Progress or Innovation?

Having pioneered low-cost, index-based mutual funds, John Bogle knows a thing or two about progress and innovation. The Vanguard Group founder’s commitment to boosting investors’ returns by reining in costs has cemented his reputation as the financial industry’s conscience. And Bogle’s ideas have withstood the test of time: The Vanguard Group continues to thrive, and the new 10th anniversary edition of Common Sense on Mutual Funds required few updates to the core text. Mr. Bogle recently talked to us about the industry’s problems and its future.

You’re a tough critic of the financial industry and Alan Greenspan. What do you regard as their missteps?

First on my list for the industry is so-called innovation, which, as the great economist Hyman Minsky pointed out, is usually bad for investors.

Innovation boils down to marketing. Innovation disregards quality and asks “What can we sell somebody?” Innovation brought us credit default swaps (CDS), collateralized debt obligations (CDO), and structured investment vehicles (SIV)–all these acronyms led investors down a primrose path that has come back to haunt us.

Innovation produced risks that were improperly calculated, while generating fees throughout the financial food chain–fees charged to the homebuyer taking out a mortgage, fees tacked on when the mortgage is sold, fees for packaging that loan with other mortgages, and yet another fee for underwriting the package to the public.

This brand of innovation has proved expensive for investors, not to mention the families involved and American taxpayers.

Focusing on speculation instead of investment is another problem. It’s no secret that turnover in the stock market and among mutual funds’ portfolios is at an all-time high. And higher turnover rates enrich traders at the investors’ expense; the middleman who takes his cut wins big from higher volumes. The more we trade and the more we speculate, the better it is for Wall Street and the worse it is for investors.

Imagine if long-term investors held half the S&P 500’s float and short-term speculators held the other half; in that scenario, long-term investors would capture the market return at minimal cost, whereas the cost of trading would erode the speculators’ profits.

Long-term investing is a winner’s game; short-term speculation is a loser’s game.

Third, over the last 50 years the world has transitioned away from equity ownership by individuals who take responsibility for their own investments–owners’ capitalism–to what I call managers’ capitalism. Mutual funds, pension funds, endowment funds and trust companies owned about 8 percent of all stocks half a century ago; today these agents own almost 70 percent of all stocks. Meanwhile, individual ownership has dropped from 92 percent to 30 percent.

And these agents oftentimes don’t act with investors’ best interests in mind; innumerable conflicts of interest outweigh a commitment to fiduciary duty.

Accordingly, some agents are sloppy and do incomplete security analysis–for example, someone must have known what was going on in those banks’ balance sheets. Others are unwilling to participate in corporate governance and advocate for shareholders’ interests.

Former Federal Reserve Chairman Alan Greenspan made two mistakes: One, he kept credit cheap to avoid a recession; and two, he claimed it’s impossible to identify a bubble in advance, an assertion that strikes me as disingenuous.

We define a bubble as the existence of market values that vastly exceed intrinsic values. Stocks typically sell at about $2 of market value for each $1 of intrinsic value. In 2001 that multiple increased to $6.60, a bubble that Greenspan failed to identify. Then he expanded access to cheap credit without any thought about risk control.

To worsen matters, Greenspan shouted down the one member of the Federal Reserve Board who suggested that the agency scrutinize the mortgage business–a power that’s within the Fed’s authority.

He acknowledged his other big mistake in his testimony before Congress, attributing the crisis to “a once-in-a-century credit tsunami,” which had arisen from the collapse of a “whole intellectual edifice.”

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity–myself especially–are in a state of shocked disbelief,” he said.

This failure of self-interest to provide self-regulation was, he said, “a flaw in the model that I perceived as the critical functioning structure that defines how the world works.”

It’s worth dwelling on the phrase “critical functioning structure that defines how the world works.” That’s a hell of a big thing to find a flaw in.

Why do you have such a strong belief that mutual fund managers have failed investors?

Take a manager that had Citigroup (NYSE: C) in his fund’s portfolio. Did that security analyst know what was in Citigroup’s portfolio? Did he know how many structured investment vehicles there were?

Even Robert Rubin [Citigroup’s former chairman] had never heard of structured investment vehicles until summer 2007. Imagine that–and the bank had $22 billion of them on the books.

Analysts defend their negligence by noting that the banks never volunteered this information. In the old days, an analyst would have bought stocks of companies that provide the necessary information. Basing your investment thesis on the profit-and-loss statement rather than the balance sheet is an absurd way to analyze securities.

Were banks just chasing what they thought was easy money?

That’s part of it. But the CEOs who decided to keep dancing as long as the music was playing share a large part of the blame.

In a way they were right because so many directors had a short-term focus and were instructing their charges to keep pace with other companies’ earnings.

That being said, a good CEO should be able to stand up and point out that the other guys are crazy. Sooner or later, you’ve got to come down to your core beliefs and stand up for what really matters in this world–if you have to pay the price of your job, that’s life.

What sort of reforms would you like to see?

Reform has stalled so far because the system is tangled with lobbyists, big money and powerful bankers. I don’t see how we’re going to get much farther than we are today, which is nowhere. But let’s ignore the fact that politics is the art of the possible.

I back even the simplest reforms–for example, the so-called Volcker plan, which aims to prevent banks from trading for their own account and owning and managing hedge funds.

But I would go even further. I would bring back the central elements of the Glass-Steagall Act, which prohibited commercial banks and investment banks from engaging in the business of underwriting. Before this proscription existed, we ran headlong into the disaster of the 1920s and 1930s, which led to their separation in 1934. Congress rolled back these reforms in 1999–a decision that played a huge role in the current mess.

I’d get banks back into the business of taking and paying interest on deposits. I’d also institute tougher capital requirements that reflect the risks in a bank’s portfolio. For example, a short-term portfolio of Treasury bonds would require a lot less capital than a portfolio filled with collateralized debt obligations.

Higher capital standards are a must, even if banks return to the traditional business of taking deposits and lending money. Things work pretty well under such a system, but bankers don’t make as much money.

It’s also worth noting that investment banks assumed added risks because they were public companies.

Do you really think the old investment banking partnerships–which put their own capital on the line–would have loaded up on all this improperly valued real estate junk and credit default swaps? Adam Smith observed a long time ago that we don’t invest other people’s money with the same care that we invest our own. You’d be hard-pressed to find truer words.

A consumer protection agency could have prevented the mortgage mess, and I think such a regulator’s authority should extend to investment products. And mutual funds ought to be required to have much better disclosure.

We’re going to go through these crises again and again until these reforms occur. Lessons only stick for so long; some kind of financial buccaneering eventually returns to the fore.

What’s your best advice for mutual fund investors going forward?

I’m a believer that broad market index funds should be the core of any investor’s portfolio. As far as asset allocation, I have a rule of thumb that an investor’s bond position should equal their age. That is, if you’re 65 years old your portfolio should be 65 percent bonds; if you’re 25 years old, your portfolio should be 25 percent bonds.

This rule may be a bit extreme, but older investors should have more bonds than stocks; after 30 to 40 years of saving and investing you’ve got more capital at risk. And as you approach retirement, investment income becomes more important. But mutual fund dividends are terrible because of expenses and low yields. Bonds will provide you with a decent income once you retire.

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