John Bogle on Dividend Policy

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.

Driven by the long bull markets in both stocks and bonds, the ever-market-sensitive mutual fund industry too has burgeoned, growing at a 17% annual rate since 1986 and increasing assets eight times over. Vanguard’s 26% growth rate since then has multiplied 19-fold. To be sure, we found ourselves in the most rapidly growing segment of the fund industry—the direct marketing (largely no-load) sector— which became the industry’s largest distribution channel in 1996. This growth reflects an increasingly cost-conscious breed of self-motivated investor. Happily, we had sensed this trend years earlier, and were well prepared. For in 1977 the Vanguard funds abandoned their 50-year dependence on stock brokers and made an unprecedented leap forward to no-load distribution. Direct marketing has grown at a 21% annual rate, resulting in an 11-fold asset growth. The runners-up in the growth sweepstakes, growing at a 16% rate, were independent firms offering load funds, largely sold by stock brokers. Their assets grew seven-fold. In a poor third place, growing at just 12%, with but a four-fold asset increase, were the proprietary load funds, managed and distributed by the brokers. Despite the obvious and innate competitive advantage held by broker-sold funds, their notably high costs and notably low returns (not entirely unrelated!) were too much for even their dedicated distribution systems to overcome.

he purposeth in his heart, so let him give not grudgingly or of necessity, for God loveth a cheerful giver . . . Being enriched in everything to all bountifulness, make liberal distribution to all. In a far more mundane context I have sought, if inadequately, to meet that spiritual standard. When, five years ago, the United Way of Southeastern Pennsylvania presented me with the Alexis de Tocqueville Society Award for service to the community, I summed up my philosophy with these words: It is especially delightful to receive an honor one has not sought, for I have always believed that the simple act of giving—of one’s wealth and one’s self alike—is its own reward, a reward in its most pristine form. Whatever I may have done to deserve this award, my spirit and my deeds reflect this principle: “For unto whomsoever much is given, of him much shall be required.” (St. Luke did not say expected, mind you, but required.) And we—all of us here tonight— have been given abundance beyond reasonable measure. As Dr. Johnson put it, “beyond the dreams of avarice.” Generosity is indeed our obligation, but more, it is our opportunity. What I am saying, then, is not much different from what I learned from Deuteronomy and from St. Paul. We mustn’t give alms because we want a guaranteed ticket to paradise, but because we know, deep down, that it is the right thing to do.

” Written by senior executives of the two firms—after consultation with as distinguished a list of money managers and powerful fund sponsors as one could possibly imagine2—the study reaches this major conclusion: Management of Embedded Alpha, the frictional costs of running a portfolio, will emerge as an essential contributor to investment manufacturing quality and performance. The Merrill Lynch/BARRA Study For me—and I think for you as investment professionals—the heart of the ML/BARRA study is not its long series of speculations, however intelligent, about the future development of investment management—the business itself, investment manufacturing (their off-putting word); distribution; viable business models; and optimal size. Rather, the heart of the study is its clear articulation of what it calls Embedded Alpha, the frictional costs that detract from the return that can be theoretically produced by an investment portfolio in a frictionless securities market. In a special appendix, firms are urged to “Manage Embedded Alpha, Cut Those Hidden Costs.” The costs are identified in these direct quotations from the study: 1 Taken to its logical conclusion, the theory suggests that the new bare-bones-cost computerized portfolios (often known as “folios”) will represent powerful competition for mutual funds, whose costs are prohibitively high.

But the fact is that most portfolio managers simply don't spend much time agonizing over the tax consequences of their decisions. Ever since the industry began in 1924, it has essentially ignored the tax issue, and in the "good old days" funds were sold as much on the basis of "looking for more income" as on the basis of total return. (In the 1940s and early 1950s, stock yields averaged 8%, bond yields 2 1/2%. Imagine!) Indeed, the industry often sloughed over the difference between income dividends and capital gains distributions, adding them together to arrive at a "total distribution yield," a practice not legally permitted since 1950. In recent years, as tax-deferred IRA accounts and 401(k) corporate retirement plans have come to the fore, tax considerations have gotten even less attention. In fact, investors in tax-deferred accounts are now the driving force in industry growth, accounting for nearly 40% of the assets of equity funds as a group. Investors in these accounts need burden neither their minds nor their checkbooks with tax issues. But the owners of the other 60% of fund assets do not have the luxury of ignoring tax considerations. Each year, they must pay taxes on the fund distributions they receive. Yet mutual funds do not provide adequate disclosure about the tax implications of their investment strategies, portfolio turnover expectations, and gain realization policies.expenses

A Much Younger Cousin, A Mixed Pedigree Vanguard, of course, is a much younger enterprise, and its pedigree rather more mixed. We trace our lineage to 1928, when another remarkable Philadelphian, financial entrepreneur and fund pioneer Walter L. Morgan, founded Wellington Fund, one of America’s oldest mutual funds. His company, Wellington Management Company, operated and managed the fund. Like its peers, however, while it was mutual in name, its management was engaged in carving out a profit from the advisory and distribution fees the fund generated. It was the creation of Vanguard in 1974 that changed the operation of Wellington Fund from being a profit-making entity for its operators to one that operated on an at-cost basis, one in which the fund shareholders actually owned the operating company. Flying in the face of industry tradition and practice, Wellington Fund, under Vanguard’s aegis, became a truly mutual mutual fund, now joined by 106 sister funds that compose the Vanguard family of mutual funds. The change in the character of Wellington and its sister funds—from profit to not-for- profit—came when they were brought under the Vanguard umbrella. How that happened is a tortuous and compelling saga, filled with success and failure, joy and sadness, good choices and bad. I will not recount it today, except to say that we began operations as a tiny company with a crew of 28 members, providing only administrative services to Wellington and the other Vanguard funds.

to retain Wellington as fund advisor and fund marketer. But because success, as it were, in the fund field is driven, not by how well the funds are administered, but by what kinds of funds are created, whether superior investment returns are attained, and how effectively funds are marketed, I feared that I had won a Pyrric victory, for our new company was formally prohibited from performing those critical portfolio supervision and distribution functions. In any event, we needed a distinctive name for our firm, and Lady Luck quickly struck again. In mid-September 1974, a dealer in antique prints happened by my office and sold me some prints of naval battles of Great Britain during the Napoleonic Wars. Glancing at the book from which they had been removed, I read the text describing the Battle of the Nile in 1798, where Lord Nelson demolished the French fleet. His dispatch announcing the glorious victory proclaimed his flagship’s name and location: “Vanguard, off of the Nile.” I knew immediately that I had the name for our new enterprise! As 1974 drew to a close, the new Vanguard Group was a tiny company with a proud name, a staff of 28, responsible for only the administration—nothing more—of $1.4 billion of mutual fund assets, and a mutual structure without precedent in the industry—a structure in which the funds would be operated at cost, and solely in the best interests of their shareholders.

Full disclosure must be the order of the day. The problem-and it is a serious one------created by the relatively prompt realization of capital gains is that taxes must also be paid currently. Yet the truly massive value of deferring capital gains taxes seems almost universally ignored. To put it simply: a tax deferred is an interest-free loan from the U.S. Treasury Department, with a maturity equal to the number of years of deferral. Just imagine the value of a ten-year interest free loan even a 25-year loan. Better still, calculate it. In fact, a $1.00 loan repayment deferred for ten years has a present value of 49¢ (a 25-year loan, 15¢). But perhaps as few as 5% of all fund holdings can expect to be held for ten years and gain that 100%-plus extra profit. Today I estimate, very roughly, that mutual funds are carrying total capital appreciation of a cool $600 billion (25% of equity fund net assets), representing a potential nearby liability to taxable shareholders of some $90 billion. An estimated $450 billion of those gains have not yet been realized, but, holding market prices constant, will ultimately be realized and subject to taxes. Some, $150 billion of this appreciation has been or will be realized and distributed to investors and subject to tax in 1997. This mammoth distribution will be comprised of about $100 billion in 10ng-tenn gains and $50 billion in short-tenn gains.

It took nearly three long years for us to develop into a full-fledged fund complex, providing not only administrative services to the funds, but distribution and investment services as well. And two more years were to pass before the new enterprise began to grow. But ever since 1981, our path has been one of unremitting growth—indeed the highest growth rate in the mutual fund industry. Mutuality—The Rock Foundation Suffice it to say that mutuality is Vanguard’s most distinctive characteristic, the rock foundation upon which all that we have accomplished depends. But without Dr. Franklin’s angels—energy and persistence—sitting on our shoulders, we never would have been able to form the new enterprise, nor to establish its character, nor to build it to its present substantial size. With assets of the Vanguard funds now exceeding $575 billion, we have become the second largest fund complex in the world.

While these might seem rather meager credentials, that structure set in motion all that was to follow. We quickly went to work to expand our mandate. Ignoring the limitations in our charter, we created the world’s first index mutual fund, and then the industry’s first targeted maturity bond funds, now the industry standard. We eliminated the seller-driven broker-dealer distribution force that had marketed the Wellington funds for nearly half a century, replacing it with our own buyer-driven “no load” system. By mid-1977, with our fund assets still below $2 billion, each of the critical elements of today’s Vanguard was not only in place, but set on a firm foundation. We had built it. Now we would test our thesis: “If you build it, they will come.” Our innovation, our structure, our strategy, our faith in stock indexing and in disciplined bond management, our over-bearing focus on low cost, and our attention to serving the needs of our clients were what we built, and millions of investors came. Year after year, unremittingly, our market share of industry assets increased, and our fund assets now total $560 billion. The Vanguard Experiment has worked.

So we had to seek yet another diamond. And we quickly found what was to prove to be the rival of the fabled Kohinoor diamond in size. The fact that investment management was outside of Vanguard’s mandate led me, within months, to what may seem obvious, a great idea that I’d toyed with for years. And before 1975 had ended, we started the world’s first index mutual fund. Our first index portfolio—based on the Standard & Poor’s 500 Stock Index—was derided for years, and first copied only after a full decade had passed. But very soon this fund, once called “Bogle’s Folly,” will be the largest mutual fund in the world, one of 28 index mutual funds that today constitute nearly one-third of our business. The trick of the index fund, I argued to the Board, was that it didn’t need to be “managed;” it would simply buy all of the stocks in the Index. The argument narrowly carried the day, and with this quasi-management step, we had edged into the second side—the investment side—of the triangle. How to get the final and third side—the marketing function? Why, just find another diamond. Our idea was to eliminate the very need for distribution, doing away with the Wellington network of brokers and relying, not on sellers to sell fund shares, but on buyers to buy them. So, in 1977, after yet another divisive battle, we made an unprecedented conversion to a no-load, sales charge-free marketing system. Once again, we’ve never looked back. We’ve never had to.

precious few portfolio managers have measured up to over time. (3) The development of a new paradigm for bond fund management, using innovative three-tier structure of short-term, long-term, and intermediate- term portfolios that quickly became the industry standard. And (4) the abandonment, literally overnight, of a proven broker-dealer, commission-oriented “supply-push” distribution system in favor of a new and untried no-sales-charge, “demand-pull” system for self-motivated investors. None of these changes came easily. To accomplish them required a devil-may-care attitude; a blasé disregard for risk; a profound conviction, without hard evidence, that they would work; and the sheer energy required to get it all done. Yet despite what we regarded as our noble intentions, the completion of our structure was initially opposed by the Securities and Exchange Commission, which rejected our structure and dawdled over our appeal for years. When the Commission finally gave us its unanimous approval, it came with an endorsement that proved to be prophetic: “The Vanguard plan actually furthers the (1940 Investment Company) Act’s objectives, and promotes a healthy and viable complex in which each fund can better prosper.” And prosper we did. By the time the SEC finally gave us the green light in 1981, seven long years after we began, the stock market recovery had begun, and our assets had doubled, from $1.4 billion to $3 billion.

languished at 1000 in 1982—sixteen years later. (In the next sixteen years a rather different market environment would take it to 8000!) Our firm experienced 80 consecutive months of capital outflow (more shares redeemed by investors than purchased, every single month). But bad times helped us in critical ways. With business so poor, the directors were open to suggestions for improvement. I had long believed that having the lowest expense ratios would not be good enough to establish us as the legitimate, low-cost provider of mutual fund services. We would have to also eliminate all sales charges. So I urged the board to abandon the old broker-based channel to a new direct channel, the better to serve a public which, I posited, would be increasingly savvy about investing, well-educated, and self-motivated. Wellington Management Company resisted, and we were able to wrest control of marketing and distribution from them, cut expenses again, and make an unprecedented conversion to no-load distribution in early 1977. (Another close call, 8 to 5, at a still-divided board.) Now we were both administrator and distributor. So we turned our attention to the third leg— investment management—of the three-legged stool on which mutual fund activities rest. The boom in money market funds, which were to grow to more than 50% of industry assets in 1985, gave us our entree.

What is more, external circumstances could exacerbate the situation. A market decline which caused net liquidations would increase per share distributions. Conversely, rising markets, which bring in new money at ascending prices, dilute per share distributions. That is why mutual fund unrealized gains have been small relative to the rise in stock prices. Curiously, investors don't seem to mind paying $10.00 per share for a fund with a tax liability on, say, $2.50 in unrealized capital gains. In a down market, when share prices tumble, it is possible, if not likely, that new fund investors with unrealized losses would nonetheless receive substantial taxable capital gains distributions. (Fund accounting practices give rise to strange outcomes!) "Forewarned is forearmed." With all this background, let's look at tax impact in a longer-term context. On the income distribution side, the tax impact is, in a perverse sense, beneficial. Equity mutual funds are today earning gross income before expenses-at the rate of about 2.1 %. (Their equity holdings yield about 1.7%; their 7% average reserve position 6%.) But fund expenses average 1.5%, meaning that equity fund investors receive a puny 0.6% yield on which to pay taxes. Expenses, in fact, are consuming 71 % of fund income. In the paradoxical world of mutual funds, then, the higher the expense ratio, the more "tax efficient" the income component of total return. "Alice in Wonderland" writ large! Alpha Takes Another Hit ...

What could possibly explain this huge differential? Could these fund directors possibly be shouldering eight times the responsibility shouldered by their corporate counterparts? Consider the facts: A corporate director is responsible for approving the corporation’s policies and business objectives; selecting the chief executive officer; approving multi-million dollar expenditures on plant and equipment; determining an appropriate capital structure, dividend policy, and stock repurchase program; and, typically, approving a mission statement focused on the creation of long-term economic value for the corporation’s shareholders, measured by returns that are higher than the corporation’s cost of capital. Money Market Fund Expenses For A Major Fund Complex Total Assets: $61 Billion Investment Management: $ 254 $ 10 Distribution: 64 64 Shareholder Services: 71 71 Total: $ 389 $ 145 Annual Fees Est’d. Ann. Expenses $ Million Chart 7.

Mutual fund directors are responsible for none of these decisions. Rather, in the industry’s own parlance, they are “watchdogs” for each of the 100-300 funds usually managed by the large fund complexes, approving (and rarely, if ever, disapproving) each fund’s advisory and distribution contracts, custodian agreements, and pricing and valuation procedures; and monitoring investments and portfolio quality and liquidity—part of a seemingly imposing list of 40 duties set out by the industry, but duties that, in the real world, are largely perfunctory. None of these duties, moreover, relates to a fund’s mission and its obligation to create economic value by earning the cost of its capital. Further, those approvals and that monitoring take place under the direction of the fund’s chairman—a chairman who is, almost without exception, also the chairman (or a high official) of the fund’s management company. The chairman controls the agenda; the staff reports are made by his subordinates; the responsibilities for management are theirs alone. It’s simply not reasonable to attribute the vastly higher fees paid to these independent fund directors to their having assumed vastly higher responsibilities than their management company counterparts. That leaves us with at least the possibility that such high fees are there to subtly encourage directors to act at the manager’s behest.

creating the first index mutual fund was exciting. It wouldn’t involve “investment management” for our new firm. The board had decreed that as a taboo at the outset. But I knew absolutely that “non- management” had to work. An “at cost” operation like ours could make the most of the opportunity, and we grabbed it. So, when Vanguard finally began operations in May 1975, we quickly developed a plan for the formation, management, and distribution of the first index mutual fund in history. The board (again, after considerable controversy) approved it four months later in September, and it was incorporated in December of the same year. Then named “First Index Investment Trust”—though known more familiarly in the industry as “Bogle’s Folly”—the fund began operations with $11 mission of assets in August 1976. It’s had a good run, solidly outpacing the returns of actively-managed funds. And the now-well-known 500 Portfolio of the renamed Vanguard Index Trust, with assets nearing $50 billion, is the second largest mutual fund in the world. It constitutes about one-half of our index book of business of 26 passively-managed stock and bond funds, now approaching $100 billion in assets. These assets, in turn, comprise nearly one- third of our $300 billion asset total today. Standing alone, our index funds would be the nation’s seventh largest mutual fund complex. All in all, it wasn’t too bad an idea.

1. An independent director should serve as board chairman. 2. No more than one management company director should serve on the board. 3. Independent directors should select their own successors, without management participation. 4. The board’s legal counsel should be completely independent of the management company. I’m delighted to note that the recent rules promulgated by the SEC deal with the last two issues. But even without SEC rules, a strong board could take appropriate action on the first two issues, opening the door to the Board’s focusing solely on the interests of shareholders. To use this independence to bring reasonableness to fund fee full levels, one more change would help. Mutual fund directors should review not only expense ratios, as is the custom, but expense dollars. The Board should demand that the manager provide an accounting for each dollar of fund assets that are spent—the sources (investment advisory fees, 12-b1 fees, etc.), and the uses (investment management, distribution, operation, manager’s profits, taxes, etc.), of cash resources for each fund and for the entire complex. Studies prepared by fund consultants should also report the dollar amounts of fees paid by peer funds, as well as their expense ratios. What might this examination of sources and uses show? Let me present just one extreme example, using a money market fund. Why a money market fund?

flow growth each year for five consecutive years. That strikes me as a shareholder-friendly approach! And that only begins the list of where owners should get involved. No, I don’t think our giant institutions have the talent and ability to manage the businesses they effectively own. But they ought to demand the right to approve large mergers and acquisitions, and the right to eliminate anti-takeover provisions, staggered boards, and poison pills, and the right to say grace over dividend policy, indeed the right to submit to a vote of shareholders any proposal that is designed to assure that a company is managed in the interests of its shareowners. Changing the System These changes will require SEC initiatives, and I confess to being disappointed in the Commission’s recent proposals to give shareholder access to nominating directors. Given the pressure from The Business Roundtable, it’s easy to understand the tortuous process that has been proposed: In year one, a “triggering event” with high trigger must take place—only a shareholder holding at least 1% of the company’s shares could propose shareholder access, and if the proposal won a majority vote (or if there were a 35% vote to withhold support from one of the directors), then in year two shareholders who have held at least 5% of the company’s stock for at least two years could nominate up to three candidates, and bear the costs of trying to persuade other owners to vote for their candidates.

Because here the conflict is clear: The manager seeks to charge high fees so as to maximize the return on its capital; the fund wants to pay low fees so as to maximize the return on its capital. And the amount of the fee represents virtually the sole differentiation in return. We’ll follow the money in a $61 billion group of money market funds managed by a large financial conglomerate. In 2000, the funds paid some $254 million in management fees, $64 million in distribution fees, and $71 million in shareholder service fees and operating costs. Total: $389 million, equal to 0.63% of assets. (Chart 7.) The fees spent on distribution and shareholder services probably cover the cost of those services. What about the amount spent on investment management? Consider a good-sized money market fund, regularly rolling over short-term U.S. Treasury bills and high-grade commercial paper, with absolutely no hope of materially exceeding the returns available in the money market.but

size of the funds they are leaving has impeded their ability to deliver outstanding returns. The fact is that today the average fund portfolio manager has an average tenure of just three and one-halfyears. To say that these are especially critical issues for wealthy investors considering investing in mutual funds in the accumulation and distribution of their estates would be a powerful understatement of the issue. As James P. Garland, President of The Jeffrey Company, has observed, "Taxable investing is a loser's game. Those who lose the least-to taxes and fees-stand to win the most when the game's all over." In an article in The Journal of Investing [Spring 1997], Garland presents an imposing case, comparing the performance of two $100 investments over a quarter century: one in an idealized index-assuming no expenses, turnover, or taxes-and one in a mutual fund with an expense ratio of 1%, a turnover rate of 80%, a capital gains tax rate of 28%, and an income tax rate of 36%. The terminal market values are strikingly different: $1,721 for the index versus $706 for the fund. This example dramatically illustrates the powerful long-term impact of costs and taxes. By the end of 25 years, the government has consumed 47% of the optimal ending dollar amount, while the manager pocketed 12%, leaving the investor with only 41 % of the investment on an after-tax, after cost basis. And it is the investor who put up 100% of the initial capital.

them with new traditions. To be persistent in pursing the mission. To look ahead as far as my vision can see, and to speak out on our goals with the zeal of a missionary, the stubbornness of an idealist, and the soul of a street fighter. To be as smart as my limited brain-power will allow. It is up to others—indeed to history—to evaluate what it is this one human being has accomplished, and the extent to which Vanguard shareholders—indeed all mutual fund shareholders—have been served by the voyage of the HMS Vanguard. But I know, as I hope you know after hearing these comments, that whatever the answer is, it would never have come to pass if I had not come here as a young man quite by accident of fate, and fortuitously discovered, indeed often at exactly the opportune moment, the Golconda that began with FORTUNE Magazine in 1949, and then Walter Morgan and Wellington Fund; then my family; and then Vanguard itself and the “Vanguard” name; and then the first index fund and the novel distribution strategy—one diamond after another right here in my own backyard, just as Russell Conwell’s words promised that I would. All that I had to do was dig for them. Oh, yes. I referred earlier to that one other diamond I found here. Paradoxically, it was a diamond in the form of a heart. (And as we all know, in games of cards, a heart beats a diamond every time.) It’s true in life, too.

costs incurred by those who would help investors to beat the market themselves constitute the reason that investment managers as a group are destined to fail at the task. Why? It is only to state the obvious when I point out that all investors as a group must of necessity earn the market returns—but only before the costs of investing are deducted. After these costs are taken into account—after all of the fees, the transaction costs, the distribution costs, the marketing costs, the operating costs, and the hidden costs of financial intermediation—investors must—and will—incur a loss, indeed a loss precisely equal to the aggregate amount of those costs. Beating the market before costs is a zero-sum game; beating the market after costs is a loser’s game. Management of Embedded Alpha At long last, this reality has taken root, even among financial market participants who are not among the lowest-cost players in the game. Consider the paper entitled Success in Investment Management: Building the Complete Firm, prepared two years ago by Merrill Lynch and BARRA Strategic Consulting Group after consultation with a distinguished list of money managers that included Fidelity, Putnam, and Citigroup. The study reached this major conclusion: Management of Embedded Alpha, the frictional costs of running a portfolio, will emerge as an essential contributor to investment performance. (It’s about time!)

4 billion, spread among eight mutual funds, all but one of whose portfolio managers had performed poorly in the market decline. Money management and distribution were still the responsibility of my former partners at Wellington Management, and our new charter limited us to administration, and nothing more. Our mutual structure would be key in our mission to become the lowest-cost provider of financial services in the world; our strategy would be to create simple mutual funds in which low-cost was not only essential to investment success, but would represent, dollar for dollar, the difference between success and failure. Strategy follows structure. We had been in operation for but three months when the first seeds of that simple vision were sown.500

Who Earns the Market Returns? But whatever returns the financial markets are generous enough to deliver, please don't make the mistake of thinking investors actually earn those returns. To explain why this is the case we need only to understand the simple mathematics of investing: All investors as a group must necessarily earn precisely the market return, but only before the costs of investing are deducted. After all the costs of financial intermediation are deducted—all of the management fees, the transaction costs, the distribution costs, the marketing costs, the operating costs, and the hidden costs of financial intermediation— the returns of investors must—and will, and do—fall short of the market return by an amount precisely equal to the aggregate amount of those costs. Result: Beating the market before costs is a zero-sum game; beating the market after costs is a loser's game. The returns earned by investors in the aggregate inevitably fall well short of the returns that are realized in our financial markets. The great paradox of investing is that you don't get what you pay for. The fact is quite the opposite: You get what you don't pay for. Consider the costs of equity mutual funds. Management fees and operating expenses—the "expense ratio"—average about 1.6% per year of fund assets.

Index. Result: Average annual fund return, 9.8%; S&P 500 return, +11.3%. To magnify that 1½ percentage point difference, I assumed a large initial investment, and compounded it. Thirty years later, the original $1,000,000 investment had grown to $16,500,000 in the average fund, but to $25,000,000 in the S&P 500 Index. Difference: $8.5 million. Our mutual low-cost structure gave us the ability to match the index at nominal cost, and quickly led to our formation of the world’s first index mutual fund. Our structure was also the linchpin of the strategy to abandon our funds’ half-century commitment to a seller-driven broker distribution channel and move to a buyer-driven no-sales- load channel in February 1977. We made that unprecedented decision just five months after the index fund initial public offering was completed. (It had raised a less-than-mind-boggling $11 million.) Ditto for our second major innovation in fund management just four months later, this time in the bond market. Casting tradition to the winds, we formed, not a single so-called managed bond fund, but a troika: Long-term, intermediate-term, and short-term. This simple innovation, while less recognized than our creation of the first index fund, changed the way investors regarded bond funds. It quickly became the industry modus operandi. So, in less than two years from our start as a tiny administrative company, Vanguard had been transformed into the full-line fund complex it is today.

—now encompasses the round-the-clock ability to buy and sell stocks by the minute—and buy and sell funds by the daily close of business—electronically, simply by pressing a computer button and watching the trade, the clearing, and the settlement take place almost automatically, right before your eyes. What is more, without technology there is no way we could effectively administer shareholder accounts holding a variety of funds; IRA accounts with small monthly deposits; 401- K corporate savings plans with almost infinite fund choice (even self-directed brokerage accounts) and loan provisions; variable annuities; and withdrawal plans that automatically meet the minimum distribution requirements of the Internal Revenue Service—and do all of that almost flawlessly, if not yet at a Six Sigma level. At the same time, we have given investors almost unlimited choice of funds, plans, and programs, and the ability to change their portfolios at a moment’s notice. But all of these miracles of technology are not only for better; they are also for worse.asset

To put it mildly, Jon did not like my idea. I still remember his exact words, “If you create a mutual structure, you will destroy this industry.” Viewed in the light of what would follow decades later, if Jon Lovelace only had added (which he surely implied), “you will destroy this industry as we now know it,” his reputation for wisdom and foresight would have been even further enhanced. II. The Upstart and the Revolution This compelling anecdote begins my story of how an upstart firm, founded at the bottom of a vicious bear market in 1974 (down 50%), overcame the high odds against its survival, let alone its success. The firm had an unprecedented mutual structure. It was compelled to use an external investment adviser with a previous record of failure. It was limited in its ambit to fund administration, and barred from engaging either in portfolio management or share distribution. It would soon stake its future on an unprecedented strategy—a stock portfolio that would require no investment adviser. And, as if those liabilities were not enough of a burden, the firm had a brand-new name. As you now must know, that name was Vanguard; that unprecedented structure was mutual; and that strategy began with the creation of the world’s first index mutual fund. Whether you applaud this novel approach to mutual fund structure and strategy—or maybe even wish that it had failed—that structure and that strategy have changed the nature of the mutual fund industry “as we then knew it.

administrative, investment management, and share distribution services, basically terminating the funds’ relationship with Wellington Management. That was a bridge too far for the Board, but they authorized me to provide a study of the options available to them.2 5. September 24, 1974. Vanguard Is Founded. The options that I presented to the Board ranged from the Funds’ acquisition of Wellington Management (my first choice) to having the Funds assume responsibilities for their own administration but retain Wellington Management for their investment management and share distribution (my last choice). They voted for that last choice. But it was better than nothing, and 43 years ago Vanguard—the name that I had chosen— was founded as a truly mutual mutual fund organization, designed to serve its shareholders. Part of our strategy focused on minimizing the management fees paid to our advisers. Now, an index fund would give me the opportunity to start a fund with no management fees. This confluence of opportunity and motive may well be the most powerful single force undergirding innovation. 6. October 10, 1974. “Challenge to Judgement.” That’s when I read Paul Samuelson’s article in the very first issue of the Journal of Portfolio Management. What a coincidence! I felt as if he had written it directly to me. Dr. Samuelson sought “brute evidence” that any mutual fund manager could consistently outpace the S&P 500 Index, but found none.

An Industry-Changing Event The ill-begotten merger finally collapsed, and in January 1974, my new partners mustered the votes to fire me. (It’s not fun to be fired!) A painful struggle followed, resolved only when I persuaded the directors of the then-Wellington Funds to retain me as their chief executive, and to operate the funds at cost, on a truly mutual basis. I named the new firm Vanguard—“leader in a new trend.” It was founded on September 24, 1974. The fund directors barred Vanguard from engaging in the investment management of our funds and in the marketing and distribution of fund shares. (They retained Wellington Management to continue to perform those two duties. Given the abject failure of those managers in advising Ivest Fund and Wellington Fund, a truly incredible decision.) We were on our own now. Fortunately, a door opened that gave the new firm an unexpected opportunity. In 1976, Congress passed legislation that allowed mutual funds to “pass through” municipal bond interest income to their shareholders. Municipal bond funds quickly came into being as a new investment category, a permanent factor in our industry. Almost immediately, a score or more fund sponsors answered the call. All were “managed” municipal bond funds, presumably meaning that their managers would shorten maturities just before interest rates rose (and prices fell), and lengthen maturities just before rates fell (and prices rose).

So, yes, I know the reality: Investing is a hard business. I repeat: Investing is a hard business. So what does an active manager do? Here are some suggestions from respected commentators about business strategies that might help today’s active managers to survive. First, Laurence B. Siegel, CFA Director of Research. Success will come to active managers when they “present convincing evidence, both historically and in the process they intend to use in the future, that they have a good chance of beating the relevant benchmarks after costs.” Second, John Rekenthaler, Morningstar guru, eminence gris, and in my book the industry’s most astute observer of mutual fund trends. He endorses three approaches: (1) Make funds “available for a limited time, until they reach a certain size, at which point they will be closed.” (2) Adopt “niche” strategies that are “capable of very large surprises . . . a fund that holds 25 stocks.” (3) “Ask more of your investors. . . . Educated investors make for better investors . . . with happier investor experiences.” Third, McKinsey & Company. In the “New Era in Asset Management,” firms “will need value propositions that are more closely aligned with the evolving needs of clients; new technology-enabled investment and distribution capabilities, new vectors of growth and productivity . . . strategic agility . . . retool their organizations, change internal mindsets, and take a ‘bifocal’ approach to resource allocation.” Well, sorry, guys.

Note that the confiscation of income is as high as 60% for the 529 C class. Also note that some of the convoluted mathematics involved in deciding which of the 16(!) classes the broker will offer clients from a single sponsor of the same fund with such different costs. Some classes have front-end loads, some have deferred loads, 11(!) have hidden loads paid by the investor in the form of 12b-1 fees for fund distribution. As a result, the net dividend yields received by investors in the 16 classes vary—in this case, from a low of 1% for the 529 C class to high of 2.16% for R6 class of this intermediate-term bond fund. Since the gross (pre-expense) yield of this fund was 2.4%—43% of the yield has been effectively confiscated. If that table tells us anything, it is that the salesmen must be paid. That’s fine for a particular firm, I guess, but investors should make sure that they receive commensurate value in return. The Metamorphosis of an Index Let me close with a few broad thoughts about how the world of bonds might change in the years ahead. As the driver of Vanguard’s dominant 23% share of bond fund assets, Vanguard Total Bond Market Index Fund offers an interesting case study of how bond market indexing works. In 1986, when I first considered the creation of a bond index fund, the sole broad bond index was the Salomon Brothers Investment Grade Bond Index. Then, U.S. Treasury bonds accounted for 50% of its weight, government agency obligations 32%, and corporate bonds 18%.

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.

By owning the entire stock market (or almost all of it) and eliminating about 95 percent of the frictional costs of investing, Vanguard 500 Index Fund would be guaranteed to beat the returns earned by financial managers in the aggregate. Our Index Fund was formed in 1975 and, after a pathetically small IPO—$11 million—was offered to investors a year later. 1975 and 1976. Innovation # 2. At the outset, our mutual funds, like almost all others, carried substantial sales loads. Like their peers, they were offered to investors via our wholesale distributor through a network of stockbrokers. Now that the fund industry had begun to mature, it seemed obvious that the U.S. investing public— growing older and better-educated, and hence more cost-conscious—would someday easily support a no- load framework, with funds directly offered to investors. So we eliminated those pesky sales loads and abandoned our distribution system—the first firm to take this daring step. We did it only after much consideration of the huge risks involved, and without prior notice. February 1977. Innovation # 3.

The new, higher dividend would be earned by emphasis on more stable, income- producing value stocks, rather than on volatile, low-yielding growth stocks. It has worked splendidly, and shareholders have rejoined the fund in droves. Taking Wellington back to its roots but adding a specific dividend objective led to its renaissance. 1978. Innovation #5.1 How Have Our Innovations Worked Out? So, innovation has been the key to Vanguard’s remarkable growth. Let’s measure the results of each of those innovations: 1. Our mutual at-cost structure (combined with our extraordinary growth) has enabled us to slash our complex-wide expense ratio (expenses as a percent of assets) to less than 20/100 of 1 percent, fully 80 percent below the 1 percent industry norm, now saving our investors a cool $17 billion annually. 2. Our index innovation has changed the world of finance. Index funds now constitute fully 28 percent of equity fund assets, and assets of that original Vanguard 500 Index Fund have grown to $250 billion. Its sister fund, Vanguard Total Stock Market Index Fund also totals $250 billion, and assets of all of our index funds combined now total $1.3 trillion. 3. Our no-load (non-distribution) system last year produced a net cash inflow from investors of $142 billion, the largest inflow in the fund industry’s 1 Really a reverse innovation. But it saved the day.

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.

speculation. (3) The rise of “product proliferation” with thousands of new funds formed each year, embracing aggressive share distribution as integral to the manager’s interest in gathering assets and increasing fee revenues. (4) The conglomeratization of the mutual fund industry, a change that served the monetary interests of mutual fund managers and a disservice to the interests of mutual fund shareholders, and finally, (5) the triumph of the index fund, which did precisely the opposite; shareholders first, managers second. Let’s take a look at each of these changes. 1. The Stunning Growth of Mutual Fund Assets When I joined the industry in 1951, fund assets totaled just $3 billion7. Today, assets total $13 trillion, a remarkable 15 percent annual growth rate. When a small industry—dare I say a cottage industry?—becomes something like a behemoth, almost everything changes. “Big business,” as hard experience teaches us, represents not just a difference in degree from small business—simply more numbers to the left of the decimal point—but a difference in kind: More process, less human judgment. For the first half-century of industry history, equity funds were our backbone. Equity fund assets topped $56 billion in 1972, and then, after a great bear market, tumbled to $31 billion in 1974. Recovering with the long bull market that followed, equity assets soared to $4 trillion.

21 percent (21 “basis points”) was 76 basis points below the 0.97 percent (97-basis-point) composite weighted average expense ratio of our largest competitors. That saving, applied to our average assets of $1.2 trillion during the year came to almost $10 billion for 2007 alone. By 2009, cumulative savings for our mutual fund owners will have crossed the $100 billion mark. Whence “Mutual”? The Vanguard structure is unique in industry annals. While the first mutual fund (Massachusetts Investors Trust, formed in 1924) was managed by its own trustees rather than by an external company—a structure it abandoned in favor of the external structure in 1969—its shares were marketed and financed by a separately-owned distribution company. And while the funds in the Tri-Continental (now Seligman) group were for many years operated at cost by their management company, the manager reaped 4 The investment advice for approximately 70 percent of Vanguard’s fund assets—largely index, bond, and money market funds—is provided internally by Vanguard itself. The remaining 30 percent is advised under contracts held by a score of external advisors.

substantial (if undisclosed) profits by serving as the broker-dealer for the funds’ portfolio transactions.5 In 1978, this structure, too, was converted into an external manager structure. Since the word “mutual” did not appear in the Investment Company Act of 1940, whence did it arise? I’ve looked through those old Investment Companies manuals published by Arthur Weisenberger & Company all the way back to the 1945 edition, and it is not until that 1949 edition, a quarter-century after the industry began, that I find the first mention of mutual funds. But while the derivation of the term remains a mystery, the paradoxical fact is that it first appears only a short time before the industry began to abandon its early mutual values. History confirms that from the inception of the first U.S. mutual fund in 1924 until the late 1940s, the predominant focus of mutual fund management was on portfolio selection and investment advice, rather than on distribution and marketing. In fact, the managers who founded not only Massachusetts Investors Trust, but State Street Investment Corporation and Incorporated Investors, the original “Big Three” of the fund industry, put themselves forth as “the twentieth-century embodiment of the old Boston trustee.”6 During the industry’s early years, sales of fund shares were often the responsibility of separate underwriting firms financed by distribution revenues from sales loads, and predominately unaffiliated with fund managers.

affairs . . . This structure has been the accepted norm for the mutual fund industry for more than fifty years.” On June 11, 1974, perhaps unsurprisingly, the board rejected my proposal to have the funds acquire the manager, and chose a different option, the least disruptive of the seven options that I had offered. We established the funds’ own administrative staff under the direction of its operating officers, with my continuing as their chairman and president. We would also be responsible, as the board’s counsel, former SEC Commissioner Richard B. Smith wrote, “for monitoring and evaluating the external (investment advisory and distribution) services provided” by Wellington Management. The decision, the counselor added, “was not envisaged as a ‘first step’ to internalize additional functions, but as a structure that . . . can be expected to be continued into the future.” Since the Board agreed that Wellington Management Company would retain its name (and Wellington Fund would also retain its name), a new name would have to be found for the administrative company. I proposed to name the new company “Vanguard” and the Board approved, albeit somewhat reluctantly. The Vanguard Group, Inc. was incorporated on September 24, 1974. Without apparent difficulty, the SEC soon cleared the funds’ proxy statements proposing the change, which the fund shareholders promptly approved. Vanguard began operations on May 1, 1975.

No sooner than the ink was dry on the various agreements, the situation began to change. The creation of Vanguard, as I’ve written, “ . . . was a victory of sorts, but, I feared, a Pyrrhic victory . . . and the narrow mandate that precluded our engaging in portfolio management and distribution services would give Vanguard insufficient power to control its destiny. Why? Because success in the fund field was not then, and is not now, driven by how well the funds are administered. Though their affairs must be supervised and controlled with dedication, skill, and precision, success (will be) determined by what kinds of funds are created, by how they are managed, by whether superior investment returns are attained, and by how—and how effectively—the funds are marketed and distributed.” We first determined to start a new fund that we would manage internally. Paradoxically (if not disingenuously), it would be a fund that arguably didn’t conflict with our limited mandate, for, technically speaking, it wasn’t managed. It was the world’s first index mutual fund, modeled on the Standard & Poor’s 500 Stock Index. Incorporated late in 1975, its initial public offering was completed in August 1976. While the offering raised a puny $11 million, despite that unhappy start, Vanguard 500 Index Fund is now among the largest mutual funds in the world.

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.

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.

“Fund independent directors . . . have been absolutely pathetic. They follow a zombie-like process that makes a mockery of stewardship. ‘Independent’ directors, over more than six decades, have failed miserably.” Then, hear this from another investor, one who has not only produced one of the most impressive investment records of the modern era but who has an impeccable reputation for his character and intellectual integrity, David F. Swensen, Chief Investment Officer of Yale University: “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 35 It is a curious fact that the operational function was ignored in the 1940 Act. It refers solely to the other two functions of fund management, investment advice and share distribution (underwriting). 36 Toward Common Sense and Common Ground, Journal of Corporation Law (Iowa), Volume 33, Number 1, Fall 2007, Page 1.

Marketing Mutual Fund Shares in the 1980’s Remarks by John C. Bogle, President The Vanguard Group of Investment Companies At a Meeting of The National Investment Company Service Association March 10, 1977 While I am pleased to be with you this afternoon, I must confess to being somewhat apprehensive as well. For I recognize that the steps we at Vanguard have just taken to almost totally restructure our distribution system—to prepare for the 1980’s, if you will—are hardly the stuff of which popularity contests are made, to say nothing of “won.” Further, I am hesitant—for reasons of propriety, caution, and competition (and not necessarily in that order)—to take you through the precise reasons why we have done what we did. But I would emphasize that we have taken two distinctive steps: 1) As of three weeks ago, to convert all of our continuously-offered funds to no-load status. 2) Effective (hopefully) May 1, to “internalize” all distribution activities under the aegis of the Funds themselves, rather than our external adviser, Wellington Management Company; and at the same time to reduce our aggregate investment advisory fees from about $7 million to $5 million per year. It may surprise you to know that, while the first of these two steps is what has received all the attention so far, it is not all clear to me which of the two steps—if either—will have the most significant implications for the industry in the years ahead.

I had come to discuss what was Vanguard’s then shocking pair of decisions to change our marketing strategy and structure: 1. To convert our Funds to no-load status by eliminating all sales charges, thus abandoning the dealer distribution system within which we had worked in partnership for nearly 50 years. 2. To “internalize” our new distribution system, having our Funds directly assume the responsibility for—and the cost of—all marketing activities, reducing our advisory fees more than commensurately, and thus reducing the total expenses borne by the Funds. The first decision was radical; the second, unique. Without precedent to guide us, we were entering a Brave New World. Doing so might seem obvious in retrospect, but it surely was frightening then. But beneath the fear was an underlying confidence far beyond what the facts would have justified. We assumed that the redemptions we might face from disgruntled dealers would not reach avalanche proportions. We also hypothesized that we could not lose much sales volume, for investor purchases of our shares were running at the puny monthly rate of $5 million. As it turned out, ten years later, in January 1987, investor purchases were $1.163 billion, a 200-fold increase. So, our no-load decision, it seems fair to say, has worked out well. We expected to complete the internalization of our distribution activities, as I said to you at that time, “effective (hopefully) May 1, 1977.” We were wrong.finally

By so doing, we would be in a position to be the “low- cost provider” in an industry where, as we saw it then—and see it now—cost was, well, everything, the ultimate competitive weapon. Following approval by the SEC and our fund shareholders, we began operations on May 1, 1975. But we were hardly unaware that if our new firm was to shape its own destiny we had to quickly move to control our investment services and distribution services as well. We immediately began that process. Within six months, we had gained our Board’s approval for the world’s first index mutual fund and entered the investment arena. Now known as Vanguard Index 500, its IPO took place on August 30, 1976. The new index fund (“Bogle’s folly”) began with a frustratingly tiny asset base of only $11 1 I also spoke to you in 1999, when I was honored to receive your Robert L. Gould Award for commitment to excellence in shareholder service. All five of my speeches are posted on my Bogle eBlog (note the anagram!), www.johncbogle.com. Note: The opinions expressed in these remarks do not necessarily represent the views of Vanguard’s present management.

I am also hesitant—for reasons of propriety, caution, and competition (and again, not necessarily in that order!)—to lay out our future marketing strategy in great detail. But I can convey to you my profound conviction that what we have done (the no-load decision and the decision to internalize distribution) is apt to prove less significant in determining our future marketing success—or failure—than how we respond to truly awesome business challenge that lies before us.

million. But, in principle, if not in materiality, it was our second giant step forward, for it enabled us to assume responsibility for supervising fund investments for the first time. Within months after the IPO, we took the third necessary step to complete our control over the triangle of mutual fund services—first, administrative services; next, investment services; and finally, marketing services. Our strategy, as I described it in that 1977 speech to NICSA, was to convert our distribution system—overnight and without advance notice—from the commission-based, broker-dealer- sold, demand-push system that we had relied on for a full half-century (and that then permeated the industry) to a new no-load, investor-purchased, supply-pull system. When we took this impulsive but monumental step, there was no evidence—none—that it would work. In fact, mutual fund assets had tumbled from $60 billion to $36 billion during the 1972-1974 bear market—yes, you heard those numbers right!—a 40 percent erosion in our asset base, and the industry was in the midst of a wave of net liquidations that would last for 9 of the next 11 years. That was no fun. And, by the way, yes, it could happen again. “The Times They Were a ‘Changin’” In the midst of that bear market, our vision was simple: “the times they were a’changin’.” When Vanguard began, this was an equity fund business (80 percent of assets in 1975).

When we add up all those hedge fund fees, all those mutual fund management fees and operating expenses; all those commissions to brokerage firms and fees to financial advisors; investment banking and legal fees for all those mergers and IPOs; and the enormous marketing and advertising expenses entailed in the distribution of financial products, we’re talking about some $500 billion dollars per year. That sum, extracted from whatever returns the stock and bond markets are generous enough to deliver to investors, is surely enough, if you will, to seriously undermine the odds in favor of success for our citizens who are accumulating savings for retirement. Yet the fact is that the finance sector has become by far our nation’s largest generator of corporate profits, larger even than the combined profits of our huge energy and health care sectors, and almost three times as much as either manufacturing or information technology.1 Twenty–five years ago, financials accounted for only about 6 percent of the earnings of the 500 giant corporations that compose the Standard & Poor’s 500 Stock Index. Ten years ago, the financial sector share had risen to 20 percent. And last year, the financial sector profits had soared to an all-time high of 27 percent. If we add the earnings of the financial affiliates of our giant manufacturers (think General Electric Capital, for example, or the auto financing arms of 1 For the record, the 2006 operating earnings of the S&P 500 totaled $787 billion.

We have also experienced half a dozen major regulatory policy pronouncements (the SEC Institutional Investor Study; the NASD Sales Charge rule and “Anti-Reciprocal” rule; the SEC Statement on the Future Structure of Securities Markets; the SEC Distribution Policy statement; the change to negotiated brokerage commission rates). Indeed, one can only add, as did the King in “The King and I,” “etcetera, etcetera, etcetera.” During this troubled decade, we have also had a lot of redemptions and not nearly as many sales; and an industry that has changed from almost exclusively a purveyor of equity securities to an industry of diversified investment products. Witness the fact that bond funds (including corporate bond funds, bond-oriented income funds, and the new municipal bond funds) have risen from only 5% of industry sales in 1966 to 55% in the past three months—an 11-fold increase. If money market funds are included, of course, the income fund shares of industry sales would be far higher. We’ve also been in an industry where—for whatever reason, and there are many—the distribution system has undergone some considerable metamorphosis. Sales by broker-dealers, the backbone of the industry (traditionally accounting for 70%-75% of all fund sales), were down to a 57% share for all of 1977, and have been running about 35%--well under half, for the first time in memory, if not in history—in the past three months.sales

But money market funds and bond funds were on the rise, and by 1981 they would constitute an amazing 83 percent of assets. (Believe it or not!) It was obvious that in these two income-driven industry segments, as well as in index funds, the impact of our low-cost advantage was even more certain—and certainly far more obvious—than in the equity fund arena. So our strategy would focus largely on these three cost-sensitive investment segments. And so it was to be. Today, index funds, money market funds, and bond funds account for nearly $800 billion of our trillion-dollar-plus asset base. We also knew that the demographics were on our side. As I noted in that 1977 speech to NICSA, “America will continue to have a population that is growing in age, education, professional status, real income, and asset accumulation,” trends that, I expected, would favor “low cost (no-load) funds that would appeal to self-motivated investors who would acquire information on their own.” If all of this seems obvious today, please remember that decades ago, one of my detractors said that all I had going for me was “an uncanny ability to recognize the obvious.” It surely worked here! We expected to complete the internalization of our distribution activities, as I told you then, “effective (hopefully) May 1, 1977.” Alas, our hope was not rewarded. Our plan was rejected by the staff of the Securities and Exchange Commission.

I suggested that while traditional no-load funds—with distribution efforts limited to a reasonable amount of advertising and a modest institutional sales program—would continue to grow, we would see the development of “quasi-no-load funds” with active retail sales forces, “following SEC approval of an ‘asset charge’ for distribution.” Such charges—now officially known as “12b-1” charges—have become part of the very fabric of our industry, though in dimensions and for purposes that I surely never imagined. (Because Vanguard’s distribution application with the SEC involved our Funds—not our adviser—assuming distribution costs, I have been called “the father of 12b-1.” We do not, nor will we, have a 12b-1 plan, but the designation seems to stick. I can empathize with the misgivings that Dr. Frankenstein must have had about his monster.) I also was close to the mark on product design—perhaps “A-“—anticipating both substantial innovation and an expansion of fund offerings to include fixed income funds, not only corporate bond funds, but also municipal bond funds offering a variety of maturities. Alas, Vanguard did not realize much competitive advantage from the three-tiered municipal bond fund we pioneered (Short, Intermediate, and Long Term Portfolios, rather than a single “managed” portfolio), and I failed to conceive of the “single state” municipals. Bond funds accounted for an incredible 75% of industry net cash flow last year.

So now let us jump to the 1980’s, and speculate on what mutual fund marketing might look like in three specific areas: (1) pricing structure, (2) product line, and (3) principal markets. As to pricing—and this may surprise you—I foresee far less of a pure dichotomy than there is today between “load” funds and “no-load” funds. To the contrary, there will probably be any number of “variations on a theme.” The focus will move away from today’s simple distinction: a maximum sales charge of 7 ½ % to 8 ½ %, or none; take your choice. Rather, there will be an evaluation of total price—or total cost effectiveness over time—including any initial sales charges, annual fund operating and advisory expenses, and perhaps specific account maintenance and service charges. Thus, there may be these four kinds of broad groupings: 1) Traditional no-load funds—without sales charges, and having relatively moderate expense ratios, with distribution efforts limited to a reasonable amount of advertising and perhaps a modest direct institutional sales program.

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.

2) No load with external cost add-ons—just like No. 1, except that an independent distribution force exists, and is compensated by advisory fees (an analogy might be the “timing services” that are operating today) or “per ticket” service charges. 3) “Quasi-no-load funds” with active retail sales forces. I emphasize the “quasi,” for while the sales charge is eliminated as such, expense ratios rise significantly, to encompass direct charges against fund assets sufficient to provide adequate commission compensation to salesmen—whether they are “captive” (as in the IDS proposal to the SEC) or broker-dealer. 4) “Sales charge funds”—as we have today, where the sales commission is paid in front, and fund expenses are in the moderate range. The elementary simplicity and, for that matter, fairness of this system is undeniable. The full development of this multi-faceted structure will presumable require SEC approval of an “asset charge” for distribution—but that will come by 1980, just as Section 22(d) (requiring a fund to maintain a uniform offering price) will probably go by then. But, total cost over time—the aggregate accumulation of any initial sales charge plus the sum of annual Fund operating expenses over the years—will become a key factor in marketing, depending in part of what products are being distributed in the 1980’s, and in part to whom they are being marketed.

1,000 A Fibonacci Sequence 1b. A Fibonacci Sequence 1a. ancestors called “the Golden Mean,” appearing all through civilization, notably in nature, in architecture, and, more mundanely, in the size of book covers and playing cards. Mandelbrot applies this concept to the daily price movements of the Dow Jones Industrial Average. Nearly always (since 1915), the standard deviation (Sigma) of the daily change in the Dow has been about 0.89 percent. (Chart 2) That is, two-thirds of the fluctuations were within 0.89 percentage points (plus or minus) of the average daily change of 0.74 percent. Nonetheless there are frequent occasions with standard deviations of 3 or 4, infrequent occasions when it exceeds 10, and just one 20- Sigma event. (The odds against such a happening are about 10 to the 50 th power.) Black Monday, of course, was that 20 and Black Thursday was that 10-Sigma event. (The possible 100-point decline that I contemplated back in 1986 would have been a 6-Sigma event.) While our markets are periodically defined by fractals and power laws (although we never know when), there are many areas in which they do not apply. The classic example is in the height of men, or the extremes of temperature, or the flipping of coins. (Chart 3) These patterns lend themselves to Gaussian (standard-frequency) distribution curves, familiarly known as bell curves.

2 3 4 5 6 7 8 9 10 11 12 Number of occurrences Expected Distribution of 1000 Rolls of Two Dice 3. -30% or more -20% to -30% -10% to -20% 0 to - 10% 0 to 10% 10% to 20% 20% to 30% 30% to 40% 40% to 50% over 50% Distribution of the S&P 500’s Annual Returns, 1926 - 2006 Number of occurrences 4. But other areas surprise. One classic fractal is the average wealth of our citizens. That figure follows a fairly neat distribution pattern, but only until we get to the very high figures. Bring a hedge fund manager with annual earnings of $200 million into a room with 100 persons earning an average of $50,000, and the average jumps to more than $2 million. So as long as we look at past patterns of market repetition on a sort of Gaussian “bell curve,” so long as we rely on Monte Carlo simulations in which past stock returns are thrown into a giant mixer that produces a million or more permutations and combinations, looking at probabilities in the stock market seems a fool’s errand. Thus, we deceive ourselves when we believe that past stock market return patterns provide the bounds by which we can predict the future.4 (Chart 4) When we do so, we ignore the potential for future Black Swans. The stock market has experienced relatively few of these extreme changes. And they are overwhelmed by the frequent—but usually humdrum—fluctuations that take place each day within 4 The average annual return on stocks during this period was 10.4 percent.

To sum up, there will be a broad range of different markets and sub-markets out t here during the 1980’s. I reemphasize that, in my perception, these markets will continue to exist for the traditional dealer-distributed funds; they will continue to exist for no-load funds. And I hope you will agree with me that the distinction between the two groups is a marketing issue, and not a moral issue. What is important for each fund group is to make sure that its marketing strategy— whichever it selects—is an integrated one. That is, it should embody an internally consistent pricing policy, product line, and target markets—implemented in such a way that they reinforce one another, rather than fragment the overall marketing approach. By now, I hope the broad outlines of our Vanguard strategy are clear; it involves:  a direct appeal to “consumerism” and the differentiated individual market that exists f or no-load funds;  a direct attack on the institutional market, competing both on a cost and performance basis.  an on-going program to reduce our costs of operation and keep them down, both through expense reductions and new pricing methods.  policy and operating control by the Funds themselves, acting in their own interest, of all administrative, shareholder service and distribution activities.  working with our own adviser, at arm’s length and with complete independence, hopefully enhancing the long-term investment performance results of our Funds.

indeed—given the pressures on sales charges and dealer discounts, and the end of reciprocal brokerage. This distribution system is still a perfectly good one, but our judgment was that it is simply too much to expect it to generate, for perhaps 25 major fund groups, enough sales volume to at least offset liquidations—and that, of course, is the name of the game. Further, any business, especially a business in as troubled an environment as this one has been, has an obligation to make the very best judgments it can to survive and to grow; to say nothing of its obligation to provide efficient, economical and productive services, and good investment performance for existing shareholders. As we move into the 1980’s, time will surely tell whether our very risky judgment was right or wrong. And time will also tell whether we were correct when, by doing what we have done, we ignored that familiar advice from Lord Keynes: “Worldly wisdom teaches that it is better for reputations To fail conventionally, than to succeed unconventionally.”

(2) We formed the world’s first index fund, a passive portfolio designed simply to provide the returns provided by the stock market, a challenge that precious few portfolio managers have measured up to over time. (3) We developed a new paradigm for bond fund management, using innovative three- tier structure of short-term, long-term, and intermediate-term portfolios that quickly became the industry standard. (4) We abandoned, overnight, a proven broker-dealer, commission-oriented “supply” push distribution system in favor of a new and untried no-sales-charge, demand-pull system for self-motivated investors. None of these changes that we all take for granted today came easily. To accomplish them required a devil-may-care attitude, a blasé disregard for risk, a profound conviction, without hard evidence, that they would work, and the sheer energy required to get it all done. What’s more, they were, well, “contentious.” Despite what we regarded as our noble intentions, the completion of our structure was initially opposed by our industry’s regulatory agency. The Securities and Exchange Commission rejected our structure, and dawdled over our appeal for four long years. When it finally gave us its unanimous approval, it came with a nice bonus and a snappy salute: “The Vanguard plan actually furthers the (1940) Act’s objectives, and promotes a healthy and viable complex in which each fund can better prosper.”

 Inured as I have become to these outrageous claims, even I did a “double take” at a recent headline reading: “Follow These 5 Simple Rules and You Too Could Make $667,000,000.” Well, it proved not to be a mutual fund ad, but who can predict tomorrow? You would also see claims of income yields that are unbelievable—largely because they are untrue. Just a week ago I received a card in the mail offering me a “high return” of 11.90 percent from a portfolio offering “the safety of U.S. government securities.” Now, I know that Treasury bonds are presently yielding 7.t percent to 8 percent, and I wondered what could possibly be going on here. The answer, like too many answers in our advertisements, was right there, but in small print. The “current distribution rate” was based on annualizing the past three months’ distributions, which comprised 60 percent interest income and 40 percent short-term gains! Obviously, the fund’s yield has been hyped with premiums earned on the sale of covered call options on its bonds. But unless the fund is run by “a genius in investment management,” it will have its bonds called away when interest rates decline, and hold its bonds when rates rise. It is difficult to fathom how the net asset value can do other than decline over time, as capital is miraculously converted into income, but the advertisements do not tell you that. The fact of the matter is that Gresham’s Law is at work in the mutual fund industry today.

In the Fund Industry, Mutuality and Indexing Rule the Seas A Conversation with John C. Bogle Founder, The Vanguard Group National Rural Utilities Cooperative Finance Corporation Conference on Capital Ideas: Powering into the Future Chantilly, VA November 13, 2012 As the founder of Vanguard way back in 1974, it’s a special honor for me to have this opportunity to discuss our truly mutual structure, and how it is at last beginning to reshape the mutual fund industry. And it seems particularly appropriate, for much like your organization, Vanguard is also a “cooperative.” Our vision, our mission, our principles, and our values are very much like yours. Paraphrasing CFC’s stated mission, “our goal is not to maximize our income, but to offer our shareholders affordable financial products and services, consistent with sound financial management.” So-called mutual funds—they’re not really mutual at all—are quite different; they are largely corporate shells, diversified portfolios of stocks and bonds with no employees of their own. Their few corporate officers usually hold the same posts with the funds’ management company, which organizes the funds, operates them, and provides, in return for a substantial fee, essentially all of the services necessary for the funds’ existence. These services include administration; portfolio strategy and investment selection; and distribution of fund shares to the public. The fund is, from birth, a captive of its management company/adviser.

record financial wealth was in fact “phantom wealth”—borne not of the cumulative earnings and dividends generated by American business, but of extraordinarily high—indeed, speculative— valuations that were accorded by the marketplace to those fundamental investment returns.1 Whatever the case, sooner or later, valuations will reflect reasonable expectations for dividend yields and earnings growth, and the wealth created by business will determine the future level of stock prices. Put another way, let’s not forget Benjamin Graham’s observation that while in the short run the market is a voting machine, in the long run it is a weighing machine. Put yet another way, “the fundamental things apply as time goes by.” Now a caveat: Corporations generate earnings for the owners of their stocks, pay dividends, and reinvest what’s left in the business. In the aggregate, over the past century, the nominal returns generated by our businesses have grown at an annual rate of about 9 ½ percent per year, including about 4 ½ percent from dividend yields and 5 percent from earnings growth. But these are the gross returns generated by the corporations that dominate our system of competitive capitalism. Investors who hold stocks, either directly or through the collective investment programs provided by mutual funds and defined benefit pension plans, receive their returns only after the cost of acquiring them and then trading them back and forth among one another.

cost,” basis; and to operate with complete independence from their investment adviser. How would that work in practice? After an examination that lasted from 1977 until 1981, here’s how the SEC expected it to work, as described in its decision on the Vanguard plan: The Vanguard plan is consistent with the provisions, policies, and purposes of the Act. It actually furthers the Act’s objectives by ensuring that the Funds’ directors, with more specific information at their disposal concerning the cost and performance of the Funds, are better able to evaluate the quality of those services. The plan will foster improved disclosure to shareholders, enabling them to make a more informed judgment as to the Funds’ operations. In addition, the plan clearly enhances the Funds’ independence, permitting them to change investment advisers more readily as conditions may dictate. The plan also benefits each fund within a reasonable range of fairness. Specifically, the Vanguard plan . . . enables the Funds to realize substantial savings from advisory fee reductions; promotes savings from economies of scale; provides the Funds with direct and conflict-free control over distribution functions; (and) promotes a healthy and viable mutual fund complex within which each fund can better prosper. The approval of Vanguard’s structure by the five commissioners of the SEC was unanimous.

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?

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.

the net returns that investors actually earn—and too powerful, too meaningful, and far too important to ignore. 2. Focusing on providing market returns and assuming market risks (but no more) is the obvious strategy for the low-cost provider—simplicity, and delivering to clients their fair share of what ever gains, or losses, the markets deliver. (The correlations of our funds average about 96 with their best-fit targets—call it “commoditization” if you will—compared with about 87 for our peers.) Our passive funds—index funds and virtual index funds, including nearly all of our bond funds—account for about 85 percent of our asset base. 3. It’s only a matter of time until investors recognize the bite that expenses take out of fund dividend yields, especially in today’s low-yielding markets. The 2.0 percent gross yield of the average equity fund, reduced by an expense ratio that averages 1.3 percent, slashes the yield to a pathetic 0.7 percent. How long will intelligent investors allow two-thirds of their dividends to be eaten up by expenses? 4. The no-load (direct distribution) segment of the industry has yet to fully realize its marketing potential. Amazingly, load funds currently represent fully 62 percent of industry sales volume, even higher (this surprised me!) than it was way back in 1996 (57 percent). Will investors continue to invest in bond funds in which the load consumes the first two years of income? I doubt it.

For long-term investors as a group, owning businesses is a winner’s game. After all, businesses earn a return on their capital, and they pay dividends, and they grow with our economy. Trading stocks with other investors, on the other hand, is inevitably, a zero-sum game—Peter’s gain is Paul’s loss. But only before costs. After the huge costs paid to the croupiers of Wall Street day after day—hundreds of billions of dollars each year—on all that frenetic activity that we read about as billions of shares of stock change hands day after day, that zero-sum game of beating the market is converted—magically, but mathematically—into a loser’s game. The minute by minute fluctuations of the market, using Shakespeare’s metaphor, are truth told “a tale told by an idiot, full of sound and fury, signifying nothing.” (You’ll know that’s Macbeth, Act V.) Even as the media covers this sound and fury if it were of surpassing importance, financial journalists ignore the fact that essentially 100 percent of the long-term return on stocks is based on the profitability of our corporate businesses. Short-term speculation does little to enhance or diminish that return. (The stock market’s long-term nominal annual return of about 9 ½ percent, for example, was produced almost entirely by dividend yields averaging 4 ½ percent and annual earnings growth averaging 5 percent.)

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.

The mutual fund “time zone trading” scandals that came to light in 2003, in which some 23 companies—including many of the largest firms in the field—were implicated. 3. “Pay-to-play” distribution agreements using fund brokerage commissions (“soft dollars”) to finance share distribution that benefits the adviser. 4. 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 with fund shareholders. 5. Rising expense ratios for established funds; the average ratio of the seven largest funds of 1960 rose from 0.48 percent to 1.02 percent in 2003, an increase of 144 percent. 6. Managing assets for giant pension funds for fees that are dwarfed by those that they charge the mutual funds that they control. Three of the largest advisers, for example, ** Securities and Exchange Commission decision, March 15, 1981. ***2002 data: page 199, The Battle for the Soul of Capitalism, by John C. Bogle, Yale University Press, 2005.

61 percent to their funds, resulting in annual fees of just $600,000 for the pension fund and $56 million for the comparable mutual fund (and presumably holding the same stocks in both portfolios). 7. Diluting the value of fund shares held by long-term investors, by allowing hedge fund managers to engage in “time zone” trading. This vast near-industry-wide scandal came to light in 2003. It involved some 23 fund managers, including many of the largest firms in the field—in effect, a conspiracy between mutual fund managers and hedge fund managers to defraud regular fund shareholders. 8. “Pay-to-play” distribution agreements with brokers, in which fund advisers use fund brokerage commissions (“soft dollars”) to finance share distribution that benefits primarily the adviser. 9. 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.

When we add up all those hedge fund fees, all those mutual fund management fees and operating expenses; all those commissions to brokerage firms and fees to financial advisors; investment banking and legal fees for all those mergers and IPOs; and the enormous marketing and advertising expenses entailed in the distribution of financial products, we’re talking about some $580 billion dollars per year. That sum, extracted from whatever returns the stock and bond markets are generous enough to deliver to investors, seriously undermines the odds in favor of success for our citizens who are accumulating savings for retirement. Yet the fact is that the finance sector has become by far our nation’s largest generator of corporate profits, larger even than the combined profits of our huge energy and health care sectors, and almost three times as much as either manufacturing or information technology.4 Twenty–five years ago, financials accounted for only about 6 percent of the earnings of the 500 giant corporations that compose the Standard & Poor’s 500 Stock Index. Ten years ago, the financial sector share had risen to 20 percent. And last year, the financial sector profits had soared to an all-time high of 27 percent. If we add the earnings of the financial affiliates of our 4 For the record, the 2006 operating earnings of the S&P 500 totaled $787 billion.

Companies, owned by the funds, employing their own officers and staff, and operated on an “at- cost” basis, a truly mutual mutual fund firm. 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. Early in 1977, we abandoned the supply-driven broker-dealer distribution system that had been operated by Wellington since 1928, in favor of a buyer-driven “no-load” approach under our own direction. Later that year, we created the first-ever series of defined-maturity bond funds, segmented into short-, intermediate-, and long-term maturities all focused on high investment quality. Then, in 1981, Vanguard assumed responsibility for providing the investment advisory services to our new fixed-income funds as well as our established money market funds. (As you can imagine, none of these moves was without controversy!) Let me give you some sense of the importance of those changes. Since our formation in 1974, the assets of the Vanguard funds have grown from $1 billion-plus to some $1 trillion today.

Some 82 percent of that trillion—$820 billion—is represented by the passively-managed index funds, the bond funds, and the money market funds that we at Vanguard manage, distribute, and advise. Some 25 external investment advisers serve our remaining (actively-managed) funds, with Wellington advising by far the largest portion of those assets. (Most of these funds have multiple advisers, the better to spread the risk of underperformance relative to their peers.) More than parenthetically, that long string of business decisions was made in a situation in which Vanguard’s very existence was in doubt. For the Securities and Exchange Commission had initially refused to approve Vanguard’s assumption of marketing and distribution responsibilities. But after a struggle lasting six (interminable!) years, the SEC reversed itself in February 1981. By unanimous vote, the Commission declared that: The Vanguard plan is consistent with the provisions, policies, and purposes of the (Investment Company Act of 1940). It actually furthers the Act’s objectives . . . enhances the funds’ independence . . . benefits each fund within a reasonable range of fairness . . .

Early in 1977, we abandoned the supply-driven, commission-based, broker-dealer distribution system that had been operated by Wellington since 1928, in favor of a buyer-driven, “no-load” approach under our own direction. Later that year, we created the first-ever series of defined-maturity bond funds, segmented into short-, intermediate-, and long-term maturities, focused on high investment quality. Then, in 1981, Vanguard assumed responsibility for providing the investment advisory services to our new fixed-income funds as well as our established money market funds. (As you can imagine, none of these moves was without controversy!) Let me give you some sense of the importance of those changes. Since our formation, the assets of the Vanguard funds have grown from $1 billion-plus to some $1 trillion today. Some 82 percent of that trillion—$820 billion—is represented by our passively-managed index funds, bond funds, and money market funds that we at Vanguard manage, distribute, and advise.Wellington

advising by far the largest portion of those assets. (Most of these funds have multiple advisers, the better to mitigate the risk of underperformance relative to their peers.) More than parenthetically, that long string of business decisions was made during a long period in which Vanguard’s very existence was in doubt. For the Securities and Exchange Commission had initially refused to approve Vanguard’s assumption of marketing and distribution responsibilities. Only after a struggle lasting six (interminable!) years did the SEC reverse itself. In February 1981, by unanimous vote, the Commission declared that: The Vanguard plan is consistent with the provisions, policies, and purposes of the (Investment Company Act of 1940). It actually furthers the Act’s objectives . . . enhances the funds’ independence . . . benefits each fund within a reasonable range of fairness . . . . . . (provides) substantial savings from advisory fee reductions (and) economies of scale . . . and promotes a healthy and viable mutual fund complex in which each fund can better prosper. A Prescient SEC? Indeed! The SEC’s words now seem prescient. In fact, “can best (rather than better) prosper” would have been more accurate. Measured by Morningstar’s peer-based rating system— comparing each fund with other funds having distinctly comparable policies and objectives— Vanguard ranked first in performance among the 40 largest fund complexes.

capital proxies, etc. My advice: look before you leap, and don’t leap until the fund has a ten-year track record. And above all, remember (courtesy of Warren Buffett), “What the wise man does in the beginning, the fool does in the end.” Commodity Funds. First principles: the prices of stocks and bonds are ultimately supported by their internal rate of return—respectively, dividends and earnings growth, and interest coupons. That is why stocks and bonds are considered investments. Commodities have no internal rate of return; their prices are based entirely on supply and demand. That is why they are considered speculations. I freely concede that the huge rise in the prices of most commodities in recent years doesn’t guarantee that speculation on future price increases will not be rewarded. But that may well be the odds-on bet. Managed Payout Funds. The fund industry apparently only recently discovered that growing millions of investors are moving from the accumulation phase of investing to the distribution phase. (Although, that demographic handwriting has been on the wall for decades). So we have new funds that, in effect, guarantee the exhaustion of your assets in whatever time period you choose (something that has always been all too easy to accomplish!) We also have funds designed to distribute 3 percent, 5 percent, or 7 percent of your assets without necessarily invading principal. Only time will tell if that will happen.