Jack Bogle Strikes Back!

Reader Response Something a bit different for this column's July 4 installment: comments from Jack Bogle, the founding father of the index-fund revolution. (If that Independence Day connection isn't sufficiently strong, consider that Vanguard's mailing address is Valley Forge. That's not quite where it conducts its business, mind you, but there's not much glamor in Malvern, Pennsylvania.)

No Surprises April 14: For Vanguard, Every Year is a Record

Vanguard shows no sign of relinquishing the fund-industry sales lead that it seized several years back. Indeed, the column concluded, "I find myself in the same position as in each of the past few years: unable to foresee Vanguard's decline."

Bogle, naturally, does not dispute that forecast. As he points out, Vanguard was constructed to avoid investor disappointment, observing the precept that has long been known by successful financial advisors: The key to investment success is avoiding avoidable errors.

"After what I had witnessed in the Go-Go era of the sixties, it was obvious that the funds with untethered returns had a failed business (let alone fiduciary!) strategy. At our (tiny and rare) executive gatherings--even before we formed the index fund--I pounded home the message of 'Relative Predictability.' My mantra: Be average before costs; win by 1.5 percentage points per year, 20% cumulatively over a full decade."

With money now flowing so heavily into index funds and institutionally priced active funds, the cost fruit no longer hangs so low. However, Vanguard's funds remain relatively predictable--dull, one might say, from a research analyst's perspective. But, as Vanguard's continued sales success demonstrates, fund investors have decided that they have had all the excitement they wish, thanks much. Dull will do.

False Hope May 12: Performance Fees: A Small Step in the Right Direction

Make that a nonexistent step. My column followed up on a report that performance fees might be coming to the mutual fund industry. Today, only 1% of mutual funds carry a variable fee that rewards management if the fund beats a specified benchmark, and penalizes management if it did not. While wondering whether this truly would occur--fund companies tend to dislike payment schemes that cut both ways--I saluted the trend as being in investors' interest.

Bogle informs me that I was pounding sand: "Performance fees are going nowhere in the fund industry. Why would a fund company charge 0.75% as a fixed management fee and a 0.25% performance fee when it could just charge 1% instead?"

Hey, I was skeptical. But in hindsight, I was too trusting. The fund industry has had almost 100 years to embrace performance fees, and it hasn't done so yet. That probably will not change, as Bogle states. All right, that column was hypothetical--but a pretty good hypothetical discussion, as far as such things go.

(Even if the fund industry becomes braver, it is unlikely ever to emulate Bogle's fellow Philadelphian Ted Aronson, who, writes Bogle, "charges a 0.60% management fee for his emerging-market investment accounts, but will do it for zero--zero!--for those who agree to pay 1.2% if the fund beats its emerging-markets benchmark." Now that is embracing the performance-fee structure!)

Will History Repeat? May 16: Is This Time Different for Value Investors?

May 19: Why Value Stocks Have Disappointed

This two-part series examines GMO co-founder Jeremy Grantham's extraordinary claim that this time might indeed be different. Mutual fund managers rarely predict permanent change (although, as with the rest of us, they are adept at spotting it in hindsight). If their strategies are succeeding, they expect more of the same; if they are failing, then the managers forecast a return to normalcy, so that once again their investments are appreciated.

Grantham, in contrast, takes seriously the possibility that the value-style stocks he holds might be in for long, cold winter. He notes that U.S. economics have indeed become different, with corporate profit margins exceeding their previous highs--and staying above that level, despite prophesies to the contrary. There is a solid, fundamental reason why value stocks have lagged growth stocks in the past 15 years: Growth-company earnings have exceeded all expectations.

Grantham isn't sure the growth-company tree can avoid the fall, but he does raise the possibility. Bogle, again, is skeptical. He doesn't believe that value-style investing is intrinsically superior to growth investing, calling that notion a "fad" that leads to value stocks becoming "overpriced" and thus "reverting to the mean." At the same time, "nothing in the world of investing is forever." Don't tell Bogle that today's earnings "now support a new, higher level" of stock prices. He's heard that one before. It always ends badly.

Two Mouths to Feed Finally, Bogle thinks I was too easy on the executives of publicly traded mutual fund companies. In the column summarizing Bogle's presentation to Morningstar's Investment Conference, I argued that it was fair and proper for fund-company CEOs to think about providing a "fair return on investment" to their firms' own shareholders, as well as to those who own the funds that they run. Bogle responds: "I don't begrudge (too much!) the right of the founders to capitalize on their investment and years of toil," but after time, he says, the costs become too much for mutual fund shareholders to bear.

He asks, "If a conglomerate were to buy a fund enterprise at a price of 50 times that company's earnings, does it have the same right [to recoup the cost of its investment, as does a fund-company founder]?" That question is rhetorical--Bogle clearly believes not. I'm less certain, but in a sense the point is moot. Unlike in the past, expensive funds no longer sell. So any conglomerate that pays up to buy a fund company and then wishes to finance that purchase by charging high management fees is doomed to fail.

Feel free to send your own observations at john.rekenthaler@morningstar.com. I'll put together another reader-comment column sometime soon.

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.