Remarks by John C. Bogle, Chairman and Founder
The Vanguard Group, Inc.
To The American Council of Life Insurance
Newport Beach, California
September 4, 1997
Thank you for your kind invitation.
I come from a business that operates on the principle of full disclosure.
So, as a wandering stranger from the mutual fund industry in the midst of
life insurance industry tycoons, I must start in with a disclosure about my
heritage. My great-grandfather, Philander B. Armstrong (1847-1927), spent
his entire career in the insurance industry, founding several
insurance companies, including the Phoenix Mutual and "The Armstrong." But
he moved from advocate to reformer to antagonist during his years in the business.
He was, as it happens, a believer that low costs were essential for policyholders,
and he became something of a missionary. I have a copy of a speech he delivered
to insurance executives in St. Louis in 1886 in which he said: "To save our
business from ruin, we must undertake a vigorous reform and the first step
must be to reduce expenses." He capped his crusade in 1917 by publishing a
book cataloging what he saw as the industry's sins. It was titled "A License
Well, I didn't know all this history until long after I found myself
following a remarkably parallel course in my own career in the mutual fund
industry. I founded Vanguarda mutual-type companyin 1974; my
mission has been to make this a better industry for its shareholders; I too
believe that my industry charges too much; and I've also written a book ("Bogle
on Mutual Funds"Grampa Armstrong and I seem to favor our family names!)
that sharply criticizes many mutual fund industry practices. I quickly add
that I have not come here to lecture you on your shortfalls, if any, but to
draw some historical contrasts between our respective industries, and some
parallel challenges both industries face today.
In this era of unprecedented enthusiasm for common stocks, mutual funds
have become the dominant financial institution in the United States. Total
fund assets now exceed those of bank savings accounts, life insurance reserves,
and private pension reserves. The soaring success of the mutual fund industrydespite
its faultscan truly be described as a phenomenon of historic proportion.
I say that, not only as a student of the history of financial institutions
but as one who has spent nearly a half-century in this industry. I think I
have seen enough during this span to qualify as a thoughtful observer, though
hardly either a disinterested or dispassionate one.
Let's go back for a moment to 1949 when I was a junior at Princeton
University. I was reading an article in Fortune magazine ("Big Money in Boston")
describing mutual funds as a "tiny but contentious industry with great potential."
I decided on the spot to write my senior thesis on this then-obscure field.
And that I did, completing "The Economic Role of the Investment Company" in
1951. I liked what I saw, and decided to try to make a career of it. Walter
L. Morganfounder of Wellington Fund in 1928, and still alive and well
today at age 99liked my thesis and gave me a job. It was the first
break of my business career.
Wellington was then a tiny company and mutual funds a tiny industry,
dwarfed by America's other financial institutions. When I began with Wellington
Fund (then our only fund), its assets were $150 million; mutual fund industry
assets were $2.5 billion; life insurance assets were $55 billion. But, as
they say, "a lot can happen in 50 years." Today, assets in the Vanguard Group
mutual fund organization (of which Vanguard/Wellington Fund is a part) have
increased 2,000-fold to $300 billion; assets in the mutual fund industry have
increased 1,600-fold to $4.1 trillion; life insurance assets have increased
45-fold to $2.4 trillion. That's what happens over time when differential
compound growth rates of, respectively, 18%, 17%, and 8% come into play. "The
magic of compounding" writ large!
I suppose what we have seen over the past half centurybut especially
in the past 15 yearsis what Austrian economist and Harvard Professor
Joseph Schumpeter described in 1911 as "creative destruction"the process
by which one industry strikes at the heart of another by bringing to bear
a novel approach to solving the needs of the publicin this case, its
perceived financial needs. Few would disagree that there has been a sea change"revolution"
is not too strong a wordin the savings and investing patterns of America's
Four Stars That Have Shined On Mutual Funds
The principal basis for the revolution is not hard to find. Stocks have
become the investment of choice by investors; bonds are playing second fiddle.
Equities are the principal (but by no means entire) focus of the mutual fund
industry, and equity market returns of +17% per year over the past 15 years
were by far the highest for any major class of financial assetsimportantly,
in this raging bull market, with very little perceived risk. By contrast, bonds have been the principal focus of the life insurance
industry. While bond market returns of +12% annually were extraordinary during
this periodgreatly improved over earlier periods, albeit with considerable
inflation risk and volatility riskthey have provided only about two-thirds
of the returns on equities. However, when these returns are compounded over
15 yearsstocks +900% versus bonds +400%we are talking, roughly
speaking, about the difference between day and night. It would be little short
of astonishing if this spread in financial market returns had not accounted
for a large part of the striking differential in the growth rates of the two
financial industries. Turning a famous quote on end, you in the life insurance
industry could easily say, "The fault, dear Brutus, is not in ourselves, but
in our stars."
The bull market, on the other hand, has been our shining starfor
better or worse. But there have been at least two other stars that have shone
on the mutual fund industry. One is the federal tax code. In 1976, it was
amended to enable municipal bond funds to exist; in 1980, it was amended to
enable individual investors to open tax-deferred IRAs; and in 1981, it was
interpreted as enabling the establishment of tax-deferred 401(k) thrift plans.
These three salutary tax changes helped cause wide shifts in individual savings
preferences and brought new focus on saving for retirement. And mutual funds
had at the ready the investment programs to meet the needs of an increasingly
different and ever-more-knowledgeable public. Together, municipal bond funds
and investor-directed retirement savings programs account for nearly one-half
of the mutual fund assets today.
And we can't ignore another star that shines on usthe computer
revolution. It provided us with communications technology, transaction technology,
and record-keeping technology without which the mutual fund, as we know it
today, simply could not exist. Imagine mutual funds without 800 numbers. Without
daily asset valuations for retirement plan investments. Without the ability
to handle huge daily cash flows. Without seemingly instantaneous liquidity
(for our investors, as well as our portfolios). Without exchanges among funds.
While technology, by encouraging the use of mutual fund shares by short-term
traders, has played hob with the traditional principles of mutual fund investing
for the long termcreating serious potential problems as yet not fully
recognizedit would be hard to argue that technology has not been a
star in our industry's transformation and growth.
All three starsmagnificent equity markets, beneficial tax changes,
and remarkable advances in information technologyset the stage for
our industry's rise to fame and fortune. But there is a fourth star that has
shone on us, and that starcreative innovationwe can claim as
our own. During the past 15 years, the number of mutual funds has increased
from 700 to 7,000. The industry has greatly broadened from its historical
dependence on equities to include bonds (which, I emphasize, have performed
well in absolute terms) and short-term investments (causing the cream of the
savings market to desert banks in favor of money market funds). And equity
funds now include not only those with the industry's traditional focus on
U.S. blue chip stocks but also funds emphasizing small-cap stocks, international
stocks, and stocks in particular industries.
From perhaps a dozen funds in 1982, a major fund family now encompasses
an average of 150 individual funds. Significantly, no-load fundspurchased
directly, without sales commissions, by investorsnow comprise fully
one-half of industry assets (including money market funds). "A fund for every
investor, and for every purpose under Heaven" could serve as an accurate slogan
for the modern mutual fund industry.
Beneath The Stars, Some Dark Spots
But, beneath these four stars that have shone on us, there are, from
my perspective, some troubling dark spots. First, there is a developing tendency
for funds to be treated as if they were individual stocksactively traded
in apparently commission-free marketplaces (where, in fact, fund investors
end up paying large costs). Since the early 1980s, the average holding period
for a mutual fund share has dropped from more than ten years to less than
three years. The development of this "casino capitalism," it seems to me,
is an absurd way to handle what I have believedfor nearly a half-centuryto
be the greatest long-term investment medium ever known.
Further, the marketing of mutual funds has become highly aggressive,
too much so for an old-timer in an industry that I conceive of primarily as
a trustee for other people's money, and not as a modern-day collection of
Procter & Gambles, Budweisers, or Coca-Colas, hawking "consumer products"
for their "franchise brands." In this business, investing is becoming marketing. The message is becoming the medium. And we appeal far
too much (for me at least) to the desire to accumulate substantial wealth
with ease, to the apparent certainty of doing so through equity funds, and
to the ease of picking superfunds based on their past performance. To compound
the problem, we simply fail to adequately address two critical issues: (a)
the risks and (b) the costs of investing in mutual funds.
Marketing and distribution, of course, are highly expensive functions.
So, "Money is no object" seems to have become our industry's tacit watchword.
But it is the fund shareholder whose money is no object, and the fund manager
who reaps the benefits of the money spent on marketing, earning rising fees
as the assets roll in. At the outset of the growth curve, some beneficial
economies of scale may accrue to a fund's shareholders. Then, shareholders
neither gain nor lose, and the benefits of growth accrue to the manager, who
enjoys rising fees. Finally, as the fund grows to an extremely large size,
fees continue to soar but asset growth constrains portfolio diversification
and liquidity, negatively impacting the shareholders. They have paid to foster
the fund's growth, and they have been disadvantaged in return.
In part because of soaring marketing expenses, fund expense ratios have
risen sharply. Fifteen years ago, the expense ratio of the average equity
mutual fund was 0.75% of assets. Despite the enormous growth in assets since
then (from $50 billion to $2.1 trillion for equity funds alone), today's expense
ratio is 1.55%, more than double. Huge economies of scale exist in this business,
but the fund manager, not the fund shareholder, has been the beneficiary.
Adding in the transaction costs incurred by ever-higher fund portfolio turnover
policies (from 35% per year to 90% a year since 1980) and the drag of cash
reserves, it appears that the future returns of mutual funds may lag market
returns by as much as 2.0% per year, compared to the 1.5% negative gap that
existed shortly after Vanguard began.
Does that gap matter? You bet it does. For in the long run, expenses
make the difference between matching the market's return and falling far short.
Call it the performance gap. Consider this extreme example: In a "normal"
market environment, stocks have earned annual returns averaging 10%. But a
2.0% expense charge would consume one-fifth of that return. Compounded over
time, the difference is enormous: a 10% return takes $10,000 to $1,170,000
over 50 years; an 8% returnthe market return net of 2% expensestakes
it to $470,000. There is a difference! The
investor has surrendered $700,000about two-thirds of his potential
accumulationto the costly financial system. And
the system didn't even put up any of the initial capital.
Thus fund expenses will have to come
downbut probably only when today's carefree perception that costs don't
matter (or at least don't matter very much) becomes tomorrow's economic reality
that costs matterenormously. Costs may, finally, be the difference
between victory and defeat in wealth accumulation. (I should note that 50
years is hardly an "extreme" test period. People now begin a lifetime of working
and investingsay, in a corporate thrift plan or an IRAat age
25, and are still living off the fruits of their accumulation at age 75.)
The industry's unwillingness to recognize the relationship between operating
costs and returns to investorsand its commensurate willingness to raise
pricesopens the door to competitorswithin the industry and without.
In a conventional situation (and with stock prices soaring to all-time highs,
today's situation is hardly conventional), the rising price structure of the
industry should mean opportunities for rivals to come in and compete. In theory,
here is where the life insurance industry comes in, as you have done with
the development of your enormous variable annuity business (and perhaps, ultimately,
will do with variable life insurance). Variable annuity separate accounts
are now a $400 billion business, in which the life insurance industry, I understand,
provides about 45% of the distribution volume, but contracts out most of the
investment management to the mutual fund industry, which has rapidly created
separate account clones modeled on existing mutual funds (a requirement of
the law that has always struck me as ludicrous). That is fair enough competitionand
indeed the business that has developed has helped fund firms to prosper: a
new business channel, as it were, and surely a product worth offering to supplement
traditional fixed annuities.
But if variable annuities are the ointment, cost
is the fly. For from my odd perspectivebut I think also
the perspective of other careful observersthe relatively high cost
of variable annuities frequently completely eliminates the advantage of tax-deferred
investing, and indeed sometimes results in a net disadvantage. This fact was
brought starkly home to me when I recently saw an advertisement for a variable
annuity by a large life insurance company. It described how "tax deferred
compounding builds wealth faster." The ad depicted the results of an investment
of $50,000 over 20 years earning an 8% average annual return (ostensibly the
market return). A bold chart pointed out that at the end of the period the
investment would have been worth $233,000 on a fully tax-deferred basis, a
windfall gain of $87,000 over the value of $146,000 in a currently taxable
But then it offered a footnote: "The illustration does not reflect deductions
for mortality and expenses for administrative charges or for specific portfolio
management fees." To say the very least, that is quite an important omission.
Since these fees might normally run in the area of 2.2%, the 8% market return
would be reduced to 5.8%. Therefore the true final value of the fully tax-deferred
investment would not be $233,000, but $154,000. The $87,000 surplus has been
slashed by 91%, to $8,000. And after taxes payable on withdrawal from the
annuity, the surplus has become a $24,000 deficit.
Given this example, is tax deferral really "building wealth faster?"
I think not. The power of extra costs has destroyed the power of tax deferral.
The "value proposition" presented in the ad has been turned on its head.
Competition, Cost, and Structure
So, the life insurance industry, like the mutual fund industry, had
best keep cost carefully in mind. Because every dayagain, in my biased
viewthere are more financially savvy, intelligent, self-motivated investors
who realize that costs matter. Worse, from
your standpoint, I fear, there are lots of low-cost vultures out there that
are eager to capture their business. Savings-bank life insurance, for all
its limited success so far, is one of them, and bankswith recently
apparent federal government supportseem eager to join the fray. TIAA-CREF
(Teachers Insurance and Annuity Association - College Retirement Equities
Fund) is another. Confession being good for the soul, I must say that Vanguard
is another. What is more, low cost is not only our good fortune and that of
our shareholders. It is our mission.
The premise on which we began the firm in 1974 was that we could succeed
in serving investors faithfully and well by offering investment services on
an "at-cost" basispaying minimal advisory fees and operating expenses,
and charging no sales commissions. (We went "no-load" in 1977.) And once we
embarked on our strategy, at least four good things lay in prospect: (1) Shareholders
would earn more money (primarily because our firm would not earn profits);
(2) The focus would be on risk-averse investing, because our professional
managers, with the cost advantage we afford them, would look good on the performance
charts without taking extra risks with client investments; (3) We would form
a minimal-cost market index fund immediately (and, yes, in 1975, the first
one) because that should be a can't-lose-the-race-in-the-long-run proposition
for investors; and (4) Marketing extravagance and the attendant hype would
be minimized. (Why would we spend our shareholders' money on advertising when
it enriches neither our clients nor our firm?) And indeed, we have been able
to deliver on all four of those promises.
And by the superficial measures of the marketplace, the strategy seems
to have worked. We are now first in the industry in long-term growth rate,
first in current cash inflow, and second in net assets. At the moment, at
least, my main concern is that we are getting so large that we have to work
harder every day to avoid the bureaucratic tendencies that all too easily
result from huge size, and be ever more careful to avoid the liquidity risk
and overdiversification tendencies that arise when investing extraordinarily
substantial investment assets. Fortunately, our initial decision, all those
years ago, to run money in a conservative, quality-oriented, structured-policy
way has been a great boon to us in dealing with the challenges of size. I
suppose our biggest handicap, if such it be, is being viewed as "the enemy" in the mutual fund industry, where our goals and structure remain unique to
But, it is our structure that engenders our mission. We can fairly,
if loosely, be described as a "mutual" mutual fund complex. Our management
organization is owned by the fund shareholders, and run on an at-cost basis
solely on their behalfnot, as is the case elsewhere in our industry,
by a privately or publicly held, profit-seeking corporation. And that is the
driving force of virtually every competitive advantage that we may enjoy.
In this context, I must candidly confess that it is not clear to me
why the major life insurance companies (and, for that matter, the rapidly
vanishing savings banks) have apparently not been able to capitalize on their
mutual structure to demonstrate the same kind of "sustainable competitive
advantage" that we seem to enjoy (at least according to Harvard Business School
strategic guru Michael E. Porter). After all, the mutual structure was developed
by leaders of your industryGrampa Armstrong among themlong before
the U.S. mutual fund industry was born in 1924.
I admit there is a key difference: A mutual fund balance sheet is composed
entirely of equity capital, bereft of debt, and the capital required to enter
this businessif you are patientis close to zero. On the other
hand, life insurance companies and savings banks have, in effect, an enormous
book of policy (or savings) liabilities with a fixed call on assets, and require
at least some significant capital. But the basic similarity is profound: all
three structuresmutual life insurance companies and their policyholders,
mutual savings banks and their depositors, "mutual" mutual funds and their
shareholderswere designed to put the client in the driver's seat. A
structure in which the client is treated not as a mere customer, but as an
owner, has a wonderful mission and even ethical virtues. And that structure
must lead to a strategy that is founded on delivering services at the lowest
reasonable cost. And I maintain a profound conviction that low cost is the
key to long-run success in the financial services field.
It is curious to me, in my ignorance, that the insurance industry seems
to be moving away from the mutual structure, a change apparently fostered
by capital needs as well as an increasingly hostile tax environment. There
are 25% fewer mutual companies today than a decade ago. Mutual companies are
developing new hybrid forms, creating special operating units that can issue
stock. Paradoxically, even the mutual funds formed by mutual life companies
are not truly mutual. (Now there's an awkward sentence!) What I mean is that,
for whatever reason, none of the insurance-sponsored mutual fund families
has chosen to adopt a structure like Vanguard or TIAA-CREF.
Whether insurance company or mutual fund, whether mutual in structure
or stockholder-owned, however, all providers of financial services face the "distribution dilemma." In the mutual fund industry, I can state with confidence
that the dilemma is the direct, frontal conflict between "low cost" (which
impacts the long-term returns earned by investors in the financial markets)
and "distribution power" (which is, today at least, virtually mandatoryand
expensivein the asset- gathering process). In the long run, I believe
the balance will shift toward favoring the client rather than the distribution
Why? Because investors are beginning to recognize that the allocation
of assets between equities and bondsnot the selection of particular
mutual fundsis what will control their long-term returns, and that
active managers claim much but, as a group, deliver nothing. And the reason
is simple: Costs make the difference. Those who ignore this plain fact, faced
by low-cost service providers, run the risk of falling victim to Schumpeter's
principle of creative destruction.
I do not suggest that chartered life underwriters, financial consultants,
and other personal financial advisers are not necessary. In the process of
establishing and implementing a sound investment program, and in estate and
tax planning in this complex world, they are often essential. They deserve
to be paid, and paid well, for the value they add. But, in the competitive
market for financial services today, we must all be working, however painful
it is, to rein in excessive marketing and distribution costs, and to run our
investment management, financial planning, and general operations with an
eye toward much greater cost efficiency. As Grampa Armstrong said in his speech
to insurance leaders in St. Louis 130 years ago: "Gentlemen, cut your costs."
In the information revolution that is upon us, many of the expensive,
once-tedious tasks of financial planning in the face of multiple variablesincluding
market returns, inflation, and taxesare now far less complex and costly.
Websites on computers all across the land can do the unimaginable. Professional
help is still requiredbut against the background of an investing public
that, quite literally, becomes better informed with each passing day. Our
challenge then, is the same as the challenge facing every industry on the
face of the globe: providing better services at lower costs, or preparing
to be creativelyif graduallydestroyed. It is a challenge that
faces each one of us.
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