  The average mutual fund holding period for a fund share holder was about 18 years or something like that.  That number started to grow and grow and grow after the go-go era and up to today, and it got up to 43 percent.  That is an average fund holding period of maybe a year and a quarter or a year and half.  I guess 50 percent would be two years, so 43 percent would be 2+ years down from 18 years at the beginning.  Every fund director who read the annual report would have known what the level of fund redemptions were.  If we had only had the directors, have someone say, “Would you look at our redemption rate for a minute?” 

What would a director of the Alger funds have said when he saw that, I think the year was in 2001, that the Alger funds had $2 billion of assets - this example is in my book - and they had $8 billion of cash inflow and $8 billion of cash outflow?  Would somebody have said with a 400 percent redemption rate that, "Why do we not take a look and see if there could be some market timing going on here?"  We need someone to bring out a lot of information that we do not get in the typical consultant studies. 

Now, I have seen the Lipper reports and I find in many respects they are wanting.  I am told, although I have never seen one that I can put my finger on for this, that they ignored Vanguard in their cost comparisons because Vanguard is different.  I do not know if that is the case or not.  Damn right Vanguard is different and I might say on that point, I would never say - think about this for a minute - I would never say that this industry, the mutual fund industry needed Vanguard.  But I would absolutely say that the mutual fund industry and every industry in this country need a vanguard, someone to say, "I see what you are doing.  I do not think it is good enough, and I would like to try a different way and may the best strategy win." 

So you need an outlier.  You need… I was going to say a loudmouth but I will retract that.  You need someone to say there is a different way of doing it and I think a better way.  So, a small staff to pick up the important information and not just the fee ratios.  But how many dollars are involved in that debate to do what I would call static portfolios?  I see you are running a 211 percent portfolio, turn over.  Could you tell me that returns that you would have had if you just held the portfolio at the beginning of the year?  The odds happen… they did not believe the numbers, 52 percent that the returns will be better if you do nothing with the portfolio during the year. 

And let me say finally that the … conflict that we really have not talked on but we trounced around, the reality is that the interest of our financial system and the interest of those whom it is duty-bound to serve are 180 degrees opposed.  It is a very serious conflict because if you think about it for more than 30 seconds, and I thought about it for a lot more than 30 seconds, the interest of the investment business out there, mutual fund distribution, stockbrokers, whatever you have investment bankers, is based on the underlying principle, "Don’t just stand there, do something.  Act, trade, respond to Alan Greenspan's later words.  Bring out something new, change something, trade something.  Buy one and sell the other." 

That is what the investment business does.  If they did not do that we would not be trading $3 billion of shares of stock everyday.  It is a business that says "Don’t just stand there, do something."  The evidence is crystal clear that the reverse is the right strategy for the mutual fund investor, the client of the investment industry.  Don’t do something, just stand there, own the market and hold it forever.

Peter Wallison:  Thank you Jack. John, Geoff, do you want to respond in any way to what Jack has just said, and then we will try to go to the audience.

Geoff Bobroff:  I have just two quick comments.  One with regard to Jack's concern or comment about my view on the fact that we have done a good job from an investment standpoint and he points to the averages that he says in terms of return, I would suggest to you as an audience, people do not buy averages.  They buy individual funds and an average is nothing more than something that is an arithmetic number.  And from a structural standpoint, I would urge you to focus on the fact of who has grown the assets during this period are those that have stronger numbers than the average.  So we cannot look at averages and reach any full conclusion that something is amiss because people do not buy averages. 

The other element and I will quickly stop here is that Jack talked about conglomerates, and I would echo his concern about conglomerates.  And if you look at the statistics, again back to one of his earlier charts, those pure play firms – and I will define a pure player - those that are in only the asset management business and not in other businesses - have been able to attract and retain investment talents that have produced above average returns.  And is it interesting to see that two of the conglomerates, Merrill Lynch, has decided to get out of the business and move into a pure play firm called Black Rock and our friends at Legg Mason and Smith-Barney have restructured themselves.  Now Legg Mason is only a pure play asset manager and the brokerage business has gone over to Smith-Barney. 

So clearly, the element is that those that are pure play firms have been able for whatever reason, to deliver better investment results because of their ability to incentivize, attract, whatever it may be, those members of our community that can produce positive alpha in terms of investment returns.  So again abstracts.  We can talk in generalizations but we really do need to come down to specific examples.

Peter Wallison:  John?

John Rea:  Yes, I just say it briefly because I know you want to go into some of the questions.  I would agree with Jack.  The industry needs a vanguard or needs Vanguard.  They need people like Jack Bogle who offer criticisms and require us to think and respond to thoughts that are not in the mainstream.  Jack and I are never going to agree, and I do want to add one sort of summary statement here.  The way I looked at his work today was to take a look at the big picture, the framework of his analysis, check out the economics and see how that stands with mainstream economic analysis. 

Let me also say that the way Jack approached I think this morning was to look at a bunch of micro data, elements or aspects of industry performance, and then build his big picture up from there.  I just want to say Jack and I would need another two hours to thresh out our differences over the charts and the data that he has there too.  And those of you who may be p