Afterword

We have concluded our commonsense journey through the world of investment strategy, investment choices, and investment performance in establishing a simple, sensible, and effective fund portfolio. Following the investment principles set forth in these pages, I have no doubt, will make you a more successful long-term investor. Similarly, I have no doubt that a prompt return of the mutual fund industry to the traditional principles of prudent, disciplined portfolio management will make mutual funds far more productive investments. This change can best be facilitated under a structure that focuses on the primacy of the interests, not of fund managers, but of fund shareholders—the individual human beings to whom this industry is responsible.

Even as I remind you, for a final time, of the importance of common sense in establishing an investment program, and in industry governance as well, so too I remind you of the importance of “Common Sense” as my inspiration for this book’s title. There is more than a passing similarity between the injustices suffered by the American colonies, articulated so powerfully by Thomas Paine, and the insufficient investment returns suffered by mutual fund shareholders. In the context of a mutual fund’s relationship to its shareholders, some of Paine’s words in “Common Sense” appear almost eerily prescient:

Paine on the Logic of Representative Government:“. . . As a colony increases the public concerns will increase likewise, and the distance at which the members may be separated will render it too inconvenient for all of them to meet on every occasion. . . . This will point out the convenience of their consenting to leave the legislative part to be managed by a select number chosen from the whole body, who are supposed to have the same concerns at stake which those have who appointed them, and who will act in the same manner as the whole body would act were they present. . . . I draw my idea of this form of government from a principle in nature, which no art can overturn, viz. That the more simple anything is, the less liable it is to be disordered, and the easier repaired when disordered.”

The parallel situation in the mutual fund industry is found in a governance structure in which the board of directors—in theory, elected to represent the interests of a large and diffuse body of fund shareholders—has lost sight of its mission. The arrangement is admirably simple, but it has produced a disordered result. The reality is that when a mutual fund delegates all of its operations to an external management enterprise under contract, it is not the fund that controls the manager, but the manager that controls the fund. Experience has shown that neither the managers nor the directors selected by the managers “have the same concerns at stake” as the shareholders. The board too often acts to serve the needs of the mutual fund management company first and those of fund shareholders second.

Paine on Specious Arguments against Independence: “. . . these colonies sustain many material injuries . . . by being connected with and dependent on Great Britain. . . . I have heard it asserted by some, that as America hath flourished under her former connection with Great Britain, that the same connection is necessary towards her future happiness, and will always have the same effect. Nothing can be more fallacious than this kind of argument. We may as well assert, that because a child has thrived upon milk, that it is never to have meat; or that the first twenty years of our lives is to become a precedent for the next twenty.”

For nearly two decades now, mutual fund shareholders have reaped large rewards from the returns earned by their funds. But because of high costs, they have missed much of the feast available in the much more generous rewards provided in the thriving stock market. In a less bountiful future environment, which we may well face, this substantial opportunity cost will loom even larger in its impact on fund returns. What is more, like a child, the mutual fund industry has grown to adulthood, with assets increasing fully 90 times in the 20 years. Now that they are adults, mutual funds no longer require the oversight of even benign parents, and fund management companies, receiving ever-soaring fees from the funds, have hardly been benign. If it is time for shareholder independence, and I believe that it is, shareholders will be best served if our industry’s past is not allowed to be prologue to its future.

Paine on the Cost of an Ideal Government:“ . . . I offer the following extracts from that wise observer on governments Dragonetti (On Virtue and Rewards). ‘The science says he, of the politician consists in fixing the true point of happiness and freedom. Those men would deserve the gratitude of ages, who should discover a mode of government that contained the greatest sum of individual happiness, with the least national expense.’”

Mutual fund shareholders are beginning to act on a parallel desire in their investments. Even as governments should provide the greatest sum of individual happiness with the least national expense, so mutual funds should provide the greatest sum of investor returns with the least management expense.

Paine on the Natural Balance of Power between Leader and Subject:“ . . . small islands not capable of protecting themselves, are the proper objects for kingdoms to take under their care; but there is something very absurd in supposing a continent to be perpetually governed by an island. In no instance hath nature made the satellite larger than its primary planet.”^ak

So too, in the mutual fund industry, the natural order has been turned on its head. The management company, typically requiring a minuscule amount of capital, is effectively the island, governing the huge continent of capital represented by the enormous assets owned by mutual fund shareholders. In today’s mutual fund world, the primary planet is held in the orbit of its satellite. That result not only defies nature, it offends common sense.

In each of these excerpts, Thomas Paine inveighed against a distant, omnipotent leadership that served its own interests at the expense of its far more numerous subjects—the residents of a large and prosperous colony, who were angrily agitating for change. It would be extreme to argue that the mood of mutual fund shareholders today is analogous to that of the American colonists of two centuries ago, but the parallels are surely striking. The best way for fund investors to receive a fair shake is for them to have the funds that they own governed solely in their interests—in terms of management focus, marketing policies, and cost structure alike—with that one aim in mind. In the long run, investment success is most likely to come to fund shareholders who apply common sense to investment strategy, investment choices, and investment performance, and who recognize that common sense demands that funds be governed in the interests of those who own them.

TEN YEARS LATER

Update on the Afterword

Thomas Paine’s Common Sense is at least as relevant to the 2009 edition as it was in 1999, especially the idea that “the more simple anything is, the less liable it is to be disordered.” The curious and complex structure of the mutual fund industry—along with the mixed motivations and divided loyalties of fund managers—has continued to have a decidedly negative impact on the returns earned by fund shareholders.

Alas, however, the management structure that prevailed during the industry’s first 75 years (1924 to 1999) proved to be the virtually universal model for the subsequent decade, now ending. What’s more, just as I warned, “In a less bountiful future environment [surely we’ve witnessed that!], this substantial opportunity cost will loom even larger in its impact on fund returns.” And so it has.

The natural order of things—a structure in which fund managers work directly for fund shareholders—remains turned on its head, and the trend toward management company ownership by financial conglomerates has, perversely, accelerated. But a few bright rays of sunlight have found their way through the clouds. Fund investors are increasingly seeking out lower-cost funds, available predominantly through privately held management companies, and by that single mutual mutual fund firm known as Vanguard, with the lowest costs and the simple structure and investment principles that best comport with, well, common sense.