It took nearly 66 years for Jack Bogle’s embrace of the index fund to become the dominant trend in the mutual fund industry. In the wake of that dominance, the rest of the industry faces a painful decline, according to Bogle. His thesis can be applied to a key group of fiduciary advisors – those that are part of a “roll-up” entity – whose business models are flawed in the same way as those doomed fund companies.
Bogle is the founder and retired chief executive of the Vanguard Group. He spoke via videoconference on April 28 at the Morningstar investment conference in Chicago. A copy of the essay upon which his speech was based is available here.
The Investment Company Institute (ICI), the trade organization for the fund industry, rejected Bogle’s proposal to present his speech at its annual convention. To its noteworthy credit, Morningstar then quickly invited him to present at its annual investment conference, said Bogle.
Neither the ICI nor Morningstar should be happy about Bogle’s key prediction, which is that active fund managers owned by banks and financial conglomerates – nearly 80% of the largest fund companies – will become “cash cows” for their corporate owners and unlikely to invest in marketing. Ultimately, he said, those funds will be sold off at substantial losses.
The ICI and Morningstar derive significant revenues from active managers. Morningstar, in particular, is a beneficiary of the marketing dollars spent by those firms.
Much of what Bogle said was a reinforcement of his prior writings and speeches. But his prediction for the fund industry – and two strategies the funds will follow – was new material.
“Now is the time I have chosen to speak out about the mutual fund industry,” he said. “But this is not a victory lap. I’ve been around too long to take a victory lap before the game is over. Nor is it a valedictory, since I have much more to accomplish in my life and in my career.”
The triumph of indexing
The first part of Bogle’s talk was a recounting of the highlights of his career, starting with his 1951 senior thesis while at Princeton. In that 66-year old document, he articulated the principles that have guided his career, starting with the notion that mutual funds should be run for the benefit of investors, with the lowest costs possible and with no claim that they can beat the market.
Bogle described how he fought a bitter battle with Wellington management to offer an index fund, which ultimately led him to found Vanguard in 1975. He credited Paul Samuelson’s article in the first issue of the Journal of Portfolio Management in 1974 as the inspiration for his efforts. In it, Samuelson demanded that “someone, somewhere start an index fund,” and Bogle did.
“Indexing has triumphed,” he said. “Active managers will have to join the index revolution and/or expand their range of Investment options by adopting active management strategies or do nothing. Whatever the case, active management is not going to vanish.”
Bogle has first-hand experience with active management, both at Wellington and Vanguard. He recounted the painful lesson he learned when Wellington’s growth funds crashed in the bear market in the 1970s. Since then, he said Wellington and Vanguard have succeeded at active management primarily by keeping costs – both expense ratios and turnover – exceedingly low.
The two strategic options for active managers
Bogle cited two prominent industry commentators for providing “reasonable” insights on how active managers can succeed. He praised Morningstar’s John Rekenthaler for advocating that funds close to investors when they reach a certain size, follow a niche investment strategy and “educate investors.” Bogle did not say on what topics investors should be educated.
Bogle quoted an Advisor Perspectives article written by Larry Siegel, director of research for the CFA foundation, who wrote that active managers will succeed when they “present convincing evidence, both historically and in the process they intend to use in the future, that they have a good chance of beating the relevant benchmarks after costs.”
But the core prediction Bogle made was that fund companies will follow two strategies based on two divergent corporate structures: closely-held firms (including some with minority ownership by publicly traded companies) and funds owned by banks and financial conglomerates.
For the closely-held firms, he said the optimal strategy will be to avoid change. Those firms, he said, might choose to offer index funds or to pursue other lines of business, but neither are likely to create value for shareholders. They need not cut fees, he said, since a modest fee reduction would offer little benefit and a large fee reduction would run counter to the interests of the shareholders. Aggressive marketing won’t help either, Bogle said.
Nor will offering smart-beta funds, which Bogle defined as a “quantitative, rules-based active strategy.” He called those funds an “actively managed wolf in an index fund sheep’s clothing. Mark me down as dubious as to their long-term staying power.”
Bogle said a “totally different strategy” will emerge for funds owned by banks and financial conglomerates. They should maintain their businesses as “cash cows,” reaping the profits while they last. Don’t invest or cut fees, he said. Ultimately, as outflows accumulate from those funds, their owners will sell them at bargain prices or merge them with other similarly situated business, Bogle said.
While a cash cow may be an optimal business strategy, Bogle said it does not constitute a passionate commitment to the mutual fund industry, nor does it serve investors.
Of the 50 largest fund companies, 30 are owned by banks and financial conglomerates and another 10 have significant ownership stakes, according to Bogle.
Offering ETFs are not a solution for either type of fund company. Bogle reiterated his long-standing criticism of the ETF structure, which he said has a flawed design that allows it to be continuously traded. The traditional index fund (or TIF, an acronym Bogle said he has been trying to popularize) is designed to be bought and held forever.
Manna from heaven
The fund industry has been “insanely profitable,” he said, with margins approaching 50%. But that success has been largely the result of two forces.
The first was the 34-year bull market in equities that began in 1982. The other was favorable regulation, which created the tax-exempt bond market and tax-sheltered investment structures, such as IRAs and 401(k) plans. Together, they represent $7.9 trillion of the $17 trillion mutual fund industry, he said.
“Our industry has benefitted from two remarkable happenings, manna from heaven that we can take no credit for,” Bogle said.
He cautioned against “presentism” – assuming a current trend will continue forever.
“If presentism leads this industry to believe that such mammoth returns will recur from this point forward, or that the federal government has some further gifts to bestow on our industry, we are fooling ourselves,” he said. Bogle predicted that the administration was likely to take away some of the favored tax structures investors enjoy.
The fund industry has grown enormously since 1951, but none of the economies of scale have accrued to investors, Bogle said. Assets, he said, grew 5,400-fold over that period, but fund advisor fees and operating expenses grew 5,600-fold, with virtually no extra returns accruing to shareholders.
No man can serve two masters
When the business owners’ interests conflict with those of the shareholders, Bogle asked rhetorically, “Whose interests come first?”
Bogle has been highly outspoken about this problem – the misalignment of interests that is most acutely present in funds owned by banks and financial conglomerates.
He faulted the industry for a lack of independent directors. Fund boards have ignored the “shareholder-first principles” he called for 34 years ago. All directors have a duty to serve investors, he said, but affiliated directors also have a duty to serve the fund company.
Affiliated directors are charged with controlling a key variable, the expense ratio. Investors benefit from lower expenses, but the fund company benefits from higher expenses. Bogle said there is no doubt which of those interests will come first.
He said he has been on record since 1971, when he was CEO at Wellington Management Company, then a publicly traded firm. He warned that the “pressure for earnings growth engendered by public ownership is antithetical to the responsible operation of a professional organization.” That has been proven over and over again, he said.
The only solution is to roll back conglomerate ownership, but it will not be an easy battle, Bogle said.
The goal of maximizing shareholder value has gone too far, at least as far as the mutual fund industry is concerned, according to Bogle. Instead, he said, funds should operate to produce goods and services that benefit society, as Adam Smith advocated in 1776 in The Wealth of Nations.
The ominous implication for advisors
Advisors face the same challenge of aligning client interests with those of the advisory firm. The fiduciary rule mitigates much of the misalignment, but there is one category of advisory firm that suffers in the same way as the problems Bogle identified with the fund industry: the so-called roll-up advisors.
Firms like United Capital and Focus Financial Partners have a business model that is predicated on buying (“rolling up”) individual advisors to achieve economies of scale. Some roll-up firms are funded by private-equity owners. The goal of virtually all owners is to take the rolled-up entity public or to sell it.
The interests of the advisors' clients are in direct conflict with those of the roll-up firm. The roll-up firm wants to maximize margins, profits and the value of the firms. Clients want lower costs.
Imagine a scenario where an advisory firm, owned by a roll-up buyer, finds that it has become highly profitable as a result of improving operational efficiency or by implementing lower cost funds. The roll-up buyer would surely oppose lowering client fees, although an advisory firm not owned by a roll-up buyer would likely contemplate such a move.
There is no solution to this misalignment of interests between clients and roll-up firms.
If you reject this thesis, then you must also reject Bogle’s key criticism of the fund industry.
Perhaps Bogle, who has been rightfully critical of the structure whereby banks and financial conglomerates own fund companies, will turn his attention to the flawed business model of roll-up firms.
Read more articles by Robert Huebscher
It took nearly 66 years for Jack Bogle’s embrace of the index fund to become the dominant trend in the mutual fund industry. In the wake of that dominance, the rest of the industry faces a painful decline, according to Bogle. His thesis can be applied to a key group of fiduciary advisors – those that are part of a “roll-up” entity – whose business models are flawed in the same way as those doomed fund companies.
