John Bogle on Management Quality

But even our novel corporate structure and our innovative investment strategy would not serve investors as they should without something more: a sense of stewardship for the assets of, yes, those real, honest-to-God, down-to-earth human beings who have turned over to us their assets and their trust alike. “Putting the shareholder first” is not just idle talk. To do so we would need a strong, determined, and integrity-laden crew, bound together in common cause by the idea of a powerful warship whose crew forged a chain that could be no stronger than its weakest link.

issue of Bloomberg Personal magazine, I describe the problem, using the famous Sherlock Holmes story about the slaying of a racehorse named Silver Blaze. Holmes noted “the curious incident of the dog in the nighttime,” curious because the dog didn’t bark. As a result of this insight, the canny detective realized that the culprit was the dog’s master. In the mutual fund industry, a majority of the fund directors are normally independent of the fund manager, and therefore nominally control the funds. But real control lies with the master of the funds—the fund manager. And history has shown that no matter what the master’s actions, the watchdog—a word almost universally used to describe the role of the independent director— simply doesn’t bark. If the fund manager is the culprit, what is the crime? For me, it is the change in the central ethic of the mutual fund industry from the profession of investing—the stewardship of shareholder assets—to the business of marketing—gathering assets, and creating whatever “products” it takes to do so. Five problems have resulted from this change: 1. Soaring Turnover Among Mutual Funds. Fifty years ago, most mutual funds held to prudent long-term investment objectives. Today, less than half of all equity funds, by my count, meet that standard. Increasingly created to capitalize on hot stock styles and hot money managers, mutual funds now come and go at an unparalleled rate.

To have such a crew, we’ve relied heavily on traditions—some venerable, such as a spirit of fair-dealing dating back to Wellington and Walter L. Morgan, others going back to the earliest days of Vanguard, such as our Award for Excellence and the Vanguard Partnership Plan. Yes, “even one person can make a difference,” and yes, each crew member has earned the right to share in the fruits of our success. Taken together, our structure-driven corporate strategy, our innovative investment ideas, and our progressive implementation of business values have made Vanguard an industry revolutionary: A company that stands for something. And the world knows what it is we stand for: The primacy of the shareholder. Stewardship. With the power of an idea we have flourished. I know no other firm in this industry about which that can be said with such crystal clarity. What of the future? “The times they are a changin.” What does a revolutionary firm do? Live off the legacy I have put my heart and soul into giving you, or build on the legacy? The answer to that question, ladies and gentleman, is in your hands, no longer in mine. But as you make these decisions, please remember that we will be judged not only by what we do but what we refrain from doing. Opportunity yes, but discipline too. And confidence. And courage, always.

consumer products at one stage in their history, products to be heavily marketed until times and fashions change and then replaced by something else that is saltier or softer or sleeker. We would offer financial services, or simply stewardship, durable mutual funds with sound investment philosophies, prudent strategies implemented with simplicity, and rock-bottom costs to investors, the better to enhance their profits. The idea: We would not make what we could sell. We would sell what we made. Finally, we did not seek customers, those who would move from one product to another depending on fad or whim, location or price. We had no interest in creating an investment version of Poke’mon or the Barbie doll or the pet rock. Long-term investors, not short-term speculators, would be the focus of our strategy. We sought clients, those who would enter into a long-term investment relationship with us, trusting in our investment skills and our stewardship. That anecdote, I think, says a great deal about Vanguard’s view of the service-profit chain. While the chart in Harvard Business School Professor Michael Porter’s 1996 article, “What Is Strategy,” nicely describes how Vanguard works (Chart 1), my story explains why Vanguard works so well. In any event, for an enterprise that began without a single employee, or a single product, or even a single customer 25 years ago, we have come a long way.

This investment strategy, at once innovative and counterintuitive, in turn depends on our unique corporate structure. We are a mutual enterprise owned not by the fund managers, but by the fund owners, an enterprise in which service to shareholders and stewardship are our highest priorities. With that combination of investment ideas and human values, we have striven to become one of those all-too-rare enterprises: A company that stands for something. We stand for the primacy of the fund shareholder. And it works! Vanguard’s growth is, to me at least, living proof that enlightened idealism is sound economics. Business: An Honorable Career Over the past half century, business has come to be my personal calling. But I’m not here to talk about my life and career. I’m here to urge you to think about your calling as you go out into the wide, wide world of business, whether it be commerce or industry, finance or technology. I urge you to fulfill your own personal destiny, to gain a sense of contributing something wonderful—perhaps unique—to society, something that you’re good at, something you enjoy, something that without you would simply not be there.

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.

cost provider of financial services in the world, able to provide commensurately high returns to our investors. The strategy may seem obvious to you today; let me say that it seemed equally obvious to me in 1974. So, let’s mark foresight as a second attribute of leadership. A third attribute is, I think, a sense of purpose. In 1974, we had a conviction about where we wanted to go and a commitment to do so ethically, with a strong moral compass as our guide. Our purpose was solely to serve our shareholders, those who would entrust the stewardship of their financial futures to us. So, we created a corporate structure in which our clients literally became our owners—a structure that remains unique in the mutual fund industry to this day. The current aphorism, “treat your customers as your owners,” took on real meaning for us, as our corporation turned its ownership over to the shareholders of our mutual funds—not, as in industry practice, to a privately or publicly-held profit-seeking corporation. While I’ve been called a fool, a Communist, and even a Marxist (and in public, at that) for creating our corporate structure, it seems to me to represent the very essence of capitalism: the control of the corporation by its shareholders.

holding period for the average fund is just over one year (1.1 years, to be exact). More charitably, on a dollar-weighted basis, the average holding period is about 1.4 years. Either way, today mutual funds are largely focused on the folly of short-term speculation. 6. Industry Mission. Over the past half-century-plus, the mission of the fund business has turned from managing assets to gathering assets, from stewardship to salesmanship. We have become far less of a management industry and far more of a marketing industry, engaging in a furious orgy of “product proliferation.” Our apparent motto: “If we can sell it, we will make it.” During the 1950s, the number of equity funds grew nicely, by about 35 percent. But during the 1980s, the number of equity funds soared by 110 percent, with another 125 percent increase during the 1990s (most of which, alas, were technology, internet, and telecommunications funds, and aggressive growth funds focused on these areas). Since every action leads to a reaction, of course, the 13 percent fund failure rate during the 1950s has also soared. The failure rate is now on track to reach nearly 60 percent this decade. “As ye sow, so shall ye reap.” 7. Costs. Ah, costs! Costs have soared. On an unweighted basis, the expense ratio of the average fund has doubled, from 0.77 percent in 1951 to 1.54 percent last year. (All right, to be fair, when weighted by fund assets, the expense ratio has risen from 0.60 percent to 0.

1. Tangible Costs . . . management fees and trading commissions. Each dollar given away for, say, management fees is a dollar explicitly detracted from the portfolio net return. 2. Managed Costs . . . unintended risk exposures, tax costs, and Not-Equitized- Cash, an opportunity cost for not keeping funds fully invested. 3. Invisible Cost . . . the adverse market impact of trading and the opportunity cost of delaying trade execution. Result: “Simply put, every incremental basis point increase in rate of return translates into competitive advantage (by which) a firm improves its absolute performance and its ranking relative to its peers.” Thus, what the study calls the Complete Firm, the firm that “will lead the way . . . will diligently seek to minimize these performance detractors.” Thus spaketh, I remind you, not Vanguard/BOGLE, but Merrill Lynch/BARRA. Here is their prescription for curing the disease: “Releasing Embedded Alpha.” 1. Take a Holistic View (whatever exactly that is in this instance). Appoint a single Embedded Alpha champion with the firm. 2. Take an Alpha Inventory. Develop a coherent policy, and review all work processes. 3. Set Priorities. Widen managerial bandwidth. (Again, I confess my ignorance of the term in this context.) 4. Develop a Strategic Agenda that sets goals by which to measure success. 5. Make It Real on the Shop Floor, communicating the agenda and aligning incentives accordingly. 6. Tell the Market.

being a sound long-term investment to a product offering a short-term marketing opportunity; from providing stewardship for a lifetime to the participating in the momentum of the marketplace. Myth #2. Mutual Fund Managers are Long-Term Investors Equally depressing, at least to me, is the baneful change in focus of mutual fund managers. I mince no words: Fund managers, once long-term investors, have become short-term speculators. From the time I wrote my Princeton thesis until the mid-1960s, average fund portfolio turnover normally ran in the 15%-20% range, a putative holding period of five to seven years for the average stock fund. In recent years, turnover has consistently run over 80%, and was 90% last year. Alas, in this era of day traders—one-day traders—fund managers can be accurately described as “406-day traders.” If “speculator” is too strong a word for the typical fund manager, it’s surely infinitely closer to the mark than “long-term investor.” Their high turnover rate, interestingly, is remarkably pervasive. It ranges from an average of 146% for mid-cap growth funds to 62% for small-cap value funds. And even the median large-cap fund turns its portfolio over at 63% (excluding stock index funds, which turn over at only about 9%). High turnover is not a statistical aberration; it is almost as prevalent as the air we breathe. Again, this industry’s shift to a marketing ethos bears an important share of the responsibility for soaring portfolio turnover.

Within this structure, in our service-profit chain the profits of investing go to our shareholders. As the world has slowly come to learn: costs matter. Costs matter because the benefits of lower costs are huge: a 100 basis point advantage applied to our $500 billion-plus asset base produces annual savings of $5 billion for shareholders. Costs matter because they represent a diversion of the returns of the financial markets from investors to investment managers. (Where are the customers’—or should I say, clients’—yachts?) And costs matter because lower costs lead directly to higher returns—a link that is readily calculable. Investment Strategy and Low Cost The magic of low cost—and it is no less than magic—is the core of our service-profit- stewardship mission, a crucial link in the chain. For our long-term investment philosophy, combined with our simple investment strategies, depends on cost-effectiveness. We are the innovators of the two investment strategies that have come to dominate our asset base, now representing $350 billion, or nearly 70% of our $500 billion-plus total (Chart 6).difference

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

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

 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 $1.3 billion in penalties  Yes, similarly, there were “only” a handful of insurance companies involved in the bid- rigging scandals, also uncovered by Mr. Spitzer. But, again, they included the largest companies in the field: American International Group, Marsh & McClennan, ACE, Aon, and Zurich, all of which agreed to settle the litigation and paid billions of dollars in penalties.  And yes, while a few of the largest mutual fund managers were not implicated in the fraudulent behavior reflected in the market timing scandals unearthed by Mr. Spitzer and his staff in 2003, many of the 23 firms that were involved were giants, holding more than $1.5 trillion of investor assets, fully one-quarter of the fund industry’s long-term asset base. This disgraceful spectacle alas, was one of many examples of how fund managers placed their own interests ahead of the interests of the fund shareholders they were duty- bound to serve—the triumph of salesmanship and asset-gathering over the stewardship and integrity that were, poignantly the hallmarks of the industry when I joined it all those years ago.

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

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.

percentage points less, a shortfall that closely parallels our three percentage point estimate for fund costs.1 In other words, the funds earned about 80% of the market’s annual return. But when we compound the annual returns based on an investment of $10,000 at the start of the period, the investor captured only 60% of the market’s cumulative wealth. The market investment would have grown by $120,000, compared to just $71,600 for the average fund. The magic of compounding investment returns; the tyranny of compounding investment costs. What is more, it’s no secret that the fund industry, once an industry that prized investment stewardship as its highest value, has now embraced product marketing as its beacon. In their battle to build assets, and thus advisory fees, mutual fund sponsors are quick to capitalize on the latest fads and fashions of the stock market. During the great NASDAQ bubble, for example, fund sponsors created record numbers of new growth and aggressive growth funds with a heavy tech-stock orientation (340 funds) and pure tech funds (116), with pace-setting budgets advertising their pace-setting short-term returns. These funds rose by an average of 85% during the final upsurge in the market from 1999 through March 2000, and those that were advertised had even higher returns. The result: Great for the marketers, horrendous for the investors. These aggressive funds were the recipients of the largest glut of cash inflow in the industry’s history—$238 billion.

Part of the problem is that these giant institutions, striving to build their own profitability, turned their focus away from management and toward marketing, toward whatever will sell, explaining ever-more-narrowly-focused, riskier portfolios. Let’s call that the triumph of salesmanship over stewardship. These agents—now largely controlled by giant U.S. and international financial conglomerates—have too often put their own interests ahead of the interests of those whom they are duty-bound to serve, those 100-million-plus fund shareholders and pension beneficiaries who inevitably feed at the bottom of the food chain of investing. What’s more, I would argue that our now-dominant institutional agents have not only failed to honor the interest of their shareholders/beneficiary principals, but they have also abandoned the time-honored investment principles that focused on the wisdom of prudent long- term investment, and turned instead to an excessive focus on short-term speculation, so clearly demonstrated by the soaring portfolio turnover that I described earlier, a change that is detrimental to their own interests as well as to our financial system.

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

and done, an advantage of nine percentage points. The message: Sweet selling is sour stewardship. The counterproductive result of this business of over-marketing and promotional hype is that the returns actually earned by mutual fund investors are even worse than the inferior returns shown in my earlier study. How much worse? Don’t take my word for it. Look at the figures reported by the fund industry’s largest firm:2 With the S&P 500 providing an annual return of +16.3% since 1984 and the average fund earning 13.1%, the return earned by the average mutual fund investor was just +5.3%(!) Nearly 40% of the fund return vanishes into thin air when we take into account where investors actually placed their money. It turns out that fund investors earned not 80% of the stock market’s annual return, but 33%. And not 60% of the market’s cumulative wealth, but 12%, because the $120,000 profit earned by simply owing the market compared with but $14,000 for the average fund investor. Is the mutual fund industry meeting the needs of individual investors? You tell me. 2 Source: Fidelity. -$60 -$40 -$20 $0 $20 $40 $60 $80 $100 Q1'99 Q2'99 Q3'99 Q4'99 Q1'00 Value Funds Growth Funds Period Total Growth: $238 Value: ($29) When Marketing Replaces Stewardship: Net Cash Flow into Growth and Value Funds (in billions) 0% 50% 100% Annual Return Profit on $10,000 Investment S&P 500 Avg. Equity Fund Investor Average Equity Fund Investor vs. The Stock Market Total Returns, 1984 - 2000 16.3% 5.33%

owning the market through a low-cost index fund, we know next to nothing about the records of SMA Managers.  Fourth, the challenges of operating SMAs is substantial. Few registered advisers and brokers are satisfied with today’s (largely) APL technology. And while tomorrow’s technology will surely be better, it’s hard to imagine that it can ever be as economical as the simple pooling of accounts that has been the crux of mutual fund operational efficiency since the industry began. A New Mutual Fund Industry Nevertheless, if mutual funds fail to change, our dominance will come to an end. We hold no permanent monopoly on the good will of our owners; we must re-earn it every day. Fund managements can no longer bask in the warm noonday sun and continue to place their own needs ahead of the needs of their clients. During the great bull market, many firms that trod the wrong path prospered. Even where prudence, principles, and stewardship took a back seat to marketing, the money rolled in. Hundreds of new aggressive funds were formed and backed with more than a billion dollars of advertising. “We’ll focus on short-term rewards, momentum, and concept stocks,” was the implicit strategy, “and don’t worry about higher fees, and portfolio transaction costs.” In an era of exploding returns on stocks, the sky seemed to be the only limit to excess. Those strategies won’t play well in the years ahead. We must make speculation passé, and put stewardship in the driver’s seat.

the fund’s volatility during those inevitable times when stock prices tumble. But “slightly lower” must be what the client is given to expect. In any event, it is important that the client understand that it is next to impossible to “market-time” a changing cash position. And most important of all, the client must understand that, in a positive stock market over time, he will pay a commensurate price in relative rate of return. Put simply, he should understand that, over the long-run, a percentage point increase in volatility is meaningless; a percentage point increase in return is priceless. That powerful, and, I think virtually unarguable syllogism, should give both adviser and client ample food for thought. Confronting the Index Challenge In this age of investment relativism, I’m convinced that—faced with the competition of index investing and quantitative investing—too many managers today are responding in the most ineffective manner possible, by “closet indexing.” But shaping an inchoate and undisclosed policy around the structure of an index is, finally, managerial suicide. It is the ultimate concession to the unarguable economic value of the low-cost, passively managed index fund over the high-cost, actively managed traditional fund.

Add to that list fair-dealing, not only fair prices and fair limitations on how and when and in what portfolios clients may invest, but focusing our energies on activities that serve clients— management, investing, administration, financial controls—rather than those that do not, such as marketing and peripheral business ventures. If we truly respect the human beings who are our clients, they will come to entrust us with the stewardship—a word too seldom used in this industry today—of their hard-earned assets. Placing service to the human beings who are our clients at the top of our priority list is easily said. It may even seem obvious, although rare indeed does the phrase “human beings” appear in a book on corporate strategy, or on competitive advantage, or even “killer applications.” But I confess that back when Vanguard began a quarter-century ago, I never thought very deeply about human beings as the central focus of our corporate strategy. Nonetheless, for as long as I can remember, I’ve held high the ideal of respecting all of the souls one meets along the long and winding road of life—from the highest in rank to the humblest—with respect, decency, and kindness. This spirit must not encompass only clients, but crewmembers as well, and with equal fervor.

 We must give shareholders a higher share of market returns, by slashing the frictional costs of fund investing—management fees, sales charges, operating expenses, turnover costs.  We must recognize that past financial market returns can’t be interpreted as actuarial tables and realize that uncertainty is the ultimate reality of investing. In our great focus on emphasizing the probabilities of reward, we must never let our investors ignore the consequences of loss.  And we must restore a proper balance between stewardship and salesmanship. Summing it all up, by managing their assets in the most honest, efficient, and economical way possible, we must give our clients a fair shake. If we do only that, the age of mutual fund dominance is not only not over, it is just beginning.

accordingly. If the fund industry doesn’t wish to recognize the need for these changes and reduce its embedded alpha, it is only a matter of time until investors will recognize it—and they will vote with their feet. Yes, as the theme of this conference indicates, the economics of wealth are a ‘changing. But it’s more than economics. Investors’ faith in their fund trustees has been shaken even more emphatically by the fact that fund managers have moved away from being prudent guardians of their shareholders’ resources and toward being imprudent promoters of their own wares. We pander to the public taste by bringing out new funds to capitalize on each new market fad, and we magnify the problem by heavily advertising the returns earned by our hottest funds. The first step in restoring the investing public’s faith is to focus far less on salesmanship and far more on stewardship. If we simply put our clients first, just imagine how well we can serve investors in the New Era. Looking Ahead In the New Era for wealth management we are facing, restoring faith must be at the top of the agenda. We have to present to our clients realistic expectations for future returns, and emphasize that while emotions can overwhelm economics in the short run—sometimes for the better, sometimes for the worse— in the long run, it is the fundamental economics of the stock and bond markets that carry the day.

It is as hard to imagine fund directors basking in the glory of this record of their stewardship as it is easy to imagine their general concern, even their embarrassment, although there is no evidence of either. So it is easiest of all to imagine that the fund directors unaffiliated with fund management are completely unaware of these facts. (To be sure, their affiliated director counterparts must be all too aware of them). Yes, I’m reasonably confident that nearly all directors receive presentations showing returns on an annual basis and a cumulative annualized basis, but I wonder how many boards are exposed to cumulative after-tax returns on a comprehensive comparative basis. Yet despite what the data shows, we have virtually no examples of the termination of contracts of fund managers primarily by reason of consistent inferior performance. That strongly suggests that directors either don’t know, or don’t care, or don’t think it is their role to take action. If they don’t know, they are derelict in their duty. If they don’t care, they are financially illiterate. And if they don’t think their role is to take action, who else do they think will fulfill that role? Where Do We Go From Here?

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?

The recent market timing scandals in the fund industry, disgusting as they are, are fairly small change relative to the losses investors have incurred by the industry's excessive costs and by the industry's overwhelming focus on promotion and asset gathering. But the scandals have the entirely beneficial effect of shining the spotlight on the myriad conflicts that exist between the interests of mutual fund managers and mutual fund shareholders, and point the way toward reform, forcing this industry to focus not on the business of marketing, but on the profession of management—not salesmanship but stewardship—a change which I expect is at last on the way. Values and Idealism Let me close with a few words about values. I began these remarks by telling you of the idealism I held during my college days, and as I began my career. I want to close by telling you that even a long career in the competitive, dog-eat-dog, give-and-take of the mutual fund business hasn't dimmed my idealism one jot. Indeed, I believe that today there is even more idealism in my heart and soul than there was all those 54-plus years ago. At Vanguard, I did my best to create a company that would live up to those ideals. While the industry has yet to emulate them, I'm certain that moving in that direction is only a matter of time. The coming wave of reform in corporate America and in mutual fund America will help turn our nation’s capital development process away from speculation and toward enterprise.

Simplicity, Stewardship and Character So, I’ll continue to have faith in the majesty of simplicity, helping investors to make uncertain but necessary judgments to determine their allocation between stocks—with all their capital opportunity and risk—and bonds—with all of their income productivity and stability—and then doing everything in our power to diversify these investments and minimize the costs—management fees, operating costs, marketing expenses, turnover impact—promising only to give them their fair share of financial market returns, no more, no less. And if index funds are the best way to assure the realization of these goals, so be it. The ultimate objective of every firm represented in this room, I think, is to build a company that stands for something. As one who has been at that task for 28 years this coming September, I can tell you that it’s a tough, demanding never-ending task. My own goal has been to build a company that stands for stewardship. Let me be clear, however, that this goal is not without a self-serving aspect. For only to the extent we adequately serve the human beings who have trusted us to help manage their wealth will Vanguard itself survive and prosper. However each of you chooses to define your own firm, I hope that stewardship will be at least part of your character, because it will pay off for you.

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

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

5/4/2015 9. 1951 1960 1970 1980 1990 2000 2013 % Then, Long-Term Shareholders, Now . . . ? Equity Fund Redemption Rates Source: Investment Company Institute Redemptions and Exchanges Out as a Percentage of Average Net Assets 6% 24% 73%, 1987 39%, 2000-2002 25% 10. 1985 1995 2005 2013 International Funds U.S. Funds % Market Timing in International Funds Redemption Rates U.S. and International Equity Funds 11. Challenges Faced by Investors in Active Funds 1. High Costs—2% annual cost = 63% of the 50-year return on stocks. 2. Critical erosion (60%+) of dividend income. 3. Giant Size—Mutual funds own 33% of U.S. equities. “A fat wallet … enemy of superior returns.” 4. High Turnover—130% of assets (purchases and sales). 5. Marketing—“We make what will sell.” Fund failure rate 50% per decade. 6. Investor (and salesman) focus on past returns. 7. Outside ownership of managers (39 of top 50). RESULT: Stewardship descends, salesmanship ascends 12. 1,000 10,000 S&P 500 MIT 0.00 0.50 1.00 1.50 1924 1940 1950 1960 1970 1980 1990 2000 2014 Growth of $1—1924-2014 Relative Return: MIT / S&P 500: -61% 0.39 $13.69 Annual Return +10.3% +9.1% Do Costs Matter? A Powerful Example $ R2 = 0.95 $10.99

consumers (“Main Street”).1 Asset managers such as Vanguard ought to be, not in the business of selling products, but in the profession of managing other people’s money. Today, the goals and values of those powerful institutional asset managers are shaped by a structure in which their owners—private and public stockholders, now, regrettably, dominated by financial conglomerates—seek to earn returns on their own capital, rather than the capital that has been entrusted to their care by their clients. In such a structure, conflicts of interest abound. Stewardship is too often trumped by salesmanship, and management is trumped by marketing. In the mutual fund field, the interests of the managers’ stockholders conflict with the interests of the managers’ fund shareholders, and it is the manager who is the master that wins. As it is said in the Bible, “no man can serve two masters.” Today, our financial sector wantonly ignores that ancient precept. Going Back in History Speaking out against such an obvious structural flaw is hardly new territory for me. Way back in 1971,2 almost a half-century ago, in remarks before Wellington Management’s partners, I despaired over the trend toward public ownership of investment institutions: It is hard to see what unique contribution public investors bring to the enterprise. They do not, as a rule, add capital; they do not add expertise; they do not contribute to the well-being of our clients.

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

Could there be a lesson here about financial ethics and stewardship? Are the morals of our financial system involved? Will our society demand that business success be harmonized with moral purpose? Ironically, that provocative question was raised in that very December 1949 issue of FORTUNE in which “Big Money in Boston” appeared. The lengthy essay was entitled, “The Moral History of U.S. Business.” Exhibit 14. American business leaders, the article noted, “do not work for money alone. A dozen nonprofit motives lie behind their labors: love of power or prestige, altruism, pugnacity, patriotism, the hope of being remembered through a product or institution, etc. American business leaders in general have offered few pure specimens of economic man . . . “It is relevant to ask,” FORTUNE added, “what are the leader’s moral credentials for the social power he wields.”

of the funds entrusted to them.” 8 The SEC Commissioners, Judge Healy said, “were anxious to protect the fund investor from the distorting impact of sales. Products (italics added) designed for their appeal to the market did not, and do not, necessarily make the best investments.” 9 Legendary industry pioneer Paul Cabot, one of State Street’s founders and a major force in the drafting of the 1940 Act, agreed with the SEC on this point. Earlier, in 1928, he had described the abuses in the investment-trust movement of the day as “(1) dishonesty; (2) inattention and inability; (3) greed, by which he meant simply charging too much for the services rendered. ‘Even if a fund is honestly and ably run, it may be inadvisable to own it simply because there is nothing in it for you. All the profits go to the promoters and managers.’”10 While the derivation of the term mutual remains obscure, the prudent idealism that undergirded the spirit of the industry when the 1940 Act was drafted arguably justified the use of the term. Yet mutual fund actually came into being just as the industry began to turn away from its original spirit of mutuality, from its early mission of stewardship of investor assets to its modern-day mission of salesmanship, a mission, as Chairman Cohen seemed to be suggesting, that would make the use of the term “mutual” something of a joke.

That narrow legal decision, now almost exactly a half-century ago, played a definitive role in setting the industry on a new course in which manager entrepreneurship in the search for personal profit would supersede manager stewardship in the search for prudent investment returns for fund shareholders. Within a decade, many of the major firms in the fund industry joined the public ownership bandwagon, including Vance Sanders (now Eaton Vance), Dreyfus, Franklin, Putnam, and even Wellington (the firm I had joined in 1951, right out of college). Over the next decade, T. Rowe Price, and Keystone (now Evergreen) also went public. In the era that followed, financial conglomerates acquired industry giants such as Massachusetts Financial Services (adviser to the fund complex of which M.I.T. had become a part), Putnam, State Street, American Century, Oppenheimer, Alliance, AIM, Delaware, and many others. The trickle became a river, and then an ocean. Today (continuing that somewhat stretched analogy), the tide of public ownership of fund management companies has come in, and the tide of private ownership is at an all time low. Among the 14 A note in the Harvard Law Review of April 1959, Volume 72, Number 6, agreed with me, taking issue with the Ninth Circuit’s decision.

“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.

The Lengthened Shadow, Economics, and Idealism Remarks by John C. Bogle Founder and Senior Chairman, The Vanguard Group and 1999 Woodrow Wilson Medalist, Princeton University before the Annual “Wilson and Princeton” Dinner Woodrow Wilson House, Washington DC September 30, 1999 Good evening, ladies and gentlemen. Thank you, Ambassador Lukens and distinguished members of the dinner committee for honoring me with the invitation to address you. In the spirit of this grand occasion, I’d like to begin with some comments about what I find especially remarkable about President Wilson; in particular, how his lengthened shadow lies over America today, and how his economic policies were shaped by his idealism. I’ll then turn to Vanguard, the now-giant mutual fund enterprise that I founded just 25 years ago. Only time will tell whether the lengthened shadow of my economic vision of fund management and my own idealism will lie over my firm a century hence. But I hope so. As I understand it, it is Vanguard’s distinctive approach to the stewardship of investors’ assets that led to Princeton University’s decision earlier this year to honor me with the Woodrow Wilson Medal—presented annually to an undergraduate alumnus for “distinguished achievement in the Nation’s service.” My humble delight in receiving this award almost (but not quite!)

Stewardship vs. Salesmanship— Bond Mutual Funds Gone Awry Remarks by John C. Bogle Founder and Former Chief Executive, The Vanguard Group FIASI Hall of Fame Speaker Series Fixed Income Analysts Society New York, NY April 17, 2007 I’m delighted and honored to be with you this evening, the third time I’ve addressed FIASI in the past decade. The first occasion was on March 18, 1998, when my theme was “Bond Funds: Treadmill to Oblivion.” In my remarks, I made the point that “fixed income funds simply cannot provide adequate returns to investors when their sound principles of management and diversification are offset by more than compensatory cost encumbrances.” (Today, it seems so obvious!) * I have no idea whether or not that speech lit the spark that led to my induction into the FIASI Hall of Fame a year and one-half later on November 10, 1999. But that surprising and wonderful event led to my second speech for FIASI. Its simple title clearly echoed the message of its progenitor: “Giving the Bond Fund Investor a Fair Shake.” Yet today, that fair shake is the rare exception to the costly penalties that the mutual fund industry imposes on its clients, in bond funds and stock funds alike. The problem, simply put, is that in the famously efficient U.S. bond markets, bond fund managers as a group are average. That is, they produce average returns. (No Lake Wobegon * The opinions expressed in this speech do not necessarily represent the views of Vanguard’s present management.

no central principle and the search for a single overarching universal condition of human existence. * My focus, however, will be much more modest: The contrasting conduct of the investment and business affairs of two types of financial institutions. One is the fox, that artful, sly, astute animal of the fields and the woods. The fox finds its counterpart in the financial institution that survives by knowing many things about complex markets and sophisticated marketing. The other is the hedgehog, that durable nocturnal animal that survives by curling into a ball, its sharp spines giving it almost impregnable armor. The hedgehog is represented by the financial institution that knows only one great thing: that in the long- term, investment success is based on simplicity. In the contrast between the hedgehog and the fox, we find some powerful lessons about investing that I’ll use to amplify my theme. Princeton’s Vital Role I should tell you now that I have no reluctance to cast my lot with the hedgehogs of the financial world who focus on honest stewardship and plain service. But before I turn to the investment and business philosophy for which I stand, I owe it to you, I think, to recount the story of the vital role in the development of this philosophy played a long time ago by the Princeton University family.

” Of course, the new game has nothing to do with “my” Vanguard, the investment firm that I created way back on September 24, 1974. Nor is the story of our wonderful organization a “saga of heroes,” save for the multitude of heroes numbered among our now-12,000 member crew who deserve so much credit for their steadfast loyalty and commitment. This philosophy is not new to me. Indeed, I’ve expressed it often over the years, quoting these words of Helen Keller: “I long to accomplish a great and noble task, but it is my chief duty to accomplish humble tasks as though they were great and noble. The world is moved along, not only by the mighty shoves of its heroes, but also by the aggregate of the tiny pushes of each honest worker.” It is these crew members who have dedicated themselves to serving—“in the most efficient, honest and economical way possible” (a phrase I’ve used since 1951)—the now-20 million “honest-to- God, down-to-earth, human beings, each with their own hopes and fears and financial goals” (another phrase I’ve used many times!), who have entrusted Vanguard with the stewardship of their investment assets. _______________ Note: The opinions expressed in this speech do not necessarily represent the views of Vanguard’s present management.

As he enumerates them in The Battle for the Soul of Capitalism, these values are: “prodigious energy, marvelous entrepreneurship, brilliant technology, creativity beyond imagination, and . . . the idealism to make our nation and our world a better place.” And like Teddy Roosevelt, in pursuit of these ideals, Jack Bogle’s conservatism is at least a little bit radical. For to conserve, he would regulate. Last month, for example, he was among a group of financial notables who wrote to SEC Chairman Christopher Cox urging him not to exempt even small companies from Sarbanes-Oxley’s annual internal controls review. To conserve, Jack Bogle would democratize. Not for him Plato’s top-down philosopher- kingmanship. He’s more of the Huey Long “every man a king” school. Hence, his reverence for shareholder democracy, “open-book management,” and other devices that would empower the little guy and little gal. To conserve, John Bogle would disempower the manager in favor of the owner, overturning large portions of the managerial revolution that powered America’s mid-century growth. “Owners of the word, unite!” Jack declares. Why, in his attacks on the paper entrepreneurs of our modern era, this lifelong Republican sounds astonishingly like another Wall Street Savonarola and Aspen Institute favorite, Robert Reich. Yes, there is something radical about Bogle’s conservatism But I’d like to suggest that his radicalism is sufficiently conservative, too.

way possible.” It was that thesis that opened the door to my first job in this industry, and I’ve been with the same firm ever since, although it has changed greatly.1 That was a pretty good characterization of how the industry worked in 1951. But it is with regret that I report to you that the ethos of today’s mutual fund industry—with some, but not nearly enough, exceptions—has moved away from those principles. I am a tough critic of today’s fund industry, but acknowledge that my views are not widely shared by my industry colleagues. Indeed, one veteran industry leader has stated that “Mr. Bogle’s view of ethics may be somewhat outside the mainstream.” He was, of course, quite right. Commercial Honor, Equitable Principles, Fair Dealing To set the stage for my remarks, I’ve chosen as my title the three central standards of the NASD Rules of Fair Practice: “a member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade,” and shall engage in “fair dealing with investors.” With these principles in mind, let me discuss how they relate to the mutual fund industry, which has changed in so many fundamental ways.  A new mission. We’ve moved our central mission from stewardship to salesmanship, and our core value from managing assets to gathering assets.

They enticed tens of thousands of investors to part with millions of dollars for cockamamie steam engines, reworked bicycle factories, and other lunatic enterprises. Yet let us not forget that Alfred Sloan’s managerial revolution at General Motors wouldn’t have been necessary had not a borderline crook named Billy Durant not brought the company—and the Dupont family’s investment—to the brink of insolvency. Yet wasn’t Durant’s bent capitalism as necessary for the automotive revolution as Sloan’s managerial capitalism? Consider the current era. Our modern equivalent of the roadway is the fiber-optic cable that stretches across ocean floors, into office buildings, to curbs and into homes. It will reshape our lives as assuredly as highways reshaped our parents’ lives. But could it ever have been laid down as rapidly as it was under a strategy of long-term buy-and-hold investing? I doubt it: The outsized greed of investors and the desire among a class of so-called entrepreneurs to find a greater fool and cash out quickly was as integral to the Internet revolution as Vint Cerf’s development of TCP/IP. Yes, in a Houston courtroom Jeff Skilling and Ken Lay are on trail for fraud for, among other things, lying about a broadband marketplace that did not really exist. But neither did the rosy future that AOL founder Steve Case predicted for Time Warner’s Gerry Levin, or that Broadcast.com founder Mark Cuban sold to Yahoo!

75% 55% 38% 100% 0% 20% 40% 60% 80% 100% Money Market Bond Funds (Expected) Equity Funds Bond Funds (Actual) Share of Assets in No Load Funds 2B. Think of it this way, using the analogy I presented in my 1998 FIASI Speech: “On the third floor of the buildings of these giant national brokerage firms (let’s call that the institutional trading floor)—their bond traders are bickering over a ‘tick’ (1/32nd of a point, or three one-hundredths of one percent), prepared to commit mayhem for two ticks, and to take out swords and pistols, willing to commit murder, for four ticks. Yet on the first floor of their buildings (we’ll call that the retail sales floor), bond fund marketers utterly ignore the baneful impact of the full 32 ticks (one percentage point)—or even 64 ticks (fully two percentage points)—that they lay on their customers.” Echoing the title of my remarks this evening—“Stewardship vs. Salesmanship—Bond Mutual Funds Gone Awry”—this dichotomy reflects the triumph of salesmanship over stewardship in the management of bond funds; it reflects building a fund’s assets by supply-push seller incentives rather than demand-pull buyer incentives; and it reflects, perhaps above all, the information asymmetry (a nice economist’s term!) that exists when the seller knows a lot about these “relentless rules of humble arithmetic” (a favorite phrase of mine, courtesy of Justice Brandeis) that I’ve earlier described, rules of which the buyer is largely ignorant.

books, but also some $25 billion of SIVs that have been “put” back to the bank, a fact not publicly disclosed by Citi until November 5. Astonishingly, Robert Rubin, chairman of Citi’s Executive Committee (and a man, one might say, of not inconsiderable financial acumen) has stated that until last summer he had never even heard of liquidity puts. (Not quite as embarrassing as former chairman Charles Prince’s earlier comment: “As long as the music is playing you have to keep dancing. We’re still dancing.”) Innovation in the Mutual Fund Industry If innovation has again gone too far in the banking sector, that sector is hardly alone. Innovation has also gone too far in the mutual fund industry. When I entered this industry way back in 1951, it was overwhelmingly dominated by equity funds holding a diversified list of blue chip stocks; investing for the long-term (15 percent portfolio turnover); operated at modest expense ratios (averaging about 75 basis points); and pretty much closely tracking (before costs, of course) the returns of the stock market itself. We were an industry that sold what we made, and we valued management over marketing, stewardship over salesmanship. And then we decided to innovate. It was the mid-1960s when the mutual fund sector began to stray from its commonsense charter that had served investors with reasonable—if not quite optimal— effectiveness.

handling of men and facts.” It is, he said, “the free capital of the mind the world most stands in need of, spiritual as well as material, which advance the race and help all men2 to a better life . . . No task rightly done is truly private. It is part of the world’s work.” The Economics and Idealism Behind Vanguard’s Founding I’ve tried to dedicate my career to, using Wilson’s words, “a task rightly done.” It was almost 25 years ago to the day when our firm was incorporated. I chose the name “Vanguard” for the new enterprise, hoping to capture the tradition of HMS Vanguard, Lord Nelson’s flagship, which led his victory over Napoleon’s fleet at the Nile 200 years ago. (Nelson’s triumph was recently crowned by The New York Times as the greatest naval battle of the millennium.) If Vanguard has distinguished itself, it is through our mission of stewardship, our single-minded devotion to giving the mutual fund investor a fair shake. It is hardly an exaggeration to say that, without Princeton, there would be no Vanguard. For my interest in this industry sprang to life in the University’s spanking-new Firestone Library, quite by accident, in 1949. There, I stumbled across an article in FORTUNE magazine that described the mutual fund industry as “tiny but contentious.” I decided on the spot that it should be the topic for my senior thesis, which I entitled, “The Economic Role of the Investment Company.

follow hedgehog-like strategies. The goal is not necessarily to index—though that is clearly the most assured route to closely approaching 100% of the market’s rate of return—but to parlay a combination of very low cost, modest portfolio turnover, long-term focus, consistent style, and management competence—not thaumaturgy or legerdemain—into solid investor returns. Thereby exists the last, best chance to outpace the market index. The Hedgehog as Businessman Let me now turn to my second contrast between fox and hedgehog: From the mutual fund industry’s investment conduct, to its business conduct. Here the foxy strategy of entrepreneurs and promoters relies on guileful but expensive marketing, hot products, and drum-beating about past performance (when it is good), while the hedgehog strategy emphasizes patience, prudence, and stewardship. The hedgehog strategy entails a sort of “if-you-build-it-they-will-come” approach, which works only if standards are established to assure that those who do come are served in a first-class fashion. Since, in the long run, the rewards of investing are determined by the allocation of market returns between the fund shareholders and the managers and distributors, the hedgehog business strategy begins with low cost.

 Three, the triumph of illusion over reality. As our professional security analysts came to focus far more heavily on illusion—the momentary precision of the price of the stock—they increasingly ignored the reality—that what really matters is the inevitably vague, but eternally transcendent, intrinsic value of the corporation. Measuring up, unfortunately, to Oscar Wilde’s wonderful description of the cynic, our money managers came “to know the price of everything, but the value of nothing.” When there is a gap between perception—illusion—and reality, it is, to state the obvious, only a matter of time until the gap is reconciled—inevitably, in favor of reality. In Mutual Fund America:  One, the industry changed. Mutual funds, once a profession with elements of a business, gradually became a business with elements of a profession. Our traditional guiding star of stewardship was transmogrified into a new star—salesmanship. Largely focused on management when I wrote my Princeton thesis about the industry, our predominant focus today is on marketing—increasing fee revenues by building up assets under management, often by creating, promoting, and advertising speculative funds that meet the fads and fashions of the day. As you will soon learn, our fund investors have paid a terrible price.  Two, the conglomerates take over.

The fact is that Vanguard’s economics, like Wilson’s, were in important measure shaped by idealism. For what distinguishes Vanguard from the typical business enterprise is our mission: To place the interest of our investors before our own commercial interests. Our truly mutual mutual fund structure is unique in the fund industry: The funds’ management is controlled by the fund shareholders, not by an outside management company, and is operated on an “at-cost” basis, not for a hefty management fee. With the substantial profits normally earned by the management company eliminated, this mutual structure has been the major contributor in generating aggregate savings to our investors—and hence added returns—that now approach $20 billion. The other contributor has been our deep, assiduous, slavish, passionate dedication to providing our stewardship to the shareholders who have entrusted their resources to our care at rock-bottom operating costs; that is, “in the most economical way possible.” Down with Costs, and Carthage Too All of this is important only if costs matter. They do. Costs matter. I repeat this phrase so often that one journalist compared me with Cato, the Roman orator whose speeches in the Forum always ended with a call for the defeat of Carthage: “Carthage delanda est.

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

year researching the fund industry for my senior thesis in Economics, inspired by an article that I happened upon in Fortune magazine in December 1949. The thesis was entitled “The Economic Role of the Investment Company.” When I wrote my thesis, assets of mutual funds totaled about $2 billion; today assets exceed $10 trillion, a 17 percent annual rate of compound growth that was exceeded by few, if any, other enterprises. (Asset of life insurance companies, by way of contrast, grew from $53 billion to $4.7 trillion—from 25 times fund assets in 1951 to less than one-half today.) The mutual fund industry has become America’s largest financial institution. Yet the record is clear that we have lost our way. Once a profession with elements of a business, we have become a business with elements of a profession—and too few elements at that. Once focused on management and investing, we are now focused on marketing and asset gathering. Once focused on stewardship, we are now focused on salesmanship. We have become an exemplar—alas, even a leader— in the new “bottom line” society that I earlier described. Lest you think that indictment is too strong, let me drive this point home with seven hard examples: 1. In 1951, mutual fund management companies were relatively small organizations, privately- held by their principals, managed by investment professionals who were prudently investing to earn a sound return on the capital invested by their fund shareholders.

strategy emphasizes prudence, stewardship, and service. This strategy entails a sort of “if-you-build-it- they-will-come” approach, which works only if standards are established to assure that those who do come are served in a first-class fashion. The record is clear that since managers as a group will fall short of market returns by the amount of their costs, the linchpin of the hedgehog strategy is maintaining minimal costs. In the long run, the rewards of investing are determined by the allocation of market returns between the fund shareholders and the managers. To help accomplish this vital goal, Vanguard has chosen a corporate structure, unique in the mutual fund industry. It is truly mutual: The fund shareholders own the management company that administers the funds. Unlike every other company in this business, we operate our enterprise on an “at-cost” basis, with each fund paying its share of corporate expenses. In turn, we hold those expenses to the bare minimum, employing a modest marketing budget and demanding stringent cost controls in every activity we undertake. We are, in a brutal but accurate word, “cheap.” (It is, after all, our clients’ money that we are spending.) The net result is savings for our investors totaling something in the range of $3 billion to $4 billion per year, a huge enhancement in shareholder returns that often makes the difference between “average” and “superior” relative to peer funds.

defeat.” The qualities that result in compromise, while valuable, even priceless in some circumstances, are rarely responsible for the building of a great institution. Finally, my idealistic view—for which I offer no apologies—is that the mutual fund firm should be of the clients, by the clients, and for the clients, holding their interests above the financial interests of the manager-entrepreneur; providing a service of stewardship to the human beings who place with the firm their assets and their trust alike. And low cost is so central to that view that, even as in Wilson’s case, the idealism that I’ve invested in Vanguard leads to its economics. “And there are other things,” he wrote in his Princeton Inaugural, “besides material success with which we must supply our generation. It must be supplied with men who care more for principles than for money, for the right adjustments of life than for the gross accumulations of profit. The problems that call for sober thoughtfulness and mere devotion are as pressing as those which call for practical efficiency.” President Wilson closed that address with this ringing peroration, with which I close my own remarks this evening: “I have studied the history of America. I have seen her grow great in the paths of liberty and of progress by following after great ideals. Every concrete thing she has done has seemed to arise out of some abstract principle, some vision of the mind.

“The financial system takes on special significance in Minsky’s theory, not only because finance exerts a strong influence on business activity, but also because this system is particularly open—or, as some might claim, prone—to innovation, as is abundantly evident today. Continues Minsky: ‘Since finance and industrial development are in a symbiotic relationship, financial evolution plays a crucial role in the dynamic patterns of the economy.’ “In addition to emphasizing the relations between finance and business, Minsky identified progression through at least five distinct stages of capitalism. The five stages can be labeled as follows: merchant capitalism (1607-1813), industrial capitalism (1813-1890), banker capitalism (1890-1933), managerial capitalism (1933-1982), and money-manager capitalism (1982-present). But the broad historical framework that Minsky developed in the last years of his life has gone almost unnoticed. According to Minsky, money-manager capitalism ‘became a reality in the 1980s as institutional investors, by then the largest repositories of savings in the country, began to exert their influence on financial markets and business enterprises.’ “The raison d’être for money managers, and basis by which they are held accountable, is the maximization of the value of the investments made by their clients. Not surprisingly, therefore, business executives became increasingly attuned to short-term profits and the stock-market valuation of their firm.

And as for character, whatever moral standard I may have developed, I have tried to invest my own soul and spirit in the character of the little firm I founded all those years ago. On a far grander scale than just one human life, these standards of mind, of heart, and of character resonate—as ever, idealistically—in how we seek to manage the billions of dollars entrusted to Vanguard’s stewardship, and in how I pray that my company will ever see itself, putting the will and the work of a business enterprise in the service of others. The Battle for the Soul of Capitalism Perhaps it is obvious that these values eventually inspired me to expand my horizons beyond the narrow confines of the mutual fund industry in which I’d spent my entire career. The result: The Battle for the Soul of Capitalism, published by Yale University Press late in 2005. In essence, Battle is my cri de coeur about the state of American capitalism and the state of American society today. The Battle is one idealistic book! Just consider its first words, with the dedication to my twelve grandchildren and the other fine young citizens of their generation. With six of them now in college, you students here tonight are part of that generation, and hence of this dedication: “My generation has left America with much to be set right; you have the opportunity of a lifetime to fix what has been broken. Hold high your idealism and your values.

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

grander scale than just one human life, these standards resonate—as ever, idealistically—in how we seek to manage the billions of dollars entrusted to our stewardship, and in how I pray that my company will ever see itself, putting the will and the world of a business enterprise in the service of others—in the Nation’s service. Woodrow Wilson had a strong moral vision. In his inaugural speech as President of Princeton University in 1902, he demanded that the university graduate “derive his knowledge from the thoughts of the generations that have gone before him,” noting that, “the ages of strong and definite moral impulse have been the ages of achievement.” He then added, “university men ought to hold themselves bound to the upper roads of usefulness which run along the ridges, and command views of the general fields of life.” His choice of those words, “the general fields of life,” surely can be read as applying to mundane works of commerce—business and finance, the trades and the services—and to those Princetonians who would spend their careers honorably pursuing them. In this sense, perhaps Woodrow Wilson is looking down on this morning’s ceremony with approval, accepting with pleasure the fact that in 1999 the award that honors him will be presented to a Princetonian who, as a businessman, has spent his career in the field of finance.

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

the Fortune essay. William Parsons, “a merchant of probity,” described the good merchant as “an enterprising man willing to run some risks, yet not willing to risk in hazardous enterprises the property of others entrusted to his keeping, careful to indulge no extravagance and to be simple in his manner and unostentatious in his habits, not merely a merchant, but a man, with a mind to improve, a heart to cultivate, and a character to form.” When I read those inspiring demands, uttered 163 years ago, they seemed directed right at me, and at the theme of my remarks this evening. As for the mind, I still strive every day—I really do!—to improve my own mind, reflecting on current events, reading history, and challenging even my own deep- seated beliefs. As for the heart, no one—no one!—could possibly revel in the opportunity to cultivate it more than I. Just three weeks ago, after all, I marked the eleventh (!) anniversary of the amazing grace represented by the heart transplant that I received in 1996. And as for character, whatever moral standards I may have developed, I have tried to invest my own soul and spirit in my family, in my life’s work, and in the character of the little firm I founded all those years ago, a firm focused on stewardship— a business, yes, but a business with strong elements of a profession.

All of this will require sensitive, objective handling by our regulators, I hope relying on the concept of “principles-based” regulation. Given the unforeseen nature of what may come along, that reliance on judgment is every bit as important as the process we put in place to require full and fair disclosure. So, to you at FINRA, I say, using the principle I regularly commended to our crew when I ran Vanguard, “Let’s always keep FINRA a place where judgment has at least a fighting chance to triumph over process.” I close by expressing again my admiration for our industry’s regulators and enforcement officers. You are doing the Lord’s work, and I heartily endorse, yet again, your mission of investor protection, buttressed by the need for investor education that I’ve emphasized today. Much of your work involves crooks and charlatans. But there are few, if any, of either in the fund business today. Our problem is more subtle: we believe unfailingly in our mission, in our competence, and in our integrity, without ever standing back and asking exactly what have we wrought in changing our traditional values of stewardship into a new set of values focused on asset gathering and marketing. That’s the vital issue that I’ve put on the table today. This dichotomy poses a major challenge to our system of regulation and enforcement. In my Battle book, I quote James Madison: “If men were angels, no government would be necessary.

Economic Markets and Public Purpose (With Some Reflections by Adam Smith) A Lecture by John C. Bogle Founder and Former Chairman, The Vanguard Group Before The Reinvestment Fund’s 24th Annual Celebration Philadelphia, PA June 11, 2009 It seems almost fated that I’d come to address you during these days of crisis in our economy and travail in our financial markets, for we have much in common. Both the Reinvestment Fund and The Vanguard Group—the firm that I created almost 35 years ago—are financial service organizations that were created to march to a different drummer, organizations that have done their best to set a new standard—to “rediscover a public purpose,” using a phrase from the title of the recent monograph authored by your Jeremy Nowak and Ellen Seidman—in our investment sector, putting service to the community (in your case) and service to investors (in our case) before service to self. The sad fact is that it is in the field of finance where the seeds of our economic crisis and market travail were sown. The financial sector is easily enough seen as a monolith, driven by opportunism rather than service, by marketing rather than management, by self-interest rather than community good, by complexity rather than simplicity, by short-term speculation rather than long-term investment, and by salesmanship rather than stewardship. Vanguard is among the few—the very few—exceptions to this profile, so it is only appropriate that we meet together today, in common cause.

On Investing-- ∑ Too Much Cost, Not Enough Value ∑ Too Much Speculation, Not Enough Investment ∑ Too Much Complexity, Not Enough Simplicity On Business-- ∑ Too Much Counting, Not Enough Trust ∑ Too Much Business Conduct, Not Enough Professional Conduct Too Much Salesmanship, Not Enough Stewardship ∑ Too Much Management, Not Enough Leadership On Life-- ∑ Too Much Focus on Things, Not Enough Focus on Commitment ∑ Too Many Twenty-First-Century Values, Not Enough Eighteenth-Century Values ∑ Too Much “Success,” Not Enough Character My mission in writing the book was to provoke readers to think about these issues, and begin to move our society to a point where it has less of those attributes that we now have too much of, and more of those attributes of which (it seems to me) we have not nearly enough. Given our celebration today of the marvelous community service performed by The Salvation Army—most recently in the completion of the fabulous Kroc Community Center up in Nicetown—I thought that Chapter 10—“Too Much Success, Not Enough Character”—would be especially relevant. It begins with a wonderful story told by The Reverend Fred Craddock, a remarkable preacher from Georgia. He may have been imagining things—the way preachers are wont to do—but he says this story really happened. Dr. Craddock was visiting in the home of his niece. There was this old greyhound, one of those speedy dogs who race around a track chasing mechanical rabbits.

responsibility to assure that these ethical principles permeate and dominate the culture of our corporate world? We’re all familiar, I’m sure, with the classic ethical principles of our society—integrity, honesty, and trustworthiness; fairness and justice; doing good and preventing harm; concern for the well-being of others and respect for their autonomy, and so on. But applying these societal principles to business is far easier said than done. Honoring Ethical Principles in Business No one can be more aware than I am that in the dog-eat-dog competition that has always been inherent in our capitalist system, these ethical principles are often difficult to honor. Dealing with this fierce competition without compromising one’s character is no mean challenge! For example, while I’m sure that 100 percent of our business leaders describe integrity and honesty as the essential elements of leadership, it’s also clear that less than 100 percent of them deliver on those two essentials. Among our large publicly held corporations, having a clear set of standards and an ethical code is now a commonplace, yet we’ve seen too many examples where these standards have been ignored, often to meet ambitious—perhaps overly ambitious—goals for growth in corporate revenues and earnings. Our corporate directors pay lip service to the responsibility of stewardship.

And so I drive to return fund managers to their traditional commitment to serve as the honest stewards of their clients—in my case, the mutual fund shareholders whom our industry is duty bound to serve. (I should note here that both our keynote speaker Jeremy Grantham and our co- host James Joslin are both paradigms of these stewardship values, and I thank them for gracing this lovely evening with their participation.) Of course my mission to build a better financial world will not be fully realized during my lifetime. But that knowledge hardly slows me down, for I love the battle itself. I relate to Gutzon Borglum, the determined sculptor of Mount Rushmore, who said “Life is a kind of campaign.good

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

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

alive, and will every now and then peep out and show itself; you will see it perhaps often in this history; for even if I could conceive that I had completely overcome it, I should probably be proud of my humility. In candor, these words serve to remind me that my own pride must be all too evident in the brief history of my career that I’ve recited here, a career focused on the stewardship of the wealth of our nation’s citizens. Too often, I’m sure, my pride has indeed peeped out and shown itself, reminding me that my own humility could doubtless use a little more development. I must work on that tomorrow . . . Thank you again. ______________ Note: My focus on what I haven’t done was inspired by Jason Gay’s Wall Street Journal column on what Denver Broncos quarterback Tim Tebow hasn’t done. December 1, 2011.

stewardship, I freely concede the profound limitations of my own human being-ness. Perhaps these few lines from Eve’s favorite anthem will convey some of the ambiguity of my life and even the lives of many of you here tonight. It closes, not with an answer, but with two questions about balancing work and life. In the evening of my life I shall look to the sunset. At a moment in my life when the night is due. And the question I shall ask, only I can answer. “Was I brave and strong and true? Did I fill the world with love my whole life through?” I believe that I’ve answered that first question in the affirmative. I promise to keep working on the answer to the second. Thank you, Dr. Lown and the Lown Foundation for the great honor you bestow on me this evening, and thanks to all of you who have joined me and my family and share in this splendid event with us. Good evening.

It was certain that if we acted always with caring, with integrity, and with candor, Vanguard would grow, and indexing would lead the way. While I concede that “growth is the only evidence of life,” my attitude was to let our growth just happen, not by forcing it, for example through expensive sales promotions, aggressive marketing schemes, nor the offering of faddish new funds that would attract the evanescent and therefore useless assets of short-term speculators. Rather we sought to attract the durable and therefore priceless assets of long-term investors by earning their trust. I was confident that an enterprise whose mantra is not salesmanship but stewardship would grow organically, a natural result of our philosophy. And so it did. We began in September 1974 with $1.4 Billion of investor assets, today our asset base exceeds $1.2 Trillion. Business or Profession? 1 Dean Howard M. Johnson, chairman of the Massachusetts Institute of Technology.

What Went Wrong in Corporate America and Investment America? So why did all these things go wrong? Simply put—and this is the main thesis of my 2005 book, The Battle for the Soul of Capitalism—what went wrong in corporate America, aided and abetted by investment America, was a pathological mutation in capitalism—from traditional owners’ capitalism, where the rewards of investing went primarily to those who put up the capital and took the risks—to a new and virulent managers’ capitalism, where a grossly excessive share of the rewards of capital investment went to corporate managers and financial intermediaries. As I see it, there were two major reasons for this baneful change: First, the “ownership society”—in which the shares of our corporations were held almost entirely by direct stockholders—gradually lost its heft and its effectiveness. It is not going to return. In its stead, a new “agency society” has developed, with financial intermediaries controlling the overwhelming majority of shares. (Since 1950, institutional ownership has risen from 8 percent of U.S. stocks to 70 percent; individual ownership has dropped from 92 to 30 percent.) But those agents haven’t behaved as owners. They have put their own interests ahead of the interest of their principals, largely those 100 million families who are the owners of our mutual funds and the beneficiaries of our pension plans. The whole notion of stewardship seemed to get lost in the shuffle.

If my ideas make you wonder whether I’m really a businessman, well, you’re very perceptive. For when one’s trade is providing investment management services to those millions of human beings whom I mentioned earlier, don’t think business, think trusteeship, think stewardship. Remove salesmanship and marketing from your agenda. Focus your career as engaging in a profession, far more than merely engaging in a business. It’s worked well for us. Of course I understand that every business has elements of a profession, and every profession has elements of a business. As I have often observed, unless its revenues exceed its expenses, “no organization—even the most noble of faith-based institutions—will long exist.” I also understand that the proper balance between business and profession varies widely, depending on the character of each company and industry. And I know full well—better than most—that maintaining that balance is a delicate challenge. In any event, I’m deeply troubled that the balance between business and profession is shifting, and for the worse. Our society is gradually moving away from the stern traditional values of yore to the flexible values of our modern age. Today’s “bottom line” society reflects the gradual mutation of our professional associations into business enterprises, in important measure because of the growing importance of making money.

And it is now arguably the largest mutual fund in the world.6 Yet the Vanguard model has yet to be copied, and we remain a renegade in our field. We prefer to be noted for our stewardship rather than our salesmanship; for our management rather than our marketing; for our focus on long-term investment rather than short-term speculation. In this sense we parallel the career of Isaiah Williamson, who made his fortune in trade by his own efforts and straight business dealing, not by speculation. Labor and Capital When capital is used for speculation rather than investment, the relationship between capital and labor in our society is distorted. Of course, as Abraham Lincoln reminded us, capital 4 David P. Billington and David P. Billington Jr., Oxford University Press, 2005. 5 In fact, in my 1951 thesis at Princeton University, I urged that mutual funds be operated “in the most efficient, economical, and honest way possible.” If honesty is understood to represent a certain kind of elegance, the ideas are identical. 6 Assets of our Index 500 funds total $125 billion; assets of our Total Stock Market Index Funds total $95 billion, a total of $220 billion.

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

In fact, much of today’s crisis finds its roots in the very failures of our financial sector that I described in my ancient thesis, and, most recently, in my seventh book, published last November. In Enough. True Measures of Money, Business, and Life, I warn of too much cost and not enough value; too much speculation and not enough investment; too much complexity and not enough simplicity; too much counting and not enough trust; too much salesmanship and not enough stewardship; and so on; even too many 21st century values and not enough 18th century values—those values exemplified by the great philosophers of The Age of Reason—men such as Rousseau and Hume and Burke, and Adam Smith, and Tom Paine—who in turn helped shape the minds of our Founding Fathers—especially Washington, Jefferson, Madison, Franklin, and Hamilton. And all of these men, in turn, stood on the shoulders of earlier giants such as Socrates, Plato, and Aristotle. (Some of them are likely quoted in the halls you walk here each day. Read their words! Think about them! Gain their wisdom!)

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

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

Part of the problem is that these giant institutions, once focused on management, began to focus on marketing, in order to build their own profitability. Let’s call that: the triumph of salesmanship over stewardship. Innovation became the watchword, but it was innovation that served managers rather than investors, exemplified by “hot fund products” and complex and risky derivatives. If these institutional agents—targeting our nation’s pension managers and mutual fund managers (34 percent of U.S. stock alone!)—had continued focused solely on the interest of their principals, the consequences of that remarkable mutation could have been modest. But these agents—now largely controlled by giant U.S. and international financial conglomerates—have too often put their own interests ahead of the interests of those whom they are duty-bound to serve, those 100-million-plus fund shareholders and pension beneficiaries who inevitably feed at the bottom of the food chain of investing. This innovation contributed to the soaring cost of the investment food chain, now estimated at $560 billion per year. (Up from about $25 billion in 1990.) Why is that a problem? Because the aggregate of the manager’s fees, expenses, and profits, plus portfolio trading commissions and other costs, are deducted from whatever gross returns our financial markets are generous enough to deliver, and the investors who put up the capital get only what’s left.

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

Values begin with telling the truth, internally and externally. Integrity must run deep in the fabric of an organization’s culture. It guides the everyday actions of employees and is central to its business conduct. Transparency is an integral part of integrity. The truth, both successes and failures, must be shared openly with the outside world. Authentic companies [dare I say real companies?] value the importance of stewardship to the people they serve—customers, employees, shareholders, and communities. Stock price is not the best measure [of shareholder value] because it is so heavily influenced by . . . investor expectations, market psychology, and the overall trend of the market. Sustained growth in revenues and earnings per share, cash flow, and return on investment are still the best measures of how well a company is performing. The best path to long-term growth in shareholder value comes from having a well-articulated mission that inspires employee commitment and the confidence and trust of clients. Focusing on a mission that calls on leaders of character and courage to develop commitment, confidence, and trust is simply another reflection of Adam Smith’s Impartial Spectator who, as I’ll quote at length later on, calls on each of us to be “honorable and noble, to live up to the grandeur and dignity and superiority of our own character.” No, this goal will never be totally achieved. I know that.that

Indeed, one Vanguard shareholder described it as “a crisis of ethic proportions” (a nice variation on the standard “epic” proportions), the title that I used for my op- ed essay published in The Wall Street Journal a week ago. For the decline in ethical values played a major role in the failure of managerial capitalism and—managerial capitalists—that led to the financial bubble, and the burst that inevitably followed. While former Federal Reserve Chairman Alan Greenspan believed that competition and free markets would reward trust and integrity, he seemed unmindful of this sea-change in capitalism that was occurring. To his credit, Greenspan admitted his mistake. In his testimony before Congress last October, he acknowledged that the crisis had been prompted by “ . . . the collapse of a whole intellectual edifice . . . Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity—myself especially—are in a state of shocked disbelief,” he said. This failure of self-interest to provide self-regulation was, he added, “a flaw in the model that I perceived as the critical functioning structure that defines how the world works.”

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

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

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

True Measures of Money, Business, and Life has ten chapters (called “the Ten Commandments” by management guru and author Tom Peters), each with a common cadence—too much cost, not enough value; too much speculation, not enough investment; too much complexity, not enough simplicity, too much counting, not enough trust; too much salesmanship, not enough stewardship, and so on. These trends clearly reflect the triumph of business standards over professional values. However, given the horrific events in the financial field during the past decade, I should have added an eleventh chapter (though that would have killed the Ten Commandments metaphor!) entitled “too much crime, and not enough punishment.” I’m not sure which bothers me more—the rampant spread of criminal conduct (that is, violations of law) during the recent era, or the disappointing lack of serious punishment of those individuals, the decision-making principals of the firms involved. The number of firms found in violation of securities laws is little short of staggering. I understand that in the academic community “Wikipedia” is not accepted as a valid source, but its “Timeline” on financial scandals covers seven full pages, with 42 separate cases.the

It guides the everyday actions of employees and is central to its business conduct. Transparency is an integral part of integrity. The truth, both successes and failures, must be shared openly with the outside world. Authentic companies [dare I say real companies?] value the importance of stewardship to the people they serve—customers, employees, shareholders, and communities. “Stock price,” Bill George continues, “is not the best measure (of shareholder value) because it is so heavily influenced by . . . investor expectations, market psychology, and the overall trend of the market. Sustained growth in revenues and earnings per share, cash flow, and return on investment are still the best measures of how well a company is performing. The best path to long-term growth in shareholder value comes from having a well-articulated mission that inspires employee commitment and the confidence and trust of clients.”

∑ Too much speculation, not enough investment. ∑ Too much complexity, not enough simplicity. In Business— ∑ Too much counting, not enough trust. ∑ Too much business conduct, not enough professional conduct. ∑ Too much salesmanship, not enough stewardship. ∑ Too much management, not enough leadership. In our Lives— ∑ Too much focus on things, not enough focus on commitment. ∑ Too many twenty-first-century values, not enough eighteenth-century values. ∑ Too much “success,” not enough character. This is a book, as it has been said, laced with both searing criticism and soaring idealism, one might even say Adam Smithian (if only I had his gifts for the well-turned phrase.) And I believe that both TRF and Vanguard continue to share my basic values. We are as one, I think, in our belief that—if they are to benefit our society—economic markets must, finally, have a public purpose. You at TRF are an exemplar of one approach to implementing this concept, and I salute you for your commitment. We at Vanguard are an exemplar of a very different approach, but an approach in which acceptance in the marketplace of ideas (and investment strategies) are quite literally growing by the day. Let us both “Press on, Regardless.”

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

The problem is not only that future returns earned or untried and often costly strategies are unpredictable and rarely live up to their hyperbolic promises; the problem is that the industry focus on salesmanship over stewardship leads to the proliferation of idiosyncratic funds that inevitably results in a fund failure rate that, however rarely publicized, is little short of astonishing. In my Little Book, I wrote that of 355 funds that existed in 1970, only 132 made it through the next 35 years. In the recent era, of the 6126 mutual funds that existed at the start of 2001, 2797 have already been consigned to the dustbin of history. (You know what I mean!) How, I ask, can a planner or adviser implement a long-term strategy of investing in mutual funds if only half of the funds can make it through a period as short as seven years—and seven pretty good years at that! * * * In any event, please forgive the bluntness of this aging mutual fund Luddite who finds himself uninspired—and unimpressed—by the rise of complexity (and excess cost) at the expense of simplicity (and minimum cost).the

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

leaders not merely “talking the talk,” but “walking the walk,” every step of the way. It means communicating these values, over and over again, ad infinitum, in the simplest possible terms— Put the shareholder in the driver’s seat . . . Do what’s right. If you’re not sure, ask your boss . . . Keep Vanguard a place where judgment has at least a fighting chance to triumph over process . . . a company that stands for something—stewardship . . . Character counts. If we can build a crew that holds high those values, and focuses not on a job, but on a lifetime career, those veterans will pass the values along to those who follow them, and the firm’s character should endure for a long, long time, and with it—if we don’t lose our way— our industry preeminence. Food for Thought Summing up: One, we still seem to have plenty of ethical principles out there, but not nearly enough ethical principals. Two, business standards (such as they may be) have, in less than a half-century, come to supersede traditional professional ethics, at great cost to society. Three, a promising new structure in money management, focused on the positive ethics of placing shareholders rather than managers at the top of the food chain of investing, has carved out a now- dominant niche in money management. At some point, if only in order to survive, other firms will have to emulate the Vanguard model. But the task remains: to elevate the ethical behavior of we all-too-human beings.

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

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