John Bogle on Economic Moats

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

success, a reputation that hangs on despite the tough sledding that has characterized its returns in recent years; and the most aggressive and expensive marketing and advertising programs in the industry’s history. (“If you sell it, they will come,” apparently.) The other leader, by contrast, has spent little on marketing and less on advertising, relying instead on the word-of-mouth recommendations of its shareholders—they are truly our apostles—and conveying our story through the financial news media. (Truth told, there are a few apostles there too!) “Earned and not bought” seems to work just fine. It is our well-deserved reputation for low costs and shareholder service, part of a truly distinctive business strategy, that lets us stand out in a field populated largely of firms that all seem to do the same things, make the same claims, and produce, over time, the same returns; fund returns that are typically driven down by the high costs of acquisition and ownership incurred by their investors. Professor Porter had it right when he spoke to the Investment Company Institute in 1993: “The mutual fund industry has grown fat and lazy, a ‘me too’ industry with most companies stuck in the middle. Only Vanguard has differentiated itself from the pack by having a genuine, unique, sustainable competitive advantage.” He did reassure industry executives, however, by telling them that our “measured, careful, gentlemanly competition” gave them some protection.

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.

in mind that the industry costs reflect fund expense ratios only; they ignore sales charges, paid on the purchase of shares in almost one-half of all mutual funds. Since we offer only no-load funds, Vanguard’s cost advantage is in fact substantially larger than it appears.) The impact of cost is greatest where the time horizon is longest. If a low-cost complex operates at a cost of ¼ of 1% (assuming a market return of 10%) over 25 years, it captures 95% of the market’s return. A high-cost complex (at 2%), would capture but 63%. So here is another form of the tyranny of compounding—cost compounds, too! Since 1980, the expense ratio of the average Vanguard fund has dropped from 59 to 28 basis points, even as the industry’s expense ratio has risen from 99 basis points to 125 (Chart 5). Thus our margin of advantage has risen from 40 basis points to almost 100—by two and one-half times—an 80% competitive advantage in unit costs. This advantage is pervasive—in our U.S. and international stock funds alike; in our balanced funds; in our tax-exempt and taxable bond funds; and in our money market funds. After all, given Vanguard’s unique mutual structure, we have two ways of earning profits for our shareholders: Investing in portfolios of securities that provide generous long-term returns; and minimizing the drag of intermediation costs so as to provide the highest possible portion of those returns.

Those frictional costs, the study suggests, constitute a dead-weight burden that detracts from the return that can be theoretically produced by an investment portfolio in a frictionless securities market. So firms are urged to “cut those hidden costs,” including: 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.” In the study’s words, the firm that “will lead the way . . .minimize

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.

that one simply does not do,” has changed to a new standard: “If everyone else is doing it, I can do it too.” In short, our ethical foundation has changed from moral absolutism to moral relativism. That change has taken our society a long way from the principal attribute of professional conduct—a commitment to the interests of clients, a commitment to serve responsibly, selflessly, and wisely . . . and to establish an inherently ethical relationship between the professional and the general society.3 “No Man Can Serve Two Masters” We see this change of course, not only in our burgeoning financial sector, but in many other segments of our society as well. Professional relationships with clients have been increasingly recast as business relationships with customers. Think about trends in medicine; in journalism; in law; in accounting; in architecture; and, yes, in the mutual fund industry—a gradual shift away from trusted professionals serving the interests of the community toward commercial enterprises seeking competitive advantage and maximizing their own wealth, with the human beings who rely on these services being the losers. In a world where every user of services is seen as a customer, every provider of services became a seller, and the broader perspective of the professional falls by the wayside. As it is said, “When the provider becomes a hammer, every customer is seen as a nail.

When our proudest professions shift their balance away from trustworthy service to the community and toward becoming commercial enterprises that seek competitive advantage and aimed at making money, the human beings in our society who rely on those services are the losers. Vanguard – The Story of a New Structure Ironically, while my concerns about our financial system began early in my career, I was able to resolve my dilemma by departing from the flawed structure that developed in the mutual fund industry. It all began in the mid-1960s, now a half-century ago. Then, the public ownership structure of institutional money managers that would come to overwhelm the earlier private ownership structure was just beginning. At the same time, the so-called “Go-Go Era” in the stock market was also just beginning. That dynamic (in the worst sense) combination changed the once-sound character of the mutual fund industry—then largely composed of middle-of-the- road equity funds investing for the long-term, holding portfolios of “blue chip” stocks. (Total fund assets in 1965 were but $35 billion.) Those near-contemporaneous changes in fund management structure and in fund investment strategy combined to seriously erode the industry’s founding values and traditional ethics of trusteeship.

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

But as so many of our nation’s proudest professions— including accounting, journalism, medicine, law, architecture, and trusteeship—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. A few years ago, the author Roger Lowenstein made a similar observation, bemoaning the loss of the “Calvinist rectitude” that had its roots in “the very Old World notions of integrity, ethics, and unyielding loyalty to the customer.”3 “America’s professions,” he wrote, “have become crassly commercial . . . with accounting firms sponsoring golf tournaments” (and, he might have added, mutual fund managers not only doing the same thing but buying naming rights to stadiums as well). “The battle for independence,” he concluded, “is never won.” Put another way, we’ve moved from a concept that there were certain things that one simply didn’t do (moral absolutism, I suppose) to the idea that since everyone else is doing it, I can do it, too (surely a form of moral relativism). III. Business Values and Investment Values Gone Awry Now let’s turn to the current state of our commercial enterprises—in particular, our giant publicly-held corporations—and our investment institutions—now largely owned by giant publicly-held financial conglomerates.

Indeed, if revenues fail to exceed expenses, no organization—even the most noble of faith-based institutions—will long exist. But with the participants of so many of our nation’s proudest professions— including the law, accounting, estate planning, and trusteeship—having gradually shifted their traditional balance away from that of trusted professionals serving the interests of the clients and the community and toward that of members of commercial enterprises seeking competitive advantage, the losers are the human beings who rely on the objectivity and the integrity of those services. A few years ago, the author Roger Lowenstein made a similar observation, bemoaning the loss of the “Calvinist rectitude” that had its roots in “the very Old World notions of integrity, ethics, and unyielding loyalty to the customer.”3 “America’s professions,” he wrote, “have become crassly commercial . . . with accounting firms sponsoring golf tournaments” (and, he might have added, mutual fund managers not only doing the same thing but buying naming rights to stadiums as well). “The battle for independence,” he concluded, “is never won.” Put another way, we’ve moved from a concept that there were certain things that one simply didn’t do (moral absolutism, I suppose) to the idea that since everyone else is doing it, I can do it, too (surely a form of moral relativism). 3 Roger Lowenstein, “The Purist,” New York Times Magazine, December 28, 2003, page 44.

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.