John Bogle on Quality Businesses

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

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

with an unfortunate decision by the U.S. Court of Appeals, Ninth Circuit (in San Francisco) that affirmed the right of a fund adviser (Insurance Securities Incorporated, or ISI) to sell a controlling interest in its stock at a premium to its book value. The SEC argued that the transaction was a sale of fiduciary office, and hence a violation of fiduciary duty. The date of that decision, April 7, 1958, then, was a date that will live in infamy. That seminal event, now long forgotten, changed the rules of the game. It opened the floodgates to public ownership of management companies; providing the huge rewards of entrepreneurship to fund managers, inevitably at the expense of fund shareholders. From 1924 through the 1950s, as I recall, every single one of the industry’s largest fund management companies was managed primarily by investment professionals, either a partnership or a closely-held corporation. But within a decade after the District Court’s decision, scores of mutual fund management companies would go public, selling their shares (but usually retaining voting control). It was only a matter of time until U.S. and international financial conglomerates acquired most of these newly publicly-owned firms, and many of the industry’s privately-owned firms as well. These acquiring firms, obviously (one could even concede, appropriately), are in business to earn a high return on their capital, and they looked at the burgeoning fund industry as a goldmine for managers. (It was!)

While my long-term optimism about this wonderful business could never be squelched, my short term view is one of deep concern. It can be expressed simply: both through the funds we have developed and the way we have promoted them, we have in too many cases raised investor expectations beyond our ability to meet them. And, since the sharply higher prices at which we are offering our services directly reduce the performance we provide, we are on a collision course that is all too likely to shake to its roots the investor confidence that we have won (with a few detours along the way) during this industry’s first sixty-three years. As to the mutual fund “product” (a word I have come to despise), we are venturing, if history is any lesson, into dangerous ground. The mutual fund built its success at first on its appeal as an investment, from our industry’s start in 1924 through the mid-1970s. The next wave of success, essentially over the past decade, has been based on its appeal to savings, first with money market funds as interest rates soared, later with bond funds as interest rates came down to more “normal” levels. But now, I fear, we are extending our ambit to speculation, sometimes implicitly (as in the tacit promotion of market timing programs via the exchange privilege), and sometimes explicitly a(as in the development of highly-volatile equity funds and market sector funds).