Chapter 16

On Marketing

The Message Is the Medium

In 1967, a New Age writer named Marshall McLuhan wrote a book entitled The Medium Is the Massage. His point was that, in the hectic pace of modern life, the lightninglike speed of communications over the airwaves had come to control the very messages that were sent. What we were witnessing on television, on entertainment and news programming alike, was a far cry from what we had read in books and newspapers. In the news media, for example, the balanced reportage, rich in detail, that had been a hallmark of the best newspapers gave way to superficial 30-second sound bites on the events of the day. Now, three decades after the publication of the McLuhan book, the Internet has become a whole new medium of receiving and processing information, and the speed and reach of communications have been increasing at an exponential rate. McLuhan was ahead of his time, and his observations seem even more profound today.

In discussing the role of marketing in the mutual fund industry, I’ m going to take two liberties with Mr. McLuhan’s title, reversing the order and changing “Massage” to “Message.” Doing so gives me a fitting subtitle for this chapter: “The Message Is the Medium.” For in this industry, marketing is now in the driver’s seat. What the industry offers to investors now shapes what funds actually provide and the cost at which they provide it. Using an old, uncomplimentary business expression: “We used to be a business that sells what it makes, but we’ve become a business that makes whatever sells.” The marketing message has overtaken the investment medium; the cart now pulls the horse.

During most of the first half-century after the industry’s inception in 1924, mutual funds were focused largely on the stewardship of shareholders’ assets. They were managed by investment advisers charged with the responsibility of managing other people’s money. And they were distributed by separate principal underwriters. In fact, many of the largest fund companies assumed neither the responsibility for nor the cost of distribution and marketing services. But at an accelerating rate over the past decade, the focus has clearly turned toward marketing and away from management. The implications of that trend are ominous.

Four principal problems are created by this overemphasis on marketing. First, it costs mutual fund shareholders a great deal of money—billions of dollars of extra fund expenses—which reduces the returns received by shareholders. Second, these large expenditures not only offer no countervailing benefit in terms of shareholder returns, but, to the extent they succeed in bringing additional assets into the funds, have a powerful tendency to further reduce fund returns. Third, mutual funds are too often hyped and hawked, and trusting investors may be imperiled by the risks assumed by, and deluded about the potential returns of, the funds. Last, and perhaps most significant of all, the distribution drive alters the relationship between investors and funds. Rather than being perceived as an owner of the fund, the shareholder is perceived as a mere customer of the adviser. At that point, the mutual fund is no longer primarily an investment account under the stewardship of a profession manager, but an investment product under the control of a professional marketer.

TEN YEARS LATER

Fund Marketing

The events of the past decade have only served to validate my deep concerns about the triumph of marketing and salesmanship in the mutual fund industry over the focus on management and stewardship that typified the industry’s early years. As noted in the previous chapter, fund expenses continued to soar, and—especially during the last years of the technology-based boom in stock prices before the 2000-2002 collapse—fund distributors hyped and hawked their hottest funds, advertising enormous past returns in newspapers, in financial magazines, and on television. Investor returns were indeed imperiled in the ensuing crash, the direct result of the substantial risks assumed by these funds.

Your Money Is No Object

Marketing and distribution are highly expensive functions, and money is no object. But it is the money of the fund shareholders. Yet, the fund manager reaps the benefits of that money, earning rising fees as the assets roll in. At the outset of the growth curve, some beneficial economies of scale may accrue to a fund’s shareholders, but the principal benefits of growth accrue to the manager. And as assets increase to boxcar levels, funds often become musclebound, bereft of the ability to follow the investment strategies that engendered their early success.

Newspaper and magazine advertisements and television commercials that foster the “branding” image now cost fund investors as much as $1 billion per year. Other marketing efforts—direct mail, literature, and promotions—are also hugely expensive, and the enormous fees paid by funds for shelf space in mutual fund supermarkets add even more to the marketing budget. It should not strain credulity to suggest that fund managers may be spending as much as $10 billion per year on marketing their wares—a huge chunk of the $50 billion that investors paid for their mutual funds in 1998, and much larger even than the $3 to $4 billion paid for the investment services that are the ostensible raison d’être for owning fund shares in the first place. It is the “management” fees paid by the fund shareholders that are being poured into these marketing efforts.

Much of the troublesome rise in fund distribution costs comes from the institution of a novel form of mutual fund fee: the 12b-1 fee (so named because the fee was permitted under SEC Rule 270.12b-1). Until October 1980, the Securities and Exchange Commission (SEC) took the position that fund managers could not spend fund assets on distribution. Before then, the industry distribution effort was largely funded by sales loads (commissions paid by buyers of fund shares to stock brokerage firms). The typical maximum load was 8 percent of the total dollar value of the transaction (8.7 percent of the value of the fund shares acquired). That traditional structure had been in place since the first U.S. mutual fund began operations in 1924. But it had become increasingly difficult to sustain after the terrible 1973-1974 bear market, and at a time when no-load funds, available without sales commissions, began to penetrate the fund marketplace. As a result of this new competition, the typical maximum load has gradually diminished to 6 percent.

Eager to earn the same amount of revenues so that the resources available to pay for the distribution effort would remain undiminished—and equally eager to make it appear that load funds were actually no-load funds—the fund industry, and the stockbrokers who sold fund shares, developed an imaginative plan that would enable them to have their cake and eat it, too. They proposed an option under which a crystal-clear front-end load of, say, 6 percent, would be replaced with two decidedly blurry fees: an annual distribution fee (say, 1 percent per year) charged against fund assets; and a descending one-time redemption fee (a so-called back-end load) that would make up the difference if the investor withdrew from the fund before all of those annual 1 percent fees totaled 6 percent. For example, if an investor redeemed after having made two payments of 1 percent each over two years, the redemption fee would be 4 percent, and after six years it would normally (but not always) vanish. The math didn’t quite add up. (The shareholder’s total costs were actually increased, as a fund’s assets grew in value in the soaring stock market.) But it came close to simply replacing a one-time front-end fee with an equivalent cumulative annual fee.

Pandora’s Box Is Opened

With this seemingly harmless change, however, came a much more ominous turn of events. When the SEC ruled that, subject to meeting the detailed requirements for the imposition of a 12b -1 fee by a fund (including approval by a majority of its independent directors), fund assets could be made available for distribution expenses, it also allowed the imposition of 12b-1 fees to be used as a simple add-on to fund expenses, whether the fund changed its sales charge structure or not. Indeed, it even allowed no-load funds to charge these fees. In a way that even Pandora could not have imagined, a modern-day Pandora’s box was opened, and almost infinite resources became available to accomplish the industry’s shift to a marketing focus.

During the waning months of the 1970s, in the aftermath of a market crash, the industry was fighting a plague of net redemptions and shrinking assets for equity mutual funds. Fund managers advanced the argument that if the industry was to build economies of scale for shareholders, it needed these resources to stem redemptions and encourage growth. Alas, the cure was far worse than the disease. Even a 12b-1 fee assessed as low as 0.25 percent of fund assets (the maximum level at which a fund could carry the “no-load” appellation) proved too much to be overcome by any remotely conceivable economies of scale.

For example, if a fund succeeded in building its assets from, say, $500 million to $5 billion, its previous expense ratio might have fallen from 1.10 percent to 1.00 percent. But with the addition of a 12b-1 fee of 0.25 percent, the new expense ratio became 1.25 percent, a net increase of 0.15 percentage points over the original fee. Total annual expenses of $5.5 million, paid by a fund when it was small, would rise to $62.5 million at its larger size. At that point, the manager would be receiving fully $12.5 million per year in 12b-1 fees for marketing expenditures, and the income earned by the fund’s shareholders would be reduced commensurately.

As the 1990s draw to a close, 12b-1 fees are rife. Some 7,000 of 13,000 mutual funds—including 60 percent of all equity funds, 67 percent of all bond funds, and 35 percent of all money market funds—are charging these onerous fees.^af As industry assets have risen, so has the general level of 12b-1 fees. Since 1980, fund assets have risen 35-fold to some $5 trillion. The 12b-1 fee, nonexistent when 1980 began and consuming only 0.08 percent of the assets of funds charging these fees in 1984, averages a full 0.40 percent of the assets of the two-thirds of the funds in this industry that impose 12b-1 fees in 1998. Total 12b-1 fees amount to more than $6 billion annually. Since 1980, the number of funds has multiplied tenfold and fund assets have multiplied twentyfold. But the percentage of funds using 12b-1 fees has multiplied thirtyfold, and the percentage level of 12b -1 fees has soared. Table 16.1 shows the rising rate of 12b-1 fees as a percentage of fund assets, and the amounts of fund shareholder dollars paid to the funds for marketing.

Say what you will about the justification for these fees, but $6.5 billion in 1998 is a huge sum and a staggering burden on fund shareholder returns. It brings with it consequences that are at best otherwise neutral, and at worst negative. The fund shareholder pays the bills, but the fund manager benefits by using these fees to garner more assets under management, higher management fees, and even higher profit margins. Curiously, there is no indication whatsoever that funds that charge 12b-1 fees are succeeding in their goal of building market share at the expense of funds that do not add these fees. The fees do not appear to be accomplishing their ostensible purpose: building market share in pursuit of economies of scale.

Sadly, even the staggering $6-plus billion of 12b-1 fees paid by shareholders in 1998 does not nearly capture the totality of fund expenditures for distribution and marketing. Some fund advisers make such large profits on investment advisory services that, rather than reduce fees to benefit fund shareholders, they spend some portion of them on fund distribution without incurring the onus of gathering proxies requesting that shareholders approve a 12b-1 fee; without subjecting themselves to monitoring by the independent directors (for whatever limited value that has had for shareholders); and without carrying the opprobrium of the 12b-1 appellation in the press and statistical services. Indeed, nothing precludes a fund from raising its advisory fee by, say, 0.25 percent and spending the entire windfall on marketing, and many funds seem to do exactly that.

TABLE 16.1 The Rise of the 12b-1 Fee

TEN YEARS LATER

12b-1 Fees

Ten years later, the absurdity of the 12b-1 fee remains: using fund assets to finance sales and distribution activity has simply proved to be a waste of money, providing no benefits to fund investors. I have yet to see a single example of a 12b-1 fee that has, by helping to build fund assets, resulted in a reduced all-in fee rate paid by fund investors. While 12b-1 fees that serve to spread front-end sales loads over a period of years seem to be drying up (that’s good!), the SEC seems, so far at least, unable to muster the courage simply to eliminate their use (that’s bad!).

Meanwhile, 12b-1 fees continued to move relentlessly upward, from $15 billion in 2000 to an estimated $28 billion in 2009. This triumph of the interests of fund distributors over the interests of fund shareholders makes it clear whose interests come first in the mutual fund arena. (Hint: it isn’t the fund shareholder.)

The Croupier’s Take

Still more distribution costs are added by the costs of the fund supermarkets, which represent a rapidly growing form of fund distribution. The going rate for shelf space (a term borrowed from grocery stores and pharmacies) continues to rise. It is now 0.35 percent of the fund assets acquired from supermarket shoppers. At that rate, fund shareholders are paying nearly $250 million every year for shelf space in the largest supermarket, which has corralled some $70 billion of fund assets in its “no-fee” marketplace. These fees may be paid directly by the fund, by a 12b-1 fee imposed on the fund, by directed brokerage of other commission arrangements that may raise the fund’s transaction costs, or by the adviser’s willingness to accept a lower profit margin on the assets the fund garners through the supermarket. (In the absence of a supermarket fee, of course, such a reduced margin could just as easily have been rebated to fund shareholders.)

These fees find an analog in the gambling casino. As increasing numbers of mutual fund investors trade fund shares in ever-shorter periods, the croupiers receive an ever-growing take. Unaware that “no-fee” casinos in fact entail heavy costs for the funds that participate in them, investors flock to the casinos. The assets in the casinos grow, and the croupiers pocket a greater take. Fund investors pay, one way or another, as in the casino, and the croupiers gather their take at the night’s end.

But whatever value—if any—a supermarket brings to the investors who purchase shares through it, the cost is paid for by both the shareholders who use it and those who don’t. For all of the fund’s shareholders are assessed these marketing fees. But shareholders are rarely, if ever, informed about the supermarket fees, perhaps on the ground that it is an adviser’s right to spend its fees as it wishes. Be that as it may, an adviser who is willing to spend some one-third of the fees received from the assets of new shareholders garnered in the supermarket could just as easily reduce the fees paid by the existing shareholders who do not use the supermarket. But that does not happen.

12b-1 Fees—Full Disclosure

To make matters worse for the fund investor (the manager is doing just fine), success in the supermarket can bring great challenges to the fund’s investment strategies—challenges that might not be able to be overcome by funds with aggressive investment policies. Funds with high portfolio turnover and funds focusing on stocks with small market capitalizations will have their investment activities muddled by frequent inflows and outflows of cash by supermarket investors. For funds with less aggressive strategies or holding larger stocks, the damage may be less, but it will still exist. Fund shareholders have paid to foster the fund’s growth, and they have been disadvantaged in return.

A recent Harvard Business School doctoral paper came to this conclusion: “There is no evidence that 12b-1 fees generate benefits which are passed along to fund shareholders who pay these fees.”¹ Rather, the study found that considerable harm was visited on fund shareholders. The analysis showed that equity funds without 12b-1 fees had outperformed their peer equity funds with such fees by a margin of 1.5 percentage points per year, an astonishing and highly significant gap.

Total returns of bond funds that are charging 12b-1 fees were only slightly higher than the returns of funds not charging them, but the funds imposing the fees were significantly more risky than their peers. The study noted that bond funds have found a fairly simple “remedy” for the performance penalty engendered by a fee that could consume up to 25 percent of a bond fund’s return: increase risk. That is not a happy consequence for fund shareholders who are not informed about the trade-off. The normal trade-off between risk and return is a sort of one -for-one affair. Here, it is a none-for-one trade-off, bereft of economic sense except for the manager.

It should be apparent to even the most naïve observer that funds cannot spend themselves into success. A poorly performing fund, for example, could spend millions of dollars in vain to overcome the shortcomings of its investment adviser. Funds, like business corporations, should have no guaranteed right to life.

The 12b-1 plan is not necessarily wrong in theory. But it can be justified only when the distribution expenditures paid for by the fund shareholders are recaptured for them in the form of lower future costs, and when full and clear disclosure is provided to investors. But in practice, 12b-1 plans have failed to fulfill their theoretical justification. The truth, as a shareholder proxy should say, but does not, is: “This plan will increase fund expenses and commensurately reduce returns. There is no evidence either that cash inflow will enhance or that cash outflow will diminish the fund’s performance. An increase in the fund’s assets may or may not benefit shareholders, but it is certain to increase advisory fees. These additional revenues may be used to enhance the adviser’s profits, to pay for additional research that benefits the fund’s investors, or to foster the sale of fund shares, which does not benefit the fund’s investors.” Perhaps unsurprisingly, this disclosure has simply never taken place.

Hawking Products, Hiding Risk

Not only are the costs of marketing a burden to investors, but the funds’ insatiable reach for more assets has another pernicious side effect: the creation and promotion of a myriad of untested new products that are apt to be attractive only for a moment in time. That is not a very credible strategy for an industry that once viewed sound investing as a lifetime task. Yet in recent years, the industry has brought to investors at least three novel types of funds that made marketing sense but only investment nonsense: the government-plus fund, the short-term global income fund, and the adjustable-rate mortgage fund.

The government-plus fund, “investing in the safety of U.S. government securities and providing a high return,” reached its crest in 1987, when aggregate assets of the dozen funds that had emerged during the previous two years totaled some $30 billion. One of them advertised a 12 percent return when U.S. Treasury bonds were yielding less than 8 percent. Only common sense was needed to see that the yield was false, that the net asset value would decline, and that the income could not be sustained. That’s just what happened over the following seven years. The decent, unknowing, and generally older shareholders of these funds never recovered their lost capital, and the assets of government-plus funds plummeted. Finally, they abandoned their fruitless strategy, often changing their names. They have not been heard from again.

Next, there was the short-term global income fund. This concept popped up in 1989, a time of 10 percent-plus yields on short-maturity international bonds. This yield quickly attracted investor assets totaling $25 billion, as nearly 40 funds joined the fray. The concept promptly fell on its face; the funds provided average annual returns of only 2 percent in 1992-1996 as net asset values tumbled, nearly offsetting all of the net income. Total assets of short-term global funds were then truly devastated, falling to $2.5 billion in 1996, at which point the category vanished.

Finally, there was the adjustable-rate mortgage fund, the best of this sorry lot, but a failure nonetheless. Billed as akin to a money market fund that offered considerable price stability but a higher yield, it quickly became popular. By 1992, 37 funds had attracted $20 billion in assets. Alas, during the next three years, annual returns averaged only 1.5 percent. By this time, assets had fallen below $5 billion, many funds had changed their objectives and their names, and by 1996 this category too had vanished.

These three examples illustrate the problems created when the fads of the day are allowed to dictate the new financial products offered to investors—when the message is allowed to become the medium. In each case, the fund shareholders paid the piper who had called the tune. The industry proved its marketing savvy, but its management prowess failed to measure up to what reasonable investors had a right to expect. Shareholders lost their capital needlessly, without receiving so much as an apology. The past decade may have been a great decade for creative marketing, but it was hardly great for investment integrity.

This litany of complaints springs from my concern that the mutual fund industry, once a trust service that offered prudent management of other people’s money, is now just another consumer products business. Elements of both have always existed in this industry, but I believe that, since the 1980s, the balance has shifted. The business aspect—a drive for market share, no matter what the cost might be—has sharply increased, and the fiduciary aspect—sound investment programs, fairly priced and fully explained—has been reduced commensurately. Investors are no longer fund owners; they have become mere fund customers.

TEN YEARS LATER

Hawking Products

The move to a product-based industry has hardly slackened over the past decade. Indeed, fund investment management is now often called “manufacturing,” one more indication that the financial sector believes that a mutual fund is no different conceptually from an automobile, a cigarette, a tube of tooth paste, or any other commercial product. So, yes, I still have grave concerns that the fund industry is continuing to become “just another consumer products business.” (My disagreement may be suggested by the fact that when I founded Vanguard, I banned the use of the word product to describe our funds.) So I continue my campaign to treat the human beings who invest in mutual funds as owners, not as mere customers.

Owners versus Customers?

How far has the acceptance of the modern concept of a fund investor as a customer instead of a shareholder spread? Consider the recent controversy between Don Phillips, president of Morningstar, which publishes the preeminent mutual fund journal, and the mutual fund industry. Mr. Phillips urged that the new profile prospectus, designed to make mutual fund information more accessible and reader-friendly for investors, should begin with this paragraph:

When you buy shares in a mutual fund, you become a shareholder in an investment company. As an owner, you have certain rights and protections, chief among them a largely independent board of directors, whose main role is to safeguard your interests.

The opposition was vocal. The president of the Investment Company Institute (ICI), the industry’s trade association, rejected the proposal out of hand, saying that Mr. Phillips was “the only person in the entire industry” who took this position. And the SEC backed up the ICI by not requiring any reference to the concept of ownership in the new profile prospectus, nor even in the more lengthy statutory prospectus.

For the record, however, I am one person who stands firmly allied with Mr. Phillips’s position. The acceptance of a mutual fund as a mere product (or, in ghastly industry parlance, a “packaged product”) is just one more step toward having the marketing message overtake the trusteeship responsibilities. Investors are owners, not customers. The mutual funds in which they invest should accord them the same kind of fiduciary responsibility that they would expect from their accountant or attorney.

An Investment Firm or a Marketing Firm?

Why should investors be concerned when marketing muscle replaces fiduciary duty as the driving force in mutual fund operations? Because this outcome directly counters the interests of investors. Respected financial journalist Jason Zweig expressed this dichotomy beautifully, and in considerable depth, at an industry forum in mid-1997:

Today, the question that you must decide as we face the future is crystal-clear: Are you primarily a marketing firm, or are you primarily an investment firm? You can be mostly one, or you can be mostly the other, but you cannot be both in equal measure.

How do a marketing firm and an investment firm differ?

Let us count the ways:

• The marketing firm has a mad scientists ’ lab to “incubate” new funds and kill them if they don’t work. The investment firm does not.

• The marketing firm charges a flat management fee, no matter how large its funds grow, and it keeps its expenses unacceptably high. The investment firm does not.

• The marketing firm refuses to close its funds to new investors no matter how large and unwieldy they get. The investment firm does not.

• The marketing firm hypes the track records of its tiniest funds, even though it knows their returns will shrink as the funds grow. The investment firm does not.

• The marketing firm creates new funds because they will sell, rather than because they are good investments. The investment firm does not.

• The marketing firm promotes its bond funds on their yield, it flashes “NUMBER ONE” for some time period in all its stock fund ads, and it uses mountain charts as steep as the Alps in all its promotional material. The investment firm does none of these things.

• The marketing firm pays its portfolio managers on the basis of not just their investment performance but also the assets and cash flow of the funds. The investment firm does not.

• The marketing firm is eager for its existing customers to pay any price, and bear any burden, so that an infinite number of new customers can be rounded up through the so-called mutual fund supermarkets. The investment firm sets limits.

• The marketing firm does little or nothing to warn its clients that markets do not always go up, that past performance is almost meaningless, and that the markets are riskiest precisely when they seem to be the safest. The investment firm tells its customers these things over and over and over again.

• The marketing firm simply wants to “git while the gittin’ is good.” The investment firm asks, “What would happen to every aspect of our operations if the markets fell by 67 percent tomorrow, and what would we do about it? What plans do we need in place to survive it?”

Thus, you must choose. You can be mostly a marketing firm, or you can be mostly an investment firm. But you cannot serve both masters at the same time. Whatever you give to the one priority, you must take away from the other.

The fund industry is a fiduciary business; I recognize that that’s a two-part term. Yes, you are fiduciaries; and yes, you also are businesses that seek to make and maximize profits. And that’s as it should be. In the long run, however, you cannot survive as a business unless you are a fiduciary emphatically first.

In the short term, it pays off to be primarily a marketing firm, not an investment firm. But in the long term, that’s no way to build a great business.²

I strongly agree with the thesis expressed by this principled journalist. At the dinner at which he spoke, however, he was vociferously hooted down and challenged by several members of his audience, who took great umbrage at his candid remarks about how investment principles take a backseat when marketing takes precedence over management. As it happened, his audience consisted largely of heavy-spending mutual fund advertisers. But I have absolutely no doubt that, had his forum been populated with mutual fund portfolio managers and research analysts, he would have received a standing ovation.

The Press Gets the Message

The acceptance of the gospel that marketing is the industry’s prime driver—and that product is what the industry offers—is so rife today as scarcely to require validation. But, to remove any doubt, let me present a series of recent excerpts from a variety of financial publications:

• Investment News

Headline: “What Are Funds to Marketers? Just Another Can of Peas.”

Article: “The challenge for fund managers [sic] is how do you stand out in the crowd and get your product off the shelf . . .funds are turning to consumer goods marketers—the toothpaste sellers—to gain an edge over competitors. . . . Fund performance and investment expertise are difficult areas . . . [but] the basic principles of marketing are the same, whether you’ re trying to sell a can of peas or a mutual fund.”

• Institutional Investor

Photo caption quoting the senior executive of a giant fund complex: “Long term, we believe that distribution is king.”

• Fund Marketing Alert

Headline: “Branding Seen as Critical to Investors. But They’re Clueless on Fees.”

Article: “70 percent of investors said that a well-known name is important. A majority do not realize they are paying fees—60 percent don’t know whether they pay 12b-1 (distribution) fees and 40 percent said no when asked whether they pay an advisory fee.”

• Wall Street Journal

Headline: “Mutual Funds Use a New Spin to Sell Wares.”

Article: “Fund companies have begun to sell their wares the way consumer goods companies market cereal and laundry detergent....The [fund] supermarket shelf is crowded, [so] promotional budgets are at record levels.”

Headline: “Now That It’s Harder to Simply Do Well, Mutual Fund Companies Plan the Blitz.”

Article: “Fund managers are finding it increasingly difficult to beat the market averages, so name recognition serves as another weapon in the battle for customers. .. .Performance is not a variable the funds can control.”

• Mutual Fund Market News

Headline: “More Fund Advisers Snare Marketing Pros.”

Article: “Like tangible consumer products, fund manufacturers are hoping for prime shelf space . . . they want investors to love their brand and come back for more . . . asset management expertise is not the determining factor in success, [but rather it is] the ability to get the right product in front of the right audience.”

• Financial World

Headline: “Brand War on Wall Street: Financial services firms are spending millions on their brand names to control your assets.”

Article: “The branding companies aren’t making product pitches based on low fees and high returns . . .they are working toward an image. . . . ‘We want our name to appear next to Budweiser, McDonald’s, IBM, Microsoft, and the car companies,’ says one industry leader. .. .It has become crucial for fund distributors to create demand . . .of course, firms will not be able to justify higher commissions or fees unless they can create at least the impression of value.” (Italics added.)

TEN YEARS LATER

An Investment Firm or a Marketing Firm?

Let’s just say that Jason Zweig, now a columnist for the Wall Street Journal, got it exactly right. He counted 10 ways to distinguish a marketing firm from an investment firm, and each one drew an apt distinction. Nothing has changed since then. By my reckoning, nearly all firms in the field are essentially marketers; very few meet the “investment management” standard. It is a curious paradox that Vanguard is one of these few, since our fund’s dominant investment policy is one of indexing and virtual indexing, where investment management (in the conventional sense) does not come into play.

The True Business—Gathering Assets

Nonetheless, there can be little doubt about where the industry is headed today. A 1995 report by the prestigious investment banking firm of Goldman Sachs & Co., entitled “The Continuing Evolution of the Mutual Fund Industry,” said it well: “Managing money is not the true business of the money management industry. Rather, it is gathering and retaining assets.” An updated report in 1998 reaffirmed the conclusion even more strongly: “The factors crucial to success are shifting from manufacturing to the distribution of asset management product.” From the medium to the message, as it were.

The press understands the nature of the business today, although only a rare journalist examines the negative implications of this baneful trend for fund shareholders. What must be clear is this: Having failed to provide market-beating returns—indeed, having trailed in the wake of the returns provided by the great bull market—the mutual fund industry has effectively dropped its traditional watchword, management, in favor of a new one, marketing. The art of persuasion has crowded out the art of performance.

Given that such expenditures on marketing cut the returns of the funds that incur them, it seems anomalous and unfair to have the existing fund shareholders bear the burden of the costs entailed in attracting new fund shareholders. As logic might suggest, the new shareholders, attracted by the lure of the supermarket’s advertising of the latest “white sale” (the funds with the best recent performance), with the added putative bargain of a “no-fee” marketplace, tend to have much shorter time horizons. They are apt to be highly sensitive to short-term returns, and can move their money seemingly for free. So they shift funds frequently, causing existing shareholders to bear the costs of the extra portfolio turnover as the fund buys and sells stocks to accommodate the inflows and outflows of capital. Serving short-term traders, perhaps even gamblers, at the expense of long-term investors may be a successful strategy for a marketing firm, but it is hardly a successful strategy for an investment firm.

Remedies for the abuses of good management policy that are engendered by the high costs of good distribution policy are not easy to come by. If adequately informed, individual investors can simply turn their backs on funds that charge direct, explicit 12b-1 fees. Fund shareholders can vote against the imposition of such fees, although they have rarely done so in the past and will probably get few opportunities in the future (most fund managers who want them have already imposed them). They could implore the fund’s independent directors to reverse their earlier endorsements, although the record of fund directors ’ taking actions that fund advisers don’t recommend suggests that those who hold hope for this process are leaning on a weak reed.

Is there a cure for the 12b-1 disease? The best remedy is sunlight; we must let more of it shine through the windows. Officials of the Securities and Exchange Commission should bring these issues into the glare of public debate, and collect and disseminate detailed industrywide statistical information on advisory and distribution fees; expenditures on portfolio management and investment research services, advertising and marketing services, and fund operations; and profits earned by advisers.

Mutual funds ought to be held to a higher standard. We are not selling skin care lotions or exotic vacations. We ought not to be selling hopes, dreams, youth, or fitness. We are not a collection of brand franchises à la Procter & Gamble, Budweiser, or Coca-Cola. We should not be hawking consumer products or imitating their naturally aggressive product marketing programs. Mutual funds are—or at least should be—first and foremost stewards of investors’ savings.

What we need in the mutual fund industry is far more focus on the management of shareholder assets and far less on the marketing of fund shares. We need to reorient our thinking about what a fund is, and whom it is designed to serve. Regarding investors as shareholders rather than customers would represent a long-overdue return to the ancient principles of fiduciary duty. And thinking about mutual funds as trusts or trusteed assets rather than products would be a huge step toward improving the lot of today’s fund shareholders. Making whatever sells—never mind whether it will stand the test of time—effectively ignores the welfare of our clients. Making something good and selling what we make would illustrate our desire to place our clients’ interests first.

Our responsibility of trusteeship for the assets of investors who need our help goes far beyond charging what the traffic will bear for our funds. It goes to giving our owners a fair shake. We’ll get there, but only if management replaces marketing in the mutual fund driver’s seat. As I write these words, I’m struck by their similarity to the bedrock principle of the mutual fund industry, explored in the previous chapter, but cited almost 50 years ago in my senior thesis at Princeton: “The principal function of investment companies is the management of their portfolios. Everything else is incidental to the performance of this function.”

It is high time we renewed that mission.

TEN YEARS LATER

Marketing and Management

During the past decade, the fund industry has moved in precisely the opposite direction from the direction I urged. In the past two years alone, consumer advertising by mutual funds totaled nearly $1 billion (of your money). New products—commodity funds, absolute return funds, emerging market funds, exotic types of funds for retirement—grew at the expense of traditional middle-of-the-road equity mutual funds. Even the substantial growth of index funds was largely attributable to the development of new index fund products that could be traded on the stock market all day long, every day, in real time—exchange- traded funds (ETFs), used largely for speculation and often the venue of fund promoters with risky strategies to sell: leverage, double leverage, trading narrow slices of the market, and even clever but untested ways to outperform traditional index funds.

We’ve moved a long way from our mission to serve investors.