Chapter 19
On Structure
The Strategic Imperative
Most mutual fund investors don’t understand how their mutual fund company is organized. Actually, very few of us probably give much thought to the structural organization of the companies with which we do business. Why should we care? Does it matter whether our bank is structured as a savings and loan or a commercial bank? In that case, with up to $100,000 per account insured, most of us probably shouldn’t care about anything but getting the best service and the highest interest rate.
But in the mutual fund business, we ought to care. A fund’s organizational structure can have an enormous impact on our returns. Yet, almost no one pays attention to this issue. The media don’t get it, don’t care, or have accepted the status quo. But the corporate structure of a mutual fund organization is more than a legal curiosity. It is a fundamental determinant of the relationship between the fund complex and the fund shareholder.
With one significant exception, all mutual fund complexes operate under a single structure: a group of related investment companies (mutual funds), owned by their shareholders (or, less commonly, trusts effectively owned by their beneficiaries) and governed by their directors. Each fund in the group contracts with an external management company to manage its affairs in return for a fee. The management company undertakes to provide substantially all of the activities necessary for the fund’s existence: investment advisory services; distribution and marketing services; and operational, legal, and financial services.
Although it has the same basic corporate structure as competing mutual fund organizations, the sole exception marches to a different drummer. Instead of retaining an outside firm to perform the requisite services for a fee, Vanguard Group, the firm that I founded in 1974, manages its own affairs on an at-cost basis. The difference between the two structures is illustrated in
Figure 19.1.
Under the Investment Company Act of 1940, both structures are contemplated. The Act treats them objectively and evenhandedly, in effect suggesting that the choice between them is a neutral one. But whichever is the case, the Investment Company Act clearly states that a mutual fund, owned entirely by its shareholders, is to be operated solely in the owners’ interests, a principle articulated in the Act’s preamble. However, within the existing legal framework, it has proven almost impossible to do justice to this fundamental principle. The industry’s conventional structure rests on a profound conflict of interest between the mutual fund shareholders and the owners of the highly profitable management companies that operate the mutual funds. For when investment returns are divided, the more the manager earns, the less the shareholder earns. A dollar in profits for the management company is a dollar less for the mutual fund shareholders. It’s as simple as that.
FIGURE 19.1 Mutual Ownership Structure versus Traditional Corporate Structure
Contrasting Ownership Structures
In the conventional structure, the fund is merely a corporate shell. Its sole role is to be the legal owner of a portfolio of investment securities. A fund typically exists solely on paper. The shareholders of the funds are its ultimate owners, but, with ownership often spread among hundreds of thousands of investors, it is not these owners who exercise working control. Control is effectively vested in the external management company, which has formed the fund, given (or licensed) it its name, and selected its directors, a majority of whom must be independent of the management company. The company provides the fund’s officers and performs all of the services necessary for the fund’s existence. In return, the fund pays the company an annual management fee, normally calculated as a percentage of the fund’s assets. The company usually performs the same services for perhaps five to 50, or more, sister funds in the same mutual fund complex. The control of the management company is usually vested in one or two owners, or a small group of partners in its employ, or even a set of outside public stockholders.
As a practical matter, under the industry’s existing structure, the fund family is controlled by the adviser; control is completely divorced from ownership. Under a truly mutual structure, in contrast, the fund is owned and controlled by its shareholders, and operated solely in their interests. Just as does a normal corporation, it employs its own officers and staff. The fund family manages its own affairs, but, for the sake of administrative convenience, it does so through a separate management company that is 100 percent owned and controlled by the fund family. The officers and directors, including the independent directors, of both the management company and the fund family are the same. Neither own stock in the management company. Effectively, the mutual structure means that the fund directors provide direction and oversight and take responsibility for the management, not only of the funds themselves, but of the fund complex—the business entity that operates the ongoing activities of the funds as a group. With a truly mutual organization, there is only one master to be served—the fund shareholders.
This fundamental difference between the two disparate corporate structures gives rise to very different corporate strategies. With a mutual structure, an organization has no choice but to pursue strategies that serve solely the needs of its owners, the mutual fund shareholders. By contrast, with a bifurcated set of masters—the fund shareholders and the management company stockholders—the traditional mutual fund complex pursues a strategy focused on serving both groups, each of which has very different needs. Sheer logic would suggest that these radically different forms of organizational structure would entail remarkably different corporate strategies. And they do. Function follows form in the fund industry. This principle is the antithesis of the great Louis Sullivan’s principle of architecture: “Form follows function.” Actual, if limited, industry experience has confirmed this important linkage. Strategy follows structure.
Before we turn to the contrasting strategies that differentiate the two kinds of structure, let’s first explore in more detail the issue of ownership and, in particular, the powerful financial incentives that have contributed to the industry’s prevailing convention.
History in the Making
Imagine our mutual fund industry as seen by an investor newly arrived from another planet. His first reaction would be confusion. Mutual funds operate under an arrangement that would be almost unimaginable in other corners of the capitalist marketplace. The shareholders, who put their capital at risk in the funds, reap their rewards only after the management companies, retained to operate the fund, receive their fees, spend what they must, and reap their own rewards. Without putting significant (if any) capital at risk, these firms enjoy a large share of the rewards. The rewards that accrue to the fund shareholders depend solely on the net returns earned by the fund. Those that accrue to the management company depend largely on the amount of assets managed for the shareholders. The fund’s relative return—the extent to which it outpaces or falls short of the return of the market, or even the returns of its peers, over the long term—seems, perhaps surprisingly, to exert little influence on the rewards reaped by the adviser.
To an intergalactic observer who knows nothing of the traditional fund structure, this situation would surely seem odd. Why shouldn’t a huge fund complex manage its own affairs? Why doesn’t it operate like virtually all other corporations in America, serving the interests of a single shareholder constituency? (While this system hardly functions with perfection, it works fairly well.) Those questions cannot be resolved using logic. History alone offers answers.
Many of the early mutual funds were founded by trustees for the beneficiaries of the trusts they served; they sought merely to pool the capital of smaller individual investment accounts and achieve diversification and efficiency. However, the dominant industry strain that has emerged—and prevails overwhelmingly today—is the fund group that has been organized by entrepreneurs who invest their capital and their reputation in a company whose mission is to develop, market, and manage a group of funds whose assets will grow to substantial levels.
The economic stakes have become huge. Management companies—nearly all of which, at the outset, were wholly owned by their founders—gradually passed into private ownership by partners and executives of the managers. Later, offerings of shares to the public, a trend that accelerated during the 1970s and 1980s, brought in a whole new set of investors, unrelated to the operations of the complex. Their sole interest was sharing in the growing profits of the managers. Now, in the late 1990s, increasing numbers of fund organizations are being sold to other firms. Earlier combinations of private and public ownership are emerging as giant financial conglomerates.
Based on the going rate—the price at which ownership changes hands—management companies are typically (albeit with some wide variations) worth something in the range of 4 percent of the market value of the fund assets under management. With mutual fund industry assets at more than $5 trillion, the separate management company industry would be worth at least $200 billion—a staggering sum by any measure. To justify this valuation, the acquiring conglomerateurs (or the industry’s existing private partners and public owners) must see the prospect of earning a good return on their capital—say, 12 percent per year after taxes, or 17 percent before taxes. For the owners of the management companies to earn a 17 percent pretax return on their $200 billion investment, fund shareholders would have to pay $34 billion annually over and above the actual cost of providing the funds’ management, marketing, and administrative services. The questions raised for mutual fund shareholders by this structure include:
• Given this diversion of the investment returns available in the financial markets from fund investors to fund managers, should this traditional fund structure prevail?
• Is the setting of the advisory fees that support this structure appropriate and fair?
• Will fund governance be responsive to the seeming imbalance between the interests of fund shareholders and management company shareholders? Or will some acceptable type of mutual structure finally emerge?
TEN YEARS LATER
Fund Ownership Structure
Over the past decade, the fund industry has ignored each of those initial questions. The status quo has been endorsed, over and over again. The traditional external-manager fund structure has remained intact. Not a single firm has joined Vanguard in operating with a truly mutual structure. While (as noted in Chapters 15 and 18) the process for setting advisory fees is under challenge in the U.S. Supreme Court, it remains—so far—in its present mode, inappropriate and unfair, in my judgment, to fund investors. And despite a few SEC- mandated improvements that demand more of fund directors, fund governance remains largely unresponsive to the need for improvement.
It is almost poignant to realize that such resistance to reform continues in an industry that has grown so huge. The $5 trillion industry of a decade ago had grown to $12 trillion in 2007 only to drop back to $9.7 trillion in 2009, following the recent stock market crash. So fund fees and costs are probably at least double the $35 billion level of a decade ago.
In fact, it could be said that the structural problems have worsened. The trend toward ownership of fund managers by giant financial conglomerates has continued. These firms now own and control 21 of the largest 40 fund management companies; another 13 firms are largely owned by public shareholders. Only six firms remain privately held. If “no man can serve two masters” is the standard of the fiduciary, how can public owner ship of fund managers be justified?
Strategy Follows Structure
The answers, it seems to me, ought to depend on which corporate strategy best serves the interests of fund shareholders in the long run. Critical contrasts in strategy would be suggested by the differences between, on the one hand, the conventional industry structure, designed to serve the often-conflicting interests of two sets of owners, and, on the other, the mutualized, internally managed structure, designed to serve the interests of the fund owners alone. Many of these differences in strategy, as it turns out, actually exist today in our sole example of the mutualized structure, as illustrated in
Figure 19.2. With the sole exception of service strategy, these differences are profound.
Profit Strategy
There is no question that the best externally owned management companies strive to earn the highest possible returns—before the deduction of their fees—for the fund shareholders. There is also no question that they strive to maximize their own profits as well. That orientation toward maximizing firm profits (as distinct from fund profits) is mandatory. These organizations are under a fiduciary obligation to their own stockholders, who, like the owners of capital in any organization, expect to earn high returns on their investment. These organizations expect to—and do—receive, from the shareholders of their mutual funds, fees that amply cover their expenses. When their fees appear low relative to other comparable funds, they may seek (and usually receive) fee increases from the fund directors, which are duly ratified by shareholders. Even as the soaring stock market has taken management company profits to levels undreamed of even three years ago, serious reductions in fee rates are conspicuous by their absence. There may not be anything wrong, as such, with the fact that the assets entrusted to these fiduciaries by fund shareholders have become the basis for the creation of scores of centimillionaires among management company shareholders. Indeed, that’s the accepted way for capitalism—as distinct from trusteeship—to work. But with all due respect, there may be a better way.
| Strategy | Mutual Structure | Conventional Structure |
|---|
| 1. Profit | High (for shareholders) | Very high (for manager) |
| 2. Pricing | At cost | What traffic will bear |
| 3. Service | Excellence | Excellence |
| 4. Risk management | Risk intolerant | Risk tolerant |
| 5. Product | Sensible | Faddish |
| 6. Indexing | Missionary zeal | Kicking and screaming |
| 7. Marketing | Conservative | Aggressive |
The mutual organization, too, strives to earn the highest possible return for its fund shareholders. Ideally, it is structured so that its profits are, in substance, rebated to fund shareholders. These so-called profits simply represent the difference between the actual expenses of the mutual organization in operating its funds and the revenues it would have received—at industry norms—if it had been structured as a separate management company. An extra dollar of cost savings for the mutual organization would be an extra dollar in profits for the mutual fund shareholder. It’s as simple as that. So, there is a contrast between the mutual organization’s sole orientation (to enhance the returns of fund shareholders) and the industry’s dual orientation (to enhance the returns of fund shareholders and management company stockholders alike).
Figure 19.2 differentiates between “high” profit orientation for fund investors and “very high” profit orientation for managers. This simply reflects the hardly counterintuitive notion that the drive to make money for others—the fund shareholders—may not be as powerful as the drive to make money for oneself through ownership participation in the management company. When Adam Smith described the concept of the “invisible hand,” he concluded that the individual businessman “generally neither intends to promote public interest, nor knows how much he is promoting it.” Hence, Smith argued that “it is not from the benevolence of the butcher, the baker, or the brewer that we expect our dinner, but from their regard to their own interest . . . their self-love.” So it is in the traditional mutual fund industry. We cannot expect management companies to operate in the public interest. We must recognize the reality that they are in the business of investing other people’s money in order to maximize their own profits, even though those profits come at the expense of their fund shareholders.
Pricing Strategy
The pricing strategy of the conventional (externally managed) fund complex, baldly stated, is to charge what the traffic will bear. Perhaps this strategy arises from the uncritical public acceptance of mutual funds, which have provided remarkably generous absolute returns during the great bull market, even after the deduction of costs. Or perhaps it arises from public ignorance of the role of costs in shaping returns. It may be no coincidence that, in the more sedate investment environment of the 1940s, the traffic could presumably bear an equity fund expense ratio equal to about 0.75 percent of assets per year, for that was the going rate. Today, in an exuberant environment, the traffic bears twice that burden: expense ratios of equity funds average more than 1.50 percent. Industry participants have harnessed their creative energies to justify a whole series of ancillary fees to pay for sales and marketing. The industrywide average expense ratio paid by shareholders of all mutual funds (including bond and money market funds) now approaches 1.2 percent, and continues to rise. In the competition among the externally managed complexes, prices are set by competitors seeking the maximum level that will be perceived as not damaging the returns fund shareholders earn, all the while gaining the managers maximum returns on their own capital. The result: Prices paid by investors are high.
Advisers have long recognized that small increases in fees, often almost invisible to fund shareholders, have an astronomical impact on management company profits. If an adviser to a $25 billion group of equity funds were to raise advisory fees (or add distribution fees) that cause the funds’ expense ratio to rise from 0.80 percent to 1.00 percent, most shareholders would hardly notice, and would vote their approval as required by law. These funds’ costs would remain in well - below-average territory. But the adviser’s fees would rise by 0.20 percentage point, or $50 million. Assuming that the adviser incurs no increase in expenses at the margin, 100 percent of this increase in revenue would filter down to pretax profit. There is a lot of profit leverage in raising fees. When the traffic doesn’t much care about what cost it bears, this is a logical outcome, although it ill-serves fund shareholders.
As a result of the difference in corporate structure, a firm with a mutual structure offers funds at costs that are far less than what the traffic will bear. On the record, funds managed by the industry’s sole mutual organization incur, by far, the lowest costs in the industry. Combined operating, advisory, and distribution costs average less than 0.30 percent of assets annually, or more than 0.90 percentage points below the industry norm of 1.20 percent. Even granting that a smaller mutually structured complex would operate at, say, 50 basis points, the resultant 70-point saving in annual profits—and, therefore, the cost savings to fund shareholders—would be calculated at $70 million for each $10 billion of assets. The mutual fund business is a very profitable business . . . for fund managers.
There are widely divergent views about the cost of mutual fund investing. As demonstrated repeatedly in this book, however, cost matters. In money market mutual funds, with quality held constant, cost differences account for virtually 100 percent of the differences in net yield to the investor; in bond funds, quality and maturity held constant, cost differences may account for about 80 percent of the differences in returns. Because of the utter clarity of the direct link between cost and return in money market and bond funds, their emergence and rise to prominence over the past 20 years raise profound questions about industry price setting, and could in time cause investors, fund sellers, and regulators to challenge the threadbare “what the traffic will bear” standard.
In a stock market that delivers more modest returns, investors in equity funds too are apt to demand a more enlightened standard. If we assume a more or less normal 10 percent return on stocks and adjust it for inflation and taxes, the annual return before fund costs might amount to just 5 percent. Annual all-in costs of, say, 2.5 percent for an equity fund would consume (believe it or not) 50 percent of the real after-tax return. In a low-cost fund, expenses of, say, 0.2 percent per year would consume less than 5 percent of the return. Never forget that while real returns (nominal returns less inflation) are what the investor can spend, it is nominal costs that must be considered in establishing the penalty investors pay through excessive costs. Whether you garner a 10 percent return on your investment or a 5 percent return, and whether it is measured in nominal or real terms, your costs will be 2.5 percent or 0.20 percent, using the range I have illustrated. Intelligent investors must recognize that the penalties of excessive costs in investing—considering potential future returns and adjusting them, first for taxes and then for inflation—are apt to be staggering.
Service Strategy
As the mutual fund industry strives not only to meet clients’ expectations, but to exceed them, service excellence is becoming a commodity. Are there better and worse providers of mutual fund investor services? Of course there are. But the gap between the two is narrowing rapidly, and woe to the firm—whatever its organizational form—that does not measure up to high standards.
Here, little contrast exists between the two types of fund organizations. Under the conventional structure, advisers seek to serve shareholders out of an enlightened sense of self-interest. After all, in the short run at least, an individual shareholder is apt to be far more aware of his or her satisfaction (or dissatisfaction) with service than with costs and their impact on returns. Satisfied shareholders don’t redeem their shares; indeed, in these days of strong financial markets, satisfied shareholders are likely to increase their investments over time and to invest in other funds offered within the complex. To the manager, a satisfied mutual fund shareholder can be described as money in the bank.
A mutual organization nonetheless enjoys an intrinsic advantage that may enhance its commitment to service excellence. The service is a bit different under a mutual structure, in which the shareholders, through their ownership of fund shares, also own the shares of the management company. Many organizations honor the tenet “Treat your customers as if they were your owners.” A mutual organization can, with accuracy, tack on the phrase “because they are our owners.” It may prove to be a critical difference in a fund’s attitude toward serving its clients. What is more, the mutual enterprise is in a position to garner an edge in service because it operates at such low cost. It can easily spend a little more at the margin to go the extra mile for its investors, without impinging significantly on its large cost advantage. The manager of a conventional fund group, in contrast, may be ambivalent about spending more on service, for expenses reduce the profits of the manager, at least over the short term.
Risk Management Strategy
The risk management strategy of conventionally operated equity funds is best characterized by relative indifference—“relative” because funds in the various categories (large-cap growth, small-cap value, etc.) are expected to carry risks generally appropriate to the classification. In the equity fund arena, risk is, at best, a difficult concept to grasp, and the use of short-term price volatility, although easily quantified, is only a crude proxy. In general, however, investors’ expectations regarding risk appear to relate largely to having a fund’s price volatility (however measured) fall roughly in the range of peers with comparable investment characteristics, as exemplified by classification according to the Morningstar tick-tack-toe boxes: value, blended, or growth styles on the horizontal axis; large, medium, or small sizes on the vertical axis. Real risk, of course, comes when the stock market takes a sharp tumble, but history suggests that the declines of the funds in these nine boxes are apt to parallel past experience; for example, large value typically suffers the smallest relative decline, and small growth has the largest decline.
When we consider bond and money market funds, however, many conventionally operated funds have demonstrated considerable risk tolerance. One of the primary differentiators that affects the choice of an income-oriented fund by investors is yield, and a fund’s net yield is largely determined by the relationship between its gross yield and its expenses—a direct, dollar-for-dollar yield trade-off. Over time, yield is the overpoweringly predominant component of total return for fixed-income funds. Differences in net yield, then, largely control differences in long-term return. Advisers of funds with very high expenses have to content themselves with noncompetitive yields, and—assuming only that the marketplace is discerning—with modest fund assets on which to earn their higher fees. Alternatively, they could increase risk, accepting some combination of lower portfolio quality or longer portfolio maturity relative to their low-cost peers, and, by so doing, elevating their net yields to marketplace norms.
Portfolio statistics for bond funds show that a good bit of this mongrelizing of quality and maturity is in fact happening. Bond funds with higher costs tend to maintain lower-quality portfolios. (See Chapter 7.) Sometimes, surprising as it may seem, the combination may even enhance returns (in an environment of high prosperity and falling interest rates, for example), but, in the long run, it will almost surely reduce returns. High cost, in and of itself, may confiscate a large portion—even all—of the risk premium accorded by the financial market to lower-grade or longer-maturity bonds.
In the money market arena, however, there is little room to increase risk, given the stringent quality and maturity regulations promulgated by the U.S. Securities and Exchange Commission. Further, management companies must concern themselves with reputation risk. If a fund’s net asset value dropped from the universally expected (if hardly insured or guaranteed) $1.00 per share to $0.99 per share, it would effectively write itself out of the money fund business. A scarlet letter would be associated with the manager, and the reputation of its bond and equity funds would be tarnished as well. For that reason, there are no instances in which the $1.00 share value of a money market fund of a major fund manager has been imperiled. When money funds have reached too far out on the limb of risk (often to compensate for their high fees) and faced this issue as a result, the funds have been bailed out by their management companies, which have bought the questionable money market investments from them at face value.
The risk management strategy for the mutual organization, in contrast, can be one of risk intolerance. What need is there to reach out for a higher yield on a bond or money market fund if, because of competitively low costs, the fund is already providing a premium yield? If the temptation to climb out to the farthest possible point on the risk limb is virtually irresistible for conventional funds, the temptation can be delightfully resistible for funds operating under the mutual structure, especially for those that maintain quality and constrain variations in maturity. If the yields are equal, as they are apt to be, wouldn’t any intelligent investor seek out a well-run, low-cost AAA-rated intermediate-term insured municipal bond fund in preference to either an A-rated intermediate-term fund or an AAA-rated insured long-term bond fund? Clearly, common sense would dictate such a choice. Contrary to the almost universally accepted maxim that “there is no such thing as a free lunch,” there is a free lunch in the world of mutual funds. High reward does not necessarily entail higher risk. Higher return, where risk is held constant, can be achieved with lower cost.
TEN YEARS LATER
Risk Management Strategy
What I worried about a decade ago, it turns out, was worth worrying about. While the industry’s sole truly mutual mutual fund provider (with its attendant low costs) demonstrated the very risk intolerance in the portfolios of the mutual funds it manages that I described, many high-cost funds—most notably bond and money market funds—demonstrated the very risk tolerance that I expected would develop. Why? Because managers of high-cost fixed income funds have only two realistic means of providing competitive yields: (1) reduce fees to produce higher net yields and/or (2) increase risk to produce higher gross yields.
In bond funds, I warned that “in the long run, [portfolios of lower-quality bonds] . . . will almost surely reduce returns.” And so it was in 2008 among the national municipal bond funds, where only 2 of 185 such funds outpaced their bench mark, with 26 of them falling from -10 percent to -32 per cent (!) in value. Among 1,025 taxable bond funds (corporate or Treasury), with the bond index up 5 percent for the year, 633 funds (more than half ) actually declined (by as much as 79 percent). In fact, the number of funds that outperformed the broad bond market index (182) was surpassed by the number that lost more than 20 percent (186).
The news was even more dire for the shareholders of the closed-end bond funds of one prominent fixed-income manager. Of the manager’s 100 closed-end funds, only two increased in value in 2008. Forty-seven of the 100 funds lost more than 20 percent for the year, including 25 funds that lost more than 33 percent.
Among money market funds, yes, for the first time in memory the use of “questionable money market investments” caused the net asset value of one giant fund to drop below $1.00 per share. And yes, the manager, with resources inadequate to bail out the shareholders at that $1.00 value, was unable to prevent the value from quickly tumbling to about $0.97, causing a flood of liquidations. With that “scarlet letter” branded on its name, the fund effectively went out of business. It’s hard to imagine that a similar fate does not await its manager.
Product Strategy
I abhor the use of the word product to describe a mutual fund—which represents, after all, a diversified investment portfolio under prudent trusteeship—but our industry today is fixated on the development of new products designed less for their disciplined investment characteristics than for their perceived attractiveness to the investing public. “Hot new products”—an even more offensive term, if highly popular with fund marketers—are the name of the game today, the better to raise additional assets, and hence additional fees and profits for their sponsors.
In the current environment, a conventional mutual fund management company almost has an obligation to jump on the bandwagon of product development. If emerging markets are hot, quickly establish an emerging market fund product, and so on. When accumulating assets under management is a crucial goal for the owners of investment advisory firms, there is little incentive to hold back from creating funds that the public seems to demand, irrespective of their intrinsic long-term merit.
Hard experience should have taught this industry that the moment of highest public demand for a new concept strongly tends to coincide with the moment when the balloon has been inflated to the maximum possible extent. We have learned that the best time to sell a concept may be the worst time to buy it. Being “firstest with the mostest” may prove to be “worstest for the mostest.” The fund shareholders pay the consequences. Certainly that has not been an infrequent happening, as witnessed by the experience of the government-plus fund, the adjustable-rate mortgage fund, and the short-term global income fund, all chronicled in Chapter 16.
The mutual organization, however, has no particular need to enter the race for so-called new products. It does not need to attract the most dollars. Its business is not to bring in faddish new business that does nothing significant to enhance shareholder returns, but to earn optimal net returns for its owners. If an investment idea is sound and sensible, even if it is momentarily overvalued by the whims of the marketplace, it may ultimately be a useful member of the fund family because it offers an attractive lower-cost option to the shareholders of its other funds who would otherwise have to invest elsewhere. But, in the fullness of time, the mutual fund organization should have the luxury of choosing its entry point based on investment merits, not on marketing opportunities.
If a truly mutual fund complex is not maximizing its profits in the conventional sense—that is, not seeking entrepreneurial profits for its manager—it can afford to stand above the fray of the mutual fund marketplace when fads emerge and common sense goes on holiday. Just because everyone else is doing it and the industry is making huge profits on new products is no reason for the mutual organization to follow along. Such a structure, given its relative immunity from some of the pressures of the marketplace, should play a major role in a “Just say no” discipline that promotes prudent vigilance in so-called product strategy.
Indexing Strategy
Nearly all mutual funds are actively managed investment portfolios. But passively managed indexed portfolios are now enjoying wide investor acceptance far beyond their limited number (about one fund in every 300). The secret of the success of the index fund is not alchemy. It is its ability to provide extraordinarily broad diversification at extraordinarily low cost (albeit buttressed by the astonishing performance superiority in recent years of the index funds modeled on the S&P 500 Index). It almost goes without saying that fund management companies, with their very high profit orientation and their high pricing strategies, will fail in their mission to create substantial value for their own stockholders if they sponsor only low-cost index funds. Instead, many companies craft tortuous arguments to dismiss the success of indexing, and struggle to keep the investor focused on high-cost active management.
Nonetheless, the significant growth of the index fund—a distinctively different type of new, if you will, “product,” especially in institutional 401(k) savings and retirement plans—has created substantial pressure for conventional managers to enter this arena. Never mind that the offering of low-cost index funds under the same roof as high-cost actively managed funds is a contradiction in terms. But, fearful that their vaunted market share of industry sales volume may drop if they don’t provide an index fund for retirement plan clients, conventional managers have reluctantly begun to offer indexed portfolios, temporarily subsidizing expenses to reduce costs to the level of what traffic will bear in this more sophisticated market. These firms almost have to hope that this particular new product will prove to be a short-term fad that is doomed to long-term failure. If not, it will seriously jeopardize the long-term returns earned by their own management company stockholders.
I have both good news and bad news for them. The good news is that the performance of index funds modeled on the Standard & Poor’s 500 Index will rarely look as powerful as it has in recent years. Indeed, after such a healthy run in the giant-cap stocks that dominate it, the S&P 500 Index may well even lag the total market for a while, as mid- and small-cap stocks finally come to lead the market. The bad news is that index funds are bound to provide long-term returns superior to those of comparable actively managed funds and should outperform about three-quarters of such funds. Elementary mathematics, the industry’s current cost structure, and the lessons of history together make this outcome almost inevitable.
The mutual organization is the logical champion for the index fund concept. Such an organization could not avoid offering an index fund even if it wished to. Low cost is its very stock-in-trade. Indexing may well be a loss leader for the industry, but it has clearly been a gain leader for investors. While the institutional marketplace is dragging the stockholder organizations kicking and screaming into indexing, the mutual organization approaches the task with something akin to missionary zeal. Indexing is destined to become almost infinitely less profitable for fund management companies as investors not only demand index funds as such—the evidence is compelling—but eventually boycott those index funds with sales loads and with high operating costs. For the investor who decides to go the index route, it should take no more than common sense to select solely no-load index funds offered at minimum cost—funds that are much more likely to be provided by mutual organizations.
TEN YEARS LATER
Product Strategy and Indexing Strategy
My impassioned earlier warnings about “hot new products” were largely ignored by the fund industry. The past decade has been rife with the development of products, often of remarkable complexity. We now have market-neutral (hedge) funds; funds that attempt to use the investor’s capital to provide retirement “income”; “absolute return” funds that come very close to promising returns of 1 percent, 3 percent, 5 percent, and 7 per cent above the Treasury bill rate (your choice); funds that allow you to bet that the stock market will fall; funds with leverage that propose to double (or even triple) the profit if you’re right, or double or triple a bet that the market will rise; funds focused on tiny market sectors. Yes, the first decade of the new millennium has seen an orgy of “product development” that seems hell-bent on serving the interests of fund marketers rather than the interests of fund shareholders.
I include indexing strategy along with product strategy in this update because—irony of ironies!—the vast majority of new fund products have been . . . index funds! A decade ago, indexing was dominated by funds with extraordinarily broad diversification and extraordinarily low cost, focused, for example, on the S&P 500 Index or the total stock market (or total bond market) index. But these classic index funds have played second fiddle to another “hot new product” using indexing principles—perhaps the hottest product ever—the exchange-traded fund (ETF). In fact, more than three-quarters of the $546 billion growth in index fund assets since 1999 has come in ETFs; only 23 per cent has come from classic index funds.
While this development is wonderful for ETF managers, the record is clear that these new instruments are being poorly used by investors, as I mentioned in Chapter 5. The vast major ity of these often exotic funds seem to be used for speculation instead of investment, a fact that is reflected in the tremendous lag between the returns earned by the average ETF investor and the returns earned by the funds themselves.
Bottom lines: (1) However sound the construction of most ETFs, investors have generally reduced their returns by invest ing in them; (2) the exciting ETF field has been host to most of the exotic fund creations of the past decade, and they have not worked well. The creators argue that’s the fault of the investors, not the funds. But I hold that true fiduciaries ought to eschew the creation of products of extreme risk, and of products that capitalize on the worst behavioral traits of investors.
Marketing Strategy
If the financial benefits of growth in this industry largely accrue to management companies, not fund shareholders, it follows, then, that stockholder organizations are aggressive asset gatherers. The industry’s largest fund complexes pour up to $100 million annually into media advertising alone. In an earlier era, the industry’s bland tombstone ads were virtually obscured by columns of agate type recording the mutual fund returns in the daily business pages. Today, those staid ads have given way to prime-time television spots: rock-music videos hyping past performance and 20-second theater with melodramatic vignettes. These approaches are likely to cause eventual dissatisfaction born of expectations unrealized by investors.
This high-voltage marketing not only is misleading, but it can have a pernicious effect on the investment results earned by fund shareholders. Marketing and distribution are highly expensive functions, but the burden is borne by the shareholders, not those who promote the fund. “Money is no object” seems to have become the industry mantra in the search for market share and ever-larger management company profits. Why should management companies worry about marketing budgets? Fees paid by shareholders are the source of the dollars, so marketing costs come right out of the investment profits of the fund shareholders. The investor pays to foster the fund’s growth, and suffers in return.
An aggressive marketing strategy is logical and productive for a fund complex that has a conventional structure and is spending a portion of its management fees so as to have larger fees in the future. By the same token, a conservative marketing strategy, with an emphasis not primarily on promotion, but on information, would be a logical and productive strategy for a shareholder-owned complex, operating at cost and so controlling costs the best it can. Like any business organization, a mutual organization would keep an eye on its market share, but only as a rough measure of its success in meeting the needs of the investing public. The mutual organization has two rules: market share is a measure, not an objective; and market share must be earned, not bought.
“Simba and the Food Chain”
It is a rare and delightful pleasure to find a kindred spirit in the investment community who shares my views about the structure problems in investment management. Keith Ambachtsheer, a widely respected commentator on pension investment management, recently compared the actual structure of the profession with the ideal structure. These excerpts from his newsletter begin with this dialogue from Disney’s
The Lion King concerning Simba’s state of mind:
Q: “What’s eating him?”
A: “Nothing—he’s on top of the food chain!”
The owners, executives, and professionals of the investment management industry are today’s undisputed Simbas of the financial food chain. From a personal wealth creation perspective, they are clearly on top. Yet, something seems to be eating at many of them too. That “something” is the continuing large gap between how the industry should operate if it is to produce “quality products at reasonable prices” for its customers, and how it actually operates. Any narrowing of the “Ideal- Actual” gap will result in more money in the pockets of customers, but less in the pockets of the suppliers.
The Market: How It Should Work
The ideal investment management industry should have three key attributes: (1) A high proportion of publicly traded financial assets is managed passively at very low fees by a small number of large, global providers, with the large economies of scale inherent in passive management passed on to the customers; (2) A low proportion of publicly traded financial assets is managed actively for performance-based fees by a larger number of smaller providers, because true value-adding active management is a scarce resource in both capability and capacity; and (3) Industry investment performance information is expressed as risk-adjusted net performance relative to pre-defined investment benchmark portfolios which reflect the managed portfolios’ stated investment policy.
Assessing the “Ideal-Actual” Gap
The actual industry characteristics are very different from the ideal: (1) A low proportion of financial assets is passively managed; (2) A high proportion of financial assets is actively managed for largely asset-based fees rather than performance-based fees; and (3) The managing fiduciaries for pension funds are increasingly aware that active management has been destroying pension fund value. There is little doubt that, were it to be measured properly, value destruction in the mutual fund sector would be greater than in the pension fund sector simply because mutual fund fees are generally higher than the fees pension funds pay.
The “Ideal-Actual” gap seems to be working in reverse today, with suppliers on top collecting asset - based active management fees, and customers at the bottom paying them without getting sufficient value.
Why Is the Financial Food Chain Working in Reverse?
First, it is counterintuitive to many otherwise perfectly rational people that when you throw tens of thousands of very smart investment professionals controlling billions of dollars at the stock and bond markets, pickings get very small. In their heart of hearts, investment professionals understand this reality. However, it is clearly not in their financial interest to make the customers understand too.
Second, most customers still don’t understand the devastating impact high fees have on long-term investment results. This economic reality has not sufficiently penetrated into the mutual fund arena.
The fact that the financial food chain is operating in reverse has not been lost on the investment management industry. The dilemma is that a better “value” balance between what the customers get and what the suppliers will take will generally mean more money for the customers, and less for many of the suppliers.
Narrowing the “Ideal-Actual” Gap
Because of the much higher fees, average results (in the mutual fund industry) will be considerably worse than the not very good results in the pension fund sector. The coming single digit return world won’t be as kind. In a world of 8 percent stock returns and 6 percent bond returns, high fees simply won’t fly. Passive managers will increasingly compete by cutting fees and offering index funds at an extremely low cost. Active managers with enough conviction in their own skill may begin to realize that it is in both their and their clients’ interests to implement performance fees. These factors should elevate customers to the top of the financial food chain, where they surely belong.
1Enlightened industry professionals, institutional 401(k) thrift plans, average investors, securities regulators, think tanks, finance professors, and Nobel laureates want to strike a better balance between the interests of clients and of managers. If they speak out like Keith Ambachtsheer, maybe we can make some progress in shaping a better mutual fund industry for the twenty-first century.
Under these two guidelines, a mutual organization can follow a far more conservative marketing strategy. Because the fund shareholder and fund management are united in their war on costs, a mutual structure implicitly calls for a low-budget approach to advertising. Unlike stockholder organizations that rely on aggressive marketing strategies, a mutual organization is likely to understand that funds are not products, to be sold whenever the investing public seems to fancy them. It would embrace a disciplined marketing strategy, refusing to undertake costly promotional campaigns that do nothing to benefit its fund shareholders.
Looking to the Future
A mutual organization’s corporate structure dictates its basic strategy—reliance on the interaction of the four dimensions of investing: risk, return, time, and cost that I described in Chapter 14. Investors, investment advisers, and academics properly accept that risk and return go hand in hand. But as “Amazing Grace” suggests, what investors have lost may soon be found: the element of cost, and how it is magnified by time. And when investors make this discovery, this industry will have to give increased attention to the heavy costs of fund expenses, portfolio turnover, and excessive taxes, and to the inherent advantages of market indexing.
Allow me to offer some futuristic thoughts on the change of course that might follow and the sparks that might eventually ignite an evolution toward more shareholder-focused strategies, if not a revolution. If this industry is to change, the change must come at the fund shareholders’ behest, just as the American colonists were required to fight to enforce their rights. The management companies, after all, like the Crown in 1776, reap enormous rewards from the status quo. Without pressure from mutual fund investors, they have no incentive to change.
When investors, as a group, begin to demand a fair shake, the forces of supply and demand will eventually invert the industry, putting fund shareholders on top, where they belong. What might prompt investors to demand a fairer shake? Trial and error is one possibility. Investors who get badly burned by a long period of equity underperformance, or even (and much more memorably!) by a significant plunge in stock prices, will not soon return to the industry’s fold. Investors buying hot funds, experimenting with market timing, and shopping and swapping funds with untoward frequency will one day learn, through painful experience, that these short-term approaches have been not only unproductive, but counterproductive.
The Information Age to the Rescue
More optimistically, the promulgation of better investor information may gradually turn the tide. Investors will learn one of the essential principles of investing: Cost matters. Fostered by corporate benefits executives who are responsible for selecting funds for tax-deferred employee stock plans with assets now approaching $1 trillion; self-motivated investors with substantial assets; the Securities and Exchange Commission, as it speaks ever more forcefully from the bully pulpit; and the increasingly sophisticated financial media, the mantra that cost matters will finally take hold. But all of that will take time. As long as present excessive costs persist, time does not run in favor of fund shareholders.
If investors vote with their feet—indicating that they favor long-term investing over short-term, and low cost over high cost—fund managers will finally get the message. A focus on long-term portfolio strategy will supplant today’s frenetic—and costly—trading of portfolio securities. Funds will more clearly define their investment objectives, describe their performance standards, and report candidly on how their results compare with their expectations. The implicit promise of equity fund managers that “We can do better than the market” will be supplanted by: “We can approach 100 percent of the market’s annual return more closely than others who have similar objectives and strategies.” At that point, there would seem to be an obligation to describe to investors how the managers will meet that goal, and then to disclose regularly the extent to which they are meeting it.
Investors must demand that industry creativity turn away from costly marketing efforts and expensive media advertising. What is the point of selling past performance that is almost surely unrepeatable? Or the value of selling hope? (One senior industry marketer approvingly cited perfume as the analogy.) Instead, the industry must focus on better solutions to investors’ needs. An investor with minimal curiosity will learn that the shortest and surest route to top-quartile performance is bottom-quartile expenses. And it shouldn’t take much more to figure out that the taxable investors in this industry—more than half of our shareholders—are being ill-served by the baneful tax and trading costs of high portfolio turnover. Lower costs and new approaches to tax sensitivity must be given a higher priority.
A Message from Another Profession
In Chapter 17, I noted a few comments by my eminent cardiologist, Dr. Bernard Lown, on the subject of the Faustian bargain struck between those who practice medicine and those who (Continued ) provide medical technology. More recently, Dr. Lown has written about the implications of the corporate tidal wave, driven by health maintenance organizations (HMOs), that is engulfing the medical profession. His concern is that the revered corporate bottom line will destroy the relationship between doctor and patient, that “the gatekeeper serves the owner of the gate, not the people trying to get through the gate.”
In this chapter, I have reflected my own concern along these lines, as manifested in the development of the mutual fund industry. The quotation that follows is from Dr. Lown’s recent writings, except that I have changed his medical terms into mutual fund terms (i.e., “patient” becomes “client” or “shareholder”; “doctor” becomes “manager”). The parallels are both disturbing and striking:
Our profession’s fundamental ethics are under assault. Investment management is a calling—at its core a moral enterprise grounded in a covenant of trust between managers and shareholders. The primary mission of the manager is to invest wisely, to work for the promotion of the clients’ financial well-being. Central to the relationship is the expectation that the manager will put the needs of the shareholder first, over and above the interests of any third party.
In contrast, the fund industry is today organized like any other business, arguably more concerned with the flow of revenue, the market share, and the market value of management company stock than with the wealth of clients. Like doctors, however, fund managers must not go back on their commitment to serve as honest stewards of the assets of mutual funds and their investor-owners.
Revision or Restructuring?
Once the industry’s sole focus turns to serving investors as productively as possible, its further evolution will take one of two critical turns: a revision of the status quo that puts more power in the hands of shareholders or a radical restructuring. The radical restructuring would be the mutualization of at least part of the American mutual fund industry. Funds—or at least large fund families—would run themselves. Funds would no longer contract with external management companies to operate and manage the portfolios. Those functions would be performed in-house. Mutual fund shareholders would, in effect, own the management companies that oversee the fund. They would have their own officers and staff, and the huge profits now earned by external managers would be diverted to the shareholders. They wouldn’t waste money on costly marketing campaigns designed to bring in new investors at the expense of existing investors. With lower costs, they would produce higher returns and/or assume lower risks. They would improve their disclosure, and report to their shareholder-owners with greater candor. They might even see the merit of market index funds.
An alternative, and perhaps more likely, turn of events would be the rise of more activist independent mutual fund directors. As noted in Chapter 18, the fund board has so far been a docile body in the industry’s conventional structure. Someday, the independent board members may become ferocious advocates for the rights and interests of the mutual fund shareholders they represent. Were they to do so, they would negotiate aggressively with the mutual fund adviser, allowing the management company to earn a fair profit, but recognizing that the interests of the mutual fund shareholders must always come first. These activist directors would parse the management company’s fee schedule and financial statements, ensuring that fees paid for advisory services are no longer funneled into the adviser’s marketing budget. They would demand performance-related fees that enrich managers only as fund investors are themselves enriched by superior returns. They would challenge the use of 12b-1 distribution fees. Independent directors would also undertake careful analysis of the investment portfolios offered by a fund complex, and would no longer rubber-stamp gimmick funds that have been cooked up by marketing executives to attract attention in an increasingly crowded marketplace. They would approve only portfolios that are based on sound investment principles and meet a reasonable investment need, and the establishment of market index funds would be high on the agenda. In short, the independent directors would become the fiduciaries they are supposed to be under the law, and would aggressively represent the interests of the mutual fund shareholders. It would be quite an imposing bundle of improvements.
If overseen by an activist board, the conventional mutual fund organization would behave much more like a mutually owned complex and recognize that the interests of the mutual fund shareholder must always be paramount. And if the creation and encouragement of activist independent directors might be a more practicable solution than the wholesale mutualization of the American mutual fund industry, then perhaps it is an objective deserving our energies and effort. And who knows? As the values of such a refocused organization move toward the values of the mutual organization, full mutualization may be only a step away.
Enhancing Economic Value
Regardless of the exact structure, mutual or conventional, an arrangement in which fund shareholders and their directors are in working control of a fund—as distinct from one in which fund managers are in control—will lead to funds that truly serve the needs of their shareholders. Under either structure, the industry will enhance economic value for fund shareholders. Fund organizations will focus on the seven strategies outlined in this chapter, seeking to provide investors with a higher share of the rewards of investing, reasonable prices, enhanced services, greater risk control, sensible product development, more index funds, and disciplined marketing efforts. Whatever the precise modus operandi of the mutual fund industry, strategy will follow structure. Function will follow form. In essence, “The form is the whole, from top to bottom, to the last detail—with the same ideas.”
1 2TEN YEARS LATER
Revision, Restructuring, and Economic Value
While a decade has now passed, my hopes for either a revision of the status quo that gives fund managers essentially absolute power over mutual fund governance or a radical restructuring (truly mutual mutual funds) that places the power in the hands of fund shareholders have not been rewarded. I am aware of no cases in which independent directors have become ferocious advocates for the rights and interests of shareholders or have begun to “negotiate aggressively” to reduce fund fee rates. And despite my choosing as the firm’s name a term that means “leader of a new trend,” Vanguard continues to stand alone with its mutual structure. The firm has yet to find its first follower.
