Full Statement of John C. Bogle
Founder and Former Chief Executive of The Vanguard Group and
President of the Bogle Financial Markets Research Center
Before the U.S. House of Representatives
Subcommittee on Capital Markets, Insurance, and Government Sponsored
Enterprises of the Committee on Financial Services
March 12, 2003
- Higher costs lead to lower investment returnsimmediately
in the case of money market funds, promptly in the case of bond
funds, and over time in equity funds, irrespective of style and
risk. Over the past twenty years, costs have deprived the average
equity fund investor of nearly one-half of the stock market's
return. Costs matter.
- Over the years, the mutual fund industry has changed in many
ways that have ill-served fund investors. With substantially rising
expense ratios and portfolio turnover, the gap between equity
fund returns and stock market returns has doubled.
- Despite the industry's 114-fold increase in assetsfrom
$56 billion in 1978 to $6.4 trillion in 2002the huge economies
of scale involved, and the addition of much lower cost bond and
money market funds, the expense ratio of the average mutual fund
during this period has risen from 0.91% to 1.36%, an increase
of 49%. There is, however, at least one exception to this trend
of rising costs. The expense ratio of the average Vanguard fund
during the same period has declined 58%, from 0.62% to 0.26%.
- Mutual fund costs include not only expense ratios, but sales
charges, portfolio transaction costs and other expenses. In fact,
expense ratios represent less than one-half of the all-in costs
incurred by fund investors.
- Powerful evidence shows that, despite the staggering growth
in mutual fund assets and huge economies of scale in fund operations,
fund expense ratios have risen sharply over the years, meaning
that the aggregate dollar amount of fees have risen even more
rapidly than fund assets.
- Given the impact of fund costs, their rise over the years,
and the apparent near-obliviousness of investors to these factors,
far better cost disclosure is required. Including information
about the dollar amount of an investor's specific costs in shareholder
statements is an important first step, and can be accomplished
efficiently and economically.
- Fund annual reports should prominently feature data showing
fund returns, expense ratios, portfolio turnover, the costs of
such turnover, and total expenses paid by the fund.
- We have far too little solid information about the nature and
extent, and sources and uses, of the expenses fund investors incur.
It's high time for an economic study of the mutual fund industry.
- Particularly in areas where relative cost is virtually the
sole difference between success and failure (i.e. money market
funds), disclosure of the costs that managers incur for
each of the services they provide is essential.
- Given the obvious success that true arms-length negotiation
of advisory fees has enjoyed in the few instances where it is
practiced, methods of providing such negotiations between funds
and their advisers should be fostered. Increasing the participation
of independent directors, providing them with their own staff,
and requiring that the chairman of the fund's board be an independent
director would all be constructive steps.
The better the investing public is informed about
mutual fund costs, the more likely it is that these costs will at
last be forced to return to reasonable levels and redress the inbalance
between the interests of fund investors and the interests of fund
managers. Giving fund boards true independence from the fund's adviser
would be a major step forward.
I have been both a student of, and an active participant
in, the mutual fund industry for more than half a century. My interest
began with an article in the December 1949 issue of Fortune
magazine that inspired me to write my Princeton University senior
thesis ("The Economic Role of the Investment Company")
on this subject. Upon graduation in 1951, I joined Wellington Management
Company, one of the industry pioneers, and served as its chief executive
from 1967 through January 1974. In September 1974, I founded the
Vanguard Group of Investment Companies, heading the organization
until February 1996, and remaining as senior chairman and director
until January 2000. Since then I have served as president of Vanguard's
Bogle Financial Markets Research Center.
Vanguard was created as a mutual organization,
with its member mutual funds as the sole owners of the management
company, Vanguard Group, Inc. The company operates the funds on
an "at-cost" basis. Essentially, we treat our clientsthe
fund shareholdersas our owners, simply because they are our
owners. We are the industry's only mutual mutual fund enterprise
Recognizing the simple mathematics of the financial
markets is our stock in trade. If a market's annual return, for
example, is 10% and the total cost of financial intermediation is
2½%, then the net annual return to investors in that market
is 7½%75% of the market's return. These mathematics
are eternal, immutable, and unarguable. So the firm that I created
is dedicated above all to minimizing the operating expenses, the
management fees, and the portfolio transaction costs that our shareowners
incur. The objective is to deliver to our investors a return that
is as close as humanly possible to 100% of the return of any market
in which they chose to invest.
I believe it is fair to say that we have succeeded
in minimizing the costs of fund ownership. Since Vanguard's creation,
the Vanguard fund expense ratios have steadily declined, from 0.73%
in 1974 to 0.60% in 1985, to 0.30% in 1994, to 0.27% in 1999, when
they leveled off. (Exhibit I). Last year, the operating expenses
and management fees paid by our funds came to 0.26% of their net
assets, the lowest "expense ratio" of any firm in this
industry. During 2002 the average expense ratio reported by Lipper
Inc. for all stock, bond, and money market mutual funds was 1.36%.
That 1.10% cost saving, applied to our present fund net assets of
$550 billion, results in annual savings for our owners of
Recognizing the critical nature of the link between mutual fund
costs and mutual fund returns has been central to Vanguard's rise
to industry leadership in asset growth, cash flows, and market share.
(Our share of industry assets has risen for twenty consecutive years,
from 1.9% in 1982 to 8.7% in 2002.) That growth has come largely
in areas where the link between cost and return is virtually causal:
Stock index funds (in 1975, we created the first index mutual fund);
index and index-like bond funds (we also created the first such
funds); and money market funds, which are sufficiently commodity-like
to assure that their net yields hold a direct, virtual one to one,
relationship to costs: The lower the cost, the higher the yield
to investors. The net assets of the Vanguard funds in these
three categories total $425 billion, or 77% of our asset base.
This linkage between cost and return is not just
academic theory. It appears most clearly in money market funds,
whose gross returns inevitably cluster around the interest
rate for short-term commercial and bank paper. But when the net
yields of money market funds are considered, the variations
are enormous. With a correlation of 0.96 (1.00 is perfect), the
rankings of money fund yields during the five years 1997-2002
closely paralleled the rankings of money fund costs during
the same period. Simply put, the lowest-cost decile of funds
earned a gross return of 4.80% and deducted an expense ratio of
0.37%, for a net yield of 4.43%. The highest-cost decile
earned 4.67%, deducted 1.74%, and produced a net yield of 2.93%.
(Exhibit II) Money fund investors
could have improved their annual yield by 51% simply by choosing
the lowest-cost funds.
While the correlation between the costs and returns
of actively-managed equity funds is less visible, it is nonetheless
powerful and profound. A study of stock fund returns during the
decade ended June 30, 2001, for example, showed that the low-cost
quartile of funds earned an average net return of 14.5% per year,
while the average high-cost fund earned an average of 12.3%, a 2.2%
gap that was even larger than the 1.2% expense ratio gap
between the two groups (0.64% vs. 1.85%). Exhibit
An additional statistical test showed that this clear
linkage between cost and return prevailed even more strongly when
fund returns were adjusted for risk. The higher-cost funds were
clearly assuming higher risks, and the return gap in favor
of the low-cost quartile rose to 3.0% per year.
The cost-return relationship also prevailed when funds
were grouped by their investment styles (large-cap growth, small-cap
value, etc.), using the nine "Morningstar boxes." Significantly,
the low-cost advantage prevailed in all nine of the style
boxes, with eight of the comparisons yielding a risk-adjusted return
advantage for the low-cost funds in the narrow range of 1.9% to
4.3%. (In the small-cap value group, there were only six funds in
each quartile. Here, the low-cost funds produced 5.3% per year in
Ten-Years Ended June 30, 2001
In both theory and practice, therefore, costs matter.
It therefore follows that fund investors should have full disclosure
of all investment costs.
A Changing Industry
The mutual fund industry that
I read about in Fortune magazine in 1949 is almost unrecognizable
today. Over and over again, the article spoke of "trustee,"
"trusteeship," "the investment trust industry,"
words that we rarely see today. Over the half-century-plus that
followed, in my considered judgment, the fund industry has moved
from what was largely a business of stewardship to a business of
salesmanship, a shifting of our primary focus from the management
of the assets investors have entrusted to our care to the marketing
of our wares so as to build the asset base we manage.
While there may be room to argue about the exact
nature of the change in industry intangibles, there can be
no question about the change in industry tangibles. These
changes can be easily measured. Exhibit
- Today's mutual fund industry is far larger ($6.5 trillion of
assets vs. $2 billion), and offers more asset allocation
choices (then 90% stock funds, now 50% bond and money market funds).
- Equity funds are more risk-oriented, with only one of eight
among 3,650 equity funds generally reflecting the broad stock
market today, compared with nine out of ten of all 75(!)
equity funds doing so in 1949.
- Then, funds were managed by investment committees. Now, the
individual portfolio manager is the modus operandi.
- Measured by annual portfolio turnoverthen 16%, now 110%our
equity fund investment philosophy has moved from long-term investing
to short-term speculation.
- With that change, we have moved away from our earlier active
role in corporate governance to a role that is largely passive.
- Our shareholders, on average, now hold their fund shares
for much shorter periodsjust over two years, compared to
16 years in the 1950s and 1960s.
- As the creation of new funds (often speculative funds, formed
to capitalize on the market fads of the day) has soared, the fund
failure rate has risen to an all-time high. (At present rates,
fully one-half of all of today's funds won't be around a decade
- The costs of fund ownership have also soared, with expense
ratios of the largest funds rising 134%from 0.64% in 1951
to 1.50% in 2002.
- Once a profession practiced almost entirely by privately-held
enterprises, the management of mutual funds has largely become
the business of giant financial conglomerates, which own 36 of
the 50 largest fund managers.
The question is: Have these changes in the fund industry
been a service to fund shareholders? Or have they been counterproductive
to their interests?
Mutual Fund Expenses
The final section of Exhibit
IV endeavors to answer that question: These changes have adversely
affected the returns earned by equity fund investors. Largely
because of far higher costs, the returns earned by the average mutual
fund in the "new" industry has lagged the returns of the
stock market itself (measured here by the Standard & Poor's
500 Stock Index) by a substantially larger amount than the lag during
the era of the "old" industry.1
Specifically, the performance lag has nearly doubled, from 1.6 percentage
points per year to 3.1 percentage points per year. Here are the
||Annual Rate of Return
|Average Equity Fund
|% of Return Captured
by Average Fund
When the impact of these returns and these lags are
compounded over time, the shortfall in the returns earned by fund
investors is dramatic. This example shows the returns on a $10,000
initial investment at the start of each period:
Proift on $10,000 Initial Investment
|Average Equity Fund
|% of Cumulative Market
Profit Captured by Average Fund
It is the investor who puts up 100% of the capital
and takes 100% of the risk. Yet in this example, the investor in
the average mutual fund received only a bit over one-half of the
market's profit in the recent bull market. It would seem obvious
that we ought to know why.
Fund Costs Make the Difference
As it turns out, the major reason that the return
of the average equity fund lagged the stock market by 3.1% is the
costs that investors' funds incurthe management fees, the
operating expenses, the-out-of-pocket fees, the portfolio transaction
costs, the sales charges, and the "opportunity cost" represented
by the significant cash positions typically held by funds. I estimate
the average annual impact of these costs over the past 20
years as follows:
|Other Operating Expenses
|Portfolio Transaction Costs (estimated)
|Sales Commissions (annualized)
|Opportunity Cost 2
It may be coincidental that the fund costs exactly
match the fund lag, but it is not coincidental that the two
numbers are similar. For intuition tells us, and the record
confirms, that equity mutual funds as a group produce before-cost
returns that are similar to the returns earned by the stock market
itself. After all, when funds buy and sell stocks, it is often among
one another and with other financial institutions. It would strain
credulity to imagine that an entire giant equity fund industrynow
owning nearly one-fourth of all of the stocks in the marketcould
provide a higher return (or, for that matter, a lower return), before
costs, than the return of the very equity market in which it invests.
Trends in Fund Expenses
It seems obvious not only that it is costs that make
the difference between success and failure in investing, but that
fund costs have been in an upward trend over the long-term and are
today at the highest levels in history. Certainly we know
that the expense ratio of the average equity fund has risen from
0.98% in 1978 to 1.61% in 2002, a 64% increase.
Such sweeping industry averages,
heavily weighted by the thousands of new funds that entered the
industry, present one perspective on the rise in fund costs. Another
perspective shows an even larger increase. An examination of the
changes in the expense ratios of the 25 funds that dominated the
"old" industry back in 1951 shows that, despite the fact
that the average assets of these funds had risen nearly 60-fold,
their average expense ratio had risen 66%from just 0.64% to
1.06%. Of the 20 funds that survived this half-century era, only
three (Vanguard Wellington, Fidelity Fund, and American Fundamental)
reduced their expense ratios. The average expense ratio of the other
17 funds rose from 0.60% in 1951 to 1.16% in 2002, an increase of
nearly 100%. Exhibit VI.
This substantial increase in expense ratios, combined
with the staggering growth of fund assets, means that the revenues
generated to fund managers rose almost exponentially. Specifically,
these 25 original funds were operated at an average cost of just
$520 thousand in 1951; in 2002, the average cost of the 20 remaining
funds came to $44 million, a 85-fold increase, dwarfing the 57-fold
increase in assets.
Of course, like the Consumer Price Index, fund operating
costs have risen during this long era, and of course funds are providing
more investor services than heretofore (though modern information
technology has created substantial efficiencies). But the fact is
that there are staggering economies of scale involved in
the investment management process. (When a fund grows from $500
million to $5 billion, the manager hardly requires ten times as
many security analysts.) There is no evidence whatsoever that
fund managers have shared these economies of scale with fund owners.
Indeed, the evidence presented in Exhibit VI clearly shows that
the preponderance of managers have not only arrogated these savings
to themselves, but have increased fees as well, adding to
their already substantial profit margins.
Following the Money
I estimate that the direct expenses incurred by all
mutual funds of all types in 2001 amounted to about $73 billion
dollars (1.1% of average fund assets of $6.7 trillion), of which
about $15 billion represented direct operating costs and $58 billion
represented fees paid to fund managers. Based on the pre-tax profit-margin
of 45%, typical of publicly-held fund managers, we can estimate
that the profits of fund managers total about $26 billion. Thus
the managers' costs of operating the funds came to about $32 billion.
Some $27 billion was probably represented by marketing costs and
other operating costs, with no more than $5 billionabout 7%
of total fund costsexpended on portfolio management and research
services, the principal service that fund investors seek.
The foregoing figures are, I believe, reasonable
estimates. But the fact of the matter is that we simply don't
know nearly as much as we should about where the money goes
in the mutual fund industry. We ought to know. It is high
time that either the SEC or General Accounting Office conduct an
economic study of this industry, showing the specific sources and
uses of shareholder dollars. Given the obvious and crucial role
of fund costs in shaping fund returns, it is high time to "follow
the money," wherever the trail may lead.
Other Studies of Costs
The Investment Company Institute
has produced numerous studies of mutual fund costs over the years.
They purport to show that what they refer to as "the cost of
fund ownership" is not only far below the cost figures presented
earlier in this statement, but reflects a long-term secular downtrend.
But because of a flawed statistical approach and an remarkably narrow
definition of "cost," the ICI conclusions are not supportable.
Exhibit VII. In brief:
- By weighting the data, not by the average fund or by
fund assets, but by sales, the ICI captures, not
a long-term reduction in the costs charged by the industry, but
investors' ever-increasing selection of lower cost funds. Price
competition, however, is properly defined, not by the action
of consumers, but by the action of producers.
- The ICI's original 1998 study noted that the cost reduction
had come largely in funds with extremely high costs, and that
the lowest-cost decile actually increased costs by an estimated
27%. (This analysis was subsequently dropped.)
- The study acknowledged that much of the cost reduction was
attributable to index funds and funds sold to large institutions;
costs for regular equity fund investors were 10% higher than the
- The ICI data also exclude many of the costs of fund
ownership, including the substantial costs of portfolio turnover.
I estimate that these other costs would increase their (flawed)
2001 annual cost figure of 1.28% for equity fund ownership to
2.70%, an increase of more than 100% (i.e. the ICI understates
fund costs by fully 50%). If unweighted, the cost would
rise to another 0.61% to 3.31%, 160% above the ICI figure.
Investors are largely unaware of the high level of
mutual fund costs, and even less aware of the powerful effect of
these costs on the compounding of their returns over the long-term.
Since managers have an obvious vested interest sustaining this ignorance,
I believe that we urgently need new SEC rules that require greater
cost disclosure. Some recommendations:
- Annual mutual fund shareholder statements should inform each
fund owner as to the dollar amount of expenses he or she
is incurring through the fund's expense ratio. This figure should
not be backward-looking, for the calculation complexities
are truly awesome. It should be forward-looking, showing
the expected annual expense based on the value of the shareholder's
investment at year-end. At the same location where the statement
presents the year-end dollar value of the account, it should also
present the dollar amount of expenses expected during the coming
year. That figure would simply be the product of multiplying the
account balance by the fund's most recent annual expense ratio,
or, if materially different, a reasonable estimate of the projected
expense ratio during the coming year. A footnote would present
both the calculation methodology and the expense ratio used to
make the calculation. For example, if a shareholder's year-end
value were $11,212 and the expense ratio were 1.58%, an annual
expense of $177 would be projected on the shareholder's statement.
- The present prospectus cost-impact statement combining expense
ratio and sales charges and providing costs on a $10,000 investment
over three-, five-, and ten-year periods should be modified by
adding transaction costs so the "all-in" cost of fund
ownership is fully disclosed. This disclosure should be included
in both the annual report and prospectus. I emphasize that these
transaction costs go well beyond mere commission costs, to market
spreads, market impact, etc., even as I recognize that these costs
are difficult to measure with precision. But even a rough estimate
(although I believe most managers have much better information
than that) would be better than no estimate at all. Once we have
had some experience with the reporting of these transaction cost
data, we should consider adding transaction costs to the direct
expenses presented in the shareholder statement. For example,
using the above example, if estimated transaction costs were equal
to 1.00% of net assets, all-in costs would be 2.58%, or $289 in
annual costs for the shareholder.
- Cost disclosure in fund annual reports must be enhanced, so
that shareholders can relate fund cost to fund returns. Funds
should be required to present a table, either on the inside cover
of the report or the immediately facing page, the following information:
- The fund's total return for the year, compared to a) whatever
market sector benchmark (if any) it deems appropriate, and
b) the annual return of the broad market in which it invests
(i.e. the total stock market, total taxable bond
market, total exempt bond market), etc.
- Rate of portfolio turnover during the year, and the estimated
impact of transaction costs on returns (i.e., the ratio of transaction
costs to net assets).
- Total costs for the year as a percentage of net assets,
including a) the expense ratio, and b) the transaction cost
- The total dollar amount of costs incurred by the fund
during the year, including the amount of the management fee,
the amount of the 12b-1 fee, and other operating expenses.
Like the disclosure of each investor's costs in the
annual shareholder statement, this added disclosure in the annual
report and would enhance the investors' understanding of the amount
of costs they are incurring and the impact of costs on the returns
A Money Market Fund Example
Cost disclosure is important because cost plays such
a crucial role in shaping the returns earned by fund owners. While
the importance of cost applies to all types of mutual funds, it
is most obvious in money market funds. There, the tension between
operating a fund in the interest of shareholders and operating it
in the interests of management companies can be measured directly.
The impact is virtually dollar-for-dollar. There is simply
no way to seriously allege that a money fund's portfolio manager
can outguess in a meaningful way the vast, efficient and professional
market for short-term funds. (In fact, the record is clear that
in the few cases where managers have attempted to do so, they have
lowered quality standards, resulting in substantial losses for the
fund, typically made whole by its management company.)
As shown earlier in Exhibit I, money fund performance
comes down almost entirely to relative costs. While there are few
examples about the nature of the costs that money funds incur, those
that we have are instructive. The Vanguard money market funds, for
example, are operated at cost by their own employees, and
report the exact amount of costs that they incur on each of the
principal activities involved: 1) investment management; 2) distribution
of shares; and 3) shareholder services and operations. The Smith
Barney money market funds, on the other hand, are among a handful
of money funds that pay separate fees to their external service
providers for each of these three services. Thus, we can make a
fair comparison of where the money goes. During 2000, the money
fund assets of the two groups were virtually identical, so the comparison
Money Market Comparison
*Vanguard's actual investment management
expenses totaled $7,697,000; this figure was doubled to account for
other general management expenses, with the "Service" expenses
||Smith Barney Funds
|Fiscal Year 2000
||Fiscal Year 2000
The aggregate assets of the Smith Barney money funds
in 2000 were $64.8 million compared to $67.4 million for the Vanguard
money funds. Yet the expenses of the two organizations were radically
different. Smith Barney's costs totaled almost $380 million,
nearly 90% higher than Vanguard's costs of just over $200 million.
The former's expense ratio was 0.59%, nearly double the latter's.
Specifically, under their investment management contracts, the funds
paid Smith Barney $257 million to "select the fund's investments
and oversee (their) operations." The actual cost of Vanguard's
analysts and portfolio managers was $8 million. Adding in another
$8 million for management overhead brought the total to almost $16
million. What could possibly account for this gap of $241
million? It couldn't be distribution or shareholder services for,
they are accounted for separately. A money market fund requires
only so much management, and it can't cost but a small fraction
of a quarter of a billion dollars. To the extent that $241 million
gap between Vanguard's costs and Smith Barney's fees
represent a profit to Citicorp, those profits come at the direct
cost of the return earned by the funds' shareholders.
It is for this obvious reason that shareowners deserve
complete information, not only about the costs incurred by their
funds in the form of management fees, but the costs incurred
by their managers in return for providing those services.
Simply providing this information to investors should help bring
the fees that mutual funds pay to their service providers into a
more reasonable relationship to the actual costs those providers
incur, especially in commodity type funds where the ability of managers
to add sustained value is not a possibility. (Or, if it is argued
that there is a small possibility, it is dwarfed by the size of
the fees themselves.)
The cost example used above is, in a sense, unfair.
Of course a mutual at-cost organization such as Vanguard
should deliver lower costs than one operated by a profit-making
firm such as Smith Barney. But the gap seems, well, disproportionate.
What is more, while Vanguard operates its money funds, most bond
funds, and all index funds at cost, it also has entered into numerous
contracts with external investment advisersprofit-making entitiesall
who provide their services to Vanguard's actively managed
funds, engaging in arms-length negotiations to establish appropriate
The fee scales we have negotiated over the years
go back to Vanguard's founding in 1974, when our investment management
fees were reduced in an amount more-than-commensurate with the direct
costs that the funds would incur when the firm assumed the responsibility
for Vanguard's operations. They were reduced again in 1977, and
again by an amount more-than-commensurate with the extra costs incurred,
when Vanguard assumed the responsibility for distribution. At that
point, controlling its own operations and distribution, Vanguard
was in a position to negotiate with its former management company,
Wellington, solely on the basis of its investment advisory
services, just as do the trustees of large corporate pension funds.
As circumstances changed and fund assets grew over
the years, Vanguard negotiated frequent fee reductions with the
external independent investment managers responsible for its actively-managed
funds. Taking into account not only these fee reductions but the
economies of scale involved in Vanguard's shareholder services and
other operations, the average expense ratio for the equity funds
(including index funds) in the Vanguard Group declined from
0.74% in 1978 to 0.66% in 1984, to 0.38% in 1994, and to 0.33% in
2002. During the same period, the expense ratio of the industry's
average equity fund actually increased from 0.98% in 1978 to 1.61%
Credit for much of this 55% drop in Vanguard's
unit costs in face of a 64% increase in the unit costs of
other equity funds came from unremitting arms-length negotiations
with our external advisers, the most recent of which took place
in 1995. Our goal was to adopt steeply-sliding fee scales that would
not require negotiations as assets grew, in effect to demand that
our investors receive their fair share of the advisers' economies
of scale, and in part to anticipate future growth that would not
require the give-and-take tension of frequent fee renegotiations.
For example, the Vanguard Wellington Fund effective fee rate, paid
to adviser Wellington Management Company, was reduced as follows:
At the fund's 2002 asset total of $22 billion, with
a base fee of $8.5 million, and each additional billion-dollar increase
in assets resulting in an additional fee of just $300,000 (three
basis points), the advisory fee average rate is 0.04%. In 2002,
the fund's expense ratio (the fund's share of Vanguard's costs of
0.30%, plus the advisory fee of 0.04%) was 0.34%, 70% below the
1.18% expense ratio of its balanced fund peer group. If Wellington
were today paid under the 1975 fee scale, its fee would have been
$92 million, or $83.5 million larger than the $8.5 million actually
paid to its external advisor.
The Vanguard GNMA fund presents a similar, if starker,
illustration. Following its founding in 1980, the fund grew substantially,
and both its advisory fee and its expense ratio dropped steadily,
from 0.65% at the outset to 0.34% in 1990, to 0.24% in 2002. The
fund's advisory fee scale was reduced as follows:
For 2002, the advisory fee amounted to 0.009% of the
fund's assets (i.e., less than one basis point). (The average
management fee on other GNMA funds appears to be about 0.45%.) At
the fund's present size of $27 billion, it generates fully $2,600,000
in advisory fees to Wellington's fixed-income group, doubtless well
in excess of their costs. While each additional $1 billion of assets
produces an added fee of only $90,000, the extra assetsinvested
as they are in securities whose principal value is guaranteed and
interest payments are guaranteed by the U.S. Governmentcreates
no extra costs for credit research. This miniscule fee rate, added
to the fund's share of Vanguard's operating expenses of 0.23%, brings
its total expense ratio to 0.24%, fully 77% below the expense ratio
of the average GNMA fund, a major advantage to investors. If
the Vanguard GNMA fund had adhered to its original fee schedule,
its fee last year would have been $21 million, more than $18 million
larger than the $2.6 million fee actually paid to its external advisor.
Exhibit X presents the actual
fee schedules for Vanguard's Wellington Fund and GNMA Fund over
Lower fees have been heavily responsible for
the fact that both our Wellington and GNMA funds have provided superior
returns to their shareholders over the years. In 1987 - 2002,
for example, Wellington outperformed 90% of all balanced funds,
and GNMA outperformed 99% of all GNMA funds. Yet our fee rate
reductions are normally very small, and only nominally erode huge
increases in the dollar amount of fees received by
our external advisers. But the examples in Exhibit X clearly illustrate
both the tremendous cumulative impact a number of reductions can
have over time, and the huge value fee negotiations can have for
fund investors. Such arms-length negotiation, however, is conspicuous
only by its absence in the mutual fund industry. Establishing some
way for funds to negotiate with advisers is a change long overdue.
1. To make matters worse, the
return of the average mutual fund shareholder fell far short of
the return earned by the average fund. While the average fund earned
10% during the past two decades, the average fund investor earned
only 2.0%. (See Exhibit IV.) Back
2. In this two-decade period in which annual
stock returns averaged 13%, short-term investments earned an average
of about 5%, an eight percentage point differential. A typical fund
with about 6% in cash reserves, therefore, would have incurred an
opportunity cost about 48 basis "points" (one-half of
one percent per year). Back
to Speeches in the Bogle Research Center.