Remarks by John C.
Founder and Former Chairman, The Vanguard Group
At the Miller Center of Public Affairs
The University of Virginia, Charlottesville, VA
February 8, 2006
I'm deeply honored by the invitation to address the Miller Forum,
right here in Thomas Jefferson's "academical village." Of course I'm humbled by the reputations
and accomplishments of the members of your Governing Council and of the scores of our nation's
leaders who have addressed the forum in recent years. But I'm not so intimidated that I could
decline this treasured opportunity to discuss the range of issues of national importance that
are the subject of my newest book, The Battle for the Soul of Capitalism, published
late last year by Yale University Press.
Like so many of you here today, I have been blessed by the
intellectual training and values of a liberal education at a great university. In my case,
it was Princeton, a school linked to Virginia by more than a few great Americans. James
Madison, son of Virginia, patriot, and President of the United States, is also a son of
Princeton, Class of 1771, who later became the first president of our Alumni Association.
And in 1904, Virginia Law graduate Woodrow Wilson, Princeton 1876, who by then was president
of Princeton, was offered the opportunity to serve as the University of Virginia's first
president. Happily for my university, he resisted the temptation and remained in his job,
only to be elected President of the United States in 1912.
While my new book is, obviously, about capitalism, I've done my best
to paint with a broader brush, beginning with an introduction entitled, "Capitalism and American Society."
At the outset, I warn about the striking similarities between the United States today and the Roman
Empire at its peak in the second century A.D. Drawing on Gibbon's epic, The Decline and Fall
of the Roman Empire, I warn, "that no nation can take its greatness for granted . . . For America
to sustain her economic strength, her national power, and her global leadership, our nation's vast
business financial complex" must function with optimum effectiveness. My clear conclusion is that
we are not doing so, in large measure because capitalism has changed, and for the worse.
It is a curious fact that my new book echoes in so many ways the
very principles set forth in my Princeton senior thesis, which focused on the need to put
fund shareowners at the top of the investment food chain. That thesis—and all that
followed—depended on an incredible stroke of luck. In Firestone Library almost 56 years
ago (though it seems like only yesterday), I happened upon the December 1949 issue of
Fortune magazine and learned for the first time that something called "the mutual fund
industry" existed. When I saw the industry described in the article as "tiny but
contentious," I knew immediately that I had found my thesis topic. Completed in the
spring of 1951, it was entitled "The Economic Role of the Investment Company."
Read today, my thesis would probably impress you as no more than
workmanlike, perhaps a bit callow, but above all, shamelessly idealistic. On page after
page, my youthful idealism speaks out, calling again and again for the primacy of the
interests of the owners of mutual fund shares. The prime responsibility (of fund managers)
must always be to their shareholders." And the deal must be fair: "there is some indication
that costs are too high," and that "future industry growth can be maximized by concentration
on a reduction of sales charges and management fees."
After analyzing fund performance, I concluded that "funds can make
no claim to superiority over the market averages," perhaps an early harbinger of my decision
to create, nearly a quarter-century later, that world's first index mutual fund. And my
conclusion powerfully reaffirmed the ideals that I hold to this day: The role of the mutual
fund is to serve—"to serve the needs of both individual and institutional investors . . .
to serve them in the most efficient, honest, and economical way possible . . . The principal
function of investment companies is the management of their investment portfolios. Everything
else is incidental."
All of this gratuitous advice from a callow college senior was, alas,
largely ignored by the fund industry. But the creation of Vanguard in 1974 as a truly mutual mutual
fund group—operated on an "at cost" basis for the benefit of its owners rather than its managers—was
my attempt to walk the walk that I had talked the talk about a quarter-century earlier. Today, I
assure you that my youthful idealism remains intact. Indeed, it is shamelessly reflected not only in
Vanguard, but in my new book, an expression of my concern about our American society today, my
conviction that our system of capital formation is essential to our economic growth and world
leadership, and my acknowledgement that much has gone wrong in that system.
There is much that needs to be fixed, for "the business and ethical
standards of corporate America, of investment America, and of mutual fund America (the three
principal elements of the book) have been gravely compromised." In each of these three arenas,
I discuss not only what went wrong, but why it went wrong, and how to go about fixing it.
Right at the outset I warn the reader that mine is a tough message, bluntly delivered,
opening with this epigram from St. Paul: "If the sound of the trumpet shall be uncertain,
who shall prepare himself to the battle?" In this case, the battle is for the soul of our
So my trumpet, as you'll now hear, is a certain one. Today's
capitalism has departed, not just in degree but in kind, from its proud traditional roots,
a system that served us admittedly imperfectly, but with remarkable effectiveness for the
better part of the past two centuries—a free enterprise system based on open markets and
private ownership, and on trusting and being trusted.
The system worked. Or at least it did work. And then, late in the
twentieth century, something went wrong, a "pathological mutation in capitalism," in the
words of journalist William Pfaff. The classic system—owners' capitalism—had been based
on a dedication to serving the interests of the corporation's owners in maximizing the return
on their capital investment. But a new system developed—managers' capitalism—in which, Pfaff
wrote, "the corporation came to be run to profit its managers, in complicity if not conspiracy
with accountants and the managers of other corporations." Why did it happen? "Because the markets
had so diffused corporate ownership that no responsible owner exists. This is morally unacceptable,
but also a corruption of capitalism itself." And so it is.
Once an "ownership society" in which direct owners of stock held
voting control over corporate America, we have become an "agency society," and we are not
going back. But the agents—largely mutual fund managers and pension fund trustees—have
failed to represent, first and foremost, their principals—pension beneficiaries and owners
of mutual fund shares. These intermediaries consume far too large a portion of whatever
returns our corporations and our financial markets are generous enough to provide, with far
too small a portion of these returns delivered to the last-line investors who have put up
all of the capital and assumed all of the risks.
Curiously enough, what has happened to our system of capitalism is
precisely what this university's great founder warned us about two centuries ago. Hear
Thomas Jefferson: "I hope we shall crush in its birth the aristocracy of our moneyed
corporations which dare already to challenge our government in a trail of strength, and bid
defiance to our laws." We didn't do that, and here are nine quick examples—three each from
corporate America, investment America, and mutual fund America—that reflect the negative
consequences of this change.
In Corporate America:
- One, the staggering increase in managers' compensation.
CEO pay has risen from 42 times the compensation of the average worker in 1980 to 340 times
currently, a 756 percent rise after inflation, while the real income of the average worker has
barely kept pace with the cost of living. Long ago, Herbert Hoover, one of our few businessmen
to serve as President, put it well: "The only trouble with capitalism is capitalists.
They're too darn greedy." Imagine what he'd say today.
- Two, the rise of financial engineering. In a remarkable
manipulation of financial statements, corporate earnings are managed to meet the "guidance"
that these executives give to Wall Street, quarter by quarter. Two of the prize tools for earnings
shenanigans: (1) mergers that are made, not with a sound business rationale, but because of the
consequent opportunity to manage "pro forma" earnings by creating a veritable "cookie
jar" of reserves, to be drawn on at will in order to present a rosy, but false, picture of
corporate growth; and (2) arbitrarily raising the assumptions for future returns on corporate pension
plans, even as prospective returns eroded. Just think of it: In 1981, the 13.9 percent yield on the
long-term U.S. Treasury bond was twice the 7 percent return projected for corporate pension funds.
Currently, despite the fact that the bond yield has tumbled to 4.7 percent—65 percent lower—
the projected pension return is now 8.5 percent, actually 20 percent higher. That return is simply not
going to happen, and the inadequacy of pension plan assets to meet their payout liabilities to retirees
is well on the way to becoming our next financial scandal.
- Three, the failure of our traditional gatekeepers. In the recent
era, auditors, through their provision of highly profitable consulting activities, became partners, if
not co-conspirators, with managements, and relaxed traditional professional standards. Regulators and
legislators (who in 1993 forced the SEC to back down on requiring that option costs to be treated as—of
all things!—corporate expenses) also ignored the public interest. And corporate directors failed to
provide, as I put it in my book, the necessary "adult supervision of these geniuses" who managed
the firms. Put more harshly, in an unattributed quotation that I came across a few years ago, "When we have strong managers, weak directors, and passive owners, don't be surprised when the looting
begins." And that's, of course, what we've seen at Enron, WorldCom, and too many others.
In Investment America:
- One, the vanishing ownership society. Almost unobserved,
direct holdings of stocks by individual investors have plummeted from 92 percent of all stocks in 1950
to only 32 percent today, as corporate control fell into the hands of giant financial institutions—largely
pension funds and mutual funds—whose share soared commensurately, from 8 percent to 68 percent, a virtual
revolution in ownership. But these agents, beset by conflicts of interest, have failed to place front
and center the interests of their principals, passively ignoring the need for good governance and allowing
corporate managers to look primarily to their own interests. As the economists would say, investment
America has an "agency problem."
- Two, the rise of short-termism. Institutional money management,
once an own-a-stock industry (holding an average stock for 6 years during my first 15 years in this field)
has become a rent-a-stock industry, now holding a typical stock for but a single year, or even less.
That sea change caused us to forget about the importance of good corporate governance. When owners are investors, they must care, and care deeply, about the rights and responsibilities of corporate governance,
and must exercise those rights and honor those responsibilities. But when owners are speculators, renters
who merely trade stocks, they could hardly care less. Simply put, as I ask in the book, "If the owners of
corporate America don't give a damn about the triumph of managers' capitalism, who on earth should?" Yet
our new agent/owners remain passive to a fault on governance issues.
- Three, the triumph of illusion over reality. As our professional
security analysts came to focus ever more heavily on illusion—the momentary precision of the price of the
stock—they increasingly ignored the reality—that what really matters is the inevitably vague, but eternally
transcendent, intrinsic value of the corporation. (As investment icon Benjamin Graham, mentor to Warren
Buffett, perceptively put it: "In the short run, the stock market is a voting machine; in the long run
it is a weighing machine.") Measuring up, unfortunately, to Oscar Wilde's piercing description of the
cynic, our money managers came "to know the price of everything, but the value of nothing." But when
there is a gap between perception—illusion—and reality—the business fundamentals of cash flow and
dividends—it is, to state the obvious, only a matter of time until the gap is reconciled . . . inevitably,
in favor of reality.
In Mutual Fund America:
- One, the industry changed. Mutual funds, once a
profession with elements of a business, gradually became a business with elements—and too few
elements at that—of a profession. Our traditional guiding star of stewardship was
transmogrified into a new star—salesmanship. Largely focused on management when I wrote my
Princeton thesis about the industry, our predominant focus today is on marketing—increasing
fee revenues by building up assets under management, often by creating, promoting, and
advertising speculative funds that follow the fads and fashions of the day. As you will soon
learn, our fund investors have paid a terrible price.
- Two, the conglomerates take over. When I entered
this field all those years ago, virtually 100 percent of mutual fund management companies
were privately-held firms, relatively small, and managed by investment professionals. Since
then, they have experienced their own pathological mutation. Today, 41 of the 50 largest fund
management companies are publicly-held, including 35 that are owned by giant U.S. and global financial
conglomerates, largely managed by businessmen bereft of professional investment training. It
shouldn't surprise you to learn that these conglomerates are in the fund business to earn a return on
their capital, not a return on your (the fund investor's) capital. They cannot do justice to both, for
the record is clear that the more the managers take, the less the investors make. Alas, in the fund
industry in the aggregate, you not only don't get what you pay for, you get precisely what you don't pay
- Three, mutual fund returns fall drastically short of market returns.
And they fall short by almost exactly the amount of the costs they incurred—all those management fees,
operating expenses, sales charges, and hidden portfolio transaction costs. How could it be otherwise?
Over the past two decades, for example, the annual return of the average equity fund (10%) has
lagged the return of the S&P 500 Index (13%) by 3 percentage points per year, largely because
of those pesky fund costs. To make matters worse, largely because of poor timing and poor fund selection,
the return actually earned by the average fund investor has lagged the return of the average fund by another 3 percentage points, reducing it to just 7 percent per year—roughly 50% of the market's annual return.
Warren Buffett accurately describes the problem: "The principal enemies of the equity investor are
expenses and emotions." The fund industry has failed investors on both counts.
An annual return of 7% in a 13% market is a shocking gap, but the
long-term reality is far worse. When compounded over this grand 20-year era for investing,
and adjusted for inflation, the average investor has captured but 16 percent of the market's
compounded real profit. (I'm not kidding! $1,000 invested in a simple index fund mimicking
the Standard & Poor's 500 Stock Index in 1984 and held today produced a profit of $5,490
after inflation; for the average fund investor, the real profit came to just $910.) No
wonder that David Swensen, the integrity-laden and remarkably successful manager of the Yale
endowment fund, characterizes such a shortfall as "the colossal failure of the mutual fund
Where Is the Public Discourse?
It ought to be obvious that there is an urgent need to face up to
these and other failures in the changing world of capitalism. These failures have arisen, in
essence, from the triumph of the powerful economic interests of the oligarchs of American
business and finance over the interests of our nation's 100 million citizen-investors, the
very concern that Jefferson expressed about “the aristocracy of our moneyed corporations” in
the quotation that I cited a few moments ago. Yet remarkably, little public discourse has
been in evidence. In the investment community, I have seen no defense of the inadequate
returns delivered by mutual funds to investors, nor of the industry's truly bizarre,
counterproductive ownership structure. No demand by institutions to gain the rights of
ownership that one would think are implicit in holding shares of stock. No serious criticism
of the virtually unrecognized turn away from once-conventional and pervasive investment
strategies that relied on the wisdom of long-term investing toward strategies that
increasingly rely on the folly of short-term speculation. And, until recent months,
almost no discussion of the profound problems we are facing in our various systems of
retirement plan funding. If my book helps to open the door to the introspection on these
issues by our corporate and financial leaders that is so long overdue, followed by corrective
action, perhaps the needed changes will be hastened.
This process must begin with a return to the original values of
capitalism, to that virtuous circle of integrity—"trusting and being trusted"—that I mentioned
at the outset. When ethical values go out the window and service to those whom we are
duty-bound to serve is superseded by service to self, the whole idea of the capitalism that
has been a moving force in the creation of our society's abundance is soured. In the era
that lies ahead, the trusted businessman, the prudent fiduciary, and the honest steward must
again be the paradigms of our great American enterprises. It won't be easy, but if we all
work long enough and hard enough at the task, we can build, out of a long-gone ownership society and a failed agency society, a fiduciary society in which the citizen-investors of
America will at last receive the fair shake they have always deserved from our corporations,
our investment system, and our mutual fund industry.
Capitalism and Values
The idea that values should be intimately embedded in the practice
of business, of course, was an important message of my idealistic Princeton thesis of 54 years
ago. But I'm hardly alone. Even before he extolled, in The Wealth of Nations, the virtues of the
invisible hand of competition and the essential nature of personal advantage and self-interest in
making the world's economic system work, Adam Smith wrote The Theory of Moral Sentiments, calling for
"reason, principle, conscience, the inhabitant of the breast, the great judge and arbitrator of our
conduct, who shows us the real littleness of ourselves, the propriety of generosity, of reining in
the greatest interests of others, the love of what is honorable and noble, the grandeur and dignity of
our own characters."
Adam Smith, here the apostle of virtue, is advising us to put the
greater interest of others before the interest of ourselves, and our failure to do so is
reflected in modern-day managers' capitalism, in which the interests of those who run our
corporations and financial institutions are ascendant. My Battle book is replete with scores
of specific recommendations to help us return to our roots, the most sweeping of which is
the call for the formation of a federal commission to (a) recommend policies that respond to
the failure of our agency society in which direct stockowners have become an endangered
species, and (b) to take the steps necessary to ultimately eliminate the frightening
shortfalls—recently estimated at $1.2 trillion for pension plans alone—in the expected future
wealth that investors will accumulate through the vastly underfunded retirement plan system
that is the foundation of our national savings. These two problems are directly related, and
best solved by the creation of a fiduciary society in which intermediaries truly represent—first,
last, and only—the interests of those they serve.
So, I recommend this federal approach for the development of an investor—oriented—not
manager-oriented—fiduciary society. But even if that recommendation is not implemented for a decade or
more, Adam Smith's legendary 'invisible hand"—each investor acting in his or her own enlightened
self-interest—will gradually bring about the changes I seek. If we investors simply have the wisdom to
understand how the financial system works and to move our own money where our own common sense dictates,
then the system of financial intermediation that has failed so many investors in the modern era will
change. One way or another, then, whether by government fiat or by the invisible hand of our citizens,
the soul of capitalism—the traditional owners' capitalism that served us so well, for so long—will be
What "The Invisible Hand" Means
Adam Smith was, of course, right. We owe it to ourselves to look
after our own economic interests. Even in a financial system whose vast strength is punctuated
with serious—and in some cases disabling—weaknesses, there is no law that requires us to be victimized,
and, however rare they may be today, attractive options for investors remain. Since the first three
rules of investing are said to be "diversify, diversify, diversify," those of us who rely on the
productive wisdom of long-term investing—and have not been lured into the counterproductive folly of
short-term speculation—are obliged to own (surprise!) stock and bond market index funds.
As evidenced from the substantial shortfall in returns experienced by mutual
fund investors in the example that I cited earlier, the investment merits of indexing—the broadest
possible diversification at the lowest reasonable cost, without sales loads or marketing fees and with
maximum tax efficiency—have proven themselves over and over again. Yes, I concede that owning such funds
is as interesting as watching the grass grow or perhaps as interesting as watching paint dry. But since
less than 10 percent of investors or investment managers are apt to beat the market over the long-term,
buying and holding a low-cost index fund and capturing nearly 100 percent of whatever annual returns the
financial markets are generous enough to deliver to us seems a far better option than plunging headlong
into a game rigged with such overpowering odds against success.
Of course, since I started the first index mutual fund a little over three
decades ago—Vanguard Index 500 is now the largest fund in the world—you would be wise to discount my
passionate advocacy of indexing. So ignore me! But listen to Warren Buffett. Listen to Yale's David
Swensen. They both say exactly the same thing. Listen to Jack Meyer, the former—but equally
sensational—manager of Harvard's endowment fund. Listen to any Nobel Laureate in Economics, beginning
with Paul Samuelson. Heck, ask the finance professors here at the University of Virginia (who are
probably indexers themselves). Let's face it: the jury is in. The verdict is: Index! (I leave the
proportion in stock and bond index funds to your own good judgment; surely some of each.)
We'd best take the problems I've outlined today seriously, for we must solve
them if our nation's citizen-investors are to be blessed by the promises of our Declaration of
Independence—"the right to life, liberty, and the pursuit of happiness"—and of our Constitution—"to
promote the general welfare . . ." Fixing today's CEO-centric corporate world, eliminating the excesses
of the financial system, and repairing the faltering mutual fund industry—returning control from managers
to owners in a new fiduciary society—is on the way. I hope my book will give it a good push. But
whether it comes about through laws and regulations, or by the wisdom finally acquired by crowds of
investors making intelligent investment decisions as they simply seek to further their own economic
interests, so it will be. That conclusion reflects my lifelong idealism, and it remains my ideal