John Bogle on Debt Discipline

top." A 20% market decline, for example, would eliminate the industry's entire potential post-1997 tax liability, even as a 20% market increase would double it. Please bear this high leverage in mind as you consider the important subject of how taxes impact mutual fund investors. In any event, these huge gains are a reflection-in fact, a muted reflection-of the gains the mutual fund industry has enjoyed by riding the crest of a bull market that is unprecedented in history. Equity fund assets, which soared from $50 billion in 1982 to $900 billion in 1994, have risen another 2 Yz times to $2.3 trillion in less than three more years. Fund managers now control some 33% of all u.s. common stocks, and fund cash flows are presently running at more that $15 billion per month, mightily contributing to the market's momentum. But if "riding the crest of the bull market" is an apt description of mutual fund asset growth, it is far too strong a phrase to describe mutual fund perfonnance. "Trailing in the wake" would be a better fonnulation. For even as funds have assumed their pre-eminent role in the market, their returns have lagged well behind market nonns. From December 31, 1994, to October 31, 1997, for example, the Standard & Poor's 500 Index has risen 112% and the Wilshire 5000 Equity Index of the U.S. total stock market is up 106%, but the average domestic equity fund has risen by but 89%.

7% on stocks during this one-and-one quarter century period, a remarkable tribute to the long run rationality of the financial markets. In the shorter run, to be sure, there is a lot of irrationality. (In particular, it seems apparent today.) Stock market irrationality can be measured by the ephemeral—but critical—factor of the price that investors are willing to pay for $1 of corporate earnings, the widely known price-to-earnings ratio. If, following Lord Keynes, we use the term investment to describe the fundamental return based on earnings and dividends, we use the term speculation to describe this second determinant of stock prices: the price that investors will pay for each dollar of earnings. If the power of fundamentals dominates market returns in the very long run—as it clearly does—the power of speculation dominates market returns in the shorter run. (Speculation, indeed, may be the only reason for the sometimes astonishing daily, weekly, or even monthly swings we witness.) Over time, investors have been willing to pay an average of about $14 for each $1 of earnings. But if, in their optimism, they are willing to pay $21, stock prices will leap by 50% for that reason alone. If, in their pessimism, they are willing to pay only $7, stock prices will fall by 50%. The changing price of $1 of earnings creates powerful leverage indeed— but it doesn’t last forever. 3 I am indebted to Jeremy J.

The words of the poet Stephen Vincent Benét aptly summed up that concern: If the idea is good, it will survive defeat. It may even survive victory. A Brief History of the Bond Fund To set a broad perspective on bond mutual funds and their role in bond investing, let’s go back some three decades. (Exhibit 1) Since 1985, bond professionals have enjoyed a great era in which to ply their trade, with the total market cap of U.S. bonds rising from $3 trillion to $25 trillion. Today, that bond debt includes $5 trillion of corporate bonds, $4 trillion of municipals, and $16 trillion of U.S. Treasuries. Yes, this has been an era of increased government, corporate, and consumer debt, much of it based on soaring mortgage debt and a debt category that barely existed in 1945—student loans, now at $1.5 trillion. It would be unwise to ignore the unknown consequences of America’s current massive debt burden. 1 This essay draws largely from remarks before the Fixed Income Analysts Society, Inc. (FIASI) on October 24, 2017 in New York.

Think of stock trading based on inside information, exemplified by hedge fund manager Raj Rajaratnam of the Galleon Group, and then-Goldman Sachs director Rajat Gupta, once respected head of McKinsey, both of whom are now behind bars. Think of the now-notorious collateralized debt obligations (specifically, “CDO-squareds”), which collapsed during the 2008-2009 financial crisis. When mortgages and other debt securities are bundled into collateralized debt obligations which are themselves bundled into a second layer of securitizations, it becomes difficult, if not impossible, for investors to determine who is bearing the risk. (Hint: they were.) Think of our investment banking firms, with leverage that soared as they moved from private partnerships subject to unlimited liability, to public corporations protected by limited liability. Have I made my point? Our financial system appears to be (I really mean “is”) deeply flawed. Why? Largely because of its underlying structure. It is a system where huge financial rewards are reaped by money managers (especially hedge fund managers) for short-term investment success. Where long- term investment takes a back seat to short-term speculation.the

have been better compliance with existing insider trading regulations and with the “full disclosure” requirements of SEC regulation FD? (Look, I know a bit about human nature, and fully understand that the illegal and unethical practices that arise from greed will be impossible to eliminate—mitigate, yes; eliminate, no.)  Wouldn’t a requirement that banks retain on their own books a portion of the mortgage loans they were divesting through securitizations in the form of CDOs have precluded their disinterest in evaluating the creditworthiness of the homeowners for whom they underwrote mortgages? (Remember the NINJAs—home buyers with No Income, No Job, and No Assets?) Alas, the most recent news from the Dodd-Frank front is the elimination of the requirement that mortgage originators retain some of the risk of their mortgages. How could that happen? (Clue: powerful lobbyists.) On this occasion, I’ll ignore the structure and incentives of our rating agencies, paid huge sums by issuers seeking that coveted AAA rating!  Finally, the new capital structure of our investment banking firms—from private partnerships to public corporations, from unlimited liability (“Be cautious and be conservative”) to limited liability (“Don’t worry much about leveraging the balance sheet. A 25-to-1 debt-to-equity ratio is just dandy.”) Under that new structure, it was all too easy to disregard, even to ignore, the risks of high leverage.

That said, despite their importance in endowment portfolios as a group, when risk is taken into account, endowment fund annual returns bear a significant correlation with the returns on balanced bond/stock portfolios. (In fact, the 15- year correlation is an amazing 0.94.) Why? Because ultimately, hedge funds are merely combinations of stock and bonds, differentiated largely by their use of leverage, short-selling, idiosyncratic strategies, widely-varying manager skills, and, of course, the staggering fees that they charge. The impacts of these extraneous elements—except for the fees!—are almost impossible to predict with any kind of accuracy. So you’ll have to look to wiser heads than mine for recommendations about selecting the “best” hedge funds for the coming decade. But, given my confidence in the power of mean reversion, I’d be especially careful about assuming that yesterday’s champions will be tomorrow’s victors. Indeed, because of RTM, I would not reject out-of-hand the possibility that conventional portfolios could outpace hedge funds as a group.greatly

The proximate causes of the current financial and economic crisis are usually laid to easy credit; the cavalier attitude toward risk of our bankers and investment bankers; “securitization,” in which the traditional link between borrower and lender was severed; the extraordinary leverage built into the financial system by derivative securities of mind-boggling complexity; and the failure of our regulators to do their job. But the larger cause of the present crisis was our failure to recognize the sea-change in the nature of capitalism that was occurring right before our eyes. The “Agency Society” Displaces the “Ownership Society” That change in capitalism, simply put, was the growth of giant business corporations, controlled not by their own shareholders, but by the agents of the ultimate owners. What went wrong in corporate America, aided and abetted by investment America, was a pathological mutation in capitalism—from traditional owners’ capitalism, in which 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. 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.percent

are usually laid to easy credit; the cavalier attitude toward risk of our bankers and investment bankers; “securitization,” in which the traditional link between borrower and lender was severed; the extraordinary leverage built into the financial system by derivative securities of mind- boggling complexity; and the failure of our regulators to do their job. The Securities & Exchange Commission was almost apathetic in its failure to recognize what was happening in the capital markets. The Commodity Futures Trading Commission allowed the trading and valuation of derivatives to proceed opaquely, without demanding transparency and the sunlight of full disclosure. And let’s not forget Congress, which in the name of “free-market capitalism” rolled back many vital regulations and gutted the Glass-Steagall Act, which, since the early 1930s, had separated traditional banking from investment banking. Market participants—now dominated by speculators, not investors—also joined the parade of miscreants, and our professional security analysts failed to do their job of appraising company balance sheets, largely ignoring the huge credit risks assumed by the new breed of bankers and investment bankers. And let’s not forget our credit rating agencies, which happily bestowed AAA ratings on securitized loans in return for enormous fees that were paid in return by the issuers themselves. (It’s called “conflict of interest.”) Yes, there’s plenty of blame to pass around.

link between borrower and lender was severed; the complicity of our rating agencies with the issuers of all those collateralized debt obligation; the extraordinary leverage built into the financial system by derivative securities of mind-boggling complexity; the failure of our regulators to do their job, and the susceptibility of our elected representatives to the temptations of political contributions. But the larger cause of the present crisis was our failure to recognize the sea-change in the nature of capitalism that was occurring right before our eyes. The crisis in capitalism also comes, in part, from our conviction that the Invisible Hand— described by Adam Smith more than 230 years ago in his seminal work, The Wealth of Nations— would benignly serve our society. Hear Smith’s words: 2 In fact, in my 1951 thesis at Princeton University, I urged that mutual funds be operated “in the most efficient, economical, and honest way possible.” If honesty is understood to represent a certain kind of elegance, the ideas are identical. 3 Assets of our Index 500 Funds total $125 billion; assets of their near-counterpart, our Total Stock Market Index Fund, total $95 billion, $220 billion in all.

“Unfettered financial entrepreneurship can become excessive—and damaging as well—leading to serious abuses and the trampling of the basic laws and morals of the financial system. Such abuses weaken a nation’s financial structure and undermine public confidence in the financial community . . . Only by improving the balance between entrepreneurial innovation and more traditional values— prudence, stability, safety, soundness—can we improve the ratio of benefits to costs in our economic system . . . When financial buccaneers and negligent executives step over the line, the damage is inflicted on all market participants . . . and the notion of financial trusteeship too frequently lost in the shuffle.” Dr. Kaufman’s early warning, of course, went unheeded. For our financial system is a greedy system, depending on high transaction volumes, high leverage, and rank speculation to maximize its own rewards. As a result, it consumes far too large a share of the returns created by our business and economic system. Writing in the Journal of Portfolio Management a year ago, I described the enormous costs of the financial sector: “. . . mutual fund expenses, plus all those fees paid to hedge fund and pension fund managers, to trust companies and to insurance companies, plus their trading costs and investment banking fees . . . totaled about $528 billion in 2007. These enormous costs seriously undermine the odds in favor of success for investors.

traditional balanced portfolio with 60 percent stocks and 40 percent bonds should provide a return of 5 ½ percent, not so different from the past decade. (Although, as I noted earlier, it was bonds, not stocks that led the way.) This return is far below the 7 ½ percent historical return on such a portfolio. And those are nominal dollars, not real dollars. If we have inflation of 2 ½ percent, that 5 ½ percent return drops to 3 percent. As we meet tonight, that’s the investment reality. Seeking Returns that are “Enough” If that’s not, in some sense, “enough” of a return for you, the options to earn income that will cover your living costs are simple, but not easy: reduce your household expenses (no matter how painful); leverage your portfolio by borrowing at today’s low interest rates (a very risky strategy); spend moderate amounts of your capital (but you can’t do that forever); reach for higher yields by owning junk bonds (with their far higher credit risk); or increase your position in high dividend stocks (which have considerable volatility risk). But in general, make only moderate changes in your asset allocations; avoid box-car changes in favor of marginal changes. In the real world, as you see, for every pro, there’s a con. As it is said, there’s no such thing as a free lunch. Or is there? In fact, there is one remarkably easy way to increase your income return and leave risk absolutely unchanged. And this brings me full circle in my discussion this evening.