Jack Bogle: It's Easier to Serve One Master Than Two

Quoth the Raven Jack Bogle opened Thursday afternoon's virtual presentation at the Morningstar Investment Conference with a prophecy. When Bogle was preparing to launch Vanguard, in 1974, he met with Jon Lovelace, who headed the large and successful American Funds complex. Lovelace told Bogle that if he followed through on his plan, he would "destroy" the mutual fund industry.

Some prophecy. In nominal terms, assets in traditional, actively managed stock- and bond mutual funds are up 25,000% (250-fold) since then. If that constitutes failure, who needs success?

As Bogle states, however, that prediction has finally come true, in a big way. Bogle spends little time on the numbers, which have been amply covered in this column and elsewhere. The traditional funds of Jon Lovelace's day are now losing more assets than they are receiving. All the fund industry's net new flows, and more, are going into index mutual funds and exchange-traded funds.

Perhaps it would not be so if traditional mutual funds had more energetically passed along their economies of scale. Indeed, says Bogle, such funds haven't passed along any economies at all. For the 65 years from 1951, when he entered the industry, until 2016, industry assets grew 5,400-fold. (Which makes that post-1974 boom seem tame.) During that same time period, total fund advisory fees and operating expenses became 5,600 times larger. No progress whatsoever.

Two Bosses Bogle offers scant consolation to the CEOs of traditional mutual fund companies for their future prospects. He shrugs off advice given by well-meaning outsiders to those companies, including suggestions offered by this columnist (whom Bogle calls an "eminence gris," which is the sort of thing Bogle says before reaching for his axe), as being beside the point. Try as they might, he says, traditional fund companies can't get past their initial handicap: They work for two masters.

That is, while Vanguard has a mutual structure, meaning that it is owned by its funds' investors, competing fund companies operate differently. One set of shareholders receives the profits that come from the funds' management fees--from the costs paid by the funds' owners--and another set receives the returns that are generated from the fund.

Those interests are directly and diametrically opposed. Every extra basis point that is added to the funds' expense ratios is a transfer payment, from fund shareholders to fund company shareholders. Every basis point saved accomplishes the reverse. Cheaper funds do well by their shareholders, but they mean less money in the fund company's coffers.

Bogle argues that those two objectives cannot both be satisfactorily met. Under pressure from extremely low-cost providers such as Vanguard (which is not the only firm these days to offer very cheap funds, although it remains the only one to use the mutual structure), traditional investment managers may indeed lower their management fees. But they can never get them down as far as they need to go. That would depress their companies' revenues too severely, thereby damaging the interests of their second set of shareholders.

Thus, Bogle says, Rekenthaler can talk about how active managers should develop niche strategies, close their funds when they have not grown too large, and adopt other tactics in response to index funds' success. But it won't happen. Active-management investment firms must satisfy the needs of those who have grown accustomed to their profits. The necessary change will not occur.

Closely Held Managers Bogle offers his own set of predictions. For business reasons--which, as discussed, are not necessarily the same as investment reasons--traditional fund managers will follow one of two paths.

Closely held firms that are controlled by their founders/partners, as opposed to being publicly traded or being subsidiaries of large organizations, will sit tight. Their motto, says Bogle, will be "Don't do something--just stand there." He continues: "Severe fee cuts would decimate profits--resulting in sharp compensation cuts for insiders that would be hard to tolerate, and for firms with minority public shareholders, a slap in the face for investors who have become used to powerful profit growth."

That final sentence reminds us to remove the white and black hats from these two sets of shareholders. Although it feels to fund investors as if their interests should come first and foremost, if not indeed exclusively, that second group of shareholders also has needs. Those who invest their time into working for fund companies, or in the case of the minority public shareholders, invest their capital into equity ownership, are justly interested parties. They have the right to a fair return on their investment.

Other Fund Families As for the other group of traditional fund companies, those that are publicly traded or owned by financial conglomerates, Bogle holds out even less hope. He never thought much of them in the first place, believing that the SEC was wrong in 1958 to permit mutual fund companies to be publicly owned, and he has not softened his views. They, he believes, will give up entirely on trying to grow their fund businesses, and will instead be content to milk their cash cows. "Don't invest more capital. Don't cut management fees."

Slowly, over time, those companies will lose their assets, and will "ultimately be sold at bargain prices or merged with other similarly situated firms." But they will extract large profits along the way.

Again, Bogle's argument carries a moral as well as financial logic (although he does not frame his claim that way). Publicly traded firms have obligations to all their stakeholders--and they are not wrong in feeling those duties. Their need to treat all parties inhibits their responses to index mutual funds and ETFs. Some companies will test new approaches, and new fee structures, but they are unlikely to move their entire businesses in that direction.

Wrapping Up My take: The founder of Vanguard, and the inventor of the mutual structure for fund companies, is unlikely to understate the prospects of the former or the advantages of the latter. The matter is not quite as inevitable as in Bogle's portrayal. That said, today's investors are voting rapidly with their wallets for low-cost funds--in many cases, exceedingly low-cost funds. And Bogle is on track when discussing the barriers to change. It will be difficult indeed for the traditional fund families that thrived in the past to adapt sufficiently for the Brave New World that they now face.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.