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MF Industry 60 Years later: For MF Industry 60 Years later: For Better or Worse? Better or Worse? John C. BogleJohn 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 managementSee 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 performanceFund management moved from consensus-oriented investment committee to a more entrepreneurial, free-form, aggressive investment approachThe 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– 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 5Increased from 1% in 1945 to 25% in 2004Role 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.– 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 loadCost 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– 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

– 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 managers8 remain privately held (plus mutually owned Vanguard)6 are publicly heldthe 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 scandalFactors that contributed to scandal:

– 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

– 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

– 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?– 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:

1. 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.

See table 10: Return comparison - 1983-03– 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: ($11.5-

7.10) = $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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ConclusionsRegardless of data precision, the equity fund returns lag stock market returns by a substantial margin

– Cost– Market timing and fund selection.

Put fund shareholders back in the driver’s seat– 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– 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).