Bill McNabb on restoring investors' trust

The following is adapted from a speech Vanguard Chairman and CEO Bill McNabb delivered to a group of financial advisors at a Morningstar conference in June 2010.

Some people view trust as kind of a warm and fuzzy topic—something you might have to write an essay about in school, or a nice word to have on a piece of advertising. But trust truly is a critical ingredient in how we function on a daily basis.

Think of a world without trust: You wouldn't get in a car. You wouldn't get on a plane. You wouldn't eat in a restaurant. You wouldn't send your kids to school—and you certainly wouldn't leave them at home by themselves, either. Now think about the role of trust in the financial industry and how essential it is to:

• The currency system.
• The capital markets.
• Borrowing and lending.
• The way we as investment professionals do our jobs every day.

One of the under-told stories of the week following September 11, 2001, was how the financial system held together: The markets were closed and the nation was struggling to cope with the tragedy. But still, certain parts of our industry had to operate. Cash had to be put to work, but there were firms that couldn't operate normally.

So, what happened? Buyers and sellers stepped into the void. And it was all done on handshakes. It was done for the good of clients, the markets and, most importantly, the country. It was done with the trust and understanding that the parties involved would "square up" when the system was up and running again. Trust stabilized the fragile markets behind the scenes at that very difficult time.

Trust has been damaged

Unfortunately, the value of trust is most easily understood in its absence, when it has been damaged or broken.

The recent financial crisis provided hundreds of examples. For instance, on a Wednesday in September 2008, Lehman Brothers told investors that its capital position was strong. By that Friday, the firm was preparing bankruptcy papers.

You could say that Lehman was simply trying to maintain confidence. At this point, it doesn't really matter. It was a last-ditch effort to save a ship that had been taking on water for a long time. And it was part of a culture of firms that had been less than forthright with investors.

In the months since, we've seen global financial markets suffer near-historic losses. We've seen massive government bailouts of some of our largest financial institutions. We've seen entire countries flirt with bankruptcy.

What effect has that had on the average investor? Trust has been damaged and faith has been shaken for investors of all ages:

• If you're in your 20s and are just starting to save for retirement, you've seen the stock market drop 55%, climb 88%, and drop again in a short span. Will an entire generation turn away from investing?
• If you're in your 30s and have been saving for the past decade, you've seen the stock market return essentially 0%.
• If you're in your 40s and have been saving for a bit longer, you've seen the ups and downs of the tech bubble, followed by the ups and downs of this past decade. It's very easy to second-guess your asset allocation decisions.
• If you're in your 50s or 60s, the big question becomes: "Will I have enough for retirement?"

We've seen investors doubt some of the very basic principles of investing and ask questions like, "Do balance and diversification really work?" "Is 'buy and hold' dead?" "Is 'stay the course' still a valid strategy?"

And then, in May 2010, we witnessed the so-called "flash crash," in which the market dropped dramatically and rebounded in a matter of minutes. This reflected the skittishness of the market and caused even greater anxiety for investors.

With so much fear out there, it's clear that we at Vanguard and other investment firms have our work cut out for us.

Rebuilding trust

So how do we rebuild and restore trust?

First, let's look at the regulatory front. We at Vanguard feel very strongly that there are several key opportunities to help restore investor trust:

1. We support the creation of a Financial Services Oversight Council to monitor risk across markets, institutions, and sectors. No one agency was really doing that before the crisis.
2. We'd like to see the derivatives market become less risky and more transparent.
3. What happens when a firm that's "too big to fail" fails? We believe that existing bankruptcy laws are the best guide to protect bond investors in such an event.
4. We must ensure that the SEC and other regulators have the resources they need to both oversee and enforce the rules.
5. We need to understand the cause of the flash crash and make sure similar events don't happen in the future.

The building blocks of trust

Second, let's consider the people issues—in other words, how do we restore trust on an individual level?

At Vanguard, we talk about the three building blocks of trust:

• Simplicity. A great rule in investing is the five-minute rule: If you don't understand an investment in five minutes or less, take a pass. This should apply to sophisticated investors, novices opening their first accounts, and everyone in between.
• Transparency. I would argue that the mutual fund is the most transparent way to invest. You know the securities your fund invests in. You know who's managing the fund. You know how much you're paying. You know how your fund is performing on an absolute basis and against an appropriate benchmark. Contrast that to what you get in a hedge fund, structured investment vehicle, or collateralized debt obligation—in which, at any given time, you might not know any of those things.
• Candor. This means being out front, upfront, and honest. It means telling clients not what they want to hear, but what they need to hear. It means telling investors that it might not be a good idea to invest in a fund just because it had a great quarter. It means, in the depths of a market downturn, telling clients exactly how bad conditions really are—and how we plan to respond.

Why we're in this business

I'll close with one last thought about trust. It's easy to talk about how valuable trust is and about the tactical steps we can take to repair trust, from regulatory reform to plain and simple straight talk. But it's pretty hollow talk if you don't understand—and don't believe—in the why.

Why do people choose to work in the investment industry? There are many reasons. Some like the challenge and excitement. Some are "numbers" people. Some seek big paychecks. But the more important question is, "Why do people use investment products and services?"

Vanguard founder Jack Bogle has always been fond of reminding folks that our clients are "honest-to-God, down-to-earth human beings, each with their own hopes and fears and goals." They're saving for tuition. Or a first home. Or a second home. Or to live comfortably in retirement. Or to leave money to their grandchildren. Or a charity.

It's a good reminder for all of us in the investment industry of why we do what we do. And why we need to work to regain investors' trust and get back to a place where people can save and invest with confidence again.

Note: All investments are subject to risk. Past performance is no guarantee of future results.