Chapter 2

The Relentless Rules of Humble Arithmetic²⁰

When asked to reflect on the theme, “Bold Thinking on Investment Management,” I’m happy to leap into the fray, well aware of my reputation as a maverick in the world of investing. But if it’s iconoclastic to focus on the reality of investing rather than the illusions of investing, so be it. Most sophisticated investors already know, deep down, the elemental truth of my central message and accept it. But others—the majority, I suspect—either have kept it out of sight and out of mind, or haven’t fully considered its implications.

Obvious as my message may be, the investment community, which has basked in the sunlight of the glorious financial excesses of the recent era, has a vested interest in ignoring the reality I’ll soon describe. This is not a new problem. Two-and-one-half millennia ago, Demosthenes warned us that “what each man wishes, he also believes to be true.” More recently, and certainly more pungently, Upton Sinclair marveled (I’m paraphrasing here) that “it’s amazing how difficult it is for a man to understand something if he’s paid a small fortune not to understand it.”

But my message today is one that we all jolly-well must understand, for it is central to the operation of our system of financial intermediation that underlies the accumulation of assets in our retirement systems and the collective wealth of our citizenry. In my book, The Battle for the Soul of Capitalism, I call it “investment America”; the current administration in Washington, D.C. calls it our “ownership society.” But whatever words we use, the future of capitalism depends importantly on our understanding my message. That message is simple: Gross return in the financial markets, minus the costs of financial intermediation, equals the net return actually delivered to investors. While truly staggering amounts of investment literature have been devoted to the EMH (the Efficient Market Hypothesis), precious little has been devoted to what I call the CMH—the Cost Matters Hypothesis. However, to explain the dire odds that investors face in their quest to beat the market we don’t need the EMH. We need only the CMH. Whether markets are efficient or inefficient, investors as a group must fall short of the market return by precisely the amount of the aggregate costs they incur. It is the central fact of investing.

Yet the pages of our financial journals are filled with statistical studies of rates of market returns that are neither achievable nor achieved. How can we talk about creating positive Alpha without realizing that after intermediation costs are deducted, the system as a whole has negative Alpha? Of what use is it to speculate on the amount of the equity risk premium when 100 percent of the return on the 10-year Treasury note (or bill, if that’s what you prefer) is there for the taking, whereas as much as 50 percent or more of the real return on stocks can be consumed by the costs of our financial system? How can we ignore the fact that, as a group, unlike those kids out there in Lake Wobegon, we’re all average before costs, and below average once our costs are deducted?

The fact is that the mathematical expectation of the short-term speculator in stocks and the long-term investor in stocks alike is zero. But it is only zero before the substantial costs of playing the game, which will produce a shortfall to the stock market’s return that is precisely equal to the sum total of all those advisory fees, marketing expenditures, sales loads, brokerage commissions, legal and transaction costs, custody fees, and securities processing expenses. So often is this mathematical certainty overlooked that I’m delighted to have the opportunity to focus on it, and on its far-reaching implications.

“Trampling with Impunity on Laws Human and Divine”

With that background, let me now turn to the quotation that I’ve chosen as my title. In 1914, in Other People’s Money, Louis D. Brandeis, later to become one of the most influential jurists in the history of the U.S. Supreme Court, railed against the oligarchs who a century ago controlled investment America and corporate America as well. He described their self-serving financial management and interlocking interests as “trampling with impunity on laws human and divine, obsessed with the delusion that two plus two make five.”²¹ He predicted (accurately, as it turned out) that the widespread speculation of the era would collapse, “a victim of the relentless rules of humble arithmetic.” He then added this unattributed warning—I’m guessing it’s from Sophocles—“Remember, O Stranger, arithmetic is the first of the sciences, and the mother of safety.”²²

As it is said, the more things change, the more they remain the same. Yet, paraphrasing Mark Twain, while the history of the era that Brandeis described is not repeating itself today, it rhymes. Our investment system—our government retirement programs, our private retirement programs, indeed, all of the securities owned by our stockowners as a group—is plagued by the same relentless rules. Since the returns investors receive come only after the deduction of the costs of our system of financial intermediation—even as a gambler’s winnings come only from what remains after the croupier’s rake descends—the relentless rules of that humble arithmetic devastate the long-term returns of investors. Using Brandeis’s formulation, we seem obsessed with the delusion that a 7 percent market return, minus 3 percent for costs, still equals a 7 percent investor return (i.e., that costs are too trivial to be considered).

Of course, no one knows exactly what those intermediation costs amount to. It’s high time that someone, maybe even the CFA Institute, conducts a careful study of the system and finds out. But we do have data for some of the major cost centers. During 2004, revenues of investment bankers and brokers came to an estimated $220 billion; direct mutual fund costs came to about $70 billion; pension management fees to $15 billion; annuity commissions to some $15 billion; hedge fund fees to about $25 billion; fees paid to personal financial advisers, maybe another $5 billion. Even without including the investment services provided by banks and insurance companies, these financial intermediation costs came to approximately $350 billion, all directly deducted from the returns that the financial markets generated for investors before those croupiers’ costs were deducted.

The price of intermediation is going up. In 1985, these costs were in the $50 billion range. And my, how they add up! In the bubble and post-bubble eras (since 1996), the aggregate costs of financial intermediation may well have exceeded $2.5 trillion, all dutifully paid by our stockowners. Of course, some of these costs created value (for example, liquidity). But by definition, those costs not only cannot create above-market returns, they are the direct cause of below-market returns, a dead weight on the amount earned by investors as a group. In investing, all of us together get precisely what we don’t pay for. So it’s essential that we develop a more efficient way to provide investment services.

The Mutual Fund Industry

Perhaps obviously, this line of reasoning brings me to my essay in the January/February 2005 issue of the Financial Analysts Journal about the largest of all of America’s financial intermediaries, the mutual fund industry. “The Mutual Fund Industry 60 Years Later: For Better or Worse?” examines the changes that have taken place in the industry in which I’ve now spent 56 years, for it was way back in 1949 that I began my research for my Princeton senior thesis, “The Economic Role of the Investment Company.” That research has continued to this day. My long study of the field, I regret to report, has persuaded me that the answer to the question raised in the title of my FAJ article was, “for worse.”

While I won’t rehash the article here, I will summarize how the industry has changed.²³ We’ve created a mind-boggling number of new and often speculative funds; we’ve moved from investment committees focused on the wisdom of long-term investing to portfolio manager “stars” engaged in the folly of short-term speculation; we’ve enjoyed an enormous growth in our ownership position in corporate America along with a paradoxical and discouraging diminution of our willingness to exercise that ownership position responsibly, if at all; we’ve imposed soaring costs on our investors that belie the enormous economies of scale in money management; our reputation for integrity, sadly, has been tarred by the brush of scandal; in the larger management companies, we’ve moved away from private ownership in favor of public ownership, and then ownership by financial conglomerates; and we’ve changed from being a profession with aspects of a business to a business with aspects of a profession. As I put it in the article, mutual funds have moved “from stewardship to salesmanship.”

That’s all in the past, of course. As I look to the future, I would add a single thought to that essay, including this warning in my conclusion: “Unless we change, the mutual fund industry will falter and finally fail, a victim, yes, of the relentless rules of humble arithmetic.” I love this industry too much to remain silent as I witness what’s happening—call it, after Robert Frost, my “lover’s quarrel” with the mutual fund industry.

Let’s Look at the Record

When we examine the record of the past two decades, as I did in the Financial Analysts Journal article, the relentless rule that I described earlier has proven hazardous to the wealth of the families who have entrusted their hard-earned wealth to mutual funds. That humble arithmetic—gross return, minus cost, equals net return—has destroyed their wealth in almost precisely the measure in which our CMH suggests. Investors have learned the hard way that in mutual funds it’s not that “you get what you pay for.” It’s that, almost tautologically, “you get what you don’t pay for.”

Let’s look at the record. Over the past 20 years, a simple, low-cost, no-load stock market index fund based on the S&P 500 index delivered an annual return of 12.8 percent—just a hair short of the 13.0 percent return of the index itself. During the same period the average equity mutual fund delivered a return of just 10.0 percent, a shortfall to the index fund of 2.8 percentage points per year, and less than 80 percent of the market’s return. Compounded over that period, each $1 invested in the index fund grew by $10.12—the magic of compounding returns—while each $1 in the average fund grew by just $5.73, not 80 percent of the market’s return, but a shriveled-up 57 percent—a victim of the tyranny of compounding costs.

And that’s before taxes. After taxes equal to 0.9 percentage points, the 500 index fund delivered a return of 11.9 percent; taxes for the average equity fund took a toll of 2.2 percentage points, producing an after-tax return of 7.8 percent, just 41 percent of the index’s return. More relevant, the gap between the equity fund and the index fund rises from 2.8 to 4.1 percentage points per year. The average fund deferred almost no gains during this period; the index fund deferred nearly all. (Deferred taxes may be the ultimate example of how you get what you don’t pay for.)

In fairness, the wealth accumulated in the index fund and the average equity fund should be measured not only in nominal dollars, but in real dollars. Now, the real annual return drops to 8.9 percent for the index fund and to 4.8 percent for the equity fund, obviously the same 4.1 percentage-point gap. But when we reduce both returns by an identical 3.0 percentage points a year for inflation, it will hardly surprise you who are in the mathematical “know” that the compounding of those lower annual returns further widens the cumulative gap. Over the past 20 years, the cumulative profit of each $1 initially invested in the equity fund comes to $1.55 in real terms, after taxes and costs, now only 34 percent of the real profit of $4.50 for the index fund. (Please don’t forget that costs and taxes are deducted each year in nominal dollars, and thus take an ever-rising bite out of long-term real wealth.)

Fund Returns versus Investor Returns

What is more, when we look at the return earned, not by the average fund, but by the average fund owner, the shortfall to the market return gets even worse. As this industry came to focus more and more on marketing and less and less on management, we deluged investors with a plethora of enticing new funds. As the market’s fads and fashions waxed and waned—most obviously in the “new economy” funds of the late market bubble—our marketing experts responded with alacrity. The fund industry aided and abetted the actions of fund investors, who not only poured hundreds of billions of dollars into equity funds as the stock market soared to its high, but chose the wrong funds as well. In addition to the wealth-depleting penalty of fund costs, then, fund investors paid a substantial penalty for the counterproductive timing of their investments, and another large penalty for their unfortunate selection of funds. (Not that investors are totally blameless for these errors.)

Intuition suggests that these costs were large. The data we have, while not precise, confirms that hypothesis. The asset-weighted returns of mutual funds—quite easy to calculate by examining each fund’s quarterly cash flows—lag the standard time-weighted returns by fully 3.7 percentage points per year. Adding that shortfall to the 2.8 percentage point annual lag of time-weighted returns of the average equity fund relative to the 500 index fund over the past two decades, the asset-weighted returns of the average equity fund stockholder fell a total of 6.5 percentage points per year behind the index fund. Average annual return for period: equity fund, 6.3 percent; index fund, 12.8 percent in pre-tax nominal returns.

Applying the tyranny of compounding both to the costs of fund operations and to the costs of, well, fund ownership, each $1 invested at the outset grew by just $2.39 over the full period, compared to the $10.12 growth that was there for the taking, simply by owning the low-cost index fund—only 25 percent of the wealth that might easily have been accumulated simply by holding the stock market portfolio (see Table 2.1).

Much of this extra lag came from the specialized, usually speculative funds that the industry created and promoted. For example, during the bull market upsurge and subsequent bear market in 1998-2003, the asset-weighted returns of the industry’s six largest broadly diversified funds lagged their time-weighted annual returns by an average of less than a single percentage point, while the six largest specialized funds lagged their time-weighted returns by an average of more than 11 percentage points. Compounded during the six-year bubble, the gap in returns was astonishing, with the specialized funds producing a positive time-weighted annual return of 6.6 percent, but losing a cumulative 25 percent of client wealth. On the other hand, despite a slightly lower annual return of 4.5 percent, client wealth in the broadly diversified large funds was enhanced by 30 percent. (That’s a 55 percentage point difference!)

TABLE 2.1 DIVERSIFIED FUNDS VS. SECTOR FUNDS: DOLLAR-WTD. AND TIME-WTD. RETURNS

Two Costly and Counterproductive Trends

The stark pattern that illustrates the huge sacrifices of wealth incurred by fund investors brings me to two other subjects that I referred to in my earlier essay about the mutual fund industry. One is the “marketing-ization” of the mutual fund industry, in which most major firms have come to make whatever funds will sell; the other is the “conglomeratization” of the industry, in which giant international financial institutions, eager to get a piece of the action for themselves—a share in the huge profits made in money management—have gone on a buying binge.

One reasonable proxy—obviously not a perfect one—for differentiating a marketing firm from a management firm is the number of funds it offers. Here, the data speak for themselves, thanks to a Fidelity study of the 54 largest firms, managing about 85 percent of the industry’s long-term assets. The nine firms that operate fewer than 15 mutual funds clearly dominate the rankings, outpacing almost 80 percent of all their common rivals (i.e., their large-cap growth fund vs. other large-cap growth funds, their balanced fund vs. other balanced funds, etc.). On the other hand, the 45 firms with more than 15 funds (averaging 52 funds each!) outpaced only about 48 percent of their peers.²⁴ Marketing focus, apparently, comes at the expense of management results.

A similar pattern prevails when we compare the funds managed by the 13 private companies and the funds managed by the 41 companies that are held directly by public investors (7 firms), or indirectly by publicly held financial conglomerates (34 firms). The funds managed by private companies—the industry’s sole modus operandi until 1958—outpaced 71 percent of their peers, while the funds under the aegis of the conglomerates outperformed but 45 percent. (See Table 2.4 in the Appendix.)

It seems reasonable to assume that a publicly held firm, run by a far-removed management that may well have never looked a fund independent director in the eye, is in the fund business primarily to gather assets and to enhance its brand name, and is far more concerned about the return on its capital than the return on the capital entrusted to it by its mutual fund owners. (We saw something of that syndrome in the recent scandals.) While the conglomerate’s management has a clear fiduciary duty both to its own owners and to the owners of its funds, however, the record suggests that, when fund fee schedules are considered, it resolves that dilemma in favor of its own public owners, ignoring the invocation in the Investment Company Act of 1940 that funds must be “organized, operated, and managed” in the interests of their shareholders, rather than in the interests of their managers.

Looking Ahead

Despite the problems I have described, fund investors (at least those investors who didn’t jump on the bull market bandwagon late in the game) seem satisfied with earning the decidedly moderate positive returns achieved by the funds during the bull market of the past two decades. They seem willing to ignore the generally invisible costs of fund investing, willing to disregard the tax-inefficiency, happy to think in terms of nominal rather than real dollars, and perhaps willing to assume some responsibility for their own mistakes in fund timing and fund selection.

But let’s look ahead to a likely era of lower returns, and measure what might be the typical experience in terms of the investment horizon of a young investor of today. Assume the investor has just joined the workforce and is looking forward to 45 years of employment until retirement and then to enjoying the next 20 years that the actuaries promise—a total time horizon of 65 years.

If the stock market is kind enough to favor us with a total return of 8 percent per year over that period and if annual mutual fund costs are held to 2.5 percent, the return of the fund investor will average 5.5 percent. By the end of the long period, a cost-free investment at 8 percent would carry an initial $1,000 investment to a final value of $148,800. However, the 5.5 percent net return for the investor would increase his cumulative wealth by only $31,500. In effect, the amount paid over to the financial system, also compounded, would come to $116,300.

The investor who put up 100 percent of the capital and assumed 100 percent of the risk, then, received just 21 percent of the return. The financial intermediaries, who put up zero percent of the capital and assumed zero percent of the risk, enjoyed a truly remarkable 79 percent of the return. Indeed, after only the 29th year, less than halfway through the 65-year period, the cumulative return of our young capitalist, saving for retirement, falls behind the cumulative return taken by the financial croupiers, never to return. Devastating as is this diversion of the spoils of investing, it is apparent that few investors today have either the awareness of the relentless rules of humble arithmetic that almost guarantee such a shortfall in their retirement savings, or the wisdom to understand the tyranny of compounding costs over the long-term.

The Wealth of the Nation

If our system of retirement savings were not the backbone of the wealth of the nation and our economic strength, perhaps this wealth-depleting arithmetic would not matter. But it does matter. Our corporate pension plans hold $1.8 trillion of stocks and bonds, our state and local pension plans another $2.0 trillion. Private noninsured pension reserves total $4.2 trillion, insured pension reserves $1.9 trillion, government pension reserves $3.1 trillion, life insurance reserves $1.0 trillion, for a total of $10.2 trillion, or nearly one-half of family assets (other than cash and savings deposits).

Since 1970, our national policy has been to increase private savings for retirement by providing tax-sheltered accounts such as individual retirement accounts (IRAs) and defined-contribution pension, thrift, and savings programs (usually 401(k) plans). The present administration in Washington seems determined to further extend the reach of these tax-advantaged vehicles, along with the amount that each family may invest in them each year. So let’s delve a little further into how the relentless rules of arithmetic affect our “investment society,” or, if you prefer, our “ownership society.”

Certainly, it is clear from the data I’ve presented that the retirement savings of American families are too important to the wealth of our nation to be entrusted to the mutual fund industry. Whatever the case, we know that the system of the tax incentives provided to investors hasn’t worked very well so far. Only about 22 percent of our workers are using 401(k) savings plans; only about 10 percent have IRAs, and about 9 percent have both. And even after three decades of experience with these tax-advantaged plans, the average 401(k) balance is now a modest $33,600, and the average IRA $26,900—hardly the kind of capital with the potential to ultimately provide a comfortable retirement.

In addition, the massive shift that has taken place from defined-benefit plans to defined-contribution plans does not seem to be working well from an investment standpoint. Not only have defined-benefit plans produced higher returns than defined-contribution plans since 1990 (144 percent vs. 125 percent), they have done so with far less volatility, falling only about half as much (-12 percent vs. -22 percent) in the recent down-market years. Part of the shortfall, of course, can be laid to the higher costs that are imposed on investors in defined-contribution plans.

The Humble Arithmetic of Pension Plans

But if our foray into defined-contribution plans is not doing the job it should in terms of producing a solid base for retirement savings, our defined-benefit plans have surely done far worse—not because of the returns they have earned, but because of the excessive returns that they have projected. It is no secret that aggressive assumptions of future returns on pension plans are rife on the financial statements of Amer ica’s corporations. Even as interest rates have tumbled and earnings yields have steadily declined, projections of future returns have soared. General Motors, for example, raised its assumption from 6 percent per year in 1975 to 10 percent in 2000. Why? Because it based its projection on “long-term historical returns.” In effect, General Motors told us, “The more stocks have gone up in the past, the more they’ll rise in the future.” Amazingly, the higher the market rose, the higher the pension plans’ expected returns rose, at least in the GM model.

To be fair, if mutual fund America has ignored the relentless rules of humble arithmetic, its peccadilloes have been vastly exceeded by those of corporate America in its projections of pension fund returns—in fact, a national scandal and an accident waiting to happen. Let’s spend a moment on those relentless rules and analyze what might be reasonable for the future return of a pension plan today, one that assumes a future return of 8.5 percent, as General Motors now does. For the stock portfolio, based on realistic expectations using today’s dividend yield and normal (say, 6 percent) earnings growth, we might say that 7.5 percent is reasonable. Looking at the current yield on a conservative bond portfolio of Treasurys and corporates, we’d project bond returns at about 4.5 percent. Once we deduct estimated plan expenses (say 1.5 percent, including fees, turnover costs, etc.), the arithmetic takes us to a net return of 4.8 percent, a little more than half of 8.5 percent total. Here, I think, is a company either looking for trouble or trying to engineer upward the earnings it reports to its shareholders (see Table 2.2).

TABLE 2.2 REALISTIC RETURN ASSUMPTIONS: CORPORATE PENSION PLAN

When I pursued the issue with General Motors, I was told that the old-policy portfolio (60 percent stocks, 40 percent bonds) is history; General Motors has added alternative investments such as venture capital, and “absolute return” investments like hedge funds. So let’s make some reasonable assumptions about what these new-policy portfolios might hold:²⁵ 30 percent in equities, 40 percent in bonds, 10 percent in venture capital, and 20 percent in hedge funds. Now let’s see what we need to do to reach that 8.5 percent total. If we leave our market returns unchanged, the equity managers will have to beat the stock market by 3 percent a year, and the bond managers beat the bond market by 0.25 percent. If we project venture capital at 12 percent, with smart managers who earn almost 18 percent, and hedge funds at 10 percent, with smart managers who earn 17 percent, and then deduct costs, voila! The pension fund reaches its goal of 8.5 percent per year! (See Table 2.3.)

Leave aside for the moment that equity managers who can beat the market by 3 percent a year are conspicuous by their absence. Leave aside, too, the risks they’ll have to take to do so. Then note that the assumed venture capital returns and hedge fund returns are far above even the historical norms inflated by the speculative boom in IPOs during the market madness of the late 1990s. Then ignore the obviously staggering odds against finding a group of “absolute return” managers who could consistently exceed those norms by six or seven percentage points per year over a decade. Surely most investment professionals would consider these Herculean assumptions absurd. But who really knows?

TABLE 2.3 EARNING AN 8.5 PERCENT RETURN: A TEMPLATE FOR CORPORATE ANNUAL REPORTS

My point, however, is not that no one knows. Assumptions are, after all, only assumptions. Rather, my point is that each corporation’s annual report should present to shareholders a simple table such as this one so that its owners can make a fair determination of the reasonableness of the arithmetic upon which the pension plan is relying to make its pension fund return assumptions. I’d put such a report high on my list of financial statement priorities, and I would hope that serious analysts would take this issue directly to corporate managements and challenge the assumptions that are being made. Corporate boards rarely touch this issue, but shareholders ought to force it.

Alas, dim as the outlook is for defined-contribution plans, the future for defined-benefit plans is fraught with challenges that can only be described as truly awesome. A recent report by Morgan Stanley’s respected accounting expert, Trevor Harris (with Richard Berner), put it well:

Years of mispriced pension costs, underfunding, and overly optimistic assumptions about mortality and retirement have created economic mismatches between promises made and the resources required to keep them. Corporate defined-benefit plans as a whole are as much as $400 billion underfunded. State and local plans, moreover, may be underfunded by three times that amount. Those gaps will drain many plan sponsors ’ operating performance and threaten the defined-benefit system itself, especially if markets fail to deliver high returns, or if interest rates remain low.²⁶

It’s time to align both our private pension system and our government pension systems with the relentless rules of humble arithmetic, just as we must do with the retirement savings of our families, whether they are investing directly in mutual funds or in defined-contribution savings plans. (Those rules of arithmetic also apply to Social Security and the issues surrounding privatization, but these are topics for another day.)

Comparative Advantage versus Community Advantage

I want to close by making the fundamental point of my remarks today: the difference between “comparative advantage” and “community advantage.” Much—sometimes I think almost all—of what I read in the learned journals of finance has to do with what I’ll call comparative advantage, such as capitalizing on a market inefficiency that improves performance relative to the total market, or gaining an edge in return over our professional rivals. But since we ply our trade in what is essentially a closed-market system, and can’t change whatever the returns the markets are generous enough to bestow on us, each dollar of advantage we gain in the market comes only at the direct disadvantage of other market participants as a group.

That’s fine, as far as it goes. As a recent article in the New Yorker put it, however, “What if I turn out to be average? Yet, if the bell curve is a fact, then so is the reality that most [investors] are going to be average.” The article continues, “There’s no shame in being one of them, right? Except, of course, there is. Somehow, what troubles people isn’t so much being average as settling for it. Averageness is, for most of us, our fate.”²⁷ Alas, however, in the world of money management, we are average before costs and losers to the market after costs are deducted—that relentless rule of humble arithmetic that we want to deny, but cannot. Put another way, costs shift our entire bell curve to the left.

None of us wants to be average, and competition, up to a point at least, is healthy in terms of providing the transaction volumes that are required for liquidity and market efficiency. That market efficiency in turn moves us ever closer to a world in which the Efficient Market Hypothesis becomes a tautology. Of course, transaction costs also fatten the wallets of Wall Street’s financial intermediaries. But if the strategy of a given fund remains undiscovered and sustained, that firm will attract more dollars under management, diverting fees into its pockets from the pockets of its rivals. Such success may even allow the firm to charge higher fees, thereby increasing (albeit only modestly, at least at first) its advisory fee revenues, by definition reducing the net returns of all investors as a group.

So it is probably vaguely painful to realize that if the upshot of all our feverish investment activity is designed to advantage Peter, that advantage comes only at the expense of Paul, a defiance of Immanuel Kant’s categorical imperative that we must “act so that the consequences of our actions can be generalized without self-contradiction.” Yet our best and brightest souls are competing in this zero-sum game that ultimately becomes a loser’s game.

Warren Buffett’s crusty but wise partner, Charlie Munger, is disturbed by the commitment of so many exceptional people to the field of investment management: “Most money-making activity contains profoundly antisocial effects. [As high-cost modalities become ever more popular], the activity exacerbates the current harmful trend in which ever more of the nation’s ethical young brain-power is attracted into lucrative money-management and its attendant modern frictions, as distinguished from work providing much more value to others.”²⁸ As Mr. Munger recognizes, in the field of money-making, as far as the interests of clients go there can be no net value added, only value subtracted.

Adam Smith’s invisible hand may give a minority of money managers a competitive edge. But it cannot improve the lot of investors as a group. Yet it is within our power to do exactly that, creating a community advantage that provides value to all investors. Enriching the returns of all investors as a group ought to be a vital goal for society itself, or at least for our ownership society. If capitalism is to flourish, we should be concerned about the recent triumph of managers’ capitalism over owners’ capitalism, not only in corporate America, but in investment America—the field of money management. So long as money-making activity simply shifts returns from the pedestrian to the brilliant, or from the unlucky to the lucky, or from those who naively trust the system to those who work at its margin, of course it has “profoundly anti-social effects.” Wouldn’t making capitalism work better for all stockowners, increasing their returns while holding risk constant, have, well, “profoundly social effects”?

Our Intermediation Society

There are two powerful forces that stand between the idealistic goal “to begin the world anew” in investment America and its realization. One of those forces is money. The field of investment management is so awesomely profitable to its participants that money has become a narcotic, and we are hopelessly addicted to those profits. But the second force may be even more powerful: the reliance of investors on financial intermediaries to protect their interests. While we may think we live in an “ownership society”—albeit one that has miles to go before it achieves its promise—with each passing day there are fewer actual owners of our wealth-generating corporations.

The fact is that we now live in an “intermediation society,” in which the last-line owners—essentially, mutual fund shareholders and beneficiaries of public and private pension plans—have to rely on their trustees to act as their faithful fiduciaries. There is too little evidence of this stewardship today, largely because of the dollar-for-dollar trade-off in which the more the managers take, the less the investors make. But if our 100-million-plus last-line owners and beneficiaries rise up and demand that their stewards provide them with, well, stewardship—how complicated is that!—then all will be well in investment America (or at least better).

So we need to change, not only the costs and the structure of our system of financial intermediation, but the philosophy of its trustees. Way back in 1928, New York’s Chief Judge Benjamin Cardozo put it well:

Many forms of conduct permissible in a workaday world for those acting at arm’s-length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the marketplace. . . . As to this there has developed a tradition that is unbending and inveterate. . . . Not honesty alone, but punctilio of honor the most sensitive, is then the standard of behavior . . . . Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd.

“The Next Frontier”

A final, poignant, note: As I began to wrap up the writing of these remarks, I glanced at the current issue of the Financial Analysts Journal, which includes my history of how the mutual fund industry has changed over the past 60 years. Of course, I was drawn to Keith Ambachtsheer’s insightful essay, “Beyond Portfolio Theory: The Next Frontier.”²⁹

His perceptive thesis noted the conventional wisdom that the next frontier in investing is about “engineering systems to create better financial outcomes for investors. But is it really true?” he asked. He doubted it, suggesting that we ought to be thinking more about information theory—knowledge about the costs of investing, for example—and agency theory—the conflicting economic interests that manager/agents confront when they make decisions on behalf of their investor/principals. He seeks “better outcomes” for investors by virtue of a material reduction in intermediation costs and a “value for money” philosophy in which the driving force is service to clients and beneficiaries. I can only express my deep appreciation for his willingness to stand up and be counted on these issues that are at the core of my message to you today.

It was Mr. Ambachtsheer’s incredibly generous—and, I fear, not entirely deserved—appraisal of the role that I have been fortunate enough to play in articulating these issues over a full half-century that inspired me to provide the strong and perhaps argumentative, even strident, form of my hypothesis—in his words, “too little value at too high a cost”; in my words, after Churchill, “Never has so little been done for so many by so few.” Creating Vanguard as a truly mutual mutual fund complex all those 30-plus years ago was an effort to pave the way for a new kind of financial intermediation that is designed to give investors their fair share of whatever returns our markets are kind enough to deliver. Had I not walked that walk ever since, I’d hardly be in a position to talk the talk I do today.

It has been a wonderful walk, enabling us to keep costs low and performance high, putting service to clients at the top of our priority list, with indexing and disciplined bond management—both focused on the broadest possible diversification—as the drivers of our remarkable growth. Our share of mutual fund assets has now risen for 23 consecutive years, from 1.8 percent in 1981 to 10.5 percent today. I hope you don’t take those comments as bragging. They merely bring me full circle to where I began this commentary, proving, as Schumpeter told us, that “successful innovation is not an act of intellect, but of will.” The fund industry has not yet emulated the innovation that is Vanguard, and it may be too much to ask that it will ever do so. But the message I bring you today is that the Relentless Rules of Humble Arithmetic—along with the attendant fiduciary concepts—will continue to resonate with investors, and they will accept no less. Forewarned is forearmed.

Appendix

TABLE 2.4 MARKETING OR MANAGEMENT?: RELATIVE RETURNS VERSUS NUMBER OF FUNDS (firms offering 15 or fewer funds are shaded)

Firm		Equal-Wtd. % Outperformance*		Number of Funds
Dodge & Cox		98		4
First Eagle		97		5
Calamos		91		8
So. Eastern / Longleaf		90		3
American Funds		79		26
Royce		79		14
Harris Associates		77		7
Vanguard		76		75
PIMCO		76		51
Franklin Templeton		71		100
T. Rowe Price		71		72
Janus		70		21
ING		69		60
Nuveen		65		36
American Century		64		54
WM Advisors		64		15
Davis		62		7
Fidelity		62		207
Waddell & Reed		61		45
USAA		61		31
Oppenheimer		60		48
MFS		59		61
Prudential		59		49
New York Life		58		22
US Bancorp		57		37
Columbia Mgmt		56		72
AllianceBernstein		55		57
Banc One		54		36
Neuberger Berman		54		14
Lord Abbett		53		27
Scudder		52		65
Van Kampen		52		43
Federated		52		37
Evergreen		51		57
Citigroup		50		57
Wells Fargo		50		39
Eaton Vance		49		73
Morgan Stanley Adv		49		50
Goldman Sachs		49		34
The Hartford		48		33
Putnam		47		54
John Hancock		47		35
Dreyfus		45		126
Delaware		44		56
Strong		44		42
Thrivent Fin’l		44		25
Trusco Cap		43		24
Merrill Lynch		40		58
Aim		39		62
Nations Funds		38		42
American Exp		37		60
BlackRock		36		32
Pioneer		33		24
JPMorgan		32		38
15 Funds or Less			More Than 15 Funds
Summary	Performance*	Number of Funds	Performance†	Number of Funds
(Average)	77%	8	48%	52
*Over 10 years.
†Outperformance data are adjusted because Fidelity study ignored initial sales charges and B-class shares.

TABLE 2.5 PRIVATE OR CONGLOMERATE?: RELATIVE RETURNS VERSUS ORGANIZATIONAL STRUCTURE (private firms are shaded, publicly held firms are in italics, and conglomerates are in roman font)

Firm	Equal-Wtd. % Outperformance
Dodge & Cox	98
First Eagle	97
Calamos	91
So. Eastern / Longleaf	90
Royce	79
American Funds	79
Harris Associates	77
PIMCO	76
Vanguard	76
T. Rowe Price	71
Franklin Templeton	71
Janus	70
ING	69
Nuveen	65
American Century	64
WM Advisors	64
Davis	62
Fidelity	62
Waddell & Reed	61
USAA	61
Oppenheimer	60
Prudential	59
MFS	59
New York Life	58
US Bancorp	57
Columbia Mgmt	56
AllianceBernstein	55
Banc One	54
Neuberger Berman	54
Lord Abbett	53
Van Kampen	52
Scudder	52
Federated	52
Evergreen	51
Wells Fargo	50
Citigroup	50
Goldman Sachs	49
Morgan Stan Adv.	49
Eaton Vance	49
The Hartford	48
John Hancock	47
Putnam	47
Dreyfus	45
Strong	44
Delaware	44
Thrivent Fin’l	44
Trusco Cap	43
Merrill Lynch	40
Aim	39
Nations Funds	38
American Express	37
BlackRock	36
Pioneer	33
JP Morgan	32

Summary