Transcript What Is Equity?

MF Industry 60 Years later: For
Better or Worse? John C. Bogle
In 1945, it was a $882M industry offering—largely
diversified equity and balanced funds.
As of 2006, it is a $10.4T titan offering 8,726
funds with a dizzying array of investment policies.
Industry has undergone a multifaceted change in
character.
– In 1945 - industry engaged primarily in the profession of
serving investors; focused primarily on stewardship
– Today, successful marketing business; focused
primarily on salesmanship; asset gathering is the
driving force.
Article outlines 10 major changes over the last 60
years in the mutual fund industry
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1. Bigger, More Varied, and More Numerous
1945 – 2004: annual growth rate of 16%.
See Table 1
– 68 funds in 1945; 8200 in 2004
– Fund Composition: 1945 – 90% stock funds
– 2004- 57% stock funds; 17% bond funds and 26% MM funds
(started in 70s).
Proliferation of investment choices
– Fund families; fund choices; fund selection, asset allocation
Investment vehicles
– Direct investment in MF; IRA; Profit sharing; Employee Savings
Plan, etc.
– Assets in these tax deferred plan: 40% of assets
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2. Stock Funds: To the Four Corners of
the Earth
Stock funds remain the industry’s backbone
See Table 2
– 1945, stock fund sector was dominated by U.S. large
cap;
– Volatility roughly commensurate with that of the
stock market
– 2004 these funds are a distinct minority; replaced by
categories that entail higher risks.
– Only 579 diversified blue-chip; 2484 other diversified
equity; 455 specialized; and 686 International
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2. Stock Funds: To the Four Corners of
the Earth
Fund Selection Process
– has become an art form; require the same assiduous
analysis as selecting an individual common stock;
Investing in portfolios of funds.
– Unmanaged index funds did not enter the field until
1975; now represent one-seventh of equity fund
assets.
– provide the nth degree of diversification
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3. Investment Committee to Portfolio
Manager
The vast changes in fund objectives brought
equally vast changes in fund management
See Table 3
– In 1945, managed almost entirely by investment
committees.
– 1960s and 1990 (New Economy) brought hundreds of
ferociously aggressive “performance funds”
– “investment committee” virtually vanished replaced by
“portfolio manager” and “Management teams,” portfolios overseen by multiple managers
– 3,387 of the 4,194 stock funds – single portfolio
manager; 807 multiple managers.
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3. Investment Committee to Portfolio
Manager
Portfolio manager’s tenure tied to performance
Fund management moved from consensus-oriented
investment committee to a more entrepreneurial, freeform, aggressive investment approach
The managers with the hottest short-term records were
publicized by their firms and, with the cooperation of the
media, turned into “stars.”
A few were stars—Fidelity Investments’ Peter Lynch,
Vanguard’s John Neff, Legg Mason’s Bill Miller, for
example—but most proved to be comets
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devastation of the recent bear market
average manager tenure is only five years
the portfolio manager system remains largely intact
the continuity provided by the investment committee is lost
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4. Investment or Speculation?
Dramatic Increase in portfolio turnover (See
Table 4)
– coming of more aggressive funds
– emphasis on short-term performance
– move from investment committee to portfolio manager
Focus has changed from long-term investing
(trusteeship) to short term speculation.
1945 -1965, annual portfolio turnover averaged
17% (held average stock for about six years).
Currently the turnover is 110 percent annually
(held stocks on average for 11 months).
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4. Investment or Speculation?
Role of portfolio turnover in the financial market
– The dollars involved are enormous
– $10 T asset sale and then reinvest that $10 T in other
stocks, $20 T total transaction.
– Cost?
– Trades often take place between two competing funds
– Is it beneficial to fund shareholders?
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5. America’s Largest Shareholders
Ownership of stocks over time- See Table 5
Increased from 1% in 1945 to 25% in 2004
Role of MF in corporate governance
– Ethical failure of corporate governance? MF
responsibility?
– own-a-stock industry to rent-a-stock industry
– industry’s focus moved from investment to speculation
– TIAA-CREF ($370B fund) is an exception:
Peter Clapman, senior VP, chief counsel, and head of the
Corporate Governance program. "First, we believe promoting
good governance will produce better long-term returns for
participants. Second, by monitoring the managements of our
portfolio companies, we believe we can help them become
more accountable to shareholders."
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6. Compressed Investor Holding
Periods
The change in the mutual fund industry’s
character dramatically changed fund redemption
rate. See Table 6.
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1945 – 50: redemption rate around 5%-10%.
By 2002 around 41% (average holding period of 3 yrs)
“Buy-and-hold” strategy became “pick and choose”
Fund supermarkets – cost hidden as access fee;
swapping funds appear free
– Investors pervasive use of timing strategies
Funds restricted excessive trading; rates dropped to around
25%.
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7. New Funds Appear, Old Funds
Vanish
Table 7 – Formation and Liquidation of Funds
1950s: 28 new funds; 10 dying funds
1990s/2000s: 2548 new funds; 1507 dying funds
“we sell what we make” to “we make what we
sell”
New Economy, Speculative, High performance,
Aggressive funds replaced “built to last” funds
Money poured into speculative funds that fueled
the market as well as subsequent downturn
Survivorship bias
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8. Cost of Fund Ownership
Table 8 – Cost of Fund Ownership: 25 largest
Funds
– 1945: aggregate assets $700M, costs $4.7M, or
0.76%.
– 2004: aggregate assets $2.5 T, costs $31.0B, or
1.56%.
– Assets up by 3,600 fold, costs up by 6,600 fold
– Rule 12-b(1) fee
Distribution fee replaced traditional front-end load
Cost of MF is impediment to fund ownership
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9. Rise of Fund Entrepreneurship
At the beginning fund management seen as a
profession—the trusteeship of other people’s money.
Today, salesmanship has superseded trusteeship.
Landmark case in 1958 that changed the industry
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Until then, a trustee could make profit by managing money but
could not capitalize that profit by selling shares of the
management company to outside investors.
SEC held that the sale of a management company represented
payment for the sale of a fiduciary office, an illegal appropriation
of fund assets.
But a California management company challenged the
regulation. The SEC went to court—and lost.
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9. Rise of Fund Entrepreneurship
Thus, as 1958 ended, a rush of initial public offerings
followed,
Investors bought management company shares for the
same reasons that they bought shares of Microsoft
Corporation and IBM Corporation
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Publicly held and even privately held management companies
were acquired by giant banks and insurance companies
at least 40 such acquisitions during the past decade; ownership
transferred numerous times
Today, among the 50 largest fund managers
8 remain privately held (plus mutually owned Vanguard)
6 are publicly held
the remaining 35 are owned by giant financial conglomerates (22
by banks and insurance cos, 6 by major brokerage firms, and 7 by
foreign financial institutions).
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9. Rise of Fund Entrepreneurship
When a corporation buys a fund, it expects to
earn a hurdle rate. For $1B acquisition, and the
hurdle rate is 12 percent, the acquirer will
require at least $120 million annual earnings.
– In a bull market, that goal may be easy for a mutual
fund firm to achieve.
– But in the bear market, we can expect a combination
of (1) cutting management costs, (2) adding new
types of fees (distribution fees, for example), (3)
maintaining or even increasing, management fee
rates, and even (4) getting the buyer’s capital back
by selling the management firm to another owner
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10. Scandal
From 1924 – 2002 industry was free of major scandal
Factors that contributed to scandal:
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Asset gathering became intense
Competing interest between the return on managers’ capital vs.
return on fund shareholders’ capital
conglomeration became the dominant structure
stewardship took a backseat to salesmanship
managers put their own interests ahead of the interests of their
fund shareholders
allowed short-term traders in their funds to earn illicit higher
returns at a direct, dollar-for-dollar cost to their fellow investors
holding for the long term.
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10. Scandal
Brought to light by New York Attorney General
Eliot L. Spitzer in September 2003, the
industry’s first major scandal
– went well beyond a few bad apples. More than a
score of firms, managing a total $1.6 trillion of fund
assets, including some of the oldest, largest, and
once most respected firms in the industry,
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For Better or Worse?
Table 9: MF Returns vs. stock market rerun
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1945–1965: average fund delivered 89% of the market’s annual
return
1.7 pps shortfall largely accounted for by the moderate costs of
fund ownership
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In 1983–2003 the shortfall at 2.7%; delivered only 79% of the
market’s annual return
Average fund investor earned 2.4% less than average fund.
What contributed to increasing gap?
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Equity mutual funds are commodities that are differentiated
largely by their costs
Managers compete among themselves in selecting stocks
Fund returns parallel those of the equity market itself
Funds fall short by the amount of their management, marketing,
and turnover costs.
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Market Returns, Fund Returns and
Investor Returns
Changes in industry characteristics contributed to reduced
earnings for average fund shareholders:
Timing Penalty: Invested relatively less in equities in the 1980s
and early 90s. Invested too much near the end of bull market
2. Selection Penalty: Investing too much into “new economy “ stocks
and withdrawing from value funds.
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See table 10: Return comparison - 1983-03
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Stock market return: 13.0%
Average equity fund return: 10.3%
Gap between market and fund: (13%-10.3%) = 2.7%
Considering average shortfall of 2.4%; average investors earned
(10.3% -2.4%) = 7.9%.
Penalty for Changes in industry characteristics: additional 2.4%.
Total gap (2.7%+2.4%) = 5.1%.
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Market Returns, Fund Returns and
Investor Returns
Growth of $1 over 1983-2003 period:
– Stock market (1+0.13)20 = $11.50
– Average equity fund (1+.103)20 = $7.10
– Gap between average fund and market: ($11.57.10) = $4.40.
– Estimated equity fund return: (1+0.079)20 = $4.57.
– Gap between average investor and average fund:
($7.1-4.57) = $2.53.
– Total gap between average investor and market:
($4.4+2.5) = $6.93.
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Conclusions
Regardless of data precision, the equity fund returns
lag stock market returns by a substantial margin
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Cost
Market timing and fund selection.
Put fund shareholders back in the driver’s seat
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Organize, operate and manage in the interest of
shareholders rather than managers and distributors.
Reduce turnover cost, management fee, sales commission,
and operating and marketing costs.
Enhance the share of fund returns by shareholders
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Reorder product strategies (diversified funds, sound
objectives, prudent policies, and long-term strategies)
Less focus on marketing and more on stewardship (better
information about asset allocation, risk, return, cost).
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