John Bogle on Long-Term Ownership

Looking At Investing From A New Perspective, A Half Century Old John C. Bogle, Founder and former chief executive The Vanguard Group ∞ ∞ ∞ Before The CFA Society of Los Angeles Los Angeles, CA February 26, 2007 I’m honored to be here with you investment professionals today, especially in this lovely city on this beautiful day. When your Board members learned that I would be in Malibu to give a lecture at Pepperdine on “Artistic Entrepreneurship and Technology,” they kindly invited me to meet with you during my visit. I was delighted to accept, and I appreciate your coming to this luncheon on such short notice. It’s ironic that at my lecture tomorrow my remarks will revolve around the theme of my previous book, The Battle for the Soul of Capitalism, published by Yale University Press in October 2005. In Battle I discuss, among other things, the failure of our new “agency society” that has developed over the past five decades, supplanting our old “ownership society,” now long gone and never to return. Today, financial institutions hold 68 percent of the shares of the stocks of all U.S. corporations, a dramatic change from 1950, when only 8 percent of shares were held by institutions and 92 percent were owned directly by individual investors.

as far as I can recall, was to move on with my life, to do the best I could, and to earn a good living. But in an extraordinary stroke of luck, I had written my undergraduate thesis on the then “tiny but contentious” mutual fund industry. Through the thesis, Walter L. Morgan, the founder of one of the industry’s finest firms, gave me my first break, hiring me and then becoming my mentor. That was a half-century ago, but as I re-read my thesis preparatory to its publication in my forthcoming book I realized that even then I had a powerful sense of idealism that even a half-century of experience has been unable to diminish. Indeed, I have little doubt that my idealism today is stronger than it’s ever been. Even back in 1951, I urged that mutual funds serve—“serve the needs of both individual and institutional investors,” and serve them “in the most efficient, honest, and economical way possible . . . with a reduction in sales loads and management fees . . . minimizing investor misconceptions . . . and claiming no superiority over the stock market averages.” As it has turned out, in those broad brushstrokes lay the core idea of the firm I would found in 1974: The soundest way to participate in the long-term growth of our nation is simply to own the stocks of all of the businesses in America, to own them at rock- bottom agency costs, and to hold them forever. (We apply that same concept to all segments of the financial markets.)

A decade later, at the beginning of 1982, the little guy had grown a bit (to $125 billion), but not much faster than his big NYSE brother ($1.1 trillion), and equaled 11% of the value of all listed stocks. And even a decade after that, the NASDAQ’s $500 billion market capitalization in 1991 still represented but 13% of the NYSE’s by-then-$3.7 trillion. And even seven years after that, the NASDAQ value ratio had risen to a still modest 18% of the NYSE—$1.7 trillion vs. $9.4 trillion as 1998 began. But the staggering $10 trillion combined increase in the value of the indexes since 1981—from $1.2 trillion to $11.1 trillion—makes an obvious point: U.S. investors were in the midst of one of the greatest bull markets of all time. Surely, we had never had it so good. And then, in this Tale of Two Markets, a great chasm opened between the NASDAQ and the NYSE. In 1998, NASDAQ Index +41%; NYSE Index +19%.1 In 1999, +87% vs. +11%. And in 2000, through March 10, the NASDAQ rose another 24%, while the NYSE Index actually declined, by 7%. With the NYSE up but 21% in the face of the 230% leap in the NASDAQ, the market capitalization of NASDAQ had leaped to $6.8 trillion, fully 60% of the $11.3 trillion market cap of the NYSE, compared to 25%, plus or minus, during the prior two decades.

diversification, and focus on the long term—to say nothing of being skeptical of stock-picking and market-forecasting wizards—would be an understatement. (Indeed, it’s pretty much what I wrote in my Princeton senior thesis in 1951.) What’s more, an entire chapter of my latest book2 is devoted to showing that, given the radical change in our investment environment during the past three decades, Ben Graham would have gone even further, and endorsed the stock market index fund as the core strategy for the vast majority of investors. (Warren Buffett, who worked closely with Ben Graham, not only personally assured me of Graham’s endorsement, but put it in writing in his endorsement of my new Little Book.) The fact is that, even when I entered the mutual fund industry 56 long years ago—hired by fund pioneer Walter Morgan, whose Wellington Fund was, and remains today, the paradigm of these sound principles—this industry invested pretty much in the way Graham prescribed. The portfolios of the major equity funds consisted largely of a diversified list of blue-chip stocks; and managers invested for the long-term, eschewed speculative operations, managed their funds at costs that were (by today’s standards) tiny, and delivered market-like returns to their investors. (As the record clearly shows, those fund managers were hardly “wizards in picking winners.”) What a difference a half-century makes! How different?

1. Faith in the Financial Markets I’m confident that few, if any, of you in this sophisticated audience have any doubt that we have moved into a new era for the financial markets. I expect that it will be an era in which the returns of stocks and bonds alike will be substantially lower than the unprecedented double-digit returns we’ve experienced in the past, indeed—unless you’ve put in more than two decades in this wonderful business—the very past that comprises your entire first-hand experience in the markets. And you need three decades to have known first-hand what the 50% market crash in 1973-74 was like. (This one’s now at 40%). Suffice it to say that it was almost exactly twenty-years ago—on August 18, 1982, in the aftermath of a nine-year bear market—that interest rates turned downward and stock prices leaped upward. The T-bill rate, 11% when August began, promptly tumbled to 8%. The Standard & Poor’s 500 Stock Composite Index leaped from 103 to 113 during that single week, and to 120 by month’s end, in the blink of an eye, a gain of 17%. We were on the way. In the great boom, which culminated with a great bubble in March 2000, the Index was to rise to 1527. By then, the annual return on stocks had reached a level unprecedented in any comparable period in history—just short of 20% per year. And the bond market, which earned a return of more than 10% annually over this long period, also performed far better than ever before.

How huge? A long-term investor who owns a portfolio of stocks of all of the companies in America, holds them for Warren Buffett’s favorite holding period—forever—and pays no management fee will!—will—end up with a financial stake that is at least double that of all other investors as a group. How to do that? Own an all-stock-market index fund. That now-pervasive idea began with the creation of the Vanguard 500 Index Fund more than 27 years ago. At first it was dubbed “Bogle’s Folly.” But today it is the largest mutual fund in the world. (Memo to young entrepreneurs: never worry about disdain for your ideas!) Energy and Persistence Low-costs and indexing are the simple rocks on which Vanguard was founded, an enterprise built on the majesty of simplicity in an empire of parsimony. So never underrate the power of common sense. Never underrate your ability to recognize the obvious, for, paradoxical as it may seem, the obvious is often the hardest thing to see. And then pursue your vision with energy and with persistence. Why? Because “energy and persistence conquer all things,” as that timeless epigram of Founding Father Benjamin Franklin reminds us. With all of his other talents, this great patriot also qualifies as the first American entrepreneur.

” There was a timely convergence of human and physical capital, supported by a network of modern systems: legal, financial, commercial, educational, governmental, and the like. Result:. Then, two centuries ago, and the modern world was born the world’s standard of living began inexorably to improve. Over the next 200 years, global living standards would rise by about 2 percent per year, increasing our worldly wealth from a mere $700 per capita to $6,000 in real terms, nearly nine times over. (Never underestimate the power of compound interest!) While capitalism has bestowed those economic blessings unevenly, it has bestowed them liberally, as living standards have risen all over the industrialized world. Those blessings are now spreading through the emerging economies of South America and Southeast Asia, including India and China, whose economy will surpass even America’s powerful economic engine within the next two decades.

Booming Markets, but Lagging Alphas How can it be that professionally managed mutual funds have failed to match unmanaged market averages? Simply put, it can be because it must be. Because mutual fund managers as a group are the market, and simply must, over the long run, underperfonn appropriately weighted market indexes by the amount of their costs. And their costs are large-and growing. Fund expense ratios have been rising for decades, and equity fund annual expenses now average more than 1.5% of assets. Fund portfolio turnover rates have also soared, presently running near 90% per year, with a consequent escalation in transaction costs, perhaps-although they are difficult to measure with precision-adding another 0.6% to the "fiscal drag" against an equity market in which frictional costs, in the abstract, do not exist. ("The market" as such has no advisory fees and no turnover.) That's a total expected annual shortfall of 2.1 % per year for fund returns. This shortfall-engendered importantly by costs-doesn't look like much when subtracted from a market providing a 30% annualized return-and, in fairness, probably wouldn't look like much if returns were, God forbid, "only" 20%. But, over time, it consumes fully one-fifth of a 10% return-to say nothing of confiscating four-tenths of a 5% return. Consider "Alpha," that vital measure of a fund's return relative to the stock market, adjusted to reflect the relative risk assumed by the fund.Funds

But in the very long run, there is a profound tendency for the returns of high- performing funds to come down to earth, and, just as inevitably, for the returns of low-performing funds to come “up to earth,” as it were. Indeed, as I shall now show, the distance traveled in the course of these descents and ascents is directly proportional to the earlier distance above or below the market’s return. In short: reversion to the market mean is the dominant factor in long-term mutual fund returns. Let’s begin with an example. I have selected the past two full decades to perform this test: the 1970s (which provided uncharacteristically modest equity returns) and the 1980s (which returned the favor by providing unusually generous returns—a sort of RTM example in a different context, but I’ll come to that later on). In performing this analysis, I’ve used the middle-of-the-road growth-and-income funds and growth mutual funds. These funds include the large, well-known funds, and carry risks at about the same level as the Standard & Poor’s 500 Composite Stock Price Index. (Aggressive growth funds, small cap funds, and international funds, which carry generally different—and higher—risks are excluded.) This graph (Exhibit II) shows how the four quartiles of funds, ranked by performance relative to the Index in the first decade, regressed toward the market mean during the second decade.for

Putting Numbers on Keynes’s Distinction While Keynes made no attempt to quantify the relationship between enterprise and speculation in shaping stock market returns, decades later it occurred to me to do exactly that. By the late 1980s, based my own first-hand experience and my research on the financial markets, I realized that equity returns were a combination of these two essential sources: enterprise and speculation. I defined enterprise as investment return— the initial dividend yield on stocks plus the subsequent annual rate of earnings growth. I defined speculative return as the change in the price investors are willing to pay for each dollar of earnings (essentially, the return that is generated by changes in the valuation that investors place on future corporate earnings).

The perfect plan would be to identify one or more mutual funds that may provide a return significantly greater than that of the stock market. And the lesson of history shows us that some mutual funds have in fact outpaced the market. But that lesson also shows us that the odds against doing so are long. In fact, even among those 145 mutual funds that have in fact survived the past three decades, only 15 have outpaced the stock market as a whole. That is, the fund investor had only about one chance out of ten to surpass the market’s return. By how much? An interesting question. Only eight funds outpaced the market by more than one percentage point per year. Thus, when we eliminate the likely statistical noise involved in a margin of plus or minus one percentage point to the market, the odds of success now drop to just one chance out of 18. And the chances of picking a loser are far higher. A total of 108 funds fell one percentage point or more behind the market, 13 losers for each winner. And fully 37 funds—one of every four—fell short of the market by three percentage points per year, surely a deep disappointment to their owners. Clearly, the odds against implementing a perfect plan by selecting winning funds are long, and the penalties for failure disproportionately large. Why was it so difficult for these mutual funds to merely match the return of the stock market?

enthusiasm again, this time in a different way (!), I plunged into the exciting challenge of building a new enterprise, an enterprise that would stand for something powerful: Stewardship—giving average investors a fair shake at building their own financial independence. And what else could explain that, at the very moment I was searching for an appropriate name for the firm, I came across a book recounting the history of the Napoleonic wars and the Duke of Wellington? I opened it to the very page that described the sweeping victory over the French at the Nile, won by Admiral Nelson aboard (you guessed it!) HMS Vanguard, the name I immediately chose for my new enterprise. And as we began, providence moved yet again: Some words that I’d written in my Princeton thesis nearly a quarter-century earlier happened to come back to me: “Mutual funds can make no claim to superiority over the market indexes,” words that led us to pioneer the index mutual fund—a fund that wins the investment race simply by owning the stock market and holding it forever. That first index fund, the backbone of our firm’s success, is now the largest mutual fund in the world. A Second Chance at Life If that series of unforeseen incidents in my life is not proof enough that commitment is rewarded by providence, I still have one more. Five years ago, at death’s door after fighting against a rare genetic heart disease for 35 years, I became the beneficiary of a heart transplant.

“indexing” as such, and almost everything to do with simply owning U.S. business (or global business) in its entirety, through a capitalization-weighted portfolio of our total stock market, and then holding that portfolio for Warren Buffett’s favorite holding period: “forever”. Simply put, if an investor buys the market portfolio, pays no sales loads, no management fees, tiny operating costs, and no portfolio transaction costs, and holds it forever, that investor will capture virtually 100 percent of the stock market’s annual return. On the other hand, for the average investor buying actively-managed funds (or for that matter, engaging in any strategy that involves heavy trading), usually carrying commissions, substantial management fees, heavy operating and marketing costs, huge costs of portfolio turnover (the average equity fund now turns its portfolio over at an astonishing rate of 100 percent per year!), that investor’s return will fall far short of the market’s return. How far short? Well, those all-in mutual fund costs that I just enumerated presently come to something like 2 ½ percent of assets per year. Since the average mutual fund manager is, well, average—you heard it here!—the return of the average fund has fallen short of the return of the Vanguard 500 Index fund by about 2 ½ percentage points over the past quarter century. And simply because of those costs, the average fund is destined to fall short by a similar amount in the years to come.

Even though I have chosen the mutual fund categories dominated by large cap funds with similar volatility characteristics to those of the Index, the capitalizations of the stocks in their portfolios are inevitably somewhat smaller. Nonetheless, during the two decades—which obviously includes considerable “survivorship bias” in favor of the funds—the comparative differences were not large. During the first decade, the survivors actually outpaced the Index by 16 basis points, a somewhat uncharacteristically favorable outcome, only to fall 152 basis points behind during the second decade, a more normal result.1 1 If we compare the decade 1987-1997 with 1977-1987, the top quartile reversion to the market was a slightly larger 6.9 percentage points, with all 44 funds reverting toward the mean, including 35 that fell below it, an even more imposing outcome. The past decade was one in which the average fund fell 2.2% behind the Index.

Myth #1. Mutual Funds are Long-Term Investments Once, mutual funds were considered investments for a lifetime. The idea was to buy a mutual fund as a complete, diversified investment program and hold it, well, forever—Warren Buffett’s favorite holding period for a stock—much as wealthy families use trust companies and private trustees. But over the years this industry has moved from a focus on sound investment management to the marketing of what have come to be known as “financial products” (I don’t care for the choice of words, but the phrase surely hits the nail on the head!) This trend means, as I recall one firm putting it, “we’re in the ice cream business. We prefer vanilla and chocolate, but if the customers want pistachio-maple-walnut, we’ll give it to them.” This change in strategy does much to explain the creation of the go-go funds of the 1960s, those lamentable “Government-plus” funds and the global short-term income funds of the 1980s (all of which came and now are gone), and of the internet, technology, and so-called focus (20-stock limit) funds of the turn of the century. During the past five years, more than 2000 new equity funds have been formed, most of them designed to capitalize on the public appetite to duplicate in the future the fabulous returns captured in the past by stocks in this so-called New Economy of technology, telecommunications, and science. If history is any guide, few of these funds will be with us a decade hence.

In the early years, pension funds accounted for by far the largest portion of indexed portfolios. But during the 1990s and through 2001, index mutual funds have been the driving force. While the rising market has carried pension fund index assets up eight times, since 1990, from $172 billion to $830 billion, the percentage of pension equity assets invested under index strategies has risen only slightly from 20% in 1990 to 23% today. During the same period, assets of index mutual funds have risen eighty fold, from $5 billion to $400 billion, from 2% of equity mutual fund assets to 12%. Truly, we are witnessing the triumph of indexing. Disquieting Cross-Currents But beneath the surface of this triumph lie disquieting cross-currents. In its original incarnation, indexing was a way to bring the wisdom of investment to those who could grasp the merit of complete diversification, buying essentially all of the stocks in the U.S. market, operating without advisory fees and at rock-bottom operating costs, minimizing turnover costs and extra taxes, and hanging on to each stock for Warren Buffett’s favorite holding period—forever. All that was required was that investors accept the self-evident fact that capturing nearly 100% of the 1% 8% 10% 5% 0.1% 0% 2% 4% 6% 8% 10% 12% 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 Domestic Equity Indexed Assets as a Percentage of U.S.Assets

The Gotrocks Family Even before you think about index funds, however, think about the eerie nature of our financial system. Using my version of a parable from Warren Buffett’s letter in the Berkshire Hathaway 2005 Annual Report (it’s in the Little Book), here’s how investing actually works: Once upon a Time . . . a wealthy family named the Gotrocks, grown over the generations to include thousands of brothers, sisters, aunts, uncles, and cousins, owned 100 percent of every stock in the United States. Each year, they reaped the rewards of investing: all the earnings growth that those thousands of corporations generated and all the dividends that they distributed. Each family member grew wealthier at the same pace, and all was harmonious. Their investment had compounded over the decades, creating enormous wealth, because the Gotrocks family was playing a winner’s game. But after a while, a few fast-talking Helpers arrive on the scene, and they persuade some “smart” Gotrocks cousins that they can earn a larger share than the other “dumb” relatives. These Helpers convince the cousins to sell their shares in overvalued companies to other family members and to buy shares of undervalued companies from them in return. The Helpers handle the transactions, and as brokers, they receive commissions for their services. The ownership is thus rearranged among the family members. To their surprise, however, the family’s share of the generous pie that U.S.

speed of light giant transactions in complex financial instruments that would have been inconceivable in an earlier age, and operating at volume levels undreamed of in an earlier era. For example, shares of U.S. stocks (NASDAQ and NYSE combined) turned over at 135% last year, three and one-half times the 40% rate of two decades earlier. Importantly, without electronic systems and the dispersal of market activity and back-up communications networks that they facilitated, the rapid reopening of our financial markets after the September 11 terrorist attacks would have been impossible. What is more, money managers today have seemingly infinite information at their fingertips. Corporations observe the rules of full disclosure, and a vast community of investment professionals analyze each firm’s financial statements in intimate detail. Soaring transaction volumes, liquidity and information availability—spread among market participants almost simultaneously—have made the markets even more efficient, arguably making it more difficult for skilled managers to ply their trade. Money managers can—and do—compare their portfolio holdings with those of their peers, and their weightings with those of the stock market indexes which the marketplace uses to evaluate them, and fiduciaries can—and do—regularly evaluate their managers on the same basis.

The secular rate of earnings growth, on the other hand, while hardly certain, is also relatively stable, usually paralleling the growth in our gross domestic product (GDP). Note that, with the exception of the depression-ridden 1930s, the contribution of earnings growth (blue bar) was positive in every decade, usually running between 4 percent and 7 percent per year. Total investment returns, then, have been less than 6 percent annually only twice (in the 1930s and in the 2000s), and only twice much more than 11 percent. Speculative return, however, (green bar) is, well, speculative. It has alternated widely, from positive to negative and back again from one decade to the next. But over the long-run, speculation has neither added to nor subtracted from investment return. In fact, when P/E ratios were historically low (say, below 12 times) they have been highly likely (84 percent probability) to rise over the subsequent decade. And when they were historically high (say, above 20 times) they have been highly likely to decline (87 percent probability), though in neither case do we know when that change is coming. Of course, certainty about the future never exists, nor are probabilities always borne out. But applying reasonable expectations to investment return and speculative return and then combining them has been a sensible and effective approach to projecting the total return on stocks (orange bar) over the decades.

In fact, the correlation between the initial yield and subsequent ten-year return of bonds is a healthy 0.91. Not bad, once we realize that perfect correlation is 1.00. The reason for this close correlation is not complicated: If interest rates remain unchanged, of course the returns would be identical. But while rising rates would depress bond prices, the higher reinvestment rate on each year’s interest payment would have a countervailing impact. And vice versa. In mid-1982, the yield on bonds—the Lehman Aggregate Bond Index of U.S. Government and investment-grade corporate bonds—was 14%; during the subsequent decade the annual return on bonds came to 13%, and to 10% over the past two decades. Today, with the bond yield at just over 6%, bond returns in the coming decade should run between, say, 5% and 7%. What we know—or at least can be highly confident about—is that we are looking at future bond returns that are also a pale imitation of those we have enjoyed in recent decades.

stock market’s annual return was an achievement earned only rarely and inconsistently by active managers, who were in any event almost impossible to identify in advance. The wisdom of index investing for the long-term was simple. It was straightforward. And it did exactly what it promised. But the upsurge in mutual fund indexing in recent years has not been based solely on the wisdom of investing. It has also been based on the folly of speculation. Increasingly, and to an astonishingly unrecognized extent, indexing is being used, not to match the market but to beat it. Long-term ownership of the stock market as a whole is apparently not good enough. A whole variety of new index funds have been designed as engines to enable investors to capture superior returns. In some cases, the funds are based on indexes representing various styles or sectors of the market (small-cap growth indexes and large-cap value indexes, for example) In other cases, the funds are based on traditional broad market indexes (Standard & Poor’s Depository Receipts—Spiders—for example), trading vehicles structured for short-term speculation rather than long-term investing. In still other cases, by a combination of both—for example, the technology-driven NASDAQ Qubes and the i-shares that index the South Korean stock market. In my view, owning the market and holding it forever is the ultimate strategy for winners.

In the money market fund segment, of course, current yields have no necessary relationship to past or future yields—don’t forget that it is impossible to have both a fixed income payment and a fixed principal value—the capital flows (at least ever since this segment reached maturity in the mid-1980s) seem to represent a residual figure, with money coming into the funds because it is coming out of stock and bond funds, and vice versa. The Tragic Flaw But the tragic flaw of this industry is that mutual funds have failed to give our investors an adequate share of the returns actually generated in the stock market, the bond market, and the money market. During the two decades ending December 31, 1999, these returns were at the highest levels in U.S. history: 18% per year for stocks, 10% for bonds, 7% for the money markets. As a result, despite relative returns that significantly lagged those of the markets in which they invested, fund investors enjoyed good absolute returns. In buoyant markets, that lag may—MAY!— have been a tolerable flaw. After all, in that 18% stock market, the average equity fund did provide a 15% return. But when the financial markets generate significantly lower returns, such a lag will become intolerable. And, in my judgment, it’s precisely such an era that we have entered. The mathematics of the stock market— today’s low dividend yield plus nominal earnings growth—suggests an investment return averaging about 6½% over the coming decade.

It is hardly farfetched, then, to expect future bond returns that are likely to parallel those of stocks. If so, the traditional 3% equity risk premium—the amount by which stock returns have exceeded bond returns over the past century—may be far smaller, perhaps even non-existent. There are, of course, those who say that there is some God-given mandate that an equity premium must exist. Yet history tells us that bond returns have exceeded stock returns in one out of every five decades. The reality is that restoring an equity premium to stocks will require either (a) lower interest rates, or (b) some combination of higher earnings growth, higher dividend yields, and lower P/E ratios, which is likely only if there is another downward leg in the stock market. In any event, my view is that we are entering an era of lower returns on financial assets. After a golden era of truly extraordinary returns, investors have to realize that reality is now the rule of the day. But the faith of investors in our financial markets will be restored far more quickly if we do three things: First, encourage our clients to develop realistic expectations about future market returns. Second, help them to invest carefully, to increase their savings, and to observe the time- honored principles of diversification and asset allocation.

1977 we made the leap into fund marketing. We took the then-unprecedented step of eliminating all sales commissions, seeking to appeal to the financial advantage of investors rather than the financial advantage of distributors. And we took the final step in becoming the full-line mutual fund complex we are today by assuming our first investment management responsibilities just four years later, in 1981. After seven long years, our structure was at last in place. And in the ensuing 16 years we have built the assets we manage internally to some $150 billion, about 60% of our total asset base. It wasn’t easy, but I think we can mark persistence--call it determination if you will—as yet another attribute of leadership. Paradoxically, our persistence had to be accompanied by patience, another trait of leadership. My favorite example is our pioneering foray into market index funds—today, sadly enough, the “industry darling” or, God forbid, “hot product.” (I cannot abide such concepts.) Struck by the insight that matching the stock market at minimal costs would over time give a low-cost passively-managed index fund a near-certainty of outpacing the vast majority of high- cost actively-managed funds, we formed the first index fund in 1975. This grand and pioneering idea was scorned by others—”Bogle’s folly” was said more than once—but patience and conviction were rewarded as our $10 million in index assets at the outset two decades ago exceed $75 billion today.

Only a few decades ago, it was the investment committee that managed the fund and focused on the long-term, but today it is the portfolio manager that is in charge. Portfolio managers, focusing on the short-term, can be “hot,” and when there is heat, huge capital inflows are not far behind. And larger assets mean larger fees. So, ever since the mid-1960s, we’ve lionized our hot portfolio managers; they became our stars, glamorous and glittering. “A star is born” has become the watchword. Alas, as we now know, most stars have proved to be comets, illuminating the financial firmament for but a few moments in time and then burning out, their ashes gently descending to earth.

(It is this recent history—covering but 8 of the entire 60 years—that has created the value stock mystique.) Then, growth stocks outperformed through 1980, and value stocks have pretty much dominated since then. Linking all of these cyclical fluctuations, as reflected in Exhibit IV, for the full six decades, the terminal investment in value stocks was equal to about nine-tenths of the growth stock investment. For the full 60-year period, the compound returns were: growth, +11.7%; value +11.5%. I’d call that match a standoff, and a tribute to RTM. My second example of market sector RTM is high-grade versus low-priced stocks. This series— not much considered by investors during the past decade—has been published by Standard & Poor’s Corporation on a consistent basis since 1926. Here, as shown in Exhibit V, the swings in market pre- eminence are much briefer than with growth and value stocks. The most sustained trends have been evident during the past four decades, with low-priced stocks enjoying a six-year feast from 1962 through 1968, followed by a complete reversal in favor of high-grade stocks, a six-year famine that lasted through 1974.

Including the costs of soaring portfolio turnover—up from about 20% to nearly 100% annually—and sales charges, fund all-in annual costs now could well reach as much as 3.3% per year. But even at 2½% of assets per year, fully 25% of an assumed 10% stock market return would go to the intermediaries rather than the investors. The industry’s shortfall to the stock market during the past three decades appears, not surprisingly, to be a directly comparable—and largely causal—2.9%, double the 1.5% shortfall that I calculated by hand in 1975 from old industry by manuals during the pre-information age. Those rising costs are the principal reason that fund performance in the Information Age is not far better. It is far worse. And, yes, costs do matter. Just compare an assumed market return of 10% with a mutual fund return of 7½%—10% gross stock market return minus even 2½% expenses—for a tax- deferred retirement plan in which $5,000 per year is invested over 40 years: Final value of the actively-managed mutual fund investment, $1.1 million. Final value of the passive stock market investment, $2.2 million. Two to one.knew

0% 5% 10% 15% 20% 25% 30% 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Financial Sector’s Share of S&P 500 Earnings, 1980 – 2007 2. Does this explosion create an opportunity for money managers? You better believe it does! Does it create a problem for investors? You better recognize that, too. For as long as our financial system delivers to our investors in the aggregate whatever returns our stock and bond markets are generous enough to deliver, but only after the costs of financial intermediation are deducted (i.e., forever), these enormous costs will seriously undermine the odds in favor of success for our citizens who are accumulating savings for retirement. Alas, the investor feeds at the bottom of the costly food chain of investing. The tremendous drain on investment returns represented by the costs of our investment system raises serious questions about the efficient functioning not only of that investment system, but of our entire society. Over the past two centuries, our nation has moved from being an agricultural economy, to a manufacturing economy, to a service economy, and now to what is predominantly a financial economy. But the financial economy, by definition, subtracts from the value created by our productive businesses.

18% for stocks, but perhaps 4% to 8%. Not 10% for bonds, but perhaps 5% to 7%. Not 7% for the money markets, but perhaps 3% or 4%. Maybe we’ll be surprised on the upside. I hope so! Taking the Toll 1: Fund Costs But whatever the returns in those markets turn out to be, the returns of comparable mutual funds will be significantly lower. The reason for the lag, of course, is costs. And we know pretty much what those costs are: management fees, operating expenses, sales charges, portfolio turnover costs, out-of-pocket fees, and cash drag. (Most stock and bond funds hold a small percentage of their assets in cash.) All-in costs for the average stock fund come to something like 2½% per year; for the average bond fund, 1 1/3%; for the average money market fund, 7/10 of 1%. In the new era I foresee (I hope I’m wrong!), equity fund costs would consume between 30% and 60% of stock market returns. Bond fund costs would consume from 20% to 25% of bond market returns. And money fund costs would consume about 25% of money market returns. Taking The Toll 2: Market Timing Further, while the average equity fund provided returns of 15% during the great bull market, please don’t make the mistake of thinking that the average equity fund investor earned 15%. No, recent data suggest that such an investor earned about 6%. Just 6%! Less than regularly rolling over a bank three-year certificate of deposit during the two decades. How can that possibly be? The answers are not very complicated.

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

Continuing a cycle that seems to vaguely parallel the seven-year cycle of Biblical prophesy, the next feast for low-priced stocks lasted for nine years, through 1983, followed by a seven-year famine through 1990. But, when all was said and done, for the full seven decades, each $1.00 initially invested in high-grade stocks was valued at about 1.4 times the investment in low-priced stocks, exactly where it was at the end of 1927, a truly great year for the high-grade issues. Even including the distorting effect of that single opening year, high-grade stocks provided a historical return of +6.8%; versus +6.2% for low-priced stocks (excluding dividends in both cases). Now to my third example. One of the seemingly indestructible myths of investing is that small cap stocks outpace large caps over time. Having accepted this proposition, its proponents then explain why, in terms easily enough understood. “Why, small caps carry higher risks, therefore it follows as the night the day that they must earn higher returns.” This reasoning would seem to make consummate good sense, but in fact the cycles of small cap superiority have been relatively spasmodic, as shown in this historical chart. (See Exhibit VI.) From 1925 through 1964—a period of 39 years—small caps and large caps provided identical returns. Then, small caps more than doubled the large cap return through 1968.

Our defined-asset class fixed-income strategy, while far less renowned, has been equally effective for investors. Our bond and money market funds now constitute $140 billion of our assets. Just as our indexing strategy reflects, finally, a skepticism that any firm, including ours, can discover the holy grail of outpacing the stock market—and then hang onto it for decades, which is every bit as important— so our bond strategy strongly manifests a similar skepticism about the ability of any firm, including ours, to consistently and accurately forecast changes in interest rates. As a result, when we joined the wave of firms offering new municipal bond funds in 1977, we followed, not the conventional path of forming a “managed” municipal bond fund, but created, for the first time in mutual fund history, a three-tier bond fund—a long-term series, a short-term series, and (this will hardly surprise you!) an intermediate-term series. We would win by approximating the pre-cost returns of the benchmarks of each sector of the bond market, then keeping our costs at the industry nadir and maintaining quality at the industry pinnacle. Result: The delivery of outstanding bond returns to our shareholders. If this simple strategy hardly sounds to you like genius at work, you are very perceptive! No more genius, indeed, than the basic mathematics of indexing: Earning the market’s return at low cost trumps earning the market’s return at high cost.“the

On an after-tax basis, that negative Alpha in fact nearly doubles to -3.3%. Professional investors all know that successful investing is a tough game. Shareholders know-or should be told with candor-how much tougher it is when fund expenses and taxes are deducted from the managers' returns. For that 3.3% slice removed fully one fourth of the stock market's return in the past decade. It's important to recognize that what's happening here is largely the product of the inordinately high portfolio turnover rates of mutual funds. Twenty years ago, portfolio turnover averaged 30%; today it averages nearly 90%. While individual stocks may be held for decades (and by some managers-Warren Buffett comes quickly to mind-rather successfully) or even generations, mutual funds are rushing to buy and sell their stocks based on transitory changes in price, without concern for tax consequences. The fact is that this behavior sharply reduces the returns generated for their taxable owners. Further, some fund managers are so hair-triggered that many ofthe gains are short-term in nature (less than one year) and are taxed at ordinary income rates. Nearly 30% of fund gains fell into this category last year, and, with the end of the long-standing limitations on "short-short" gains under the new Tax Reform Act, this figure could well increase. Now, portfolio managers can feel free to realize an unlimited percentage of the fund's income in the form of gains realized in less than 30 days.

return on their capital, not a return on your (the fund investor’s) capital. They cannot do justice to both, for the record is clear that the more the managers take, the less the investors make. Alas, in the fund industry in the aggregate, you not only don’t get what you pay for, you get precisely what you don’t pay for.  Three, mutual fund returns fall drastically short of market returns. And they fall short by almost exactly the amount of the costs they incurred—all those management fees, operating expenses, sales charges, and hidden portfolio transaction costs. How could it be otherwise? Over the past two decades, for example, the annual return of the average equity fund (10 percent) has lagged the return of the S&P 500 Index (13 percent) by three percentage points per year, largely because of those pesky fund costs. To make matters worse, largely because of poor timing and poor fund selection, the return actually earned by the average fund investor has lagged the return of the average fund by another 3 percentage points, reducing it to just 7 percent per year—roughly 50% of the market’s annual return. Warren Buffett accurately describes the problem: “the principal enemies of the equity investor are expenses and emotions.” The fund industry has failed investors on both counts. An annual return of 7% in a 13% market is a shocking gap, but the long-term reality is far worse.

Turbulence and Financial Innovation To be sure, financial institutions have held the majority of all U.S. equities for several decades now and their focus on short-term expectations with the attendant high turnover has been in place even longer. So what is it that accounts for the recent surge of market turbulence? To begin with, in this new environment, the raison d’être for money managers, and basis by which they are held accountable, became the maximization of the value of the investments made by their clients, measured over periods as short as years or even quarters. Even as institutional managers turned increasingly to speculation (just as Keynes had predicted), corporate executives became increasingly attuned to short-term profits and the stock-market valuations of their firms. I call this the “happy conspiracy” among institutional owners of stocks and corporate managers and directors to focus more on stock prices—speculation—than on long-term intrinsic values— investment. Another culprit is financial innovation. While innovation is broadly regarded as an unmixed blessing, in the financial sector it is hardly uniformly so. There is a sharp dichotomy it seems to me, between the value of innovation to the financial institution itself—the investment bank, the money manager—and the value of innovation to its clients.

domination in 1973-1983—but one of seven decades in the period—large caps were actually superior. Annual returns: large cap +11.1%, small cap +10.4%. In any event, the relationship between large caps and small stocks, if not entirely dominated by RTM, is permeated with the force of market gravity. We don’t have an historical chronicle of comparable length to those I’ve used for my first examples of RTM. So, for the evidence in U.S. versus international stocks, I can rely only on data for the past 38 years. Here, as shown in Exhibit VII, we again see profound evidence for my thesis. Here, I’ll compare the returns of the Standard and Poor’s 500 Stock Index and the Morgan Stanley Capital International Europe, Australasia, and Far East (“EAFE”) Index. While there were frequent swings to and fro, our ratio of cumulative value slightly favored the EAFE Index for the first 24 years through 1984. The compound returns were EAFE +9.7%; S&P +8.4%. Then EAFE exploded, outpacing the U.S. by fully two times during the brief 1984-1988 cycle. Since then, the U.S. has fully repaid the compliment, more than redressing that flash of EAFE brilliance during the subsequent nine years. For the full period, the compound returns on U.S. stocks and international stocks were identical at +11.5%. The relative value of each initial $1.00 invested by the investor who stayed in the U.S. was worth precisely the same for the internationalist.

Given the inevitable mathematics of the stock market that I described at the outset, the industry began to develop passive, low-cost mutual funds that assured a market-like performance, and thus virtually guaranteed superiority over peer funds. The index fund could merely buy all of the stocks in the market and hold them forever, paying no advisory fees, engaging in no costly portfolio trading, holding administrative and marketing costs to rock- bottom levels, and charging no sales loads. While its concept is simple—buying American industry and holding it forever—however, its implementation is not.Growth

Over the long run, then, RTM has clearly manifested itself in global equity markets. I’ve now illustrated the powerful force of the law of relative market gravity, if not with Sir Isaac's precision.2 His discovery of the law of universal gravitation has been described as the high point of the Scientific Revolution of the 17th century. To be sure, the utility value of mean reversion to investors in diversified equity funds and in stock market sectors that I have described here will hardly be the high point of this fading century. But RTM is a principle borne out by history, even though it may take decades to appear. The intelligent investor will ignore it at his or her peril. Indeed, Newton’s third law: “every action has an equal and opposite reaction,” is perhaps even a better translation of what happens in the financial markets. I’m willing to stake my own retirement investment strategy on the fact that it will continue to exist. 3. RTM in Common Stock Returns Let me now turn to my third area of mean reversion: the long-term returns of common stocks. Here, unlike the previous two areas on which I’ve just commented, RTM relates, not to relative but to 2 For the record, his equation: Force = G m1m2/d2; i.e., force equals the relative masses of two objects divided by the distance squared, times the gravitational constant.

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

fund began operations with only $11 million in assets. While what quickly became known as “Bogle’s folly” had an infinitely modest beginning, however, it was a beginning. It took two decades of energy and persistence for us to bring that tiny original index fund to its present eminence. But today its assets of some $90 billion mark it as the largest mutual fund in the world. We made no attempt to patent the investment, and indeed “freely and generously,” in Franklin’s words, encouraged others to follow suit. And while some of our rivals copied it, however, their high cost structures precluded success. Even without a patent, the index fund has become our trademark, the backbone of the Vanguard book of business. Together the assets of our stock index funds, our bond index funds (another of our inventions, if an obvious one), and our other funds that are managed with index-like strategies total $410 billion, all because of that original invention of 1975. Opportunity and Motive Just as Franklin’s desire to enhance the public weal undergirded his invention of the Franklin stove and the lightning rod, so Vanguard’s investor-friendly mutual structure undergirded the invention of the index fund. While I was hardly the only person who understood the simple principles behind the index fund—there must have been hundreds of others—the traditional fund firm would have had little interest, regarding it with suspicion if not horror.

sectors of the market offers less diversification and commensurately more risk. Third, if the original paradigm was minimal cost, it’s clear that holding market sector index funds that are themselves low-cost obviates neither the brokerage commissions entailed in trading them nor the tax burdens incurred if one has the good fortune to do so successfully. And as to the fourth and final, quintessential aspect of the original paradigm—assuring, indeed guaranteeing, that you will earn your fair share of the stock market’s return—the fact is that an investor who trades ETFs—and especially sector ETFs—has nothing even resembling such a guarantee. The typical ETF investor has absolutely no idea of what relationship his or her investment return will bear to the return earned by the stock market itself. But, after all of the selection challenges, the timing risks, the extra costs, and the added taxes, I’d bet on a substantial shortfall. (Think Gotrocks here.) But the fact is that, despite the demonstrated success of the classic indexing strategy over three decades now, the growth in market share of traditional index funds stopped dead in 1999, at 10 percent of equity fund assets. All of the increase since then—the remaining 6 percentage points of that 16 percent total has come in ETFs. This stampede into exchange traded funds (ETFs) has been dominated overwhelmingly by highly specialized funds that, in the words of an ETF advertisement, “can be traded in real time, all day long.

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

First, the dividend yield was a known quantity. It had fallen to an all-time low of 1.1%, eliminating it as a major driver of future investment return, and leaving the heavy lifting to earnings growth. I picked 6% as a reasonable expectation for the coming decade, a bit above the trend line. If so, investment return in the decade ahead would have come to 7.1%. Chart – Past Stock Returns, and a Look to the Future What about speculative return? Over the previous two decades, the market's p/e ratio soared from seven times to 30.5 times, producing a 7.5% annual rate. With a p/e more than double the century-long norm, even if one naively believed that "this time is different," and that such a stratospheric ratio wouldn't decline, even if it held, the future speculative return would be zero. But my guess was that the p/e ratio might drop to the neighborhood of 18 times, providing a negative speculative return of about 5% per year. Result: An expected average return on stocks in 1999–2009 of less than just 2% per year—and not ten individual years at 2%; stock markets just don't behave that way. More likely, I said, was a 40% or 50% drop over a few years, followed by a return to more normal returns, say in the range of 9% annually. I've often said, "while we may know what will happen in the market, we never know when." But in an April 6, 2000 speech, I threw caution to the winds: "So let me be clear.have

decades—increasing at an annual rate of 25%—it is clearer that declining costs are just one more myth. Myth #5. Mutual Funds are Meeting the Reasonable Expectations of Investors. Given the high fees and operating costs, the short-term investment horizons, and the substantial transaction and tax costs that go hand-in-hand with this rise in investment activity, it is small wonder that mutual fund returns have lagged so far behind the substantial returns generated by U.S. stocks during this greatest of all bull markets. Assuming only that the expectation of most fund investors is at least to enjoy a fair participation in the long-term returns generated by common stocks—and that seems a minimal assumption indeed—the idea that mutual funds have met the reasonable expectations of investors proves to be yet another myth. I am speaking not only of the failure of the average fund to match the returns of the Standard & Poor’s 500 Stock Index. While that large-cap index is not a bad comparison—after all, it represents 75% of the stock market, and its return has been identical to that of the total stock market over the past 30 years—it is a crude comparison, given that nearly one-half of all equity funds today focus principally on mid-cap and small-cap stocks.

(IBM, which was to be the star performer of the subsequent two decades, didn’t join the Index until 1957.) Surprisingly, AT&T, with a market capitalization larger than General Motors’, was conspicuous by its absence. Despite its initial “Old Economy” base, the S&P Index dominated the active fund managers during the era that followed. Now advance the calendar to 1964. AT&T, now part of the index, had a 9.1% weight, followed by General Motors at 7.3%, Standard Oil of New Jersey at 5.0%, and IBM at 3.7%. The “top ten” then accounted for 39% of the index, again far higher than today’s top ten weight of 24%. But even this continued reliance on the Old Economy of autos, chemicals, oils, and utilities—together, 52% of the index—failed to diminish its sharp advantage over the average mutual fund during the subsequent decade, despite the surge of the “go-go” concept stocks during the middle of the period.

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

folly of short-term speculation—are obliged to own (surprise!) stock and bond market index funds. As evidenced from the substantial shortfall in returns experienced by mutual fund investors in the example that I cited earlier, the investment merits of indexing—the broadest possible diversification, at the lowest reasonable cost, without sales loads or marketing fees, and with maximum tax efficiency—have proven themselves over and over again. Yes, I concede that owning such funds is as interesting as watching the grass grow, or perhaps as interesting as watching paint dry. But since less than 10 percent of investors or investment managers are apt to beat the market over the long-term, buying and holding a low-cost index fund and capturing nearly 100 percent of whatever annual returns the financial markets are generous enough to deliver to us seems a far better option than plunging headlong into a game rigged with such overpowering odds against success. Of course, since I started the first index mutual fund a little over three decades ago— Vanguard Index 500 is now the largest fund in the world—you would be wise to discount my passionate advocacy of indexing. So ignore me! But listen to Warren Buffett. Listen to Yale’s David Swensen. They both say exactly the same thing. Listen to Jack Meyer, the former—but equally sensational—manager of Harvard’s endowment fund. Listen to any Nobel Laureate in Economics, beginning with Paul Samuelson.

When managers of traditional active equity funds claim to have a way of uncovering extra value in our highly- (but not perfectly-) efficient U.S. stock market, investors will look at their past record, consider the manager’s strategies, and then invest or not. These new index managers are in fact active managers. But they not only claim prescience, but a prescience that gives them confidence that most sectors of the market (such as dividend-paying stocks) will remain undervalued for as far ahead as the eye can see. But, if these factors are underpriced, why won’t investors, hungry to capitalize on that apparent past inefficiency, bid up prices until the undervaluation no longer remains? Put another way, if these promoters of the purported new paradigms actually have been right in the past, won’t they therefore be wrong in the future? Interestingly, the choice of the ETF structure—rather than the standard mutual fund format—by these confident entrepreneurs would seem to belie the fact that their “fundamental indexing” approach may take decades to prove itself, if indeed it does so at all. Because by choosing the ETF format, they imply even more strongly that investors who actively buy and sell their new fundamental funds will lead to even larger short-term profits than buying and holding them for the long term. I recommend skepticism about these purported “new paradigms.” I’ve witnessed too many new paradigms over the years. None has persisted.

And so it was that after the spring of hope a year ago, we have now completed a summer, a fall, and a winter of, if not despair, surely disappointment. We await the next season. What does it hold for investors? The Sources of Stock Market Returns With apologies to Dickens, I turn again to a tale of two markets . . . but a tale of two other markets: Stock markets past, and stock markets yet-to-come. Do we have everything before us, or nothing before us? To answer that question, we must look at the U.S. stock market in total, well-represented by the Standard & Poor’s 500 Stock Index, which includes both listed stocks (now 85% of its value) and Nasdaq stocks (15%). Let’s begin with the eternal mathematics of the stock market, in which returns are derived from two distinct elements: Investment, and speculation. Investment return is represented by the sum of a stock’s dividend yield plus the rate of its earnings growth: It tends to be steady, recurrent, and almost always positive. Speculative return is measured by the willingness of investors to pay more—or less—for each dollar of earnings: It is intermittent, spasmodic, and may as easily be negative (a falling price-earnings ratio) as positive (a rising price/earning ratio). Simply adding the two elements together gives us the total market return. But over the long run, it is investment return—earnings and dividends—that calls the market’s tune.

the other hand, began at $7.91 in 1991, and has remained above $7.10 each year. It should be about $7.20 in 2001. Variable income vs. stable income. Is stable income or stable principal the higher priority for you? Or some of each? Be clear on what you plan to achieve in your defensive holdings, and invest accordingly. Pillar 10. Beware of “Fighting the Last War.” Too many investors—individuals and institutions alike—are constantly making investment decisions based on the lessons of the recent, or even the extended, past. They seek stocks after stocks have emerged victorious from the last war, bonds after bonds have won. They worry about the impact of inflation after inflation, having turned high real returns into so-so nominal returns, has become the accepted bogeyman. You should not ignore the past, but neither should you assume that a particular cyclical trend will last forever. None does. When I wrote my book, inflation was at the forefront of investors’ minds. But, ever the contrarian, I raised a caveat emptor suggesting that “it would be foolish to assume that inflation would be an eternal fact of life.” Sure enough, inflation, having averaged 5.7% during the fifteen previous years, has run at less than one-half that rate (2.6%) since then. “The last war,” it turned out, was over. Similarly, stocks in high-tech companies soared during the late 1990s, and large-cap tech stocks came to dominate the portfolios of growth funds.

“This golden age for equities won’t last forever . . . but the mean for equities is probably somewhat higher than in the past, and famine will follow feast as it always has.” This firm concluded that the new mean market return would be, “7%-8% real, but below the 10% today’s bulls talk about. The real returns of around 12% generated for a decade now are simply not sustainable. Over time, returns will have to gravitate back toward the new mean.” If—if—this is so, the strategy bulletin seems to imply, stocks at today’s levels are overvalued (i.e., overpriced relative to the fundamentals) by about 20%. In such an environment of revaluation, we would face a protracted period with real stock returns in the 3%-5% range. Stocks, then, would face serious competition from bonds. For bonds, based on today’s yields, should provide returns of about 3 ½%-4% on average over the coming decade, at considerably lower risk. Given the hazardous nature of market forecasting, however, and the powerful odds against being right twice (selling at or near the highs, and buying back at or near the lows, a winning strategy of extraordinary unlikelihood), the possibility— even the probability—of inferior risk-adjusted returns on stocks should not be sufficient, in my judgment, to cause long-term investors to abandon stocks in their entirety.

97 with the total market; and its performance has been virtually identical to that of the Wilshire 5000 Total Equity Market Index over the nearly three full decades in which both indexes have been available. That is not to say the S&P is an easy target for an investor—or even an average index fund manager—to track. Change it does! Indeed in the past 20 years there have been an astonishing 489 changes in the 500 Stock Index. These are not trivial changes; on average during that period, each year has resulted in the addition of stocks accounting for 2.8% of the index’s capitalization—an aggregate two-decade replacement equal to 58% of its value. Typically, these changes are represented by mergers; the few stocks deleted from the index for other reasons typically have very small market caps. In essence, we have a process in which old stocks are deleted from the Index at a rate of about three percent per year, meaning that the weightings of each of the other holdings is reduced by about three percent per year.the

 Our original index fund is now the world’s largest mutual fund, and our panoply of stock index funds total $180 billion. Our market share of no-load stock index fund assets is a dominant 82%.  Our original troika of tax-exempt bond funds, and the similarly-structured taxable bond funds that followed—all relying on index-like strategies—total $112 billion in assets, including $24 billion in bond index funds. Market share: Now 45%, vs. 18% in 1980.  Our money market funds, also capitalizing on the low-cost-equals-high- return equation have assets totaling $93 billion. Market share: 33%, vs. 4% two decades earlier.  And the assets of our traditional actively-managed equity funds total $144 billion. Market share: 15% down from 25%, the inevitable result of our focus on indexing. The magnificent returns in the financial markets—stock, bond, money market—through most of our history, really right up to the spring of 2000, have given HMS Vanguard a powerful wind at her back. Our assets have grown at a compound rate of 25% per year, and at a remarkably steady pace, carrying our asset base from $1 billion to $565 billion. But the overwhelming portion of that huge increase has come from our rising share of market. Had our share held steady, our assets today would be $110 billion. The remaining $455 billion is accounted for by the increase of our share of total industry assets from 1.7% in 1981 to 8.3% today—without a single year of decline.

past six years, Microsoft, Cisco, and Intel, for example, would have apparently represented, not the 4.9%, 2.8%, and 2.3% of the Index that they represented as 2000 began, but 5.5%, 3.2%, and 2.5%. While these are not to be taken as hard numbers, they do suggest that a strategy of gradually selling winners may have helped to marginally improve the performance of the index. Active managers may want to take note. No similar adjustments are required in the Wilshire 5000 Total Stock Market Index, which includes not only the large-cap stocks in the S&P 500, but mid- and small-cap stocks as well. Yet despite modest short-term variations, it has tracked the S&P 500, as I noted, with virtual perfection over the long-term. Stocks normally come into the index when they are very small and there is no reason to remove them when they hit an arbitrary size. And they are held forever . . . or at least until they are merged into another corporation. It is largely for these reasons that I favor the all-market index fund as the best choice for most investors. “Benchmarking” The compelling data I’ve presented shows a substantial shortfall in the long-term returns of mutual funds despite cost and tax assumptions that are remarkably conservative. I’ve also assumed that domestic funds as a group can be fairly compared with the S&P 500 Stock Index, which closely tracks the total U.S. stock market.

A New Idea, Sixty Years Old With all of the high-priced creative and imaginative talent in this industry, I find myself wondering why someone, somewhere, hasn't dreamed up a still better way to enhance after-tax mutual fund returns. Surely the opportunities abound. Let me describe my own idea. I start with a fund that simply buys a large sampling of high quality blue-chip growth stocks, and holds them unless fundamental circumstances change radically. Where, you ask, do we fmd the budding Warren Buffett to manage it? Honestly, I don't know. So, I shift gears. Why not a fund that buys, say the 50 largest stocks in the Standard & Poor's Growth Index universe? (That's nearly 30% of the capitalization of the entire stock market.) Simply hold them "forever" and don't rebalance as prices change. If there is a merger, keep the merged company; if a company is bought for cash, reinvest the proceeds, either in the next largest company or in the fund's other holdings (it probably won't matter which you do); ifit fails and goes out of business, well, just realize that can happen. Then, run the fund at an expense ratio of 20 basis points, just incurring bare-bones operating costs. Minimize exposure to shareholder redemptions with a stiff redemption fee and/or strong limitations on daily liquidity (i.e., open the fund for redemption only, say, on the last day of each quarter). These latter steps will, of course, make it difficult to attract quick-triggered opportunists. That's good!it

For exceptional funds with exceptional past returns that are substantially superior to the market will regress toward, and usually below, the market in the future. Regression to the mean-I call it the law of gravity in the financial markets-is measurable and apparently almost inevitable. For example, in two studies of returns over consecutive decades, a remarkable 99% of top quartile funds moved closer to-and even below-the market mean from the first lO-year period to the subsequent 10-year period. There was only one single, solitary exception to the rule, a fund that ruled the world during the 1970s and 1980s alike. But so far in the 1990s, it has regressed magnificently, falling far below the market's return. Sometimes mean reversion requires patience! Make no mistake about it: the record is clear that top performing funds inevitably lose their edge. This industry is well aware of that certainty.most

Looking Ahead—A Personal Note As we look back over the three adventurous voyages I’ve described this evening, it’s worth speculating about what may lie ahead. For the stock market, the odyssey is destined to continue, but the two easy golden decades we have reveled in are now history, and the voyage will be rougher and slower in the years ahead. For the mutual fund industry, the odyssey is already waning, and its course will—as it must—at last turn away from high-costs and fad- following, back toward our original roots of prudent management and stewardship. And for Vanguard, our fantastic odyssey, which has already helped to change the way people think about investing, will proceed with even greater alacrity in the years ahead. Unless I miss my guess, in the financial markets and the fund industry alike, we’re facing an extended climate of Vanguard weather. After 50 years in this business, the last 27 with the renegade firm I created all those years ago, I close with a few personal reflections. Peter Bernstein was right. It has been no easy task. The road has not always been smooth, and I’ve experienced headaches and heartaches, hopes and fears, delights and disappointments, even triumph and disaster. But, following Kipling’s advice, I’ve treated those two imposters just the same.

realistic about what fund managers might accomplish. Even excluding the oppressive impact of sales loads, Graham’s view was that fund returns “were not very impressive . . . on the whole, the managerial ability of invested funds has been just about able to absorb the expense burden and the drag of uninvested cash.” Graham’s timeless lesson for the intelligent investor, as valid today as when he described it in his book, is clear: “the real money in investment will have to be made—as most of it has been made in the past—not out of buying and selling but of owning and holding securities, receiving interest and dividends and increases in value,” again exemplified in the distinction between the business market and the expectations market that I mentioned earlier. Owning and holding a diversified list of securities? Wouldn’t Graham recommend a fund that essentially buys the entire stock market and holds it forever, patiently receiving interest and dividends and increases in value? Doesn’t his admonition to “strictly adhere to standard, conservative, and even unimaginative forms of investment,” eerily echo the concept of market indexing? When he advises the defensive investor “to emphasize diversification more than individual selection,” hasn’t Benjamin Graham come within inches of describing the modern-day stock index fund?

When I led Vanguard to offer the fund industry’s first small-cap index fund in 1989, and its first growth and value index funds in 1992, I found nothing in stock market history to suggest either such high turnover or such radical changes in the composition of style indexes. My idea was to offer particular funds that investors would buy and then hold for the long-term, either to diversify an actively-managed portfolio by adding market segments that were not included, or to do some intelligent portfolio allocation under special circumstances; i.e., a growth index fund for a young investor accumulating assets and seeking capital growth and tax-efficiency, a value index fund for the investor seeking higher dividend income and perhaps lower risk at retirement. Alas, to an important degree, those good intentions have been frustrated by investors who seem to use the growth and value index funds to make counterproductive investment decisions, just as they do even more spectacularly with actively-managed funds. At first our two index funds proved equally attractive. During 1992-96, investors placed approximately $700 million in both growth and in value. But as growth stocks soared, the temptation to jump on the bandwagon proved too strong to resist. During 1997 through the first quarter of 2000, investors poured $10.6 billion into the growth index fund, vs. $2 billion into value.

Investors will require these qualities more than ever in “the present period,” using Dickens’ words, “for good or for evil, in the superlative degree of comparison only.” For in this double-edged Tale of Two Markets, we have seen both the spring of hope and the winter of despair in the NASDAQ market, a despair that now seems to be easing over to the NYSE market. And we have also seen two remarkable decades—the 1980s and 1990s—which began when investors in the U.S. stock market had everything before us. The best of times—literally—that came to pass in the stock market has now been succeeded by the worst of times—at least, the worst of times investors in our generation have ever seen. So we must move from incredulity about the past to belief in the future, and confidence in our Nation’s economic strength. As the age of speculative foolishness gradually vanishes in our stock market, it must be succeeded by an age of wisdom, as we learn from the lessons of market history. Armed with the perspective of that character-building experience, we can take the long view, and stay the course.

past doesn’t require that you be wrong forever. Start today to alter your portfolio gradually. Begin with 25% of your equity holdings, and over, say, the next year or two, make the full conversion of your individual holdings to whatever index-based asset allocation fits your circumstances. Then, when you complete your program, get investing as far out of your mind as you can. Look at your portfolio no more often than once a year, but don’t change it, except to reduce the stock allocation a bit every five years or so. I can’t predict how much you will have in your account when you reach retirement, but I can predict—with as much certainty as is possible in the uncertain world in which we live—that it will be, not only considerably larger than the account of anyone you know who has put the same amount of money to work in a different fashion, but far less time-consuming and worrisome. Yes, you will be one of those fortunate souls who has been well served by this industry, and you will look at the wealth you have accumulated with a smile on your face. So, just go out and do it. And while you’re about it, if you work in the mutual fund industry, use your knowledge and your common sense to help us make the marriage between technology and mutual funds better, not worse, so that fund investors will be richer, not poorer in the years ahead.

“Surviving Defeat, Surviving Victory”1 By John C. Bogle When I was paid the high honor of being inducted into the FIASI Hall of Fame on November 10, 1999, I spoke about the triumph of indexing—the investment strategy based on passively-managed funds designed to track, at rock-bottom cost, the returns earned by broad market indexes of stocks and bonds, and to be held forever—a long-term investor’s entire investment lifetime. Then, I mentioned the struggle to survive the early defeat of the world’s first index mutual fund, founded in 1975. (Now known as Vanguard 500 Index Fund, tracking the returns of the S&P 500 Stock Index.) Before exploding upward in the late 1990s, our acceptance grew at a glacial pace. Similarly, our early municipal bond funds, first offered in 1977, were also slow to gain investor favor. But, defeated at the outset, both would survive, and then prosper. Patience! In my 1999 acceptance speech, I also expressed my concerns about the high growth rates and burgeoning assets that the Vanguard family of stock and bond funds were experiencing—then nearly $100 billion, now closing in on $5 trillion. Vanguard’s remarkable growth has been driven by our index funds, now numbering 59 stock funds, 18 bond funds, and 61 balanced funds (largely our target-date retirement funds-of-funds, a field in which our market share exceeds one-third). So I also wondered if we could survive victory.

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

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.

” Call it creative destruction. Call it disruptive innovation. Call it luck. (Good luck for Vanguard; not such good luck for our peers.) But more than anything else, call it good karma. For surely fate would have eventually awakened the investment world to this fundamental truth: before intermediation costs are deducted, the returns earned by equity investors as a group precisely equal the returns of the stock market itself. After those costs, therefore, investors earn lower-than-market returns. Fact: The only way to maximize the share of the financial market returns earned by the 100 million families whom the fund industry serves is by minimizing the costs borne by fund shareholders. I’ll soon celebrate my 66th anniversary in this wonderful business, beginning when I joined Wellington Fund in July 1951. I decided to mark the occasion of my (I think) unprecedented record of service in the fund industry by offering a brief history of how I came to found Vanguard and First Index Investment Trust (now Vanguard 500 Index Fund). The world of investing knows too little of this history and of the revolution that, decades later, would follow.

Now a bit of history about my interest in bonds. From the time that I joined Wellington Management Company in July 1951 right out of college—my first “grown-up” job—I was imbued with the philosophy of the balanced fund: Wellington Fund, our only mutual fund from the firm’s founding on December 28, 1928 until we added Wellington Equity Fund (now Windsor Fund) in October 1958, three decades later. As assistant to Wellington’s founder, president, and fund industry pioneer Walter L. Morgan, the philosophy of balance was drummed into me unremittingly and passionately by Mr. Morgan himself. Wellington’s balance typically ran about 65% blue-chip stocks and 35% investment-grade corporate bonds. In 1951, on that lucky day when I walked into Wellington’s Philadelphia offices for the first time, the Fund’s assets under management totaled $145 million. Tiny by today’s standards, we were then the sixth largest mutual fund and the only dealer-distributed balanced fund among the industry’s “Big Ten” funds. (In those ancient days, most fund managers ran but a single fund. Today, the ten largest fund firms run an average of 244 funds.) I was indoctrinated into the Wellington philosophy—stocks for capital appreciation, bonds for income and risk reduction—and totally bought into it. The stock/bond balance was remarkably successful as a marketing concept, and the Fund was (as I recall) the most widely-sold dealer-distributed mutual fund in the nation, year after year.

deserved to hear from the pioneer of the revolution that is changing the fund industry as we knew it, not so many years ago. My request was inspired by Louise Cooper, a journalist for The Times of London, who interviewed me last autumn. When she learned that I had not been invited to speak to the ICI for nearly three decades, she was shocked, and urged me to request a speaking slot at this year’s GMM. It was not to be. I was politely informed by Institute President Paul Stevens that the GMM is designed to pull the industry together around a common theme, not to pit one competitor against another. (Leave aside that the industry’s common theme of active investment management doesn’t seem to be working very well, and that competitors regularly speak at the ICI gathering.) To me, Paul’s decision seemed to be classic presentism, short-sighted and provincial. But I didn’t bother arguing with him.care,

The addition of the bond index fund to Vanguard’s internally-managed asset base was followed by our creation of major additions to our menu of bond funds: three Admiral (lowest-cost) U.S. Treasury funds in 1991; the Intermediate-Term Investment-Grade (taxable) Bond fund in 1993; and Short-Term, Intermediate-Term, and Long-Term Bond Index Funds in 1994. This new wave of funds grew slowly but surely, with aggregate assets of $140 billion in October 2017. Industry Leadership Together, the combination of the bond market index fund and its defined-maturity cousins (and, of course, our rock-bottom costs) brought Vanguard to its leadership in the bond fund arena. (Exhibit 7) From a mere 4% of bond mutual fund assets three decades ago to 13% in 2005, to 23% today. Today, industry leadership is highly concentrated. The six largest bond fund sponsors (Exhibit 8) oversee a dominant 50% share of total assets of bond funds of all types. Vanguard’s bond fund assets are more than two-and-one-half times the $390 billion of our next largest peer.

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

these conglomerates will have a perfectly good business rationale, but I’m guessing that many of their mutual fund subsidiaries will ultimately be sold at bargain prices or merged with other similarly-situated firms. As we consider today’s index fund tsunami, it’s critical to understand its two distinct components, a distinction largely ignored by the industry and the media. One component is the ETF—the exchange traded fund—enabling investors to trade a seemingly infinite variety of index funds using almost 2000 different indexes, often tailor-made by their sponsors. As the original ETF advertisements said, “now you can trade the S&P 500 Index all day long, in real time.” (I’m compelled to point out that broad market ETFs are fine, as long as you don’t trade them.) ETFs are also a key ingredient in the growth of robo- advisors, which are bringing down the costs of advice for investors. The other component is the TIF, the acronym that I’m struggling to establish (so far without much success) for the traditional index fund, essentially a low-cost, broad market index fund designed to be bought and then held forever. That first S&P 500 Index fund that I created way back in 1975 was (and is) a TIF. When the late Nathan Most, creator of the ETF, offered Vanguard the opportunity to join forces with him by making our TIF available in ETF form, I declined his offer without hesitation.

I stood on the principle that trading mutual funds is ultimately a loser’s game, and that our 500 Index Fund was designed for long-term investors. I have nary a regret about my decision. Yet without its own acronym, our data collectors have largely turned “a blind eye” (as Lord Nelson did at Copenhagen) to TIFs. As 2017 begins, TIF assets—$2.5 trillion—are identical to the ETF total. In fact, TIFs have grown at a slightly faster rate than their tradeable cousins since 2011. (Both TIFs and ETFs have grown at about 18% annually.) I expect both kinds of index funds to continue to grow, eventually at a much slower rate, and for very different reasons. But I concede that challenged active managers are most likely to go the ETF route. Good news for active managers. Presentism leads us to assume that today’s powerful dominance of index funds will continue indefinitely. But as Herb Stein, Chairman of President Nixon’s Council of Economic Advisers, pointed out, “If something cannot go on forever, it will stop.” But will index fund dominance fade? Or will it grow? Will it end? When? Only time will tell.

Expense ratios of actively-managed funds had declined to 84 basis points, still 53% above the 1960 level. With the growth of lower-cost bond funds, the industry-wide asset-weighted expense ratio for long-term funds is now at 68 basis points, almost 25% above the 1960 level. With total fund assets averaging $17 trillion in 2016, fund advisory fees and operating expenses come to a total of $110 billion per year—5,600 times the 1951 level of $20 million in an industry whose assets grew by 5,400 fold. Economies of scale for fund investors—zero. The industry’s huge revenue growth has been a bonanza for the owners of fund managers. Just look at the returns on the stocks of publicly held fund managers. Over the past two decades alone, the shareholders of the three largest publicly-owned fund managers have enjoyed annual returns averaging 13%, almost double the annual return of 7.7% on the S&P 500 Index, a return earned by remarkably few mutual funds. Cumulative returns: fund managers +1167%, S&P +339%. More than triple. Wow!

8% for the next three decades, that investor has made a bargain that will be honored—no bubble there!. For the vast majority of investors, bonds should be bought and held for relative price stability and regular income, not traded in a vain attempt to capitalize on momentary fluctuations in market price. Despite the current low interest rate environment, bond mutual funds, driven largely by the total bond market index fund, have flourished in this challenging environment. In 2017, cash flow has totaled some $335 billion. About 50% of that total ($162 billion) has flowed into bond index funds.investment

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

Today 30 of the 50 largest fund managers are held by banks and financial conglomerates, 10 more with significant public ownership—in all, 40 of the 50 largest fund managers. The SEC’s concern was prescient. For decades, trafficking in management company ownership has characterized much of the fund industry. Management companies are bought and sold in the marketplace. Fund directors seemingly sign up with the new management company (which bought the firm from the previous management company), but rarely extract any material benefit for the fund shareholders whom they are duty bound to represent. In the 2003 Berkshire Hathaway Annual Report, Warren Buffett used far tougher words than mine: Year after year, at literally thousands of funds, directors had routinely rehired the incumbent management company, however pathetic its performance had been. Just as routinely, the directors had mindlessly approved fees that in many cases far exceeded those that could have been negotiated. Then, when a management company was sold— invariably at a huge price relative to tangible assets—the directors experienced a “counter-revelation” and immediately signed on with the new manager and accepted its fee schedule.old

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

5/4/2015 33. Convergence! The Great Paradox: Just as Active Fund Management Becomes More and More Like Passive Indexing, So Passive Indexing Becomes More and More like Active Fund Management John C. Bogle “The Art of Indexing” Conference Washington, DC September 30, 2004 A Speech Title Sums It Up 34. First Index Mutual Fund (1974)—Principles • Own the U.S. stock market • Diversify to the Nth degree • Minimize transaction costs • Tiny expense ratio—500 Index: 0.05% (Admiral) • Bought to be held “forever” (redemption rate 10%) Exchange-Traded Index Funds (1993)—Principles • Pick your own index (1,100 now available) • Diversify within sector you chose • Lower expenses … but not too low (0.50%) • Bought to be traded (average annual turnover of large ETFs: 1244%) “What Have They Done to My Song, Ma?” Enter the Exchange-Traded Fund (ETF) 35. 725% 274% 319% 144% 524% 337% SPDR Gold Shares iShares Russell 2000 Vanguard S&P 500 ETF Vanguard FTSE Emerging Markets ETF Vanguard Total Stock Market ETF iShares MSCI EAFE iShares Core S&P 500 SPDR S&P 500 ETF 200 400 800 0 2600 4200% 2014 Dollar Turnover as a Percentage of Average Annual Assets Asset-Weighted Turnover, 20 Largest ETFs: 1244% 4274% 2724% ETF Turnover 36. ETFs—The New Way to Speculate 2014 Trading Volume 100 Largest Stocks: $18.6 Trillion 100 Largest ETFs: $15.7 Trillion 2014 Turnover Rate 100 Largest Stocks: 179% 100 Largest ETFs: 1428%

Focus on appropriate asset allocations relative to each client’s investment goals. Focus on portfolio risk, for the day will come—indeed, I believe it is here now—when avoiding excessive risk is every bit as important as seeking high rewards. And whether you are an investment professional or a portfolio manager; an investment adviser to a large pool of capital or to the retirement plan of a beginning investor; a client or a trustee of a pension fund, endowment fund, or a philanthropy, mind your investment behavior! By which I mean, take the long view. Hold hope, greed, and fear—the three classic enemies of investment success—at bay. It is ever thus. Wrapping Up Yes, I’ve been saying these things for four-plus decades at Vanguard and for almost a quarter- century before that at Wellington Management Company, under the tutelage of my great mentor Walter Morgan. Indeed, these ideas appear in that idealistic thesis on the fund industry I wrote at Princeton University during 1949-51. Dare I say that they have stood the test of time.

First Index Mutual Fund (1974)—Principles • Own the U.S. stock market • Diversify to the Nth degree • Minimize transaction costs • Tiny expense ratio—500 Index: 0.05% (Admiral) • Bought to be held “forever” (redemption rate 10%) Exchange-Traded Index Funds (1993)—Principles • Pick your own index (1,100 now available) • Diversify within sector you chose • Lower expenses … but not too low (0.50%) • Bought to be traded (average annual turnover of large ETFs: 1244%) Yes, There Is a Difference Traditional Index Funds vs. Exchange-Traded Funds “BUY AND HOLD” vs. “TRADE IN REAL TIME” . . .

economy, which has moved forward, despite interruptions, at a steady pace of about 2 ½% per year (in inflation adjusted dollars) over the past century. When the stock market leaps up and plunges down— second-by-second, day-by-day, year-by-year—it reflects nothing more than those transitory emotions— hope, and greed, and fear—that have affected investors (or, I should say, speculators) forever. These emotions represent investors’ reactions to momentary events, or their expectations of future events, or their expectations of how other investors might perceive these events. That’s why we call it the expectations market, with speculative sentiment often raising or lowering stock prices far above or below their intrinsic value. In other words, speculative return reflects the change in price investors are willing to pay for each dollar of earnings. Over the long run, however, speculative return has played no role whatsoever in shaping the market’s total returns. Rather, it is investment return that has accounted for virtually all of the long-run returns generated by stocks. Over the entire history of the U.S.has

 Had fund managers never been allowed to go public, and had the fund industry’s traditional private ownership structure remained intact, many of the obvious conflicts of interest that mangers face in trying to serve both their mutual fund shareowners and their conglomerate (or other public) shareholders would have been mitigated. Giving fund investors (and pension beneficiaries) a fair shake, and a fair participation in the staggering economies of scale that are available in managing the growing pools of other people’s money (OPM), would have come to characterize this now-giant ($15 trillion) industry. But in fact, fund managers arrogated the lion’s share of these economies of scale to themselves.  If we had built a formal structure of international cooperation and information-sharing on money flows (and a structure of enforcement as well), wouldn’t money laundering and tax dodging have been greatly reduced?  If today’s structure of electronic communication (e-mails seem to last forever!) and judicially approved federal wiretaps had been prevalent in an earlier age, wouldn’t the cheaters who traded on inside information have been discovered—and punished—far earlier?there

averaged 9%—4 ½% from dividend yields, and 4 ½ % from earnings growth.2 Speculative return, over the long term, has accounted for zero—nothing. That’s why I describe the stock market as “a giant distraction from the business of investing.” Ethical Values The great Bull Market of the 1980s and 1990s led to a focus on stock prices over intrinsic values. Paraphrasing Oscar Wilde’s definition of the cynic, the “security analyst became one who knows the price of everything, but the value of nothing.” We reveled in our greed when markets were good. We suffered in our fear when they were bad. And during the two 50% Bear Market declines we’ve experienced since 1980, we relied on the hope that things would get better. (They did!) During two consecutive decades of strong returns for stocks, Wall Street was all too likely to overreach, and investors seem to accept with equanimity the idea that the costs of all those croupiers didn’t matter much. After 20 years of earning above-average returns of, say, 9% each year, most investors wouldn’t pay much attention to the fact that the market itself earned 11% per year. During the rising stock market, it shouldn’t be surprising that the field of finance has flourished.

transaction costs to a bare minimum; produced greater liquidity, and improved (perhaps only slightly) price discovery and greater market efficiency for professional investors. That’s all to the good. But the huge risks of a technology breakdown in our increasingly computerized stock market remains hidden out there, beyond the horizon. In our data-intensive, speed-driven society, yes, HFT is here to stay. ETF Toys I find it both astonishing and deeply discouraging that index funds have become one more example of the apparently irresistible impulse of investors to speculate. Imagine! In 1975, Vanguard created the world’s first index mutual fund, following this elemental strategy: (1) buy and hold all of the stocks in the Standard & Poor’s 500 Index; (2) operate at rock-bottom cost; and (3) attract long-term investors who wish to hold the stock market portfolio, well, forever. Those original sensible strategies of indexing have reshaped investing in a highly positive way for long-term investors. But the exchange-traded index fund (ETF) is the antithesis of that third key to index success—holding the market forever. Formed in 1991,6 the first ETF was also based on the S&P 500, but with the added “feature”—embodied in its advertising slogan—that its shares could be “traded all day long, in real time.” (I’m not making this up!) With $160 billion of assets, the so-called “SPY” is now the world’s largest ETF.

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

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

Mutual Fund Asset Growth 1951-2012 $2.5 $6.4 T $0.7 0.5 T $1.0 3.5 T $3.7 2.6 T 1,000 10,000 1951 1960 1970 1980 1990 2000 2012 Equity Balanced Bond Money Market $13.0 T $ billions 5. During the 1950s, assets of bond funds seemed stuck at around $500 million, with little growth during the next two decades. But, following the 1973-1974 bear market, bond funds began to assert themselves. As the financial markets changed, so did investors’ needs; income became a high priority. After that unpleasantness in the stock market, bond fund assets grew nicely, reaching $250 billion in 1987, actually exceeding the $175 billion total for equity funds. Bond funds then retreated to a less significant role during the 1990s. But today, following years of generous interest rates that were to tumble in recent years, bond fund assets have risen to $3.5 trillion, 25 percent of industry assets. As the dominance of equity funds waned, money market funds—the fund industry’s great innovation of the mid-1970s—bailed out the industry’s shrinking asset base. Exhibit 6. They quickly replaced stock funds as the prime driver. By 1981, money fund assets of $186 billion represented fully 77 percent(!) of industry assets. While that share has declined to 20 percent today, it is still a formidable business, with $2.6 trillion of assets. But given today’s pathetic yields and the possibility of a new business model for money funds (which will actually reflect their floating net asset values), it won’t be easy.

rate of the 1950s and early 1960s to the 140 percent rate of the past three decades.8 While most fund managers were once investors, they now seem to be speculators. The new financial culture of ever-higher trading activity in stocks was embraced by investors of all types. Then institutional traders, of course, were simply swapping shares with one another, with no net gain for their clients. What’s more, the old equity fund model of blue-chip stocks in market-like portfolios— and commensurately market-like performance (before costs, of course!)—evolved into a new, more aggressive model. The relative volatility of individual funds increased, measured in the modern era by “Beta,” the volatility of a fund’s asset value relative to the stock market as a whole. This increase in riskiness is easily measured. Exhibit 7. The volatility of equity fund returns increased sharply, from an average of 0.84 (16 percent less volatile than the market) in the 1950s to 1.11 during recent years (11 percent more volatile). That’s a 30 percent increase in the relative volatility of the average fund. In the earlier era, no equity fund had volatility above 1.11; during recent years, 38 percent of equity funds exceeded that level. Relative Volatility of Equity Mutual Funds Relative Volatility 1950-1956 2008-2011* Difference Over 1.11 0 % 38 % +38 % 0.95-1.11 34 38 +4 0.85-0.94 30 10 -20 0.70-0.84 36 6 -30 Below 0.70 0 9 +9 7. * *S&P 500 = 1.

Quantitative Investing—An Example of Financial Innovation Few commentators seem to have noticed that the rise of speculation in the financial markets represents not just a difference in degree from its earlier form, but a difference in kind. Speculation has come to mean, not only the inevitable uncertainty surrounding a company’s profits or losses, its assets and liabilities, but the uncertainty surrounding the market price of its shares. The focus of the new market is less on business fundamentals, and more on the market valuation of a company’s shares . . . the expectations market. Decades before that baneful trend reached its full flower, legendary investor and author (The Intelligent Investor) Benjamin Graham warned about the rise in speculation. Here are some excerpts from his prescient 1958 keynote speech to The New York Society of Security Analysts—more than a half- century ago!

Investment Companies” was born on September 24, 1974.9 As I took on my new job, I was once again, “fired with enthusiasm.” (Again! Think about that!) Recalling the analysis of the fund industry that I had presented in my senior thesis, and buttressed by my research data (in those days, using a hand calculator and a slide rule), I documented the failure of mutual fund managers generally to gain “superiority over the market averages” (using the Standard & Poor’s 500 Index) during the previous three decades. Equally important, I was inspired by powerful encouragement from Nobel Laureate Paul Samuelson. Result: We formed the world’s first index mutual fund. Our board was skeptical, for its mandate to the warring partners precluded Vanguard from providing investment advisory services to the funds. But when I explained that an index fund required no adviser, the board reluctantly acceded to my recommendation. That day of infamy for mutual fund managers “changed a basic industry in the optimal direction,” as Dr. Samuelson wrote in his 1993 foreword to my first book.10 It was the beginning of a far better direction, one aimed at placing front and center the interests of the mutual fund shareholders. The IPO for our index fund took place on August 28, 1976. It was a flop. The underwriters raised only $11 million of initial assets. It barely grew for years, and industry leaders scorned it publicly.

no extravagance, and to live within his means . . . Simple in his manner and unostentatious in his habits of life, he abstains from all frivolities and foolish expenditures . . . It is this spirit of rectitude, I hope, that will again come to animate the values and conduct of our industry. Wrapping Up Yes, six-plus decades after I read that FORTUNE article, there’s still “Big Money in Boston” today. While no longer the center of the industry, Boston firms manage about $2.2 trillion of industry assets or 18 percent, well down from that 1951 peak of a dominant 46 percent. Exhibit 15. Whether we like it or not, there have been some significant changes, not only in the center of the industry’s core, but in the business model of many firms. First, the old M.I.T. is no longer the embodiment of pure trusteeship, bereft of a marketing agent for the fund. In 1969 it became the nucleus of a new privately-owned fund complex (Massachusetts Financial Service) whose funds were managed and distributed by a profit-seeking firm. More than incidentally, in 1976 MFS was purchased from its fairly new owners by a publicly-owned Canadian insurance company. The firm’s one-time market share of 14 percent of industry assets is now 4 percent. Since 1995 alone, Sun Life has earned almost $4 billion of profits from its ownership of MFS, a goldmine, as I mentioned earlier, for the financial conglomerate. (MFS was put up for sale in 2007, but “after a strategic review,” Sun Life decided not to sell.)

Past returns tell us absolutely nothing about the return that a Treasury note purchased at the end of any period would earn during the subsequent decade. For example, the returns on the 10-year Treasury note. During 1926-1981, its return averaged 3.8 percent. But with the entry yield in 1981 at 13.7 percent (!), the return over the 1981-1991 decade turned out to be 13.1 percent. So both our arithmetic and our logic confirm that the current yield of a bond has been—and should almost certainly continue to be—a highly reliable guide to its future return. (The correlation between year-end yield and subsequent ten-year return for Vanguard Total Bond Market Index Fund is a still impressive 0.80.) Stock Returns The methodology for stock returns is similar but more complex. Keynes focused on the two broad sources that explain the returns on stocks. The first was what he called enterprise—“forecasting the prospective yield of an asset over its entire life.”3 The second was speculation—“forecasting the psychology of the market.” While Keynes made no attempt to quantify the relationship between enterprise and speculation in shaping stock market returns, however, it occurred to me, decades later, to do exactly that. What Keynes had described as “enterprise,” I defined as investment return—the initial dividend yield on stocks plus the subsequent annual rate of earnings growth.

earnings have, with remarkable consistency over time, grown at about the rate of the U.S. Gross Domestic Product, this relative consistency is hardly surprising. Combining dividends and earnings, the total investment return (TOP LINE) on stocks averaged almost 9 percent. In only two decades (the 1930s and the 2000s) was the investment return less than 6 percent annually, and only two others were more than 12 percent. Speculative return is, well, speculative, and has alternated from positive to negative over the decades. (GREEN) But note the powerful tendency of volatile P/E multiples toward reversion to the mean (RTM). Indeed, in each decade in which P/Es fell significantly—the 1910s, 1940s, and 1970s—was followed by a rise of almost identical magnitude in the subsequent decade—the 1920s, 1950s, and 1980s. That second consecutive blow-out decade for speculative return in the 1990s was totally without precedent. (A nice Black Swan! Such is the nature of our financial markets.) RTM is a fundamental law of the markets, and, as I’ll discuss shortly, RTM may well apply to alternative investments as well. Applying reasonable expectations to future investment returns and speculative returns, and then combining them has been a sensible and effective approach to projecting the total return on stocks over the decades.

(ORANGE) The point is this: Over the very long run, it is the durable economics of investing—enterprise—that has determined total return; the evanescent emotions of investing— speculation—so important over the short run, has ultimately proven to be virtually meaningless. In the eleven decades shown in the chart, for example, the 9.1 percent average total annual return on U.S. stocks has been dominated by those 8.8 percentage points of investment return (an average dividend yield of 4.5 percent plus average annual earnings growth of 4.3 percent), and only 0.3 percentage points of speculative return, borne of an inevitably period-dependent increase in the price- earnings ratio from 12.5 times to 22 times, amortized over the decades.college

He fought in India, in the Sudan, and in the Boer War, where he was captured and then escaped. He was ousted as Lord of the Admiralty after the disastrous Gallipoli campaign in World War I. In and out of Parliamentary office for decades, he became Prime Minister in 1940. His determination, spirit, and never-say-die leadership rallied Britain in World War II, finally leading the Allies to victory in 1945. Rejected by the voters later that year, he never gave up, returning as  Churchill’s biographers cite a 1941 speech at Harrow entitled “Never Give In.” Whether he returned 20 years later, as the legend goes, has never been confirmed. But it’s a wonderful story anyway.

eight heart attacks, I fought my way through the four decades that followed. (Take that, you predictors of my early demise!) But by then, half of my heart had stopped pumping. The only hope was a heart transplant. After 128 days waiting in the hospital, suffused with life-sustaining intravenous drugs, the strong spirit and the frail body never gave up, and the new heart arrived on February 21, 1996. Such a second chance in life is something of a miracle, and though the last few years have presented their own health challenges. (After all, I’m now almost as old as Churchill was when he delivered that powerful peroration at Harrow.) But my reaction is simple: “If you’ve been given fourteen additional years of life, it doesn’t seem to be a good idea to go around bitching.” (Forgive me, please for my crude choice of words, but “complaining” simply doesn’t do the job!) During all those decades of health challenges, I faced major challenges in my career. It’s no fun to be fired—some of you, I’m sorry to say, will also have to learn that—but that’s exactly what happened to me in January 1974, eight years after I made a foolish—even stupid—decision to merge the firm I then headed. Corporate power politics, alas, trumped common sense; the merger blew up, and I found myself out of work. But—as you may now suspect—I wasn’t the giving-up type. By September 1974, I’d started a new firm, named it Vanguard, and went back to work.

The Straw That Broke the Camel’s Back As with any transformation, multiple, doubtless innumerable, factors were responsible for the sea change that gradually subverted the fund industry’s mission. Operating for decades as an industry composed of a group of small firms, entirely privately-owned by the professional managers who were actually providing the advisory services, and focused on earning a return on the capital that investors had entrusted to them, the industry gradually morphed into a group of giant firms, largely publicly-owned and controlled by corporate executives whose mission was asset gathering, and focused on earning a return on the capital of the owners of the management company. But the proverbial “straw that broke the camel’s back” of the traditional industry was when the owners of privately-held management companies gained the right to sell their ownership positions to outsiders, and then to the public, and finally to giant financial conglomerates.125

Outside ownership, in effect, demands that investment funds be viewed as products of their management companies, manufactured (in the current grotesque parlance) and distributed to earn a profit for the company. Mutual ownership, on the other hand views mutual funds, yes, mutual funds, as trust accounts, managed under the direction of prudent fiduciaries.16 It’s high time to look at the record, and compare the results achieved by the firms following these opposing philosophies. As I’m fond of saying, over our three-plus decades of our existence, Vanguard has proven to be both a commercial success and an artistic success. A commercial success, because our structure has been proven to be a superb business model. The assets we manage for investors have grown from $1.4 billion at our 1974 founding to some $1.2 trillion today. At this moment, in fact, we may well be the largest firm in our industry. (In fairness, Vanguard, American Funds, and Fidelity have gone back and forth in the lead position for several years now. Each of these giants manages about three times the fund assets of the next largest firms, Franklin Templeton and Barclays Global.) 16 I intensely dislike the use of the word “product” to describe an investment company, and, early in Vanguard’s history, banned its use at the firm.

The three firms with the highest performance ratings are the very same firms—in the very same order—that have the lowest annual expense ratios, averaging 0.30 percent. For the top- performing group in total, the average ratio is 0.69 percent. Expense ratios for the middle group average 1.24 percent, fully 80 percent higher.22 The bottom group of performers, on the other hand, have the highest expense ratios, averaging 1.57 percent per year, 110 percent above the top-performing group. Together, these data tell us that, when looking to the sources of mutual fund returns, yes, costs matter. But please don’t take my word for it. In fact, these data merely confirm what industry experts and academics have been saying for decades. Morningstar puts in unequivocally: “expense ratios are the fund world’s best predictor” of performance, adding that, “all studies show that expenses are the most powerful indicator of a fund’s performance.” (Italics added.) Nobel laureate (in Economics) William F. 21 Since the largest variations in fund expense ratios come in equity funds, I have excluded bond fund expense ratios—which are generally lower—from this comparison. This practice also eliminates the distortion that would be created when firms manage different proportions of bond funds to stock funds. 22 The funds managed by Barclays, with a ratio of 0.41 percent, largely follow lower-cost index or index-like strategies.

I expected that becoming the low-cost provider in any industry where low cost (by definition) is the key to superior returns, would force our competitors to emulate our structure. Indeed, I chose the name “vanguard” in part because of its meaning: “leadership in a new trend.” But I was wrong. After more than three decades—during which at least one of our industry peers has described us as “the organization against which others must measure themselves”—we have yet to find our first follower.29 We remain unique. Of course, not everyone shares my view of the positive power of the mutual structure. Hear the American Enterprise Institute (AEI), in a recent book entitled Competitive Equity–A Better Way to 28 “Competition in the Mutual Fund Industry,” by John C. Coates IV and R. Glenn Hubbard, The Journal of Corporation Law, University of Iowa, Volume 33, Number 1, Autumn 2007, page 173-4. 29 I had hoped that when Marsh & McClennan decided to sell its Putnam Management Company subsidiary— obviously a deeply troubled firm whose previous management ill-served its investors in so many ways—it would mutualize and internalize its organization. However, my attempts to persuade three directors of the funds (including its then independent chairman) fell on deaf ears. The fund board approved the sale of the management to a Canadian conglomerate for $4.9 billion.

“Regardless of the exact structure, mutual or conventional, an arrangement in which fund shareholders and their directors are in working control of a fund—as distinct from one in which fund managers are in control—will lead to funds that truly serve the needs of their shareholders, meeting the crying need to return this industry to the traditional role of trusteeship that largely characterized its modus operandi through its first three decades. Under either structure, the industry will enhance economic value for fund shareholders.” What’s to be Done? Given the industry’s growth; its sharp turn from stewardship to salesmanship; the army of conglomerates that has swept across it, leaving only a handful of survivors; its failure to produce anything like satisfactory returns to the investors who have entrusted funds with their hard-earned dollars; and, dare I say, the success of the singular, still unique, firm that has, for nearly 34 years now, almost unequivocally demonstrated the value of that internalization that the SEC was unprepared to mandate all those years ago, not a single additional moment should elapse before those long-justified, long awaited “more sweeping steps” are not only considered, but enacted into the law. My idealism tells me to fight for compulsory internalization,33 at long last making it possible to delete those quotation marks around “mutual” fund that reflected the prescient concerns expressed by Chairman Cohen in the speech he delivered in 1966.

“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.

Response to Bogle Remarks at Aspen Institute Breakfast by Randall Rothenberg, Senior Director, Booz Allen Hamilton New York, New York March 14, 2006 It is the fancy to think of Jack Bogle as (and to call Jack Bogle) a “maverick.” Sure, he seems a maverick! Here, in this age of terror and physical insecurity, he dares write that one of the “major threats” to our culture is “the remarkable erosion that has taken place over the past two decades in the conduct and values of our business leaders, our investment bankers, and our money managers.” But if I might be forgiven the mixing of a zoological metaphor, there’s something fishy about John’s designation as a maverick. Vanguard, the company he founded, is enormous: More than $950 billion under management. It’s also very popular. The pioneer of low-cost index funds, Vanguard is one of the three largest mutual funds companies in America. Big and popular? That’s how we describe football captains. Mavericks are scrawny and live in the basement. Rather, Jack Bogle—and I hope he’ll forgive me for speaking of him so impersonally and historically, in his presence no less!—is a different kind of American creature. He is an institutionalist—if you will, a “small-c” conservative. Like Teddy Roosevelt, Bogle is driven by the desire to conserve the elements of the American dream that might, to a cynic, seem fanciful. But these are the values which still draw to our shores some three-quarters-of-a-million legal immigrants each year.

“High Standards of Commercial Honor . . . Just and Equitable Principles of Trade . . . Fair Dealing with Investors” Remarks by John C. Bogle, Founder and former Chief Executive, The Vanguard Group Before the Financial Industry Regulatory Authority at its first Joint Meeting Washington D.C. October 15, 2007 I’m greatly honored to be invited to address the first annual joint Enforcement Meeting of FINRA. While I have had little experience with regulators for the New York Stock Exchange, this visit reminds me that I maintained an active involvement with NASD regulation for something like two full decades during the 1960s and 1970s, as a member and then chairman of the Investment Companies Committee, and as a member of the Long-Range Planning Committee. In the mid-1970s, long-range planning for the securities industry was no mean challenge. The long era of (high) fixed commissions on brokerage transactions had ended in 1974, replaced by today’s system of (minuscule) negotiated commissions. Financial technology was just being introduced, and it was clear that the slow old order hath changeth, to be replaced by a new order operating at a millisecond pace. And securities regulations were beginning to change and litigation to grow. In the phrase I used then, “competition, communications, and the courts will reshape the securities industry.

There, the careful observer will see that the black necktie I’m wearing is awash in little orange tigers, a gift from one of my granddaughters. So my loyalty to my alma mater is uncompromised, and Princeton remains nearest and dearest to my heart, echoing that quotation from Sophocles engraved on a plaque on Goheen Walk on the lower campus: “Stranger, you have reached the noblest home on earth.” And so Princeton is to me tonight, and so Princeton will remain to me forever. I. The Battle for the Soul of Capitalism Let me begin by discussing the deep concerns about the vanishing values of our nation that I expressed in The Battle for the Soul of Capitalism. The Battle begins with a remarkably modest rewriting of the opening paragraph of Edward Gibbon’s The Decline and Fall of the Roman Empire, adapted to the present era. Compare the two first sentences. Gibbon: “In the second century of the Christian Era, the Empire of Rome comprehended the fairest part of the earth and the most civilized portion of mankind.” Note: The opinions expressed in these remarks do not necessarily represent the views of Vanguard’s present management.

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

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.

75% 55% 100% 0% 20% 40% 60% 80% 100% Money Market Bond Funds (expected) Equity Funds Share of Assets in No Load Funds 2A. to 5.3 percent for the bottom-tier funds, reducing their disadvantage by 0.9 percentage points, more than a 40 percent reduction in the spread. Clearly, before costs are deducted, remarkably small rewards—indeed, almost non-existent rewards—can be attributed to manager skill, luck, and randomness. The Great Marketing Machine In the great marketing machine we know as the mutual fund industry, these perhaps obvious findings are largely ignored, even as the costs of mutual fund investing are themselves largely ignored. Think with me for a moment of how mutual funds are distributed in relationship to the clarity of the impact of costs on returns. In money market funds, when the correlation between expense ratio and total return is virtually 1 to 1, even on a daily basis. Here, 100 percent of total money market fund assets of $1.8 trillion is represented by no-load funds. (Chart 2A) In equity funds, the correlation of costs with returns over, say, a single year is cloudy but negative, at about the minus 0.13 level. The correlation of costs with returns over three decades is much more visible, and negative at an imposing minus 0.69 level. Yes, higher costs are associated with lower returns.

* Two, when you begin to invest so that you will have enough for your own retirement many decades hence, do so in a way that minimizes the extraction by the financial community of the returns generated by business. This is, yes, a sort of self- serving2 recommendation to invest in low-cost all-U.S.—and global—stock market index funds, the only way to guarantee your fair share of whatever returns our financial markets are generous enough to provide. * Three, no matter what career you choose, do your best to hold high its traditional professional values, now swiftly eroding, in which serving the client is always the highest priority. And don’t ignore the greater good of your community, your nation, and your world. After William Penn, “we pass through this world but once, so do now any good you can do, and show now any kindness you can show, for we shall not pass this way again.” Most commencement speakers like to sum up by citing some eminent philosopher to endorse his message. I’m no exception. So I now offer to you new Masters of Business Administration these words from Socrates, spoken 2500 years ago, as he challenged the citizens of Athens. “I honor and love you: but why do you who are citizens of this great and mighty nation care so much about laying up the greatest amount of money and honor and reputation, and so little about wisdom and truth and the greatest improvement of the soul. Are you not ashamed of this? . . .

To use a gambling analogy, visualize actively trading stocks as gambling in a casino, where after each round of betting, the croupiers rake their share off the table: The fund managers, the brokers who execute the funds’ near-complete turnover of their portfolios in a single year, the mutual fund marketplaces, the funds-of-funds inspired by Bernie Cornfeld, and finally the federal and state governments. There are lots of croupiers! With the hyperactive level of mutual fund portfolio trading, and with mutual fund shares traded like stocks and sold on the basis of hot past performance that doesn’t repeat itself, the analogy to the casino is hardly far-fetched. And the outcome is just as predictable. Precious few mutual funds beat the market. Just as Lord Keynes warned, “When the capital development of a country becomes the by-product of a casino, the job is likely to be ill-done.” The job has been ill-done for fund investors. The Hedgehog Strategy Enter the hedgehog. The one great thing the hedgehog knows is the strategy of buying businesses and holding them, ideally, forever. This is the strategy followed by the king of the hedgehogs, America’s most successful investor, Warren Buffett. He has achieved his preeminence by buying substantial interests in a few well-chosen large businesses and holding them, if not “forever” (his favorite holding period), for a very long time.

Contrast this strategy with the typical mutual fund strategy, not owning businesses but trading pieces of paper. Few investors are going to be Warren Buffetts, so let’s consider the closest thing to his hedgehog-like strategy available to us mere mortals. What fills the bill is buying a participation in every publicly-held business in America, and holding it forever. Yes, an all market index fund. Managed with virtually no portfolio turnover and operated—as it must be—at minimal cost, such an index fund is simply a hedgehog that enjoys three priceless certainties: (1) a certain participation in the growth of corporate America; (2) certainty that the crafty investment foxes as a group must earn the market’s annual return before costs, but deliver only about 85% of the return after costs; and (3) a certainty that, given its own minimal costs, it will deliver 98% of the market’s annual return to its investors. Clearly, just as the performance data show, the one great thing that characterizes the hedgehog approach—pristine simplicity—is the winning strategy. Perhaps it goes without saying that Vanguard is the industry’s principal hedgehog. While indexing need not be the only hedgehog strategy (witness Warren Buffett), it works, and we are the only firm that is deeply and fiercely committed to index funds.also

While academic distinction continued to elude me, fate smiled down on me once again a year later. Determined to write my senior thesis on a subject that no previous thesis had ever tackled, Adam Smith, Karl Marx, and John Maynard Keynes were hardly on my list. But what topic should I choose? In one of the many fantastic appearances of luck in my life, I was perusing Fortune magazine in the reading room of the then-brand-new Firestone library in December 1949; I paused on page 116 and began to read an article about a business which I had never even imagined. And when “Big Money in Boston” described the mutual fund industry as “tiny but contentious,” this callow and insecure—but determined— young kid decided that mutual funds would be the topic of his thesis. I entitled it, “The Economic Role of the Investment Company.” A Design for a Business? There’s no question that many of the values I identified in my thesis would, decades later, prove to lie at the very core of our remarkable growth. “The principal function of mutual funds is the management of their investment portfolios. Everything else is incidental . . . Future industry growth can be maximized by a reduction of sales loads and management fees,” and, with a final rhetorical flourish, funds should operate “in the most efficient, honest, and economical way possible” (a phrase you heard earlier in my remarks). Sophomoric idealism? A design for the enterprise that would emerge a quarter- century later?

 Three, mutual fund returns fall drastically short of market returns. And they fall short by almost exactly the amount of the costs they incurred—all those management fees, operating expenses, sales charges, and hidden portfolio transaction costs. How could it be otherwise? Over the past two decades, for example, the annual return of the average equity fund (10 percent) has lagged the return of the S&P 500 Index (13 percent) by three percentage points per year, largely because of those pesky fund costs. To make matters worse, largely because of poor timing and poor fund selection, the return actually earned by the average fund investor has lagged the return of the average fund by another 3 percentage points, reducing it to just 7 percent per year—roughly 50% of the market’s annual return. Warren Buffett accurately describes the problem: “the principal enemies of the equity investor are expenses and emotions.” The fund industry has failed investors on both counts. A return of 7% in a 13% market is a shocking gap, but the reality is far worse. When compounded over this grand 20-year era for investing, and adjusted for inflation, the average investor has captured but 16 percent of the market’s compounded real profit. (I’m not kidding! $1,000 invested in a simple index fund mimicking the Standard & Poor’s 500 Stock Index in 1984 and held today produced a profit of $5,490 after inflation; for the average fund investor, the real profit came to just $910.)

professional investors succumbing to the speculative psychology of ignorant market participants, I argued, these pros would focus on enterprise. In what I predicted—accurately—would become a far larger mutual fund industry, our portfolio managers would “supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic [italics added], a demand that is based essentially on the [intrinsic] performance of the corporation rather than the public appraisal reflected in the price of its shares.” Alas, the sophisticated and analytic focus on enterprise that I had predicted from the industry’s expert professional investors has failed to materialize; rather, the emphasis on speculation by mutual funds has actually increased many fold. Call the score, Keynes 1, Bogle 0. Interestingly, Keynes was well aware of the fallibility of forecasting stock returns, noting that “it would be foolish in forming our expectations to attach great weight to matters which are very uncertain.” He added (shades of Frank Knight!) that “by very uncertain I do not mean the same thing as ‘improbable.’” While Keynes made no attempt to quantify the relationship between enterprise and speculation in shaping stock market returns, however, it occurred to me, decades later, to do exactly that.

For throughout our society we have seen another troubling mutation, much like the mutation in capitalism itself that I described earlier: our professional associations are becoming more like business enterprises, moving away from the stern traditional values of yore toward the, well, flexible values that characterize our modern age. This change is of relatively recent vintage. In 1965, according to an article in Daedalus,1 “everywhere in American life, the professions were triumphant.” But in the four decades that followed, almost without our noticing, that triumph had melted away, as our professions were gradually, “subjected to a whole new set of pressures, from the growing reach of new technologies to the growing importance of making money.” You’ll have to tell me whether these pressures have affected any of you here today in this organization, composed—in the words of your summary description—of “professionals involved in estate planning.” So, let’s step back for a moment and consider what we mean when we talk about professions and professionals. The Daedalus article defined a profession as having six common characteristics: 1 Daedalus, The Journal of the American Academy of Arts & Sciences, Summer 2005, “The Professions in America Today: Crucial but Fragile,” by Howard Gardner, Professor at the Harvard Graduate School of Education, and Lee S. Shulman, president of the Carnegie Foundation, pages 13-18.

 a broad product line, with innovations as required. (For example, our index fund, and an innovative concept of the municipal bond fund, which we are now just developing.)  Finally, operational facilities that will assure our ability to service shareholders effectively and efficiently, to expand the range of our services, and to control our marketing efforts. We do not believe our precise strategy would necessarily be right for anyone else in the industry. We do believe that it is right for us. But it comes only by relinquishing our marketing relationships—but maintaining our execution and research relationships—with the brokerage community that we worked with for many decades. I regret that departure, above all.troublesome

hand, is simply to buy a diversified list of stocks and hold them, well, forever. This is, of course, a fair depiction of the strategy of Warren Buffett. But it is also the driving force in Vanguard’s success: The passively managed market index fund. In its most pristine form, the index fund—operated at a cost best described as trivial—owns a share in every business in America, and never sells it. Who wins, the fox or hedgehog? Well, let’s look at the record. If you had invested $10,000 with the typical mutual fund fox at the outset of this 17-year bull market—the greatest in all history—it would today be valued at $136,000. The same investment with the all-market fund hedgehog would be valued at $182,000. Just owning American business—at low cost—and doing nothing else, resulted in an extra $46,000 in return. The difference lies solely in relative cost. No wonder investors are starting to appreciate indexing. And no wonder the financial foxes hate it. For, as the record shows, foxy active management, with its heavy fees and costs, simply results in a diversion of the market’s returns from the shareholders to the managers.

After a half-century observing this industry, I may have become too much the philosopher, maybe even too much the cynic. But it occurs to me that most mutual fund managers are barking up the wrong tree. I just can’t imagine that any of those foxes in the mutual fund industry don’t understand the simple arithmetic that gives the all-market index fund its powerful advantage, let alone the extra boost added by its extraordinary tax-efficiency. That I am virtually the industry’s sole apostle of indexing makes the thesis easy to ignore. But even when Warren Buffett, with his unchallenged credentials, speaks—“Most investors will find that the best way to own common stocks is through an index fund that charges minimal fees. . . it is certain to beat the net results delivered by the great majority of professionals”—this industry fails to listen. Except, that is, for the former chairman of one giant fund complex who defends his firm against the clear truth that underlies the superiority of the index with these words: “Investors ought to recognize that mutual funds can never (his word) beat the index.” The index fund is not merely another kind of mutual fund. It approaches investing, not as a matter of trading pieces of paper for advantage, but as a matter of owning businesses and watching them grow. Through an all- market index fund, investors own the shares of virtually every publicly-held business in the U.S., and hold them forever.

Yet, going back to 1981, consensus estimates for future five-year annual earnings growth projected by corporate managers have averaged 11.6%, nearly twice the 6.3% actual annual growth actually achieved over the two decades. As a result of the happy conspiracy between business executives and financial institutions—relying on market expectations rather than business realities—we witnessed a bubble in stock market prices that inevitably burst, as all bubbles do, sooner or later, Then, the idea of value slowly returns to the stock market. It is truly astonishing how pervasive have been the failures in our capitalistic system. While it’s often alleged that these problems have been limited to just “a few bad apples,” the evidence suggests that the barrel that holds all those apples, good and bad alike, has developed some serious problems. For example:  Yes, there have been “only” a few Enrons, WorldComs, Adelphias, and Tycos. But during the past five years, there have been 5,989 restatements of earnings by publicly-held corporations, with stock market capitalizations aggregating more than $4 trillion, often reflecting overly aggressive accounting procedures.  Yes, the investment banking scandals involved “only” twelve firms, but among them were eight of the nine largest firms in the field. As a result of the investigations by New York attorney general Eliot Spitzer, they ultimately agreed to pay some $1.

A Lengthened Shadow? Is Vanguard, too, “the lengthened shadow of one man?” I’m not so sure. But I hope and pray that the shadow of the investment philosophy and the human values—the economics and the idealism—I have championed will lie forever on our firm. For they are the right philosophy and the right values, sound, enduring, even eternal. As for the man himself, I assure you that Vanguard today is far more durable than its now-aging founder, and indeed far greater than any one man. Our superb crew, now numbering more than 10,000, is committed and deeply dedicated to our core values. And our investors, from whom I hear with extraordinary frequency, demonstrate a remarkably sophisticated understanding of what Vanguard is all about. Even as Wilson placed his hopes in the people and believed that the real wisdom of human life is compounded out of the experiences of the common man, so I freely place my trust in the wisdom and common sense of our shareholder-owners, and in their continued recognition of the soundness of Vanguard’s approach to investing. Of all that I admire about Wilson—his powerful intellect; his commanding presence; his graceful, flowing use of the English language; the length of his foresight and the breadth of his vision—I admire most his stubborn, uncompromising idealism, reflected, in a colleague’s view, in “his recklessly, passionately-outspoken, crusading spirit.

But if we recognize that corporate earnings have, with remarkable consistency, grown at about the rate of the U.S. Gross Domestic Product, this relative consistency is hardly surprising. Speculative return is, well, speculative, and has alternated from positive to negative over the decade. But over the long-run speculation hasn’t produced any Black Swans either. In fact, if P/E ratios are historically low (say, below 10 times) they have been likely to rise over the subsequent decade. And if they are historically high (say, above 20 times) they have been likely to decline (though in neither case do we know when the change is coming). Nonetheless, certainty about the future never exists, nor are probabilities always borne out. But applying reasonable expectations to investment return and speculative return and then combining them has been a sensible and effective approach to projecting the total return on stocks over the decades. The point is this: Over the very long run, it is the economics if investing—enterprise—that has determined total return; the evanescent emotions of investing—speculation—so important over the short run, have ultimately proven to be virtually meaningless. In the past century, for example, the 9.6 percent average annual return on U.S. stocks has been composed of 9.5 percentage points of investment return (an average dividend yield of 4.5 percent plus average annual earnings growth of 5 percent), and only 0.

In 1951 (and for nearly two decades thereafter), portfolio turnover averaged about 16 percent per year; during the last five years, portfolio turnover of the typical fund has averaged about 100 percent per year—six times as high. Yes, even my one-time “own-a-stock” industry has become a “rent-a-stock” industry. 4. Managed largely by prudent investment committees making painfully deliberate investment decisions in 1951, investment management in the fund industry today is handled largely by individual portfolio managers with the ability to act immediately, indeed precipitately, in responding to fluctuations in the prices and valuations of specific stocks. In part for marketing reasons, we have developed a “star system” in which particular managers are portrayed, at least by implication, as having a durable talent for providing superior returns. Yet the fact is that nearly all of these one-time stars eventually prove to be insignificantly different from average.then

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

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

$31,200 $38,700 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Vanguard Total Bond Mkt Avg Taxable Bond Fund Actively Managed Bond Funds Versus Vanguard’s Total Bond Market Index Fund Avg. Annual Return 5.9% 7. 7.0% Fund operates at an effective advisory fee rate of 2 basis points, and our High Yield Bond Fund at less than 4 basis points. That is what negotiating fees for the benefit of the fund investor is all about. It’s unfortunate that such negotiation is conspicuous by its total absence—or at least near- total absence—elsewhere in the mutual fund industry. Owning the Bond Market It is because of low investment expenses, low operating expenses, low marketing expenses, low portfolio turnover costs, and the absence of sales charges that Vanguard Total Bond Market Index Fund most clearly reflects the optimal approach to capturing for investors the maximum possible portion of whatever returns the bond market is generous enough to favor us in the years ahead. At the end of 2006, VTBMF, if you will, celebrated its twentieth anniversary. Given the magic of compounding investment returns—and the tyranny of compounding large costs—the Fund’s record during these two decades speaks for itself. Let’s look at the record. (Chart 7) Based on an initial investment of $10,000 on December 31, 1986, the total value on December 31, 2006, would have come to $38,700, a cumulative rate of return of 7.

annual cost and without sales loads is the obvious winning strategy. Broadly-diversified, actively managed (but not too actively managed) bond funds on attractive terms of ownership are an excellent choice, and the index fund is the paradigm of that strategy. That being the case, how can it be that only a single firm offers very low-cost no-load funds, and only that same firm (or now perhaps two or even three) seriously offers bond index funds? And how can that continue to be the case? Especially since we can be highly confident that bond returns in the years ahead will be far lower than that 7 percent return of the past two decades. Surely no one here tonight can be oblivious to the fact that today’s entry yield of about 4.8 percent on taxable bonds (4.2 percent for municipal bonds) establishes the reasonable expectation for returns over the coming decade. So now understand the simple arithmetic: Those low gross returns, reduced by the excessive all-in annual costs of about 2.1 percent for the average load fund—say 1 percent per year in expense ratios plus heavy sales loads (amortized) of about 1.1 percent per year—will enviably lead to shockingly low net returns for investors. Costs will likely consume 45 percent or even 50 percent of the coming annual returns in the bond market, and therefore 50 or 55 percent of the market’s cumulative ten-year return. What’s to be done?

Fixing a Broken Financial System Remarks by John C. Bogle Founder and Former Chief Executive, The Vanguard Group Before A Stradley, Ronan, Stevens & Young Assembly Philadelphia, PA February 12, 2009 I’m so pleased with this wonderful turnout—surely an indication that many leaders in our Greater Philadelphia business and legal community are deeply concerned by the financial crisis that continues to unfold as we meet. And I thank Stradley Ronan for giving me the opportunity to present my views to you, as well as their presenting each of you with my newest book—number seven—published just a few months ago. As it happens, in many respects, ENOUGH, anticipated—some say, predicted—the crisis in our markets and our economy. But the book also sends a message about the decline in our society’s character and values that we have witnessed over the past few decades. No one would have been more appalled by what has gone wrong than Stradley’s former senior partner, the late Andrew B. Young, Esq. I benefited greatly from Andy’s mentorship as Wellington Management Company’s counsel during the 25 years we worked together, as well as from the insight and wisdom of this great man for the remaining 25 years of his long life. So I take the liberty of dedicating these remarks to his memory. (Stradley, Ronan, Stevens & Young people here: never forget your fine heritage.

3. Client Focus. Our management company is owned and controlled by our own shareholders rather than by the national and international financial conglomerates that now largely control the fund industry. (41 of the 50 largest fund firms are now controlled by these giants.) Our unique structure is particularly relevant since the clients of financial planners and registered investment advisers—your clients—constitute a significant portion of our client base. When we serve them effectively, we serve you; when we serve you effectively, we serve them. Providing intelligent and productive financial planning advice to the “honest-to-God, down-to- earth human beings, each with their own hopes, fears, and financial goals” (a phrase I’ve used for decades) is, in my view, more demanding today than ever before. I make that observation only after careful consideration of how today’s financial environment differs from what has gone before. Today I’ll give you three poignant examples of that change:: 1. The folly of short-term speculation has come to dominate our financial marketplace; the wisdom of long-term investing has diminished commensurately. 2. Relative to historical norms, the outlook for future returns on stocks and bonds is, in a word, subdued. In such an environment, the temptation to go beyond traditional markets to garner extra returns is enormous. 3.

You could say, I suppose, that I’ve come a long way from there. In my career, from waiter and then part-time post office clerk to founder and for decades chief executive of what is now the largest ($2 trillion of assets) mutual fund complex in the world. It surprises even me! I was raised in a close but broken family, and both of my parents died the year after I graduated from college. But right here, 56 years ago, it was “Acres of Diamonds” all over again.children,

1. A Parable The first of the two relentless rules of humble arithmetic I’ll mention is a simple one: Gross return in the financial markets, minus the costs of financial intermediation, equals the net return that we investors share. To understand that is how our financial system really works. Consider my version of this parable told by Warren Buffett, chairman of Berkshire Hathaway Inc., in the firm’s 2005 annual report. It clarifies the foolishness and counterproductivity of our vast and complex financial market system. Here goes: Once upon a time . . . a wealthy family named the Gotrocks, grown over the generations to include thousand of brothers, sisters, aunts, uncles, and cousins, owned 100 percent of every stock in the United States. Each year, they reaped the rewards of investing: all the earnings growth that those thousands of corporations generated and all the dividends that they distributed. Each family member grew wealthier at the same pace, and all was harmonious. Their investment had compounded over the decades, creating enormous wealth, because the Gotrocks family was playing a winner’s game. But after a while, a few fast-talking Helpers arrive on the scene, and they persuade some “smart” Gotrocks cousins that they can earn a larger share than the other relatives. These Helpers convince the cousins to sell some of their shares in the companies to other family members, and to buy some shares of others from them in return.

I’m not one to accept such advice. So I decided to search for the best cardiologist in America. The name that kept coming up was, of course, Dr. Lown. He took on my case, beginning a 20-year doctor-patient relationship that saved my life, and gave me a bridge over the troubled waters of a mysterious heart disease. As he would write to me years later, “that dire early prognosis left out of the calculus the indefinable human spirit that can powerfully tilt the balance toward life.” In the words from a song in Les Miserable, Bernard Lown not only “gave me hope when gone, he gave me strength to carry on.” Over the following two decades, I made a score of extended visits to Brigham Hospital where he frequently inspected me (if you will) on his legendary rounds. Believe me, it was not only the residents and fellows who accompanied him who were intimidated. So were his patients! But I was also inspired and utterly confident that I had his rapt attention and concern— yes, and love—every moment that he stood by my bedside. I should add that sadly one of my four daughters, Nancy, inherited my genetic malady. Dr Lown also helped her along the difficult road, and she shares my feelings about him, perhaps even more fervently. At Brigham I endured a then-record 50 stress tests, evaluating the effectiveness of the various experimental drug therapies with which he tried to alleviate my frequent bouts of ventricular tachycardia.

Early in my career, I worked with our bond and stock analysts, helping them with basic data on corporate balance sheets, income statements, and other financial statistics, later serving on our Investment Committee. While I should have known better, I’m afraid I was largely responsible (though well-intentioned!) for our firm’s ill-fated change in focus from long-term investment to short-term speculation, beginning in 1966. My decision to merge Wellington Management Company with a much smaller Boston firm of hot managers of that “go-go” era was simply stupid. It had unfortunate consequences for our funds, including Wellington Fund, our crown jewel. To my everlasting regret, I came to believe that these new managers could outperform the market forever. (Yes, I did!) But it quickly became apparent that they could not meet that lofty standard. All too soon, I came to realize the obvious: there is no such a thing as a permanently superior long-term mutual fund manager: Good, rarely; superior, never.

If one has the patience to wait 50 years, perhaps anything can find its way into the library. The First 50 Years was followed in 2002 by Character Counts, my fourth book, a collection of the speeches I had given to our Vanguard crew over the first three decades of our firm’s history, with some explanatory text added. My idea was to set down the truth about events as they actually happened, not only so that our history wouldn’t be rewritten by others, but so it wouldn’t be rewritten by me. I presented these speeches, warts and all, without editing, so they compose a sort of oral history, without the benefit of hindsight. The Battle for the Soul of Capitalism That brings me to my fifth book, The Battle for the Soul of Capitalism. As 2004 began, I had absolutely no plans—none, nada—for writing another book. But only until I received a letter from Michael O’Malley, senior editor of business and economics for the Yale University Press, who wrote: “I think that your next book will be your best. As your ideas begin to take shape, I was wondering if we might discuss Yale as the publisher of your work.”

imagine that a man who first experienced congestive heart failure six decades ago would, God willing, soon begin the ninth decade of his life? Were my case unique, my story would hardly be worth the telling. But Nancy and I are microcosms representing all those individual patients to whom Dr. Lown has given—one at a time—an extra lease on life. I have no doubt that his art of healing each of these human beings is every bit as important as the macrocosm of his mission—yes, his battle—fought to save the world from nuclear madness, driven by his remarkable ability, as a concerned citizen of the world, to summon those spirits. And make them come! To pay tribute to the great humanitarian and cardiologist whom we honor this evening, I close with a daring leap from Shakespeare to the Beatles, paraphrasing the words of my favorite Beatles’ song. If you’ll think “Bern-ard” rather than “Hey, Jude,” you’ll get the picture. I’ve talked Kai-Yun Lu, clarinetist with the Atlantic Symphony Orchestra (which graces us with their beautiful music at tonight’s celebration), into giving me some musical support. Here we go: Bern-ard, you’ve made it good You took a sad song and made it better You remembered to let the world get under your skin Then you began . . . to make it better. Better, better, better, better, better, oh Na, na na na na na Na na na na, Ber-nard. Now, please, all join me in the chorus. . . Then you began. . . to make it better.

Fund portfolio turnover, about 16 percent during my first two decades in this field, soared to 100 percent during the recent era.) My conclusion powerfully reaffirmed the ideals that I hold to this day: “The principal function of investment companies is the management of their investment portfolios. Everything else is incidental.” The role of the mutual fund is to serve—“to serve the needs of both individual and institutional investors . . . to serve them in the most efficient, honest, and economical way possible.” This gratuitous advice about efficiency, honesty, and economical operation from a callow college senior was also largely ignored by the fund industry. But the creation of Vanguard in 1974 as a truly mutual mutual fund group—operated on an “at cost” basis for the benefit of its owners rather than its managers—was my attempt to walk the walk that I had talked the talk about nearly a quarter-century earlier. Today, I assure you that my youthful idealism remains intact. Indeed, it is shamelessly reflected not only in Vanguard but in my book The Battle for the Soul of Capitalism, published by Yale University Press in 2005, and also in The Little Book of Common Sense Investing, published by Wiley in 2007.about

on an “at cost” basis for the benefit of its owners rather than its managers—was my attempt to walk the walk that I had talked the talk about nearly a quarter-century earlier. Today, I assure you that my youthful idealism remains intact. Indeed, it is shamelessly reflected not only in Vanguard but in my Battle book, an expression of my concern about our American society today, my conviction that our system of capital formation is essential to our economic growth and world leadership, and my acknowledgement that much has gone wrong in our financial system. 2. A Parable So what’s gone wrong? Let’s begin with a parable that describes how the system really works. It’s my version of a story told by Warren Buffett, chairman of Berkshire Hathaway Inc., in the firm’s 2005 annual report, and it clarifies the foolishness and counterproductivity of our vast and complex financial market system. Here goes: Once upon a time . . . a wealthy family named the Gotrocks, grown over the generations to include thousand of brothers, sisters, aunts, uncles, and cousins, owned 100 percent of every stock in the United States. Each year, they reaped the rewards of investing: all the earnings growth that those thousands of corporations generated and all the dividends that they distributed. Each family member grew wealthier at the same pace, and all was harmonious. Their investment had compounded over the decades, creating enormous wealth, because the Gotrocks family was playing a winner’s game.

creative destruction—new ideas driving out old businesses—actually works to the benefit of society as a whole, for entrepreneurship is the engine of progress and economic advancement. Why is it that the public non-profit institutions that focus on faith, enlightenment, and moral values—and certainly on service to others before service to self—have had so much greater staying power than their private corporation counterparts? Could it be that society ultimately places a lesser value on institutions that focus more heavily on profits than on building better products and providing better services to customers? Or that while they cannot survive without creating value for others, these private institutions are expressly designed to serve their owner/stockholders? (Be clear, please, that I’m not arguing that, at its best, capitalism is bad; rather, that it is too often short-sighted.) While I’ll let you muse about these existential questions, I will say (if you’ll forgive this personal note) that I founded Vanguard on a principle quite the opposite from every other investment management firm in the mutual fund field—a truly mutual structure designed to serve the fund shareholders—our clients—rather than the management company owners. With Wellington Fund—founded by Walter L. Morgan in 1928, the oldest member of The Vanguard Group—we’ll be joining that 100-year club just a few decades from now. (I’m actually already planning the celebration.)

But I’m embarrassed about the field in which I ply my trade. All too many of its leaders bear a heavy responsibility for running our economy into the ground, even as they made personal fortunes by playing fast and loose with the system and taking absurd risks, not (of course!) with their own money but with other people’s money; even successfully lobbying for the rollback of regulations that had well-served investors for decades. Taking on the System But I’ve marched to a different drummer. I’ve challenged the financial system and done my best to improve it—to build a better world for investors. Vanguard, the company that I founded almost 35 years ago, was built on a firm foundation of service to our investors rather than service to ourselves, in a unique mutual mutual fund structure in which our fund shareholders actually own the funds’ management company. Vanguard operates on an “at-cost” 3 I’ve not been able to identify the source of the quotation.

In my 1951 Princeton senior thesis on the mutual fund industry, I cited Keynes’ conclusions. And I had the temerity to disagree with the great man. Rather than professional investors succumbing to the speculative psychology of ignorant market participants, I argued, these experienced pros would focus on enterprise. In what I predicted—accurately—would become a far larger mutual fund industry, our portfolio managers would “supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic [italics added], a demand that is based essentially on the [intrinsic] performance of the corporation rather than the public appraisal reflected in the price of its shares.” Alas, the sophisticated and analytic focus on enterprise that I had predicted from the industry’s expert professional investors has utterly failed to materialize. In fact, the emphasis on speculation by mutual funds has actually increased many fold. Call the score, Keynes 1, Bogle 0. Interestingly, Keynes was well aware of the fallibility of forecasting stock returns, noting that “it would be foolish in forming our expectations to attach great weight to matters which are very uncertain.” He added that “by very uncertain I do not mean the same thing as ‘improbable.’” While Keynes made no attempt to quantify the relationship between enterprise and speculation in shaping stock market returns, however, it occurred to me, decades later, to do exactly that.

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

One result of this crazy speculation—you all must know this by now—has been the unprecedented market turbulence I have described. A simple measure makes the point: During my first few decades in this business, we might have three or four days each year in which stocks rose or fell by two percent or more. Since July 2007, however, stocks have risen or fallen by that amount on 52 days, 21 up and 31 down—volatility without precedent in all history. But does this market craziness reflect reality? No it doesn’t. Since the October 2007 high, the total capitalization of the U.S. stock market has crashed from about $18 trillion to $10 trillion, at the low last Friday, a drop of some $8 trillion. But that’s “the market.” Does anyone here tonight really believe that the value of American corporate business in the aggregate has dropped by $8 trillion—by 40 percent! Well, I for one do not. Over the entire modern era, U.S. business has grown, with remarkably few interruptions, (for example the Great Depression), at about the pace of the real economy. Much of the responsibility for the crash in prices can be laid on Wall Street. Investment bankers, brokers, and money managers shifted their attention away from honoring, first and foremost, the interests of their clients and toward increasing their personal wealth and the earnings of their (largely publicly held) firms.

hardly certain, has been remarkably stable. Corporate earnings have, with considerable consistency, grown at about the rate of the U.S. Gross Domestic Product (GDP). In the Great Depression, of course, corporate earnings plummeted, just as they have risen, seemingly inevitably, with the long-term growth of our productive, innovative, and competitive U.S. economy. The speculative return on stocks has proven to be, well, speculative. It has alternated from positive to negative over the decades. But usually when price/earnings ratios are historically low (say, below 10 times) they have been likely to rise over time. And when they are historically high (say, above 20 times) they have been likely to decline. (Of course in neither case do we know when the change is coming.) While certainty about the future never exists nor are probabilities always borne out, applying reasonable expectations to investment return and speculative return and then combining them has proved to be a sensible and effective approach to projecting the total return on stocks over the decades. Relying on this simple but proven methodology, then, it is reasonable to expect annual stock returns in the range of 7 percent in the coming decade, well below the long-term norm of 9.6 percent. The dividend yield is 2 percent (not the 4 ½ percent norm of yesteryear), and earnings generated could reach 6 percent, a total investment return of 8 percent.

shareholders, in the miniscule costs that they bear, and in the overwhelming trust that our shareholders have placed in us. But I couldn’t forget Kipling’s implicit warning, “if you can meet both Triumph and Disaster, and treat those two imposters just the same.” After my earlier brush with Disaster in my career, it was easy for me to understand that Triumph too is an imposter. Far better than preening over the past, please realize that it is focusing on the future that must be the order of the day. Creating a new kind of fund company defied the conventional wisdom. So did creating a new kind of fund which would not trade stocks in the market, but simply buy all of the stocks in the stock market—owning corporate America, and holding it, well, forever. The world doubted that this tiny new firm called Vanguard would make a go of it. In fact, our index fund was called “Bogle’s Folly” for years. (But no longer!) So, yes, “when all men doubt you,” as Kipling put it, simply “trust yourself.” And when opportunity knocks, don’t forget to answer the door! Reflections on Today’s Crisis In our present financial and economic crisis, Vanguard’s simple strategies have paid off in spades. In a fund industry now deeply troubled by its aggressive marketing of investment fads, its speculative policies, its excessive costs, and its periodic scandals, our firm remains vibrant, healthy, and pristine.

quantify the relationship between enterprise and speculation in shaping stock market returns, however, it occurred to me, decades later, to do exactly that by putting numbers on Keynes’s distinction. By the late 1980s, based on my own first-hand experience and my research on the financial markets, I concluded that, consistent with what Keynes had written, the two essential sources of equity returns were: (1) investment (Keynes’ “enterprise”), and (2) speculation (the word Keynes used). I defined Investment Return as the initial dividend yield on stocks plus their subsequent annual rate of earnings growth over a decade. I defined Speculative Return as the change in the price investors are willing to pay for each dollar of earnings (essentially, the rate of return on stocks that is generated by changes in the valuation that investors place on future corporate earnings). Simply adding speculative return to investment return, I concluded, produces the Total Return generated by the stock market. For example, if stocks begin a decade with a dividend yield of 4 percent and generate subsequent earnings growth of 5 percent, their investment return would be 9 percent. If the price-earnings ratio rises from 15 times to 20 times, that 33 percent increase, spread over a decade, would translate into an additional speculative return of about 3 percent annually. Simply adding the two returns together, the total return on stocks would come to 12 percent. It’s not very complicated!

For the investor feeds at the bottom of the costly food chain of investing, paid only after all the agency costs of investing are deducted from the market’s returns.” We Are All Indexers So what’s to be done? First, we need our citizens to understand the difference between investment and speculation, and to recognize that—simply because of the costs of the financial system—long-term investors must win and short-term speculators must lose. I dare say that the optimal solution lies right before our eyes: Owning the entire stock market as our equity position, and holding it forever. Yes, I’m speaking of the stock market index fund. But please don’t think about that as a self-interested statement on my part. Think, instead of this reality: As a group, we are all indexers.

The fact is that (after-tax) corporate earnings have historically grown at about 5 percent (in nominal terms), roughly the same rate as the growth of our economy. Earnings have rarely represented less than 4 percent of our annual Gross Domestic Product, nor more than 8 percent. With the exception of the depression-ridden 1930s, the contribution of earnings growth was positive in every decade, usually composing between 4 percent and 7 percent per year of total stock returns. If we can but recognize that corporate earnings have, with remarkable consistency, grown at about the rate of the GDP, we can understand that the fundamentals of our economy drive long-term stock returns. But in the short-term, it is speculative return that calls the tune. Speculative return is, well, speculative, and has alternated from positive to negative over the decades, as price-earnings multiples are highly volatile. Over history, P/Es have generally ranged from 10 times to about 25 times (although as high as 40 times a decade ago!) When P/E ratios are historically low (say, below 10 times) they have been highly likely to rise over the subsequent decade.have

been historically high (say, above 20 times) they have been highly likely to decline. But in neither case is it given to us to know when the change is coming. So, certainty about the future never exists, nor are probabilities always borne out. But applying reasonable expectations to investment return and speculative return and then combining them has proved to be a sensible and effective approach to projecting the total return on stocks over the decades. The point is this: Over the very long run, it is the economics of investing—enterprise— that has determined total return. The evanescent emotions of investing—speculation—so important over the short run, have ultimately proven to be virtually meaningless. In the past century, for example, investment return accounted for fully 9 percent of the 9.5 percent annual return on U.S. stocks (an average dividend yield of 4.5 percent plus average annual earnings growth of 4.5 percent). Speculative return—the result of an inevitably period-dependent increase in the price-earnings ratio from 13 times to 21 times—accounted for only 0.5 percent of the total. Long-term ownership of American business, then, has been a winner’s game. Hyman Minsky Adds the Crucial Ingredient These simple insights based on the sources of stock market returns provides a solid framework for understanding how markets work.

$1 $10 $100 $1,000 $10,000 $100,000 Investment Return Versus Market Return Growth of $1: 1900-2012 Investment Return Market Return Annual Growth Rate 9.3% 9.5% 1900 2012 1930 1960 1990 Chart 1 Note in Chart 1 that as cumulative investment return (blue line) has marched ever onward, ever upward, it is closely shadowed by the cumulative return produced in the stock market itself (red line). When the market return gets ahead of investment return, either it comes back down or the investment return comes up. When the market return falls behind the investment return, it catches up, a reasonably predictable pattern that reflects the omnipresent rule of the stock market, reversion to the mean (RTM). From 1900 to date, the nominal annual returns were: investment return, 9.3 percent; market return, 9.5 percent. Over shorter-term periods, however, the differences can be—and often are—substantial. For example, it’s illuminating to track the sources of these differences over the past decades since the 1900s.

performance returns had slipped significantly—even relative to other conservative balanced funds—and I was sure that we needed new portfolio managers. But, contrary to the lessons of investment history that I had learned at Mr. Morgan’s knee, I naively believed that we also needed to offer our own Go-Go fund, and to expand into the burgeoning business of managing money for corporate pension funds, a market then controlled by the leading New York banks. (These banks, alas, would also succumb to the “new era” illusion. That I had plenty of company in my arrogant stupidity is no excuse whatsoever.) I was eager to make my mark, and I arranged a merger with one of the hottest new firms of the era—the Boston firm of Thorndike, Doran, Paine, and Lewis. They were among the stars of the new era, stars that soon turned out to be comets and quickly burned out. But suddenly we had our Go-Go fund, our new money managers, and our entry into the field of pension management. The large, established, conservative firm combined with the young, far smaller, Go-Go upstart. To make the merger happen, I shared with them my voting control of Wellington Management Company, and we merged in 1966. “Rock, Paper, Scissors” In a sense, that unwise and counterproductive merger was a harbinger of the crazy merger boom among American corporations that took place decades later. As I would write a few years ago, the urge to merge was like the children’s game of “Rock, Paper, Scissors.

career that followed) on the mutual fund industry. It was entitled, “The Economic Role of the Investment Company.” This dual nature of returns is reflected when we look at stock market returns over the decades. Using Keynes’s idea, I divide stock market returns into two parts: (1) Investment Return (enterprise), consisting of the initial dividend yield on stocks plus their subsequent earnings growth, which together form the essence of what we call “intrinsic value”; and (2) Speculative Return, the impact of changing price/earnings multiples on stock prices. Let’s begin with investment returns on the average annual investment return on stocks over the decades since 1900. (Chart 2a) Note first the steady contribution of dividend yields to total return during each decade; always positive, only once outside the range of 3 percent to 7 percent, and averaging 4.5 percent. Then note that the contribution of earnings growth to investment return, with the exception of the depression-ridden 1930s, was positive in every decade, usually running between 4 percent and 7 percent, and averaging 5 percent per year. Result: Total investment returns (the top line, combining dividend yield and earnings growth) were negative in only a single decade (again, in the 1930s). These total investment returns—the gains made by business—were remarkably steady, generally running in the range of 8 percent to 13 percent each year, and averaging 9.5 percent. Enter speculative return.

If you can fill the unforgiving minute With sixty seconds’ worth of distance run, Yours is the Earth and everything that’s in it, And—which is more—you’ll be a Man, my son! Today, the Earth, as it were, needs leaders with the insight and wisdom that you have the opportunity to develop right here at your extraordinary school, and with determination and virtue that, perhaps without your even realizing it, you are already beginning to develop right here at Roxbury Latin as you grow to maturity. You can help—you must help—to make our world a better place. So do your best, every day, to develop the will which says to you, “hold on.” Hold on to your values, and live a full and active life. And do what’s right for your family, your school, your community, your nation. Although none of you is my son—and only one of you is even my grandson—let me pretend for a moment that you are all my sons. So it is that I close by taking the liberty to urge each of you to live your own life, and to give it your best shot over those many exciting decades that lie before you. Run your own distance, at your own pace, with your own values, with your own brains and your own character. Trust yourself. Trust yourself, and be worthy of the trust of others. Live a life of honor. Then, I assure you, young gentlemen of Roxbury Latin, that “yours will be the Earth, and everything that’s in it,” and, which is more, you’ll all be men, my sons.

(Chart 2b) Compared with the relative consistency of dividends and earnings growth over the decades, truly wild variations in speculative return punctuate the chart as price/earnings ratios (P/Es) wax and wane. A 100 percent rise in the P/E, from 10 to 20 times over a decade, would equate to a 7.2 percent annual speculative return. Curiously, without exception, every decade of significantly negative speculative return was immediately followed by a decade in which it turned positive by a correlative amount—the quiet 1910s and then the roaring 1920s, the dispiriting 1940s and then the booming 1950s, the discouraging 1970s and then the soaring 1980s—reversion to the mean (RTM) writ large. Then, amazingly, there is an unprecedented second consecutive exuberant increase in speculative return in the 1990s, a pattern never before in evidence. By the close of 1999, the P/E ratio had risen to an unprecedented level of 32 times, setting the stage for the return to sanity in valuations that soon followed.stock

Speculative return is, well, speculative (shown in green in Chart 2). It has alternated from positive to negative over the decades. But note that every decade of significant negative speculative return has been followed by a decade of positive speculative return—the terrible 1910s, then the booming 1920s; the awful 1940s, then the great 1950s; the nasty 1970s, then the booming 1980s and 1990s—an unprecedented double decade of large speculative returns. But over the full century, speculative return had virtually no influence on the general level of stock returns, contributing only 0.2 percent to the 9.5 percent total investment return (shown in orange in Chart 2). The point is this: Over the very long run, it is the economics of investing—enterprise—that has determined total return; the evanescent emotions of investing—speculation—so important over the short run, have ultimately proven to be virtually meaningless. As we show, in the past eleven decades, the 9.5 percent average annual return on U.S. stocks has been composed of 9.3 percentage points of investment return (an average dividend yield of 4.5 percent plus average annual earnings growth of 4.8 percent), and only 0.2 percent of speculative return, borne likely of an inevitably period-dependent increase in the price-earnings ratio during this long period. Over the long term, ownership of American business has been a winner’s game. III.

stock market is at the previous high in 1929 was 140 percent; it fell to about 25 percent during my first few decades in this business. Last year, turnover was about 350 percent, speculators trading with other speculators, each with the idea of taking advantage of those on the other side of the trade, creating—to state the obvious—zero in economic value. It is the rise of speculation that explains why in a typical year the market never moved by daily increments of 3 percent or more (up or down) but have experienced 50 such days since 1/1/08. Speculation is in the Driver’s Seat But Wall Street marketers and entrepreneurs loved this new system of speculation in complex products, quantification, innovation, and unconstrained risk, for it made them billions in profits. So it was easy for Wall Street insiders to wallow in the wealth it generated for themselves, and ignore its destruction of their clients’ wealth. Revenues of our stock brokerage firms, money managers, and the other insiders soared from an estimated $60 billion in 1990 to some $600 billion in 2007.

market prices gave us our comeuppance. With earnings continuing to rise, the P/E currently stands at 18 times, compared with the 15 times level that prevailed at the start of the twentieth century. As a result, speculative return has added just 0.1 percentage points to the annual investment return earned by our businesses over the long term. When we combine these two sources of stock returns, we get the total return produced by the stock market. (Chart 2c) Despite the huge impact of speculative return—up and down— during most of the individual decades, there is virtually no impact over the long term. The average annual total return on stocks of 9.6 percent, then, has been created almost entirely by enterprise, with only 0.1 percentage point created by speculation. The message is clear: in the long run, stock returns depend almost entirely on the reality of the investment returns earned by our corporations. The perception of investors, reflected by the speculative returns, counts for little. It is economics that controls long-term equity returns; emotions, so dominant in the short- term, dissolve. After almost 55 years in this business, I have little conviction about how to forecast these swings in investor emotions, nor when they will occur, although it is clear that when p/es are high (say above 25) they are apt, ultimately to decline and when they are low (say, below 12) they are apt ultimately to rise.

Darwin identified me. Given his persistence, I finally caved in and in 1993 wrote Bogle on Mutual Funds. Darwin quickly wrote back “Jack, you hit a home run!” A fine memory indeed. That bestseller was, I imagine, partly responsible for my being honored in 1998 with the CFA Institute’s highest honor: the Award for Professional Excellence. I was introduced at the awards dinner by both Warren Buffett and John Neff. IV. Has Our Profession Lived Up To Its Potential? My fourth and final subject is our too-frequent failure to meet the high standards of professionalism that we have put in place. We have the right mission, but we have often fallen short in practice, especially in recent decades. Yes, security analysis has been professionalized, but too many participants in our financial system, including financial analysts, have lost sight of some of their basic professional responsibilities. For one thing, far too many analysts have focused on ephemeral stock prices, giving short shrift to intrinsic corporate values. As a result, during the recent era we’ve seen the folly of short-term speculation crowding out the wisdom of long-term investment. Well ahead of his time, Benjamin Graham saw it coming. In his 1958(!)

Chart 4 1926 1935 1944 1953 1962 1971 1980 1989 1998 2007 The Bond Market Current Yields vs. Future Returns* Initial Yield Return 10 Years Hence % *Intermediate-term Government Bond R-squared: 0.90 2011 This relationship meets the test of logic, and has been quite stable through time. For example, the correlation between the initial yield on an intermediate-term U.S. Treasury bond and its subsequent ten- year return has been a remarkable 0.90. While reversion to the mean in P/E ratios has been a powerful force in stock returns, interest rates have no reason to revert to the mean. The fact that bonds have earned, on average, 5 percent per year in the post-World War II era is utterly irrelevant. What matters is today’s 3 percent yield on a portfolio of treasuries and investment-grade bonds of intermediate-to-long maturity. The yield on a bond or a bond portfolio so nicely matches Lord Keynes’ concept of enterprise—“the yield on an asset over its entire life.” Today, with the continuing decline in interest rates, the yield-to-maturity on a blended bond portfolio is a far cry from that halcyon era. With the 10-year Treasury at 1.6 percent, the 30-year Treasury at 2.6 percent, and investment-grade corporates at 3.3 percent, the combined yield is approximately 3 percent at best, a far cry from the 9.5 percent annual return we enjoyed during the decades of the 1980s and 1990s.

Portfolio managers, in what I predicted—accurately, as it turned out—would become a far larger mutual fund industry, would “supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic [italics added], a demand that is based essentially on the [intrinsic] performance of a corporation [Keynes’s enterprise], rather than the public appraisal of the value of a share, that is, its price [Keynes’s speculation].” Alas, the steady sophisticated, enlightened, and analytic demand I had predicted from our expert professional investors is now nowhere to be seen. Quite the contrary! Our money managers, following Oscar Wilde’s definition of the cynic, seem to know “the price of everything but the value of nothing.” Portfolio turnover of equity mutual funds, then running steadily about 15 percent, year after year—has soared in recent years to more than 100 percent—an average holding period of less than one year. So, a half-century-plus after I wrote those words in my thesis, I must reluctantly concede the obvious: Keynes’ sophisticated cynicism was right, and Bogle’s callow idealism was wrong. But that doesn’t mean we should let that system prevail forever.

These thoughts were echoed by Coolidge: “When people begin to cherish plans for everything save the common welfare, the decay of that country has begun.” It’s been a special delight for me to see so many parallels between my own humble work and the solid, traditional and conservative values of President Calvin Coolidge. Here’s how he summed them up, Material resources do not, and cannot, stand alone. They are the product of spiritual resources. It is because America, as a nation, has held fast to the higher things of life, because it has had a faith in mankind which it has dared to put to the test of self-government, because it has believed greatly in honor and truth and righteousness, that a great material prosperity has been added unto it. I too have spent most of my recent decades focused on character and values, the homespun elements that come down to moral conduct, integrity, and honor. Tonight, let’s pledge never to forget them. And, yes, let’s hold our persistence and determination high, more than ever in the challenging global environment which demands the active participation of our entire citizenry. In President Coolidge’s timeless words with which I opened these remarks: “The slogan ‘Press On’ has solved and always will solve the problems of the human race.” Thank you for your attention, ladies and gentlemen. And press on—Press On, Regardless.

So the most productive strategy for equity investors (my opinion) is to own the entire stock market, own it at the lowest possible cost, and hold it forever, come what may. Then capitalize on the wisdom of investing, and free yourself from the folly of speculation, with Benjamin Graham’s simple but profound observation: “In the short-run, the stock market is a voting machine; in the long-run it is a weighing machine.” Alas, in the recent era, we’ve forgotten that wisdom.

amounts of your capital—but an investor can’t do that forever; (4) Reach for higher yields by using junk bonds—with their far higher credit risk—or shift some of the bond portion into high dividend stocks—with much more volatility risk. But in general, make only moderate changes in your asset allocations; avoid box-car changes in favor of marginal changes. For in the real world, as you see above, for every pro, there’s a con. As it is said, there’s no such thing as a free lunch. . . . Or is there? In fact, there is one remarkably easy way to increase your clients’ income returns while leaving risk absolutely unchanged. And this brings me full circle in my discussion. The simple mathematical fact is that, because of high mutual fund expenses, the passively- managed all-stock-market index fund typically holds the same composite portfolio as the average actively-managed fund, and generates about the same gross dividend yield, say, 2.1 percent for stocks and 2.9 percent for taxable bonds. (Chart 6) But active stock funds (the managed funds are in red) subtract expenses averaging about 1.2 percent, leaving less than 90 basis points for the investor. Active taxable bond funds generate gross income of about 3 percent, but subtract about 0.9 percent in expenses on average, consuming more than 30 percent of the yield and leaving just 2.0 percent to distribute.

forever; and own it through a company with a truly mutual structure, a company where serving two masters is anathema, and where the rewards of investing go to the investors rather than to the managers. In a sense, most of the funds Vanguard offers are products of simple arithmetic, a reflection of these words of Sophocles’: “Remember, O Stranger, that arithmetic is the first of the sciences, and the mother of safety.” Yes, arithmetic and engineering. So Next Let’s Consider the Culture of the Humanist Even as Princetonian David Billington became one of my guiding spirits on the culture of the engineer, so Elliot McGucken, Princeton Class of 1992, has lifted my spirits on the culture of the humanist. Dr. McGucken received a B.A. in Physics from Princeton, and earned a Ph.D. in physics at University North Carolina in Chapel Hill. Now teaching at Pepperdine University, he has created a business school course entitled “Artistic Entrepreneurship and Technology,” linking today’s Information Age to the great values of Western Civilization. His required reading list includes Homer’s Odyssey, and Dante’s Inferno. Believe it or not, “Dr. E.” discovered my 2005 book, The Battle for the Soul of Capitalism when he was browsing in a bookstore. It formed one of three foundations for reading in his course. When he told me that, of course I was thrilled. (Heck, truth told, astonished!)

Put another way, ETFs used for investment are perfectly sound, but using them for speculation is apt to end badly for your clients. “Fundamental” Indexing. While this method of value investing has been presented as some sort of Copernican Revolution, the idea behind the methodology is many decades old. But offering such funds in ETF form suggests that they are useful for short-term trading—a dubious proposition on the face of it. And bringing them out only after the sharp upsurge in value fund relative returns during the 2000-2002 stock market collapse suggests the kind of marketing motivation and performance chasing that, as I’ve noted earlier, has ill-served investors. Of course, we’ve been assured that “value investing wins” (not “has won in the past”), especially in troubled markets. But the troubled markets of the last twelve months the leading “fundamental index” fund is down nearly 12 percent, almost double the 6 percent decline in a standard S&P 500 Index fund. Mark me down (Surprise!) as a market-cap-weighted indexer. As for value-weighted versus dividend-weighted strategies, I’m interested to read that they’re now arguing with each other! “Absolute Return” Funds.equity/venture

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.

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