John Bogle on Corporate Governance

“The Case of the Dog that Didn’t Bark” Remarks to Mutual Fund Directors Education Council By John C. Bogle, Founder, The Vanguard Group Washington, DC January 11, 2001 Good evening. By way of full disclosure, let me say a few words about Vanguard. We are a large mutual fund complex (assets of some $560 billion), managed under a unique corporate and governance structure that shapes the perspective I’ll present. Our management company is owned by the mutual funds themselves. We operate on an “at cost” basis, and this year our expense ratio will average a bit more than 0.25%. We provide investment advisory services for almost $400 billion of our assets. The remaining assets are supervised by external advisors under contracts negotiated at arms-length, with a weighted average fee rate of about 0.09%. You are unlikely to see any of this information in the studies prepared for fund directors by consultants. We are omitted, I am told, because we are “different”—as indeed we are. One can argue that difference is “good,” and I suppose one can also argue it is “bad.” But it is unarguable that our structure is cheap in terms of the services we provide our funds. I appreciate Dean Ruder’s gracious invitation to be with you, and to discuss my views on the role and responsibilities of fund directors. I have given several talks on this subject, and I understand that you have in your folders a copy of my last year’s speech to the Practicing Law Institute.

It’s High Time We Return Capitalism to its Owners Keynote Speech John C. Bogle, Founder & Former CEO The Vanguard Group to the 2004 Institutional Shareholder Services Annual Conference “Corporate Governance: The New Reality” Washington, DC February 26, 2004 Only a week ago, that consistently passionate voice of the free enterprise system, the editorial page of The Wall Street Journal, hit the proverbial nail on the head: “The constant tension at the heart of corporate life: ensuring that the managers serve the shareholders and not themselves.” During the recent era, that constant tension has, far too often, been resolved in favor of the managers, the diametrical opposite of the cause that the Journal champions. It is high time that we return capitalism to its owners. Yes, corporate governance is indeed “the new reality.” The evidence of how far we have departed from Owners Capitalism is pervasive. One corporate scandal has followed another, and the egregious behavior of some of the imperial chief executives whom we so recently lionized provides additional eloquent evidence of the departure.

Owners Capitalism vs. Managers Capitalism Remarks by John C. Bogle Founder and Former CEO, The Vanguard Group Before the 2003 National Investor Relations Institute Conference Orlando, FL June 11, 2003 I’m honored to be with you today to discuss the profound issues regarding corporate governance in our nation today, and to offer some thoughts on the role that Investor Relations professionals might play in their resolution. In the year and one-half since Enron blew up in our faces—doesn’t it seem like an eternity ago?—a score or more of large, once-reputable companies have been scandalized, the “Big Five” accounting firms have shrunk to the “Final Four,” Wall Street’s reputation has withered—and deservedly so—as much as its research turned out to be sales promotion for investment banking clients, and rarely has a week gone by without some new disclosure of wrongdoing in corporate America. It’s not yet clear how much of these distasteful goings-on represent criminal behavior. And we have often been reminded that there have been, so far, few convictions and almost no jail sentences. But when that’s the best defense is the best that capitalism can offer to justify its status, Adam Smith must be turning over in his grave. How often have you heard that the problems of American capitalism are confined to just “a few bad apples”? In the context of our tens of thousands of corporate executives and Wall Street leaders, of course that’s true.

A New Era for Corporate America, for Mutual Funds, and for Investors Remarks by John C. Bogle Founder and Former Chairman, The Vanguard Group Distinguished Speaker Series The Owen School of Management Vanderbilt University November 11, 2003 Nashville, Tennessee I'm delighted to return to Vanderbilt and to the Owen School of Management. (Congratulations, by the way, on being named one of the top MBA "hidden gems," and your great leap forward to a rank of #15 in the recent Wall Street Journal rankings!) I'll talk to you today about the new era for investing that lies ahead—a new era in our financial markets in which we can expect more subdued returns then those of the latter half of the second century, a new era for the governance of corporate America after the egregious financial manipulation of the 1990s; and a new era for the mutual fund industry growing out of the recent scandals. Our business institutions need to be reinvigorated, and that situation creates great opportunities for each one of you. Of course I'm especially pleased that my son Andrew is preparing here for his MBA, continuing the tradition begun by his brother, John, Owen 1983, who moved on to a distinguished and successful business career and now runs his own money management firm. It was eleven years ago when I was honored to deliver the Commencement address to your Class of 1992. It was entitled "Press On, Regardless," and while I don't know how many graduates took the advice, it's clear that I did.

up to yesterday afternoon, when a shareholder on my flight down here from Philadelphia asked me why, in view of my reputation for thrift, I was flying in the first-class section. (The answer, I told her, was that I got a free step-up with my frequent flyer miles. But she didn’t seem satisfied. I think, truth told, that she shouldn’t have been!) The root causes of the disease in our system are deep, and the remedies that are required to cure it will not be easy to come by. For what we have witnessed in the failure of corporate governance in America has been, as journalist William Pfaff described it, “a pathological mutation in capitalism.” He was right on the mark. The classic system—owners capitalism—had been based on a dedication to serving the interests of the corporation’s owners, maximizing the return on their capital investment. But a new system developed—managers capitalism—in which “the corporation came to be run to profit its managers, in complicity if not conspiracy with accountants and the managers of other corporations.” Why did it happen? “Because,” in Mr. Pfaff’s words, “the markets had so diffused corporate ownership that no responsible owner exists. This is morally unacceptable, but also a corruption of capitalism itself.

Today I’m going to present to you graphic evidence of these trends, which, I fear, bode ill for this industry, and for the financial markets as well. While I have been speaking out on these trends for more than a decade now, they’ve only gotten worse. On the other hand, confession being good for the soul, I acknowledge that there is little evidence of their baneful effects on the stock market—so far at least. Protecting the Interests of Those Whose Funds They Command . . . Nonetheless, these trends—the focus on marketing, the soaring levels of fund investment activity, and the huge increase in fund expenses—could combine to engender, a year or two or three down the road, the kind of statement made in 1934 by Justice Harlan Fiske Stone as he reviewed the events that led to the Great Crash of 1929 and the Great Depression that followed. “When the history of the financial era which has just drawn to a close comes to be written, most of the mistakes and its major faults will be ascribed to the failure to observe the fiduciary principle, the precept as old as holy writ, that ‘a man cannot serve two masters’ . . . The development of the corporate structure so as to vest in small groups control over the resources of great numbers of small and uninformed investors, make imperative a fresh and active devotion to that principle if the modern world of business is to perform its proper function.

And the owners didn’t even seem to notice until it was too late. Then, institutional investors were quick to blame corporate directors for their failure to check the self-serving behaviors of CEOs. But these giant shareholders—the 100 largest own 56% of all U.S. publicly- held common stocks—have a lot to answer for themselves. Without the passivity of these institutions in their capacity as owners—or as agents for their own principals, the owners they are supposed to represent—this pathological mutation in capitalism could never have transpired. Most of these institutional owners manage both pension funds and mutual funds. And mutual fund governance is even more flawed than corporate governance. Despite the obvious conflicts of interest involved, fund managers control the entire operating mechanism of the funds that contract for their services. It’s hardly absurd to argue, as I in fact did in a speech in this city six years ago, that our industry’s forbearance in challenging corporate governance reflects a fear that our own far weaker governance structure might be challenged, an echo of the aphorism that, “people who live in glass houses shouldn’t throw stones.” For example, while the compensation of U.S.

chief executives—which last year averaged something like $7½ million annually, or 200 times the earnings of the average worker—is stunning, how about paying $257 million per year to the management company (other fees go to the distributor and the administrator) of a money market fund, a fund that inevitably underperformed its peers by the precise amount of its excess fees? How about paying some $3.6 billion(!) over the past decade to the management of an equity mutual fund that was promoted heavily, and grew so large as to become a closet index fund, but in fact fell short of the Standard & Poor’s Index by more than twice the costs it incurred? Surely nowhere has the triumph of Managers Capitalism been more obvious than in the money management field, where substantial waste of corporate assets is taking place right before our eyes. While the governance models of both corporate America and mutual fund America have the same flaw, however, the remedies to deal with the fundamental causes of the systemic failures we have observed in both areas are quite different. If that handful of giant institutional owners merely acts to bring corporate America back to its roots, it will happen, and happen relatively quickly.

“As a result,” he wrote shortly after my graduation, “we have added Mr. Bogle to our Wellington Organization.” By age 36, I had become head of the company, entered into an unwise merger, and eight years later, was fired. (Yes, I was!) But even then, providence moved. Fired With Enthusiasm For what else but providence could possibly explain how when that door closed (more accurately, it slammed), a window of opportunity opened. Being fired—and with enthusiasm at that—gave me a providential opportunity to create a new and, I passionately believed, a better form of mutual fund organization, one truly mutual in its structure and governance.with

Their prime responsibility must always be to their shareholders." (Important advice that the industry seems to have ignored in the recent scandals.) Shortly thereafter, "there is some indication that costs are too high," and that "future industry growth can be maximized by concentration on a reduction of sales charges and management fees." (My advice fell upon deaf ears there as well!) After analyzing mutual fund performance, I conclude that "funds can make no claim to superiority over the market averages," perhaps an early harbinger of my decision to create, nearly a quarter-century later, the world's first index mutual fund. Still later in the thesis, "fund influence on corporate policy . . . should always be in the best interest of shareholders, not the special interests of the fund's managers." (Again, my advice fell by the wayside, and shareholders remain ill-served by the passive governance policies of most funds.) My conclusion powerfully reaffirmed the ideals that I hold to this day: The role of the mutual fund is to serve—"to serve the needs of both individual and institutional investors . . . to serve them in the most efficient, honest, and economical way possible . . . The principal function of investment companies is the management of their investment portfolios. Everything else is incidental."

Ellis articles, to persuade a dubious Vanguard board of directors to approve the creation of the first index mutual fund. The idea of an index fund was hardly anathema to me. Way back in 1951, the anecdotal evidence that I had assembled in my Princeton University senior thesis on the mutual fund industry shaped my conclusion that funds “can make no claim to superiority to the market averages.” When the newly-formed Vanguard began operations in May 1975, I had realized my dream of establishing the first truly mutual mutual fund complex. While the idea of an index fund would have hardly appealed to a high-cost fund manager whose very business depended on the conviction that, whatever his past record, he could outpace the market in the future, indexing would be a natural for Vanguard. Uniquely, we operated on an at-cost basis and sought to become the world’s lowest cost provider of financial services. What is more, at the outset Vanguard provided only administrative services to our then-$1.4 billion fund group, which continued to rely on Wellington Management Company for all investment management and distribution services. Added to my conviction that indexing was a winning strategy, my powerful itch to expand our narrow mandate provided an irresistible urge to create the first index mutual fund. As I’ve often noted, many firms had the same opportunity, but like the prime suspect in a murder mystery, only Vanguard had both the opportunity and the motive.

Corporate America and Democracy Given the constraints of time, I’ll address my remarks this morning largely to the subject of returning corporate America to its owners. Since so few owners hold such great power, all that is required is that they assert their obvious authority. The corporation is the property of its owners, and it is utterly logical that they should be put in a position to have their ownership interests honored. Put another way, I urge a return to corporate democracy. Not everyone agrees! Logical or not, the reverse has been authoritatively argued. No lesser a light than top securities attorney Martin Lipton argues that enhancing shareholder ownership rights to nominate directors and to make proxy proposals could “disrupt the proper functioning of the board and limit the ability of the directors to fulfill their fiduciary duties.” And in an op-ed essay in The Wall Street Journal, Henry G. Manne, dean emeritus of the George Mason University School of Law, argues that “the theory of corporate democracy . . . has long been a standing joke among sophisticated finance economists.” (He names no names.) “A corporation is not a small republic . . . and the board is not a legislature . . . a vote attached to a share is totally different from a political vote . . . the essence of individual shareholder participation is ‘exit,’ not ‘voice’ . . . and they can exit their corporate `citizenship’ for the cost of a stockbroker’s commission.

Early in 1974, the four partners with whom I’d earlier joined banded together to fire me. It was the end of my Wellington career. January 1974, Break #2–A Door Slams . . . A Window Opens But a new career was only months away. Heartbroken when the door slammed at what I considered “my” company, I wasn’t sure where to turn. But a window opened when I recalled an idea I’d been playing with for some years, an idea, in fact, whose genesis may have been in that 1951 thesis that talked about building a better industry. The idea, simply put, was to “mutualize” Wellington Fund and its ten sister funds, making the funds independent of Wellington Management Company, the firm that controlled them and the firm that had just fired me. (The Funds’ Board of Directors was largely independent of the Management Company’s.)continuing

Alas, ever the optimist, I failed to take into account the power of inertia. Unprecedented extreme moves are rarely the province of a thoughtful, conservative board of directors, especially a board where the stakes are high and the board philosophically and politically—Philadelphia vs. Boston—divided. The idea failed, but I had a fallback plan. We would internalize the business side of the business—operations, administration, legal, and accounting (hardly the entrepreneurial side)—and leave investment management and marketing—the fun side—to Wellington Management Company. The compromise was struck, and I and some 28 souls who trusted me to make it all work moved from Wellington to become full-time employees of the funds—Wellington, Windsor and eight others. I confess to being a bit devious—but only in a worthy cause!—at this point. While I accepted the compromise, I had no thought whatsoever that the structure just put in place would remain intact. Rather— though I said very little about it—I was certain that our future required full mutualization, also running the investment management and marketing activities in-house. Only in this way could whatever entrepreneurial spark I had fully flourish. The first step was to give the new fund-owned company a strong name. (To my horror then—but a blessing in disguise—the fund directors had determined that the Wellington name—except for Wellington Fund itself—would remain with my adversaries.)

in 1993, a full decade ago. As a group, alas, our corporate directors have failed to measure up to that standard. Two centuries ago, James Madison said, “if men were angels, we wouldn’t need government.” Today, I would echo that idea: If chief executives were angels, we wouldn’t need corporate governance. Extending this analogy of political systems to corporate systems when I recently spoke to the Business Council, I said that we should avoid corporate governance based on the dictatorship of the CEO. While democracy might not be possible, I suggested, at least we should establish a republic, with the elected representatives of the shareholders fully empowered to assure that the corporation held high the interests of the shareholder, above all competing claims. (The assembled group of CEOs, by and large, didn’t seem to care for the analogy, and there was a rather heated response from the floor.) There is powerful evidence that directors failed to do just that. The result: a raft of misleading corporate financial statements and the grotesquely excessive executive compensation that helped create the stock market bubble and—bubbles being bubbles—its subsequent burst. Yet the directors of corporate America couldn’t have been unaware of the management’s aggressive “earnings guidance.” Nor that management’s focus was on raising the price of the stock, never mind at what cost to the value of the corporation.

Headstrong, impulsive, and naïve, I found a merger partner—in Boston, of all places— that I hoped would do exactly that. Alas, despite the glitter, I found no diamonds there. The merger worked beautifully for about five years, but the investment managers who were my new partners let our fund shareholders down, the stock market dropped 50%, and the assets we managed plunged from $3 billion in early 1973 to $1.3 billion in late 1974. Not surprisingly, the new partners had a falling out. But my adversaries had more votes at the Company than I did, and it was they who fired me from what I had considered “my” company. What’s more, they intended to move all of Wellington to Boston. I wasn’t about to let that happen. I not only loved Philadelphia, my adopted city that had been so good to me, but by 1974 I had established my roots here, finding unimaginable diamonds, first, in my beloved wife Eve, who was born and grew up here, and then in six wonderful children. We intended to say where we were, and I had a plan to do just that. For when the door slammed, a window opened, and the acres of diamonds I had begun to discover in 1951 were to remain in Philadelphia. Pulling off this trick was not easy. But I was able to parlay a slight difference in the governance structure of the Wellington funds, owned by their own shareholders, and Wellington Management Company, owned largely by my former partners, into a new career—and with it more diamonds than I ever could have imagined.

I’m speaking, of course, of Vanguard, the little company that I founded all those years ago, a company started by accident and begun as an experiment. The legends about Vanguard’s creation happen to be true. Yes, in January 1974, I was fired from my job as chief executive of Wellington Management Company. Yes, I then presented a plan to the directors of the Wellington-managed mutual funds under which I would remain as their chief executive, and the funds would retain their own operating staff. Yes, after months of tussling, the directors approved that initial plan, and Vanguard was incorporated on September 24, 1974. (And yes, I picked that name out of an old book of Great Britain’s naval history, where I learned for the first time of Lord Nelson’s flagship at the Battle of the Nile in 1798; it was HMS Vanguard.) The creation of that unique new structure led to: (1) the establishment of a new form of governance in the mutual fund industry, a mutual structure in which the interests of fund investors would take precedence over the interests of fund managers and distributors, in constitutional terms, a governance “of the investor, for the investor, and by the investor.that

Or should they? Think about it for a moment. Why should the board bear the ultimate responsibility when it doesn’t even have the ultimate responsibility? It is the stockholders themselves—surely this audience, above all, knows that!—who bear the ultimate responsibility for corporate governance. And as investing has become institutionalized, stockholders have gained the real—as compared with the theoretical—power to exercise their will. Once owned largely by a diffuse and inchoate group of individual investors, each one with relatively modest holdings, today the ownership of stocks is concentrated—for better or worse!—among a remarkably small group of institutions whose potential power is truly awesome. The 100 largest managers of pension funds and mutual funds alone now represent the ownership of one-half of all U.S. equities: Absolute control over corporate America. Together, these 100 large institutional investors constitute the great 800-pound gorilla who can sit wherever he wants to sit at the board table. But the gorilla doesn’t even come to the meetings. With all that power has come little interest in corporate governance. There is an amazing disconnection between the potential and the reality—awesome power, but rarely exercised. Yet institutional managers could hardly have been ignorant of what was going on in corporate America.

But these agents, beset by conflicts of interest, have failed to place front and center the interests of their principals, passively ignoring the need for good governance and allowing corporate managers to look primarily to their own interests. As the economists would say, investment America has an “agency problem.”  Two, the rise of short-termism. Institutional money management, once an own-a-stock industry (holding an average stock for six years during my first 15 years in this field) has become a rent-a-stock industry, now holding a typical stock for but a single year, or even less. That sea change caused us to forget about the importance of good corporate governance. When owners are investors, they must care, and care deeply, about the rights and responsibilities of corporate governance, and must exercise those rights and honor those responsibilities.stocks,

stewards, of the corporate property entrusted to them. But when the CEO becomes not only boss of the business, but boss of the board, the concept of stewardship became conspicuous by its absence from the agenda of corporate America, and the traditional separation of powers between management and governance was abrogated. How will we restore that balance of power? If the directors aren't up to the task, well, shareholders will have to start acting like owners. While too many of our corporate stewards have failed to earn our faith, we mutual fund managers and our clients have, I fear, gotten the corporate governance that we deserve. For we have not acted as owners, focusing on corporate value and investing for the long-term. Rather, we have acted as traders, turning our fund portfolios over at an average of 110% per year, engaging in short-term speculation in stock prices. (We have been called, accurately I think, the "rent- a-stock industry.") Partly as a result, even after the great bear market fallout, the role of most giant institutional investors in governance has been conspicuous only by the sound of its silence. But to get the governance our shareholders deserve, we need to begin to act as good corporate citizens, recognizing that ownership entails not only rights, but responsibilities. This change will demand a major realignment of mutual fund priorities.

they could hardly care less. Simply put, as I ask in the book, “If the owners of corporate America don’t give a damn about the triumph of managers’ capitalism, who on earth should?” Yet our new agent/owners remain passive to a fault on governance issues.  Three, the triumph of illusion over reality. As our professional security analysts came to focus ever more heavily on illusion—the momentary precision of the price of the stock—they increasingly ignored the reality—that what really matters is the inevitably vague, but eternally transcendent, intrinsic value of the corporation. (As investment icon Benjamin Graham, mentor to Warren Buffett, perceptively put it: “In the short run, the stock market is a voting machine; in the long run it is a weighing machine.”) Measuring up, unfortunately, to Oscar Wilde’s piercing description of the cynic, our money managers came “to know the price of everything, but the value of nothing.” But when there is a gap between perception—illusion—and reality—the business fundamentals of cash flow and dividends—it is, to state the obvious, only a matter of time until the gap is reconciled . . . inevitably, in favor of reality. In Mutual Fund America:  One, the industry changed. Mutual funds, once a profession with elements of a business, gradually became a business with elements—and too few elements at that—of a profession. Our traditional guiding star of stewardship was transmogrified into a new star— salesmanship.

Sharply reduced costs in this fund industry will obviously serve fund shareholders, but it should not go without saying that it will also serve personal financial advisers. You charge, as you must, fees for the services you provide your clients, and you deserve a wide choice of suitable, fairly-priced funds from which to choose the mutual funds you offer. That simple fact, indeed, lies behind my conviction, reached more than a decade ago, that Vanguard, with its low- costs, should be the natural ally of financial planners and registered investment advisers, with their need to keep the total level of client costs at reasonable levels. Working in unison, personal financial advisers can press the funds to reduce their costs with a power far greater than my idealistic vision. If your association, representing individual investors, could somehow join with retirement plan trustees, representing institutional investors, and demand a fair shake for fund investors, you could make a real difference in enhancing the future returns earned by your clients. In this context, I was struck by your Code of Ethics. It uses wonderful words that, as it happens, rarely if ever appear in mutual fund literature: “fiduciary responsibility to clients. . . practicing fairness and suitability. . . integrity and honesty.” These are the right words to describe the values of firms and individuals entrusted with the stewardship of the assets of investors.

Congress . . . a massive failure in the governance system.” But while Enron may prove to be the worst failure of our corporate stewards, I need not tell you it is hardly alone in its failure to merit the faith of investors. Casino Capitalism Lord Keynes warned us long ago of what happens when speculation achieves predominance over enterprise, and I also quoted some of these words in my ancient university thesis: “In one of the greatest investment markets in the world, namely, New York, the influence of speculation is enormous . . . it is rare for an American to ‘invest for income,’ and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that he is attaching his hopes to a favorable change in the conventional basis of valuation, i.e., that he is a speculator. But the position is serious when enterprise becomes a mere bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” The analogy of the casino to the recent era in our financial markets is hardly far-fetched. Investors have focused on short-term speculation based on the hope that the price of a stock will rise, rather than long-term investment based on the faith that value of a corporation will grow.

everything but the value of nothing,” he could have as easily been talking about the typical fund manager. The Mutual Fund Barrel Clearly, if we are to return to a system of owners capitalism, the active participation of institutional investors is essential and the mutual fund industry must be involved. That will not be easy, for the deeply-flawed mutual fund governance barrel makes the corporate governance barrel seem pristine. Think about it: Fund independent directors in actuality have only two important responsibilities: Obtaining the best possible investment manager and negotiating with that manager for the lowest possible fee. Yet their record has been absolutely pathetic. They follow a zombie-like process that makes a mockery of stewardship. Able but greedy managers have overreached and tried to dip too deeply into the shareholders’ pockets, and directors haven’t slapped their hands. They have failed as well in negotiating management fees. “Independent” directors, over more than six decades, have failed miserably. Fee reductions mean nothing to “independent” directors, while meaning everything to managers. So guess who wins? I would not have the temerity to use such highly charged language. Those words were actually written by Warren Buffett in his recent Berkshire Hathaway annual report. Mr. Buffett is, of course, right. And I dare to add, “as usual.” Of course the managers win. For the chairman of the fund is almost invariably the head of the management company.

seems a specious, even self-serving, reason for allowing those at the top of the business pyramid to have complete protection from challenge and possible removal from office. The entrenched business interests also allege that even limited access to the slate would open the door to “special interest” directors, less-well qualified directors, and dysfunctional boards. But these developments could only occur with the consent of the owners, and there is no reason to assume that a majority of owners would vote for unqualified or irresponsible directors. While a board constantly engaged in civil war would hardly serve the owners’ interests, however, it is not at all clear that those interests aren’t equally ill-served when harmony is so embedded that no dissent can be brooked. Surely we can all think of individual cases in which shareholders have paid a high price for collegiality so deep-seated that it stifles dissent. What is more, all directors, no matter how nominated, have a fiduciary duty to act solely in the interests of the shareholders of the corporation. It’s up to the owners, not the managers, to weigh the pros and cons of the issues surrounding electoral challenges and board composition and, by exercising their franchise, decide them. It’s called corporate democracy. Beyond the Board Slate The second issue regarding shareholder access to the corporate ballot is the ability of owners to make proposals regarding corporate activities.

Fixing our business and financial system must begin with a return to the original values of capitalism, to that virtuous circle of integrity—“trusting and being trusted”—as I mentioned at the outset. When ethical values go out the window and service to those whom we are duty-bound to serve is superseded by service to self, the whole idea of the capitalism that has been a moving force in the creation of our society’s abundance is soured. In the era that lies ahead, the trusted businessman, the prudent fiduciary, and the honest steward must again be the paradigms of our great American enterprises. It won’t be easy, but if we all work long enough and hard enough at the task, we can build, out of a long-gone ownership society and a failed agency society a “fiduciary society,” one in which the citizen-investors of America will at last receive the fair shake they have always deserved from our corporations, our investment system, and our mutual fund industry.

A Failure of Character But there’s more at stake than that. This nation’s founding fathers believed in high principles, in a moral society, and in the virtuous conduct of our affairs. Those beliefs shaped the very character of our nation. If character counts—and, as my book underscores, I have absolutely no doubt that character does count—the failings of today’s business and financial model, the willingness of those of us in the field of wealth management to accept practices that we know are wrong, the conformity that keeps us silent, the selfishness that lets greed overwhelm reason, all erode the character we’ll require in the years ahead, especially in the post-September 11 era. The motivations of those who seek the rewards earned by engaging in commerce and finance struck the imagination of no less a man than Adam Smith as “something grand and beautiful and noble, well worth the toil and anxiety.” I can’t imagine that anyone in this room today would use those words to describe our corporate governance system at the outset of the 21st century. So, yes, too many of our corporate stewards have failed to earn our faith. By focusing on short-term speculation at the expense of long-term investing, we institutional managers have, I fear, gotten the corporate governance that we deserve. Yet most giant institutional investors have been conspicuous only by their silence.

inception in 1924 through the early 1960s, fund managers operated largely as prudent trustees of the assets that investors entrusted to them, and put their investors’ interests first. The managers of yore were privately owned, relatively small professional firms whose role was focused largely on stewardship. In the sense, then, that fiduciaries faithfully honored the interests of the actual owners—the mutual fund shareholders—it was indeed the era of owners capitalism, if you will, by proxy. But over the years, the focus of the mutual fund industry has gradually shifted—from management to marketing, from stewardship to salesmanship, and—just as in the case of corporate America—from owners capitalism to managers capitalism. Funds vs. Active Investors—Then and Now One of the main victims of that change came in our industry’s role in corporate governance. As those earlier privately-owned trusteeships whose managers focused on long-term investing in highly-diversified equity funds gradually metamorphosed into giant publicly-held corporations whose managers focused on short-term speculation in ever-more-aggressive specialized funds, portfolio turnover went right through the roof. Up until 1966, it was a rare year when annual turnover exceeded 16%, an average holding period of six months. But today fund managers turn their portfolios over at an astonishing average annual rate of 110%(!), an average holding period of just eleven months. We are no longer an own-a-stock industry.

If we simply act as good corporate citizens and recognize that ownership entails not only rights but responsibilities, we will again get the governance we deserve. And our clients will benefit accordingly. If we all take the initiative to stand up and be counted, we will at last return to an era in which the great creative energy of American business and finance shifts from its short-term focus on the price of a stock—speculation—to a long-term focus on the value of the corporation—enterprise. When we do, our corporate stewards will respond appropriately, and that change will well-serve both investors and our nation. 3. Faith In Our Trustees For in addition to the troubled financial markets and the failings of the stewards who run our corporations, the trustees of the investment dollars of American families—the pension funds, the mutual funds, and other financial institutions—have also failed to live up to the faith investors have placed in them. To explain how this situation has come about, we need first to understand the simple mathematics of investing: The returns earned by investors in the aggregate inevitably fall well short of the returns that are realized in our financial markets.very

We are a rent- a-stock industry, a world away from Warren Buffett’s favorite holding period: Forever. But while a fund that owns stocks has little choice but to regard proper corporate governance as of surpassing long-term importance, a fund that rents stocks could hardly care less. The 1949 Fortune magazine article that led me to write my Princeton senior thesis about mutual funds, which in turn got me my first job in this business, shows how much our attitude toward corporate governance has changed. Fortune wrote, all those years ago, that mutual funds were “the ideal champion of . . . the small stockholder in conversations with corporate management, needling corporations on dividend policies, blocking mergers, and pitching in on proxy fights,” even as the SEC was calling on mutual funds to serve “the useful role of representatives of the great number of inarticulate and ineffective individual investors in corporations in which funds are interested.” Back then the industry owned less than two percent of all stocks. Yet even though our ownership has soared to 23 percent, it was not to be.

1. Remember that the mathematics are immutable. Explicitly recognize and acknowledge that investment success—not just in the long-run, but every day of every week, and every month of every year—is defined by the apportionment of market returns between investors on the one hand and financial intermediaries on the other. 2. Reduce basic advisory fees, but endeavor to maintain firm revenues by incorporating incentive/penalty fees. These actions will reward the successful firm and penalize the unsuccessful. (They will, of course, reduce the total level of industry-wide advisory fees.) 3. Cut operating and administrative costs. This may mean less awesome views of America’s most magnificent skylines and harbors, less lavish entertainment, fewer client junkets, fewer seminars in Bermuda, less glossy presentations, less first-class travel, and more modest wine cellars . . . the whole nine yards. 4. Reduce marketing expenses to the bare-bones level. Advertising is expensive! Special note to the mutual fund industry, where some firms’ annual marketing budgets exceed $100 million: Those expenses raise serious questions of fiduciary duty, questions about whether the investment interests of fund clients are playing second fiddle to the marketing interests of the adviser. 5. Take a hard line on transaction costs. Even more importantly, take a hard line on transactions.

Mutual Funds and the Governance Failure This industry’s notorious passivity on corporate governance issues means that we bear no small share of the responsibility for the ethical failures in corporate governance, the excessive executive compensation, the earnings overstatements, and the co-opting of accountants that we’ve seen during the recent era. But it’s going to take a lot of work to bring mutual funds into a 21st century world of increased investor activism, for we face a profound conflict of interest when we come to vote the shares of the corporations whose pension and 401(k) assets we manage. In addition, our own weak governance system—where separately owned management companies essentially control their associated funds—places us in the role of people who live in glass houses: We’ve implicitly decided that it doesn’t seem like a good idea to cast stones at the governance of corporate America. Nowhere was that fact made more obvious than in the fund industry’s almost unanimous opposition to the SEC’s proposal that we disclose to our own shareholders how we vote the proxies of the companies they own via our portfolios. While it would seem utterly obvious that a fund manager (the agent) would be expected to report his actions to the fund owners (the principals), the industry fought the proposal.

In the era that lies ahead, the trusted businessman, the prudent fiduciary, and the honest steward must again be the paradigms of our great American enterprises. It won’t be easy, but if we all work long enough and hard enough at the task, we can build, out of a long-gone ownership society and a failed agency society, a fiduciary society in which the citizen-investors of America will at last receive the fair shake they have always deserved from our corporations, our investment system, and our mutual fund industry. Capitalism and Values The idea that values should be intimately embedded in the practice of business, of course, was an important message of my idealistic Princeton thesis of 54 years ago. But I’m hardly alone.greatest

But it’s hard to imagine that few, if any, of you couldn’t be better stewards of the assets shareholders have entrusted to your care if you operated under a more enlightened governance structure. When fund directors examine the apportionment of fund returns between managers and shareholders; when directors consider the baneful trends that have developed in investment activity and fund costs; when the bright spotlight of public attention is focused on directors’ fees that seem grossly disproportionate to the responsibilities assumed and the time commitments involved; when board leadership devolves to independent directors served by independent counsel; and when the watchdog has no master but the investors that he or she is duty bound to serve; then, whenever trouble is afoot, we shall hear that barking dog, the strong watchdog that will lead the way in giving the fund investor a fair shake.

interests of others, the love of what is honorable and noble, the grandeur and dignity of our own characters.” Adam Smith, here, the apostle of virtue, is advising us to put the greater interest of others before the interest of ourselves, and our failure to do so is reflected in modern-day managers’ capitalism in which the interests of those who run our corporations and financial institutions are ascendant. My Battle book is replete with scores of specific recommendations to help us return to our roots, the most sweeping of which is the call for the formation of a federal commission to (a) recommend policies that respond to the failure of our agency society in which direct stockowners have become an endangered species, and (b) to take the steps necessary to ultimately eliminate the frightening shortfalls—recently estimated at $1.2 trillion for pension plans alone—in the expected future wealth that investors will accumulate through the vastly underfunded retirement plan system that is the foundation of our national savings. These two problems are directly related, and best solved by the creation of a fiduciary society in which intermediaries truly represent—first, last, and only—the interests of those they serve. So, I recommend this federal approach for the development of an investor-oriented—not manager-oriented—fiduciary society.

. . they can hire and fire managements and bend them completely to their will.” He was—and is—right. But he was—and is—right when he added that “the assertion of rights by stockholders in practice is almost a complete washout. They show neither intelligence nor alertness unless prodded violently into action. They vote in sheep-like fashion for whatever management recommends and no matter how poor the record of accomplishment may be . . . this attitude of the financial world toward good and bad management is utterly childish.” Yet the cause is not lost. Even after all these years, perhaps Benjamin Graham’s words can awaken us, and force us to consider ways that institutional stockowners, working in concert with corporate managers, can root out the problems that plague our system. Here are four suggestions: 1. Encourage Corporate Citizenship. The only way investors—and particularly institutional investors—will become better owners is if we at last return to behaving as responsible corporate citizens, voting our proxies thoughtfully and communicating our views to corporate managements. The SEC’s recent decision to require mutual funds to disclose how we vote our proxies is a long overdue first step in increasing our motivation to participate in governance matters. But we also need the ability to act—“access” to corporate proxy statements—so that we can place both nominations for directors and proposals for compensation policy and business conduct directly in the proxies.

decline—which was to reach 50%—following the burst of the earlier Go-Go bubble in the market. They banded together to fire me, accomplishing the deed on January 24, 1974. I was devastated. But I promptly set out to recoup my job. In brief, I was able to persuade the directors of the mutual funds that were managed by Wellington to set off on a new course: Establishing a staff dedicated solely to the funds shareholders’ best interest; operating, not for a percentage fee but on an at-cost basis; and giving the funds complete independence from the managers who had fired me. I named the new company after Lord Nelson’s flagship HMS Vanguard—another lucky break—and described our unprecedented foray into running truly mutual mutual funds as The Vanguard Experiment, a test of whether our novel corporate structure and unprecedented form of fund governance that focused on profits to fund shareholders rather than profits to fund managers could succeed. In the words of author-economist Peter L. Bernstein: Jack Bogle’s goal was to build a business whose primary objective was to make money for his customers by minimizing the elements of the inherent conflict of interest (between seller and buyer), but at the same time be so successful that it would be able to grow and sustain itself. It has been no easy task. Strategy Follows Structure We were incorporated in September 1974, almost at the very bottom of the bear market. Our asset base was $1.

Passivity in the Face of Power The pervasive passivity of stock owners in pressing their own interests presents an ironic counterpoint to the astonishing concentration of voting power among a relative handful of institutional managers. The nation’s 100 largest financial institutions hold 56% of all shares of U.S. corporations. Overwhelmingly (77 of the 87 private firms), these giant institutions are managers of both mutual funds and pension funds, responsible for $5.4 trillion of the $5.5 trillion private (non-state) total invested in stocks. We can examine the behavior of these investment managers to get some sense of why this passivity exists. One major reason is the short-term investment horizons that have, over the past several decades, come to characterize the field of money management. While corporate governance issues would seem to call for vital concern by the long-term investor, it is not much of an issue for the short-term speculator. So as mutual fund turnover leaped from a remarkably stable 15% annual rate during the 1950s and early 1960s to 100% (or more) since the late 1990s, interest in governance faded accordingly. If a six-year holding period for the average common stock in a fund portfolio once marked mutual funds as an own-a-stock industry, surely the one-year holding period of today marks us as a rent-a-stock industry.

suggests that it is caused by “aggressive marketing executives who see short-term numbers as the best way to attract new shareholders.” One top strategist says, “that’s the marketing side of the business talking, not someone with a fiduciary duty.” Another asserts, “relative investing is ridiculous.” Still another routinely consults what he describes as his 11th Commandment: “Thou shalt not do relative investing.” Warns another, “relativity worked well for Einstein but has no place in investing.” Such mutual fund managers who elect to be different—and I wish that there were more of them—need to make it absolutely clear to shareholders that their returns will not closely track the quarterly returns, nor even the annual returns, of a market index, even as the managers should make it equally clear that their expectation is to outpace the market over the long run. The short- term nature of today’s pervasive environment of comparisons is merely noise, a discordant element that ill-serves managers and financial markets alike. In this context, I reiterate a thought, courtesy of William Shakespeare, contained in my book. I describe the short-term noise in the market as “a tale told by an idiot, full of sound and fury, and signifying nothing.” In short, relativism is the triumph of process over judgment. I believe that it is possible for some managers to apply judgment borne of wisdom and experience to outpace the market over time, without assuming undue risk.

Given the hyper-short-term trading activity that now characterizes institutional investing, the forbearance of portfolio managers from governance issues actually reflects a perverse common sense. Why spend money on evaluating a company’s governance when you likely won’t even be holding your shares when the next proxy season rolls around? But there’s more than short-termism that accounts for the absence of funds from the governance scene. Consider that index funds—and other funds that follow essentially static buy- and-hold strategies—comprise some 25% of the assets of the Institutional 100. Yet the voices of these consummate long-term investors have been, if not totally silent, at least seriously muted. And even active managers engaging in what passes for low turnover in the current environment (say, below 35%) have generally refrained from intrusion into the affairs of the corporations in which they invest. One obvious reason for this passivity is the desire to avoid controversy. In the asset-gathering business that money management has become, a high profile on a divisive issue is more liability than asset.

Heck, ask the finance professors here at the University of Virginia (who are probably indexers themselves). Let’s face it: the jury is in. The verdict is: Index! (I leave the proportion in stock and bond index funds to your own good judgment; surely some of each.) We’d best take the problems I’ve outlined today seriously, for we must solve them if our nation’s citizen-investors are to be blessed by the promises of our Declaration of Independence— “the right to life, liberty, and the pursuit of happiness”—and of our Constitution—“to promote the general welfare . . .” Fixing today’s CEO-centric corporate world, eliminating the excesses of the financial system, and repairing the faltering mutual fund industry—returning control from managers to owners in a new fiduciary society—is on the way. I hope my book will give it a good push. But whether it comes about through laws and regulations, or by the wisdom finally acquired by crowds of investors making intelligent investment decisions as they simply seek to further their own economic interests, so it will be. That conclusion reflects my lifelong idealism, and it remains my ideal today.

Another reason for such forbearance is conflict of interest. While such conflicts are regularly denied, it is easy to imagine that private institutional managers would be reluctant to vote against the entrenched corporate managements that have hired them to manage most of the more-than-$2 trillion of equities in their pension plans and 401-k thrift plans. But that’s only the beginning of the problem. While the votes of the mutual funds in a company’s thrift plan presumably must be voted as a whole, the corporation itself could direct its pension managers to vote the shares of the corporations held in its pension plan in any way it wished. But it doesn’t take a lot of imagination to realize that corporations, too, are unlikely candidates for aggressively voting the shares their pension plans hold in other corporations. Why be known as a trouble-maker among your Business Council colleagues? So, whether tacit or explicit, a system has emerged in which “let he who is without sin cast the first stone” has become the watchword of behavior for corporations that control trillions of dollars worth of shares of other corporations—a sort of American Keiretsu. Further, of course, passivity in governance pays. Let others undertake the hard work and costs of activism. If their efforts are successful, the passive-ists—holding, say, the remaining 95% to 99% of shares, will not only reap the rewards, but increase their chances of getting the pension and thrift business of the activists.

Mutual Funds as Proxy Voters A new development may well inspire mutual funds to join those investors to become more conscious of their responsibilities of corporate citizenship, and to take their voting responsibilities more seriously. Early in 2003, the Securities & Exchange Commission approved a requirement that funds (the “agents”) report to their owners (the “principals”) how their (the owners’) shares were voted in corporate proxies. While such disclosure would seem totally logical, the fund industry brought out its biggest guns to battle the proposal, and even long-time rivals Fidelity and Vanguard joined together in expressing their opposition in a Wall Street Journal op-ed piece signed by their chairmen. (“Politics makes strange bedfellows.”) Despite the opposition, the SEC stood its ground, and in August we’ll learn how each mutual fund voted each of its corporate proxies during the 2004 season. It’s about time, and it will matter. For I believe that the requirement to disclose proxy votes will begin the process of giving mutual funds the motivation to become better corporate citizens. For example, The Vanguard Group, which has traditionally regarded regular voting of proxies as a fiduciary duty, adopted more aggressive proxy voting guidelines in 2003. While the funds had previously endorsed 90% of director slates, last year they ratified all directors in only 29% of the slates, withholding votes from at least one nominee in a stunning 71% of the cases.

The Vanguard funds also voted against auditors at 21% of the firms, and against 64% of stock option plans. I believe that active voting policies by mutual funds will become more evident with each passing year. Once owners become used to acting like owners, once corporate citizens understand their rights and responsibilities in a democracy, once institutions begin to cooperate with their peers for the common good, we can at last begin the process of replacing Managers Capitalism with Owners Capitalism. Some Mind-Expanding Wisdom But there is more that needs to be done. And some important ideas about radical reform have been put forth by Robert A.G. Monks. Few individuals have been as deeply involved in corporate governance issues—and even fewer have played as constructive a leadership role—as Mr. Monks, founder of ISS as well as the corporate activist firms Lens, Inc., and Lens Governance Advisors. His fact-filled 564-page tome Corporate Governance (with Nell Minow) is a must-read for those who seek to understand what went wrong in corporate America and what needs to be done.Maker’s

To make his point, Mr. Surowiecki uses the example of the 1956 comedy, “The Solid Gold Cadillac.” Judy Holliday played Laura Partridge, a small investor whose continual harassment of the board finally gets the company to put her on the payroll as its first director of investor relations. She uses the position, however, to organize a shareholder revolt that topples the corrupt CEO. As Surowiecki concludes: “American companies are the most productive and inventive in the world, but a little adult supervision (by the owners) wouldn’t hurt. Laura Partridge had it right a half a century ago: ‘Somebody’s gotta keep an eye on these geniuses.’” That “somebody” must be the owners. For it is shareholder involvement in corporate governance that will be required to return us to owners capitalism, and eradicate the system of managers capitalism that we never should have allowed to come into existence in the first place. It’s high time we all work together to achieve that mission.

independent directors who have the responsibility for careful scrutiny that assures the primacy of those interests. The Ten Commandments You don’t have to tell me how tough a job it will be for this industry to reach that worthy goal. I’ve been doing my best, even in the years before “The Vanguard Experiment” began, but the tangible results are disappointingly few. Vanguard began its thousand mile journey with a single step in 1974, and lots more steps have followed. (Few of you know how arduous and demanding each of those steps have been, and continue to be.) But let me suggest some further steps along the way to meeting the clear—and wholly desirable—mandate of the ‘40 Act. While I wish we could take a giant step—establishing a federal standard of fiduciary for fund directors would be my choice—the fact is that a series of small but deliberate steps is more realistic. So I would propose that we begin by setting down these Ten Commandments for independent directors: 1) Thou Shalt Retain Thy Own Independent Counsel. Recommended by the Securities & Exchange Commission, this step seems so obvious and so essential that it is hard to imagine why it hasn’t been mandatory ever since this industry began in 1924. Just imagine, in any other business, the anomaly of a firm being represented, not by its own counsel, but by counsel for its largest supplier of services, who depends on it for its very existence.

Guide to Reform (with Allan Sykes)2, he sets forth a framework for fixing the system. His wisdom is worth considering. “Government involvement is clearly needed in corporate governance to guarantee the nation’s citizens the neglected rights of ownership of their stocks. What is needed is a clear and consistently enforced public policy that gives all owners’ representatives, the intermediary investment institutions and their fund managers, the clear fiduciary requirement to be active with respect to companies held in their portfolio accounts, and the confidence that they will not be placed at a competitive or reputational disadvantage with their competitors by complying. Above all else, it must be unmistakable that government intends, and is capable of enforcing, the trustee and fiduciary laws for the sole purpose and exclusive benefit of their beneficiaries’ interests—the great part of the funded pensions of most citizens—in an even-handed way. “1. In support of the fundamental principle that there should be no power without accountability, government should affirm that creating an effective shareholder presence in all companies is in the national interest and that it is the nation’s policy to aid effective shareholder involvement in the governance of publicly owned corporations. “2.

But there's even more at stake than improving the practices of governance and investing. We must also establish a higher set of principles. Our founding fathers believed in high moral standards, in a just society, and in the virtuous conduct of our affairs. Those beliefs shaped the very character of our nation. If character counts—and I have absolutely no doubt that character does count— the ethical failings of today's business and financial model; the manipulation of financial statements; the willingness of those of us in the field of investment management to accept practices that we know are wrong, the conformity that keeps us silent, the selfishness that lets our greed overwhelm our reason; all have eroded the character of capitalism. Yet character is what we'll need most in the coming new era I've described today; more than ever in the wake of the great bear market and the investor disenchantment it reflects; more than ever in these days when economies around the globe are struggling to find their bearings; more than ever in the strife-ridden world around us, where America's strength lies more than ever in her values, her ideals, her goodness. The motivations of those who seek the rewards earned by engaging in commerce and finance struck the imagination of no less a man than Adam Smith as "something grand and beautiful and noble, well worth the toil and anxiety."

All pension fund trustees, mutual funds and other fiduciaries must act solely in the long- term interests of their beneficiaries and for the exclusive purpose of providing them with benefits, in order to ensure the functioning of an appropriate board of directors. “3. To give full effect to the first two proposals institutional shareholders should be made accountable for exercising their votes in an informed and sensible manner. Votes are an asset which should be used to further beneficiaries’ interests on all occasions, and their voting should be virtually compulsory. “4. To complete and powerfully reinforce the other three proposals, such shareholders should have the exclusive right and obligation to nominate at least three non-executive directors in each company (held in their portfolios).” Wrapping Up The title of Mr. Monk’s monograph—Capitalism Without Owners Will Fail—is not an overstatement. Corporate America can only be an engine of the nation’s growth and prosperity and a major source of innovation and experiment if its managers are focused on creating long- term value for its owners. To the extent that managers sit unchecked in the driver’s seat, 2 Available at www.ragm.com/library/topics/ragm_sykesPolicyMakersGuide.html

(Two of the three largest institutional equity managers and three of the largest six are primarily indexers.) And there are other notable long-term active managers (for example, Capital Group, Wellington, Dodge and Cox) that would be prime candidates for subsequent membership. For too many years, I’ve called for such a “Federation of Long-Term Investors” to discuss issues of corporate governance and corporate citizenship. But it is only a matter of time until the idea gains traction. One way or another, institutional investors that own companies, as distinct from those that trade stocks, must cooperate to make their will felt for the common good. The Economist of London expressed a similar sentiment as it described “the ideal owner”—a long-term stockholder, perhaps even a permanent owner, whose goals are closely aligned with the corporation . . . “Everything now depends on financial institutions pressing even harder for reforms to make boards of directors behave more like overseers, and less like the chief executive’s collection of puppets . . .their

collective interest as owners. Chief executives would still run their firms; but, like any other employee, they would also have a boss.” The task of returning capitalism to its owners will take time, true. But if the will is there, the way will be there as well. For “the New Reality”—increasingly visible with each passing day—is that proper corporate governance is not merely an ideal nor a luxury, but a vital necessity. The role of the owners, I underscore, is to do no more than assure that the interests of directors and management are aligned with those of the shareholders. And when there is a conflict of interest, it is the shareholders who should make the decision. It is in the national public interest and in the interest of investors that the owners begin to realize that enlightened corporate governance is not merely a right of business ownership. It is a responsibility to the nation.

Yet largely as the result of a redemption fee of 2% in the first year and 1% for the next four years, the funds in the industry’s first tax-managed series, now in their sixth year, have an annual redemption rate running at just 5%. Surely there are lessons to be learned from this potential 90% reduction in redemption activity. (Alas, even as it effectively excludes short-term investors, the redemption fee retards marketing. So you serve the shareholders at the expense of the manager.) 10) Thou Shalt Evaluate Thy Fund as If It Were Your Own Money. Bring this attitude to your work as a director: Is this the way my money should be run? Is my performance satisfactory? How about my tax-efficiency? How about continuity of my portfolio management? How much would I be willing to pay for this service? When performance lags, how patient would I be? When would I terminate my own fiduciary relationship and move to another? In all, behave as if you were a large shareholder, and assume that the assets were important to you. Better yet, actually own shares of the funds you serve as trustee.investment

Duty-bound to serve their shareholder/principals or not, corporate managers have relegated the interests of their owners to second place behind their own. They have rewarded themselves with shockingly outlandish salaries, bonuses, and stock options; they engage in vigorous financial engineering of the earnings they report to their shareholders; and they have orchestrated huge stock buy-back programs that are often undertaken to offset the dilution of earnings entailed by the exercise of the stock options that they have awarded to themselves. Corporate managers do all of this because they care deeply about their own financial interests and prestige over their peers. And the money manager/agents, ostensibly overseeing them, have let it all happen without significant protest. These money manager agents don’t seem to care about corporate governance, in part because they have their own conflicts of interest. Most are lavishly compensated, so they don’t dare to cast the first stone at their wealthy fellow agents in corporate America. Further, the portfolio managers of these agents are too often short-term traders in a company’s stock (“renters”) rather than long-term holders of stock (“owners”). Stock renters don’t care—and perhaps shouldn’t care—about corporate governance. When one side cares and fights for itself with a passion, and the other side doesn’t care and prefers low-profile passivity, it is hardly surprising which side wins.

contrasting strategy designed to serve fund investors. Finally, I’d like to give you a few personal reflections about my long career in this industry. Strange as it may seem, during my career began with my 1951 Princeton senior thesis on “The Economic Role of the Investment Company,” calling out values that have been reaffirmed all through my career.  Mutual funds’ “prime responsibility must always be to their shareholders.”  Funds must operate in “the most efficient, economical, and honest way possible.”  Funds “can make no claim to the superiority over the market [indexes].”  Funds should represent “the great number of inarticulate and ineffective individual clients” in corporate governance. Foresight? I doubt it. Callow? Sure. The new paradigm I created for mutual funds may well have found their genesis 66 years ago in the callow idealism of a prototypical college student. Truth told, I hoped to present the story of Vanguard and its implications for the mutual fund industry at the coming General Membership Meeting of the Investment Company Institute. My credentials: former chairman of the ICI board; a leader who brought three of ICI’s future chairmen into the fund industry (and helped to groom a fourth); founder and long-time CEO of the ICI’s largest member and largest dues payer; a voice that ought to be heard, discussing the new and disruptive trends that those fund executives gathering in Washington D.C.

The idea of splitting the two jobs—the fund role, traditionally titular in nature; the management company job, holding the implicit power to control the funds—seemed sort of, well, weird. But to me, the concept of putting the fund directors—and thus the shareholders to whom they are responsible—in the driver’s seat was a far more rational structure for mutual fund governance than the traditional convoluted structure. We called it “the Vanguard Experiment” in mutual fund governance. By eliminating the profits to an outside firm, Vanguard would quickly become the low-cost provider in an industry where costs are (almost) everything, and where—except for the highly cost- competitive index fund segment—our peers have little interest in competing on costs. (It’s bad for management company profits!) The mutual “at cost” structure would put the fund clients first. A declaration of independence of the funds from their investment adviser. This solution appealed to my logic, my contrarian streak, my determination, and my idealism. But in addition to those (I think) noble motives, I had a less noble motive: I wanted to survive. I wanted to continue my then 23-year career in this wonderful industry.may

4 One might have expected that as stock ownership moved from a diffuse group of often unsophisticated individual investors to a concentrated group of powerful investment professionals, these new owner/agents would make their will known. Yet until recently, nearly all money managers have been conspicuous by their absence from the corporate governance 3 Quoted from journalist Jason Zweig’s column in The Wall Street Journal, August 21, 2017. 4 The title of my speech in New York before The New York Society of Analysts, October 20, 1999.

Yes, this new focus will change our profession, but business values must still be balanced with fiduciary values. Strong ethics and professional competence must still be the bulwark of finance. We must develop a keener awareness of how our financial system works, a profound introspection about how we can make it better, a knowledge of the long history of finance, and a deep involvement in fostering in our profession the high character it requires if we are to serve investors effectively, efficiently, honestly, and prudently in the years ahead. Balancing Business Values and Professional Values I hope you will read my impassioned paper on business values and professional values in the most recent edition of the Financial Analyst Journal, and will consider my perspective. I’ve plied my trade of investing for almost 66 years, and I’ve seen so many of my principles find acceptance—not just on indexing, on the importance of low costs, and on short-term speculation vs. long-term investment, but on investment standards, ethics, and fiduciary duty. Of course I’m pleased to have been alive long enough to see the growing acceptance of these ideas. But we still have far to go— “The trees I planted still are young.” “The songs I sing will still be sung.” I suppose it’s ironic that I close my remarks to this distinguished audience of investment professionals with the word “cash.” But those words are the words of Johnny Cash. Take heed. Thank you.

well have been my only chance to do so, and I appealed to the board of directors of the Wellington funds depart from their normal presentism mindset and take this drastic step. It would not be easy. The structure that I proposed quickly led to a bitter fight—the fired CEO vs. those who had fired him. The outcome was in doubt until the battle ended, six months after it began. The new firm had perhaps one chance out of ten to survive. But finally, Vanguard was born. In 1975, we made our first strategic move—to create an index fund. While all of our peers had the opportunity to create the first index fund, only Vanguard, with our unique mutual structure, had not only the opportunity, but the motive. The seed of the idea of the index fund was planted in my 1951 senior thesis (remember, funds “can make no claim to superiority over the market [indexes]”). The foundation of our philosophy was my first-hand experience in trying but failing to select winning managers. And a timely and fortuitous inspiration from Nobel Laureate Paul Samuelson then precipitated the creation of the first index mutual fund. Dr. Samuelson’s essay, “Challenge to Judgment,” was published in the first edition of the Journal of Portfolio Management in the fall of 1974. It struck me like a bolt of lightning. By happy coincidence, I read his essay just as the stock market hit bottom and moments after Vanguard was founded.

scene, generally endorsing slates of corporate directors and approving management’s proxy recommendations. The dominant money managers of our time run both mutual funds and pension plans. Based on a recent study by Institutional Investor magazine, we can estimate that this group of professional investors oversees some $16 trillion of U.S. equities, a 73% share of the total.5 The mutual funds that they oversee alone hold 37% of total equities, and their other institutional clients hold 36%. This is by far the most dominant stock ownership position in history. If at long last our stock owner/agents are to provide countervailing power to the power of our corporate manager/agents, mutual funds will carry a major portion of the response. This is not a new idea for me. Way back in 1951, in my Princeton University senior thesis, “The Economic Role of the Investment Company,” I noted that the Securities and Exchange Commission, in its 1940 report to Congress, called on mutual funds to serve . . . . . . the useful role of representatives of the great numbers of inarticulate and ineffective individual investors in . . . corporations in which (mutual funds) are also interested. My conclusion, all those years ago: Mutual funds “seem destined to fulfill this segment of their economic role.” (But I didn’t expect to wait 65 years to see it begin!) The fact is that mutual fund managers are charged by law with a fiduciary duty to their fund shareholders.

The charge is not express, but it is crystal clear. The Investment Company Act of 1940 declares that “the national public interest and the interest of investors” require that mutual funds are “organized, operated, [and] managed” in the interest of their shareholders, and not “in the interest of directors, officers, investment advisers . . . underwriters, brokers, or dealers.” Such a fiduciary duty must include responsible proxy voting. Governance Activism by Mutual Funds 5 The field of institutional money management is highly concentrated. The ten largest asset managers account for almost half of all institutionally managed assets.

But mutual funds are hardly a unity. Funds differ substantially in their interest in governance. Considering these four industry segments provides a good starting point: (1) Two classes of passively managed equity index funds. (a) Traditional index funds (TIFs). Broad-market-based, miniscule-cost, passive index funds designed to be held for a lifetime by passive investors. The prototypical TIF remains the world’s first index (S&P 500) fund that I founded in 1975. (b) Exchange-traded index funds (ETFs). Low-cost passive index funds designed to be traded “in real time” by active investors. ETF portfolios are usually more concentrated than TIF portfolios, and often leveraged. (2) Two classes (often blurred) of actively managed mutual funds. (a) Generally, large-cap funds. These funds have average management costs and portfolio turnover typically in the 50% annual range—by today’s standards, long- term stockholders—too often chosen by investors on the basis of outstanding past returns. Of course such returns rarely recur. It’s called “reversion to the mean,” or RTM. (b) Smaller-cap and specialized funds. These funds carry higher costs, and annual portfolio turnover rates that often run in the range of 100% or more. The performance of these funds tend to be more volatile than the large-cap funds, and their investors tend to focus on extraordinary past returns, turning their fund holdings over more rapidly. Here, RTM strikes even more powerfully.

During the past two decades, index funds have created a revolution, one in which the interests of our citizen/investors (“Main Street”) are increasingly taking priority over the interests of money managers, brokers, marketers, and financial buccaneers (“Wall Street”). But—mark my words—it is the traditional index fund that will remain the prime mover in the revolution in the field of corporate governance that is now emerging. Yes, it’s taken a long time. But remember that the impact of the first index fund on the world of finance also took a long time. That index fund (“Bogle’s Folly”) was the subject of sarcastic jokes and skepticism. Fully two decades (1975-1995) passed before index funds began to gain traction. Yet today index funds hold some 41% of the assets of all U.S.mutual

funds, on the way to topping 50%. Indexing is an idea whose time has finally come, a disruptive innovation that places the interests of investors ahead of the interests of fund managers. Early Signs of Progress We have a long way to go before corporate governance participation by active money managers and passive index funds reaches full fruition. But the tide is moving strongly in that direction. One encouraging sign is the “Commonsense Corporate Governance Principles,” an open letter from a group of major institutional managers that calls for a focus on “long-term value creation.” Its set of governance principles was developed by a group of giant index fund managers (Vanguard, BlackRock, and State Street) and active money managers with a strong tendency to invest for the long term (including American Funds and T. Rowe Price). Another encouraging sign of greater participation in corporate governance (especially to yours truly!) is the evolution of Vanguard, now the world’s largest index fund manager ($3 trillion) and second largest money manager ($4.5 trillion). The turnaround in the firm’s philosophy has been dramatic. In 2003, Vanguard joined Fidelity in a major public statement opposing even the disclosure of its proxy votes at corporate annual meetings. But by 2012, Vanguard was actively engaging with the managers of its portfolio holdings. Then in 2017, Vanguard came full circle, providing its first formal annual report on “Investment Stewardship.

The Structure of the Corporation of Tomorrow Pushing governance reform even further, here are some constructive ideas, courtesy of Uwe Reinhardt, professor of Political Economy at Princeton University’s Woodrow Wilson School7: “The cornerstone of the model would be the complete independence of the Board of Directors from the corporation’s management, so that the Board can truly respect its constituency, the shareholders, vis a vis management.” This principle would require that large, publicly held corporations be organized as follows: 6 This list echoes the reforms passionately advocated by long-time corporate governance advocate Robert A.G. Monks. 7 Dr. Reinhardt, a prince of a human being who pulled no punches with his students nor with vested interests, departed this earth on November 14, 2017 at age 80. The world will miss his wisdom, his passion, and his unshakable integrity. So will I!

Mutual fund managers and their boards of directors have a fiduciary duty to their fund shareholders. But when fund expenses are consuming as much as 37% of a bond fund’s yield and comparable index funds are consuming as little as 2%, we have no choice but to ask ourselves: “Have the fund directors who approved the advisory contracts that result in such confiscation breached their fiduciary duty to shareholders? Have fund sponsors who distribute such funds violated their fiduciary duty? Have brokers who sell such funds to their clients failed to place their client’s interests first?” It is high time for industry participants to examine the issue of the excessive fund costs that confiscate such mammoth portions of the investment income earned on the vast majority of active bond funds. Sales loads are another important factor. While nearly all bond index funds are available solely on a “no-load” basis, fully 2,300 share classes of actively managed bond funds require the payment of sales commissions to brokers and investment advisers. Today, those loads run in the range of 1% to 4% for bond funds, averaging about 2 ½%. How much is 2 ½%, you ask? Well, if you pay such a load, you relinquish more than your entire net investment income during the first year that you hold the fund’s shares. Given the obvious hardship imposed on investors by sales loads on active bond funds, leading fund distributors are attempting to compromise. How?

1. A Board chairman who is completely independent of management. 2. A Board on which no executives of the corporation, except for the chief executive officer, would serve. (The CEO would be a non-voting member.) 3. A small staff to serve the board, reporting to the chairman. 4. The firm’s public accountants would report directly to the Board. 5. Such a Board structure would mean that the compensation and nominating committee would be composed only of independent directors. In addition, each corporation should be required to provide limited but fair access to its annual proxy statement to stock owners who wish to offer proxy proposals or to nominate directors. Achieving these goals will not be easy. I recognize that many of these proposals for reform are idealistic and out of today’s mainstream. Most CEOs are unwilling to cede part of their imperial power to anyone else. A small staff for the board has also been a non-starter. But where there is a will to reform our flawed governance system, there will be a way. Nor Are the Money Managers Without Sin If only “he who is without sin may cast the first stone,” our nation’s money managers, too, have work to do to mitigate their own flaws so that they can enter the corporate governance arena with clean hands. The fact is that mutual fund managers have their own conflicts. A bizarre industry structure in which even giant fund groups holding $1 trillion of assets or more find it necessary to hire an outside firm to manage them.

A corporate dichotomy in which these managers are often publicly held and thus have conflicting fiduciary duties in serving two different masters (the fund shareholder and the management company shareholder), with financial incentives that favor the management company master. And a counterproductive set of priorities in which aggressive marketing supersedes professional management. Further, given the fact that so many institutional managers must be considered short-term renters of stocks rather than long-term owners, it’s not at all clear why we should allow full corporate voting rights to the renters. Perhaps we need a sort of tapered voting rights in which holders of stock for, say, at least two years earn full voting rights and holders for less than a year have none.

Let me be clear: I believe that the “stay the course” strategy is the optimal business strategy for today’s largest active fund managers. I also believe that the cash-cow approach is the optimal business strategy for the fund managers owned by financial conglomerates—just one more of their “product lines,” rather than a passionate commitment to our industry. VI. The Optimal Fiduciary Strategy for Mutual Funds But wait a minute. What if the optimal business strategy for fund managers ill-serves the mutual fund shareholders who have entrusted their assets to the funds? We cannot ignore a very different strategy—really a counter strategy—one that serves the interests of fund shareholders. Let’s call it the fiduciary strategy—a strategy that puts fund owners first. Look, I understand that all enterprises face conflicts of one kind or another, and balancing business values with fiduciary values is no easy task. (Even at the only firm in which the fund shareholders own the management company, conflicts exist.) But it is my deeply-held opinion that the flawed structure of this industry has created deep fissures that will, ultimately have to be closed. Far too little introspection on this distinction between business values and fiduciary values has permeated the minds of industry leaders, including the ICI. Managing mutual funds typically remains an insanely profitable business, with pre-tax profit margins often exceeding 50%. How could it be otherwise?

This provision may sound extreme. But if the idea is that the greatest business success comes to corporations that focus on the long-term, it makes considerable sense. Finally, some combination of passively managed traditional index funds (TIFs) and actively managed large-cap funds that invest for the long term will hold the key to corporate governance reform.8 Finally, I confess my surprise (and disappointment) that the growth of TIFs—typically bought and held by passive investors for the long-term—has been eroded by the intercession of ETFs—typically traded in the short term by active investors—often focused on the short-term. My long experience in mutual fund investing has completely persuaded me that great marketing ideas for the fund industry are rarely, if ever, productive investment ideas for its shareholder/clients. Past experience confirms that insight. The average TIF has provided significantly higher investment returns than the average ETF during every year of the past decade, usually by two to three percentage points annually. The cumulative investor returns: TIFs +105%, ETFs +62%. (Even the 71% investor return of actively managed equity funds exceeded the ETF return.) All that is required for the final triumph of the TIF is that ETF investors learn from their own experience. Please don’t be intimidated by this litany of flaws that have come to pervade today’s debased version of capitalism. We can fix them, and we will.

The nation’s citizen/investors will demand nothing less. Our nation is already moving, if haltingly, toward returning the system to its traditional roots of trusting and being trusted. Our old individual ownership society is gone and will not return. Our present agency society has failed to serve its principals, as corporate managers and fund managers alike have placed their own interests above the interests of their beneficiaries and owners. It is time to begin the world anew, and build a fiduciary society in which stewardship is our talisman. The Modern Corporation and the Public Interest Let me close by returning to my title—“The Modern Corporation and the Public Interest”—and endeavoring to answer the question: “What is the public interest that the modern 8 In early 2002, in a speech to the New York Society of Security Analysts, I first suggested creating a “Federation of Long-Term Investors.” Intrigued by the idea, Warren Buffett offered to be part of it if I could persuade some of the largest fund managers to join. I failed in that effort. The idea died.

” While that love/hate pairing is too strong even for me, the point is a valid warning to the mutual fund industry. Hence the question: When the business strategy for the owners of the firm conflicts with the fiduciary strategy for the owners of the funds, whose interests comes first? To me, the answer is obvious. If this industry is to realize its promise to investors, the fund owners must be the master. VIII. Can a Fiduciary Serve Two Masters? In 1985, I gave a speech to a gathering of state financial regulators. It was entitled, “Where Are the Independent Directors?” My concluding words were, “I hope they’ll be back soon.” Today, 32 years later, there is little evidence that the directors have returned. One can only wonder why so many fund boards of directors have seemed to have ignored that “shareholder first” principle, and failed to garner for benefit of the fund shareholders at least a portion of those staggering economies of scale.

It doesn’t matter whether the fund director is served by a privately-held manager or a giant financial conglomerate. Nor whether he or she is an “unaffiliated” director who meets the legal criteria for independence, or an “affiliated” director, associated with the management company. Both types of fund directors have an identical fiduciary duty to serve fund shareholders. Of course the affiliated director has a fiduciary duty; both to the fund shareholder and to the management company shareholder, two related enterprises with at least one critical factor that is in direct conflict—the level of management fees. I think we all know which master has received the love. You may not be aware that public ownership of mutual fund managers did not come along until almost three decades after the industry began. Way back in 1958, the SEC fought the sale of Insurance Securities, Incorporated, a California fund manager to an outside buyer. The Commission argued that the sale represented a breach of fiduciary duty by ISI, and would ultimately lead to trafficking in management contracts. The Commission lost its case in the U.S. Court of Appeals for the Ninth Circuit, and the U.S. Supreme Court determined to let the decision stand. The floodgates to public ownership were swung wide open, and the character of this industry changed.

We must understand the nature of traditional capitalism; the wisdom of long-term investing and the folly of short-term speculation; the productive power of compound interest to build returns; and the confiscatory power of compound costs to slash those very same returns. In all, the relentless rules of humble arithmetic. We all need to stand back, take a moment for introspection, and finally recognize that these obvious precepts must drive institutional investment management in the years ahead. The arc of investing is bending toward fiduciary duty and the public interest, and its progress is inevitable. 9 Roosevelt’s speech was delivered at the dedication of the John Brown Memorial Park in Osawatomie, Kansas, on August 31, 1910.

management company was the party that should manage the shareholders’ money in the future . . . sadly, “boardroom atmosphere” almost invariably sedates their fiduciary genes.” My own concern about this issue goes back even further than Mr. Buffett’s. In 1971, as CEO of Wellington Management Company, then a publicly-held manager, I addressed our executives with these words: “It is possible to envision circumstances in which the pressure for earnings growth engendered by public ownership is antithetical to the responsible operation of a professional organization.” That proposition has been proven over and over again. The necessary resolution of this issue would be to roll back conglomerate ownership, came to grips with the public shareholder issue, and at last make it clear that the interests of mutual fund investors must come first. It will not be an easy battle. IX. What Would a Fiduciary Strategy Mean? So yes, the fiduciary duty of fund directors and fund managers must take precedence over the business strategy of fund managers. The Investment Company Act of 1940 clearly demands this fiduciary strategy. Section 1 declares that is in “the national public interest and the interest of investors,” in the words of the SEC, that “funds should be managed and operated in the best interests of their shareholders, rather than in the interests of advisers, underwriters, or others.” This industry has largely ignored that fundamental principle.

When that legislative policy is finally honored, a fiduciary strategy for fund owners will emerge. Fund directors will surely demand sharp reductions in management fee rates, perhaps implemented gradually. Discipline in the fund line-up, with funds that are focused on long-term objectives and policies rather than funds formed to capitalize on the fashions of the day. Adding index funds to their offerings. Far fewer dollars spent on marketing. And maybe even the adoption of a truly mutual shareholder structure, with elected fund directors in full control of the mutual funds “managed and operated in the best interests of their shareholders.” And a return to the industry trademark principle from which we’ve strayed, a traditional policy that “we sell what we make,” abandoning our present policy of “we make what will sell.” That particular form of presentism can no longer keep on happening.leaders:

So that’s it. To sum up my long career (so far!): My enthusiasm for life and for this industry, ever changing, remains; caring about our investors, making them the primary focus of our efforts; earning— and, I believe, deserving—their trust; helping to build a fiduciary society with a noble purpose; making a difference in an industry that I’m proud to have joined almost 66 years ago; and still striving to measure up to Paul Samuelson’s 1993 appraisal of me as a man who “changed a basic industry in the optimal direction.” Whatever the case proves to be, whatever the future may hold, the mutual fund industry has changed, in part because I took the road less traveled—indeed, never traveled before—all those years ago. What better way to close these remarks than with these words by Robert Frost? “I shall be telling this with a sigh Somewhere ages and ages hence: Two roads diverged in a wood, and I— I took the one less travelled by, And that has made all the difference.” * * * On the very day that I completed this final draft of this essay, I received a neatly handwritten note from a young and appreciative shareholder who had read my book Common Sense on Mutual Funds. He then invested in the Vanguard Total Stock Market Index Fund, and intends to hold it forever. In one more of the happy coincidences that have marked my long career; his closing words were, “And that has made all the difference.”

“Putting Investors First” Remarks by John C. Bogle Founder and former Chairman, The Vanguard Group before the CFA Society of Philadelphia Endowment & Foundation Event Philadelphia, PA June 4, 2015 I love the theme of the CFA Institute campaign for May 2015: “Putting Investors First.” But I believe that such a campaign should be, well, eternal. For it is in those three little words—putting investors first—that we find the fundamental justification for our profession of investment management, our investment strategies, our securities analysis, and our financial planning. And yes, “putting investors first” is at last gaining momentum in the evolution of our nation’s financial system. That phrase is simply another way of stating the core principle of my own campaign to establish a federal standard of fiduciary duty, the duty of everyone who touches “other people’s money” (OPM) to place the interests of our clients above our own interests. The idea of fiduciary duty is simple enough, and, I think unarguable. (How many members of our profession would want to operate under the mantra: “We put our clients’ interests second, but it’s close.”?) But the implementation of this simple idea has proven fraught with challenges. Ferocious opposition exists. Even worse, to the extent that reluctant acceptance exists, it pays little more than lip service to the fiduciary principle. The reality of the U.S. investment system is that it has rarely been dominated by this principle.

Challenges in Finance Let me now turn to three current challenges in finance. First, the underlying reality of our current market system. Almost all industry leaders, academics, and regulators agree that the fundamental purpose of our financial markets is to raise capital for companies that create jobs, build organizations, and manufacture products or provide services, with growing efficiency and with lower costs to consumers. Capital formation, as this process is known, is largely represented by the raising of equity capital for new and existing companies. In recent years, total public stock issuance (IPOs, etc.) has averaged some $250 billion annually. On the other hand, during the same period, the annual volume of stock trading has averaged $35 trillion. Thus, capital formation has represented just 7/10ths of 1% of the activities of our financial system, trading activity 99.3%. And much of that trading, to state what must be obvious, has nothing to do with long-term investment. In fact, much of that frenzied activity is merely short-term speculation. Our challenge is to return long-term investing to its starring role in the financial movie, not merely as a co-star or in a cameo role, nor as a mere extra. Second, consider the recent proposal by the Department of Labor to apply an explicit standard of fiduciary duty to those providing investment advice to individuals in retirement plans, notably IRAs and 401(k) thrift plans.

These plans are now being relied upon as retirement plans by the vast majority of Americans, without ever having implemented the appropriate and necessary structural changes to transform these savings plans into retirement plans. The proposed DOL rule would subject stock brokers to a standard of fiduciary duty when advising on the retirement plan investments of their clients (with a generous “carve-out” for exceptions), as distinct from the existing—and lower—standard of “suitability.” But the proposal of this simple “putting investors first” standard is being opposed with a vengeance that I’ve rarely witnessed. Opponents of the fiduciary standard say: “too much regulation” . . . “will damage the small investor” . . . “will ruin the business.” The challenge we face is to support the principle that our investor/clients have the right to demand that their interests take precedence over our own businesses. CFA Institute has already taken the lead in this stand. It is up to CFA professionals to follow. Third, consider the structural anomaly of America’s largest financial institution—the mutual fund industry, now overseeing $18 trillion of OPM. The mutual fund industry is dominated by firms that are publicly-owned or are owned by financial conglomerates. Of the 50 largest fund providers, 40 are in this category—30 owned by banks and other financial conglomerates, 10 directly held by public shareholders.

5/4/2015 21. “The Colossal Failure” “[T]he colossal failure of the mutual fund industry; resulting from [its] systematic exploitation of individual investors . . . extract[ing] enormous sums from investors in exchange for providing a shocking disservice. … Thievery, even when dressed in the cloak of SEC-approved governance, remains thievery . . . as the powerful financial services industry exploits vulnerable individual investors.” David Swensen, manager of Yale University’s endowment fund 22. “The vast majority of American families are sentenced to a lifetime of investing in the existing mutual fund penal system. But if they’re smart, they’ll do their time in an index fund.” John Bogle Grant’s “Great Debate” April 7, 2015 Mutual Funds Are the Only Practical Option for Individual Investors 23. Enter Vanguard “The Vanguard plan actually furthers the objectives [of the Investment Company Act of 1940] by ensuring that the Funds’ directors … are better able to evaluate the quality of services rendered to the funds … improved disclosure to shareholders … promotes savings from economies of scale … clearly enhances the Funds’ independence … provides them with conflict-free control over distribution … and promotes a healthy and viable fund complex within which each fund can better prosper.” (Unanimous decision, 1981) 24.

imperative for him, and he sharply criticized firms that had sold out to insurance companies and other financial institutions. In 1971, he recalled the negotiations over the 1940 Act: “Both the SEC and our industry committee agreed that the management contract between the fund and the management group was something that belonged . . . to the fund . . . and therefore the management group had no right to sell it . . . or to make money on the disposition of this contract. . . . The fiduciary does not have the right to sell his job to somebody else at a profit.” The spirit of the ’40 Act seemed to reflect that principle. Alas, the letter of the act failed to be specific on that point. (Ironically, in 1982, the private owners of State Street Management—including Mr. Cabot—sold their company to Metropolitan Life Insurance Company for a profit of $100 million.) Personal Experience I know from first-hand experience about the challenges of dealing with these two masters. One was the management company, a firm fighting for its place in a highly competitive marketplace; the other, the mutual fund, a pooled investment trust seeking to earn solid returns (consistent with its stated objectives) without assuming undue risks. When fund managers were under the ownership of investment professionals, and when the industry was small and, in the grand scheme of things, inconsequential, this conflict seemed of little importance.

Journal Papers by John C. Bogle Winter 2016 (Forthcoming) Putting Investors First Fall 2015 (Forthcoming) Occam’s Razor Redux: Establishing Resonable Expectations for Financial Market Returns (with Michael W. Nolan) Summer 2014 No Speed Limits: High-Frequency Trading and Flash Boys Fall 2013 Big Money in Boston… Spring 2011 The Clash of the Cultures Fall 2009 The Fiduciary Principle: No Man Can Serve Two Masters Summer 2009 Peter Bernstein Commemorative Issue Winter 2008 A Question So Important… Spring 2002 An Index Fund Fundamentalist Summer 1998 The Implications of Style Analysis… Summer 1995 The 1990s at the Halfway Mark Winter 1992 Selecting Equity Mutual Funds Fall 1991 Investing in the 1990s--Occam's Razor Revisited Spring 1991 Investing in the 1990s Journal of Portfolio Management (14 papers) * * * “Outstanding Article” Award FROM “OCCAM’S RAZOR REDUX” . . .

But during the 1964-1974 era, highly risky “Go-Go” funds came to dominate the mutual fund industry and manager profits soared. The conflict between fiduciary duties owed to the management company stockholders and the fund shareholders quickly surfaced. In 1965—a mere half-century ago—legendary Wellington founder Walter L. Morgan discussed with me the dire situation that our firm was then facing. Our flagship fund, the conservative and balanced Wellington Fund, was looking staid and out-of-step with the “new era.” Mr. Morgan, deeply concerned, told me—a kid, really, age 35—to take charge of his firm and “do whatever it takes to fix Wellington’s problems.” (To this day, I remember those words.) Loaded with unwarranted self-confidence—arrogance?—and ignoring the industry’s challenges that I’d recounted in 1951 in my Princeton senior thesis on the fund industry, I rose to the challenge! Before a year had passed, I’d put in motion a merger that would, well, “fix” Wellington Management Company. Our new, much smaller partner from Boston ran one of those Go-Go funds (Ivest Fund, now lost in the dustbin of history), and we were once again competitive in the marketplace.this

merger brought us into the pension fund management business, which I thought would be a natural extension of the talents of our new management team’s mutual fund activities. So, I honored my fiduciary duty to the owners of Wellington Management Company—Mr. Morgan and its public shareholders. The firm had “gone public” in 1960, joining the parade of fund managers who poured through the gates opened by the ISI case. But I also believed that I had honored my separate and distinct fiduciary duty to the shareholders of Wellington Fund, for I expected that our new managers would apply their investment talents to enhancing the fund’s faltering returns . . . Wrong! Wrong! Wrong! Looking back, the merger was an abject failure—perhaps the worst merger ever, although AOL/Time Warner sets a high standard indeed. Though the “new era” finally ended, in this case, as 1973 began. Then, Wellington Fund had reached the most aggressive allocation to equities in its near-half-century history (82%, often of marginal investment quality). Its returns tumbled, and its reputation plummeted. Every one of our equity and balanced funds—including several new ones— failed its shareholders. And Wellington Management’s stock would trade at $6 per share, down 90% from its 1968 high of near $60. And, having given up too much stock to our new partners in the merger (who were largely responsible for our dismal performance) they fired me. My promising career had ended.

Lessons Learned Why am I telling you these tales of challenges in finance, corporate law, fiduciary duty, and a small but significant slice of my personal saga? Because random events, seemingly unimportant when they occur, often come to be consequential, changing the nature of the investment profession. Back in the 1950’s, who would have imagined that turnover of stocks (25%) would have reached such extraordinary heights (180% in 2014)? Who would have imagined that the “tiny but contentious” mutual fund industry (Fortune magazine’s words in 1949, words that inspired my senior thesis on mutual funds) would come to dominate American finance? Who would have imagined that the respected trust departments of the Philadelphia banks during the 1950s—whose leaders were the consummate fiduciaries—would vanish, or that every major bank here would be acquired by a giant national bank conglomerate? While we’re about it, who would have imagined that a little-noticed legal case involving a small mutual fund management company would precipitate a new structure that would reshape an industry.Or

A Year in My Life . . . II. Vanguard 2014 September 16 Washington, D.C.—Lead Witness, US Senate Finance Committee Hearing on Retirement System 18 PrimeCap 30th Anniversary Meeting with Principals. 22 NYC Bloomberg “Most Admired Investor” Forum (with AQR’s Cliff Asness). October 17 Speech, Easttown (PA) Library. 22-24 BOGLEHEADS XIII! 31 Speech, Georgetown Law School (D.C.). November 4 Visit from Georgetown Law Students. 13 Princeton/Federal Reserve Economics conference, with Paul Volcker. 14 Interview Session with Wharton Executive MBA Students. 20 Princeton—Business Ethics Seminar. December 16 Full day’s visit from Stanford MBA Class. 30 White House Staff Re: DOL Fiduciary Standards. 2015 January 16 Skype Interview, Durham Bogleheads. 26 Phone Meeting with White House Staff Re: Fiduciary Duty. 28 Phone Meeting with White House Staff Re: Fiduciary Duty. 29 Presentation: Committee for Fiduciary Responsibility. March 12 Jon Stein, Betterment (Robo Advisor) 17 Quarry Ridge (Vanguard) talk with Crew. Major Presentations and Events

5/4/2015 41. Tiny Transaction Transforms Giant Industry Transaction: Owners of ISI (book value $300,000) sold the manager to other investors for 14 times book value ($4.2 million). SEC v. Insurance Securities, Inc., 1958 The Ninth Circuit Court of Appeals ruled that ISI could sell it’s fiduciary obligation to its fund shareholders, opening the floodgates to IPOs, mergers, “trafficking” in management contracts, and acquisitions of fund management companies. By the mid-1960s, a score of fund management firms went public, including industry leaders Wellington, Vance Sanders, Dreyfus, Franklin and Putnam. Later, MFS, T. Rowe Price, State Street, American Century, Oppenheimer, Alliance, AIM, Delaware, and many others. 42. It Wasn’t Supposed to Be That Way… For Paul Cabot, president of State Street Investment Trust, the private ownership of fund managers was essential. Indeed it represented a moral imperative for him, and he sharply criticized firms that would sell out to insurance companies and other financial institutions.* In 1971, he recalled the negotiations over the Investment Company Act of 1940: “Both the SEC and our industry committee agreed that the management contract between the fund and the management group was something that belonged … to the fund … and therefore the management group had no right to sell it … or to make money on the disposition of this contract … the fiduciary does not have the right to sell his job to somebody else at a profit.

A Year in My Life . . . II. Vanguard April 7 NYC – “Great Debate” on Indexing, at publisher James Grant’s Forum. 16 Lecture, Aspen Institute, D.C. 20 Blair Academy—Speech to student assembly. 28 Lecture, SEC Enforcement Staff, D.C. May 6-7 ICI General Membership Meeting. June 4 Speech to the CFA Society of Philadelphia, “Putting Investors First.” July/August “Working Vacation” in Adirondacks. Editing book chapter on Adam Smith, AQR extended interview, and JPM papers, correspondence; DOL and Labor Secretary Perez on fiduciary duty rule; and more. September 24 Skype Interview, iMoney 29 SEC-Lead Presenter at 1940 Act 75th Anniversary Forum. October 2 Princeton Humanities Seminar. 7 Princeton Lecture on “Business Ethics and Modern Religious Thought.” 14-16 Bogleheads XIV! . . . . And the “Day-to-Day” Events: Awards for Excellence 21 TV Appearances 11 Client Visits 18 Crew/Team Meetings 84 PR Interviews 45 Speeches 32 TOTAL 211* *Oh, yeah. Also 17 appointments with doctors. And 40 physical therapy sessions. NOW LET’S TURN TO THE INDUSTRY . . .

See his 1976 book The Unseen Revolution, describing the 1950 genesis of General Motors’ precedent-setting pension plan, designed to invest in “The American Economy.” But he would have been appalled—appalled— to see how rarely these institutional owners would exercise their immense voting power. Even a decade ago, who could have imagined that the intersection of technology and indexing would lead to the creation of a whole new way of providing investment guidance to individual investors. Asset allocation—not stock-picking or fund picking—is now well on its way toward becoming the principal function of the registered investment adviser (RIA). Or that low costs (low fees, and low-cost index funds) would become the desideratum of the rapidly emerging new system? Will “Robo” advice work? Why not? The record is crystal clear that while the average RIA should be expected to match the gross return generated in our financial markets, and to lag the net return (after costs), even that expectation has proven to be optimistic. As professor Burton Malkiel wrote in a recent Wall Street Journal op-ed piece, a strict fiduciary standard—echoed in the theme of CFA Institute, “Putting Investors First”—“is likely to result in massive changes in traditional ways of doing business.”

5/4/2015 45. Fiduciary Duty A Precept as Old as Holy Writ No man can serve two masters: for either he will hate the one, and love the other; or else he will hold to the one, and despise the other. Matthew 6:24 46. What’s To Be Done? 1. Reduce Conflicts 2. Disclose Conflicts 47. Reducing Conflicts: Structural Changes • Funds’ board chairman must be an independent director* • Board must have independent staff, reporting to the chairman* • Regulation should move its focus from individual funds (industry, 1924-1940) to fund complexes (today’s industry) • Ultimately, mutualization (full or partial) *Applicable only to managers supervising assets of long-term funds of $25 billion or more, and operating 20 or more funds. In 2015, the 50 largest fund managers have aggregate assets of $12.4 trillion, 86% of the industry’s long-term assets. 48. Sunlight—Disclosing Conflicts Improvements in Prospectus Disclosure All investors should have access to these data: • Redemption Rate—Redemptions + exchanges out as a percentage of average fund assets • Fund expenses—percentage of investment income • Fund return (time-wtd) vs. investor return (asset-wtd) • Long-term vs. short-term capital gains distributions • Turnover—Total purchases + total sales as a percentage of average fund assets • All-in compensation of 5 highest-paid fund officers (comprehensive) • Investment Advisory Fees—Rates and dollars (10-year history of each) Jones v. Harris Associates

5/4/2015 49. What’s All This about “Basis Points?” Jones v. Harris Associates Brief for John C. Bogle as Amicus Curiae in Support of Petitioners It is important to distinguish between the already-high rates (as a percentage of assets) that advisers charge and the even more excessive dollar amounts that are produced by those fee rates. It was the huge increase in mutual fund assets and, therefore, the amount of mutual fund fees, that concerned the SEC in 1966, since the cost of providing advisory services (essentially, managing an investment portfolio) rises far more slowly than the fees generated by taking a percentage of the increase in assets . Yet courts have generally acceded to the advisers’ desire to frame any debate about fees in percentage—not dollar—terms, thereby giving advisers a license to charge fees that are unjustifiable by any standard. 50. High-Priced Index Funds and Fiduciary Duty Fund Assets Expense Ratio Principal Large Cap S&P 500 Index $4.7 B 0.74% Voya US Stock Index 4.6 B 0.66 Columbia Large Cap Index 3.7 B 0.83 MM S&P 500 Index 3.6 B 0.68 Dreyfus S&P 500 Index 2.9 B 0.50 JP Morgan Equity Index* 1.9 B 1.20 Total (87 Funds) $19.3 B 0.85% Vanguard 500 Index-Admiral Shares $143 B 0.05% -Institutional Plus Shares $85 B 0.02% What were directors of these funds thinking? S&P 500 Index Funds with Expense Ratios of 0.40% or More * “A” series shares carry an expense ratio of 0.45% and a sales load of 5.25% 51.

Heed Yale’s brilliant endowment manager David Swensen in Unconventional Success, his book about personal investing: “The fundamental market failure in the mutual-fund industry involves the interaction between sophisticated, profit-seeking providers of financial services and naïve, return-seeking consumers of investment products. The drive for profits by Wall Street and the mutual-fund industry overwhelms the concept of fiduciary responsibility. The powerful financial services industry exploits vulnerable individual investors. . . . Ultimately, a passive index fund managed by a not- for-profit investment management organization represents the combination most likely to satisfy investor aspirations.” The accumulated wisdom of Messrs. Buffett, Graham, and Swensen—three of the great minds of investing—hardly requires a genius to understand. But acting on that wisdom is never easy. Why? Because our investment system is based on action. (“Don’t just stand there. Do something!)is

5/4/2015 53. The Road to Fiduciary Duty 1. Price Competition • Investor experience • Investor awareness • Complete disclosure 2. Awaken the Independent Directors • Awareness • Board structure • Mutualize? 3. Lawmakers/Regulators • DOL—Retirement Plans • SEC—Mutual Funds • Dodd-Frank Believe me—WE WILL GET THERE! 54. The Wisdom of Adam Smith “Consumption is the sole end and purpose of all production; and the interest of the producer ought to be attended to only so far as it may be necessary for promoting that of the consumer. The maxim is so perfectly self-evident that it would be absurd to attempt to prove it.” The Wealth of Nations 1776

1. Tibble v. Edison Unanimous ruling of the U.S. Supreme Court reaffirming fiduciary duty for retirement plans From The New York Times, 2/24/2015: Jonathan Hacker, a lawyer for Edison, said it can’t be the case that companies have to “constantly look and scour the market for … cheaper investment options,” for retirement-plan participants. “Well, you certainly do, if that’s what a prudent trustee would do,” Justice Anthony Kennedy responded. Four Closing Quotations: 52

2. Andrew Ang Professor, Columbia Business School; Author, Asset Management “… Fund managers’ real loyalty lies with the firm that runs the funds, rather than with the investors who are the owners of the fund. The relationship is incestuous, and investors lose. Many directors of the mutual fund—especially the board chair—are insiders of the investment advisory firm. Fund directors usually do not, and in many cases cannot, independently verify the information given by the advisor. Separating the fund’s governance from its sponsor is not enough to ensure protection of the investors.”

“… What happens to the wealth of individual investors cannot be separated from the structure of the industry that manages those assets. Bogle’s insight into what that structure means to the fortunes of the individuals whose welfare concerns him so deeply is what makes this book most rewarding.” The flawed structures of financial firms—varied though they may be—can easily be seen as largely responsible for the ills that I described earlier. Think for a moment about the evidence that I presented about the multi-faceted structural flaws in finance, and how better structures might have helped our society:  Had they been structured to honor a federal standard of fiduciary duty, the institutional asset managers who collectively control our nation’s corporations would have demanded that our corporation’s act solely in the interest of their shareholders. These manager/owners would have been tough in their evaluations of executive compensation; tough about the excessive use (and “free-rider” structure) of stock options; and tough about allowing corporations to throw around vast sums of their shareholders’ money, undisclosed, on political contributions. And that list only begins a long litany.

” Such a trend has been reflected in the sea-change in finance and money management—from a profession of fiduciary duty and trusteeship to a business of marketing and salesmanship. The mutual fund industry itself has much to answer for. Its enormous growth—from $2 ½ billion when I started in the industry in 1951 to $15 trillion today—led to the expansion of what was mostly a small profession into a giant business. Its investment focus moved from the long term to the short term, with annual portfolio turnover soaring from 22% when I entered the field to 85% currently—a five-year average holding period for a portfolio stock has fallen to a holding period of only fourteen months. Product proliferation—a fund for every imaginable purpose—has crowded out the fund industry’s traditional focus on portfolios dominated by “blue-chip” stocks—a “complete investment program in one security.” In the most baneful change of all, the small private fund management companies of yore have been largely replaced by giant public companies. Today, 40 of the 50 largest mutual fund firms are owned and controlled by financial conglomerates or other outside shareholders. As this new set of masters sought 3 These ideas were inspired by articles in the Summer, 2005 issue of Daedalus, the Journal of the American Academy of Arts & Sciences, including “The Professions in America Today: Crucial but Fragile” by Howard Gardner and Lee Schulman.

For centuries, it remained industrious, ambitious, and frugal . . . Over the past 30 years, much of that has been shredded. The social norms and institutions that encouraged frugality and spending what you earn have been undermined. The country’s moral guardians are forever looking for decadence out of Hollywood and reality TV. But the most rampant decadence today is financial decadence, the trampling of decent norms about how to use and harness money.” You can see this change all through finance. We focus on numbers, numbers, numbers—all easily manipulated—and lose sight of our fiduciary responsibility to serve investors, (as I have so long said) “honest-to-God, down-to-earth human beings, each with their own hopes, fears, and financial goals.” A sign in Albert Einstein’s office read: “Not everything that counts can be counted, and not everything that can be counted counts.” Yet today the traditional investment standards and ethical values that truly count have been overwhelmed by the dominance of our, yes, “bottom-line” society.

I’ll make one final comment about indexing, and yet one more biblical reference. In her sermon several weeks ago, Bryn Mawr Presbyterian Church pastor Dr. Agnes Norfleet cited one of my favorite Biblical passages, from Psalm 118 (repeated in Matthew 21, Mark 12, and Luke 20). “The stone which the builders rejected has become the chief cornerstone.” Similarly, in the field of finance, the index fund—originally scorned, derogated, and rejected by Wall Street as “un-American” and worse (try “Bogle’s Folly”)—has become our industry’s chief cornerstone. Index funds now account for more than one-third(!) of the assets of all U.S. equity mutual funds. The triumph of the index fund has even broader implications for corporate governance, at least as profound as their implications for investing. Today, the dominance of index funds belies the old “Wall Street Rule”—“if you don’t like the management, sell the stock.” A new “Index Fund Rule” is emerging. Since index funds can’t sell the stock (if it’s in the index, it stays in the fund, no matter what), the new mantra must become, “if you don’t like the management, fix the management.” This is a truism for permanent investors in each corporation’s shares. While it is yet to be honored, that sound principle will, sooner or later, alter profoundly the relationship between Financial America and Corporate America, and ultimately, I fervently hope, re-establish a proper relationship between business and our society.

Financial America and Corporate America With the growth in finance and investment, our institutional managers now hold absolute voting control over the corporations in their clients’ portfolios. The mutual fund industry alone holds some 32 percent of all U.S. stocks. Their pension-manager affiliates hold another 20 percent of the total. All told, 52 percent of all U.S. equity shares are held by these money management giants. Yes, that is absolute voting control. Since our institutional money managers now hold the controlling interest in U.S. corporations, we are living in a new and different world. The relationship between Corporate America and Financial America is deeper than ever before. As the interdependence of finance and business grows closer, the times demand that the money managers play an ever more active role in corporate governance. This new factor in governance will ultimately change our ideas about the role of the corporation in our society . . . for the better. To be sure, a tacit link between financial firms and corporate businesses has always existed.profit-driven

demands of business leaders and individual investors, but also as a result of the profit-seeking entrepreneurial spirit of financial firms . . . Since finance and industrial development are in a symbiotic relationship, financial evolution plays a crucial role in the dynamic patterns of the economy.” But today that link has gotten even more potent. Why? Simply because, as noted earlier, Financial America controls (or holds potential control) over Corporate America. The result is our unprecedented “Double-Agency Society”—corporate CEOs and directors are agents who too often place their own interests ahead of the interests of their shareholders, coupled with CEOs and directors of institutional money managers, who, similarly, are agents who too often place their own interests ahead of the fund shareholders (or pension beneficiaries) whom they are duty bound to serve. Economists have been concerned about this “agency problem” that has permeated our society, well, forever. But to have two sets of powerful agents whose financial interests are so often at odds with the fiduciary duty that both sets of managements owe to their principals is indeed “something new under the sun.” The Failure of the Corporate Governance System Let’s not kid ourselves. There are fundamental ways in which our mutual funds and other institutional money managers—our “producers”—have failed to serve the interests of fund shareholders and pension beneficiaries—our “consumers.

” Question: how do these fund managers actually use their power? Answer: very sparingly. Fund managers have demonstrated little appetite for action on corporate governance issues. Indeed, the mutual fund industry fought a proposed SEC regulation that would require fund managers to even disclose to their fund shareholders how their corporate proxy votes were cast. (The good news: their effort failed.) Let me touch briefly on some of the vital corporate governance issues on which mutual funds have been largely silent: ∑ Executive compensation. One word: Appalling. Seemingly limitless amounts are paid to corporate CEOs. An important contributing factor is that compensation consultants that recommend pay cuts aren’t long in business. A recent New York Times article entitled “Executive Pay: Invasion of the Supersalaries” pointed out that the median compensation for CEOs of major corporations in 2013 was $13.9 million(!), a nine percent increase over 2012.of

an expression of concentrated power—of enterprise power concentrated in the chief executive and of national power concentrated in corporations.” That power must be curbed, and the fair balance between the corporation and the government must be re- established. That is an uphill battle that will take a great deal of time and effort. A Federal Standard of Fiduciary Duty My preferred solution to this issue is the creation of a federal standard of fiduciary duty for all of those who manage Other People’s Money. (Since our corporations are chartered by the states, we also need a model standard of fiduciary duty shared by those states.)and

distributors.” But that’s just not happening. Today fiduciary duty and corporate governance issues are near the bottom of the priority list for most fund managers.9 Surely passivity by the financial institutions that control Corporate America is unacceptable. Distinguished NYU professors Ralph Gomory and Richard Sylla agree, “There is a need to find ways of inducing corporations to act in ways that produce better social outcomes . . . [this] is not the first time in history that people have wondered whether ours is a government of the people, or of, by, and for the corporations.”10 They cite Theodore Roosevelt’s first annual message to Congress in 1901: “Great corporations exist only because they are created and safeguarded by our institutions; and it is therefore our right and our duty to see that they work in harmony with those institutions.” Roosevelt spoke those words more than a century ago, yet those kinds of challenges still plague our society today. What’s to be done? The first step is building public awareness. That’s what I’m striving to do—to shine light on these issues in my books and speeches, including my words to you this evening. And, while I may one day slow down my busy pace, now is not the moment to slacken my efforts nor to vitiate my passion for building a better financial system. I’m no hero in my own industry, but, as I was long ago warned, “a prophet is without honor in his own country.” (Yes, Mark 6 and Matthew 13, my final biblical reference!)

It’s a lonely task, but I find common cause with many independent thinkers, including many, if not most, of our nation’s leading academics. So that’s what I do. What can you do? The answer does not come easily, for if you own individual stocks, you are among a definite minority, being dwarfed by the voting power of those giant money managers. But if you own mutual funds, get out your pen and paper, and write to their CEOs and their independent directors, demanding that they step up to the plate on corporate governance issues. It is with our huge mutual funds that battle of bringing the spirit of fiduciary duty to today’s double-agency society must begin. Paraphrasing Doris Kearns Goodwin’s words in her recent best-seller The Bully Pulpit: Theodore Roosevelt, William Howard Taft, and the Golden Age of Journalism, I hope that my remarks this evening 9 In a sign of impending change, Laurence D. Fink, the Chairman and CEO of BlackRock (the nation’s largest holder of corporate stock—about 7% of every company—recently wrote to the CEOs of all 500 companies in the S&P 500 Index, condemning the focus on short-term stock prices. “[Our] mission,” Fink writes, “is to earn the trust of our clients by helping them meet their long-term investment goals. . . . We share those concerns [about the short-term demands of the capital markets], and believe it is our collective role to challenge that trend.” 10 “The American Corporation,” Daedalus, 142 (2), Spring 2013.

of their money managers. To accomplish that goal, this tiny new organization—managing but $1-billion- plus and with only 28 employees (we call them crewmembers)—employed a mutual structure, in which the (truly) mutual funds and their shareholders would own and control their own management company, which would operate at cost. The Vanguard Experiment in fund governance, then, began with a unique structure that had never before been tested or tried. 1974. Innovation # 1. Next, our investment strategy would be focused on the fact—confirmed by volumes of independent data, again and again—that beating the market is a zero-sum game for investors. Why? Simply because the average manager must, by elementary arithmetic, be average. Money managers, as a group, must provide the market return, for after all, they are the market. But that return comes only before their exorbitant fees, operating expenses, and portfolio turnover costs are deducted. So, after absorbing the burden of those costs, the average manager must—and will—lose to the market. The zero-sum game before costs becomes a loser’s game after costs. For the cognoscenti, fund managers in aggregate produce zero Alpha before those costs, but negative Alpha after the costs of financial intermediation are deducted. So, the first decision of the newly-formed Vanguard Group was to create the world’s first market index mutual fund, an idea that I had hinted at in my Princeton senior thesis of a quarter-century earlier.

The Old Model . . . the New Model The idea of trusteeship—indeed the so-called “Boston trustee”—dominated the industry’s image, as this photo of the M.I.T. trustees in 1949 suggested. Exhibit 4. The original fund industry operating model was much like M.I.T.’s: professional investors who owned their own small firms, and often relied on unaffiliated distributors to sell their shares. (In those days distribution was a profitable business.) But the industry culture changed, and changed radically. In 1951—and in the years that immediately followed—the fund industry that I read about in FORTUNE was a profession with elements of a business. But soon it began its journey to become a business with elements of a profession (and, I would argue, not enough of those elements). Some notion of fiduciary duty and stewardship was crowded out by an overbearing focus on salesmanship, as management played second fiddle to marketing—gathering assets to manage. That is where our industry remains today. Trustees of Massachusetts Investors Trust 4. From left to right: George Whitney, L. Sherman Adams, Chairman Merrill Griswold, Dwight Robinson, and Kenneth Isaacs. What explains this profound change in the culture of mutual funds?6 I’d argue that these were the major factors: (1) Gargantuan growth.

assets, each with his or her own hopes and fears and financial goals. Isn’t that what managing other people’s money—a fiduciary duty—should be all about? “The Optimal Direction” Although the remarkable growth of this organization has earned us our position as first in the industry in investor trust and respect, Vanguard has become the firm that our competitors love to hate. Despite moving the industry in “the optimal direction” for investors—Dr. Samuelson’s words—not a single one of our competitors has changed its conflict-ridden structure to a mutual structure. Doing so, of course, would be ruinous to the wealth of their managers and their public shareholders, to say nothing of the detriment of the financial conglomerates that own them. (40 of the 50 largest fund complexes are publicly held; only 10 remain private.) But if the Vanguard example has so far failed to change the self-serving structure of the mutual fund industry, we have surely changed the industry at the margin. Those who have copied our strategies of indexing and bond fund management have had to at least pay lip service to cost-control, for the essential difference between funds tracking the same index is simply the difference in costs. (Obviously, low costs serve the fund investor; high costs serve the fund manager.) But a dramatic change is underway. Investors have begun to look after their own interests, as if by an invisible hand, they are improving the interests of society. Adam Smith strikes again!

(Fidelity once managed just a single fund; the firm now manages 294 funds. Similarly, Vanguard also began the period with a single fund, and is now responsible for 140 funds. One can only trust that each member of the board of directors—in both cases—takes seriously his or her fiduciary duty to know and to understand each one of the scores of funds under the board’s aegis.)

New York University professor Nouriel Roubini, is the “Three Player Game between the state, private entrepreneurial innovation, and financial capitalism . . . The state has a key role in funding scientific research that leads to innovation. Amply funded by financial capitalism, innovation is a source of long- term growth. But speculative funding of innovation is also associated with asset and credit bubbles that end up in financial crashes. Then, following Keynes, the state has to intervene again to limit the economic and financial fallout from such crashes. (Janeway’s book) is a Minsky-inspired synthesis of the financial excesses of Schumpeterian creative destruction.” A Change of Heart8 Finance is a system that needs a change of heart. It will not be easy, given the age-old problems inherent in government regulation (never my favorite means of resolving complex business and economic issues), the powerful and hugely compensated lobbyists of K Street, and the determination of financial leaders to fight the regulations proposed under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The task of reform is a huge challenge, even before we consider our dysfunctional Congress. But we ought to be able to find agreement on a principle affirming that our money manager/agents have as their guiding star a solemn duty to serve their client/principals—a statutory federal standard of fiduciary duty for all managers of Other Peoples’ Money.

Advisers must be required to put the interest of clients first; focus on long-term investing rather than short-term speculation; minimize investment costs; observe the rights and responsibilities of stock ownership; and be free from the massive conflicts of interest that permeate our financial system today. Even that small step will take time. Until then, we’ll have to rely on what I call “the Adam Smith solution.” If we investors will simply cut away all the confusing complexities and hyperactivity that characterize today’s financial system and focus on our own best interests, select managers and advisers who best personify the tenets of fiduciary duty, and move our investments away from those who don’t meet that standard, the system will change. What will emerge—what must emerge—is a system that involves far less speculation, less trading, more reasonable fees and costs, and surely less of the misguided confidence that each one of us is smarter than our fellow investors—a logical contradiction. Once again, I call this the Adam Smith solution because of his timeless insight: 8 This turn of phrase allows me to brag (again). For this very day marks the 17th anniversary of the heart transplant that I received on February 21, 1996.

with an unfortunate decision by the U.S. Court of Appeals, Ninth Circuit (in San Francisco) that affirmed the right of a fund adviser (Insurance Securities Incorporated, or ISI) to sell a controlling interest in its stock at a premium to its book value. The SEC argued that the transaction was a sale of fiduciary office, and hence a violation of fiduciary duty. The date of that decision, April 7, 1958, then, was a date that will live in infamy. That seminal event, now long forgotten, changed the rules of the game. It opened the floodgates to public ownership of management companies; providing the huge rewards of entrepreneurship to fund managers, inevitably at the expense of fund shareholders. From 1924 through the 1950s, as I recall, every single one of the industry’s largest fund management companies was managed primarily by investment professionals, either a partnership or a closely-held corporation. But within a decade after the District Court’s decision, scores of mutual fund management companies would go public, selling their shares (but usually retaining voting control). It was only a matter of time until U.S. and international financial conglomerates acquired most of these newly publicly-owned firms, and many of the industry’s privately-owned firms as well. These acquiring firms, obviously (one could even concede, appropriately), are in business to earn a high return on their capital, and they looked at the burgeoning fund industry as a goldmine for managers. (It was!)

So yes, opening the doors to public ownership produced exactly what the SEC was worried about a half-century ago in the ISI Case: “Trafficking” in management contracts, and the likelihood that it would dramatically erode the sense of fiduciary duty that largely characterized the industry during its early era. And product proliferation hardly helped. So I reiterate: How can an independent fund director feel a fiduciary duty to the hundreds of fund boards on which he or she serves? What’s the problem? It’s summarized in Matthew 6:24: “No man can serve two masters.” Yet when a management firms is owned by a giant conglomerate (or even by public owners), the conflict of interest is palpable. When a conglomerate buys (or builds internally) a fund management company, the acquirer’s goal is to earn the highest possible return on that capital. That’s American way! The idea: maximize fees by gathering assets and creating new products, and resist reductions in fee rates that would enable fund shareholders to benefit from the economies of scale. But fund shareholders, of course, would benefit from lower fee rates, which would increase their returns, dollar for dollar. Think of it this way: the officers and directors of financial conglomerates have a fiduciary duty to increase the returns earned by their corporate shareholders; they also have a fiduciary duty to increase returns to their mutual fund shareholders.

But as Thomas Paine reminded us all those years ago, “the harder the conflict, the more glorious the triumph.” And just as Paul Samuelson predicted, indexing changed the fund industry in the optimal direction. Index fund assets leaped to $100 billion by 1996, and to $1 trillion by 2006, and to more than $2 trillion today. So, no, I don’t think that the word triumph in the subtitle of this section is hyperbolic. Consider that during the past five years, investors have liquidated some $386 billion of their actively-managed equity funds and poured $667 billion into passively-managed index equity funds—a $1 trillion-plus shift in investor preferences. Today, assets of passively-managed equity index funds are equal to almost 40 percent of the assets of their actively-managed peers, their superiority confirmed by scores—perhaps hundreds—of independent academic studies, and denied by none. Index fund growth seems certain to continue, and likely even accelerate, even from today’s massive total. “The Moral History of U.S. Business” The polar nature of those two days of infamy—one in 1958 and one in 1975—the first placing a heavy burden of costs on the returns earned by mutual fund investors, the second an automatic boost in the returns that they earn—can be said, I think, carry a subtle lesson for fund investors and their managers. For the first reflects a diminution of the power of the fiduciary, the second reflects a clear buttressing of the concept of fiduciary duty.

Paul Cabot did not approve of that change. For him, the private ownership of fund managers was essential. Indeed “it represented a moral imperative for him, and he sharply criticized firms that would sell out to insurance companies and other financial institutions. In 1971, he recalled the negotiations over the Investment Company Act of 1940: “Both the SEC and our industry committee agreed that the management contract between the fund and the management group was something that belonged . . . to the fund . . . and therefore the management group had no right to hypothecate it, to sell it, to transfer it, or to make money on the disposition of this contract . . . the fiduciary does not have the right to sell his job to somebody else at a profit.”11 Yet, ironically, in 1982, Paul Cabot’s successors did exactly that: the partners of State Street Research and Management Company sold the firm to the (paradoxically, then-mutual) Metropolitan Life Insurance Company for an astonishing (in those ancient days) profit of $100 million. The stated reasoning of the Fund’s board: “the affiliation of State Street with an organization having the financial and marketing resources of Metropolitan Life will result in the development of new products and services which the fund may determine would be beneficial to its (the fund’s) shareholders.”12 (Mr. Cabot, still a partner, was apparently enriched to the tune of $20 million, in 1982 dollars.)

failed explicitly to articulate this sound principle. It would be only a matter of time until a sale would take place. That sale opened the floodgates to public ownership of fund management companies. The date was April 7, 1958, when the United States Court of Appeals for the Ninth Circuit ruled that the 1956 sale of shares in Insurance Securities, Incorporated (ISI), at a price equal to nearly 15 times its book value, did not constitute “gross misconduct” or “gross abuse of trust” under Section 36 of the 1940 Act. The SEC had gone to court to oppose the sale, on the grounds that the excess price represented a payment for succession to the adviser’s fiduciary office. The Court agreed with the Commission that “the well-established principles of equity barred a trustee standing in a fiduciary relationship with another from either transfer of the office or exploiting such a relationship for personal gain. But it weighed even more heavily the fact that the value of the contract, rather than representing an asset of the trust fund, represented the reality that the manager receives a profit for rendering its services in return for stipulated fees that the fund had contracted to pay. Well-decided or ill-decided by the Ninth Circuit (I believe the latter14 ), the U.S. Supreme Court refused certiorari. And that was that.

“If (the Act) is construed to incorporate the basic principle that a fiduciary owes individual loyalty to the beneficiary and must avoid any conflict of interest, then a seller should not be allowed to transfer his fiduciary office for personal gain . . .” page 180.

50 largest mutual fund management complexes, only eight have maintained their original private structure—including Fidelity, Capital Group (American Funds), Dodge & Cox, and TIAA-CREF, plus Vanguard, owned by its fund shareholders. Of the remaining 41 firms on the list, nine are publicly-held (including T. Rowe Price, Eaton Vance, Franklin, and Janus) and 32 are owned by banks, giant brokerage firms, and U.S. and international conglomerates. As we shall soon see, this seemingly irresistible tide of public—largely conglomerate—ownership has ill-served mutual fund shareholders. Vanguard Goes the Other Way Only a single firm resisted this epic tide. In the context of my theme this evening, the story of its creation is a story worth telling. As you may recall, in 1960, my employer, Wellington Management Company was among the firms to ride that early wave of industry IPOs. In 1965, when I was given the responsibility of leading the firm, I recognized the challenge involved in serving those two demanding masters whose interests were so often in direct conflict. To state the obvious, we had a fiduciary duty both to our fund shareholders and to our management company shareholders as well. However, when a privately-held management company becomes publicly-held, this conflict is exacerbated. In September 1971, I went public with my concerns.

Speaking at the annual meeting of my Wellington partners, I began my remarks with a 1934 quotation from Justice Harlan Fiske Stone: “Most of the mistakes and major faults of the financial era that has just drawn to a close will be ascribed to the failure to observe the fiduciary principle, the precept as old as holy writ, that ‘a man cannot serve two masters’ . . . Those who serve nominally as trustees but consider only last the interests of those who funds they command suggest how far we have ignored the necessary implications of that principle.” I endorsed that point of view. Then I revealed “an ancient prejudice of mine: All things considered, it is undesirable for professional enterprises to have public shareholders. Indeed it is possible to envision circumstances in which the pressure for earnings growth engendered by public ownership is antithetical to the responsible operation of a professional organization. Although the field of money management has elements of both a business and a profession, any conflicts between the two must, finally, be reconciled in favor of the client.” It is a matter of fiduciary principle. I then explored some ideas about how such a reconciliation might be achieved, including, “a mutualization, whereby the funds acquire the management company . . .with

incentives for both performance and efficiency, but without the ability to capitalize earnings through public sale.” Within three years, a situation developed in which I was put in a position in which I would not only talk the talk about mutualization, but would walk the walk.15 Even before the 1973-74 bear market began, the investment returns of the Wellington funds had begun to deteriorate (both on an absolute and on a relative basis) and the large cash inflows they had enjoyed had turned to huge cash outflows. Assets of our flagship, the conservative Wellington Fund, had tumbled from $2 billion in 1965 to less than $1 billion, on the way to a low of $480 million. Wellington Management Company’s earnings plummeted, and its stock price followed suit. This concatenation of dire events was enough to destroy the happy partnership formed by an unfortunate merger I implemented in 1966, and I got the axe as Wellington Management Company’s CEO on January 23, 1974. But—here’s the catch—I remained as chairman of the mutual funds, with their largely separate (and largely independent) board of directors. Shortly before the firing, seeing the handwriting on the wall, I submitted a proposal to the mutual fund board of directors under which the Wellington Group of mutual funds would acquire Wellington Management Company and its business assets. The company would become a wholly-owned subsidiary of the funds and serve as investment adviser and distributor on an ‘at-cost’ basis.

Our control over fund marketing came only shortly thereafter. On February 9, 1977, after yet another contentious debate, the fund board accepted my recommendation that the funds terminate their distribution agreements with Wellington Management, eliminate all sales charges, and abandon the broker-dealer network that had distributed Wellington shares since its inception in 1929. (I argued that we weren’t violating the memorandum of understanding by internalizing distribution. Rather we were eliminating distribution.) While the board approval was by the narrowest of margins, Vanguard moved, literally overnight, from a seller-driven, load-fund channel we had relied upon for almost a half-century to the buyer-driven, no-load channel we maintain to this day. Only 21 months after Vanguard began operations, the fledgling organization had become a fully-functioning fund complex. What we called “the Vanguard Experiment” in fund governance was about to begin in earnest. Let’s See How it All Worked Out It will soon be 34 years since Vanguard began operating under its unique mutual structure, and almost exactly fifty years since that ghastly Ninth Circuit decision opened the door of public ownership to fund managers and led to the age of conglomeration that has now overwhelmed the industry. Surely it must occur to you that the philosophies underlying these two events are diametrically opposite.

While the most vigorous industry advocates find “evidence of price competition clear,”28 the data presented by these advocates show that while there were 1,240 fee decreases during 1998-2004, there were even more fee increases—1480 in all. Even these advocates do not dispute “the empirical fact that mutual fund boards of directors rarely ‘fire’ advisers and do not put advisory contracts up for bids among advisers.” Without such competition, mutual fund managers are hardly likely to reduce their fees, and hence their own profitability. Recap of the Issues Let me summarize here the arguments I’ve made so far: In its early years, the investment company industry had many characteristics that well-served fund investors. The focus was largely on private trusteeship; prudence and diversification were the watchwords of investment policy; fund trustees often were a step removed from fund distribution; expense ratios were moderate, and far below today’s levels. Today public ownership—largely by giant conglomerates—overwhelmingly dominates the fund industry, and it has ill-served fund investors. By way of contrast, the results of that “Vanguard Experiment” in mutual fund governance are now clear. It has been both a remarkable commercial success for the firm itself, and an artistic success for its shareholder/owners. Our central idea was to create a firm honoring the industry’s original values.

a basic standard that would make clear that those who derive benefits from their fiduciary relationships with investment companies cannot charge more for services than if they were dealing with them at arm’s length.” The SEC described reasonableness as a “clearly expressed and readily enforceable standard [that] would not be measured merely by the cost of comparable services to individual investors or by the fees charged by other externally managed investment companies . . . [but by] the costs of management services to internally-managed funds and to pension funds and other non-fund clients.” If the standard of reasonableness does not “resolve the problems in management compensation that exist . . . then more sweeping steps might deserve to be considered.” With vigorous lobbying by the Investment Company Institute, the self-anointed representative of fund shareholders but in fact the powerful voice of fund managers, that reasonableness standard was never adopted. Yet, even as fund fees soared and conglomeration gradually took over, transaction after transaction, unchallenged (and, arguably, unchallengeable) after that ghastly 1958 decision by the Ninth 31 U. S.1966

But my pragmatism disagrees. Powerful and well- financed lobbyists—led by the Investment Company Institute, the fabulously profitable management companies and their conglomerate owners, and the U.S. Chamber of Commerce (of course!)—would take up arms against such a seemingly radical proposal. The campaign would come with unbridled enthusiasm and virtually unlimited financial firepower, K Street’s dreams come true. Given the state of our nation’s governance, such opposition, self-interested as it obviously is, would defeat “the national public interest and the interest of investors,” the very interests that the 1940 Act was designed to protect. But hope is not lost. There is a way—not, of course, an easy way—to honor the spirit and letter of the Act so that investment companies are organized, operated, and managed in the interests of their shareholders rather than their managers and distributors. It would take a series of logical steps to achieve this goal, some already in the works; some proposed by an earlier Commission and now seemingly 33 But not for all fund complexes, only for complexes that exceed certain thresholds; for example, fund complexes that manage over $25 billion in assets and more than 30 mutual funds.

abandoned; new steps that take us even further toward that goal; one simple—if dramatic—organizational change that would create enormous momentum toward fund operational independence from their advisers; and a change in federal law. Here’s the plan I propose: 1) Require that 100 percent of fund directors be unaffiliated with the management company. There is simply no point in any longer subjecting management company officers to the profound conflicts of interest that they face when they also serve as fund directors. It’s time to honor the principle that “no man can serve two masters.” (As noted earlier, since the firm’s inception the Vanguard funds have prohibited representatives of any external adviser from serving on their boards. It hasn’t seemed to impair the returns we earn for investors.) 2) Require that the chairman of the fund board be independent of the management company, even if, as under the Commission’s 2004 proposal, only 75 percent of the board is required to be independent. Such a separation of powers, ordained for our federal government in the Constitution, is not only a fundamental principle of governance, but simple common sense. 3) Require the retention by the funds of legal counsel independent of the adviser and a chief compliance officer. Both are already mandated by the Commission, but we must require them to be responsible to the fund board, reporting to the independent fund chairman.

5) A specific regulatory authorization that enables funds to assume responsibility for their own operations, including administration, accounting, compliance, shareholder record-keeping, etc. Such a structure would cut the Gordian knot that gives fund managers de facto control over the funds they manage. 35 It is this very step that was central to the creation of Vanguard, which (as noted earlier) soon enabled the fledgling firm to extend its reach to investment management and then to distribution. 6) Enact a federal standard of fiduciary duty for fund directors. The fact is that mutual fund managers, indeed pension fund managers, public and private alike, face serious conflicts of interest in carrying out their duties. In today’s relatively new agency society, in which financial institutions control more than 70 percent of stock ownership, there has been a serious failure to serve their principals—largely fund shareholders and pension beneficiaries. As the Honorable Leo E. Strine, Jr., Vice Chancellor of the Delaware Court of Chancery, has noted, it would be “passing strange if professional money managers would, as a class, be less likely to exploit their agency than the managers of corporations that make products and deliver services.”36 Yes, the world has changed, and we need to redress that imbalance in favor of the principals. Two Powerful Endorsements Once again, this critical analysis of the mutual fund industry is not mine alone. Listen to Warren Buffett.

industry overwhelms the concept of fiduciary responsibility, leading to an all too predictable outcome . . . the powerful financial services industry exploits vulnerable individual investors . . . “The ownership structure of a fund management company plays a role in determining the likelihood of investor success. Mutual-fund investors face the greatest challenge with investment management companies that provide returns to public shareholders or that funnel profits to a corporate parent—situations that place the conflict between profit generation and fiduciary responsibility in high relief. When a fund’s management subsidiary reports to a multi-line financial services company, the scope for abuse of investor capital broadens dramatically . . . “Investors fare best with funds managed by not-for-profit organizations, because the management firm focuses exclusively on serving investor interests. No profit motive conflicts with the manager’s fiduciary responsibility. No profit margin interferes with investor returns. No outside corporate interest clashes with portfolio management choices. Not-for-profit firms place investor interest front and center. Ultimately, a passive index fund managed by a not-for-profit investment management organization represents the combination most likely to satisfy investor aspirations.” I regard these two powerful endorsements of the positions that I hold as a clarion call for action.

Yes, it’s time to make fund directors aware of their duty to serve the fund shareowners rather than the entrenched fund managers, and to bring independent leadership—real leadership—to fund boards. That is the purpose of the six changes I’ve delineated. And yes, I’m well aware that, for some firms, these changes may lead to the full mutualization that, in the only case study that exists, has served shareholders so well. Yes, it’s also time to overturn the ghastly legacy of the Ninth Circuit’s erroneous decision in 1958 that opened the floodgates first to public ownership and then to conglomerate ownership.37 It’s also high time for firms that now place asset gathering at the heart of their mission to return to the industry’s professional roots and again act as true fiduciaries. So, yes, it’s time for a new order of things. It’s time to facilitate the development of mutualization in the mutual fund industry. It’s time to go back to the future and honor the vision of trusteeship held by Paul Cabot, and the vision of SEC Commissioner Healy to protect investors from the distorting impact of 37 Interestingly in light of my recommendations here, the note in the Harvard Law Review cited in note 13 concludes with this caveat. “However, the sellers might be allowed to sell control for any consideration if the fund had an independent board of directors . . . with control of the proxy machinery and the power to select another adviser.”

The Role of the Fiduciary in Risky Financial Markets Remarks by John C. Bogle Founder & Former Chief Executive, The Vanguard Group Before The Philadelphia Estate Planning Council Philadelphia, PA May 1, 2007 I’m honored to be invited to address the Philadelphia Estate Planning Council this afternoon on two subjects that have been near and dear to my heart for as long as I can remember. Indeed, it’s arguable that I’ve been thinking about fiduciary duty and the financial markets since the autumn of 1950, when, as a Princeton senior, I began the research on the mutual fund industry for my senior thesis. In fact, a half-century later—proving that if you’re patient enough, anything you write can be published—that thesis was published by McGraw-Hill, the final section of my third book John Bogle on Investing - the First 50 Years. Even more relevant to my subject today, my fifth book—The Battle for the Soul of Capitalism (Yale University Press, 2005)—is heavily focused on fiduciary duty; and my sixth book—The Little Book of Common Sense Investing (John Wiley, 2007)—is focused on the financial markets. Part I. Full Disclosure Perhaps if I begin with the story of my senior thesis, you’ll see, in today’s parlance, “where I’m coming from.” The fact is that the fundamental values that I hold today about fiduciary duty and the financial markets were formed during my undergraduate years at Princeton University.

From the time of my matriculation in 1947—a shy young kid whose serious education began with two years at Blair Academy—right up to today, many Princetonians paved the way for my career. The first was Charles C. Nichols, Class of 1906, who lent me $60 to pay the General Fee required before I could enroll. (I repaid him shortly after I went to work following my graduation.) The providers of the two endowed scholarships that paid my tuition—the Class of 1918, in memory of Roy S. Leidy, a son of Nassau who tragically died at the Argonne less than a month before the Great War ended; and Mrs. Alexander Maitland, daughter of President James McCosh, in memory of her husband. The professors who did their best to educate me. My fabulous classmates in the Class of 1951, many of whom, over these past fifty years, have become good friends to this intense and determined nerd of college days. (I was not smart enough to avoid long hours of studying.) And Professor Burton G. Malkiel, Graduate School, Class of 1964, with whom I share so many investment principles, and who has both supported me and sharpened my thinking not only in professional circles, but in his two decades of service on the Vanguard Board of Directors. * I give special note to the extraordinary British philosopher Sir Isaiah Berlin, whose 1953 essay “The Fox and the Hedgehog” was the source of my inspiration to use this theme.

(This basic tenet of fiduciary duty was clearly ignored in the market timing scandals of a few years ago, in which some 30 fund groups conspired with hedge fund managers to subvert the interests of the funds’ long-term shareholders.) I also argued that "there is some indication that costs are too high," and that "future industry growth can be maximized by concentration on a reduction of sales charges and management fees." (That advice also fell upon deaf ears, and despite the quantum leap in industry assets, fee rates have actually risen, and rather sharply at that.) After analyzing mutual fund performance, I concluded that "funds can make no claim to superiority over the market averages," perhaps an early harbinger of my decision to create, nearly a quarter-century later, the world's first index mutual fund. Still later in the thesis, "fund influence on corporate policy . . . should always be in the best interest of shareholders, not the special interests of the fund's managers." (Once again, my advice fell by the wayside, and shareholders remain ill-served by the passive governance policies of most fund managers.) And when I wrote about investment policy, this immature and inexperienced college senior even had the temerity to take on the brilliant British economist John Maynard Keynes.Theory,

fund complex within which each fund can better prosper; enables the Funds to realize substantial savings from advisory fee reductions; promotes savings from economies of scale; and provides the Funds with direct and conflict-free control over distribution functions.2 A Wonderful Coincidence All those nice words have been borne out in the years that followed. In fact, the Commission’s powerful endorsement marked the very moment that the uninterrupted ascendancy of Vanguard began. As 1981 ended, our share of mutual fund industry assets had fallen to just 1.7 percent. Over the next quarter century, it was to increase, without interruption, every single year.3 By 1987 our market share had doubled to 3.5 percent. By 1997, it had doubled again, to 7.3 percent. At 10.5 percent today, our share is on track to double yet again over the next five to ten years. The major reason that what we once called “The Vanguard Experiment” in mutual fund structure and governance has worked in the marketplace is also obvious. It has worked for the benefit of Vanguard shareholders. (Please forgive this commercial message!) Check almost any independent rating of mutual fund investment performance and you’ll see that the returns we have earned for our shareowners have consistently ranked at or near the top among all fund complexes. Most recently, Global Investor ranked us #1 over-all; #1 in international equities, #1 in bonds, and #3 is U.S. Equities.

” All of this gratuitous advice from a callow college senior was, alas, largely ignored by fund industry leaders. But the creation of Vanguard in 1974 as a truly mutual mutual fund group—operated on an "at-cost" basis for the benefit of its owners rather than its managers—was my attempt to walk the walk that I had talked the talk about a quarter-century earlier. Today, I assure you that my youthful idealism remains intact. Indeed, it is shamelessly reflected not only in Vanguard, but especially in my two latest books, which express profound concern about the deterioration in the values of our nation’s capitalistic system, in our concept of fiduciary duty, and in the operation of our financial markets. Part II. A Fiduciary Society The fact of the matter is that something has gone profoundly wrong in these critical areas. The root causes of the disease are deep, and the remedies that are required to cure it will not be easy to come by. What we have witnessed, in the words of journalist William Pfaff, is “a pathological mutation in capitalism.” The classic system—owners’ capitalism—had been based on a dedication to serving the interests of the corporation’s owners, maximizing the return on their capital investment.in

complicity if not conspiracy with accountants and the managers of other corporations.” Why did it happen? “Because,” in Mr. Pfaff’s words, “the markets had so diffused corporate ownership that no responsible owner exists. This is morally unacceptable, but also a corruption of capitalism itself.” When most owners either don’t or won’t or can’t stand up for their rights, and when corporate directors lose sight of whom they represent, the resulting power vacuum quickly gets filled by corporate managers, living proof that Spinoza was right when he told us, “nature abhors a vacuum.” Little good is likely to result when the CEO becomes not only boss of the business but boss of the board, erasing the “bright line” that common sense tells us ought to exist between management and governance. Put more harshly, in a quote that I came across last spring, “when we have strong managers, weak directors, and passive owners, don’t be surprised when the looting begins.” There were two major forces behind this baneful change: First, the “ownership society”—in which the shares of our corporations were held almost entirely by direct stockholders—gradually lost its heft and its effectiveness. Since 1950, direct ownership of U.S. stocks by individual investors has plummeted from 92 percent to 30 percent, while indirect ownership by institutional investors has soared from 8 percent to 70 percent. Our old ownership society is now gone, and it is not going to return.

In Investment America:  One, the vanishing ownership society. Almost unobserved, direct holdings of stocks by individual investors have plummeted from 92 percent of all stocks in 1950 to only 32 percent today, as corporate control fell into the hands of giant financial institutions—largely pension funds and mutual funds—whose share soared commensurately, from 8 percent to 68 percent, a virtual revolution in ownership. But these agents, beset by conflicts of interest, have failed to place front and center the interests of their principals, passively ignoring the need for good governance and allowing corporate managers to look primarily to their own interests.  Two, the rise of short-termism. Part of this failure came because institutional money management, once an own-a-stock industry (holding an average stock for six years during my first 15 years in this field) became a rent-a-stock industry, now holding a typical stock for but a single year, or even less. While as investors, owners must care, and care deeply, about the rights and responsibilities of corporate governance, and must exercise those rights and honor those responsibilities. But as speculators, renters who merely trade stocks could hardly care less. Simply put, as I ask in the book, “If the owners of corporate America don’t give a damn about the triumph of managers’ capitalism, who on earth should?” Yet our new agent/owners remain passive to a fault on governance issues.

those years earlier, and, to my shame, what I dismissed.) During the recent era, we entered the age of expectations investing, where projected growth in corporate earnings—especially earnings guidance and its subsequent achievement, by fair means or foul—became the watchword of investors. Never mind that the reported earnings were too often a product of financial engineering that served the short-term interest of corporate managers and Wall Street security analysts alike. But when long-term owners of stocks become short-term renters of stocks, and when the momentary precision of the price of the stock takes precedence over the eternal vagueness of the intrinsic value of the corporation itself, concern about corporate governance is the first casualty. The single most important job of the corporate director is to assure that management is creating value for shareholders; yet our new agent/investors seemed not to care when that goal became secondary. While these institutional agents now hold absolute voting control over corporate America, all we hear from these money managers is the sound of silence. Not only because they are more likely to be short-term speculators than long-term investors, but also because they are managing the pension and thrift plans of the corporations whose stocks they hold, and thus face a serious conflict of interest when controversial proxy issues are concerned.

Redesigning the Fund Industry “I have a dream.” Or rather, five dreams for redesigning the mutual fund industry in the years to come. I’ll discuss first, mutual fund pricing, and second, the burgeoning of our retirement plan business, in both cases using the predictions I’ve made in my various talks to NICSA as a springboard. Then I’ll discuss, third, a new design for investment policy, fourth, a new design for “product development,” and fifth, a new design for governance structure, three of my other perennial favorites. Here, then, is the design of my dreams. 1. The Dream of a Fair Shake for Shareholders The first dream is to design a new industry in which we give our investors a fair shake in terms of costs. In my 1977 speech, I boldly predicted that investors would come to focus far more heavily on fund costs, evaluating “total price—or total cost-effectiveness over time, including any initial sales charges and fund operating and advisory expenses.” Alas, by my 1987 talk, I could only grade myself with an “F” on that prediction. Over the decade then ended, the expense ratio of the average equity fund had risen from an average of 0.96 percent to an estimated 1.38 percent, a 44 percent increase in unit terms. This increase came despite the fact that total industry assets had grown from $37 billion to $588 billion, and the dollar amount of annual fund costs had risen 4000 percent, from $232 million to $4.2 billion.

consistency is crucial, that high portfolio turnover is counter-productive, and that the soundest strategy is not short-term speculation, but long-term investment. Every month, market share data confirm that fund investors increasingly accept these ideas, even as the foxes in the fund industry seem increasingly antagonized by them. But I have yet to see even one of the foxes take the other side, let alone with a compelling, fact-founded rebuttal. There is no debate. Silence, it seems, is golden. Perhaps so… Yet facts are facts. And given the brute evidence of the past, I’d now like to set some new directions for the future as we move into the 21 st century, directions for the foxes in the mutual fund industry that will serve investors and, in the long run, serve fund managers:  Return to prudent management and fiduciary duty, rather than opportunistic marketing and commerce, as our guiding lights.  Emphasize a client-focused approach to serving human beings, rather than simply gathering assets.  Redirect the mutual fund strategy toward long-term investing—owning business and holding them over the years—and away from short-term speculation—trading pieces of paper held for not much larger than a single year.

When they do—and they will—our financial intermediaries will be forced to respond with a focus on long term investing in businesses, not short term speculation in stocks. But we need more. Since our agency society has so diffused the beneficial ownership of stocks among our 100-million mutual fund shareholders and pension beneficiaries, we also need to create, out of our disappearing ownership society and our failed agency society, a new “fiduciary society.” Here, our agent/owners would be required by federal law to place the interest of their principals first—a consistently enforced public policy that places a clear requirement of fiduciary duty on our financial institutions to serve exclusively the interests of their beneficiaries. That duty would expressly require their effective and responsible participation in the governance of our publicly-owned corporations, and demand the return of our institutional agents to the traditional values of professional stewardship that are so long overdue. Part III. Profession vs. Business While we need to articulate—and enforce—clear standards of fiduciary duty for our professional money managers, we in other areas of the investment profession must also do our part. But that too will be no easy task.

The second reason for the debasement of the values of our capitalistic system is that our new investor/agents not only seemed to ignore the interests of their principals, but also seemed to forget their own investment principles. In the latter part of the twentieth century, the predominant focus of institutional investment strategy turned from the wisdom of long-term investing to the folly of short-term speculation. During the recent era, we entered the age of expectations investing, where projected growth in corporate earnings—especially earnings guidance and its subsequent achievement, by fair means or foul—became the watchword of investors. Never mind that the reported earnings were too often a product of financial engineering that served the short-term interest of corporate managers and Wall Street security analysts alike. But when long-term owners of stocks become short-term renters of stocks, and when the momentary precision of the price of the stock takes precedence over the eternal vagueness of the intrinsic value of the corporation itself, concern about corporate governance is the first casualty. The single most important job of the corporate director is to assure that management is creating value for shareholders; yet our new investors seemed not to care when that goal became secondary. While our institutional agents now hold absolute voting control of corporate America, all we hear from these money managers is the sound of silence.

If my book helps to open the door to the introspection by our corporate and financial leaders that is so long overdue, and then corrective action, perhaps the needed changes will be hastened. This process must begin with a return to the original values of capitalism, to that virtuous circle of integrity—“trusting and being trusted”—as I mentioned at the outset. When ethical values go out the window and service to those whom we are duty-bound to serve is superseded by service to self, the whole idea of the capitalism that has been a moving force in the creation of our society’s abundance is soured. In the era that lies ahead, the trusted businessman, the prudent fiduciary, and the honest steward must again be the paradigms of our great American enterprises. It won’t be easy, but if we all work long enough and hard enough at the task, we can build, out of a long-gone ownership society and a failed agency society a “fiduciary society,” one in which the citizen-investors of America will at last receive the fair shake they have always deserved from our corporations, our investment system, and our mutual fund industry. Fixing the system is not a task for the faint of heart, for it will not be easy.recommend

 If index funds are anathema, at least capitalize on the advantages that have given index funds their edge in providing optimal market-related returns to investors—lower fees and costs, lower turnover, higher-tax efficiency, and fully-invested equity portfolios that don’t time the market.  Consider a mutual investor-owned structure—or something that approaches it—for management companies. Funds that required parental support when they were born have now reached their majority. They should be treated as dependent children no longer. There is no reason funds can not directly offer entrepreneurial incentives to managers—at least within reason.  Take action willingly now. Recognize that time is money for fund investors, and “when you give, give with an open hand.”  Managers that act promptly may avoid a decidedly unpleasant later confrontation by fund directors (who may yet honor their fiduciary duty to shareholders—I can dream can’t I?), by the derivative bar, by the Securities and Exchange Commission, by Congress, or even by their own fund shareholders. Or by all of the above. Perhaps surprisingly, I also have a few directions for the hedgehogs:  If you’re style is out of style—and your conviction unshaken—remember reversion to the mean, and stay the course.  If you’re an indexer, don’t get complacent. While the tide is going your way now, it’s just too good to persist. You remember reversion to the mean, too.

policies that respond to the failure of our agency society in which direct stockowners have become an endangered species, and (b) to take the steps necessary to ultimately eliminate the frightening shortfall— recently estimated at $1.2 trillion—in the expected future wealth of the vastly underfunded public, private, and individual retirement plans that are the foundation of our national savings. These two problems are directly related, and best solved by the creation of a federal statutory standard of fiduciary duty which will require our intermediaries to truly represent—first, last, and only—the interests of those they serve. But even if that recommendation of a federal approach doesn’t come to pass for a decade or more, Adam Smith’s legendary “invisible hand”—each investor acting in his or her own enlightened self- interest—will gradually bring about these changes. So my second recommendation is to speed-up that process by an intense focus on investor education. If we investors simply have the wisdom to understand how the financial system works, and to move our own money where our own common sense dictates, then the system of financial intermediation that has failed so many investors in the modern era will change. One way or another then,—whether by government fiat or by invisible hand—the soul of capitalism—that traditional owners’ capitalism that served us so well, for so long—will be reclaimed.

I’m fond of saying that I left my old job at Wellington in the same way that I began my new job at Vanguard: “Fired with enthusiasm.” Time does not permit me to describe in detail the Vanguard odyssey that was to follow our fortuitous launch. But its parallels to Homer’s Odyssey, while hardly exact, are nonetheless there. We’ve wasted our own time with the Lotus-Eaters. We’ve been enticed by our own wily Sirens. We’ve sailed uneasily between Scylla and Charibdis. We’ve brazenly defied more than one Cyclops. We’ve been threatened by the wrath of our own Poseidon. And we’ve been temporarily entranced by some bewitching Calypsos. But we’ve survived our now-32-year voyage, and returned home, proud and prosperous, for a brief moment of reflection. Of course we know that life is a journey, not a destination, and a new odyssey lies before us. As you might imagine, it’s difficult for me to believe that such a new voyage could have the excitement and challenge of Vanguard’s first one. After all, putting a new name on the map, creating a unique new structure, and establishing a new set of ethical values can’t recur with regularity. True entrepreneurship or not, (1) we created a new form of governance in the mutual fund industry, a mutual structure in which the interests of fund investors take precedence over the interests of fund managers and distributors.

Fixing today’s CEO-centered corporate world, the excesses of the financial system, and the faltering mutual fund industry—returning control from managers to owners in a new fiduciary society—is on the way. I hope my book will help. But whether forced to do so by law or regulation, or by the wisdom finally acquired by crowds of investors making intelligent investment decisions as they simply seek to further their own economic interests, so it will be. That’s my ideal, and that’s my idealism. Thank you.

There’s another great benefit in again becoming an “own-a-stock” industry. We would be forced to recognize that the interest of our shareholders demands that we act as responsible corporate citizens, carefully examining company financial statements, making our views known on matters such as stock options, executive compensation, and corporate governance, and assuring that the corporations whose shares we hold are operated in the interests of their shareholders rather than their managers. In today’s “rent-a-stock” industry, where stocks are treated as mere pieces of paper to trade back and forth rather than as the talisman of ownership, those governance issues are too often ignored. So my dream is that we return to our roots as investors. Not only because it will be to the economic benefit of our clients, but because we can play the determining role in returning corporate America to its own roots of democratic capitalism. 4. A Dream that We Serve Long-Term Investors My fourth dream is that we again serve long-term investors. That is not how it works today. For even as the investment horizons of our fund managers diminished, so, too, have the horizons of mutual fund investors. Small wonder, since we have shaped our business to meet the demands of short-term investors!

advertising. One industry participant recently said, “selling mutual funds is just like selling perfume; we’re selling hope.” I pray that that is a minority view. A $700 Billion Trust At the 1936 General Membership Meeting of the Investment Company Institute, there was a huge banner reading “Mutual Funds: A $600 Billion Industry.” My hope today, as I come full circle in these remarks, is that this year’s banner will read “Mutual Funds: A $700 Billion Trust.” For we are much more than a mere “industry.” And we must hold ourselves to higher standards, standards of trust ;and of fiduciary duty. If we fail to do so—if we follow the lead of marketing companies in conventional consumer businesses, if we continue to create investment expectations we cannot possibly meet, often overlaid with high risks and laden down with exorbitant costs—the future of mutual funds is not bright. But if we return to the philosophy that a fully-informed investor paying a fully-disclosed cost for a sensible investment program is the best possible base for building an ever more successful business, our finest hours lie yet ahead. Dealing with this dichotomy—between an industry and a trust—is surely the critical challenge of change that we face. Indeed, what I have presented today is more accurately described as “the challenge to change.

So my fourth dream is that we return to our roots in providing broadly diversified mutual funds—not narrowly-defined products—that can be bought and held “forever.” 5. The Dream of Putting Fund Investors in the Driver’s Seat My fifth dream is putting the investors in the driver’s seat of fund governance. Only in this way can we honor the demand of the Investment Company Act of 1940, the statute that governs our industry, demands that mutual funds be “organized, operated, and managed in the best interests of their shareholders rather than in the interest of their advisers and underwriters.”5 Yet for all of the Act’s noble intentions, that’s simply not the principle under which our industry operates today. Once focused on management and investment, we are now focused on marketing and asset-gathering. Of course our managers are eager to earn a fair return on the capital entrusted to them by their fund shareholder/clients. But they also are in business to earn the highest possible return on their own capital. That’s what we call a “conflict of interest.” For so long as the gross returns earned by fund investors as a group are reduced by the costs of fund investing—management fees, operating costs, marketing costs, portfolio turnover costs (to say nothing of the excessive taxes imposed on shareholders by those short-term investment policies)—their net returns will be far less.

0% 20% 40% 60% 80% 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 Share of Corporate Equities Held by Institutions Source: Federal Reserve 6. I’ve written a book about these issues,8 and I express my conclusion bluntly. Using words remarkably close to those of Minsky, I describe how capitalism has changed for the worse. In a half- century we’ve moved from an ownership society where individual shareholders owned 92 percent of all stocks and financial institutions owned only 8 percent (Chart 6) to an agency society in which institutional shareholders now own 74 percent of all stocks. But we haven’t changed the rules. These mutual fund and pension fund managers have largely ignored the interests of their principals—fund shareholders and pension beneficiaries. To restore balance to the system, we need a new fiduciary society in which the interests of these 100 million principals—the last-line investors of America—come first. The Rise of the Financial Economy I’ve taken you on this long trip through risk and uncertainty, not only because I find these ideas both important and intellectually stimulating, but because they set the stage for my discussion of the concerns I hold today regarding our financial system and our society. I recognize that some of these ideas are complex, so let’s summarize the ground we’ve covered so far: 1. Black Swans—extreme and unexpected outcomes—are part of investing, and can’t be predicted in advance. 2.

It is but a truism to state of this industry in the aggregate: “The more fund managers take, the less fund investors make.” I am convinced that the coming of public ownership of fund management companies in the late 1950s bears an important share of the responsibility for many of the problems I’ve described in my remarks today: rising costs for investors, and the failure to deliver our huge economies of scale to shareholders; the failure to make the most of our opportunity in retirement planning; the move away from long-term investment in favor of short-term speculation; the asset-gathering mentality and the focus on fads like size and style, all of which have meant staggering profits for fund managers and substantial cumulative shortfalls to returns in the financial markets for fund shareholders. Just check the record. So what’s to be done? Shareholder education is glacially slow, yet time is money. The conglomerates that dominate the industry today—owning 40 of the 50 largest fund complexes—will not soon accept eroded returns on their capital, nor will they willingly return their profits to their clients. So I see no recourse but to put fund shareholders in the driver’s seat of fund governance, thereby at last honoring both the letter and the spirit of the 1940 Act. 5 SEC Decision “In the Matter of the Vanguard Group” February 28, 1981, page 6.

What is necessary is that the governance of mutual funds comports with just what the Act calls for: a board of directors that is beholden first and foremost to the shareholders who elected them. We must eliminate the blatant conflict of interest that exists when the chairman of the fund board is the same person as the chairman of the management company board. (As Warren Buffett says, “negotiating with one’s self seldom produces a barroom brawl.”) For the same reason, we need a board wholly independent of the manager. (The requirement that 75 percent of the directors must be independent is a good beginning, but at Vanguard our outside advisers have zero board representation, obviously without adverse consequences for our shareholders.) Regulations already require an independent legal counsel and a chief compliance officer for the funds themselves, and I strongly favor, at least for the larger fund complexes, a fund staff, responsible to the board, that provides the board with objective and unbiased information on fund costs, performance, marketing, etc. So my dream of fund independence means not only that today’s pending board reforms will be preserved by the SEC, but that groundwork will be laid for an industry that at last acts under the spirit of our federal statute that demands that fund shareholders, through their elected representatives, are placed in the driver’s seat of fund governance.

Conclusion What I’m looking for is an industry that is focused on stewardship—the prudent handling of other people’s money solely in the interests of our investors—an industry that is of the shareholder, by the shareholder, and for the shareholder. Or, if I may refer to the overarching theme of this 25 th Annual NICSA Conference, an industry with both vision and values: a vision of fiduciary duty and shareholder service, and values rooted in the proven principles of long-term investing and of trusteeship that demands integrity in serving our clients. Part of my dream, as you might imagine, is that we’ll ultimately find the first follower of Vanguard’s fund-shareholder-oriented, mutualized, “at cost” model, and then our second follower and then our third, and then more, as we move away from today’s management-company-oriented and increasingly financial-conglomerate-dominated structure. Not necessarily because we as an industry want to change, but because the demands of intelligent investors who “vote with their feet” will drag us kicking and screaming into the Brave New World that I foresee. But even if that sea change to a structure that has clearly worked so effectively for both our investors and for our firm doesn’t happen, I expect that this industry will finally move, at least philosophically, in the direction of the Vanguard model. How close will we get to these lofty—some might say idealistic—goals in the coming decade?

Well, you already know that one of the dreams that I expressed at NICSA in the past remains unrealized (I’m still waiting for lower costs), and that a second took decades to come to fruition (our primacy in retirement planning). It also may take decades for the other three dreams I’ve dreamt with you today to come to pass—long-term portfolio strategies, shareholders who invest with us for the long-term, and our client/owners sitting firmly in the driver’s seat of fund governance. But I fervently hope that change will come much sooner. Only time will tell. But if you’ll invite me back ten years hence, I’ll report to you on our progress. Ever the optimist, I’ve marked my calendar for February 2017. Please do the same. See you then . . . . . . God willing.

latest book, published this month, drives this message home: The Little Book of Index Investing—The Only Way to Guarantee Your Fair Share of Stock Market Returns.) But we need more. Since our agency society has so diffused the beneficial ownership of stocks among 100 million or so mutual fund shareholders and pension beneficiaries, we also need to create, out of our disappearing ownership society and our failed agency society, a new “fiduciary society.” Here, our agent/owners would be required by federal law to place the interest of their principals first—a consistently enforced public policy that places a clear requirement of fiduciary duty on our financial institutions to serve exclusively the interests of their beneficiaries. That duty would expressly require their effective and responsible participation in the governance of our publicly-owned corporations, and demand the return of our institutional agents to the traditional values of professional stewardship that are long overdue. We also need to raise our society’s expectations of the proper conduct of the leaders of our businesses and financial institutions. So, in addition to Adam Smith’s almost universally-known Invisible Hand, we need to call on his almost universally-unknown Impartial Spectator. This impartial spectator first appears in Smith’s earlier Theory of Moral Sentiments—the force that arouses in us values that are so often generous and noble.

During the recent era, we entered the age of expectations investing, where projected growth in corporate earnings—especially earnings guidance and its subsequent achievement, by fair means or foul—became the watchword of investors. Never mind that the reported earnings were too often a product of financial engineering that served the short-term interest of both corporate managers and Wall Street security analysts. When long-term owners of stocks become short-term renters of stocks, and when the momentary precision of the price of the stock takes precedence over the eternal vagueness of the intrinsic value of the corporation, concern about corporate governance is the first casualty. The single most important job of the corporate director is to assure that management is creating value for shareholders; yet investors seemed not to care when that goal became secondary. If the owners of corporate America don’t give a damn about corporate governance, I ask you, who on earth should?the

While (as we say at Vanguard) “even one person can make a difference,” the task of restoring the vanishing values of business and investing is far larger than one person can handle. We need wisdom and introspection from our business and investment leaders to learn from the lessons of history and to realize that, however profitable the operation of today’s businesses and investment institutions may be to their managers, in the long run today’s practices will be self-defeating. We need investors everywhere to join together to demand the development of that fiduciary society I have described, and we—all of us—need to awaken our fellow citizens to respect that Impartial Spectator who demands virtuous conduct and a return to traditional values by the leaders of our corporate businesses and our investment institutions. Without that, those treasures will indeed vanish.

managed, low-cost, broadly-diversified, and tax-efficient no-load index fund would provide even higher real returns relative to those earned by actively-managed equity funds than the enormous advantage it has achieved over the past quarter century. Like it or not, the index fund remains, if I may take the liberty of citing the subtitle of my new Little Book, “the only way to guarantee your fair share” of whatever returns our markets are generous enough to provide in the years ahead. I conclude by reiterating my theme that the link between fiduciary duty and financial markets is not only an unbreakable one, but that in today’s risky investment world, it is more important than ever. Trusteeship, fiduciary duty, and professional standards are not just idle phrases. They represent the very essence of good business—ethical conduct, fair-dealing, “just and equitable principles of trade” (in the lexicon of NASD regulations)—in which service to clients, and for that matter, service to society, is the paramount value. Writing about professional obligations in the spring edition of the Yale School of Management Quarterly Review, Harvard Business School professor Rakesh Khurana suggests this stern standard as the watchword of the true professional: “I will create value for society, rather than extract it.

If The Battle helps to open the door to the introspection—and then corrective action— by our corporate and financial leaders that is so long overdue, perhaps the needed changes will be hastened. This process, I conclude, must begin with a return to the original values of capitalism, to that virtuous circle of integrity—“trusting and being trusted.” When ethical values go out the window and service to those whom we are duty-bound to serve is superseded by service to self, the whole idea of the capitalism that has been a moving force in the creation of our society’s abundance is soured. In the era that lies ahead, the trusted businessman, the prudent fiduciary, and the honest steward must again be the paradigms of our great American enterprises. I know it won’t be easy, but if we all work long enough and hard enough at the task, we can build, out of our long-gone ownership society and our failed agency society, a new “fiduciary society,” one in which the citizen-investors of America will at last receive the fair shake they have always deserved from our corporations, our investment system, and our mutual fund industry.Conclusion

It concluded: “Should mutual funds even worry about trying to prevent these strategies? Because the gains are offset by losses to the other (long- term) shareholders in the funds, the funds have a fiduciary duty to take preventative action . . . Why (don’t they)? . . . because short-term trading increases assets under management and (increases) management compensation . . . and managers may have the perception that (blocking these strategies) puts the fund at a competitive disadvantage.” In short, taking action to limit trading would hurt fund marketing. Rather than being alerted to the problem, the industry ignored it. Worse, the only published response to the article came from a senior executive of an industry leader, who condemned the Journal for publishing the article: “Your article raises serious questions about the policies, oversight and judgment in selecting articles. Publishing (it) is a bad idea in the best of times but is abhorrent in a period when investor confidence is shaken by corporate greed and fraud, bad accounting, and a bear market overall.” That response is a classic “shoot the messenger” reaction. (It was about this time that his firm finally added redemption fees for its international funds, at last curtailing the trading.) But it wasn’t only managers of international funds that participated in this scandalous conduct. One example: in its 2002 annual report, a U.S.

I think few would disagree that the Vanguard experiment in mutual fund governance; our creation of the first index mutual fund, the first series of defined-maturity bond funds, and the first series of tax-managed funds; our focus on low-costs—not only in expense ratios, but also in eliminating sales charges, and minimizing portfolio turnover costs—has created substantial shareholder value. And surely target-date retirement funds and asset-allocation funds, properly used, also offer substantial potential benefits to investors. But the new wave of innovation is something else again. I’ve long made my position clear that exchange traded funds (ETFs)—index funds that one can trade “all day long, in real time” (as the advertisement says), and overwhelmingly focused on narrow, even minuscule, sectors of the market—are likely to do investors more harm than good. The stolid, simple, classic old index funds—that have, in fact, worked brilliantly—are also being challenged by new funds purporting to be “better” index funds, but in fact are pursuing active investment strategies. Variable annuities are another problem. The original TIAA-CREF annuity was a truly great creation, and with costs that are so low as to barely be believed, deservedly leads the field to this day. But, with rare exceptions, its successors have piled on costs that are totally unacceptable (to investors, although hardly to salesmen).

Fiduciary Duty in an Age of Consumerism Remarks by John C. Bogle Before the “The Campaign for Investors” Sponsored by The Institute for the Fiduciary Standard The National Constitution Center, Philadelphia, PA May 24, 2016 On April 6, 2016, the U.S. Department of Labor (DOL) established a fiduciary duty principle— the requirement that investment advisers and brokers who give advice to clients holding retirement plans place the interests of investors first. One of the recent press reports on the rule headlined its story: FINALLY, JOHN BOGLE’S DREAM OF A FIDUCIARY STANDARD WILL COME TRUE. Yes, the new rule is complex, but previous comments from the fund industry have made it considerably more workable, with disclosures that are more practical and easier for advisers and brokers to follow. Nonetheless, the DOL fiduciary standard continues to face powerful adversaries. The U.S. Chamber of Commerce, as usual, places business interests ahead of consumer interests and, along with eight other groups, has filed a federal lawsuit seeking to block implementation of the new rule. But I strongly support the rule. I’ve arguably been campaigning for it ever since I wrote my senior thesis at Princeton University 65 years ago. There, I wrote at length about the use of mutual fund shares by fiduciaries and retirement plans, suggesting that such use “seems destined to increase in the future.

Ethical Principles and Ethical Principals Remarks by John C. Bogle, Founder and former chief executive The Vanguard Group ∞ ∞ ∞ Upon receiving The Exemplary Leadership Award from The Center for Corporate Excellence at The “Charging the Game” Forum Denver, CO November 1, 2006 I’m deeply honored to receive your award. During my now 55-year career in the mutual fund industry I’ve done my best to meet your standard of “consistent ethical leadership.” But I freely confess that, perhaps like all of us, I could have provided even more leadership toward a better corporate and investment America. In whatever years may remain, I pledge to you this evening that I will “press on, regardless” in this quest.1 The title of my remarks this evening arises from, of all things, a typographical error. In a mailing sent out by the Center for Corporate Excellence earlier this year to announce that General Electric would receive your Long Term Excellence in Corporate Governance award, you quoted GE President Jeffrey Immelt on the importance of “sound principals of corporate governance.” But while the quotation said, yes, principals, it clearly meant principles. I can’t help myself from noticing that sort of stuff (query whether it’s a strength or a weakness!), and as I did, it occurred to me that there might be a speech in that distinction.

The Age of Fiduciary Duty has Arrived Remarks by John C. Bogle, Vanguard Founder Before the Eastern Chapter of The National Association of Personal Financial Advisers Baltimore, Maryland November 8, 2012 Thanks to all of you for coming out to this important conference. And a special thank you to those of you who use our Vanguard funds with your clients (and often in your own investment portfolios). And thanks to all of you for working with investors—honest-to-God, down-to-earth human beings—and for helping them to meet their financial goals. The vast majority of investors need financial advisors, and you and your firms are likely the soundest approach to that mission. It’s a special honor to join you at your conference once again. On my previous visit in 1999, you honored me with your Special Achievement Award—the first time that your award had been presented to a fund industry executive (as distinct from an academic, regulator, or author). Deserving or not, I am both proud and humbled to hold that distinction. The fact is that I’ve always deeply believed that Vanguard is a natural partner for most independent registered investment advisers. My reasoning (perhaps like all of my reasoning) is simple, straightforward, and mathematical.

The Fiduciary Principle: “No Man Can Serve Two Masters” A Lecture by John C. Bogle Founder and former chairman, The Vanguard Group Columbia University School of Business New York City, NY April 1, 2009 This evening, we meet at a time of financial and economic crisis in our nation and around the globe. I venture to assert that when the history of the financial era which has just drawn to a close comes to be written, most of its mistakes and its major faults will be ascribed to the failure to observe the fiduciary principle, the precept as old as holy writ, that “a man cannot serve two masters.” No thinking man can believe that an economy built upon a business foundation can permanently endure without some loyalty to that principle. The separation of ownership from management, the development of the corporate structure so as to vest in small groups control over the resources of great numbers of small and uninformed investors, make imperative a fresh and active devotion to that principle if the modern world of business is to perform its proper function. Yet those who serve nominally as trustees, but relieved, by clever legal devices, from the obligation to protect those whose interests they purport to represent, corporate officers and directors who award to themselves huge bonuses from corporate funds without the assent or even the knowledge of their stockholders . . .

Building a Fiduciary Society Remarks by John C. Bogle Founder and former Chairman, The Vanguard Group IA Compliance Summit Washington, DC March 13, 2009 Not so long ago, Rahm Emanuel, President Obama’s chief of staff, expressed one of the eternal verities of our society: “Never allow a crisis to go to waste. (Crises) are opportunities to do big things.” That principle applies in a particularly profound way to the financial sector of our economic society. The crisis in our stock market and in our economy has presented us with the opportunity to do a really big thing—to reform our financial system. Over the past half-century, that system has changed radically, and for the worse. Our old ownership society, in which stocks were owned largely by individuals is long gone and will not return. Its successor, the agency society, now prevails, institutional money managers holding and trading the lion’s share of U.S. stocks and operating in their own financial interests. The present crisis is, in important measure, a reflection of that change, and it gives us the opportunity to build, out of the ashes of our failed agency society, a new fiduciary society in which the interests of the investors who put their capital to work come first. The Financial Crisis There’s no doubt that we have a financial crisis on our hands. In my long career in finance, going way back to 1951, I’ve witnessed ten bear markets (defined as stock market _______________ John C.

Yes, I’ve tried to create a business with character and class, holding human values high. That’s a task I’ve yet to complete . . . But it’s not the only task before me, for I’ve yet to climb all Seven Summits, host the Oscars; nor (despite my Scots’ heritage) solve the mystery of Loch Ness; nor been a candidate to manage the Phillies (or even the Red Sox); and it’s too late for me to run for President. (Sorry ‘bout that!) Yes, I’m now writing my tenth book, many of which have been best-sellers . . . But only for a little while. After a single week on the New York Times best-seller list, ENOUGH. was replaced by—I guess it’s okay to say it aloud—Real Sex for Real Women. “Is this a great country or what!” Yes, I’ve been among the strongest advocates in my field for activism in corporate governance . . . But words aren’t the same as deeds, and I’ve yet to see any tangible results whatsoever. “The Silence of the Funds” remains deafening, but I’m not about to give up the mission. Yes, I’ve had a few portraits painted . . . But one sits in my office (it’s a long story), not in the Louvre nor even the Philadelphia Museum of Art. I confess too that there is a larger-than-life sculpture of me on the Vanguard campus . . . But its only function seems to be to allow fund industry leaders to describe me (cynically, of course) as “a saint with a statue.

As you may have already figured out, those words (except for the very first sentence) are not mine. Rather they are the words of Harlan Fiske Stone, excerpted from his 1934—yes, 1934—address at the University of Michigan Law School, reprinted in The Harvard Law Review later that year. But his words are equally relevant—perhaps even more relevant—on this very day. For they could hardly present a more appropriate analysis of the causes of the present-day collapse of our financial markets and the economic crisis now facing our nation and our world. You could easily react to Justice Stone’s words by falling back on the ancient aphorism, “the more things change, the more they remain the same,” and move on to a new subject. But I hope you’ll react differently, and share my reaction: In the aftermath of that Great Depression and the stock market crash that accompanied it, we failed to take advantage of the opportunity to demand that our giant businesses and financial organizations—the trustees of so much of our nation’s wealth—measure up to the stern and unyielding principles of fiduciary duty described by Justice Stone. So, 75 years later, for heaven’s sake, let’s not make the same mistake again. The Columbia Connection Given this history and this topic, it seems singularly fitting to present this lecture at Columbia University. For Harlan Fiske Stone (1872-1946) ranks among Columbia’s most distinguished sons.

I. Principals and Principles The first of these three subjects focuses on the title I have chosen for my remarks this afternoon—“Ethical Principles and Ethical Principals.” That talk was inspired by, of all things, a typographical error. A mailing I received a few years ago announced that General Electric would receive an award for long-term excellence in corporate governance; GE President Jeffrey Immelt was quoted as focusing on the importance of “sound principals of corporate governance.” But while the quotation spelled principals with the concluding a-l-s, Mr. Immelt clearly meant principles, with the concluding l-e-s. But, at least in this instance, that is distinction without a difference. After all, no matter how strong the ethical principles of the world of business may be, of what use are they without ethical principals to honor them, especially ethical leaders who have the responsibility to assure that these ethical principles permeate and dominate the culture of our corporate world?1 I describe these classic ethical principles of our society in words very similar to those of Steven Pinker— integrity, honesty, and trustworthiness; fairness and justice; doing good and preventing harm; concern for the well-being of others and respect for their autonomy, and so on. But applying these societal principles to business principals is far easier said than done.

The 1971 Challenge In 1971, even more pointedly, speaking to the partners of Wellington Management Company— where I served as chief executive from 1965 through early 1974—I expressed my focus on fiduciary duty in much sharper terms. In a section of my remarks entitled, “The Challenge of Fiduciary Duty,” I said: “We live in a world that is increasingly intolerant, not only of conflicts of interest, but even the appearance of conflicts. It is hard to argue either that this trend is baneful or that it is likely to abate. For this is but one aspect of the “consumerism” whose impact pervades almost every aspect of our society, and certainly is not limited to the world of money management. It seems beyond question that consumerism, along with the entire thrust of the legislative, regulatory, and judicial overview of our profession will play a critical role in how we conduct our affairs in the years ahead.” And then—yes, 45 years ago—I pulled out all the stops. The next section of my talk was entitled, “A Man Cannot Serve Two Masters.” “Listen, for example, to Justice Harlan Fiske Stone, speaking in 1934: ‘I venture to assert that when the history of the financial era which has just drawn to a close comes to be written, most of the mistakes and its major faults will be ascribed to the failure to observe the fiduciary principle, the precept as old as holy writ, that a man cannot serve two masters . . .

tough standards established by the Congress were worthwhile. I supported them—as did our board of directors—without reservation.) My comments on auditor rotation are hardly the stuff of which headlines are made. While I do not believe that mandatory rotation would come close to resolving the plethora of issues surrounding auditor independence, such rotation would be a step in the right direction. “Independence” can be fairly defined as the requirement that “the audit be performed in a disinterested manner, free from influence by the client,” and that the auditor should “exercise appropriate professional skepticism and make objective auditing judgments.” But meeting that standard will call for much more than mere rotation. As to frequency of the mandatory rotation, I would think that a formal review of the existing auditor no later than at the 10-year mark of service would be reasonable, and that there should be a flat limit of 20 years for any audit firm’s service with a client. While my own audit firm experience was limited to companies whose auditing issues seemed not particularly complex, my conclusion is that concern about the costs of rotation are generally rather exaggerated, and the benefits are understated. Here, I take the liberty of expressing my strong reservation that the (theoretically wonderful) requirement that a “cost-benefit analysis,” a requirement of federal regulators since 1993, is the paragon of common sense.

But preserving, protecting, and defending the corporation’s resources with the interests of its owners as the highest priority seems the exception rather than the rule today. We know that the CEO is the senior employee of the corporation, responsible, through the board of directors, to the owners. Yet we live in a world with many imperial CEOs who seem to view themselves as solely responsible for the creation of “shareholder value” (more about that later) and, worse, and paid accordingly. Indeed, with the abject failure of the owners of our corporations to aggressively demand their rights of ownership and equally aggressively assume their responsibilities of ownership, why should we expect our corporate managers to honor the responsibilities they so clearly owe to their owners? We see corporations preach “the balanced scorecard” that calls for fair dealing with the corporation’s other constituencies—customers, employees, suppliers, the local community, government, and the public.companies

In the new ownership structure of our corporations and institutional money managers, the “Double-Agency Society,” giant corporate manager/agents interface with our giant investment manager/agents in a symbiotic “Happy Conspiracy,” focusing on the momentary fluctuations of evanescent stock prices rather than the building of durable, long-term intrinsic corporate value. 3. In corporate governance, the failure of our institutional investors—who now control, not 8 percent of stocks as in 1950, but a controlling 70 percent—to step up to the plate and exercise the rights and responsibilities of corporate governance in the interests of the fund shareholders and plan beneficiaries whom they are duty-bound to serve. 4. In mutual funds, the cottage industry that I joined in 1951—a profession focused on stewardship—has become a giant business focused on salesmanship, and where old notions of fiduciary duty have been subverted both by short-term investment focus and by control of money managers by financial conglomerates (41 of the 50 largest fund complexes are now publicly-held or under conglomerate domination.) 5.being

responsibility must always be to their shareholders.” Shortly thereafter, “there is some indication that costs are too high,” and that “future industry growth can be maximized by concentration on a reduction of sales charges and management fees.” (My advice, however, fell upon deaf ears.) After analyzing mutual fund performance, I concluded that “funds can make no claim to superiority over the market averages,” perhaps an early harbinger of my decision to create, nearly a quarter-century later, the world’s first index mutual fund. Still later in the thesis, I urged that “fund influence on corporate policy . . . should always be in the best interest of shareholders, not the special interests of the fund’s managers.” (Again, my advice fell by the wayside, and shareholders remain ill-served by the passive governance policies of most funds.) Finally, I predicted that rather than engaging in short-term speculation focused on forecasting the psychology of the stock market, funds would bring far greater focus on wise long- term investment. Defying Lord Keynes’s prediction that professional investors would join the ignorant crowd of stock traders, I predicted that fund managers would be “steady, sophisticated, enlightened, and analytic” institutional investors, focused on corporate performance and intrinsic value rather than momentary and evanescent share prices. (Once again, I was wrong.

While the 40 fund management companies with public owners of one kind or another predominate the number of firms, their share of industry assets is smaller relatively smaller—about $6 trillion, less than half of the $12.5 trillion industry total. The 10 privately-held and mutual firms are disproportionally large, with these firms managing some $4.5 trillion. Under each of the first three forms of ownership, to varying degrees, management companies face a profound conflict of interest. They wish to earn the highest possible return on their ownership stake, by gathering ever-larger pools of assets and steadily increasing their management fee revenues and profits. But this objective comes at the direct expense of the returns that they deliver to the mutual fund shareowners whom they are duty-bound to serve. For the publicly-owned and conglomerate-owned firms, the conflict of interest is, ironically, even more severe than for the privately-held managers. Arguably, they have a fiduciary duty to maximize the returns of both their own shareholders and their fund shareholders. To understand the severity of the problem, just consider the Biblical warning, “no man can serve two masters.”

” Yes, I think I’ve played a major role in bringing into the public discourse the importance of long- term investing, of rational expectations for returns in the financial markets, and of the crying need for a fiduciary standard . . . But there’s so much I haven’t done: Walk on water, leap tall buildings at a single bound, publish poetry in Russian, make the cover of TIME, or Fortune, or FORBES, or Bloomberg Business Week. Despite my infinite failings, however, I’m simply unable to conceal my pride on this great day of celebration. I’m reminded again of Benjamin Franklin, whose character was central to his dedication to the public interest, so easily observable in his entrepreneurship, in the joy he took from his creations, and in his ingenuity, his energy, and his persistence. That trait of character also found its expression in Franklin’s ongoing struggle, not unlike my own, to balance pride with humility—a balance that, in this age of bright lights, celebrity, and money, our society seems to have largely ignored. As Franklin wrote in his autobiography: In reality, there is, perhaps, no one of our natural passions so hard to subdue as pride.still

After analyzing mutual fund performance, I conclude that “funds can make no claim to superiority over the market averages,” perhaps an early harbinger of my decision to create, nearly a quarter-century later, the world’s first index mutual fund. Still later in the thesis, “fund influence on corporate policy . . . should always be in the best interest of shareholders, not the special interests of the fund’s managers.” (Again, my advice fell by the wayside, and shareholders remain ill-served by the passive governance policies of most funds.) My conclusion powerfully reaffirmed the ideals that I hold to this day: “The principal function of investment companies is the management of their investment portfolios. Everything else is incidental.” The role of the mutual fund is to serve—“to serve the needs of both individual and institutional investors . . . to serve them in the most efficient, honest, and economical way possible.” This gratuitous advice from a callow college senior was also largely ignored by the fund industry.group—operated

awareness of the ethical dilemmas faced by today’s business leaders. Included among these leaders are the chiefs who manage our publicly-held corporations—today valued in the stock market at some $10 trillion—and the professional managers of “other people’s money” who oversee equity investments valued at some $7 trillion of that total, owning 70 percent of all shares and therefore holding absolute voting control over those corporations. Like their counterparts in business, those powerful managers have not only an ethical responsibility, but a fiduciary duty, to those whose capital has been entrusted to their care. Fiduciary Duty The concept of fiduciary duty has a long history, going back more or less eight centuries under English common law. Fiduciary duty is essentially a legal relationship of confidence or trust between two or more parties, most commonly a fiduciary or trustee and a principal or beneficiary, who justifiably reposes confidence, good faith, and reliance in his trustee. The fiduciary acts at all times for the sole benefit and interests of another, with loyalty to those interests. A fiduciary must not put personal interests before that duty, and, importantly, must not be placed in a situation where his fiduciary duty to clients conflicts with a fiduciary duty to any other entity. Way back in 1928, New York’s Chief Justice Benjamin N.

of all shares. Ownership of U.S. stocks by institutions, on the other hand, has soared more than seven times over—from 8 percent of shares all those years ago to more than 70 percent today. But in our new “agency society,” with financial intermediaries as a group now holding clear voting control of corporate America, our agents have failed to behave as owners. Indeed, in far too many cases, they have placed their own interests ahead of the interest of their principals, largely those 100 million families who are the owners of our mutual funds and the beneficiaries of our pension plans. It’s not that we were not warned about the consequences of our failure to honor the fiduciary principle that “no man can serve two masters,” and that fiduciary duty imposes a high standard of morality upon those entrusted with managing the property of others. Indeed, it was way back in 1934—75 years ago—in the aftermath of the Great Crash in the stock market that Supreme Court Justice Harlan Fiske Stone warned: The separation of ownership from management, the development of the corporate structure so as to vest in small groups control over the resources of great numbers of small and uninformed investors, make imperative a fresh and active devotion to [the] principle [that “no man can serve two masters] if the modern world of business is to perform its proper function.

Our corporate directors pay lip service to the responsibility of stewardship. But preserving, protecting, and defending the corporation’s resources with the interests of its owners as the highest priority seems the exception rather than the rule today. We know that the CEO is the senior employee of the corporation, responsible, through the board of directors, to the owners. Yet we live in a world with many imperial CEOs who seem to view themselves as solely responsible for the creation of “shareholder value” (more about that later) and, worse, are paid accordingly. Indeed, with the abject failure of the stockholders of our corporations to aggressively demand their rights of ownership and equally aggressively assume their responsibilities of ownership, why should we expect our corporate managers to honor the responsibilities they so clearly owe to their owners? We see corporations preach “the balanced scorecard” that calls for fair dealing with the corporation’s other constituencies—customers, employees, suppliers, the local community, government, and the public. But the record suggests, for one example, that too many companies demand loyalty from their employees even as they fail to reciprocate by demonstrating loyalty to their employees. And how about the integrity of the firm’s financial statements, let alone the true independence of the independent auditor who attests to their conformity with generally accepted accounting principles (GAAP)?

Simply put—and this is the main thesis of my latest book, The Battle for the Soul of Capitalism—what went wrong in corporate America, aided and abetted by investment America, was a pathological mutation in capitalism—from traditional owners’ capitalism, where the rewards of investing went primarily to those who put up the capital and took the risks—to a new and virulent managers’ capitalism, where an excessive share of the rewards of capital investment went to corporate managers and financial intermediaries. There were two major reasons for this baneful change: First, the “ownership society”—in which the shares of our corporations were held almost entirely by direct stockholders—gradually lost its heft and its effectiveness. It is not going to return. In its stead, a new “agency society” has developed, with financial intermediaries controlling the overwhelming majority of shares. (Since 1950, institutional ownership has risen from 8 percent of U.S. stocks to 68 percent; individual ownership has dropped from 92 to 32 percent.) But those agents haven’t behaved as owners. They failed to honor the interest of their principals, largely those 100 million families who are the owners of our mutual funds and the beneficiaries of our pension plans. If the owners of corporate America don’t give a damn about corporate governance, I ask you, who on earth should?

Cardozo put it well: Many forms of conduct permissible in a workaday world for those acting at arm’s length are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the marketplace . . . As to this there has developed a tradition that is unbending and inveterate . . . Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior . . . Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd. It has been said, I think accurately, that fiduciary duty is the highest duty known to the law. It is less ironic than it is tragic that the concept of fiduciary duty seems far less imbedded in our society today than it was when Stone and Cardozo expressed their profound convictions.the

markets. As I have often put it: We have moved from a society in which “there are some things that one simply does not do,” to one in which “if everyone else is doing it, I can do it too.” I’ve described this change as a shift from moral absolutism to moral relativism. Business ethics, it seems to me, has been a major casualty of that shift in our traditional societal values. You will hardly be surprised to learn that I do not regard that change as progress. At least a few others share this view. In her 2006 book Trust and Honesty, Boston University Law School professor Tamar Frankel provides worthy insights on the diminishing role of fiduciary duty in our society. She is concerned—a concern that I suspect that many of you here tonight would share—that American culture has been moving toward dishonesty, deception, and abuse of trust, all of which have come to the fore in the present crisis. What we need, she argues, is “an effective way to increase trust (by) establishing trustworthy institutions and reliable systems,” even as she despairs the pressures brought out by the stock market and real estate bubbles that led to “deteriorating public morals . . . and burst into abuse of trust.” In Professor Frankel’s view, “we reduced the power of morality in law . . . emasculated the regulation of trusted persons (that is, fiduciaries) . . . abused the laws that govern fiduciaries’ honesty . . . and opened the door to enormous losses to the public and the economic system.

fiduciary duty. In my tenth and newest book, The Clash of the Cultures: Investment vs. Speculation, I spell out what I’m looking for: A Federal Standard of Fiduciary Duty 1. Promote long-term focus. 2. Effective shareholder presence is in the national interest. 3. Exercise rights and responsibilities of corporate ownership. 4. Ability to nominate directors. 5. Eliminate conflicts of interest. 1. A requirement that all fiduciaries must act solely in the long-term interests of their beneficiaries. 2. An affirmation by government that an effective shareholder presence in all public companies is in the national interest. 3. A demand that all institutional money managers should be accountable for the compulsory exercise of their votes, in the sole interest of their shareholders. 4. A recognition of the right of shareholders to nominate directors and make proxy proposals, subject to appropriate limits. 5. A demand that any ownership structure of money managers that entails conflicts of interest be eliminated. And of course, reasonable costs are central to meeting the fiduciary standard. For fiduciary duty, in a sense, comes down to a simple mathematical calculation: How are the rewards of investing divided between the providers of financial services and their clients who put up their capital. Why? Because for investors as a group, gross returns in the financial markets, minus the costs of financial service providers, equals the net returns that are actually delivered to investors.

It was the final stamp of approval on what proved to be a new way of operating a fund complex that would ultimately lead to a major reordering of the fund industry. The rest, as they say, is history. “A Journey of a Thousand Miles” With that history as background, where are we today? In my view, the formation of Vanguard and its “shareholder first” structure marks the beginning of a long arc that is bending toward fiduciary duty. As it is said, “a journey of a thousand miles begins with a single step.” And thanks importantly to the determination of Assistant Secretary of Labor Phyllis Borzi, the DOL has given vital support to that fiduciary principle, recently approving a rule that requires both registered investment advisers (RIAs) and stock brokers to place the interests of their clients holding retirement plans before their own.

If the owners of corporate America don’t give a damn about corporate governance, I ask you, who on earth should? The second reason is that our new investor agents not only seemed to forget the interests of their principals, but also seemed to forget their own investment principles. (There’s a somewhat different distinction between a-l-s and l-e-s.) In recent decades, the predominant focus of institutional investment strategy turned from the wisdom of long-term investing to the folly of short-term speculation. We entered the age of expectations investing, where growth in corporate earnings—especially earnings guidance and its achievement—became the watchword of investors. Corporate managers and corporate stockholders—now no longer true owners of stocks, but renters of stocks—came to accept that whatever earnings were reported were, well, “true.” In effect, as a corporate Humpty Dumpty might have told institutional investor Alice in Wonderland: “When I report my earnings it means just what I choose it to mean, neither more nor less . . . the question is who is to be the master—that’s all.” And Alice said, “aye, aye, sir.”

is my ninth book, following Enough., The Battle for the Soul of Capitalism, Character Counts, and others. I’m not about to stop “giving back,” even in these later years of my life. I close with this proverb recounted by Mario Cuomo—a member of my pantheon of American heroes—in last Sunday’s New York Times Magazine: An Arab traveler comes across a sparrow in the desert, laying on his back, with his claws outstretched to the sky. The traveler asks what the bird is doing, and the bird replies that he has heard the sky is about to fall and he wants to be ready to hold it up. “You foolish creature,” says the Arab, laughing. To which the bird replies, with resignation, “one does what one can.” And so I continue to do what I can, to work toward building a better financial world in which institutional money managers honor their fiduciary duty to the clients they serve, focusing on investment rather than speculation, on prudence and due diligence, and at last honor both their rights and responsibilities for good corporate governance; a brave new world in which fund investors get a fair shake. Our financial sky, truth told, is not in very good shape, and I’m doing my best to hold it up. If you tell me it’s going to fall anyway, well, I’ll just try a little harder.

This area continues to provide the perfect environment for growth—excellent colleges and universities, world-class health care facilities, and remarkable cultural institutions (including our National Constitution Center). Keeping our roots firmly planted in the Philadelphia region was—and still is—the perfect choice for Vanguard and many other financial organizations and this region remains a major factor in the financial firmament. Back in the 1950s and 60s, investment management was focused on long-term time horizons and minimizing the impact of high taxes—capital gains taxes were an especially important consideration for the trust companies. The professional culture was based largely on prudence and fiduciary duty.Robert

” We also came to ignore the critical distinction between fiduciary law itself and a fiduciary relationship subject to contract law. What’s more, she writes, “the movement from professions to businesses was accompanied by changes in the way the law was interpreted.” We forgot the fundamental principle expressed by Matthew and Luke, and repeated by Justice Stone: “No man can serve two masters.” My principal objection to moral relativism is that it obfuscates and mitigates the obligations that we owe to society, and shifts the focus to the benefits accruing to the individual. Self-interest, unchecked, is a powerful force, but a force that, if it is to protect the interests of the community of all of our citizens, must ultimately be checked by society. The recent crisis—which has been called “a crisis of ethic proportions”—makes it clear how serious that damage can become.

RIAs have always been subject to the fiduciary duty test, but applying the test to stock brokers who serve retirement plan clients raises, at least theoretically, some challenging questions for a broker: 1) Do I serve my clients who have retirement plans differently from my other investor/clients without retirement plans? How? Why? 2) When client/investors hold both, do I handle their retirement plans any differently from their regular accounts, and hold myself to a lesser standard. How? Why? As a practical matter, I can’t imagine brokers serving their non-retirement plan clients with a lower standard of duty and care than their retirement plan clients. How could they possibly defend such actions? So, I would expect the brokerage system to move quickly to the all-encompassing application of the fiduciary standard to all of their clients. But the issue would be far better resolved if the SEC took parallel action to the DOL’s, and promptly established a fiduciary standard for all intermediaries in serving all of their clients. But, believe me, the creation of a tough federal standard of fiduciary duty will not end there. It is not only financial advisers and brokers handling client accounts who must subordinate their own financial interests to those of the investors that they serve. That fiduciary standard must be applied to every person and every entity that touches Other People’s Money (OPM), applied to every dollar entrusted by investors to our nation’s financial system.

accounted for properly—is legal.) And so the management consultant’s bromide—“If you can measure it, you can manage it”—became the mantra of the chief executive, if not with the knowledge of the directors, at least with their tacit blessing. In short, the managers of our public corporations came to place their own interests ahead of the interests of their owners, exploiting the powers of their agency, yet unchecked by traditional gatekeepers such as directors, accountants, and regulators, and even the owners themselves. For true owners now play but a small and gradually vanishing role in our investment world. Our now-dominant money manager agents blithely accepted the new environment in which management self-interest held sway. Indeed, they fostered it by accepting as holy writ whatever earnings our corporations reported, and by generally ignoring corporate governance issues such as proxy access, executive compensation, board composition, and even mergers and acquisitions and dividend policy. Adam Smith presciently described the characteristics of today’s corporate and institutional managers (many of which are themselves controlled by giant financial conglomerates) with these words: Managers of other people’s money [rarely] watch over it with the same anxious vigilance with which . . . they watch over their own . . . they very easily give themselves a dispensation. Negligence and profusion must always prevail.2 So what’s to be done?

6. Marketing Strategy ∑ Mutual— Demand pull. Minimal effort; low expense commitment. ∑ Manager— Supply push. Spend aggressively to gather assets. 7. Time Horizon Strategy ∑ Mutual—Long-term, value oriented; increase intrinsic values for fund shareholders; free from Wall Street pressures. ∑ Manager—Short-term and focused on price of the manager’s stock; subject to the whims of Wall Street. How Has It All Worked Out? The mutual structure—an experiment in mutual fund governance that has now had those strategies in place for more than 38 years—has yet to be emulated or copied. Vanguard’s structure remains unique in the annals of mutual fund history. How has it all worked out? The numbers tell the story. While I have no intention to “plug” the Vanguard line-up of mutual funds before this audience, I do believe you have a right to know whether our journey, so far, has been a productive one. So, let’s look at three facts: (1) Since our humble beginning with $1.4 billion of assets, today’s assets under management is now approaching $2 trillion—a compound annual growth rate of 21 percent. (Chart 5) As you can see, that growth has been almost a straight line, virtually uninterrupted.

Costs Matter! 10,000 100,000 1,000,000 1 10 20 30 40 50 60 Market Return: 7% Growth Rate Less 2% in Fees: 5% Growth Rate $579,000 $177,000 $ In year 1, costs consume 30% of return After 30 Years: Costs consume 50% of return By year 60, costs consume 69% of return As investors focus on the long term, and recognize the ever more powerful role of costs, there will be an awakening. “Knowledge is power.” Note now the role of costs in the allocation of market returns between investors and service providers. After year one, costs have consumed only 30 percent of the return; at year 10, it grows to 35 percent; after 25 years, to 46 percent; it crosses 50 percent in year 30, rises to 63 percent after 50 years and to 69 percent after 60 years. To borrow a phrase first coined by Justice Brandeis almost 100 years ago—there is simply no denying the Relentless Rules of Humble Arithmetic. How Is The Fund Industry Responding To The Cost Challenge? Yet, as I look around the competitive landscape, I see the apparent denial of this obvious tautology. While I have the greatest personal respect for BlackRock chief Lawrence Fink, his firm’s dominant position in exchange traded funds (ETFs) is threatened—caught on the horns of a nasty dilemma: On the one hand, he has a fiduciary duty to the shareholders of the BlackRock, Inc. to maximize assets under management, to maximize advisory fees, and to maximize profits.

I propose that we undertake the “Fiduciary Duty” solution: To create, out of our disappearing ownership society and our failed agency society, a new fiduciary society. Here, our money-manager agents would be required—by federal statute—to place the interests of their principals ahead of their own interests, a consistently enforced public policy that places a clear requirement of fiduciary duty on our financial institutions to serve exclusively the interests of the owner/principals whom they are duty-bound to serve. That duty would require the long overdue return of our institutional agents to traditional standards of professional stewardship; their effective and responsible participation in the governance of our publicly-owned corporations; pressing the managers of the business corporations whose shares are held in their portfolios to govern in the interest of their owners; and assuming an ethical responsibility to serve society at large. 2 In Smith’s era, profusion was defined as “lavish or wasteful expenditures, excess amount of money, squandering, waste, etc.”

A Broader Fiduciary Standard Ultimately, then, the fiduciary standard must also encompass the behavior of all institutional money managers responsible for investing Other People’s Money, so far a curious omission from consideration in the debate. (Financial institutions hold some 70% of all U.S. stocks.) It must also include officers, directors, trustees, employees, custodians, and even certain marketing officials of these institutions. Alas, in a curious omission from the Dodd-Frank Act, the SEC is asked to report to the Congress on the subject of fiduciary duty, but it is barred from considering institutional money managers in its study. (One wonders which industry lobbyist snuck that one in, through which member of Congress?) The role of politics and money managers in this debate suggests that the full extension of the fiduciary standard will be a long battle.

This remarkable increase in ownership has placed these managers—largely of mutual funds (holding 25 percent of all shares), pension funds (20 percent), hedge funds, and endowment funds—in a position to exercise great power and influence over corporate America. But they have failed to exercise their power. In fact, the agents of investment America have failed to honor the responsibilities that they owe to their principals—the last-line individuals who have much of their capital wealth committed to stock ownership, including mutual fund shareowners and pension beneficiaries. The record is clear that, despite their controlling position, most institutions have failed to play an active role in board structure and governance, director elections, executive compensation, stock options, proxy proposals, dividend policy, and so on. Given their forbearance as corporate citizens, these managers arguably played a major role in allowing the managers of our public corporations to exploit the advantages of their own agency, not only in executive compensation, perquisites, and mergers and acquisitions, but even in accepting the “financial engineering” that has come to permeate corporate financial statements, endorsed—at least tacitly—by their public accountants.

It is the values of these giants of Western Civilization that have inspired me—yes, as you well know, the dead teach the living*—to speak out on the ethical failings of so many of the leaders of our corporations and our money managers, our regulators and our legislators. What we refer to as Wall Street has become a casino, one in which enormous—but momentary—changes in short-term stock prices are treated as intrinsic reality, rather than ephemeral perception. Think about it. All of today’s frenetic trading simply pits one speculator against another, with the only winners being the croupiers—the traders, the brokers, the investment bankers, and the money managers who facilitate those trades. If that undeniable reality reminds you of gambling in Las Vegas, or going to the race track, or hoping to hit the jackpot in the state lottery, well, you see where I’m coming from. The stock market casino has become a giant—and costly—distraction to the serious business of investing. Greed, recklessness, and self-interest ride in the saddle of today’s capitalism, and it is high time we undertake the necessary reform, with federal laws that demand the return of fiduciary duty and stewardship to their traditional role in the trusteeship of other people’s money. That is my dream. But in this case, I confess, I’ve failed Kipling, for that dream may indeed have become my master. (I don’t apologize for that!)

Such a fiduciary society would guarantee that those last-line owners—largely the mutual fund shareholders and pension fund beneficiaries who have committed this capital to equity ownership and whose savings are at stake—their rights as investment principals. These rights must include: (1) The right to have their money-manager/agents act solely in their behalf. The client, in short, must be king. (2) The right to rely on high professional standards and due diligence on the part of our money managers and securities analysts who appraise securities for our portfolios.3 (3) The right to demand some sort of discipline and integrity in the mutual funds and financial products that they offer. (4) The assurance that our agents will act as responsible corporate citizens, restoring to their principals the neglected rights of stock ownership, and demanding that corporate directors and managers meet the fiduciary duty that they owe to their own shareholders. (5) The establishment of advisory fee structures that meet a “reasonableness” standard based not only on rates but dollar amounts, and, importantly, their relationship to the fees and fee structures available to other clients of the manager. (6) The elimination of all conflicts of interest that could preclude the achievement of these goals. Of course it will take federal government action to foster the creation of this new fiduciary society that I envision.

If saying that I’ve been fighting this battle since I wrote that thesis in 1951 is a push (and it is!), it is clear that I’ve been at it since at least 1971 (note that earlier speech) and surely since 1974, with the formation of Vanguard as the first mutual, shareholder-owned firm, driven ahead largely by our 1975 creation of the first and ultimate fiduciary-oriented, consumer-oriented mutual fund: the index mutual fund. Our First Index Investment Trust was designed to track the S&P 500 Index. The beginning of an indexing strategy that was the logical, even obvious, result of our mutual structure. Indeed, it was our first strategic move. That index fund began with an IPO in 1976 that was, to be blunt, a flop, raising only $11 million—far less than the underwriters’ goal of $150 million. But, now known as Vanguard 500 Index Fund, its assets exceed $450 billion. With its sister index funds at Vanguard, indexing strategies now account for some $2.4 trillion of the firm’s $3.2 trillion asset base. Most of my books touch on (pound on?) the same theme: “Put the investor first.” Bogle on Mutual Funds (1993), Common Sense on Mutual Funds (1999/2009), and The Battle for the Soul of Capitalism (2005) all emphasize this message of fiduciary duty.

But the failures of our institutional investors go beyond governance issues to the very practice of their trade. These agents have also failed to provide the “due diligence” that our citizen/investors have every reason to expect of the investment professionals to whom they have entrusted their money. How could so many highly-skilled, highly-paid securities analysts and researchers have failed to question the toxic-filled leveraged balance sheets of Citicorp and other leading banks and investment banks and, lest we forget, AIG?* The ethics-skirting sales tactics of CountryWide Financial? Even earlier, what were these professionals thinking when they ignored the shenanigans of “special purpose entities” at Enron and “cooking the books” at WorldCom? Again, going back to the stock market high reached in 2007, how many analysts questioned the typical corporate assumption that their pension plans would earn future returns of 8½ percent per year, now obviously a deeply flawed assumption that is sowing the seeds of another crisis in the financing of our private and public retirement systems. The Role of Institutional Managers But the failure of our newly-empowered agents to exercise their responsibilities to ownership is but a part of the problem we face. The field of institutional investment management—the field in which I’ve now plied my trade for almost 58 years—also played a major, if often overlooked, role.

On the other hand, he also has a fiduciary duty to the clients of BlackRock’s mutual funds and ETFs to maximize their returns. But since BlackRock’s mutual fund business is dominated by index funds, he can enhance their performance in only one way: by reducing fees.

Above all else, it must be unmistakable that government intends, and is capable of enforcing, standards of trusteeship and fiduciary duty under which money managers operate with the sole and exclusive purpose of serving the interests of their beneficiaries. In short, allowing “no man to serve two masters.” Together, these changes will compel—and perhaps even inspire—the principals of our corporations and our money managers to improve their own ethical principles. (One more play on that important distinction!) But we also need to raise our society’s expectations that our leaders meet high standards of ethical conduct. So, in addition to Adam Smith’s almost universally- 3 Peter Fisher, widely-respected BlackRock executive and former Treasury Department official, believes we should force institutional investors to do a better job of investment research, and develop and enforce higher minimum standards of competence for security analysts.

As a group, we veered off-course almost 180 degrees from stewardship to salesmanship, in which our focus turned away from prudent management and toward product marketing. We moved from a focus on long-term investment to a focus on short- term speculation. The driving dream of our advisor/agents was to gather ever-increasing assets under management, the better to build their advisory fees and profits, even as these policies came at the direct expense of the investor/principals whom, under traditional standards of trusteeship and fiduciary duty, they were duty-bound to serve. Conflicts of interest are pervasive throughout the field of money management, albeit different in each sector. Private pension plans face one set of conflicts (i.e., minimizing plan contributions helps maximize a corporation’s earnings). Public pension plans another (i.e., political pressure to invest in pet projects of legislators). And labor union plans yet another (i.e., * I’m speaking here of the “buy-side” analysts employed directly by these managers. The conflicts of interest facing “sell-side” analysts were exposed by the investigations of New York Attorney General Spitzer in 2002-2003.

When we individually compete to beat our fellow market participants, we lose. But when we abandon our inevitably futile attempts to obtain an edge over other market participants and all simply hold our share of the market portfolio, we win. Corporate Citizenship In addition to its excessive costs, the speculation that permeates today’s financial system has another unfortunate consequence. Investors must care about corporate governance. Speculators do not care, and arguably—much as I hate to say it—should not care. So when our money management agents fail to exercise the rights and responsibilities of corporate ownership, in particular, by assuring that the governance of the corporations in our portfolios is focused on serving the interests of the shareholders of those corporations rather than the interests of their management. The massive substitution of agency ownership of stocks for personal ownership, then, is one of the major challenges of twenty-first-century capitalism, and it is high time for our agents to represent their principals.

The Clash of the Cultures (2012) even has the temerity to set forth 15 objective standards by which investors can measure the extent to which their mutual funds are being operated by managers who are meeting the fiduciary standards, “The Stewardship Quotient.” The SQ, for example considers management fees and expense ratios, portfolio turnover, sales loads, longevity of portfolio managers, fund share ownership by insiders, board composition, and so on. The SQ sets a high standard, one which too many fund groups fail to meet. Adam Smith to the Fore Now think about this: it may not matter when and even if my expansive goals for the fiduciary standard are achieved. For we live in an Age of Consumerism in which consumers are empowered to demand that businesses serve their needs, and businesses that fail to satisfy those demands face a dim future. This represents the most powerful single economic force in all human history. With today’s rapidly expending availability of information, technology has radically reordered the consumer markets, and continues to do so. In finance, this new age will bring much improved disclosure, more transparency, investor education that separates fact from fiction, and raises “red flags” on key issues such as returns, risks, costs, and management quality. Today’s Age of Consumerism shows no sign of abating; more likely, it will accelerate.

simply put, was the growth of giant business corporations—corporate America—controlled not by their own shareholders, but by the money manager agents of the ultimate owners—investment America. Two major trends set the stage for this baneful change: First, the old ownership society shrank radically in size and importance. Only a half-century ago, 92 percent of all shares of our corporations were held by direct stockholders. Today individual investors own barely 30 percent of all shares. Ownership of U.S. stocks by institutions, on the other hand, has soared more than seven times over—from 8 percent of shares all those years ago to more than 70 percent today. But in our new agency society, with financial intermediaries as a group now holding clear voting control of corporate America, our agents have failed to behave as owners. Indeed, in far too many cases, they have placed their own interests ahead of the interest of their principals—largely the 100 million families who are the owners of our mutual funds and the beneficiaries of our pension plans—a direct violation of the traditional concept of fiduciary duty. Fiduciary duty, of course imposes a high standard of morality upon those entrusted with managing the property of others. It’s not that we have not been warned about the consequences of our failure to honor the fiduciary principle that “no man can serve two masters.

Isn’t it high time we stand on their shoulders and shape national policy away from the moral relativism of peer conduct and greed and short-term speculation—gambling on expectations about stock prices? Isn’t it high time to return to the moral absolutism of fiduciary duty, to return to our traditional ethic of long-term investment focused on building the intrinsic value of our corporations—prudence, due diligence, and active participation in corporate governance? So, yes, now is time for reform. Today’s agency society has ill-served the public interest. The failure of our money manager agents represents not only a failure of modern-day capitalism, but a failure of modern-day capitalists. As Lord Keynes warned us, “when enterprise becomes a mere bubble on a whirlpool of speculation, the job of capitalism will be ill-done.” That is where we are today, and the consequences have not been pretty. In all, our now-dominant money management sector has turned its focus away from the enduring nature of the intrinsic value of the goods and services created, produced, and distributed by our corporate businesses, and toward the ephemeral price of the corporation’s stock—the triumph of perception over reality.of

We could hardly expect even a man with the wisdom, intelligence, logic and clear vision of Adam Smith to have anticipated in detail the various streams—really rivers—of commerce of today’s business and technological environment. But his overarching vision was surely a harbinger of this Age of the Consumer. As Adam Smith wrote in 1776: Consumption is the sole end and purpose of all production; and the interest of the producer ought to be attended to, only so far as it may be necessary for promoting that of the consumer. The maxim is so perfectly self-evident, that it would be absurd to attempt to prove it . . . [T]he interest of the consumer . . . [must be] the ultimate end and object of all industry and commence. Applying Smith’s insight to the investment industry, I firmly believe Smith would endorse not only the power of the consumer, but it’s implications for the principle of fiduciary duty. Paraphrasing that final sentence: The interest of the investor must be the ultimate end and object of the entire financial system. Whatever fabric the pattern of these threads of history ultimately weaves, many of you in this audience today can take pride in being, dare I say, in the vanguard of this movement. Today begins “The Campaign for Investors” of the Institute for the Fiduciary Standard. It will lead to greater financial freedom for America’s citizen/investors, and will serve, in the words of the Investment Company Act of 1940, “the national public interest” as well.

When long-term owners of stocks become short-term renters of stocks, and when the momentary precision of the price of the stock takes precedence over the eternal vagueness of the intrinsic value of the corporation, concern about corporate governance is the first casualty. The single most important job of the corporate director is to assure that management is creating value for shareholders; yet investors seemed not to care. If the owners of corporate America don’t give a damn about corporate governance, I ask you, who on earth should? And so in corporate America we have the staggering increases in executive compensation, unjustified by corporate performance and grotesquely disproportionate to the pathetically small increase in real (inflation-adjusted) compensation of the average worker; financial engineering that dishonors the idea of financial statement integrity, and the failure of the traditional gatekeepers we rely on to oversee corporate management—our auditors, our regulators, our legislators, our directors. In investment America, control has devolved to a new class of institutional owners. The 25 largest institutional investors alone hold nearly 40 percent of all stocks, yet all we hear from these agent-owners on corporate malfeasance is the sound of silence.

Review, written in 1934 in the aftermath of the Great Depression. See if you don’t agree that it was eerily prescient in describing a major force in creating the economic problems we are facing today. . . . When the history of the financial era which has just drawn to a close comes to be written, most of its mistakes and its major faults will be ascribed to the failure to observe the fiduciary principle, the precept as old as holy writ, that ‘a man cannot serve two masters,’ . . . The separation of ownership from management, the development of the corporate structure so as to vest in small groups control over the resources of great numbers of small and uninformed investors, make imperative a fresh and active devotion to that principle . . . Yet those who serve nominally as trustees, but relieved, by clever legal devices, from the obligation to protect those whose interests they purport to represent, corporate officers and directors who award to themselves huge bonuses from corporate funds without the assent or even the knowledge of their stockholders . . . financial institutions which, in the infinite variety of their operations, consider only last, if at all, the interests of those whose funds they command, suggest how far we have ignored the necessary implications of that principle. The loss and suffering inflicted on individuals, the harm done to a social order founded upon business and dependent upon its integrity, are incalculable.

pressure to employ money managers who are willing to “pay to play”). But it is in the mutual fund industry where the conflict between fiduciary duty to fund shareholder/clients often directly conflicts with the business interests of the fund manager. Perhaps we shouldn’t be surprised that our money managers act first in their own behalf. Indeed, as Vice Chancellor Leo E. Strine, Jr., of the Delaware Court of Chancery has observed, “It would be passing strange if . . . professional money managers would, as a class, be less likely to exploit their agency than the managers of the corporations that make products and deliver services.” In the fund industry—by far the largest of all financial intermediaries—that failure to serve the interests of fund shareholders has wide ramifications. Ironically, the failure has occurred despite the clear language of the Investment Company Act of 1940 that demands that, “mutual funds should be managed and operated in the best interests of their shareholders, rather than in the interests of (their) advisers.”** Here, in summary form, are just a few examples of how far so many fund managers have departed from that basic fiduciary principle, clearly enunciated in the 1940 Act: 1. The domination of fund boards by chairmen and chief executives who also serve as senior executives of the management company that controls the funds. 2.

Justice Stone’s words, excerpted from his 1934 essay in The Harvard Law Review, are equally relevant—perhaps even more relevant—at this moment in history. Indeed, they sound like they were written, well, yesterday. They could hardly present a more appropriate analysis of the causes of the present-day collapse of our financial markets and the resultant economic crisis now facing our nation and our world. In short, the managers of our public corporations came to place their own interests ahead of the interests of their owners, exploiting the powers of their agency, yet unchecked by traditional gatekeepers such as directors, accountants, and regulators, and even the owners themselves. For true owners now play but a small and gradually vanishing role in our investment world. Our now-dominant money-manager agents blithely accepted the new environment in which management self-interest held sway. Indeed, they fostered it by accepting as holy writ whatever earnings our corporations reported, and by generally ignoring corporate governance issues such as proxy access, executive compensation, board composition, and even mergers and acquisitions and dividend policy. Indeed, these agents turn over their portfolios with such alacrity that is fair to say that the old own-a-stock industry is now a rent-a-stock industry.

(4) In our parochial interest in winning the investment game by betting against other market participants, we have defied the mathematical certainty that the higher the costs of investing, the lower the returns that, as a group, investors earn. (5) Together, these trends have led to an abandonment of investor concerns about corporate governance, and the inadequacy of investment research and security analysis. While these issues may be different from those of the past, the principles are age-old. Consider this warning from Adam Smith way back in the 18th century: Managers of other people’s money [rarely] watch over it with the same anxious vigilance with which . . . they watch over their own . . . they very easily give themselves a dispensation. Negligence and profusion must always prevail. And so in the recent era, negligence and profusion have prevailed among our money manager/agents, even to the point of an almost complete disregard of their duty and responsibility to their principals. Too few managers seem to display the “anxious vigilance” over other people’s money that once defined the conduct of investment professionals.

I know something about how the financial system works, for I’ve been part of it for my entire 58-year career. The mutual fund industry is the paradigm of what’s gone wrong with capitalism. Here are just a few examples of how far so many fund managers have departed from the basic fiduciary principle that “no man can serve two masters,” despite the fact that the 1940 Act demands that the principal master must be the mutual fund shareholder: 1. The domination of fund boards by chairmen and chief executives who also serve as senior executives of the management companies that control the funds, an obvious conflict of interest and an abrogation of the fiduciary standard. 2.financial

charged an average fee rate averaging 0.08 percent to their pension clients and 0.61 percent to their funds, resulting in annual fees averaging $600,000 for the pension funds and $56 million for the mutual funds (presumably while holding the same stocks in both portfolios). 7. Spending enormous amounts on advertising—almost a half-billion dollars in the last two years alone—to bring in new fund investors, using money obtained from existing fund shareholders. 8. Creating exotic and untested “products” that have far more ephemeral marketing appeal than investment integrity. Given such failures as these, doesn’t Justice Stone’s warning that I cited at the outset seem even more prescient? Let me repeat the key phrases: The separation of ownership from management . . . corporate structures that. . . vest in small groups control over the resources of great numbers of small and uninformed investors . . . corporate officers and directors who award to themselves huge bonuses . . . financial institutions which consider only last, if at all, the interests of those whose funds they command. Just as we ignored the fiduciary principle all those years ago, so we have clearly continued to ignore it in the recent era. The result in both cases, using Justice Stone’s words: the loss and suffering inflicted on individuals, the harm done to a social order founded upon business and dependent upon its integrity, are incalculable.

You will not be surprised to learn that Adam Smith presciently described the characteristics of today’s corporate and institutional managers (many of which are themselves controlled by giant financial conglomerates) with these words: Managers of other people’s money [rarely] watch over it with the same anxious vigilance with which . . . they watch over their own . . . they very easily give themselves a dispensation. Negligence and profusion must always prevail.4 Like Justice Stone’s warning about the consequences that follow when business operates in its own self-interest, Smith’s ancient warnings about the consequences of money-manager capitalism—agency capitalism—could hardly have been more accurate. So what’s to be done? I propose that we undertake the “Fiduciary Duty” solution: To create, out of our disappearing ownership society and our failed agency society, a new fiduciary society. Here, our money-manager agents would be required—by federal statute—to place the 4 In Smith’s era, profusion was defined as “lavish or wasteful expenditures, excess amount of money, squandering, waste, etc.”

Building a Fiduciary Society So what we must do is develop a new fiduciary society which guarantees that our last- line owners—those mutual fund shareholders and pension fund beneficiaries whose savings are at stake—their rights as investment principals. These rights must include: (1) The right to have their money-manager agents act solely in their behalf. The client, in short, must be king. (2) The right to rely on due diligence by managers, in the services, the mutual funds, and the financial products that they offer. (3) The guarantee that our agents will be responsible corporate citizens, restoring to their principals the neglected rights of ownership of stocks. (4) The elimination of all conflicts of interest that could preclude the achievement of these goals. Of course it will take federal government action to foster the creation of this new fiduciary society that I envision. Above all else, it must be unmistakable that government intends, and is capable of enforcing, standards of trusteeship and fiduciary duty under which money managers operate with the sole purpose and in the exclusive benefit of the interests of their beneficiaries— largely the owners of mutual fund shares and the beneficiaries of our pension plans. While the government action is essential, however, the new system should be developed in concert with the private investment sector, an Alexander Hamilton-like sharing of the responsibilities.

benefits to fund managers and brokers, and commensurately great costs to fund investors. 3. Failure to exercise adequate due diligence in the research and analysis of the securities selected for fund portfolios, enabling corporate managers to engage in various forms of earnings management and speculative behavior, largely unchecked by the professional investment community. 4. Failure to exercise the rights and assume the responsibilities of corporate ownership, generally ignoring issues of corporate governance and allowing corporate managers to place their own financial interests ahead of the interests of their shareowners. 5. Soaring fund expenses. As fund assets soared during the 1980s and 1990s, fund fees grew even faster, reflecting higher fee rates, as well as the failure of managers to adequately share the enormous economies of scale in managing money with fund shareholders. Example: the average expense ratio of the ten largest funds of 1960 rose from 0.51 percent to 0.96 percent in 2008, an increase of 88 percent. (Wellington Fund was the only fund whose expense ratio declined. Excluding Wellington, the increase was 104 percent.) 6. Charging fees to the mutual funds that managers control that are far higher than the fees charged in the competitive field of pension fund management. Three of the largest advisers, for example, charge an average fee rate of 0.08 percent of assets to their pension clients and 0.

So while trading back and forth with one another—foolish as it is—is by definition a zero-sum game, once the costs of our Wall Street croupiers are deducted it is a loser’s game. (Think Las Vegas, think the Atlantic City Race Track. Heck, think Governor Rendell’s lottery.) So for investors as a group—who inevitably feed at the bottom of the food chain of investing receiving whatever market returns remain after the croupiers costs—trading is a loser’s game, by the amount of these costs. That $600 billion in 2007 plus many hundreds of billions in earlier years, obviously represent a truly staggering hit to the gains investors earned in the bull market, and a financial slap in their face in the bear market that followed. Any confidence in Wall Street that our investors once may have had has largely vanished, just as it should have. The speculators among us, and those of us who have forgotten the distinction between investment and speculation—two groups that inevitably display a large amount of greed—must share a portion of the responsibility for the financial bubble and the ensuing crash. When an own-a-stock industry becomes a rent-a-stock industry, concern about corporate governance is the first casualty—a harbinger that our capitalistic system is not working properly.

Today, as you know, much of that harm can be calculated all too easily, amounting to several trillions of dollars. So, this time ‘round, let’s pay attention, and demand a return to fiduciary principles. A Piece of History While the overwhelming majority of financial institutions operate primarily in the interests of their agents and at the expense of their principals, not quite all do. So I now draw on my personal experiences in the mutual fund industry to give you one example of my own encounter with this issue. As far back as 38 years ago, I expressed profound concern about the nature and structure of the fund industry. Only three years later, my convictions led to action, and 35 years ago this September, I founded a firm designed, to the best of my ability, to honor the principles of fiduciary duty.

interests of their principals ahead of their own interests, a consistently enforced public policy that places a clear requirement of fiduciary duty on our financial institutions to serve exclusively the interests of the owner/principals whom they are duty-bound to serve. That duty would require the long overdue return of our institutional agents to traditional standards of professional stewardship: ∑ Focus on long-term investing rather than short-term speculation. ∑ Due diligence in security analysis and investment research. ∑ Effective and responsible participation in the governance of our publicly-owned corporations. ∑ Pressing the managers of the business corporations whose shares are held in their portfolios to govern in the interest of their owners. ∑ An ethical responsibility to serve society at large. ∑ Elimination of all conflicts of interest that inhibit the placing first and foremost the interest of the investor/principals. Adam Smith IV – Wealth, Greatness, Invention, and Ennoblement It is high time for our corporations and our money managers to return to the idea of stewardship and faithful service. We need to restore the integrity of our system of capital formation. We need to demand that our financial institutions focus on long-term investment rather than on short-term speculation. We need our corporations to be run to benefit their outside owners, not their inside managers to return to the way capitalism operated when it began all those years ago.

The task of returning capitalism to its ultimate owners will take time, true enough. But the new reality—increasingly visible with each passing day—is that the concept of fiduciary duty is no longer merely an ideal to be debated. It is a vital necessity to be practiced. What’s at stake here is the very role of capitalism in our society. Should it serve corporate managers and money managers? Or should it serve the citizens who invest their capital? Is speculation to ride in the saddle, or will investment call the tune? Some 70 years ago the eminent British economist John Maynard Keynes warned us: “When enterprise becomes a mere bubble on a whirlpool of speculation, the consequences may be dire . . . when the capital development of a country becomes a by- product of the activities of a casino . . . the job (of capitalism) will be ill-done.”

This process, I conclude, must begin with a return to the original values of capitalism, to that virtuous circle of integrity—“trusting and being trusted”. When ethical values go out the window and service to those whom we are duty-bound to serve is superseded by service to self, the whole idea of the capitalism that has been a moving force in the creation of our society’s abundance is soured. In the era that lies ahead, the trusted businessman, the prudent fiduciary, and the honest steward must again be the paradigms of our great American enterprises. I know it won’t be easy, but if we all work long enough and hard enough at the task, we can build, out of our long-gone ownership society and our failed agency society, a new “fiduciary society,” one in which the citizen-investors of America will at last receive the fair shake they have always deserved from our corporations, our investment system, and our mutual fund industry. Support from the Present and the Past That’s the substance of The Battle, so now for a little background. As I mentioned at the outset of my remarks this evening, many of the ideas in my book are consistent with the ideas of some of our best and brightest economic thinkers.investment

10. Creating exotic and untested “products” that have proved to have far more ephemeral marketing appeal than enduring investment integrity. Each one of these ten practices, it seems clear, represents a violation of the fiduciary principle. A Piece of History While the overwhelming majority of financial institutions are operated primarily in the interests of their manager/agents and at the expense of their principals, not quite all do so. I now present one exception to this rule, drawing again on my personal experiences in the mutual fund industry. As far back as 38 years ago, I expressed profound concern about the nature and structure of the fund industry. Only three years later, my convictions led to action, and 35 years ago this September, I founded a firm designed, to the best of my ability, to honor the fiduciary principle. I expressed this principle when doing so was distinctly counter to my own self-interest. Speaking to my partners at Wellington Management Company in September 1971—1971!—I cited the very same words of Justice Stone which I cited earlier in these remarks. I then added: I endorse that view, and at the same time reveal an ancient prejudice of mine: All things considered . . . it is undesirable for professional enterprises to have public stockholders. This constraint is as applicable to money managers as it is to doctors, or lawyers, or accountants, or architects.

Once a profession in which business was subservient, the field of money management has largely become a business in which the profession is subservient. That job is indeed being ill-done today. Business enterprise has taken a back seat to financial speculation. The multiple failings of our flawed financial sector are jeopardizing, not only the financial security of our nation’s savers but the economy in which our entire society participates. Fiduciary Duty Let me take a moment to be clear and explore what we mean by fiduciary duty, a concept that goes back some eight centuries in British common law. Fiduciary duty is essentially a legal relationship of confidence or trust between two or more parties, most commonly a fiduciary or trustee and a principal or beneficiary, who justifiably reposes confidence, good faith, and reliance in his trustee. The fiduciary acts at all times for the sole benefit and interests of another, with loyalty to those interests. A fiduciary must not put personal interests before that duty, and must not be in a situation where his fiduciary duty to clients conflicts with a fiduciary duty to any other entity. Whether we like it or not, fiduciary duty is, in a sense, creeping up on us. ERISA requires companies that sponsor defined contribution plans to be subject to the standard of fiduciary duty—even as it exempts (oddly enough!) some plan service providers, usually mutual fund management companies, from such a standard.

most noble of faith-based institutions—will long exist. But as so many of our nation’s proudest professions—of which accounting, journalism, and medicine are hardly the only examples— gradually shift their traditional balance away from that of trusted profession serving the interests of the community and toward that of commercial enterprises seeking competitive advantage, the human beings who rely on those services are the losers. Crime and Punishment I reserve some of my harshest criticism for the financial world, including the mutual fund sector in which I’ve spent my entire career. The traditional notion of the trustee was as a financial or legal professional whose overriding duty as a fiduciary was to serve the interests of those whose assets were entrusted to his care. Yet, with the dominance of the agency world of institutional money management that I described earlier, the trustees of “Other People’s Money” (OPM) seem to have turned away from stewardship in favor of building assets under management, increasing fee revenues, carefully controlling costs (even investment management costs), marketing, and taking advantage of any short-cuts available to achieve these goals, carefully avoiding breaking the letter of the law but hardly its spirit. My 2008 book Enough.

focus on long term investing in business, not short term speculation in stocks. (My next book, to be published in February 2007, drives this message home: The Little Book of Index Investing— The Only Way to Guarantee Your Fair Share of Stock Market Returns.) The second path is what I call the “Societal Solution:” to create, out of our disappearing ownership society and our failed agency society, a new fiduciary society. Here, our agent/owners would be required by federal law to place the interest of their principals first—a consistently enforced public policy that places a clear requirement of fiduciary duty on our financial institutions to serve exclusively the interests of their beneficiaries, that duty would expressly require their effective and responsible participation in the governance of our publicly-owned corporations, and demand the return of our institutional agents to traditional standards of professional stewardship that is long overdue. The Impartial Spectator Together, these changes will compel—and perhaps even inspire—the principals of our corporations and our money managers to improve their own ethical principles. But we also need to raise our society’s expectations of the proper conduct of our leaders. So, in addition to Adam Smith’s almost universally-known Invisible Hand from The Wealth of Nations, we need to call on his almost universally-unknown Impartial Spectator, from Smith’s earlier Theory of Moral Sentiments.

And early in 2008, one fund manager (Federated Investors) called for “A New Paradigm for Federal Regulation of Financial Intermediaries,” suggesting that “all financial intermediaries that provide advice to individual customers should be fiduciaries.” A few weeks ago, Federated received what seemed to me surprising support from Paul Stevens, President of the Investment Company Institute, the principal lobbyist for fund management companies. The fiduciary standard, Stevens suggested, requires advisers to put their clients’ interests first, and “does provide a standard of responsibility and accountability.” He then asked the rhetorical question, “Isn’t that something that all of our recent experience suggests is important?” My answer: “Unequivocally yes.”

My candor may well have played a supporting role in my dismissal as chief executive of Wellington Management Company in January 1974. While it’s a saga too complex to detail this evening, my firing gave me the chance of a lifetime—the opportunity to create a new fiduciary- focused structure for our funds. I proposed just such a structure to the directors of the Wellington funds.* Wellington Management Company, of course, vigorously opposed my efforts. Nonetheless, after months of study, the directors of the funds accepted my recommendation that we separate the activities of the funds themselves from their adviser and distributor, so that the funds could operate solely in the interests of our fund shareholders. Our new structure involved the creation of a new firm, The Vanguard Group of Investment * This lecture at Columbia University is essentially the third part of a trilogy that chronicles the development of the fund industry and of Vanguard itself. The first two parts of the trilogy were my speech at Boston University Law School on January 21, 2004 (“Re-Mutualizing the Mutual Fund Industry—The Alpha and the Omega”); and my speech at George Washington University on February 19, 2008 (“A New Order of Things: Bringing Mutuality to the ‘Mutual’ Fund”).

When they return—as they must—to their traditional focus on long-term investing, these institutional owners must fight for the access to the levers of control over the corporations they own that are both appropriate for their dominant ownership position and a reflection of their willingness to accept both the rights and responsibilities of corporate citizenship. And if these institutions do not soon return to traditional standards of prudent investment, we’ll have to institute a Federal stature of fiduciary duty, under which the interests of those whose capital is at stake comes first—a new ownership focus for our flawed agency-society. And this is one of the major reforms in the regulation we need in our emerging financial system. The task of returning capitalism to its owners will take time, true enough. But the new reality—increasingly visible with each passing day—is that proper corporate governance is not merely an ideal to be debated. It is a vital necessity to be practiced. The role of the owners, I underscore, is to do no more than ensure that the interests of directors and management are aligned with those of the shareholders in a substantive way. When there is a conflict of interest, it is the shareholders who should make the decision. It is in the national public interest and in the interest of investors that the owners—represented largely by investment America—come to realize that enlightened corporate governance is not merely a right of business ownership.

values of capitalism, the virtuous circle of integrity and trust and trustworthiness that is its obligation to our society. In the era that lies ahead, the prudent fiduciary, the trusted businessman, and the honest steward must once again be our paradigms. For the fact is that, in the long run, good ethics is good business, part of that virtuous circle that builds our society. Enough. True Measures of Money, Business, and Life I wrote my new—7th—book largely because I care deeply about the issues I’ve discussed today. The crisis in capitalism, the failure of our agency system, the need to restore our traditional values that have been so severely eroded, not only in our communities but in our financial system, in our businesses, and even in our own lives. The story of ENOUGH. begins with a sort-of-poem by Kurt Vonnegut entitled “Joe Heller,” that appeared in The New Yorker in April 2005. It was a tribute to the late author of Catch 22—one of the seminal books of the post-World-War-II era, and one of its most successful. I can summarize the short poem in just a few words: At a party given by a billionaire on Shelter Island, Kurt Vonnegut tells Heller that their host, a hedge fund manager, had made more money in a single day than Heller had earned from his wildly popular novel Catch - 22 over its whole history. Heller responds, “Yes, but I have something he will never have . . . enough.” Enough. I was stunned by the profound and simple elegance of that word. Think about it.

Yet both the Federated and the ICI comments seemed to gloss over the fact that there are two types of investment advisers, albeit similarly defined. In the 1940 Investment Company Act, the term “investment adviser” essentially means a management company that regularly furnishes advice to a mutual fund with respect to the selection and management of portfolio securities. In the Investment Advisers Act, the term “investment adviser” essentially means any firm that engages in the business of advising others and receives compensation for doing so, and excludes broker- dealers whose performance of such services is solely incidental to the conduct of his business as a broker-dealer. I totally support the efforts of FI360 to extend the standards of fiduciary duty that now apply to advisers registered under Investment Adviser Act to all financial advisers. While, the earliest financial planning group to operate under this standard is NAPFA, consisting of fee-only planning and advisory firms but that standard is now advocated by the Financial Planning Association (FPA), the Investment Adviser Association, the North American Securities Administration and the CFA Institute. But the fiduciary industry standard must be extended to other financial advisors, including broker-dealers who elect to act as advisors. Of course this idea generates considerable heat, but I am not sure why.

me the chance of a lifetime—the opportunity to create a new fiduciary-focused structure for our funds. I proposed just such a structure to the directors of the Wellington funds. Wellington Management Company, of course, vigorously opposed my efforts. Nonetheless, after months of study, the directors of the funds accepted my recommendation that we separate the activities of the funds themselves from their adviser and distributor, so that the funds could operate solely in the interests of our fund shareholders. Our new structure involved the creation of a new firm, incorporated on September 24, 1974, The Vanguard Group of Investment Companies, owned by the funds, employing their own officers and staff, and operated on an “at-cost” basis, would be unique in the field, a truly mutual mutual fund organization. While Vanguard began with a limited mandate—to provide only administrative services to the funds—I realized that, if we were to control our own destiny, we would also have to provide both investment advisory and marketing services to our funds. So, almost immediately after Vanguard’s operations commenced in May 1975, we began our move to gain substantial control over these two essential functions. By year’s end, we had created the world’s first index mutual fund, run by Vanguard.

Never mind that the reported earnings were too often a product of financial engineering that served the short- term interest of corporate managers and Wall Street security analysts alike. But when long-term owners of stocks become short-term renters of stocks, and when the momentary precision of the price of the stock takes precedence over the eternal vagueness of the intrinsic value of the corporation itself, concern about corporate governance is the first casualty. The single most important job of the corporate director is to assure that management is creating value for shareholders; yet when that goal became secondary, our new investors seemed not to care. While their 70 percent ownership position gives our institutional agents absolute voting control of corporate America, all we hear from these money managers is the sound of silence. Not only because they are more likely to be short-term speculators than long-term investors, but also because they are managing the pension and thrift plans of the corporations whose stocks they hold, and thus face a serious conflict of interest where controversial proxy issues are concerned.

While the buy-side analysts employed by our financial institutions have fewer profound conflicts, there is little evidence that they delve deeply into the failure or our corporate system. But finally, of course, it is the stock owners who must be the ultimate gatekeepers. The very futures of the corporations whose shares they own are at stake. The greatest mystery of all is how and why our powerful institutional investors with such dominant ownership of all corporate shares—holding absolute voting control over virtually all of our nation’s public corporations— have remained largely silent. The record is clear that these institutions stand on the sidelines on proxy issues related to the governance of our corporations. What are these agent/owners thinking? Have they forgotten their fiduciary responsibilities?taking

Surely it should be made clear to clients whether they are relying on (1) trained investment professionals, paid solely through fully-disclosed fees to oversee their investments; or (2) sales representatives who sell the products and services of the companies that they represent, whether life insurance, annuities, mutual funds, or anything else. Simply put, the first group is representing its clients; the second group is representing its employers. And each firm’s advertising and promotion should make this distinction clear. But I believe that a federal standard of fiduciary duty should also apply to mutual fund advisers. That is the best way—perhaps the only way—for this industry to honor the lofty goal expressed in the preamble to the Investment Company Act of 1940: “the national public interest and the interest of investors” require that mutual funds be “organized, operated, and managed . . . in the best interests of their shareholders, rather than in the interests of advisers, underwriters or others.of

This conflict is pervasive, for it is said that money managers have only two types of client they don’t want to offend: actual, and potential. And so in corporate America we have witnessed staggering increases in executive compensation not only unjustified by corporate performance, but also grotesquely disproportionate to the pathetically small increase in real (inflation-adjusted) compensation of the average worker; financial engineering that dishonors the idea of financial statement integrity; and the failure of the traditional gatekeepers we rely on to oversee corporate management—our regulators, our legislators, our auditors, our attorneys, our directors. It’s high time for our now- empowered institutional agents to fight for the rights of their investor principals, honoring their agency responsibilities of corporate ownership and exercising their rights in overseeing governance. Building A Fiduciary Society So, out of the ashes of our old ownership society and our failed agency society we must develop a new fiduciary society, one that guarantees that our last-line owners—those mutual fund shareholders and pension fund beneficiaries whose savings are at stake—have their rights as investment principals protected. These rights must include: 1. The right to have money manager/agents act solely on their principals’ behalf. The client, in short, must be king. 2.

precedence over the interests of their shareholders? Do they exercise their rights and responsibilities of ownership to demand corporate governance in the interest of the shareholders whom these institutional managers represent? Executive Compensation and Political Contributions The failure of our gatekeepers has lead to massive failures of corporate governance in cases such as Enron and WorldCom in 2001-02. (Don’t forget them!) But other important failures remain. Today, two of the most significant corporate governance transgressions relate to executive compensation and corporate political contributions. In the case of executive compensation, our stockowner/gatekeepers seem particularly reluctant to take on this issue. By failing to do so, they must assume at least partial responsibility for the ridiculously high salaries, bonuses, deferred compensation, stock options, and other compensation paid to corporate CEOs, numbers that have been driven to amounts beyond reason—aided and abetted by the executive compensation consultants. Yet how many of the highly paid CEOs of these large institutional investors have dared to cast the first stone? Yet one more agency conflict. Another major emerging issue on corporate affairs relates to political contributions. The Supreme Court’s decision in the 2011 Citizens United case opened the door to virtually unlimited political contributions by our corporations.

investors,” but they permitted, as we now know, a governance structure that would later fly directly in the face of the national public interest and the interest of investors. 2 It is only to state the obvious that a once-small mutual fund industry, managed by firms whose owners were the investment professionals who managed the money is now a giant industry in which the vast majority of firms—26 of the largest 30 firms are either publicly-owned (7 firms) or, more likely (19 firms), owned by financial conglomerates—face a conflict of interest, with a duty owed to two parties with opposing interests, a situation that would be precluded by a fiduciary duty standard. These owners are in business to maximize the returns on their capital, not to maximize the returns of the capital of their mutual fund investors. (Although they do their best to do so, but of course without even the remotest incentive to reduce their fees. Au contraire!) Most of the private firms of yore have vanished, although it is significant that those that yet remain rank among the very largest firms in the industry. Success in the fund field, then, is largely measured by gathering the largest possible base of assets under management, the surest route to maximizing advisory fees.

The right to rely on due diligence and high professional standards on the part of money managers and securities analysts who appraise securities for principals’ portfolios. 3. The assurance that agents will act as responsible corporate citizens, restoring to their principals the neglected rights of ownership of stocks, and demanding that corporate directors and managers meet their fiduciary duty to their own shareholders. 4. The right to demand some sort of discipline and integrity in the mutual funds and financial products that they offer. 5. The establishment of advisory fee structures that meet a “reasonableness” standard based not only on rates but dollar amounts, and their relationship to the fees and structures available to other clients of the manager. 6. The elimination of all conflicts of interest that could preclude the achievement of these goals.

This strategy has led to aggressive marketing, over-the-top advertising of the fund performance, creation of exotic new fund products—yes, capitalize on products—to meet the investment fads of the day, and quantitative approaches to investment management based on historical investment returns that are, truth told, virtually meaningless. So it is small wonder that the huge economies of scale in mutual fund management have benefited fund managers far more than fund shareholders. Small wonder that the industry’s focus has moved from management to marketing. Small wonder that in all the rush to salesmanship in the fund industry, stewardship seems to have been left in the dust. To return stewardship to the preeminent position it deserves in money management, establishing a federal fiduciary standard for all money managers is essential. Quoting ICI leader Stevens again, “isn’t that something that all of our recent experience suggests is important?” Again, of course it is important! 2 I recognize that in the 1960 amendments to the Investment Company Act, the fund adviser “is deemed to have a fiduciary duty with respect to the receipt of compensation.” But that provision has been largely eliminated by the courts. It now seems likely to receive further review in the U.S. Supreme Courts.

Hevesi has pleaded guilty and awaits sentencing; Mr. Morris is said to have agreed to a guilty plea to a single felony. Mr. Rattner has not yet settled with New York or Federal regulators, but it can’t help his case that his former advisory firm, Quadrangle, has described his actions as “inappropriate, wrong and unethical.” His punishment, if any, remains to be seen. I’ve chosen these three examples out of scores—even hundreds—of examples, reluctantly leaving out that pillar of probity, Bernard Madoff. While his long jail sentence for his crimes surely is fair punishment, the hedge fund managers whose clients paid them some $500 million for the privilege of having Mr. Madoff defraud them remain scot-free. But the fact is that a disturbingly high percentage of the violations of law and of traditional ethics have occurred in the financial field, where the financial rewards are simply too tempting to ignore. The traditional emphasis on professional standards and fiduciary behavior focused on preserving and enhancing the wealth of clients has given way to business standards aimed at acquiring and accumulating wealth for agents, ethical principles be dammed. III. Vanguard – Structure, Strategy, and Values There is a better way. So in this third and final section of my remarks this afternoon, let me turn to some reflections on Vanguard and the structure, strategies, and values that have brought us to the pinnacle of the mutual fund industry—the largest fund manager in the world.

To Build the Financial World Anew Vanguard represented my best effort to align the interests of fund investors and fund managers under established principles of fiduciary duty. I leave it to wiser—and surely more objective—heads than mine to evaluate whether or not I overstate or hyperbolize what we have accomplished, even as I freely acknowledge that we owe our accomplishments to the three simple principles: the firm is (1) structurally correct (since we are owned by our fund investors); (2) mathematically correct (since it is a tautology that the lower the costs incurred in investing, the higher the returns); and (3) ethically correct (since we exist only by earning far greater trust and loyalty from our shareholders than any of our peers. There’s simply no close rival for our #1 position.) Please be appropriately skeptical of that self-serving claim, but look at the data. In a 2007 survey, an independent research group concluded, “Vanguard Group generates far more loyalty than any other company.”* As you have just learned, restructuring the firm was no easy task. Without determination, expertise, luck, timing, and the key roles played by just a handful of individuals, it never could have happened. So when I suggest to this forum that we must now go beyond restructuring the nature and values of a single firm to restructuring the nature and values of the entire money management business, I am well aware of how difficult as task it will be to accomplish that sweeping task.

If you are willing to accept—based on that solid data—that Vanguard has achieved both commercial success (asset growth and market share) and artistic success (superior performance and low costs), you must wonder why, after nearly 35 years of existence, no other firm has elected to emulate our shareholder-oriented structure. (A particularly ironic outcome since I chose the name Vanguard in part because of its conventional definition as “leader in a new trend.”) The answer, I think, can be expressed succinctly: under our at-cost structure, all of the darned profits go not to the managers, but to the fund shareholders, resolving the transcendent conflict of interest that besets the mutual fund industry. In any event, the leader, as it were, has yet to find its first follower. To Build the Financial World Anew Vanguard represented my best effort to align the interests of fund investors and fund managers under established principles of fiduciary duty.

accountants and the managers of other corporations.” Why did it happen? “Because,” in Mr. Pfaff’s words, “the markets had so diffused corporate ownership that no responsible owner exists. This is morally unacceptable, but also a corruption of capitalism itself.” When most owners either don’t or won’t or can’t stand up for their rights, and when corporate directors lose sight of whom they represent, the resulting power vacuum quickly gets filled by corporate managers, living proof that Spinoza was right when he told us, “nature abhors a vacuum.” Little good is likely to result when the CEO becomes not only boss of the business but boss of the board, erasing the “bright line” that common sense tells us ought to exist between management and governance. Put more harshly, in a quote that I came across last spring, “when we have strong managers, weak directors, and passive owners, don’t be surprised when the looting begins.” There were two major forces behind this baneful change: First, the “ownership society”—in which the shares of our corporations were held almost entirely by direct stockholders—gradually lost its heft and its effectiveness. Since 1950, direct ownership of U.S. stocks by individual investors has plummeted from 92 percent to 30 percent, while indirect ownership by institutional investors has soared from 8 percent to 70 percent. Our old ownership society is now gone, and it is not going to return.

have set demanding standards for those of us who follow in their footsteps, lest history forget that even a handful of dedicated idealists can move the world forward. I’ve also offered some provocative ideas on improving corporate governance, a mission in which true professionals must lead the way in bringing about needed reform. Today, the CFA Institute has an enlightened mission—providing “the highest standards of ethics, education, and professional excellence for the ultimate benefit of society.” We’re reaching for those stars, but our reach inevitably will exceed our grasp. (That’s the way the world works.) But tonight, on the 70th Anniversary of the CFA Society of Philadelphia, I ask you for something more than ethics, and education, and excellence. As essential as those goals are, I ask each of you to develop a keener awareness of the “big picture” of our financial system; a profound introspection into how we can make it better, a sense of our long and proud history, and a deep involvement in giving our profession the high character it requires if it is to serve investors effectively and honestly in the years ahead. Yes, these are idealistic goals. But what would our profession be without a healthy dose of idealism? Indeed, a bright future for finance— in Philadelphia and across our nation— depends upon it.

Conclusion Let me close with this warning: “I venture to assert that when the history of the financial era which has just drawn to a close comes to be written, most of the mistakes and its major faults will be ascribed to the failure to observe the fiduciary principle, the precept as old as holy writ, that ‘a man cannot serve two masters’ . . . the development of the corporate structure so as to vest in small groups control over the resources of great numbers of small and uninformed investors, make imperative a fresh and active devotion to that principle if the modern world of business is to perform its proper function. Yet, those who serve nominally as trustees, but relieved, by clever legal devices, from the obligation to protect those who interests they purport to represent . . . [and] consider only last the interests of those whose funds they command, suggest how far we have ignored the necessary implications of that principle.” I wish that those were my words. But they are not. They are the words of Supreme Court Justice Harlan Fiske Stone, and they were written in 1934. “The more things change, the more they remain the same.

What we must do is develop a new fiduciary society which guarantees that our last-line owners—those mutual fund shareholders and pension fund beneficiaries whose savings are at stake—their rights as investment principals. These rights must include: (1) The right to have their money-manager/agents act solely in their behalf. The client, in short, must be king. (2) The right to rely on due diligence and high professional standards on the part of our money managers and securities analysts who appraise securities for our portfolios. (3) The assurance that our agents will act as responsible corporate citizens, restoring to their principals the neglected rights of ownership of stocks, and demanding that corporate directors and managers meet their fiduciary duty to their own shareholders. (4) The right to demand some sort of discipline and integrity in the mutual funds and financial “products” that we offer. (5) The establishment of advisory fee structures that meet a “reasonableness” standard based not only on rates but dollar amounts, and their relationship to the fees and structures available to other clients of the manager. (6) In all, measuring up to the 1940 Act standard that funds are in fact “organized, operated, and managed in the interest of their shareholders,” by eliminating of all conflicts of interest that could preclude the achievement of these goals.

As you may have suspected, I’ve once again cited a section of Justice Stone’s 1934 speech, and it’s high time we take it seriously. For the fact is that there has been a radical change in our investment system from the ownership society of a half-century ago—which is gone, never to return—to our agency society of today—in which our agents have failed to serve their principals—mutual fund shareholders, pension beneficiaries, and long-term investors. Rather the new system has served the agents themselves—our institutional managers. Further, by their forbearance on governance issues, our money managers have also served the managers of corporate America. To make matters even worse, by turning to short-term speculation at the expense of long-term investment, the industry has also damaged the interests of the greater society. Hear Lord Keynes on this point: When enterprise becomes a mere bubble on a whirlpool of speculation, the consequences may be dire . . . when the capital development of a country becomes a by- product of the activities of a casino . . . the job (of capitalism) will be ill-done. Yet despite these changes in the very nature of corporate ownership we have failed to change the rules if the game. Indeed, in the financial sector we have rolled back most of the historic rules regulating our securities issuers, our exchanges, and our investment advisers.

latter part of the twentieth century, the predominant focus of institutional investment strategy turned from the wisdom of long-term investing to the folly of short-term speculation. During the recent era, we entered the age of expectations investing, where projected growth in corporate earnings—especially earnings guidance and its subsequent achievement, by fair means or foul— became the watchword of investors. Never mind that the reported earnings were too often a product of financial engineering that served the short-term interest of corporate managers and Wall Street security analysts alike. But when long-term owners of stocks become short-term renters of stocks, and when the momentary precision of the price of the stock takes precedence over the eternal vagueness of the intrinsic value of the corporation itself, concern about corporate governance is the first casualty. The single most important job of the corporate director is to assure that management is creating value for shareholders; yet our new agent/investors seemed not to care when that goal became secondary. While these institutional agents now hold absolute voting control over corporate America, all we hear from these money managers is the sound of silence.

without understanding that the Greeks also insisted that such energy was to be monitored and restrained by a host of cultural protocols that have nearly disappeared: civic responsibility, philanthropy, a world view that is rather absolute, a brief that life is not nice, but tragic and ephemeral . . . an entire way of looking at the world, a way diametrically opposite to the new gods that now drive America: therapeutics, moral relativism, blind allegiance to progress and the glorification of material culture.” So you can see why Dr. E and I get along so well! We have reached common ground in loving the classics and in seeking the triumph of virtue and ethics—and even fiduciary duty!— over the vanishing values of the day. It is time to accept our responsibility to reverse the recent triumph of unfettered business conduct, and fight to restore the professional conduct that once permeated our society.

I should note that this final provision would seem to preclude the ownership of money management firms by financial conglomerates, now the dominant form of organization in the mutual fund industry. Among today’s 40 largest fund complexes, only six remain privately-held. The remaining 34 include 13 firms whose shares are held directly by the public, and an astonishing total of 21 fund managers owned or controlled by U.S. and international financial conglomerates—including Goldman Sachs, Bank of America, Deutsche Bank, ING, John Hancock, and Sun Life of Canada. Painful as such a separation might be, conglomerate ownership of money managers is the single most blatant violation of the principle that “no man can serve two masters.” Of course it will take federal government action to foster the creation of this new fiduciary society that I envision.their

As my newest book, The Clash of the Cultures, makes clear, I am dissatisfied, disappointed, and angry about how our financial system is working today. But I am pleased with how those remarkably simple ideas that I expressed at Princeton all those years ago have proven themselves. Index equity fund assets are rapidly approaching one-half of the assets of active equity mutual funds, and growing apace. In these days of low market yields and high mutual fund expenses, I expect that growth to accelerate. A journalist recently reported that I take “almost childlike delight” in seeing my idealistic dreams come true, as the low-cost mutual model of mutual fund structure and the dominance of index funds have come into their own, reflecting two vital ingredients of fiduciary duty that our clients expect of their investment advisers and of their mutual fund providers. (He was accurate, I think, except for the almost!) But I’ve long since realized that what passes for success in this funny world of ours is really a journey, not a destination. My long journey continues, and I thank you for being in the, well, vanguard of the coming new order of fiduciary duty in the investment advisor field and the field of mutual fund management.

created, their relationship to the lives of individuals in widely separated communities engaged in widely differing activities, and the adaptation to those forces of old conceptions developed in a different environment to meet different needs.* To deal with the new and complex economic forces our failed agency society has created, of course we need a new paradigm: a fiduciary society in which the interest of investors come first, and ethical behavior by our business and financial leaders represents the highest value. Building a Fiduciary Society While challenges of today are inevitably different from those of the past, the principles are age-old. Consider this warning from Adam Smith way back in the 18th century: Managers of other people’s money [rarely] watch over it with the same anxious vigilance with which . . . they watch over their own . . . they very easily give themselves a dispensation. Negligence and profusion must always prevail. And so in the recent era, negligence and profusion have prevailed among our money manager/agents, even to the point of an almost complete disregard of their duty and responsibility to their principals. Too few managers seem to display the “anxious vigilance” over other people’s money that once defined the conduct of investment professionals.

So what we must do is develop a new fiduciary society which guarantees that our last- line owners—those mutual fund shareholders and pension fund beneficiaries whose savings are at stake—their rights as investment principals. These rights must include: (1) The right to have their money-manager/agents act solely in their behalf. The client, in short, must be king. (2) The right to rely on due diligence and high professional standards on the part of our money managers and securities analysts who appraise securities for our portfolios. (3) The right to demand some sort of discipline and integrity in the mutual funds and financial products that they offer. * Again, words from Justice Stone’s article.

(4) The assurance that our agents will act as responsible corporate citizens, restoring to their principals the neglected rights of ownership of stocks, and demanding that corporate directors and managers meet their fiduciary duty to their own shareholders. (5) The establishment of advisory fee structures that meet a “reasonableness” standard based not only on rates but dollar amounts, and their relationship to the fees and structures available to other clients of the manager. (6) The elimination of all conflicts of interest that could preclude the achievement of these goals. More than parenthetically, I should note that this final provision would seem to preclude the ownership of money management firms by financial conglomerates, now the dominant form of organization in the mutual fund industry. Among today’s 40 largest fund complexes, only six remain privately-held. The remaining 34 include 13 firms whose shares are held directly by the public, and an astonishing total of 21 fund managers owned or controlled by U.S. and international financial conglomerates—including Goldman Sachs, Bank of America, Deutsche Bank, ING, John Hancock, and Sun Life of Canada. Painful as this separation might be, it is the single most blatant violation of the principle that “no man can serve two masters.” Of course it will take federal government action to foster the creation of this new fiduciary society that I envision.

government or for the market, but not for both. He saw entrepreneurial freedom, limited but energetic federal power, and national greatness as qualities that were inextricably linked. It was always the cause America represents—universal freedom—that was uppermost in Hamilton’s mind, spurring individual initiative, but also gathering the fruits of that energy in the cause of national greatness. Were Alexander Hamilton alive today, I simply cannot imagine that he would not agree with the notion that it’s high time to restore the integrity of our system of capitalism, and high time to rethink the nation’s investment process. In today’s wrongheaded version of capitalism, corporate managers are in charge of our business wealth, almost unchecked by traditional gatekeepers; and the investment community is too heavily focused on short-term stock prices and too lightly focused on long-term intrinsic corporate values to challenge their domain. I believe that a federal standard of fiduciary duty would play a major role in reversing that focus. Given the vicious circle in which corporations, in important degree, act as if they own themselves, our investment intermediaries have proven reluctant to use their latent power. Further, even for those intermediaries who have the motivation to exercise it, hopelessly archaic proxy rules serve to handcuff the exercise of that power.

to create, out of our disappearing ownership society and our failed agency society, a new “fiduciary society.” Here, our agent /owners would be required by federal law to place the interest of their principals first—a consistently enforced public policy that places a clear requirement of fiduciary duty on our financial institutions to serve exclusively the interests of their beneficiaries. That duty would expressly require their effective and responsible participation in the governance of our publicly-owned corporations, and demand the return of our institutional agents to the traditional values of professional stewardship tat are so long overdue.

If that is the dual course you choose to follow, however, dare I recommend that the lion’s share of your clients’ assets be committed to the former stay-the-course approach that has worked so well for me over, yes, now 57 years of investing in the mutual funds whose investors I’ve done my best to serve. But whatever course you choose to follow, I wish you every success. Less than a month from now, those who hold the CFP designation will be required to honor an explicit standard of fiduciary duty that I’ve talked about for more than a decade. I’m sure that the overwhelming majority of financial planners have observed such a standard throughout their careers, and I’m equally sure that such an approach has served your clients and your careers alike. If my thoughts today have increased your focus on investment rather than speculation; on setting your expectations for future stock and bond returns, not on history but on their known sources; and on demanding that the firms whose mutual funds you offer to your clients focus less on innovation and more on substance, then, I’ve achieved what I’ve attempted to achieve in these remarks. Thanks for your patience, and for your attention.

Above all else, it must be unmistakable that government intends, and is capable of enforcing, standards of trusteeship and fiduciary duty under which money managers operate with the sole purpose and in the exclusive benefit of the interests of their beneficiaries—largely the owners of mutual fund shares and the beneficiaries of our pension plans. While the government action is essential, however, the new system should be developed in concert with the private investment sector, an Alexander-Hamilton-like sharing of the responsibilities. The task of returning capitalism to its ultimate owners will take time, true enough. But the new reality—increasingly visible with each passing day—is that the concept of fiduciary duty is no longer merely an ideal to be debated. It is a vital necessity to be practiced. So a lot is at stake in reforming the very nature of our financial system itself, which in turn is designed to force reform in our failed system of governance of our business corporations.colleagues

And the prospects seem increasingly dim for opening even a tiny crack in the rigid regulatory doorway that precludes owners from their rights of ownership by denying them reasonable access to corporate proxy statements. With mutual fund managers firmly ensconced in the driver’s seat of the governance of the funds themselves, we are captives of a system in which both corporate directors and fund directors seem not only unwilling but unable to take on the role and responsibility of the gatekeeper as a steward, one who holds the interests of the shareholder as his highest priority. Summing Up So I await—with no great patience!—the return of the standard so beautifully described by Justice Cardozo all those years ago, excerpts from his words: Those bound by fiduciary ties . . . (are) held to something stricter than the morals of the marketplace . . . a tradition unbending and inveterate . . . not honesty alone but the punctilio of an honor the most sensitive . . . a level of conduct . . . higher than that trodden by the crowd.

and peers. But soon, perhaps, many others will ultimately see the light. Only last week the idea of governance reform got encouraging support from Professor Andrew W. Lo of M.I.T., one of today’s most respected financial economists: . . . the single most important implication of the financial crisis is about the current state of corporate governance . . . a major wake-up call that we need to change (the rules). There’s something fundamentally wrong with current corporate governance structures, (and) the kinds of risks that typical corporations face today. In sum, the change in the rules that I advocate—applying a federal standard of fiduciary duty to their clients for institutional money managers—would be designed in turn to force these managers to use their own ownership position to demand that the managers and directors of the corporations in whose shares they invest honor their own fiduciary duty to the holders of their shares. Finally, it is these two groups that share the responsibility for the prudent stewardship over corporate assets and investment securities alike that have been entrusted to their care, not only reforming today’s flawed and conflict-ridden model, but developing a new model that, at best, will restore traditional ethical mores. And so I await—with no great patience!—the return of the standard so beautifully described by Justice Cardozo all those years ago, excerpts from his words cited earlier in my remarks: Those bound by fiduciary ties . . .

The change in the rules of the game that I advocate—applying to institutional money managers a federal standard of fiduciary duty to their clients—would be designed in turn to force these managers to use their own ownership position to demand that the managers and directors of the business corporations in whose shares they invest also honor their own fiduciary duty to the holders of their shares. Finally, it is these two groups that share the responsibility for the prudent stewardship over corporate assets and investment securities alike that have been entrusted to their care, not only reforming today’s flawed and conflict-ridden model, but developing a new model that, at best, will restore traditional ethical mores. I close with a Biblical quotation (John 10: 11-13): I am the good shepherd: the good shepherd giveth his life for the sheep. But he that is a hireling, and not the shepherd, whose own the sheep are not, seeth the wolf coming, and leaveth the sheep, and fleeth: and the wolf catcheth them, and scattereth the sheep. The hireling fleeth, because he is an hireling, and careth not for the sheep.” This parable reminds us that our financial hirelings didn’t protect us sheep from the wolves that created this financial crisis, either because they didn’t see them coming, or saw them and decided to flee the pastures of capitalism.

” In one sense this explosion is wonderful, suggesting that our professional designation is highly valued. But it also raises serious concerns that the field will get more and more crowded, causing the costs of financial intermediation will to rise to even higher levels. This is not to say that bright individuals from today’s remarkable younger generation should not enter the profession of money management. Rather, it is to say that those who enter this field should do so with their eyes wide open, recognizing that any endeavor that extracts value from its clients may, in times more troubled than these, find that it has been hoist by its own petard. While it is said on Wall Street that “money has no conscience,” the future leaders of this profession must not let that truism cause them to ignore their own consciences, nor to alter their own conduct and character. Indeed, I expect you future leaders to bring to the operation of our system of financial intermediation a level of honest introspection that I find too often lacking among today’s leaders, and a return to our traditional focus on fiduciary duty, and on service to others before service to self.