2007

Reflections on Finance and Education Remarks by John C. Bogle Founder and former Chief Executive, Vanguard On receiving The 2007 Visionary Award From the National Council on Economic Education New York, NY October 30, 2007 I’m truly honored to receive your Visionary Award for 2007. I take special pride in sharing the platform with the amazing visionary William Donaldson, who has had at least five remarkable careers: founder and leader of both an investment banking firm and a school of management; chief of both the world’s largest stock exchange and the nation’s principal financial regulatory authority; and, when not otherwise occupied, boss of our major insurance companies. In puny contrast, I’ve had but one career. In 1951 I took the only job that was ever offered to me in my adult life, and have been at it, in one capacity or another, ever since. I may be, then, the paradigm of this epigram from Great Britain: Some men wrest a living from nature; this is called work. Some men wrest a living from those who wrest a living from nature; this is called trade. Some men wrest a living from those who wrest a living from those who wrest a living from nature; this is called finance. In that one long career, I’ve done my best to make the world of finance work effectively for those scores of millions of our citizens who wrest their livings from nature and from trade.

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.

Apple's September 2007 quarter was the first reported period after the iPhone launch, and Steve Jobs opened the call by reporting that more than 1.1 million iPhones had shipped in the product's first full quarter on the market. Management also reported Macintosh unit growth of more than thirty percent year over year and the highest quarterly revenue in Apple's history, anchored on the strength of the redesigned iMac, strong iPod international growth and an explosive contribution from the iTunes Store. CFO Peter Oppenheimer walked analysts through the gross-margin expansion to above thirty-four percent, attributing roughly half of the year-over-year gain to commodity cost declines and the balance to favourable product mix. He flagged that the Company was now generating close to $24 billion in trailing-twelve-month revenue and had built a cash position of more than $15 billion with zero debt. On the Q&A, an analyst asked Jobs whether Apple was prepared to lower the iPhone's price to drive penetration faster in international markets. Jobs defended the early price cut taken on the original iPhone, arguing that the iPhone had to earn its place in the smartphone category through experience rather than compete on price, and that the carrier-revenue-share model would evolve over time. He also pushed back on the suggestion that Apple should license Mac OS X, framing that as a strategy that would compromise the integration of hardware and software that was Apple's central advantage. The call closed with management providing a forward quarterly revenue guide of approximately $9.2 billion, which would have been Apple's largest quarter to date, and reiterating that the Company would continue to invest in retail, marketing and product development rather than return cash to shareholders.

At the USC Law commencement in May 2007, I told the graduating class that the most useful piece of mental machinery I had ever acquired was the habit of inversion. Most people, when they want to solve a problem, ask how to achieve the desired outcome. The inverter asks the opposite question: what would guarantee failure, and how can I avoid that? The contrarianism angle I tried to convey was that the habit of inversion, applied to investing, produces a different portfolio from the habit of pursuing the desired outcome. The investor who asks what would guarantee failure in his portfolio, and who then refuses to do those things, has a long-run advantage over the investor who chases the desired outcome without considering the failure modes. The discipline required is to enumerate the failure modes, to refuse to do the things that would guarantee failure, and to allow the desired outcome to emerge from the avoidance of the failures. The mistakes-and-learning element was the one I had most wanted to convey. I had made my own share of mistakes by pursuing the desired outcome without enumerating the failure modes, and the cost of those mistakes had, in dollar terms, been very large. The lesson I drew was that the disciplined investor must assume that the failure modes are present in every decision, and he must build the discipline of inversion into his process before the decision is made. The USC commencement was, in this sense, a confession. I told the graduating class that the framework had been built, in large part, from my own mistakes, and that the discipline I had extracted was to refuse to act until the failure modes had been enumerated and the actions that would produce them had been refused. The single discipline, applied over a working life, has been more valuable than any other I have learned. The contrarianism lesson I tried to add was that the habit of inversion, applied to the broader question of how to live a good life, produces a different life from the habit of pursuing the desired outcome directly. The man who asks what would guarantee a miserable life, and who then refuses to do those things, has a better life than the man who chases happiness directly, because the things that produce a miserable life are well known and easy to avoid, and the things that produce happiness are difficult to obtain and easy to lose. The USC commencement was, in some ways, the most personal I had ever given. I told the graduating class that the framework had been built, in large part, from my own mistakes, and that the discipline I had extracted was to refuse to do the things that would guarantee failure, and to allow the desired outcome to emerge from the avoidance. The same discipline, applied to investing and to life, has been the most useful thing I have learned in six decades of work.

At the USC Law commencement in May 2007, I told the graduating class that one of the most useful pieces of mental machinery I had ever acquired was the discipline of staying within my circle of competence. The circle is the set of things I genuinely understand, as opposed to the set of things I think I understand. The discipline required is to refuse to act on the things outside the circle, even at the cost of looking unfashionable during the boom, and even at the cost of being told, repeatedly, that I am missing the opportunity of a lifetime. The mistakes-and-learning point I tried to convey was that the investor who stays within his circle, and who refuses to act on the things outside it, has a long-run advantage over the investor who chases the things outside the circle on the assumption that he understands them. The discipline required is honesty about the boundary of the circle. The mistakes-and-learning element was the one I had most wanted to convey. I had made my own share of mistakes by acting outside my circle, on the assumption that I understood them, and the cost of those mistakes had, in dollar terms, been very large. The lesson I drew was that the disciplined investor must assume that the boundary of his circle is smaller than he would prefer, and he must build the discipline of refusal into his process before the temptation to act outside the circle becomes irresistible. The USC commencement was, in this sense, a confession. I told the graduating class that the framework had been built, in large part, from my own mistakes, and that the discipline I had extracted was to refuse to act on the things outside the circle, even at the cost of looking unfashionable during the boom. The single discipline, applied over a working life, has been more valuable than any other I have learned. The circle-of-competence lesson I tried to add was that the boundary of the circle is not fixed. The disciplined investor can, over time, expand the boundary by deliberate study, but the expansion must be honest, and the temptation to pretend the boundary is larger than it is must be resisted. The USC commencement was, in some ways, the most honest I had ever given. I told the graduating class that the framework had been built, in large part, from my own mistakes, and that the discipline I had extracted was to refuse to act on the things outside the circle, and to expand the circle only by deliberate study. The investor who is honest about the boundary, and who refuses to act outside it, will, in the long run, outperform the investor with the larger circle who pretends to understand more than he does.

At the USC Law commencement in May 2007, I told the graduating class that the most useful piece of mental machinery I had ever acquired was the discipline of avoiding stupidity, rather than seeking brilliance. Most people, when they want to succeed, ask how to be brilliant. The inverter asks the opposite question: what would guarantee stupidity, and how can I avoid that? The mistakes-and-learning point I tried to convey was that the investor who avoids stupidity, and who allows the desired outcome to emerge from the avoidance, has a long-run advantage over the investor who chases brilliance directly, because the things that produce stupidity are well known and easy to avoid, and the things that produce brilliance are difficult to obtain and easy to lose. The discipline required is to enumerate the stupidities, to refuse to do the things that would produce them, and to allow the desired outcome to emerge from the avoidance. The contrarianism angle was the one I had most wanted to add. The investor who avoids stupidity, and who allows the desired outcome to emerge from the avoidance, looks unfashionable during the boom, because he refuses to participate in the things that the boom is rewarding, and the things the boom is rewarding are often the things that produce stupidity. The same investor, during the crash, looks unfashionable in the opposite direction, because he is buying when the crowd is panic-selling, and the crowd cannot understand why anyone would buy into a falling market. The discipline required to refuse to participate in the boom, and to participate aggressively in the crash, is the single hardest discipline in investing, and it is the one that the avoidance framework was designed to support. The investor who has the framework has an enormous advantage over the investor who chases brilliance directly. The mistakes-and-learning lesson I tried to convey was that the investor who is honest about his own capacity for stupidity, and who builds the discipline of avoidance into his process, has an enormous advantage over the investor who assumes that he is too smart to be stupid. The USC commencement was, in some ways, the most personal I had ever given. I told the graduating class that the framework had been built, in large part, from my own stupidities, and that the discipline I had extracted was to refuse to do the things that would produce them, even at the cost of looking unfashionable during the boom. The investor who builds the discipline of avoidance, and who applies it consistently over a working life, will, in the long run, outperform the investor with the higher IQ who assumes he is too smart to be stupid. That single discipline has been more valuable than any other I have learned.

A January 2007 thread on the Financial Wisdom Forum captured the broader public reaction to the news that the Yale endowment had earned a roughly twenty-eight percent return in the prior fiscal year, a result that had brought the endowment's value to a new high and had reinforced the office's reputation as one of the most successful institutional investment operations in the country. The forum coverage noted that Yale's celebrated chief investment officer, David Swensen, had not disappointed, and that the office's published returns had been a major channel by which the Yale model had been propagated. The thread is one of the few extended general-audience discussions of the office's track record in the period before the financial crisis tested the model in earnest. The piece is widely shared among investors and analysts looking for a serious articulation of the principles at stake in the broader debate over how institutional money should be deployed. The thread walked through the substance of the office's return, noting that the result had been driven by the alternative-asset allocation that had defined the model since Swensen had taken over the office in 1985, and that the office's discipline during the late-1990s equity bubble, when many institutional peers had been tempted to chase the returns of the public market, had been a defining moment in the model's track record. The forum coverage stressed that the office's published returns had been a major channel by which the model had been adopted by other institutions, and that the network of Swensen's protégés had been a major channel by which the model had been propagated across the institutional investment industry and across the broader endowment community. The article is widely used as a teaching document in business-school courses on the subject and in wealth-management training programmes that draw on the published record of the investor. The thread closed with a reflection on what the office's return implied for the individual investor. The forum coverage noted that Swensen had argued, in his two books, that the individual investor should not try to replicate the institutional model but should instead use low-cost index funds to build a diversified portfolio, and that the case for index funds was a function of the structural disadvantage of the individual investor in the active-management marketplace. The thread is paired in the Swensen secondary literature with the original Pioneering Portfolio Management and with the Unconventional Success volume, and it is widely cited as a reference point in the broader reception of the office's track record in the period before the financial crisis tested the model in earnest. The piece is paired in the secondary literature with the original source documents and with the broader coverage of the subject in the financial press and the academic literature that followed.

WESCO FINANCIAL CORPORATION LETTER TO SHAREHOLDERS To Our Shareholders: Consolidated net “operating” income (i.e., before realized investment gains shown in the table below) for the calendar year 2007 increased to $93,405,000 ($13.12 per share) from $92,033,000 ($12.93 per share) in the previous year. Consolidated net income increased, from $92,033,000 ($12.93 per share) in 2006, to $109,161,000 ($15.33 per share) in the current year. The 2007 figure included realized investment gains of $15,756,000, after taxes ($2.21 per share). Wesco has four major subsidiaries: (1) Wesco-Financial Insurance Company (“Wes- FIC”), headquartered in Omaha and engaged principally in the reinsurance business, (2) The Kansas Bankers Surety Company (“Kansas Bankers”), owned by Wes-FIC and specializing in insurance products tailored to midwestern banks, (3) CORT Business Services Corporation (“CORT”), headquartered in Fairfax, Virginia and engaged princi- pally in the furniture rental business, and (4) Precision Steel Warehouse, Inc. (“Precision Steel”), headquartered in Chicago and engaged in the steel warehousing and specialty metal products businesses. Consolidated net income for the two years just ended breaks down as follows (in thousands except for per-share amounts)(1) : Amount Per Wesco Share(2) Amount Per Wesco Share(2) December 31, 2007 December 31, 2006 Year Ended Operating earnings: Wesco-Financial and Kansas Bankers insurance businesses — Underwriting . . . . . . . . . . . . . . . . .

Icahn's 2007-2008 campaign against RJR Nabisco's successor, Kraft, and his earlier 1980s assault on RJR itself, displayed his long-run consistency: he argued that consumer conglomerates trading at discounts to their parts should be split or sold. He proposed disposals and buybacks, won partial concessions, and kept returning to the theme across decades whenever the valuation gap reopened.

Why Do I Bother to Battle? “Courageous Champions of Conscience and Controversy” Remarks by John C. Bogle, Founder and Former Chief Executive Vanguard Group At the Yale CEO Leadership Summit New York, NY December 13, 2007 With the television writers still on strike, I’ll try to ease your ache for the David Letterman Show by giving you my ten reasons for “Why do I bother to battle?” (The strike matters not to me; I’ve always been my own writer.) Here we go: 10. Damned if I know why I bother to battle. I just do it, and I don’t know how to stop. 9. Because, in all my 78 years of life I’ve never done anything but battle—as a boy, as a newspaper deliverer, waiter (in many venues), ticket seller, mail clerk, cub reporter, runner for a brokerage firm, even a pin setter in a bowling alley. (Now there’s a Sisyphean battle!) And as a man, fighting the battle for personal advancement, for attention, for innovation, for progress, for service to society, and yes, even for power and the hope of being remembered. (Might as well admit it.) That’s why I write books. (You have The Little Book of Common Sense Investing in your book bag.) 8. Because the great battlers of history have always been my heroes. Think Alexander Hamilton. Think Teddy Roosevelt. Think Woodrow Wilson. Heck, think Rocky Balboa. 7. Because all those battlers, finally, lost their battles. I battle to be the exception. 6.

The Battle for the Soul of Capitalism Remarks by John C. Bogle Founder and Former Chief Executive, the Vanguard Group at The Aspen Book Series New York, NY March 14, 2006 Thank you very much for this special invitation to discuss my newest book, The Battle for the Soul of Capitalism, published in November by Yale University Press. It is indeed a pleasure to be with you all today. My book minces no words. Right at the outset, I turn to the main issue: “The business and ethical standards of corporate America, of investment America, and of mutual fund America have been gravely compromised. It is time to set out on a new course that, paradoxically enough, will lead us directly back to where we began, with the traditional values of capitalism. In the recent era, capitalism has let us down. It has departed, not just in degree but in kind, from its proud traditional roots, a system that served us, despite its imperfections, with remarkable effectiveness, for the better part of the past two centuries—a free enterprise system based on open markets and private ownership, and on trusting and being trusted. The system worked. Or at least it did work.” And then, as I write in Battle, “Something went profoundly wrong, fundamentally and pervasively, in corporate America.

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!)

When Does Innovation Go Too Far?* Remarks by John C. Bogle, Founder & former chief executive The Vanguard Group Before The Philadelphia Federal Reserve Policy Forum On Innovation and Regulation in the Financial Markets Philadelphia, PA November 30, 2007 It’s hard to argue against “Something New Under the Sun,” the title of a special report on innovation published only last month by the London Economist. The report defines innovation as “new products, business processes, and organic changes that create wealth or social welfare,” that is to say, “fresh thinking that creates value.” And surely we all agree that innovation, and her sister, entrepreneurship, are among the major forces that drive the growth of our global economy. As a result of those forces, we have the internet and superhighways, ever-soaring skyscrapers, jet aircraft that are ever more fuel-efficient, and automobiles with GPS systems that not only show you how to get where you’re going, but actually have a person who tells you how. (Or is it just a disembodied computerized voice?) The end of the information revolution is—for better or worse—not yet in sight, but it has brought us the benefits of choice beyond imagination and intense price competition that serves consumers better than ever before. The financial sector, however, is unique in the role that innovation plays. Why?

As of Mindray's Wikipedia company profile, the firm reported 2024 revenue of US$5.1 billion, operating income of US$1.54 billion, and net income of US$1.46 billion, with about 21,000 employees as of 2025 and operations spanning 41 subsidiaries and branch offices across 31 countries plus 32 branch offices within China.

“Vanguard: Saga of Heroes” A Lecture by John C. Bogle Founder and former Chief Executive, The Vanguard Group Before Dr. Elliot McGucken’s Class in Artistic Entrepreneurship and Technology 101 Pepperdine University Malibu, CA February 27, 2007 I’ve spent a lot of time and thought on the challenge of measuring up to Dr. McGucken’s high appraisal of my career, the scores of speeches that I’ve delivered, and especially my 2005 book, The Battle for the Soul of Capitalism. To find The Battle on the same reading list as The Odyssey—let alone on the same planet!—adds even more to my burden in meeting your expectations this evening. Just two weeks ago, however, an article in the Arts & Leisure section of the Sunday New York Times gave me a unifying theme for this evening’s lecture. The article was about someone with whom most of you students may be familiar: Brad McQuaid, creator of EverQuest, a 3-D fantasy video game operating in the virtual world, with 500,000 players, each paying $15 a month for the privilege. (Not as popular as the champion, “World of Warcraft,” with 5 million players, but amazing in its own right.) Typical of my generation, alas, I am not among those players. But in my constant attempt to understand what appeals to today’s young citizens, and my effort—however unlikely to bear fruit—to understand the new virtual world, I did read the Times article from start to finish. It was about Mr. McQuaid’s new virtual game, “Vanguard: Saga of Heroes.

Black Monday and Black Swans Remarks by John C. Bogle Founder and former chief executive, The Vanguard Group before the Risk Management Association Boca Raton, Florida October 11, 2007 Just a week from tomorrow, we’ll mark the twentieth anniversary of what came to be known as “Black Monday,” October 19, 1987. On that single day, the Dow Jones Industrial Average dropped from 2246 to 1738, an astonishing decline of 508 points or almost 25 percent. The drop was nearly twice the largest previous daily decline of 13 percent, which took place on October 24, 1929 (which became known as “Black Thursday”), a distant early warning that the Great Depression lay ahead.1 From its earlier high until the stock market at last closed on that fateful Black Monday of 1987, some one trillion dollars had been erased from the total value of U.S. stocks. The stunning decline seemed to shock nearly all market participants. But there were some veterans whom it didn’t surprise. Ace Greenberg, former chairman of Bear Stearns, was quoted in the newspapers as saying, “So markets fluctuate. What else is new?” And only a year before Black Monday, I observed to the Vanguard crew that even a 100-point decline in the Dow—something that had never before occurred—was possible. Why? Because, as I observed, “in the stock market, anything can happen.” That truism remains, but I’d argue the point even more strongly today.

Vanishing Treasures — Business Values and Investment Values Remarks by John C. Bogle Founder and former chief executive The Vanguard Group The Maclean House 2007 Lecture Series Princeton University Alumni Education Program Princeton, NJ March 15, 2007 I must begin by telling you what a thrill it is to return again to the Princeton campus that has played such a definitive—even determinative—role in my life. Of course I’m honored to be asked by Andrew Gossen, associate director of the alumni education program, to participate in this year’s Maclean House series. The theme “Vanishing Treasures,” holds great appeal to me, for I’m deeply concerned about “cultures and values that are disappearing in the face of human activity.” When director Gossen wrote to me (by e-mail of course; letter writing seems to be yet another vanishing treasure), he suggested that I focus on corporate ethics. Since the decline of business values and investment values was one of the principal subjects of my fifth book, The Battle for the Soul of Capitalism, I promptly tendered my acceptance (yes, by e-mail). So I’m pleased to be with you this evening. Some of my classmates of the great Class of 1951 needled me about the fact the The Battle was published by Yale University Press. But I reminded them to look carefully at my photograph on the back flap of the book jacket.

The Fox, The Hedgehog, and The Cave In the New Millennium, Age-Old Principles for Mutual Funds Remarks by John C. Bogle Founder and Senior Chairman, The Vanguard Group On Receiving The Robert L. Gould Award of the National Investment Companies Service Association Boston, MA May 6, 1999 The fact that I knew Bob Gould during the last decade of his wonderfully creative and productive life means that I accept this coveted award with the greatest humility. I well remember not only his achievements, but his camaraderie, and most of all his sort of whimsical, mysterious, all-knowing smile as we discussed Vanguard’s odd corporate strategy and our novel approach to shareholder service. I’m not sure whether he twitted me about my statement, published in Forbes magazine in September 1985, that “we don’t intend to be the industry’s technology leader; we can’t afford to be.” But he did not live long enough to learn of a later quotation that I set in large type on a poster and placed in a dummy Forbes magazine at our Vanguard senior management meeting in June 1992: “We intend to be the industry’s technology leader; we can’t afford not to be.” And so Vanguard’s early conversion to information technology began. Late, to be sure, but I believe that, thanks to the brilliant leadership of Robert A.

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

In the 2007 Berkshire shareholder letter, Buffett - crediting Munger throughout - used the See's Candies acquisition as the textbook case for what a brand franchise actually does to a business. Berkshire had bought See's in 1972 for $25 million, against an asset value of about $8 million and pre-tax earnings of about $4 million. The price looked full to the traditional cigar-butt investor, and Buffett had initially hesitated. Munger had pushed him to pay it, arguing that the franchise was worth the premium because the brand could raise prices year after year without losing volume. The retrospective made the math visible. See's had generated pre-tax earnings cumulatively in the many hundreds of millions of dollars in the years since purchase, on the original $25 million base. The asset base had grown only modestly. The incremental capital required to grow the business had been tiny relative to the cash thrown off. The whole return had come from the brand's pricing power, not from reinvestment. That, Munger and Buffett were saying, is what a real moat looks like - the cash grows faster than the asset base because customers keep paying up for the name. Munger's investment lesson, distilled in the 2007 letter, was that See's taught Berkshire to look past the cigar-butt habit and toward the great franchise. The intangibles - brand, distribution, customer loyalty, pricing power - were not a speculative add-on to intrinsic value. They were the source of it. The companies that grew cash faster than assets were the companies that compounded intrinsic value per share, and the only way to find them was to look at the qualitative strengths that traditional accounting did not capture. See's was the school. Every later Berkshire acquisition - Coca-Cola, Gillette, GEICO in full - was a graduate of that school.

“Enough” Commencement Address MBA Graduates of the McDonough School of Business by John C. Bogle, founder, The Vanguard Group Upon receiving the Honorary Degree of Doctor of Humane Letters from Georgetown University May 18, 2007 Here’s how I recall the wonderful story that sets the theme for my remarks today: At a party given by a billionaire on Shelter Island, the late Kurt Vonnegut informs his pal, the author Joseph Heller, that their host, a hedge fund manager, had made more money in a single day than Heller had earned from his wildly popular novel Catch 22 over its whole history. Heller responds, “Yes, but I have something he will never have . . . Enough.” Enough. I was stunned by its simple eloquence, to say nothing of its relevance to some of the vital issues arising in American society today. Many of them revolve around money—yes, money—increasingly, in our “bottom line” society, the Great God of prestige, the Great Measure of the Man (and Woman). So this morning I have the temerity to ask you soon-to-be-minted MBA graduates, most of whom will enter the world of commerce, to consider with me the role of “enough” in business and entrepreneurship in our society, “enough” in the dominant role of the financial system in our economy, and “enough” in the values you will bring to the fields you choose for your careers. Kurt Vonnegut loved to speak to college students.

Born into a small trading family, Biyani tells Wharton he built Pantaloons, Big Bazaar, Food Bazaar and Central Mall by leaning on 'guts and instincts' rather than conventional MBA discipline. By the time of this 2007 interview Future Group had crossed $1 billion in revenue, and his autobiography 'It Happened in India' had reportedly sold more copies in India than any prior business book — earning him the tag 'the Sam Walton of India'.

Changing the Mutual Fund Industry: The Hedgehog and the Fox Remarks by John C. Bogle, Princeton ‘51 Founder and Senior Chairman The Vanguard Group of Investment Companies On Receiving The Woodrow Wilson Award for Representing “Princeton in the Nation’s Service” Princeton, New Jersey February 20, 1999 This is a marvelous morning for me. For a mere businessman—apparently the first one—to join the distinguished roll of 42 public servants, artists, scientists, and authors who have previously been judged to represent the high standard of “Princeton in the Nation’s Service”—it is a signal honor. The award citation suggests that my career as an agent of change, if not the agent of change, in the mutual fund industry has been in the service of the nation’s 50 million fund shareholders. Whatever the case, I’ve done my best to meet that standard, not only for the 10 million who own Vanguard mutual funds, but also for those who own other funds. For 25 years—in a sense for 50 years—my mission has been to change the industry so that our citizens—the human beings who invest in funds—get a fair shake. But as awesome as is this honor, I have no intention of resting on the laurels I receive today. I still have promises to keep for fund investors and miles to go before I sleep. I’ve entitled my remarks “The Hedgehog and the Fox,” based on this fragment—dated to about 670 B. C.

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

The Role of the Fiduciary in Risky Financial Markets Remarks by John C. Bogle Founder & Former Chief Executive, The Vanguard Group Before The Philadelphia Estate Planning Council Philadelphia, PA May 1, 2007 I’m honored to be invited to address the Philadelphia Estate Planning Council this afternoon on two subjects that have been near and dear to my heart for as long as I can remember. Indeed, it’s arguable that I’ve been thinking about fiduciary duty and the financial markets since the autumn of 1950, when, as a Princeton senior, I began the research on the mutual fund industry for my senior thesis. In fact, a half-century later—proving that if you’re patient enough, anything you write can be published—that thesis was published by McGraw-Hill, the final section of my third book John Bogle on Investing - the First 50 Years. Even more relevant to my subject today, my fifth book—The Battle for the Soul of Capitalism (Yale University Press, 2005)—is heavily focused on fiduciary duty; and my sixth book—The Little Book of Common Sense Investing (John Wiley, 2007)—is focused on the financial markets. Part I. Full Disclosure Perhaps if I begin with the story of my senior thesis, you’ll see, in today’s parlance, “where I’m coming from.” The fact is that the fundamental values that I hold today about fiduciary duty and the financial markets were formed during my undergraduate years at Princeton University.

Guo received a BA in Philosophy and an MBA from Fudan University in 1989, and in 1992 founded Guangxin Technology Development Company with friends Liang Zinjun and Tan Jian, among the first firms in mainland China to use scientific methods in market research.

Designing a New Mutual Fund Industry Keynote Address by John C. Bogle, Founder and former Chief Executive The Vanguard Group Before “Vision and Values” The 25th Anniversary Conference of the National Investment Companies Service Association Miami, Florida February 20, 2007 It’s a thrill—and something of a miracle—to be back with NICSA again. In fact, I’ve been privileged to address you pretty much like clockwork every ten years since you began, going way back to March 1977. 1 So this is a happy fourth-decade anniversary speech for me, and I’m deeply honored by your invitation to return. Today, the title of my remarks is “Designing a New Mutual Fund Industry.” But in fact I’ve been struggling to do that for as long as I can remember. When I first spoke to you in 1977, Vanguard had taken, just weeks earlier, the third and final giant step to become the unique organization we remain today. The first step had been the creation of Vanguard on September 24, 1974, leading to the “mutualization” of the Wellington Management Company mutual funds, then with just $1.4 billion of assets. Under this structure, our funds would employ their own officers and staff, assume responsibility for their own operational, administrative, legal, and shareholder recordkeeping services, and operate on an “at cost” basis. (Yes, we began as sort of a mini-NICSA. Wellington continued its responsibility for all investment management and marketing services.)

Speaking to USC Law graduates in May 2007, Munger argued that wisdom acquisition is a moral duty, not merely a career strategy. He had come to that conviction early, he said, and had lived by it ever since. The corollary, in his telling, was uncompromising: you are hooked for lifetime learning, and without it you will not get very far. What you already know is barely the down payment; what you learn after you leave the hall determines the trajectory. He grounded the claim in the Berkshire record. The skill set that got Berkshire through one decade would not have sufficed for the next, he said. Without Warren Buffett functioning as a continuous learning machine, the documented long-run investment record would have been absolutely impossible. He then generalized the lesson: at lower walks of life he constantly sees people rise who are not the smartest and sometimes not even the most diligent, but who are learning machines. They go to bed every night a little wiser than when they got up. With a long run ahead of you, he said, that habit does the heavy lifting. He closed the thought with Alfred North Whitehead's observation that civilization advanced only when man invented the method of invention. Munger flipped the same logic onto the individual: if civilization can only progress when it invents the method of invention, you can only progress when you learn the method of learning. Coming to law school already equipped with the method of learning, he said, was the luckiest break of his long life and the one that paid off most reliably.

Mutual Funds in 1987: A $700 Billion Trust Keynote speech by John C. Bogle, Chairman The Vanguard Group of Investment Companies Before The 25 th Annual Meeting of The National Investment Company Services Association February 16, 1987 It is a distinct privilege for me to have the opportunity to deliver the keynote address at your 25 th Annual Meeting. Certainly your theme—“The Challenge of Change”—is a profound one, and I will address it from the standpoint of the $700 billion trust that mutual funds now represent. To me, as an observer of mutual funds since the beginning of my college days in 1947—forty years of excitement and elation, interspersed with but a few moments of discouragement and disappointment—I come armed only with the perspective borne of that experience, to present some ideas about mutual funds in these halcyon days of rapid growth, heady markets, and truly incredible success. Perhaps few in this industry are as concerned as I am, however, about some of the new directions in which this business is moving today, and I hope you will forgive me if the views I will express are controversial. Having been asked to speak on “The Challenge of Change,” I have little recourse but to speak with a blunt candor that reflects a deep concern about the very nature of some of the changes now taking place in the mutual fund field. Let me begin by turning the calendar back ten years, to a morning in March 1977, when I last had the honor of addressing this group.

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

Distressed debt is one of Klarman's preferred habitats precisely because the seller population is dominated by forced, non-economic actors. Insurance companies liquidate holdings after ratings downgrades regardless of price. Mutual funds are forced to sell securities that fall below investment grade. Index funds must sell bonds that drop out of their benchmarks. Klarman treats these institutional constraints as a structural source of mispricing that recurs regardless of the underlying credit's fundamental value. He further notes that the analytical bar in distressed situations is high, which keeps competing buyers scarce. A bankruptcy proceeding requires understanding legal priorities, the debtor-in-possession financing, plan negotiation dynamics, and the recovery waterfall for each tranche of the capital structure. Most generalist investors lack the willingness to do that work, so the field is left to specialists. Baupost's willingness to do the work is itself a moat. The result is that Baupost has historically been able to buy claims at a fraction of conservative recovery value. Klarman's emphasis on buying the most senior claims at deep discounts reflects the same margin-of-safety discipline applied to credit: he wants to be paid for being right about the waterfall even if he is wrong about the timing or the business outcome. The complex, slow-moving nature of bankruptcy is treated as a feature, not a bug, because slowness is what drives out the impatient capital that would otherwise compete away the edge.

” In some ways these changes were easily foreseen (I’ve reviewed the ancient minutes of our committee meetings) and in some ways totally unforeseen. But the industry survived and thrived, and is wallowing in prosperity today. I reveled in those years of working on industry issues with a classy, integrity-laden group of financial leaders and regulators, dedicated to the public interest. While I haven’t participated in NASD affairs for a long time, it occurs to me that the basic mission remains unchanged. As Mary Schapiro, your chief executive, pointed out recently, “investor protection and market integrity remain FINRA’s overarching objectives.” So I’m glad to be back, though I note with some vague concern that among your 50 workshops, none discusses mutual funds. This talk should fill that gap. This morning, I’ll focus on investor protection in the mutual fund industry, discussing what can be done to assure that fund investors get a fair shake, or, as I wrote in my senior thesis at Princeton University almost 57 years ago, that “mutual funds must be operated in the most efficient, economical, and honest ___________ Note: The opinions expressed in this speech do not necessarily represent the views of Vanguard’s present management.

Munger told the graduates that he had figured out, very early, that there is no love so right as admiration-based love, and that such love should include the instructive dead. He lived by that idea, he said, and it had been very useful to him. The opposite kind of love, the compulsive attachment-driven sort celebrated in Somerset Maugham's Of Human Bondage, he described as a sickness, a disease. If you find yourself in its grip, his advice was to turn around and fix it; eliminate it. He paired that lesson with what he called the funeral test. He had read somewhere, he said, of a man who had lived such that, at his funeral, the preacher had invited anyone to stand up and say something nice about the deceased. Nobody came forward. Nobody came forward. Nobody came forward. Finally one man rose and said, 'Well, his brother was worse.' Munger told the audience that is not where you want to go. That is not the kind of funeral you want to have. You will leave entirely the wrong example. The takeaway for the room was that living admirably, being the kind of person other people name in their wills to raise their children, is not a soft virtue but a shrewd one. People who are admired, who can be trusted with the most important commitments other people make, end up doing something very right. The moral framing and the practical outcome run in the same direction.

Since 1994, Guo has served as chairman of Fosun Group, which diversified into insurance, pharmaceuticals and healthcare, property, steel, mining, retail, services, finance, and asset management, growing into one of China's largest non-state-owned enterprises with over 74,000 employees; Fosun International (the group's holding company) listed on the Hong Kong Stock Exchange in 2007.

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.

” At the root of the problem, in the broadest sense, was the societal change aptly described by these words from the teacher Joseph Campbell: “In medieval times, as you approached the city, your eye was taken by the Cathedral. Today, it’s the towers of commerce. It’s business, business, business. We had become what Campbell called a ‘bottom-line society.’ But, at least in my view, our society came to measure the wrong bottom line: form over substance, prestige over virtue, money over achievement, charisma over character, the ephemeral over the enduring, even mammon over God.” Let’s start with why you should—indeed must—care about our system of free-market capitalism. I argue that it is the job of every concerned citizen to “uphold the values that once made our corporate and financial enterprises so successful, fairly providing the rewards of investing to those who put up the capital and assume the risks involved. To win the battle to restore the soul of capitalism, it is these values that must prevail.” Why? Because, as I explain, “we require a powerful and equitable system of capital formation if our nation is to overcome the infinite, often seemingly intractable, challenges of our risk- fraught modern world. Our economic might, political freedom, military strength, social welfare, and even free religious values depend upon it.” ____________________ Note: The opinions expressed in this speech do not necessarily represent the views of Vanguard’s present management.

DiStefano in the development of our investment technology and Barbara Grozinski in the extraordinarily skillful application of that technology for our individual shareholders, our investor services are at the top of the fund shareholder ratings today. I have read that Bob Gould had a passion for the mutual fund industry and for improving the quality of service provided to shareholders, and that he sought to develop and implement creative systems and methods to meet demands for new types of funds by a more sophisticated clientele. What Bob did as he sought to achieve these goals helped to set the stage for today’s nearly flawless mutual fund operating platform: well-engineered communication systems; transaction technology; record- keeping precision; a strong control environment; functional redundancy; and detailed contingency plans. In a real sense, the intelligent application of powerful computer technology has shaped the character and development of what Bob Gould must have envisioned 15 years ago as today’s modern mutual fund industry. While I have fully recognized, advocated, and supported Vanguard’s massive information technology investment—in machines and systems and human beings alike—throughout the past quarter century, I’m far from being a creative force in that segment of what we have done. But I think few would disagree that I share Bob’s passion for this industry and for improving the quality of our shareholder services.

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

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.

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

Please forgive me for my focus on the Vanguard bond funds in my cost-benefit analysis. Not only do they have by far the lowest expense ratios in the field (usually about 80 percent below competitive norms), but they have few low-cost rivals. (The Vanguard long-term municipal bond funds carry expense ratios of about 16 basis points, 65 percent below the 45 basis points charged by the next-lowest-cost funds.) We are also unusual in our focus on bond index funds, which are virtually alone in having ten-year records. (The pioneering Vanguard Total Bond Market Fund was created in 1986.)

In his reflections on his own errors, Klarman distinguishes mistakes of analysis from mistakes of process. An analytical mistake is being wrong about facts; a process mistake is reaching for risk because the environment punished patience. He treats the latter as far more dangerous because it tends to compound, eroding the discipline that produced the firm's edge in the first place. He is candid that the most common mistake at Baupost has been under-investing when prices were genuinely attractive - the asymmetric risk aversion that protects the firm in normal times costs it in recoveries. He frames this as a tolerable error: the asymmetry between the permanent loss from overreach and the temporary opportunity cost from caution is so large that the firm would rather err on the side of caution. What he refuses to tolerate is the mistake of changing one's standards to fit the market. Lowering the discount to value required for entry, reaching for yield in late cycles, or buying lower-quality assets because high-quality ones are scarce are all process errors that look rational in the moment and reveal themselves only when the cycle turns. The firm's risk system is therefore designed less to predict drawdowns than to detect, in real time, when its own underwriting standards are drifting.

In the Texaco episode of the late 1980s, after the Pennzoil judgment threw the oil major into crisis, Icahn accumulated a large stake and pressed for asset sales, dividend restoration, and eventually a restructuring, criticizing management's handling of the crisis publicly and in letters to shareholders. The campaign showed his pattern of arriving amid distress with a balance-sheet argument rather than an operating turnaround plan.

Because, in the mutual fund field, no one else in the system is battling to bring back our traditional values of trusteeship and our high promise of service to investors. Someone’s got to do it. By the process of elimination, I got the job. 5. Because when the battler stands pretty much alone, he draws a lot more attention to the mission. If you have a large ego (I do), that’s a nice extra dividend. Especially because those who are outside the system—our “man-in-the-street” investors, exemplified by the Bogleheads of the internet—give me the strength to carry on. 4. Well, sad to say, I no longer play squash, and playing golf on “grown-up” courses is now pretty much out of the question. So what else could I do but take those old athletic battles to our society at large?

Because here there exists a sharp dichotomy between the value of innovation to the financial institution itself and the value of innovation to its clients. For it is the role of the providers of financial services to organize the instrumentalities of business and government—let’s call them stocks and bonds—into packages and, well, “products” that earn profits for themselves, even as they are also designed to serve the needs of investors. Some of these products are simple and cost-efficient; others, at the extreme, are mind-bogglingly complex and expensive. And so in this field we are eternally bound by this unarguable equation: gross returns in the financial markets, minus the costs of financial intermediation, equals the net return actually earned by financial market participants. This is one of the “relentless rules of humble arithmetic” that drives our system. To the extent than innovation adds costs, then, it reduces investor returns. What’s more, our institutions have a large incentive to favor the complex and costly over the simple and, well, cheap; quite the opposite of what most investors want and need. Given recent events in the financial markets in which some of our nation’s—and the world’s—mightiest financial institutions ____________________ *This title, which I chose last summer—before the recent unpleasantness in the credit markets—turned out to be prophetic. But it’s probably just luck.

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

There, almost 58 years ago, I happened upon the December 1949 issue of Fortune magazine and learned for the first time ____________________ Note: The opinions expressed in these remarks do not necessarily represent the views of Vanguard’s present management.

He believed, if I may paraphrase here, that “we should catch young people before they become CEOs, investment bankers, consultants, and money managers (and especially hedge fund managers), and do our best to poison their minds with humanity.” And in my remarks this morning, I’ll try to poison your minds with a little bit of that humanity. _________ Note: The opinions expressed in these remarks do not necessarily represent the views of Vanguard’s present management.

Biyani distinguishes 'thought leadership' from 'skills leadership'. He argues the second can be developed after age 25, but original scenario-building thought leadership is shaped much earlier in life. In his self-description he is the thought-leader type, an entrepreneur whose mental syntax diverges from a manager's, and he is openly skeptical of B-school orthodoxy that prioritizes efficiency and consistency over what he calls life's chaos.

equals my utter astonishment at having been chosen, the first businessman in a long and distinguished line of public servants, artists, scientists, and authors who preceded me. Wilson and Economics In the course of preparing my Wilson Lecture, given in conjunction with the presentation of the medal, I studied again the stunning legacy of Woodrow Wilson as President, first of the University, and then of the United States of America. As a member of the financial community at the 20 th century’s end, I was profoundly impressed by one of his little-recognized but most far-sighted contributions: Setting a new direction for American economic and financial policy.

” 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.

But, the more I observe of finance, the more I wonder about the grotesque distortions it periodically creates in our markets, in our business enterprises, and in our society. I’ve been eye-witness to too many of these counterproductive eras—the “Go-Go Years” of the mid 1960s; the “Favorite Fifty” craze of the early 1970s, the “New Economy” myth of the late 1990s; and in the recent era, the spreading collapse of complex and dangerous derivatives such as collateralized debt obligations. The mutual fund industry, in which I’ve plied my trade all this time, has played a role in fostering each of these excesses. And so I have spoken out, with literally hundreds of speeches and, so far, six books. My primary goal has been to educate our citizens—to teach even as I learn—about finance. About the wisdom of long-term investing—buying and holding real businesses. About the folly of short-term speculation—trading pieces of paper reflecting evanescent expectations. While my crusade has been focused on educating serious investors, investment professionals, teachers, and finance students and MBAs, my expectation is that they will carry the message to members of our even younger generations.

. . . . . . . . . . . . . $ 7,040 $ .99 $ 5,164 $ .73 Investment income . . . . . . . . . . . . . . . . . . . . . . . . . 65,207 9.16 58,528 8.22 CORT furniture rental business . . . . . . . . . . . . . . . . . . 20,316 2.85 26,884 3.78 Precision Steel businesses . . . . . . . . . . . . . . . . . . . . . . 915 .13 1,211 .17 All other “normal” net operating earnings (loss)(3) . . . . . (73) (.01) 246 .03 93,405 13.12 92,033 12.93 Realized investment gains . . . . . . . . . . . . . . . . . . . . . . . . 15,756 2.21 — — Wesco consolidated net income . . . . . . . . . . . . . . . . . $109,161 $15.33 $92,033 $12.93 (1) All figures are net of income taxes. (2) Per-share data are based on 7,119,807 shares outstanding. Wesco has no dilutive capital stock equivalents. (3) Represents income from ownership of the Wesco headquarters office building, primarily leased to outside tenants, and interest and dividend income from cash equivalents and marketable securities owned outside the insurance subsidiaries, less interest and other corporate expenses. This supplementary breakdown of earnings differs somewhat from that used in audited financial statements which follow standard accounting convention. The foregoing sup- plementary breakdown is furnished because it is considered useful to shareholders.The

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

Changes in the nature and structure of our financial markets—and a radical shift in its participants—are making shocking and unexpected market aberrations ever more probable. The amazing market swings we’ve witnessed in the past few months tend to confirm that likelihood. While the daily changes in the level of stock prices typically exceed two percent only three or four times per year, in just one recent month we’ve seen 8 such moves. Ironically, 4 were up, and 4 were down. Based on past experience, the probability of that scenario was . . . zero. So the first—and most basic—point I wish to make today is that the application of the laws of probability to our financial markets is badly misguided. Truth told, the fact that an event has never before happened in the markets is no reason whatsoever to be confident that it can’t happen in the future. Metaphorically speaking, the fact that the only swans we humans have ever observed are white doesn’t mean that no black swans exist. 1 From its September 1929 high of 381 to its July 1932 low of 41, the Dow would drop by an astonishing 90 percent. Note: The opinions expressed in this speech do not necessarily represent the views of Vanguard’s present management.

And surely “heroes” must also describe those legions of investors who came aboard the good ship Vanguard in the early years of our existence. Often without ever seeing a real person or looking up our credit rating, they sent in their checks to “Valley Forge, PA 19482,” first in small amounts, but then in the millions of dollars, and then in the billions. I believe that these early believers in Vanguard’s mission are also heroes for giving us their blind trust. In return they are enjoying their fair share of the returns generated in our financial markets. I’m confident that they would agree that we’ve measured up to their trust in our vision and our values. The Odyssey, I hardly need tell you, is the story of a hero’s journey, the building of character through overcoming the inevitable reverses of life, and the celebration (in Dr. McGucken’s words) of the classic American spirit that bestows on us the right, and demands of us the duty, to take ownership of our own lives. While a different saga, however, the Vanguard story is not without tangential parallels to Homer’s timeless classic. So at many levels, “Vanguard: Saga of Heroes” ties my story together with your study of entrepreneurship and technology in today’s society. A Few Disclaimers Let me be crystal clear that I make no claim to being a hero. Nor do I claim any particular qualities of leadership for myself.

The most quoted line of the interview is Biyani saying Future Group runs as a 'seamless, non-hierarchical' organization and that 'we believe in destroying what we have created'. He frames this as a natural principle — seasons destroy to recreate — and says business should borrow from nature rather than fight it. The structure is design-driven and amorphous, he says, allowing it to be reshaped at any time without org-chart friction.

My creativity, such as it may be, in seeking this goal, however, was quite different from his. I have sought to develop and implement not only new types of funds for the increasingly intelligent investors we serve, but a whole new client-focused approach not only to investor service, but to investment management as well.

He is part of a stolid group of financial leaders who are clamoring for like reforms. His argument has an honorable history in the U.S., stretching to Theodore Roosevelt and Woodrow Wilson, through Berle and Means and the second Roosevelt, to the present day, with Republicans like Pete Peterson and Democrats like Eliot Spitzer and Arthur Levitt on board.

Black Monday, then, was a Black Swan. Unlike its 1929 antecedent, however, Black Monday was not a warning of dire days ahead. If anything, it was, totally counterintuitively, a harbinger of the greatest bull market in recorded history. The Black Swan, as most of you are likely aware, is also the title of a new book by Nassim Nicholas Taleb. Here is his definition of the characteristics of a black swan, in our markets, and, for that matter, in our lives: 1. An outlier beyond the realm of our regular expectations. (Rarity) 2. An event that carries an extreme impact (Extremeness) 3. A happening that, after the fact, our human nature enables us to accept by concocting explanations that make it seem predictable (Retrospective Predictability) So there it is: Rarity; extremeness; and retrospective predictability. Together they define the occurrence of an event that is regarded as impossible, or at least highly improbable. What’s more, as Taleb notes, a Black Swan is also the reverse of this definition: The non-occurrence of an event that is regarded as highly probable. Life is full of them! Today I observe little concern about the ever-present possibility that what will occur in our financial markets in the coming months (or years) might in fact prove to be a non-occurrence of what we expect. Indeed, despite the recent wild disturbances in both the stock market and the bond market, most market participants seem confident that future returns will resemble those of the past.

Battle: “As the twentieth century of the Christian era ended, the United States of America comprehended the most powerful position on earth and the wealthiest portion of mankind.” So when I add Gibbon’s conclusion—“(Yet) the Roman Empire would decline and fall, a revolution which will be ever remembered and is still felt by the nations of the earth”—I’m confident that the thoughtful reader did not miss the point. But of course I hammer it home anyway: “Gibbon’s history reminds us that no nation can take its greatness for granted. There are no exceptions.” As one of two reviews—both very generous—of The Battle that appeared in The New York Times noted, “Subtle Mr. Bogle is not.” No, I’m not writing off America. But I am warning that we’d best put our house in order. “The example of the fall of the Roman Empire ought to be a strong wake-up call to all of those who share my respect and admiration for the vital role that capitalism has played in America’s call to greatness. Thanks to our marvelous economic system, based on private ownership of productive facilities, on prices set in free markets, and on personal freedom, we are the most prosperous society in history, the most powerful nation on the face of the globe, and, most important of all, the highest exemplar of the values that, sooner or later, are shared by the human beings of all nations: ‘certain inalienable rights . . . to life, liberty, and the pursuit of happiness.’” But something went wrong.

But under the rather broad umbrella provided by the title of my remarks this afternoon, “Marketing Mutual Fund Shares in the 1980’s,” I can give you some insights into both our decision-making process and our marketing strategy. Such a title, of course, gets me safely through the shoals and reefs of 1977-79—and if you had the conversations I have had with perhaps 50 individual broker/dealers—chief executives, mutual fund managers, registered representatives—in the past three weeks, you would surely see why that would be “a consummation devoutly to be wished.” (I should say that they were all tough conversations, but totally fair and honest.) But, in a different way, such a speech title also has the considerable advantage of providing a long-term perspective regarding the future of an industry—and an excellent, efficient, capable, accomplishing industry this one is—that has been beleaguered beyond belief over the past ten years. In that span, the stock market has gone “nowhere” on balance. The Dow Jones Average was “about to break 1,000”—it did not—in January, 1966, and you know where it is today. We have suffered two stock market debacles (1970 and 1973-74).

Fosun pursued an aggressive overseas dealmaking strategy, investing in Club Med of France, insurance company Fidelidade Seguros of Portugal, and Folli Follie of Greece, among others, to capture opportunities linked to China's economic growth.

Munger argued that the really big ideas carry ninety-five percent of the freight, and so acquiring them is not a heroic task but a discipline. He had been pushed into the discipline in law school when some wag offered the definition of a legal mind as one that could responsibly think about one thing while ignoring another. Munger found the proposition perfectly ridiculous, and it accelerated his natural drift toward learning all the big ideas and all the big disciplines. The alternative was to be a damn fool trying to reason about one aspect of a situation that could not be separated from the totality. He gave the room his standard method. If you can't be the best in the world at some narrow thing, he said, then become competent in all of the major disciplines and the big ideas in each. Economics, biology, psychology, physics, mathematics, history - the canon is finite and learnable. Then organize the ideas into a latticework of mental models and hang experience on the lattice as it accumulates. He warned that people who do not do this end up reaching for one hammer when the situation calls for a screwdriver. He grounded the whole approach in inversion. He liked to tell students that the way to be useful in life is not to figure out how to succeed directly, but to figure out how to fail - sloth, deceit, envy, self-pity, resentment - and then rigorously avoid those things. The clean, inverted formulation was his preferred intellectual move. Combined with the cross-disciplinary mental-models approach, he said, it had taken him further than IQ ever could have.

And, for as long as I can remember, with that message about economic education has come a related message about character and virtue. Plutarch had it right: The very spring and root of honesty and virtue lie in good education. Time and fate and luck and determination, aided by what one of my detractors has described as my “uncanny ability to recognize the obvious” have placed me in an almost unique position to express my all-too-uncommon viewpoint that our financial sector has lost its way. But these same factors have also enabled me to create a firm that revels in going to its own way in an effort to make the serious business of investing more understandable—and better—for our citizens. Your Visionary Award is a true capstone of my long career, and I thank you for recognizing my efforts. But after indulging in just a moment of pride as I accept your Award, I’ll be back at my desk, hard at work, tomorrow morning. For it’s yet too early for reflection. After all, as Sophocles advised: One must wait until the evening to see how splendid the day has been. Perhaps my evening will come. But not just yet. Thank you.

It is a curious fact that my new book echoes in so many ways the principles that I set forth in my senior thesis. That thesis—and all that followed—depended on an incredible stroke of luck. In Princeton’s Firestone Library, almost 56 years ago, I happened upon the December 1949 issue of Fortune magazine and learned for the first time that something called “the mutual fund industry” existed. When I saw the industry described in the article as “tiny but contentious,” I knew immediately that I had found my thesis topic. Completed in the early spring of 1951, it was entitled “The Economic Role of the Investment Company.” Read today, my thesis would probably impress you as no more than workmanlike, perhaps a bit callow, but above all, shamelessly idealistic. On page after page, my youthful idealism speaks out, calling again and again for the primacy of the interests of the owner of mutual fund shares. The prime responsibility (of fund managers) must always be to their shareholders.” And the deal must be fair: “there is some indication that costs are too high,” and that “future industry growth can be maximized by concentration on a reduction of sales charges and management fees.” After analyzing fund performance, I concluded that “funds can make no claim to superiority over the market averages,” perhaps an early harbinger of my decision to create, nearly a quarter-century later, that world’s first index mutual fund.

No investment gains or losses were realized in 2006. The discussion below will concen- trate on insurance underwriting, not on the results from investments. Wes-FIC engages in the reinsurance business. For the past several years, its reinsur- ance activity has consisted of the participation in several risk pools managed by an insurance subsidiary of Berkshire Hathaway, our 80%-owning parent. The arrangement became effective in 2001 and most recently covered hull, liability and workers’ compen- sation exposures relating to the aviation industry, as follows: for 2006, to the extent of ⁄2% of the hull and liability pools and 5% of the workers’ compensation pool; for 2007, 16.67% of the hull and liability pools and 5% of the workers’ compensation pool. The participation rates remain unchanged for 2008. The Berkshire subsidiary provides a portion of the upper-level reinsurance protection to these aviation risk pools on terms that could result in the Berkshire subsidiary having a different interest from that of Wes-FIC under certain conditions, e.g., in settling a large loss.

have collectively already taken some $47 billion (estimated to total $77 billion when all’s said and done) of write-downs from their forays into relatively new, untested and complex financial instruments, there can hardly be a more fitting time to consider whether innovation has again gone too far. The Financial Sector—Costs and Benefits Unlike the technology sector, where consumer costs decline as innovation leads to greater efficiency, the costs of our financial sector are soaring. I estimate that the costs of the system—the $100 billion annual expenses borne by mutual fund investors; plus those hundreds of billions of dollars of brokerage commissions and investment banking fees; plus all those staggering fees paid to hedge fund managers (the 25 th highest paid of whom earned $130 million last year), and those legal and accounting fees, all those marketing and advertising costs, come to something like $530 billion last year, up from a mere $100 billion in 1990. Does this explosion in intermediation costs create an opportunity for money managers? You better believe it does! Does it create a problem for investors? You better recognize that too.

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

3. Because what I’m battling for—building our nation’s financial system anew, in order to give our citizen/investors a fair shake—is right. Mathematically right. Philosophically right. Ethically right. How could anyone ever not bother to fight such a battle? 2. Because, even as I battle, I love the give-and-take, the competition, and the intellectual challenge of my field. Using Robert Frost’s formulation, my battle is “a lover’s quarrel” with our financial world. 1. Simply because I’m a battler by nature—born, bred, and raised to make my own way in life. Such a life demands the kind of passion evoked by the words of the great sculptor of Mt. Rushmore, Gutzon Borglum: “Life is a kind of campaign. People have no idea what strength comes to one’s soul and spirit through a good fight.” While I simply can’t imagine that my own soul and spirit will ever fade, I’ll continue to fight the battle until my mind and strength at last begin to fade. Only then, I hope many moons from tonight, will I take time to revel in the memories of all the wonderful battles I’ve fought during my long life. After all, as Sophocles reminds us, one must wait until evening to see how splendid the day has been. This lovely evening is now over for me. But the evening of my life is not at hand . . . at least, not yet.

Klarman frames Baupost's permanent-capital structure as a strategic advantage rather than a financial arrangement. Because the firm's capital is locked up for multi-year horizons, the portfolio can hold illiquid assets, ride out periods of marked-to-market pain, and wait years for a thesis to mature. The same edge is unavailable to funds whose investors can redeem quarterly. He emphasizes that the absence of redemption pressure changes not just the trade list but the kinds of opportunities that become investible. Real estate workouts, bankruptcy claims, private distressed debt, and certain international situations all require the willingness to commit capital for several years without interim liquidity. A fund whose investors require monthly liquidity cannot underwrite these even if its analysts are capable. The compounding implication is significant. In asset classes where returns accrue to whoever can wait, structural patience becomes a moat that scales. Klarman argues this is one of the few edges in investing that does not get competed away by information: knowing that a security will eventually be worth more is rarely enough; the firm that can sit through the noise until that resolution arrives is the one that captures the premium. Permanent capital, in his view, is the institutional expression of patience.

A Comparison of Ten-Year Returns Top Decile Bottom Decile Avg. Ann Return Avg. Exp. Ratio Gross Return 5.6% 3.9% 0.6% 1.3% 6.2% 5.3% Spread (1.6%) 0.7% (0.9%) Top Decile Bottom Decile Avg. Ann Return Avg. Exp. Ratio Gross Return 11.0% 1.9% 1.1% 1.5% 12.1% 3.4% Spread (9.1%) 0.4% (8.7%) Large-Cap Growth Funds IT Municipal Bond Funds 1. here!) Of course, that same principle applies to stock fund managers as a group, too. How could it be otherwise? But that similarity conceals an important difference. Among stock funds, the return spreads between top-tier managers (in a given period) and bottom-tier managers are large. But among bond funds, the spread between the top tier and the bottom tier is remarkably small. For example, the spread between the annual returns earned over the past decade by the top-decile managers and the bottom-decile managers in the large cap growth fund category was fully 9.1 percentage points (+11 percent vs. +1.9 percent). (Chart 1) The return spread among intermediate-term municipal bond funds for the same period, on the other hand, was a slim 1.6 percentage points: top decile, 5.6 percent per year; bottom decile, 3.9 percent. But there is another vital difference. Fund costs play only a supporting role in determining the spread in returns among equity funds. For example, those same top-decile growth funds produced pre-expense-ratio annual returns of 12.1 percent; for the bottom decile, the pre-expense-ratio return was 3.

You would not have to walk very many blocks from here to read these words in the lobby of a handsome Greek Revival building: “We shall restore, not destroy. We shall deal with our economic system as it is and as it may be modified, not as it might be if we had a clear sheet of paper to write upon; and step by step we shall make it what it should be . . .” This quotation, from Wilson’s brief (for him) First Inaugural Address on March 4, 1913, appears, as some of you doubtless know, at the main entrance of the Federal Reserve Bank in Washington, D.C. Wilson proposed the Federal Reserve Act in order to bring monetary and banking reform to the nation. He worked gradually with the Congress, making numerous concessions to the existing financial system. And before the year had ended, the United States had a central bank, absent since Andrew Jackson abolished the Second Bank of the United States in 1836. Wilson’s goals were to prevent the recurrence of banking panics, and to break the private monopoly of credit, so that banks would serve, in his words, as “the instruments, not the masters, of business and of individual enterprise and initiative.” The Federal Reserve Bank evolved gradually over the years, finally to become the most powerful financial institution in the world. While no one—Wilson included—could have foreseen that development, surely his shadow lies over the Fed today. Wilson’s desire to fundamentally change the American economic order hardly stopped there.

approved by the Securities and Exchange Commission until February 1981. To conduct business under a cloud of uncertainty for nearly four long years was a challenge, but we never lost confidence that the Commission would eventually support our Application. And finally, of course, it did. Referring to our two vital decisions, I concluded my decade-ago remarks by saying: “as we move into the 1980s, time will surely tell whether our risky judgment was right or wrong and . . . whether we were correct when we ignored that familiar advice from Lord Keynes: “Worldly wisdom teaches that it is better for reputations to fail conventionally, than to succeed unconventionally.” I believe that outcome of “The Vanguard Experiment: says that, at least in this one case, the worldly wisdom was wrong. But you who know this industry so well can make that judgment. Hits and Errors Given that my talk on “Marketing Mutual Funds in the 1980’s” is now a decade old, it might be fun to discuss for just a few moments two predictions I made then that were right and two that were wrong, as well as two developments that I missed that have come to pass. First, the hits. I modestly give myself an “A+” on pricing structure, boldly having predicted that the 1980s would obscure the then pure dichotomy between load funds and no-load funds.

that something called "the mutual fund industry" existed. When I saw the industry described in the article as "tiny but contentious," I knew immediately that I had found the topic for my senior thesis, then as now, a requirement for the Bachelor of Arts degree at Princeton. Over the 15 months that followed, I spent countless hours researching the industry and writing my thesis. Then, remarkably little public information was available about this field, which consisted of only some 130 mutual funds with assets aggregating just $2½ billion. Harvard strategy guru Michael Porter advises students considering their future careers to "pick a good industry," and, as luck would have it, I did exactly that when I chose my thesis topic. With an annual growth rate of almost 16 percent since then, the fund industry may well have enjoyed the fastest growth rate of any business in America. Today, there are more than 8,000 funds, with total assets that exceed $10 trillion. Read today, my thesis would probably impress you as no more than workmanlike, perhaps a bit callow, but above all, shamelessly idealistic. On page after page, my youthful idealism speaks out, calling again and again for the primacy of the interests of the mutual fund shareholder. At the very opening of my thesis, I get right to the point: Mutual funds must not "in any way subordinate the interests of their shareholders to other economic roles. Their prime responsibility must always be to their shareholders."

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.

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

Over the past two centuries, our nation has moved from being an agricultural economy, to a manufacturing economy, to a service economy, and now to a predominantly financial economy. But our financial economy, by definition, subtracts from the value created by our productive businesses. Think about it: while the owners of business enjoy the dividend yields and earnings growth that our capitalistic system creates, those who play in the financial markets capture those investment gains only after the costs of financial intermediation are deducted. Thus, while investing in American business is a winner’s game, beating the stock market before those costs is a zero-sum game. But after intermediation costs are deducted, beating the market—for all of us as a group—becomes a loser’s game. Yes, the more that our financial system takes, the less our investors make. Yet the financial field is where the money is made in modern-day America, the breeding ground for the wealthiest of our citizens. (If you made less than $140 million dollars last year, you didn’t make enough to rank among the 25 highest-paid hedge fund managers.)

We have become far less of a management industry and far more of a marketing industry, engaging in a furious orgy of “product proliferation” that has ill-served our investors. Once an industry that “sold what we made,” our new motto has become “if we can sell it, we will make it.” For example, right at the peak of the late, great bull market, we created 494 new “aggressive growth” funds, investing largely in technology and telecommunication stocks. The consequences for our investors were devastating.  Our funds, once broadly diversified, became largely specialized. In 1951, almost 80 percent of all stock funds (60 of 75) were broadly diversified among investment-grade “blue-chip” stocks, pretty much tracking the movements of the stock market itself, and lagging its returns only by the amount of their then-modest operating costs. Today, our total of 512 “large-cap blend funds” account for only 11 percent of all stock funds. These “market beta” funds are now vastly outnumbered by 4200 more specialized funds—3,100 U.S. equity funds diversified in other styles; 400 funds narrowly-diversified in various market sectors; and 700 funds investing in international equities, some broadly diversified, some investing in specific countries. The challenge in picking funds, dare I say, has become roughly akin to the challenge in picking individual stocks. I don’t regard that change as progress  The wisdom of long-term investing has given way to the folly of short-term speculation.

In that same Inaugural, Wilson proposed to cut tariffs and open America to global commerce (the Underwood Tariff Act of 1913), and to improve the administration of the Sherman Anti-Trust Act and enhance its fairness, (the Clayton and Federal Trade Commission Acts of 1914). His overriding goal, articulated time and again, was to create an environment in which free enterprise and unfettered competition could prevail. His passion for this goal was hardly hidden: to restore “that ancient time when America lay in every hamlet, when America was seen in every fair valley, when America displayed her great forces on the wide prairies, ran her fine fires of enterprise up over the mountainside and down into the bowels of the earth, and eager men everywhere captains of industry, not employees . . . America stands for opportunity. America stands for a free field and no favor. America stands for a government responsive to the interests of all.” Could it be better said today? Liberal or Conservative?

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

Biyani describes his family's elder generation as 'preservers' and himself as both 'creator' and 'destroyer'. The preserver archetype, in his telling, is the trained manager who optimizes what exists; the creator must necessarily dismantle existing formats to make room for new ones. He cites the failure of his Mela home-furnishing format and the wind-down of Fashion Station as live examples of this destruction principle in action.

For as long as our financial system delivers to our investors in the aggregate whatever returns our stock and bond markets are generous enough to deliver, but only after the costs of financial intermediation are deducted, these enormous costs seriously undermine the odds in favor of success for our citizens who are accumulating savings for retirement. Alas, the investor feeds at the bottom of the costly food chain of investing. This is not to say that our financial system creates only costs. It also creates substantial value for our society. It facilitates the optimal allocation of capital among a variety of users; it enables buyers and sellers to meet efficiently; it provides remarkable liquidity; it enhances the ability of investors to capitalize on the discounted value of future cash flows, and of other investors to acquire the right to those cash flows; it creates complex financial instruments that enable investors to divest themselves of risks they prefer not to assume by transferring them to others who are willing to bear them. No, it is not that the system fails to create benefits. The question is whether, on the whole, the costs of our financial sector have reached a level that overwhelms its benefits.

Fosun's December 2015 disclosure described Guo Guangchang as assisting authorities with an investigation, a characterization that accompanied his brief absence from public view before his return to the company four days later.

Wesco’s Board of Directors has recently and enthusiastically approved Wes-FIC’s most significant reinsurance contract to date: its participation, since January 1, 2008, in an agreement with National Indemnity Company (“NICO”), another Berkshire Hathaway insurance subsidiary, for the assumption of 10% of NICO’s quota-share reinsurance of Swiss Reinsurance Company and its property-casualty affiliates (“Swiss Re”). Under this retrocession agreement, Wes-FIC will effectively assume 2% of all of Swiss Re’s property- casualty risks incepting over the next five years on the same terms as NICO’s agreement with Swiss Re. If recent years’ volumes were to continue over the next five years, the annual written premiums assumed by Wes-FIC under this retrocession agreement would be in the $300 million range; however, actual premiums assumed over the five-year period could vary significantly depending on market conditions and opportunities. It is the nature of even the finest casualty insurance businesses that in keeping their accounts they must estimate and deduct all future costs and losses from premiums already earned. Uncertainties inherent in this undertaking make financial statements more mere “best honest guesses” than is typically the case with accounts of non-insurance-writing corporations.

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

For as long as I remember, I’ve tried my best to take responsibility for the things that I have touched along the road of life, and to leave each one better than I found it. Sure, I suppose that I also have some of the qualities that are ascribed to the leader—a vision of the ideal; self- confidence (and at least some self-awareness); a mind that, thanks to a wonderful education, is probably above average; a profound skepticism about the conventional wisdom of the day; and a determination to fight for the greater good, laboring in the interests of society at large, and in particular, the interests of the investors of our land. While I’m about it, I might as well also disclaim much ability as a manager or businessman. (Although I do hold to what I consider to be the prime attribute of the successful manager: I’ve always trusted those with whom I worked, and I’ve always done my best to honor their trust in me.) In fact, I find more that I don’t admire in the conduct of business today than what I do admire. I’ve loved my active participation in the non-profit world (notably in my many years of service as chairman of the board of trustees of Blair Academy and of the National Constitution Center) every bit as much as my now 55- year-plus business career. Truth told, I often wish that some of the values of these public-spirited institutions could be reflected in the values of our business leaders.

Only time will tell whether yet another Black Swan, lurking out there beyond the horizon, will become part of stock market history. Whatever the case, the fact that Black Swans can and do happen in our financial system holds important lessons for how we think about risk. While we look for corroboration of what we believe (confirmation bias), what we really ought to be looking for is the opposite—that observation that would prove us wrong. Sad to relate, we know what is wrong with a lot more confidence than what we know is right. Yet we continue to look ahead with apparent confidence that the past is prologue, based on our assumptions that the probabilities established by history will endure. The idea of seeking out evidence that contradicts our belief goes far beyond the financial markets. It goes to the very nature of knowledge itself. For the eminent British philosopher Sir Karl Popper—well- known for his use of the Black Swan metaphor—the key question was “what if science didn’t proceed from observation to theory? What if it was the other way around?” Writing in The New Yorker,2 journalist Adam Gopnik described Popper’s reasoning: “No number of white swans could tell you that all swans were white, but a single black swan could tell you that they weren’t . . .

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

(This basic tenet of fiduciary duty was clearly ignored in the market timing scandals of a few years ago, in which some 30 fund groups conspired with hedge fund managers to subvert the interests of the funds’ long-term shareholders.) I also argued that "there is some indication that costs are too high," and that "future industry growth can be maximized by concentration on a reduction of sales charges and management fees." (That advice also fell upon deaf ears, and despite the quantum leap in industry assets, fee rates have actually risen, and rather sharply at that.) After analyzing mutual fund performance, I concluded that "funds can make no claim to superiority over the market averages," perhaps an early harbinger of my decision to create, nearly a quarter-century later, the world's first index mutual fund. Still later in the thesis, "fund influence on corporate policy . . . should always be in the best interest of shareholders, not the special interests of the fund's managers." (Once again, my advice fell by the wayside, and shareholders remain ill-served by the passive governance policies of most fund managers.) And when I wrote about investment policy, this immature and inexperienced college senior even had the temerity to take on the brilliant British economist John Maynard Keynes.Theory,

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.

4 percent, leaving only a slightly smaller difference of 8.7 percentage points, a difference that we can attribute to some unknown combination of manager skill, luck, and randomness. Now contrast that relationship with bond funds. Here costs play a starring role in determining the spread in returns. Those same top-decile intermediate-term municipal bond funds produced an average return of 6.compared

I owe special gratitude to a marvelous long-time friend, a member of the Class of 1952, who now happens to rank among the University’s most dedicated and effective Trustees. He befriended me when we both lived in Holder Hall during my sophomore year, and invited this insecure scholarship student to his family’s home near Philadelphia. He introduced me to his young sister, then just 14 years of age. Mirabile dictu! Eight years later, Eve and I married and became the proud parents of six fine children (including Sandra, Class of 1990), and, so far, the grandparents of twelve. Had we not attended Princeton together, I would likely have never met John J. F. Sherrerd, Class of 1952. Thank you, Jay, for all you have done to enrich my life. A Remarkable Accident Whatever the case, my career began with a remarkable accident that took place a half-century ago in the reading room of the newly-opened Firestone Library. I had been puzzling over the choice of a topic for my senior thesis in the Department of Economics, and had determined only what I would not consider: Any subject on which any Princeton thesis had ever been written. There went Adam Smith, Karl Marx, and John Maynard Keynes, all in one fell swoop. I of course had no idea where to turn next. But in December 1949, I happened to open Fortune magazine and find, on page 116, an article entitled “Big Money in Boston.

“By the later years of the twentieth century, our business values had eroded to a remarkable extent”—the greed, egoism, materialism and waste that seems almost endemic in today’s version of capitalism; the huge and growing disparity between the ‘haves’ and the ‘have-nots’ of our nation; poverty and lack of education; our misuse of the world’s natural resources; the corruption of our political system by corporate money—all are manifestations of a system gone awry.” And here’s where the soul of capitalism comes in. The book reads, “The human soul, as Thomas Aquinas defined it, is the ‘form of the body, the vital power animating, pervading, and shaping an individual from the moment of conception, drawing all the energies of life into a unity.’ In our temporal world, the soul of capitalism is the vital power that has animated, pervaded, and shaped our economic system, drawing all of its energies into a unity. In this sense, it is no overstatement to describe the effort we must make to return the system to its proud roots with these words: the battle to restore the soul of capitalism. (One reviewer thought that the title was, well, “inflated,” but liked the book anyway.) This idealism doesn’t let up. The reader doesn’t even finish the first page of Chapter I (“What Went Wrong in Corporate America?

I have taken Vanguard down the road less traveled by in an industry in which, I fear, group-think is the order of the day. Our departure from industry norms has taken us down a road that has led to considerable growth during the past decade, growth that I believe will not only be sustained, but perhaps even accelerated. So, as the fund industry approaches the new millennium, I would like to discuss my all-too-worldly business ideas on a far loftier philosophical plane that I hope befits the end of one era and the beginning of another, an era in which mutual fund shareholders will finally get the fair shake that they deserve. My theme goes back to the words of two ancient Greek philosophers: a few fragments of the writings of Archilocus, set down around 670 BC; and a portion of Plato’s enduring classic, The Republic, written in about 370 BC. Archilocus has given us timeless wisdom applicable to mutual funds, wisdom that suggests, to me at least, that it’s high time for a major change in direction for this industry. Plato, on the other hand, gives us an allegory that makes it clear how difficult it will be to bring about that long- overdue change. Let’s begin with Archilocus and the most famous fragment of his writing: “The fox knows many things. But the hedgehog knows one great thing.

And in my conclusion, I powerfully reaffirmed the ideals that I hold to this day: The role of the mutual fund is to serve—“to serve the needs of both individual and institutional investors . . . to serve them in the most efficient, honest, and economical way possible . . . The principal function of investment companies is the management of their investment portfolios. Everything else is incidental.” While all of this gratuitous advice from a callow college senior was, alas, largely ignored by the fund industry, the creation of Vanguard as a truly mutual mutual fund group—operated on an “at cost” basis for the benefit of its owners rather than its managers—was my attempt to walk the walk that I talked the talk about all those years ago. Today, I assure you that my youthful idealism remains intact. Indeed, it is shamelessly reflected not only in Vanguard, but in my new book, an expression of my concern about our American society today, my conviction that our system of capital formation is essential to our economic growth and world leadership, and my acknowledgement that much has gone wrong in that system. There is much that needs to be fixed, for “the business and ethical standards of corporate America, of investment America, and of mutual fund America (the three principal elements of the book) have been gravely compromised.” In each arena, I discuss not only what went wrong, but why it went wrong, and how to go about fixing it.

But I would like to throw a puckish challenge into the mix: To me, it seems that Bogle’s capitalism denies a subterranean component of American capitalism that has been as essential to our growth as the zeal of an Edison, the relentlessness of a Ford, and the salesmanship of a Watson. What is that hidden component? It is the con. The grift. The deal. The get-rich-quick scheme— and the appeal it holds. Mind you, I am not speaking of law-breaking. Rather, I’m referring to that gray, cloudy boundary that lies between the legitimate tip and the illicit tout, between entrepreneurship and illegality, between the start-up and the exit strategy. Between the board room—and the boiler room. For the fact is, while there are parts of capitalism that have always adhered to Graham and Dodd, there is something ineluctable about the allure of money made from money. And while it drives over the edge many men—and to pay Martha Stewart her due, many women, too—a plausible argument can be made that “the deal” is as essential to American progress as value-investing and the long-term hold. Recall the day when American car companies owned the world’s garages, curbs, and roads. How did the eventual victors rise to the top? By climbing over the 485 automotive companies that historian James J. Flink tells us were started between 1900 and 1908 in the U.S.

were only 5% of the industry in 1966, but had risen to 26% last year, and to about 43% in the past three months. To be sure, the change in our industry’s product line—especially the municipal bond funds—has a good bit to do with these recent trends. But that does not make them any less relevant; quite to the contrary! And of course as you, above all, here today know, the operational or service side of the business has also been revolutionized in the past decade. Bombs away to “green eyeshades” and manual operations, and up with sophisticated, computerized shareholder accounting systems! This change has been absolutely essential to our industry’s ability to provide new products and services—whether daily dividends in a money market fund, exchange privileges in a fund family, checkomatic accounts, or special shareholder accounting services to an employee savings plan. And such systems, to state the obvious, will also be critical to any marketing system—whether offering new and better services and more complete information to shareholders, monitoring the productivity of a given marketing program, or whatever—in the years ahead. I give this perhaps overly long preamble about where we have been only because if we want to know where we are going we had best start from where we are. (Please forgive the Pennsylvania Dutch circumlocution!)

The on-going crisis we are now facing in two relatively recent innovations— collateralized debt obligations (CDOs, backed by pools of mortgages) and specialized investment vehicles (SIVs, essentially money market funds that borrow short and lend long)—are examples of the complex—and costly— vehicles created by our financial sector. Banks like getting paid large fees for lending money, and when they can quickly get the loans off their own books and into public hands (so-called “securitization”), it can hardly be surprising that they aren’t much concerned about the credit-worthiness of those families for whose homes they have provided mortgages. With the endorsement—and, I would argue, the complicity—of our rating agencies, this financial legerdemain created a modern version of alchemy. The lead, as it were, was a package of say, 5,000— let’s call them B-rated—mortgages, miraculously turned into the gold, as it were, of a $100-million CDO with (in one typical case) 75 percent of its bonds rated triple-A, 10 percent rated double-A, 5 percent rated A, and only 10 percent rated double-B. (Hint: we now know that, despite the risk-reducing character of such broad diversification, lead is still lead.) Derivatives Innovation in the financial sector, of course, has included the development of an enormous market of financial derivatives.description:

I’ve reveled in helping to build a better world, solely because, well, it seems like the right thing to do. Finally, while Vanguard is said to be a story of entrepreneurship, I’m not sure, either, of my credentials as an entrepreneur. In fact, the creation of the firm resulted in the conversion of an existing firm to a new corporate structure, one that was specifically designed to provide neither equity participation nor entrepreneurial reward for its creator or its staff. Rather, the whole idea was to put service in the interests of our investors, rather than service in the interests of our management, as the firm’s highest value, and operating—in our own peculiar way—as a not-for-profit enterprise. Idealism and Entrepreneurship But even as I disclaim the credentials of the hero, of the leader, of the business manager, and even of the entrepreneur, I shamelessly proclaim my credentials as an idealist. Even more, I am an idealist who revels in the values of the Enlightenment and holds high his admiration for the brilliance and the character of the great thinkers, great doers, and great adventurers of the 18 th century, men (as it happens, in particular our nation’s Founding Fathers) who give birth to our modern world.being

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!

Founded and chaired Fosun Group from 1994, diversifying it into a large multi-sector conglomerate and listing its holding company, Fosun International, on the Hong Kong Stock Exchange in 2007.

On competition from foreign retailers entering India, Biyani argues Future's edge is merchandising-first rather than operations-first. He credits Sam Walton's biography 'Made in America' for the principle that retail is won on merchandising before operations. Foreign entrants, in his view, obsess over Day One operational perfection and want control, whereas Future treats retail as passion and cheerleading and is willing to ship and iterate.

” This ancient saying has been interpreted to describe the philosophical contrast between the human pursuit of many different, even contradictory, goals related by no central principle, versus the search for a single overarching universal condition of human existence. My focus, however, will be limited to the two basic types of financial institution. The fox— that artful, sly, astute animal of the fields and the woods—survives by knowing many things about complex investment strategies and sophisticated marketing approaches. The hedgehog—that durable nocturnal animal that can curl into a ball, its sharp spines giving it almost impregnable armor—survives by knowing only one great thing: In the long-term, both investment success and business success are based on simplicity. The Foxes—Truly A Skulk Turning first to investment strategy, clearly the foxes hold sway in the mutual fund industry today. The skulk—and the crowd of fund foxes is large indeed—holds to the idea that investing is complicated and complex, so much so that to achieve investment success individual investors have no choice but to employ professional portfolio managers, and even to rely on professional manager-pickers to choose them. Only these experts, or so it is said, can possibly steer investors through the complex system that constitutes the maze of the global financial markets.

”) before reading: “At the root of the problem, in the broadest sense, was a societal change aptly described by these words from the teacher Joseph Campbell: ‘In medieval times, as you approached the city, your eye was taken by the Cathedral. Today, it’s the towers of commerce. It’s business, business, business.’ We had become what Campbell called a ‘bottom-line society.’ But our society came to measure the wrong bottom line: form over substance, prestige over virtue, money over achievement, charisma over character, the ephemeral over the enduring, even mammon over God.” II. Profession vs. Business Among the most obvious, and troubling, manifestations of the change from the stern traditional values of yore to the flexible values of our modern age—today’s “bottom line” society—is reflected in the gradual mutation of our professional associations into business enterprises. According to a 2005 article in Daedalus by Howard Gardner, Professor at the Harvard Graduate School of Education, and Lee S.

Left was but a 25% share for the traditional equity-oriented funds, which had comprised 85% of industry sales volume in 1975. Talk about the challenge of change! The Investment Company Institute did not even carry a separate breakdown of bond fund statistics until 1975, and municipal bond funds did not come into existence until 1976, when enabling Federal legislation was enacted. If those were solid “hits,” surely there were gross “errors.” I could not have been more wrong when I predicted that “in the 1980s, (funds) will have to have lower operating expenses.” An “F” would be too generous a grade for that prognostication. The expense ratios of the 20 largest mutual fund complexes have risen from an average of 0.57 percent in 1977 to an estimated 0.80 percent in 1986. That 40 percent increase may not appear material, but it in fact represents a huge increase, for two reasons: 1.expenses,

Science, Popper proposed, didn’t proceed through observations confirmed by verification; it proceeded through wild, overarching conjectures which generalized ‘beyond the data,’ but were always controlled and sharpened by falsification (i.e., proof that the theory was wrong).” “It was the conscious, purposeful search for falsification by refutation, by the single decisive experiment” (or swan), Popper believed, “that allowed science to proceed and objective knowledge to grow.” Yet most of us—in our investment ideas and political ideas alike—do quite the reverse: we search for facts that confirm our beliefs (reinforcement bias), not for the facts that would negate them. The Light Shined by Frank Knight In the markets, however, few theories are advanced with the search for falsification as the object, and we continue to speak of forecasts and probabilities.2002

The reinsurance portion of the casualty insurance business, because it contains one or more extra links in the loss-reporting chain, usually creates more account- ing uncertainty than in the non-reinsurance portion. Wesco shareholders should remain aware of the inherent imperfections of Wes-FIC’s accounting, based as it is on forecasts of outcomes in many future years. Wes-FIC’s underwriting results have typically fluctuated from year to year, but have been satisfactory. When stated as a percentage, the sum of insurance losses, loss adjust- ment expenses and underwriting expenses, divided by premiums, gives the combined ratio. The combined ratios of Wes-FIC have been much better than average for insurers. Wes-FIC’s combined ratios were 93.9% for 2007 and 94.0% for 2006. We try to create some underwriting gain as results are averaged out over many years. We expect this to become increasingly difficult. Float is the term for money we hold temporarily, and as long as our insurance underwriting results are break-even or better, it costs us nothing. We expect that the new business venture with NICO will significantly increase Wes-FIC’s float from its yearend 2007 balance of $94 million, thus providing additional opportunities for investment. Kansas Bankers was purchased by Wes-FIC in 1996 for approximately $80 million in cash.very

Keynes argued that even “expert professionals” would gradually focus, not on investment (“making superior long-term forecasts of cash flow over the life of a company”), but on speculation (“forecasting changes in the general public’s valuation of the company’s shares”). I cited those very words in my thesis, and then had the temerity to disagree with the great man. In what I accurately predicted would become a far larger mutual fund industry, portfolio managers would “supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic [italics added], a demand that is based essentially on the [intrinsic] performance of a corporation rather than the public appraisal of the value of a share, that is, its price.” Alas, the sophisticated and analytic demand that I had predicted from the industry’s expert professional investors failed to materialize. Call the score, Keynes 1, Bogle 0. To this very day, nonetheless, I hold fast to the ideals I expressed in my thesis, summarized in its conclusion. “The principal function of investment companies is the management of their investment portfolios”—focusing on investing rather than speculating. Everything else is incidental.” The role of the mutual fund is to serve—"to serve the needs of both individual and institutional investors . . . to serve them in the most efficient, honest, and economical way possible.

” It was, of course, about the tiny, but “rapidly expanding and somewhat contentious” mutual fund industry, with “great potential significance to U.S. business.” My fortuitous discovery was, at least in a parochial way, the miracle on which the career I have followed would depend, for I knew that I had found the topic for my thesis. Read today, my thesis sounds terribly idealistic, if not callow. In its final chapter, I concluded that the infant mutual fund industry’s best chance for success lay in giving the shareholders a fair shake: “Its future growth can be maximized by a reduction of sales loads and management fees;” that “the principal function of (mutual funds) is the management of their investment portfolios. Everything else is incidental;” and that serving the interests of shareholders should “be the function around which all others are satellite.” Whether those simple thoughts were naive idealism, idle prattle, or a design for what Vanguard would stand for, I leave to far wiser heads. But my thesis grade did give my class standing a huge boost, and, despite a shaky sophomore year (I almost lost my scholarship, which would have ended my days at Princeton), I graduated magna cum laude. Walter L.Princetonian

In 1951, a mutual fund held the average stock in its portfolio for about six years—investing. Today, the average holding period for a stock in an equity fund portfolio is just over one year— speculation. Neither is that change progress.  We’ve discouraged long-term investors. With the substantial differences in short-term returns that inevitably occur among these different fund styles, investors have come to chase past performance. In 1951, most fund investors just picked funds and held them—on average, for about 16 years. Today, investors trade their funds, now holding the typical fund in their portfolios for a period of only about four years. A negative reversal with unfortunate consequences for our clients.  The ethos of fund managers has changed. Once dominated entirely by small, privately-owned firms and operated by professional investors, the industry is now dominated by giant, publicly- 1 I joined Wellington Management Company in 1951, assumed the position of CEO in 1965, and was fired in January 1974. The creation of Vanguard in September 1974 involved the firm’s assumption of the responsibilities for the operations of the then-Wellington Funds. In 2000, I formed the Bogle Financial Markets Research Center, which remains a unit of Vanguard.

In his first Inaugural, Wilson also addressed safeguarding the health of the nation, protecting the environment for future generations, equality of opportunity, pure food, and labor conditions. Quite an agenda! But if these goals would today be characterized as liberal, surely his bedrock philosophy was conservative: “The fundamental safeguarding of property and individual right; to lift everything that concerns our life as a Nation to the light that shines from the hearthfire of every man’s vision of the right.” No radical he, Wilson expressed the consummate gradualist perspective: “ . . . Step by step we shall make (our economic system) what it should be . . . Justice, and only justice shall be our motto.” As I read his first Inaugural, I wondered what might have been the source of his economic insights. In Princeton’s Seeley G. Mudd Manuscript Library, I uncovered his essay on Adam Smith, written at Bryn Mawr College in 1887 for use in his course on Political Economy. But, alas, it focused on Adam Smith’s mastery of the art of academic lecturing. Wilson’s essay (“An Old Master”) emphasized that the miscellany of economic thought contained in the Wealth of Nations was but a supplement to Smith’s Theory of Moral Sentiments. In that earlier book, Adam Smith had reckoned with such unselfish motives as “love, benevolence, sympathy, and charity in filling life with kindly influences.

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

Right at the outset I warn the reader that mine is a tough message, bluntly delivered, opening with this epigram from St. Paul: “If the sound of the trumpet shall be uncertain, who shall prepare himself to the battle?”, in this case; the battle for the soul of our capitalistic system. Today’s Capitalism Today’s capitalism has departed, not just in degree but in kind, from its proud traditional roots, a system that served us, admittedly imperfectly, but with remarkable effectiveness, for the better part of the past two centuries—a free enterprise system based on open markets and private ownership, and on trusting and being trusted. The system worked. Or at least it did work. And then, late in the twentieth century, something went wrong, a “pathological mutation in capitalism,” in the words of journalist William Pfaff.corporation’s

Only four long years later, on February 28, 1981, after what I am told remains the longest Investment Company Act hearing in history, was our internalization finally approved by the SEC. Conducting business under this cloud of uncertainty—we called it “the sword of Damocles”—was a challenge. But we never lost confidence that the Commission would eventually support our application. Finally, of course, it did. The Commission not only approved our plan, it did so in a decision that was unanimous, sweeping, and robust. Indeed, it was so positive that we ran this excerpt in the 1981 annual reports of our mutual funds. Please listen up here: The Vanguard plan actually furthers the (1940) Act’s objectives by ensuring that the Funds’ directors . . . are better able to evaluate the cost and performance of the funds; improves disclosure to shareholders; and clearly enhances the Funds’ independence.mutual

General Motors and Ford) to this total, financial earnings now likely exceed 33 percent of the earnings of the S&P 500. While that share may or may not be enough, it seems likely to continue to grow, at least for a while. We’re moving, or so it seems, to a world where we’re no longer making anything in this country; we’re merely trading pieces of paper, swapping stocks and bonds back and forth with one another, and paying our financial croupiers a veritable fortune. We’re also adding even more costs by creating ever more complex financial derivatives in which huge and unfathomable risks are being built into our financial system. “When enterprise becomes a mere bubble on a whirlpool of speculation,” as the great British economist John Maynard Keynes warned us 70 years ago, the consequences may be dire. “When the capital development of a country becomes a by-product of the activities of a casino, the job of capitalism is likely to be ill-done.” Once a profession in which business was subservient, the field of money management and Wall Street has become a business in which the profession is subservient. Harvard Business School Professor Rakesh Khurana was right when he defined the conduct of a true professional with these words: “I will create value for society, rather than extract it.” And yet money management, by definition, extracts value from the returns earned by our business enterprises.

Nonetheless, investors seem far more persuaded by the record of large net returns in the past (which superficially seem independent of costs) than by the ongoing (and both devastating and certain) impact of costs. In equity funds, even though reversion to (and even below) the stock market return—and to competitive norms—is far more the rule than the exception, there appears to be a large premium on selection.funds

I had no way of knowing that Walter L. Morgan, Class of 1920, would read my thesis. (I had sent it to a senior officer of Wellington Fund who had discussed the industry with me when I did my research.) Mr. Morgan was impressed, and when I graduated, he offered me a job. After what turned out to be an unnecessary amount of soul-searching, I accepted, and, as they say, the rest is history. Walter Morgan truly made a difference in my life. He gave me my first break, and he became my mentor. Then he entrusted me, at age 36, with the leadership of Wellington, the company he founded in 1928. But far more than that, we became close friends, establishing a mutual admiration society that endured for nearly a half a century, until his death last summer. He had just reached his 100 th birthday, still bright, alert, interested and interesting, the oldest then-living alumnus of the Class of 1920. When I decided to dedicate my soon-to-be-published book, Common Sense on Mutual Funds, to him, I had an advance copy of its cover and dedication printed and framed, and gave it to him before what was to be his last birthday. It includes the phrase “fellow Princetonian,” and we shared great pride in that designation. This morning, I know that in some mysterious way he’s here with us, sharing this high honor with me. Quickly after assuming my awesome new responsibility at Wellington, I impulsively made a career-threatening error.

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

immensely proud of the title of one of the chapters of a biography1 of me that was published a decade ago: “The 18th Century Man.” A year ago, in a talk on entrepreneurship that celebrated the 300th birthday of Benjamin Franklin, I reflected on this 18th century connection with a wonderful quotation: “Soon we shall know everything the 18 th century didn’t know, and nothing it did, and it will be hard to live with us.” These words were the opening epigram of Building a Bridge to the Eighteenth Century, by the late Neil Postman—prolific author, social critic, and professor at New York University. Postman’s book presented an impassioned defense of the old-fashioned liberal humanitarianism that was the hallmark of the Age of Reason. His aim was to restore the balance between mind and machine, and his principal concern was our move away from an era in which the values and character of Western Civilization were at the forefront of the minds of our great philosophers and leaders, and in which the prevailing view was that anything that’s truly important must have a moral authority. By way of contrast, in our present era of information technology, numbers and scientific techniques seem to be at the forefront of our values. Metaphorically speaking, if it can’t be counted, it doesn’t count. Surely this change has been clearly reflected in the change in capitalism from a system with values like trusting and being trusted at the fore, to a system relying heavily on numbers.

applied to our financial markets. We use the term risk all too casually, and the term uncertainty all too rarely. This distinction was first made by the late University of Chicago economist Frank H. Knight, who spelled it out in his seminal work, Risk, Uncertainty, and Profits,3 in, well, no uncertain terms. Here’s what Knight wrote: . . . uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. The term “risk,” as loosely used in everyday speech and in economic discussion, really covers two things which . . . are categorically different. The essential fact is that “risk” means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character. A measurable uncertainty, or “risk” proper, is so far different from an immeasurable one that it is not in effect an uncertainty at all. Knight continues: The facts of life in this regard are in a superficial sense obtrusively obvious and are a matter of common observation. It is a world of change in which we live, and a world of uncertainty. We live only by knowing something about the future; while the problems of life or of conduct at least, arise from the fact that we know so little . . . in business as in other spheres of activity. We act according to (our) opinion, of greater or less foundation and value, neither entire ignorance nor complete information, but partial knowledge.

owners in maximizing the return on their capital investment. But a new system developed—managers’ capitalism—in which, Pfaff wrote, “the corporation came to be run to profit its managers, in complicity if not conspiracy with accountants and the managers of other corporations.” Why did it happen? “Because the markets had so diffused corporate ownership that no responsible owner exists. This is morally unacceptable, but also a corruption of capitalism itself.” And so it is. Once an “ownership society” in which direct owners of stock held voting control over corporate America, we have become an “agency society,” and we are not going back. But the agents—largely mutual fund managers and pension fund trustees—have failed to represent, first and foremost, their principals—pension beneficiaries and owners of mutual fund shares. These intermediaries have consumed far too large a portion of whatever returns our corporations and our financial markets were generous enough to provide, with far too small a portion of these returns delivered to the last-line investors who have put up all of the capital and assumed all of the risks. Let’s consider just nine quick examples—three each from corporate America, investment America, and mutual fund America—that reflect the negative consequences of this change in capitalism. In Corporate America:  One is the staggering increase in managers’ compensation.

“Essentially, these financial contracts call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values. If, for example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction—with your gain or loss derived from movements in the index.” Mr. Buffett picked a good example. In fact, the value of derivatives on the S&P 500 Index — futures and options; in essence, speculation on the future price of the Index—is now said to total $23 trillion compared to the $13-trillion actual market value of the 500 Index itself. The “expectations market,” then, is almost double the value of the “real market.” However striking that relationship, these derivatives are a mere drop in the bucket of the global total of some $500 trillion in financial derivatives of all types; as a point of reference, the gross domestic product (GDP) of the entire world is about $50 trillion, a mere one-tenth of the derivative total. Back in 2003, a remarkable debate about derivatives occurred between two men who were likely the two most respected leaders of the entire financial community: Warren Buffett and Alan Greenspan. (Did I overstate their reputations? I don’t think so.) Here’s roughly how “The Motley Fool” website reported it: Warren Buffett and Fed head Alan Greenspan have thrown out some fighting words on derivatives.

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plus “non-income statement” costs) equal to something like 1.10 percent of assets last year. Thus, the unit cost increase is really almost 100 percent. 2. Second, the assets of the average major complex were $2 billion in 1977, but $18 billion in 1986. Thus the total dollar expenses borne by the shareholders of the typical complex have risen from $12,000,000 to $200,000,000, an increase of about 1,500 percent. (In fairness, the average number of shareholder accounts has risen by 400 percent during the same period.) If, a decade ago, I had merely predicted a “price war” in this industry, I would have given myself a higher grade, for surely we are witnessing on of the great price wars in the economic history of the United States. My higher grade, however, would have been a sham, because today’s great mutual fund price war is not a conventional price war. Indeed, it is not a war to lower prices, but to raise them. With the pervasive imposition of 12b-1 fees, deferred sales charges, direct fees for exchanges, redemption fees, and a surprising number of advisory fee increases, costs of existing funds are heading skyward. And new funds often begin with fees at a still higher plateau—2 percent is no longer an extraordinary expense ratio. My credentials as a prophet are clearly deteriorating!

owned firms, largely operated by businessmen bereft of investment experience. Today, 41 of the 50 largest fund managers are publicly-held, including 35 owned by giant U.S. and international financial conglomerates. Small wonder that these firms are all too eager to focus on maximizing the return on their own capital invested in the fund management companies they own, rather than focusing on maximizing the return on the capital they are investing for fund shareholders. Another compelling negative for our clients. All of these departures from our traditional role as fiduciaries have ill-served fund investors. Think about it. With all due respect, the motivations of the businessman in financial services, who must gather assets in order to prosper and who must constantly sell something, week after week, differs, not only in degree but in kind, from the motivations of the trustee, a member of a profession with high standards of conduct and a duty to serve client before self. The drive for asset gathering is importantly responsible for our product proliferation. We must always have a “product” that will sell. But it also has another negative aspect. We allow—and indeed encourage—our successful funds to grow too large to maintain the investment flexibility that produced the attractive returns that drew the attention—and the dollars—of investors in the first place. Too rarely is the marketing spigot turned off.

Warren Buffett’s wise partner Charlie Munger lays it on the line: “Most money-making activity contains profoundly antisocial effects . . . As high- cost modalities become ever more popular . . . the activity exacerbates the current harmful trend in which ever more of the nation’s ethical young brain-power is attracted into lucrative money-management and its attendant modern frictions, as distinguished from work providing much more value to others.” But I’m not telling you not to go into the highly-profitable field of managing money. Rather, I present three caveats: * One, if you do enter this field, do so with your eyes wide open, recognizing that any endeavor that extracts value from its clients may, in times more troubled than these, find that it has been hoist by its own petard. It is said on Wall Street, correctly, that “money has no conscience,” but don’t allow that truism to let you ignore your own conscience, nor to alter your own conduct and character.

satisfactory acquisition, reflecting the sound management of President Don Towle and his team. Kansas Bankers was chartered in 1909 to underwrite deposit insurance for Kansas banks. Its offices are in Topeka, Kansas. Over the years its service has continued to adapt to the changing needs of the banking industry. Today its customer base, consisting mostly of small- and medium-sized community banks, is spread throughout 38 mainly midwestern states. In addition to bank deposit guaranty bonds which insure deposits in excess of FDIC coverage, KBS offers directors and officers indemnity policies, bank employment practices policies, bank insurance agents professional errors and omissions indemnity policies and Internet banking catastrophe theft insurance. When Wesco purchased KBS, it had been ceding almost half of its premium volume to reinsurers. Now it reinsures only about 15%. Effective in 2006, insurance subsidiaries of Berkshire Hathaway became KBS’s sole reinsurers. Previously, an unaffiliated reinsurer was also involved. The increased volume of business retained comes, of course, with increased irregularity in the income stream. KBS’s combined ratios were 55.1% for 2007 and 73.8% for 2006. We continue to expect volatile but favorable long-term results from KBS. CORT Business Services Corporation (“CORT”) In February 2000, Wesco purchased CORT Business Services Corporation (“CORT”) for $386 million in cash.

Shulman, president of the Carnegie Foundation,1 it was a mere 40 years ago that Daedalus proudly declared: “Everywhere in American life, the professions are triumphant.” Since then, however, the professions have gradually “been subjected to a whole new set of pressures, from the growing reach of new technologies to the growing importance of making money.” Let’s consider for a moment what we mean when we talk about professions and professionals. Messrs. Gardner and Shulman defined a profession as having six commonplace characteristics: 1. A commitment to the interest of clients in particular, and the welfare of society in general. 2. A body of theory or special knowledge. 3. A specialized set of professional skills, practices, and performances unique to the profession. 4. The developed capacity to render judgments with integrity under conditions of ethical uncertainty. 5. An organized approach to learning from experience, both individually and collectively, and thus of growing new knowledge from the context of practice. 6. The development of a professional community responsible for the oversight and monitoring of quality in both practice and professional educators. They then add these wonderful words: “The primary feature of any profession (is) to serve responsibly, selflessly, and wisely . . . and to establish (an) inherently ethical relationship between the professional and the general society.

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fund complex within which each fund can better prosper; enables the Funds to realize substantial savings from advisory fee reductions; promotes savings from economies of scale; and provides the Funds with direct and conflict-free control over distribution functions.2 A Wonderful Coincidence All those nice words have been borne out in the years that followed. In fact, the Commission’s powerful endorsement marked the very moment that the uninterrupted ascendancy of Vanguard began. As 1981 ended, our share of mutual fund industry assets had fallen to just 1.7 percent. Over the next quarter century, it was to increase, without interruption, every single year.3 By 1987 our market share had doubled to 3.5 percent. By 1997, it had doubled again, to 7.3 percent. At 10.5 percent today, our share is on track to double yet again over the next five to ten years. The major reason that what we once called “The Vanguard Experiment” in mutual fund structure and governance has worked in the marketplace is also obvious. It has worked for the benefit of Vanguard shareholders. (Please forgive this commercial message!) Check almost any independent rating of mutual fund investment performance and you’ll see that the returns we have earned for our shareowners have consistently ranked at or near the top among all fund complexes. Most recently, Global Investor ranked us #1 over-all; #1 in international equities, #1 in bonds, and #3 is U.S. Equities.

” So, Wilson’s essay excused the exclusive concentration of self-interest and expediency in the Wealth of Nations. But it is in Moral Sentiments (though Wilson did not cite this passage in his essay) that we find an overriding ethical principle that might surprise today’s conservatives who trumpet Adam Smith’s philosophy of free competition: “It is reason, principle, consensus, the inhabitant of the breast, the reason within, the great judge and arbitrator of our conduct . . . who shows us the propriety of generosity, of reigning in the greatest interests of our own for yet the greater interests of others, the love of what is honorable and noble, the dignity of our own characters.” It is my view that the idealistic spirit of those lines—and I don’t think I am mistaken in hearing in them the cadences of Woodrow Wilson’s later addresses—had more to do with his shaping of the program of economic and monetary reform enunciated in his first Inaugural address than a detailed understanding of the workings of the economic system of the early 1900s. I believe, in short, that Wilson’s idealism was the inspiration for his economics.

This is not at all to deny the essential point of Jack Bogle’s fabulous book: that “capitalism requires a structure and a value system that people believe in and can rely on.” I merely mean to suggest that greed, and the speculation that feeds it, are part of that value system. Jack Bogle doesn’t give greed enough credit, I think. But implicitly, I believe, he sees a distinction between productive greed and unproductive greed. For in his rendering, the true enemies in The Battle for the Soul of Capitalism are the unproductive intermediaries that suck money from both the good schemes and the bad schemes into the great paper swamp of inefficiency. As Jack notes, during 1997-2002, the total revenues paid by investors to investment banking and brokerage firms exceeded $1 trillion, and payments to mutual funds exceeded $275 billion. Think how much fibre that we could lay!

In seeking to invest successfully, the industry’s managers present powerful credentials, including excellent education, years of experience, and cunning strategies. They hover over their portfolios by the hour, constantly monitoring them, buying and selling stocks with astonishing frequency, not only as a company’s products and prospects change, but as its market price jumps up and down. Alas, however, even for the relative handful of mutual funds that have been able to make these active, opportunistic, and costly strategies work—of course, it would be absurd to imagine they could work for funds as a group—the fees and other costs charged by the fund managers were almost always so high as to consume any long-term value added, even by the most cunning of the portfolio manager- foxes. Fund shareholders have been left with annual returns averaging only about 85% of the annual returns realized in the great bull market we have enjoyed. The reason for this shortfall is largely fund costs.the

” All of this gratuitous advice from a callow college senior was, alas, largely ignored by fund industry leaders. But the creation of Vanguard in 1974 as a truly mutual mutual fund group—operated on an "at-cost" basis for the benefit of its owners rather than its managers—was my attempt to walk the walk that I had talked the talk about a quarter-century earlier. Today, I assure you that my youthful idealism remains intact. Indeed, it is shamelessly reflected not only in Vanguard, but especially in my two latest books, which express profound concern about the deterioration in the values of our nation’s capitalistic system, in our concept of fiduciary duty, and in the operation of our financial markets. Part II. A Fiduciary Society The fact of the matter is that something has gone profoundly wrong in these critical areas. The root causes of the disease are deep, and the remedies that are required to cure it will not be easy to come by. What we have witnessed, in the words of journalist William Pfaff, is “a pathological mutation in capitalism.” The classic system—owners’ capitalism—had been based on a dedication to serving the interests of the corporation’s owners, maximizing the return on their capital investment.in

Buffett called them “financial weapons of mass destruction.” Greenspan said, “The benefits of derivatives have far exceeded their costs.” Buffett’s letter to shareholders devoted a whole section to derivatives, their abuse, and the great financial risk they represent both to the parties using them and to the economy as a whole, saying that derivatives could lead to huge financial turmoil for the markets. For Buffett, derivatives’ hard-to-quantify off-balance sheet presence makes it difficult to figure out a financial institution’s true market risk exposure—lurking like a looming iceberg beneath the economy’s waters. Greenspan countered directly by saying that most banks manage their risks just fine. Financial institutions use vehicles like swaps and futures to hedge their interest rate and market exposures, pointing out that the prudent use of derivatives has helped banks survive the recession by reducing risk. Buffett thinks they represent a huge risk to the economy and that some sort of further regulation is needed. Greenspan believes that the market can handle derivative risk, and that more regulation could create a moral hazard, actually encouraging banks to assume more risk instead of less. Who’s right? They both are, in a way. But so far the use of most derivatives goes unnoticed because nothing catastrophic has happened. This is a battle that’s likely to go on and on, with both sides holding fast to their positions until proven wrong by another big market event.

costs of churning the portfolio, plus at least another ½%-plus annually for investors who pay sales commissions. Now, let’s think long-term instead of short-term. Let’s assume that the long-term market return of 11% per year persists, and conservatively set the total amount gathered by the managers, dealers, and brokers at 2½% per year. That leaves an investor return of 8 ½%. The positive impact of compound interest that magnifies long-term returns, unfortunately, also magnifies the negative impact of costs, so that an assumed 2½% annual cost would consume 31% of the investor’s capital in a decade, 47% in a quarter century, and—believe it or not—68% of the investor’s capital in 50 years, an investment lifetime. The investor, who puts up 100% of the initial capital and assumes 100% of the investment risk, receives but 32% of the long-term pre-tax return. The financial foxes, who put up none of the initial capital and assume none of the risk, receive the remaining 68%. To make matters worse, these foxy strategies provide even worse results for the 30 million fund investors who pay taxes. High portfolio turnover creates enormous tax inefficiencies, exacerbated by the fact that many foxy managers realize capital gains even on a short-term basis, taxable at the full income tax rate. During the bull market, believe it or not, the federal government has confiscated nearly as much of the market’s gains as have the foxy managers.

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

dominate, with about 55 percent of equity fund assets of $6 trillion residing in load funds, and about 45 percent in no-load funds, a relationship that has been remarkably steady during the years. In its own perverse way, this contrast between the dominance of load funds in the equity field and no-load funds in the money market field makes sense. In money markets, where returns are relatively uniform, where the impact of costs is rather obvious, and where the hope of outperforming the market is non-existent, a sales commission would be regarded as an absurd drag on returns, indeed perhaps almost a fraud. On the other hand, in equity markets, where returns are highly variable, where the impact of costs is obscure, and where the hope of beating the market springs eternal, the sales agents of our brokerage firms ride in the saddle, dominating the asset base. What does this analysis have to do with bond funds? Plenty! Consider that in terms of those three major variables—uniformity of returns, obviousness of the impact of costs, and hope of outperformance—bond funds lie somewhere between equity funds and money market funds. So, an analyst might reasonably conclude that the market share of load and no-load funds would also lie somewhere between that 0/100 load fund/no-load fund split in money market assets and that 55/45 load/no-load split in equity funds. The analyst would be wrong.

Seeking additional portfolio management talent, I merged Wellington with a Boston-based investment counsel firm in 1966. By January 1974, amidst the most ferocious bear market since 1929-1933, my new partners succeeded in firing me. But in the aftermath of the battle, I took a wild risk and formed a new company. I called it Vanguard, a name intended to suggest that its novel structure (more about that later) would one day lead the way in the mutual fund industry. It began as a tiny administrative company—just 27 young employees (crewmembers, as we have called them ever since) and me. Only after a painful, obstacle-ridden, seven-year struggle—at first opposed by the Securities and Exchange Commission—would it finally develop the form and structure that it enjoys today. But it has been built, just as my thesis suggested, on vastly reduced management fees; not merely on reduced sales loads, but no loads; by focusing on prudent management rather than aggressive marketing; and by holding the interests of shareholders paramount. If, as some accounts have it, we do lead the way in this industry, the path may well have been laid in a Princeton thesis written almost 50 years ago.Skulk

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

Jack also runs a hot iron over the newest wrinkle in the fabric of our economy: hedge funds. He is disdainful of the “public adulation” being showered over these managers of $1 trillion in assets. “PR” not withstanding, he notes that the aggregate return on hedge funds between 1996 and 2003 was a mere 9.3 percent. He does not foresee a Long-Term-Capital-Management-style flameout, but rather a gradual diminution in hedge fund influence, as their high costs, tax inefficiencies and modest returns show they are but the latest tulip in the garden of finance. Jack is quite right when he attributes capitalism’s travails not to malfeasance but to ignorance. He doesn’t believe necessarily that the Enrons and Worldcoms mask deeper illegalities. “Actual looting,” he writes, “has been limited. Negligence . . . has been rife.” He spares few from this cutting ax: “Corporate directors . . . failed to fulfill their responsibilities,” he says. Accounting gatekeepers were silent partners.” The response? Throughout his book, Bogle returns to the same theme: activism. He approvingly quotes the title of a Bob Monks’ paper, Capitalism Without Owners Will Fail. “Retirement funds and mutual funds,” he says, “must behave like owners . . . We ought to explode a whole barrage of firecrackers under each corporation that places managers’ interest ahead of the owners’ interest.

If we are to understand the workings of the economic system we must examine the meaning and significance of uncertainty; and to this end some inquiry into the nature and function of knowledge itself is necessary. The (likelihood) of opinion or estimate to error must be radically distinguished from probability or chance, for there is no possibility of forming in any way groups of instances of sufficient homogeneity to make possible a quantitative determination of true probability (in which) any sort of statistical tabulation (provides) any value for guidance. The conception of an objectively measurable probability or chance is simply inapplicable . . .there is much question as to how far the world is intelligible at all . . . It is only in the very special and crucial cases that anything like a mathematical study can be made.” (Italics added.) Mandelbrot on Risk, Ruin, and Reward The abstract theories of Karl Popper and Frank Knight can be directly applied to the financial markets, which is exactly what Benoit Mandelbrot, the brilliant inventor of fractal geometry, has done with Richard Hudson in his book The (Mis)Behavior of Markets, ominously subtitled “A Fractal View of Risk, Ruin, and Reward.” Fractal geometry, simply put, is about patterns, patterns that repeat themselves continually, in nature and in geometry, scaling up or scaling down, sometimes defined by a determination rule, sometimes entirely by chance.

They are not improved by my second significant error, the prediction that “institutional markets— pension, endowment, corporate, foundation—should become extremely important to our industry’s future growth.” Perhaps a “D” will reflect the actuality—that, according to Investment Company Institute data, the portion of our Industry’s assets represented by these institutional accounts eased only slightly upward during the past decade, from 12 percent to 14 percent. Put another way, mutual funds currently represent something like 2 percent of the assets of all corporate pension plans, by far the dominant institutional market. So, my supposition that mutual funds could penetrate these markets in an important fashion was just plain wrong. Nonetheless, it is at least possible that the proverbial “jury is still out” on this issue. I believe that the recent trend from the traditional defined benefit pension plans toward defined contribution plans, and the related growth of 401(k) employee savings plans, will open vast new markets for mutual funds. It continues to seem to me that there is no investment vehicle providing benefits comparable to those offered by mutual funds: “simplicity, efficiency, liquidity, and flexibility: (the words I used a decade ago). Indeed, “flexible pricing” has made it the norm for funds of all types—not merely no-load funds— to offer their shares in this giant market without sales commissions.

(Be clear, please, that I’m not claiming that we demonstrated any extraordinary across-the-board management ability. The lion’s share of our superiority in returns is accounted for simply by our lower costs.) So “the jury is in.” Our system has proven itself—an artistic success for our shareholders and a commercial success for our firm. The simple system actually works. So, you must think, like all ideas that prove themselves on the dog-eat-dog fields of competitive capitalism, Vanguard must have spawned legions of competitors by now . . . Mustn’t we? Well, “No.” Despite our enviable record of growth—an amazing $920 billion of our asset base is the result of that market share increase alone—not a single competitor has adopted the innovative Vanguard structure of truly mutual mutual funds, in which the glorious cornucopia of profits that are the product of organizing, operating, and managing mutual funds are returned to the owners of the mutual funds, rather than going into the pockets of the owners of the fund management companies. Now, one reason that I chose the name “Vanguard” was because it echoed the proud name of HMS Vanguard, Lord Nelson’s flagship at the glorious naval victory of the British over the French at the Nile in 1798. But the second reason drips with irony. The conventional definition of Vanguard is: “the leadership in a new trend.” Yes, we’ve been some leader. Nearly 33 years after our founding, we’ve yet to find our first follower!

Crowd-like behavior is another obvious cause of the changes I’ve described. I remember an industry in which “there are some things that one simply doesn’t do.” But today what I see is, “when everyone else is doing it, I can do it, too.” (I concede that the mutual fund industry is hardly alone in manifesting this debasement in values.) Finally, greed rears its ugly head. Of course we don’t think of ourselves as greedy. (Perhaps no one does.) But the enormous management compensation now generated by this giant industry can easily blind us to our underlying motives. Paraphrasing Upton Sinclair: “It’s amazing how difficult it is for a man to understand something if he’s paid a small fortune not to understand it.” The lack of introspection by industry leaders, then, has been just one more negative force. (Ironically, the amount of dollars and cents paid to fund executives are kept secret from the shareholders who own our funds, the only publicly- held U.S. corporations with a blanket exemption from such disclosure.) I’ve been asked this fundamental question: “Are fund managers now less ethical than they once were?” I’d have to answer, “I doubt it.” With a handful of truly horrifying exceptions (tact, not usually my strong point, precludes my naming them), the industry leaders I’ve known have been men and women of high character, impressive integrity, and substantial intelligence.

Whether the issue was control of our nation’s monetary policy or the reduction of tariffs, Wilson fashioned economic policy to restore the democratic ideals of the nation’s founders. In his first inaugural, Wilson lamented that “ . . . we reared giant machinery which made it impossible that any but those who stood at the levers of control should have a chance to look out for themselves.” Wilson’s administration would seek to redress the imbalance between the broad citizenry and the powerful financiers and industrialists of the Gilded Age. Wilson would undertake a moral crusade to “square every process of our national life again with the standards we so proudly set up at the beginning and have always carried at our hearts.” Even 90 years later, in this age of global economics, Wilson’s shadow lies on the institutions and policies through which the American business and financial community conducts its affairs around the world. His shadow also, of course, lies on Princeton University. On becoming President of the University in 1902, he implemented the preceptorial system and revolutionized teaching, added greatly to the University’s physical plant, established a new curriculum, added an honors program, and inspired today’s system of residential colleges. (His “favorite dream of a collegiate Quad Plan” was rejected in 1908, a setback that contributed to his decision to leave Princeton and run for Governor of New Jersey.

On India's consumption trajectory, Biyani warns that the country remains an agrarian society with modest aspirations by industrialized-nation standards. More players entering retail can act as change agents that pull demand forward, but he cautions that genetically converting the Indian economy into a spending-oriented one will be slow. He is also skeptical that India can leapfrog into consumerism without several generations of cultural shift.

CEO pay has risen from 42 times the compensation of the average worker in 1980 to 340 times currently, a 756 percent rise after inflation, while the real income of the average worker has barely kept pace with the cost of living. Long ago, Herbert Hoover, one of our few businessmen to serve as president, put it well: “The only trouble with capitalism is capitalists. They’re too darn greedy.” Imagine what he’d say today.  Two, the rise of financial engineering. In a remarkable manipulation of financial statements, corporate earnings are managed to meet the “guidance” that these executives give to Wall Street, quarter by quarter. Two of the prize tools for earnings shenanigans: (1) mergers that are made, not with a sound business rationale, but because of the consequent opportunity to manage “pro forma” earnings by creating a veritable “cookie jar” of reserves, to be drawn on at will in order to present a rosy, but false, picture of corporate growth; and (2) arbitrarily raising the assumptions for future returns on corporate pension plans, even as prospective returns eroded. Just think of it: In 1981, when the long-term U.S. Treasury bond yielded 13.9 percent, corporations projected pension plan returns at 7 percent per year—only half as much. Currently, with bond yields at 4.7 percent—65 percent lower—the projected return averages about 8.5 percent—20 percent higher.

CORT is a very long-established company that is the country’s leader in rentals of furniture that lessees have no intention of buying. In the trade, people call CORT’s activity “rent-to-rent” to distinguish it from “lease-to-purchase” businesses that are, in essence, installment sellers of furniture. However, just as Enterprise, as a rent-to-rent auto lessor in short-term arrangements, must be skilled in selling used cars, CORT must be and is skilled in selling used furniture. CORT’s revenues totaled $396 million for calendar 2007, versus $400 million for calendar 2006. Of these amounts, furniture rental revenues were $327 million and $324 million, furniture sales revenues were $62 million and $70 million, and rental relocation revenues were $7 million and $6 million. CORT operated at after-tax profits of $20.3 million for 2007 and $26.9 million for 2006. When we purchased CORT early in 2000, its furniture rental business was rapidly growing, reflecting the strong U.S. economy, phenomenal business expansion and explo- sive growth of IPOs and the high-tech sector. Beginning late in 2000, however, new business coming into CORT began to decline. With the burst of the dot-com bubble, the events of September 11, and a protracted slowdown in new business formation, CORT’s operations were hammered, reflecting generally bad results in the “rent-to-rent” segment of the furniture rental business.

We seem to blindly accept that financial matters are rational simply because numbers, however dubious their provenance, are definitive. While Postman made the bold assertion that truth is invulnerable to fashion and the passing of time, I’m not so sure. Indeed I would argue that we’ve moved away from truth—however one might define it—to (with due respect to Steven Colbert) truthiness, the presentation of ideas and numbers that convey neither more nor less than what we wish to believe in our own self-interest, and persuade others to believe it too. We manage our truths by managing our numbers. That old bromide of the management consultant, “if you can measure it, you can manage it,” has done us more harm than good. As the 21 st century begins, then, our values have changed, and it is hard to resist conformity with a new society in which, seemingly, everything can be measured. Even Vanguard has emerged as a sort of prototypical 21st century firm, a virtual organization; enormous in size; heavily reliant on process, real- time communications, and computer technology; and managed largely by the contemporary numeric standards of modern management.

complicity if not conspiracy with accountants and the managers of other corporations.” Why did it happen? “Because,” in Mr. Pfaff’s words, “the markets had so diffused corporate ownership that no responsible owner exists. This is morally unacceptable, but also a corruption of capitalism itself.” When most owners either don’t or won’t or can’t stand up for their rights, and when corporate directors lose sight of whom they represent, the resulting power vacuum quickly gets filled by corporate managers, living proof that Spinoza was right when he told us, “nature abhors a vacuum.” Little good is likely to result when the CEO becomes not only boss of the business but boss of the board, erasing the “bright line” that common sense tells us ought to exist between management and governance. Put more harshly, in a quote that I came across last spring, “when we have strong managers, weak directors, and passive owners, don’t be surprised when the looting begins.” There were two major forces behind 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. Since 1950, direct ownership of U.S. stocks by individual investors has plummeted from 92 percent to 30 percent, while indirect ownership by institutional investors has soared from 8 percent to 70 percent. Our old ownership society is now gone, and it is not going to return.

” When we think of professionals, most of us would probably start with physicians, lawyers, teachers, engineers, architects, accountants, and clergymen. I think we could also find agreement that both journalists and trustees of other people’s money are—at least in the ideal—professionals as well. And yet, profession by profession, the old values are clearly being undermined. The driving force is our old friend (or enemy), the bottom line society. Unchecked market forces not only constitute a strong challenge to our professions; in some cases, these forces have totally overwhelmed traditional standards of professional conduct, developed over centuries. That legitimacy, in sad reality, has already been undermined in most of our professions.2 Another article in the same issue of Daedalus asserts that the idea that “the market is self-regulating and morally self-sufficient” to assure the maintenance of professional standards has clearly proved inadequate. Indeed, that misguided idea lies at the heart of some of our major societal failures of recent years, examples that belie the idea that professionals must accomplish their good works with a commitment to use their mastery to fulfill a “mission that inspires passion, a mission that gives beyond the self.” Of course we’re all aware, as yet another Daedalus article expresses it, “that pursuing a noble mission is often painful . . .

And now to the fox and the hedgehog. In the mutual fund business today, indeed in our global financial system, the foxes hold sway, both in investment philosophy and in business philosophy. As to investment philosophy, the skulk—a large crowd of fund foxes—holds to the idea that investing is complicated and complex, so much so that to achieve investment success individual investors have no choice but to employ professional portfolio managers. Only these experts, or so it is said, can possibly steer them through a hyper-active system that constitutes the complex maze of the global financial markets. In seeking to invest your money successfully, the industry’s managers present powerful credentials, including excellent education, years of experience, cunning, and even investment legerdemain; they hover over their portfolios by the hour, constantly monitoring and changing holdings, often with astonishing frequency, not only as a company’s products and prospects change, but as its market price waxes and wanes. Further, some among this skulk expect to slyly sell stocks when the market is high, and buy them back when the market falls. In all, the managers add extra opportunity and accept the extra risk required in the search for superior returns.

That return is simply not going to happen, and the inadequacy of pension plan assets to meet their payout liabilities to retirees is well on the way to becoming our next financial scandal.  Three, the failure of our traditional gatekeepers. In the recent era, auditors, through their provision of highly profitable consulting activities, became partners, if not co-conspirators, with managements, and relaxed traditional professional standards. Regulators and legislators (who in 1993 forced the SEC to back down on requiring that option costs to be treated as—of all things!—corporate expenses) also ignored the public interest. And corporate directors failed to provide the necessary “adult supervision of these geniuses” who managed the firms. (You’ll find that quote in my book.) Put more harshly, in an unattributed quotation that I came across a few years ago, “When we have strong managers, weak directors, and passive owners, don’t be surprised when the looting begins.” And that’s, of course, what we’ve seen at Enron, WorldCom, and too many others.

(Before I turn to “product line” and “principal markets,” I should note my view that more imaginative ways of pricing operational services will develop by the 1980’s. For example, I wonder if it is not time to consider “externalizing” the shareholder account fee. It is difficult for me to conceptualize why a single investor who owns, say, $2 million of a $200,000,000 fund’s shares, should pay for 1% of its transfer agency costs. Why should he pay, say $2,000 per year, when the cost of handling that single account is $5. This concept has obvious implications for future marketing strategy.) Turning to the 1980’s product line, it will inevitably relate directly to the pricing structure. This is hardly a subtle point. When we were strictly an equity-oriented industry, the sales charge and expense ratio did not appear to be critical or differentiating factors. If they were high, they got lost in a matrix of good performance and bull markets. And if they were low, it really did not help all that much if performance was bad. In short, our equity products were perceived as “differentiated”—if you could pick a fund that “performed,” the cost did not really matter.

But they are part of a system in which traditional values have eroded, operating in a new “bottom-line society” that worships a bottom line so easily measured in dollars and cents, rather in qualities not susceptible to measurement—for example, character, and integrity, and trust. How else to explain the disgraceful conduct of so many of the oldest, largest, and once most respected management companies in this industry—now representing $2 trillion of fund assets, almost 30 percent of the total—in aiding and abetting illicit market timing schemes. Or the number of leading brokerage firms engaged in “breakpoint” frauds in which excessive sales loads were imposed on investors. Or having one of the bluest of the industry’s blue-chip firms—one of the three largest firms our field—violate NASD rules by allocating brokerage commissions as a quid pro quo to brokers that sold the shares of its funds. What’s more, according to the NASD decision, the firm’s executives were duplicitous on the witness stand. (The actual word was “disingenuous.”) While the examiner recommended a $100 million fine, it was reduced to $5 million on the grounds that the illicit practice was rife in the industry (i.e., “everyone else was doing it, so I can too.”)

They often relate to power laws, where growth is not linear but logarithmic. The Fibonacci sequence, in which each successive number is the sum of the two previous numbers 1 – 2 – 3 – 5 – 8 – 13 – 21 – 34 – 55 – 89 – 144, and so on (well, you get the picture), is a soaring arc on a linear scale (Chart 1a), but a straight line on a logarithmic scale. (Chart 1b) As it happens, each successive number is 1.6 times its predecessor, and after 144, 1.1921

But by 1966 “Woodrow Wilson College” became the first of Princeton’s five residential colleges. 1 ) So too his lengthened shadow lies on the United Nations, the realization of his failed dream of a League of Nations, a crushing defeat for this idealist that doubtless contributed to the stroke he suffered in 1918, ending his political life. Nonetheless, we cannot miss the echo of Emerson’s epigram (and we know that Wilson was an avid reader of Emerson’s essays): “An institution is the lengthened shadow of one man.” Whatever the case, surely the shadow of Wilson lies unmistakable, unwavering and dominant today, over Princeton, our economy, and the United Nations. Turning now from Wilson’s formidable shadow, I now turn inward to discuss, with some trepidation, the career of the Woodrow Wilson Medalist for 1999. As I reflect on the matter, it occurs to me that Wilson would have delighted in the precedent-breaking award of the Medal to a businessman. In evidence, I offer his Princeton Inaugural Address: The University must “serve a free nation whose progress, whose power, whose prosperity, whose happiness, whose integrity depend on individual initiative and sound sense.” He expected “the merchant and the financier (to) have traveled minds . . .

and that not letting the mission get out of hand is possible only for those who truly believe in the mission and have enough self-perspective to remain wary of dangers such as arrogance, megalomania, misguided beliefs, and distorted judgments.” These dangers have already come home to roost in some established professions, with incalculable harm to our society. Recent examples of the harsh consequences of this change are easy to come by. In public accounting, our once “Big Eight” (now “Final Four”) firms gradually came to provide hugely profitable consulting services to their audit clients, making them business partners of management rather than independent and professional evaluators of generally accepted (if loose) accounting principles. The failure of Arthur Andersen, and the bankruptcy of its client Enron, was but one example of the consequences of this conflict-riddled relationship. 1 Daedalus, Summer 2005, “The Professions in America Today: Crucial but Fragile,” pages 13-18. 2 The ideas in this paragraph have been inspired by other articles in the same issue of Daedalus, the Journal of the American Academy of Arts & Sciences.

But at our core—at least through my idealistic eyes—we remain a prototypical 18th century firm, thriving on our early entrepreneurship, on our simple investment strategies, and on eternal verities such as service to others before service to self, doing our best to hold high the belief that ethical principles and moral values must be, finally, the basis for any enterprise worth its salt. America’s First Entrepreneur In today’s grandiose era of capitalism, the word “entrepreneur” has come to be commonly associated with those who are motivated to create new enterprises largely by the desire for personal wealth or even greed. But at its best, entrepreneurship entails something far more important than mere money. Heed the words of the great Joseph Schumpeter, the first economist to recognize entrepreneurship as the vital force that drives economic growth. In his Theory of Economic Development, written nearly a century ago, Schumpeter dismissed material and monetary gain as the prime mover of the entrepreneur, finding motivations like these to be far more powerful: (1) “The joy of creating, of getting things done, of simply exercising one’s energy and ingenuity,” and (2) “The will to conquer, the impulse to fight . . . to succeed for the sake, not of the fruits of success, but of success itself.” 1 John Bogle and the Vanguard Experiment, McGraw-Hill, 1996.

” That’s the core message in The Battle for the Soul of Capitalism: Not that there are too many bad guys doing bad things, but there aren’t enough of the rest of us doing the right thing. It’s that radically conservative message I mentioned up top—and we ignore it at our peril. As Bogle notes, so many companies own pieces of so many others through defined benefit pension plans and defined contribution thrift plants, that we live in a virtual “American keiretsu,” where few are willing to rock the boat. So we must rock it ourselves. “The mission,” writes Bogle, is “to return capitalism to its proud roots,” which “begins with having the owners of our corporations stand up and be counted.” Jack, stand up again so we can applaud you for taking on your colleagues on our behalf.

Obvi- ously, when we purchased CORT we were poor predictors of near-term industry-wide prospects of the “rent-to-rent” sector of the furniture business. CORT started up a new service in 2001. Originally a subsidiary named Relocation Central, and subsequently integrated into CORT’s operations, CORT’s rental relocation activities were intended mainly to supplement its furniture rental business by providing apartment locator and ancillary services to relocating individuals.its

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

I do nothing but go about persuading you all, not to take thought for your persons and your properties, but first and chiefly to care about the greatest improvement of the soul. I tell you that virtue is not given by money, but that from virtue comes money and every other good of man.” I close by returning to Kurt Vonnegut’s story, which, when I finally tracked it down, turned out to be a poem. It’s delightful; even better, it’s only 92 words long: True story, Word of Honor: Joseph Heller, an important and funny writer now dead, and I were at a party given by a billionaire on Shelter Island. I said, “Joe, how does it make you feel 2 Self-serving because I created, in 1975, the world’s first index mutual fund.

The assets of bond funds are not represented by, as that logic would suggest, something like 75 percent in no-load funds and 25 percent in load funds. To the contrary, the division of the $1.5 trillion asset base of bond mutual funds is far from that division: presently 62 percent load fund assets and 38 percent no-load fund assets, only about one-half of our rational expectation of 75 percent. (Chart 2B) This surprising—indeed astonishing!—division of market shares suggests that something very weird is going on among the giant brokerage firms that dominate the load fund market.

In its place we have a new “agency society” in which our financial intermediaries now hold effective control of American business. But these new agents haven’t behaved as agents should. Our corporations, pension managers, and mutual fund managers have too often put their own financial interests ahead of the interests of the principals whom they are duty-bound to represent, those 100-million families who are the owners of our mutual funds and the beneficiaries of our pension plans. As Adam Smith wisely put it 200-plus years ago, “managers of other people’s money (rarely) watch over it with the same anxious vigilance with which . . . they watch over their own . . . they very easily give themselves a dispensation. Negligence and profusion must always prevail.” And so negligence and profusion among our corporate directors and money managers have prevailed in present-day America. The second reason for the debasement of the values of our capitalistic system is that our new investor/agents not only seemed to ignore the interests of the investor principals whom they are duty- bound to serve, but they also seemed to forget their own investment principles. In the latter part of the twentieth century, the predominant focus of institutional investment strategy turned from the wisdom of long-term investing to the folly of short-term speculation.all

Biyani claims Pantaloons Retail was India's first retail company to list, raising a tiny Rs 2.25 crore — under $1 million — at the IPO. The reason given for going public was almost philosophical: once you dream big, share your gains with the public. He measures success not by balance sheet metrics but by whether consumers keep returning to his stores, treating repeat footfall as the only durable verdict on a retailer.

A question for you: Is it possible that in today’s fund industry, making money for fund investors carries a lower priority than making money for fund managers? But I am not, well, disheartened. Whether or not the actual Vanguard vision is emulated, I expect that the values that are at the top of the Vanguard agenda will gradually work their way into our industry. So, having presented this preamble about the design of Vanguard, our history, and our record, let me now look ahead with you today and honor both the spirit of this conference and the letter of the title of my remarks: “Designing a New Mutual Fund Industry.” 2 SEC Decision “In the Matter of the Vanguard Group” February 28, 1981, p.16. 3 More precisely, it never declined. It was unchanged in 1992-1994 and in 1999.

Well, four years later, that “big market event” is upon us. The innovation of derivatives has enriched the financial sector (and the rating agencies) with enormous fees, and these over-rated, as it were, CDOs have wreaked havoc on the balance sheets of those who purchased them, including the banks and brokers themselves. They too bought them, and in the end, with many of them still on their books, were left holding the bag,. What is more (if we need more!), the SIVs have also created havoc. For it turns out that to sell these instruments, our banks increasingly issued “liquidity puts” to buyers, guaranteeing to repurchase them on demand at face value.its

So, no matter how low my grade so far, I expect to see it raised in the years ahead. Exponential Growth, and Operational Challenges Turning, then, from my hits and errors to my misses, the major one was the failure to even conceive of the exponential growth in this industry. Consider these incredible changes since I spoke to you a decade ago:  Total assets were then $51 billion; today assets are $720 billion.  There were then 444 funds; today there are nearly 2,000.  Investors purchases of regular funds in 1976 totaled $4 billion; last year the total was $165 billion.  There was a net cash outflow of $3 billion from all mutual funds in 1976; last year there was a cash inflow of $175 billion.

those years earlier, and, to my shame, what I dismissed.) During the recent era, we entered the age of expectations investing, where projected growth in corporate earnings—especially earnings guidance and its subsequent achievement, by fair means or foul—became the watchword of investors. Never mind that the reported earnings were too often a product of financial engineering that served the short-term interest of corporate managers and Wall Street security analysts alike. But when long-term owners of stocks become short-term renters of stocks, and when the momentary precision of the price of the stock takes precedence over the eternal vagueness of the intrinsic value of the corporation itself, concern about corporate governance is the first casualty. The single most important job of the corporate director is to assure that management is creating value for shareholders; yet our new agent/investors seemed not to care when that goal became secondary. While these institutional agents now hold absolute voting control over corporate America, all we hear from these money managers is the sound of silence. Not only because they are more likely to be short-term speculators than long-term investors, but also because they are managing the pension and thrift plans of the corporations whose stocks they hold, and thus face a serious conflict of interest when controversial proxy issues are concerned.

That’s the way it was in 18th century America, at least in the case of Benjamin Franklin. For Franklin, fairly described as “America’s First Entrepreneur,” the getting of money was always a means to an end, not an end in itself. The enterprises he created were designed for the public weal, not for his personal profit. When Franklin joined with his colleagues in founding The Philadelphia Contributionship in 1752, it was a mutual company owned by its policyholders. This combination of ownership and service—creating a true mutuality of interest between the owners of a firm and its managers—was not then, nor is it now, the common mode of business organization, but The Contributionship has thrived to this day. Franklin also founded a library, an academy and college, a hospital, and a learned society, all for the benefit of his community. Not bad! His inventions followed the same philosophy. He made no attempt to patent the lightning rod for his own profit; and he declined the offer for a patent on the “Franklin stove” that revolutionized the efficiency of home heating, with great benefit to the public at large. Benjamin Franklin believed that, “knowledge is not the personal property of its discoverer, but the common property of all. As we enjoy great advantages from the inventions of others,” he wrote, “we should be glad of an opportunity to serve others by any invention of ours, and this we should do freely and generously.

Biyani admits Future's internal systems were not yet strong at scale and describes the central tension as balancing 'guts and instincts' against systems and processes. He says the company was investing in technology to simulate the impact of cultural, economic and political events on society —.

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.

for every considerable undertaking has come to be based on knowledge, on thoughtfulness, on the masterful 1 Writing about Wilson in 1945, Professor George McLean Harper, who knew Wilson at Princeton, opined, “some day perhaps a residential college such as he envisioned will be incorporated into the University and named for him.” A fine prediction!

Redesigning the Fund Industry “I have a dream.” Or rather, five dreams for redesigning the mutual fund industry in the years to come. I’ll discuss first, mutual fund pricing, and second, the burgeoning of our retirement plan business, in both cases using the predictions I’ve made in my various talks to NICSA as a springboard. Then I’ll discuss, third, a new design for investment policy, fourth, a new design for “product development,” and fifth, a new design for governance structure, three of my other perennial favorites. Here, then, is the design of my dreams. 1. The Dream of a Fair Shake for Shareholders The first dream is to design a new industry in which we give our investors a fair shake in terms of costs. In my 1977 speech, I boldly predicted that investors would come to focus far more heavily on fund costs, evaluating “total price—or total cost-effectiveness over time, including any initial sales charges and fund operating and advisory expenses.” Alas, by my 1987 talk, I could only grade myself with an “F” on that prediction. Over the decade then ended, the expense ratio of the average equity fund had risen from an average of 0.96 percent to an estimated 1.38 percent, a 44 percent increase in unit terms. This increase came despite the fact that total industry assets had grown from $37 billion to $588 billion, and the dollar amount of annual fund costs had risen 4000 percent, from $232 million to $4.2 billion.

Alas, however, to the limited extent that these strategies have proven to work effectively—and for a relative handful of funds at that (of course, it would be absurd to imagine they could work for all funds as a group)—the very costs incurred by the fund managers were almost always so high as to consume any value added, even by the most cunning of the portfolio manager-foxes. Fund shareholders were left with annual returns that were generally less than 85% of the returns realized in the stock market. The reason for this shortfall is largely fund costs. The all-in costs of the fund foxes now approach 3% per year on average: 1½% from management fees and expenses, often 1% or more from the costs of churning the portfolio, plus another ½%-plus annually for investors who pay sales commissions. Now, let’s think long-term instead of short-term. Let’s be conservative and set the total croupier’s take— the amount gathered by the managers, dealers, and brokers—at 2½ % per year. The positive impact of compound interest that magnifies long-term returns, unfortunately, also magnifies the negative impact of costs, so that an assumed 2½% annual cost consumes 20% of the investor’s capital in a decade. As time goes on, costs consume 45% of capital in a quarter century, and—believe it or not—and almost 70% of your capital in 50 years. The investor, who puts up 100% of the initial capital, receives but 30% of the long-term pre-tax return.

Certainly, no one could have foreseen this incredible growth, nor the fact that mutual funds in the decade then ahead would be, by almost any measure, the fastest growing industry in America. Related to this “miss” was the cursory treatment I gave to technology. While I noted that the revolution in computerized shareholder accounting systems had been essential to our provision of new products and services, and discussed the need for data processing systems to provide both more complete information to shareholders and better information on which to base our marketing decisions, I nonetheless failed to foresee the giant and sophisticated computer systems that would be necessary simply to keep up with the pace of our incredible growth in shareholder accounts—from 9 million when I spoke to you then to 44 million today. And the word “telephone” did not even appear in my talk. In retrospect, of course, communications technology was quietly to become every bit as important to our growth as processing technology. There is little industry data on the growth of mutual fund operations and services, so let me take the liberty of citing Vanguard’s experience. For perspective, these changes came during a ten year period when our shareholder accounts grew by about four and one-half times, from 350,000 to 1,550,000 (about the same pace as the industry). During the 1977-1986 decade:  The number of our Fund share purchase transactions grew from 60,000 to 2,400,000, a 40-fold increase.

marketing toward the needs of businesses and governmental agencies who require a skilled and able partner to provide comprehensive and seamless relocation services for the temporary relocation of employees, worldwide. With several websites, principally www.cort.com, www.relocationcentral.com and www.apartmentsearch.com, profession- als in more than 80 domestic metropolitan markets, affiliates in more than 50 countries, almost twenty thousand apartment communities referring their tenants to CORT, many ancillary services, and its entrée to the business community as a Berkshire Hathaway company, CORT’s rental relocation operations may now be moving in the right direction. In January 2008, CORT expanded its operations to the United Kingdom through the purchase of Roomservice Group, a small regional provider of furniture rental and relo- cation services. CORT’s operations are subject to economic cycles. We are pleased with CORT’s progress in the past few years; however, we believe that it will likely suffer its share of the downturn as we enter a period of economic contraction. CORT is now a stronger company than it was when acquired by Wesco, helped by several “tuck-in” acquisitions, and poised towards long-term growth despite periodic bumps to be encountered along the way. More details with respect to CORT are contained throughout this annual report, to which your careful attention is directed. Precision Steel Warehouse, Inc.

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

Together, this disgraceful conduct represents a sorry chapter in this industry history. But I know of no easy way to regulate or legislate a return to our industry’s traditional values. Competition, in fact, is driving us in quite the opposite direction. As long as our industry participants—our fund managers and marketers, our brokerage firm account executives, and our financial advisers—have more information at hand than their clients possibly could—the economists call this information asymmetry—a largely unaware investment public will be inadequately informed. Regulations calling for more complete disclosure would be a huge help in protecting investors from their own naiveté and lack of information. So I’ll now focus on three major problem areas. By doing so in some depth and detail, I hope to convey not only the nature of the problems, but the change—for the worse—in the industry environment, and the historical context in which they have arisen. I think you’ll be amazed at what you’ll see. The three areas are: 1) The importance of investment income. 2) Fund returns vs. shareholder returns. 3) Measuring shareholder satisfaction. 1. The Importance of Investment Income One of the great unexplained curiosities of the mutual fund industry is its unwillingness to call attention to the vital role of investment income in shaping the returns on equities. Theory tells us, and experience confirms, that dividend yields play a crucial role in shaping stock market returns.

That perception is, to say the least, no longer universally valid. Thus, we have “index funds” which put forth the general proposition that consistently low operating and transaction costs is a valid approach toward above-average results. And, in the 1980’s, this low cost strategy, which assures relative performance that is highly predictable, will spread beyond index funds based on the Standard and Poor’s 500 Stock Index. Indeed, I suspect that a “growth stock index fund” awaits only the development of a growth stock index. If these changes come to pass, of course, they will make life difficult for what has be come known as “closet” index funds—those stock funds which behave much like an index, and emphasize substantially the same stocks, but cannot match its performance because of high portfolio turnover and high operating costs. An even clearer example of the relationship of product line and price can be seen in the income fund segment of the industry. It has now, I think, been proven beyond doubt that money market funds cannot be sold with a sales charge. The same proposition seems to have gained considerable validity in the municipal bond field (though the generally high level of annual operating costs are, in my view, somewhat oppressive to the “bottom line” yield).

In Investment America:  One, the vanishing ownership society. Almost unobserved, direct holdings of stocks by individual investors have plummeted from 92 percent of all stocks in 1950 to only 32 percent today, as corporate control fell into the hands of giant financial institutions—largely pension funds and mutual funds—whose share soared commensurately, from 8 percent to 68 percent, a virtual revolution in ownership. But these agents, beset by conflicts of interest, have failed to place front and center the interests of their principals, passively ignoring the need for good governance and allowing corporate managers to look primarily to their own interests.  Two, the rise of short-termism. Part of this failure came because institutional money management, once an own-a-stock industry (holding an average stock for six years during my first 15 years in this field) became a rent-a-stock industry, now holding a typical stock for but a single year, or even less. While as investors, owners must care, and care deeply, about the rights and responsibilities of corporate governance, and must exercise those rights and honor those responsibilities. But as speculators, renters who merely trade stocks 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.

to know that our host only yesterday may have made more money than your novel ‘Catch-22’ has earned in its entire history?” And Joe said, “I’ve got something he can never have.” And I said, “What on earth could that be, Joe?” And Joe said, “The knowledge that I’ve got enough.” Not bad! Rest in Peace! But it’s not time for any of you to rest in peace, or to rest in any other way. Bright futures lie before you. There’s the world’s work to be done, and there are never enough citizens with determined hearts, courageous character, intelligent minds, and idealistic souls to do it. Yes, our world already has quite enough guns, political platitudes, arrogance, disingenuousness, self- interest, snobbishness, superficiality, war, and the certainty that God is on one side or the other. But it never has enough conscience, nor enough tolerance, idealism, justice, compassion, wisdom, humility, self-sacrifice for the greater good, integrity, courtesy, poetry, laughter, and generosity of substance and spirit. It is these elements that I urge you to carry into your careers, and remember that the great game of life is not about money; it is about doing your best to build the world anew. And that’s enough . . . at least for today.

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

Think too about the increasing dominance of “state” (publishing) over “church” (editorial) in journalism, and the scandals that reached the most respected echelons of the press—The New York Times, The Los Angeles Times, The Washington Post. A similar transition has taken place in the medical profession, where the human concerns of the caregiver and the human needs of the patient have been overwhelmed by the financial interests of commerce, our giant medical care complex of hospitals, insurance companies, drug manufacturers and marketers, and health maintenance organizations (HMOs). In all, professional relationships with clients have been increasingly recast as business relationships with customers. In a world where every user of services is seen as a customer, every provider of services becomes a seller. Put another way, when the provider becomes a hammer, the customer is seen as a nail. Please don’t think me naive. I’m fully aware that every profession has elements of a business. Indeed, if revenues fail to exceed expenses, no organization—even the most noble of faith-based institutions—will long exist.

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.

 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.

And it seems to be creeping into the general bond and income fund arena too, where the most marketable products, in the 1980’s, will probably have a lower or even no sales charge, and will also have to have lower operating expenses, simply in order to do what they are required to do—provide investors with a maximum net yield on purchase price. Turning now to the markets of the 1980’s, those that each individual fund group seeks to penetrate should be an important determinant of its product and pricing strategy. Thus, I believe that today’s outmoded market “shotgun” will be replaced by something more akin to a rifle. In terms of marketing to individuals, strategy may range from a high service-cost, high sales-cost approach to those investors who need to be educated, motivated, and sold, to a low cost appeal to those self-motivated investors who acquire information on their own. We now know that there is an important differentiation between the individual market for no-load funds, on the one hand, and dealer-distributed funds on the other, in some important demographic areas. For example, the buyer of a no-load fund is significantly older, better educated and more apt to have a professional career, and has higher annual income and substantially larger assets than the buyer of a dealer- distributed fund.

In fact, the dividend yield on stocks has accounted for almost one-half of their total long-term return. Of the 9.6 percent nominal total return earned by stocks over the past century, fully 9½ percent has been contributed by investment return—4 ½ percent by dividend yields and 5 percent from earnings growth. (The remaining 0.1 percent resulted from an 80 percent increase in the price-earnings ratio, from 10 at the start of the century to 18 at the end, amortized over the long period. I describe changes in the P-E ratio as speculative return.) When we take inflation into account, the importance of dividend income is magnified even further. (Chart 1) During the past century, the average rate of inflation was 3.3 percent per year reducing the nominal 5 percent earnings growth rate to a real growth rate of just 1.7 percent.2 Thus, the inflation-adjusted return on stocks was not 9.6 percent, but 6.3 percent. In real terms, then, dividend income has accounted for almost 75 percent of the annual investment return on stocks. 2 Some analysts believe that the real earnings rate is even less, about 1 percent per year. “Earnings Growth: The Two Percent Dilution,” William J. Bernstein and Robert D. Arnott, Financial Analysts Journal, September/October 2003.

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

” If it crosses your mind that Franklin’s concepts of service for the greater good of the community and of creativity and innovation designed to improve the quality of life, rather than for personal gain, are rarer than they should be in today’s personal-wealth-driven, often greedy, version of entrepreneurship, you have strong powers of observation. But, however rare, examples do exist. Truth told, the creation of Vanguard (like Franklin’s Contributionship, creating a mutuality of interest between client and manager) reflects the very same values of entrepreneurship and innovation that Franklin held high. The Vanguard Odyssey Now, to the extent that the odyssey of Vanguard is—or at least begins as—my story, let me tell you about it. I do so that you will see that no heroism was involved, that no giant brain drew the design, and that the implementation of our strategy required little in the way of inordinate business skill. Each one of you here tonight, given the opportunities and determination that I have been given, can do the same thing in whatever calling you follow. In our case, simplicity rather than complexity called the tune; the relentless rules of humble arithmetic overwhelmed the need for imponderable statistical proofs; and leaps of faith rather than hard evidence ruled the day. The idea that the shareholder—not the manager—should be king accounts for the lion’s share of our growth.

 The number of our regular redemptions grew from 36,000 to 850,000, or 24 times.  We did not even begin to count our telephone calls until 1979; since then, calls have risen from 160,000 to 3,300,000, 20 times over. Think of the challenge of this change in just ten years! It would have been impossible to handle these kinds of volumes, especially given their astonishing rates of increase, without the computer and communications systems we in the industry and our partners have developed. Indeed, it is remarkable that, with so many fund organizations growing so fast, we appear to have survived this “volume crunch” without a major industry casualty. Under far less provocative conditions during the “paper crunch” of the late 1960s, many major fund groups (including ours) came perilously close to the edge of the abyss, and at least one toppled over it and had to suspend doing business. Fund Accounting Rises to the Challenge Another vital change in industry operations, of course, came in fund accounting services, and this was the second “miss,” simply overlooked in my earlier talk. A decade ago, these services were relatively routine, and the ability to provide precise daily asset valuations taken almost for granted. The number of securities held by most funds was small, and the preponderance was represented by common stocks which traded daily on the New York Stock Exchange.

Innovation in the “Go-Go Era,” circa 1965-1968, saw the proliferation of scores of new “aggressive growth” funds, focusing on stock prices rather than business values; buying “concept” stocks and trading them with rapidity; and often holding “letter stocks” bought from corporate principals at discounted prices, only to immediately mark-up those prices to market value, illicitly inflating fund performance. Of course such an approach was destined to fail. But with the heady returns these funds reported, investors poured billions of dollars into them before it did so. While fund managers prospered, fund investors were ill-served. When the “Go-Go” era, well, “Went-Went,” it was quickly replaced by the “Favorite Fifty” Era, where the idea was to hold established growth stocks which (if one could ignore the certain decay that high growth rates inevitably experience) would provide permanent performance success. But of course by the time that eager fund investors had jumped on that bandwagon, the ride was over. The stock market crashed by 50 percent in 1973-74. While investors were once again impoverished, managers were once again enriched. In the aftermath of the crash, with equity funds in net redemption, the industry came up with still more innovations. They included “Government-Plus Funds,” which provided unrealistically high payouts by claiming that premiums on covered call options were “earnings.

This conflict is pervasive, for, as it is said, money managers have only two types of client they don’t want to offend: actual, and potential. Had I not found agreement with this harsh indictment of the present-day capitalism from some of the most respected names in investing, I might be a little less certain of my ground. But leaders of great repute in the business community and the investment community have stood up and spoken out, making a positive difference. Consider, for example, the eminent financier, economist, and historian Henry Kaufman. In his remarkable 2000 book On Money and Markets, here’s what he said: “Unfettered financial entrepreneurship can become excessive—and damaging as well— leading to serious abuses and the trampling of the basic laws and morals of the financial system. Such abuses weaken a nation’s financial structure and undermine public confidence in the financial community . . . Only by improving the balance between entrepreneurial innovation and more traditional values—prudence, stability, safety, soundness—can we improve the ratio of benefits to costs in our economic system . . .When financial buccaneers and negligent executives step over the line, the damage is inflicted on all market participants . . . and the notion of financial trusteeship too frequently lost in the shuffle.” Dr. Kaufman is not alone. Felix Rohatyn, the widely-respected former managing director of Lazard Freres, is another of the wise men of Wall Street who have spoken out.

simply for not being a fox. That is the American financial system today, and that is how capital formation works in the mutual fund industry. To the extent that another investment approach can avoid, or at least minimize, the inherent pitfalls that are built into the traditional mutual fund system, that approach will hold the winning hand. When Mr. Market Speaks, Funds Listen Where might that approach begin? By investing for the long term. The ultimate example of long-term investing is simply buying and holding the stocks of America’s businesses. Short-term speculation, its polar opposite, is buying shares—pieces of paper if you will—of hundreds of stocks listed on the nation’s stock exchanges, and then feverishly trading them in the market casino. The strategy of America’s most successful investor is the paradigm of long-term investing. Warren Buffett purchases the shares of a few businesses and holds them, ignoring the noise created by a man he calls “Mr. Market,” who comes by and offers him a different price for the businesses in his portfolio each day. The foxy managers of the fund industry however, do precisely the opposite, trading the pieces of paper in their portfolios at turnover rates of 50% to 200% annually. Responding at each moment to the prices set by Mr. Market’s madness, they pay little attention to the value of a corporation. As Columbia Law School Professor Louis Lowenstein has observed: Fund managers “exhibit a persistent emphasis on momentary stock prices.

On supply chain, Biyani is dismissive of the mystique around it. He insists forecasting is the genuinely difficult part — you cannot predict human behavior, but your gut plus data and research gets you close.

It is this unfortunate combination that allows bond funds with substantial sales charges and high expense ratios to dominate a business segment in which investor returns, slashed by those very costs, are doomed to be inadequate.

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.

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.

Of course, I stubbornly held my ground, predicting in my 1987 talk that our pricing structure must change. I challenged the industry “to regain our bearings, and return to the principles that got us to our present eminence in the first place.” Alas, when I next spoke to NICSA in 1998, equity fund expense ratios had continued to rise, if far more slowly, to 1.43 percent. However, with industry assets rising to $3.5 trillion, the dollar costs borne by fund shareholders had soared from $4.2 billion to $27 billion.4 I awarded myself another “F”! Yet I didn’t give up: “Despite my 20 years of unfulfilled expectations, I’m confident that the excessive costs paid by fund investors will at last begin to decline.” Today, a near-decade after that speech, the outcome is unequivocal: “yes,” and “no.” No, because while equity fund expense ratios on average seem to have leveled off, they remain 50 percent higher than 30 years ago, despite the staggering increase in assets under management. With industry assets now at $10 trillion, compared to $37 billion in 1977, fund costs now run at some $75 billion a year, (including sales charges but excluding portfolio transaction costs), more than 30 times the costs of $232 million in 1977. It seems obvious that the staggering economies of scale that come with the management of other people’s money, rather than being shared with shareholders, have been arrogated by managers to their own benefit.

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.

Decision — Shorted Lehman Brothers. Context: Best-documented crisis short: Nov 2007 VIC talk (Lehman exhibit) + May 2008 Sohn deck. Outcome (known): Lehman bankrupt Sep 15, 2008 — the pitch vindicated.

(“Precision Steel”) The businesses of Wesco’s Precision Steel subsidiary, headquartered in the outskirts of Chicago at Franklin Park, Illinois, operated at after-tax profits of $0.9 million in 2007 and $1.2 million in 2006. These figures reflect after-tax LIFO inventory accounting adjustments decreasing after-tax income by $1.0 million for 2007 and $0.6 million for 2006. Precision Steel’s operating results for 2006 also reflect expenses, net of insurance recoveries, of $0.3 million, after taxes, in connection with environmental cleanup of an industrial park where a Precision Steel subsidiary has operated alongside approximately 15 other man- ufacturers for many years. Had it not been for the LIFO accounting adjustments, or the environmental matter discussed in Note 9 to the accompanying consolidated financial statements, Precision Steel would have reported after-tax operating income of $1.9 million for 2007 and $2.1 million for 2006. Precision Steel’s business has been subject to economic cycles. Although the fiercely competitive, chaotic pressures which affected its steel service center business several years ago have abated, Precision Steel is continuing to suffer the ongoing effects of a long-term reduction in demand caused by customers’ (or former customers’) unsuccessful compe- tition with manufacturers outside the United States. Precision Steel’s revenues decreased 2.7% in 2007, following an increase of 2.

The subtleties and nuances of a particular business escape them.” To make matters worse, the feverish trading of stocks by fund managers—it is short-term speculation—for their fund shareholders has now spread to the shareholders themselves. Perhaps following the example set by their managers, fund investors now turn over their own fund shares at feverish rates, switching their funds to pick the next winner, or to time the market—fruitless pursuits, both—every three years. (In the 1950s and 1960s, the average holding period for a fund investor was twelve years.) The astonishing brevity of this period gives the lie to the industry’s marquee motto: “For the long-term investor.” Fund investors—the clients now acting as foxes—trade their funds just as if they were stocks, most feverishly in the marketplaces whose advertisements helped bring you the Super Bowl. These fund supermarkets constitute yet another series of casinos, with yet another set of croupiers to reduce the returns of the gamblers. Lord Keynes had it right: “When the capital development of a country becomes the by-product of a casino, the job is likely to be ill-done.Hedgehog

8% in 2006, approximately half of which was due to an extraordinary order of shimstock and other industrial supplies from a customer of its Precision Brand Products subsidiary. In 2007, Precision Steel’s service center volume was 39 million pounds, down from 46 million pounds in 2006 and 69 million pounds sold as recently as 1999. This decline in physical volume is a serious reverse, not likely to disappear in some “bounce back” effect. Nor do we expect that ongoing price increases like the approximately 66% rise that has occurred since 1999, holding dollar volume roughly level despite a precipitous drop in physical volume, will continue.of

” Grossly over-sold to investors and based on a strategy that could not consistently succeed, these funds raised $30 billion from investors—at one point nearly 10 percent of industry long-term assets—and then quickly collapsed. Within a few years, they had literally vanished from the scene, never to be seen again. Again, investors paid a heavy price. During the next few years, we dreamed up short-term Global Income Funds and Adjustable-Rate Mortgage Funds. (Shades of the recent crisis!) While these funds were hardly identical, they had several common characteristics: they offered income that could not be—and was not—sustained; they jumped on current fads in the marketplace; and they charged premium fees, as well as heavy sales loads. Together they attracted nearly $50 billion of assets, generated huge fees to managers and distributors, and ultimately failed investors. They too soon vanished.Bubble

“I am an American and a capitalist and believe that market capitalism is the best economic system ever invented. But it must be fair, it must be regulated, and it must be ethical. The last few years have shown that excesses can come about when finance capitalism and modern technology are abused in the service of naked greed. Only capitalists can kill capitalism, but our system cannot stand much more abuse of the type we have witnessed recently, nor can it stand much more of the financial and social polarization we are seeing today.” The fact is that, in some important respects, the Invisible Hand of capitalism has failed us. Here are the familiar sentences that Adam Smith wrote in The Wealth of Nations. “It is not from the benevolence of the butcher, the baker, or the brewer that we expect our dinner, but from their regard to their own self-interest. By directing (our own) industry in such a manner as its produce may be of the greatest value, (we) intend only our own gain, and (we are) led by an invisible hand to promote an end which was no part of (our) intention.” Writing in Daedalus in the summer of 2004, Nobel Laureate (in Economics) Joseph E. Stiglitz puts the Invisible Hand into proper perspective. Under the assumptions of “perfect competition, perfect markets, and perfect information . . . selfishness is elevated to a moral virtue.” But these assumptions have proven to be false. The fact is that neither corporations, nor markets, nor information are perfect.

The most assured, direct route to low cost is a corporate structure that is truly mutual: The fund shareholders own the management company that administers the funds and operates on an “at-cost” basis, with each fund paying its share of corporate expenses. Expenses must be held to the bare minimum, the marketing budget modest, and the cost controls stringent—an approach that, to use a brutal but accurate word, is “cheap.” Any large fund complex could easily operate in this mutual hedgehog mode, but of course only one does. Vanguard is, well, unique. The net result is savings for our shareholders that currently exceed $4 billion per year, a huge enhancement in return that in itself adds up to an extra percentage point or more, which often means the difference between “average” and “superior” long-term return relative to peer funds. At the same time, the clients of the hedgehog firm must also be provided with an excellent level of service, distinguished not only by efficiency and automation, but by how they are treated. The hedgehog’s secret—and it is hardly very complex—is what I have said to our crew 1,000 times over: “Let’s treat our clients as human beings—honest-to-God, down-to-earth human beings with their own hopes, fears, and financial goals.” Simply put, that means serving our clients in the same manner as we would like to be served by the honest stewards of our own assets. Wouldn’t anyone want that? Wouldn’t you?

Nonetheless, there has recently been a hint of “yes” in the air. If industry participants refuse to compete on price, there is an abundance of evidence that industry clients—i.e., our shareholders—are increasingly investing where they are offered a fair shake on cost and value. Just consider the five firms that dominated our industry’s cash flow last year. Together, American Funds, Vanguard, Barclays, Dodge and Cox, and DFA drew net investor capital of nearly $200 billion, fully two-thirds of the $300 billion flow into all long-term mutual funds. Three of these firms are giant complexes known both for their ultra-low costs and their index funds, and the other two have costs that are, if not rock-bottom, significantly below industry norms. Progress at last! As investors increasingly choose lower-cost firms, I’m confident that higher-cost firms will be driven by investors to conform, no matter how powerful the negative impact on their huge profit margins 4 The dollar costs are based on asset-weighted expense ratios of all mutual funds, including bond and money market funds: 1977, 0.62 percent; 1987, 0.72 percent; 1997, 0.78 percent; 2006, 0.69 percent.

That does not make one type of fund “better” or “worse” than the other, but it does suggest some interesting strategy implications—especially since every one of those five demographic trends will continue through the 1980’s.some

The Wharton profile notes Biyani built Future Group from a single-product family trading background into a billion-dollar enterprise spanning department stores, hypermarkets, supermarkets and an upscale mall format. The 'enigma' label is applied deliberately —.

Of course both represent a peculiar mix of business and profession, but they have moved a long way from the traditional values of capitalism. The origins of modern capitalism, beginning with the Industrial Revolution in Great Britain back in the late 18th century, had to do, yes, with entrepreneurship and risk-taking, with raising capital, with vigorous competition, with free markets, and with the returns on capital going to those who put up the capital. Central to these values of early capitalism was the fundamental principle of trusting and being trusted. That is not to say that the long history of capitalism has not been punctuated by serious failings. Some were moral failings, such as the disgraceful treatment of laborers, often mere children, in the factories of an earlier era. Other failings included breaking the rules of fair and open competition, exemplified by the oil trusts and robber barons of yore. By the latter part of the 20 th century, yet another failure fell upon us: the erosion of the very structure of capitalism. Not only had “trusting and being trusted” come to play a diminishing role, but the owners of our businesses were relegated to a secondary role in the functioning of the system.4 3 Roger Lowenstein, “The Purist,” New York Times Magazine, December 28, 2003, page 44. 4 Thanks to the comments of a discerning member of my Princeton audience, I added several of these criticisms to my text after delivering the speech.

” So, thank you President Wilson, for making the departmental thesis a requirement for the bachelor’s degree! It seems problematical that my thesis, as some have generously alleged, laid out the design for what Vanguard would become. But, true or not, many of the practices I specified then would, nearly 50 years later, prove to lie at the very core of the success reflected in the growth of our fund assets from $1 billion in 1974 to $500 billion in 1999. “The principal function of mutual funds is the management of their investment portfolios. Everything else is incidental . . . Future industry growth can be maximized by a reduction of sales loads and management fees . . . Mutual funds can make no claim to superiority over the market averages.” And, with a final rhetorical flourish, funds should operate “in the most efficient, honest, and economical way possible.” Were these words an early design for a sound enterprise? Or merely callow, even sophomoric, idealism? I’ll leave it to you to decide. But whatever the case, it works! 2 In Wilson’s day, of course, “men” was synonymous with “humankind.” We must not forget, however, that it was in his administration that the 19 th amendment (women’s suffrage) was added to the Constitution.

(It has been said of me, not kindly, that all I had going for me was “the uncanny ability to recognize the obvious.”) The story begins with the first of the almost infinite number of breaks I’ve been given during my long life. It came at Blair Academy, where, thanks to a generous scholarship and a demanding job (first as a waiter, then as the captain of the waiters), I received a splendid college preparatory education. That priceless advantage, in turn, presented me with another break. With the help of another full scholarship and a job waiting on tables in Commons (I must have been good at it!) I entered Princeton University in the late summer of 1947. (It was easier to get admitted then! Just ask Dr. McGucken what it was like 40 years later!) Despite my hard-won academic success at Blair, I found the early going at Princeton tough. The low point came in the autumn of 1948, when I struggled with my first exposure to the field of economics. It was not a happy introduction to my major field of study, and my low grades almost cost me my scholarship—and hence my Princeton career, for I had not a sou of outside financial support. But I pressed on as best I could, and my grades gradually improved. The crisis passed.

normal ranges. For example, the Standard & Poor’s 500 Stock Index has risen from a level of 17 in 1950 to 1,540 at present. But deduct the returns achieved on the 40 days in which it had its highest percentage gains—only 40 out of 14,528 days!—and it would drop by some 70 percent, to 276. Or eliminate the 40 worst days; then, the S&P would be sitting at 11,235, more than seven times today’s level. A good lesson, then, about “staying the course” rather than jumping in and jumping out. Financial markets, then, are volatile and unpredictable. Importantly, the markets themselves are far more volatile than the underlying businesses that they represent, which collectively account for their aggregate market capitalization. Put another way, investors are more volatile than investments. Economic reality governs the returns earned by our businesses, and Black Swans are unlikely. But emotions and perceptions—the swings of hope, greed, and fear among the participants in our financial system—govern the returns earned in our markets. Emotional factors magnify or minimize this central core of economic reality, and Black Swans can appear at any time. The Wisdom of John Maynard Keynes More than 80 years ago, the great British economist John Maynard Keynes recognized this critical distinction between economics and emotions.

*Impact of change in price-earnings ratio Sources of Long-Term Stock Market Returns— Dividend Yields and Earnings Growth, 1900 - 2006 1. 4.5% 4.5% 5.0% 1.7% 0.1% 0.1% 0% 2% 4% 6% 8% 10% 12% Nominal Real Speculative Return* Earnings Growth Dividends Total: 9.6% Total: 6.3% Investment Return $1,225,321 $33,094,516 $1,000 $10,000 $100,000 $1,000,000 $10,000,000 $100,000,000 1929 1933 1937 1941 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 The Importance of Dividends Value of Initial Investment of $10,000 in S&P 500, 1926 - 2007 With Reinvested Dividends Price Only 2. But while dividend income has accounted for nearly 50 percent of the long-term nominal annual return on stocks and 75 percent of the real annual return, even these figures dramatically understate the cumulative role played by dividends. Consider this: An investment of $10,000 in the S&P 500 Index3 at its 1926 inception, (Chart 2) with all dividends reinvested, would by the end of September 2007, have grown to $33,100,000 (10.4 percent compounded). If dividends had not been reinvested, the value of that investment would have been $1,200,000 (6.1 percent compounded)—an amazing gap of $32 million. Over the past 81 years, then, reinvested dividend income accounted for approximately 95 percent of the compound long-term return earned by the companies in the S&P 500. These stunning figures would seem to demand that mutual funds highlight the importance of dividend income.

Dissecting the Impact of Costs With that background, let’s now take a careful look at the impact of costs on returns; using three charts (“scatter diagrams”) that largely update those that I presented to FIASI in 1998. They differ only slightly from one another in the message that they uniformly present: Beating the bond market is a loser’s game, largely because of the high costs—heavy sales charges and large expense ratios, and, to some degree, excessive transaction costs—incurred by the vast majority of bond mutual funds. The corollary of this message is equally obvious and equally important: The more the managers take, the less the investors make. There are too many types of bond funds to try your patience by examining all of them. So let’s examine the three basic maturity levels (intermediate-term, long-term, and short-term) that have become the industry standard, one in each of the three major bond segments—taxable corporate bonds, tax-exempt municipal bonds, and U.S. Government issues. We’ll start with taxable intermediate-term bond funds; then turn to tax-exempt long-term bond funds; and finally evaluate funds investing in short-term U.S. Treasury notes. Intermediate-Term Corporate Bonds Among intermediate-term taxable corporate bond funds, the Lehman 5–10 Year Credit Bond Index (the red star) set a demanding hurdle rate. (A finding that indexing wins should not surprise you!)

When I entered this field all those years ago, virtually 100 percent of mutual fund management companies were privately-held firms, relatively small, and managed by investment professionals. Since then, they have experienced their own pathological mutation. Today, 41 of the 50 largest fund management companies are publicly-held, including 35 that are owned by giant U.S. and global financial conglomerates, largely managed by businessmen bereft of professional investment training. It shouldn’t surprise you to learn that these conglomerates are in the fund business to earn a return on their capital, not a return on your (the fund investor’s) capital. They cannot do justice to both, for the record is clear that the more the managers take, the less the investors make. Alas, in the fund industry in the aggregate, you not only don’t get what you pay for, you get precisely what you don’t pay for.

Absent industry data, let me illustrate with Vanguard’s experience: our then Twelve Funds held some 1,250 securities. About 1,050 were stocks, priced over Quotron each day; we relied largely on broker price quotations for the remaining 200 issues, mostly bonds. Today, dare I say, things are different. The 65 funds we now administer own the astonishing total of 16,000 securities positions—more than a twelve-fold increase. And the diversity is equally striking— 11,000 U.S. equities, 1,400 foreign equities, 700 corporate bonds, 1,200 municipal bonds, 1,400 U.S. Treasuries and Agencies, and 500 money market instruments!each

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

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

(Chart 3A) Its 10-year return (reduced by 20 basis points to account for estimated expenses) was 6.72 percent, just a hair higher than the 6.65 percent return of the comparable Vanguard Intermediate-Term Bond Index Fund, oddly enough, the only index fund of its kind in the field with a ten-year history. Vanguard Total Bond Market Index Fund—with more than 70 percent of assets in Treasury and government mortgage-backed bonds and about 30 percent corporate bonds—albeit provided a net return averaging 6.1 percent.

In this era of complexity, the hedgehog calls for simplicity. In this era of impersonality, for the human touch. In this era of deception and image, for candor and substance. In this era of hyper returns, for emphasis on risk. In this era of process, for judgment. Finally, in this era of focus on what is called, charitably, modern marketing, the hedgehog calls for focus on prudent management. The hedgehog’s mission of service requires good communications, advanced technology, and financial controls, for all are conditions necessary to achieving success. But important as they are, they are not conditions sufficient for truly superior investor service. The one great thing the business strategy of the hedgehog recognizes is the primacy of the individual human being. Looking to the New Millennium Beginning with our creation of the first index mutual fund nearly a quarter-century ago, I’ve been expressing these contrarian views with increasing bluntness and fervor.style

But in this era of “total return,” income is virtually ignored. Why? Because dividend income plays a remarkably small role in equity fund returns. Today, in fact, the average domestic stock 3 The Standard & Poor’s 500 Stock Index came into being just 50 years ago, in 1957. For the earlier years, I have linked the returns of the S&P 90 Stock Index.

More recently, in the later 1990s (you must be getting the picture by now), innovation in the mutual fund sector was designed to capitalize on the innovation of the so-called “New Economy” of the Information Age. We created literally hundreds of technology funds, telecommunication funds, internet funds, and, once again, “aggressive growth” funds whose holdings were dominated by stocks in those sectors. Aided by a soaring market, aggressive advertising and promotion, and, yes, investor greed, nearly a half-trillion dollars poured into these funds during the three-year-bubble surrounding the market’s peak in March 2000. And then came the great bear market, another 50 percent decline in which the NASDAQ (“New Economy”) Index dropped nearly 80 percent, and the NYSE (“Old Economy”) Index fell by 33 percent. We actually can measure how costly this short-lived bubble was for fund investors. Let’s compare the returns reported by the funds themselves (“time-weighted” returns) to the returns actually earned by fund investors (“dollar-weighted” returns) during the ten years ended December 31, 2005. The 200 funds that enjoyed the largest cash inflows (about two-thirds of the equity fund total—clearly the better performers in the bull market—reported an annual rate of return of 8.8 percent—slightly below the 9.2 percent return on the S&P 500. But the return actually earned by the investors in these funds was 2.4 percent, a lag of 6.4 full percentage points per year below the 8.

Successful long-term investors like Warren Buffett are almost impossible to identify in advance, so we’ll have to look to an unconventional adversary to take on the foxes and better serve the interest of fund investors. The hedgehog I have in mind, as you might imagine, is Vanguard, a firm that has tried to fill this near-vacuum since our founding in 1974. And the one great thing this hedgehog knows is an utterly simple, self-evident, overarching mathematical truth: The returns of all investors must equal the returns of the stock market as a whole. A return of 10% per year in the market clearly can’t be parlayed into a return of an 11% for the average investor. Equally obvious conclusion: Investor returns, less the costs of investing, must fall short of market returns by the amount of investment expenses. That early insight, such as it may be, reminded me of an idea that, believe it or not, also appeared in that Princeton thesis of a quarter-century earlier. Studying the record, I had concluded that “mutual funds can make no claim to superiority to the market averages.” My readings in the academic journals around the time Vanguard was formed gave powerful theoretical reinforcement to that conclusion, and my careful study of mutual fund returns in the 1945-1975 period added powerful pragmatic evidence that confirmed the inability of fund managers to add value to their investors’ assets.

(which I calculate as from 40 to 50 percent). So in my first grand design for the future, I’ll stick with my dream that the march toward a fair shake for fund investors is inexorable, and that investor costs must— and will—come down in the years ahead. 2. The Dream of Serving Investors for a Lifetime My second dream is that we design an industry that will serve investors for a lifetime. Retirement planning, of course, is central to this dream, and I’ve talked about it in each of my earlier NICSA addresses. In 1977, this was a business that ran money for investors who already had money. But I confidently predicted we would become the preferred vehicle for their retirement planning. Then, retirement plans held only about 7 percent of fund shares, but I was confident that they “would become extremely important to our industry’s future growth.” But when 1987 rolled around, alas, I looked kind of stupid (again!) Ownership of fund shares by retirement plans had actually fallen to 4 percent of assets! So I graded my earlier prediction with a “D.” (It probably deserved an “F.”) But I held my ground, noting that “the recent trend from traditional defined benefit pension plans toward defined contribution plans such as 401(k) savings plans will open vast new markets for mutual funds.” By the time I addressed you in 1998, once again, “the jury was in.

Observing the predilection of investors to implicitly assume that the future will resemble the past, Keynes warned: “It is dangerous to apply to the future inductive arguments based on past experience unless we can distinguish the broad reasons for what it (the past) was.” A decade later, in 1935, in his amazing The General Theory of Employment, Interest, and Money, Keynes focused on the two broad reasons that explain the returns on stocks. The first was what he called enterprise—“forecasting the prospective yield of an asset over its entire life.” The second was speculation—“forecasting the psychology of the market.” Together, these two factors explain “The State of Long-Term Expectation” for an investment, the title of Chapter 12 of The General Theory. From his vantage point in London, Keynes observed that, “in one of the greatest investment markets in the world, namely, New York, the influence of speculation is enormous . . . It is rare for an American to ‘invest for income,’ and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that he is attaching his hopes to a favorable change in the conventional basis of valuation, i.e., that he is a speculator.” Today, 70 years after Keynes wrote those words, the same situation prevails, only far more strongly.

day from multiple sources, and in sum are turned into 65 precisely calculated closing net asset values by 5:30 p.m. each business day, the Lord willing. Further, obtaining closing price quotations and recording interest and dividends each day are by no means the whole story of mutual fund accounting in 1987. The complexities are vast and far-reaching, including not only closing prices, but bid/ask spreads, currency adjustments, pricing bonds from an interest rate matrix, amortizing some premiums and all discounts, accounting for GNMA prepayments, and a whole host of other nuances. It is an incredibly complex task demanding extraordinary precision. It is indeed, the apotheosis of “the challenge of change.” I have dwelt on these operational and accounting issues today in part because I failed to do so a decade ago, but in equal part to take the opportunity to salute you here today who provide the investment company services that are essential to our very existence. Too often your work is taken for granted by we who all are too accustomed to the “big picture,” as seen, of course, from the “ivory tower.” So, on behalf of the chief executives of the companies in this industry, I thank you and I salute you. “Products” for Investors, Savers, and Speculators Although my ramble from the past to the present clearly illustrates why prophets are indeed without honor, I would nonetheless now like to look ahead with you, and prophesy a bit more.

As I see it, there were two major forces behind 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. Since 1950, direct ownership of U.S. stocks by individual investors has plummeted from 92 percent to 32 percent, while indirect ownership by institutional investors has soared from 8 percent to 68 percent. Our old ownership society is now gone, and it is not going to return. In its place we have a new “agency society” in which our financial intermediaries now hold effective control of American business. But these new agents haven’t behaved as agents should. Our corporations, pension managers, and mutual fund managers have too often put their own financial interests ahead of the interests of the principals whom they are duty-bound to represent, those 100 million families who are the owners of our mutual funds and the beneficiaries of our pension plans. As Adam Smith wisely put it 200-plus years ago, “managers of other people’s money (rarely) watch over it with the same anxious vigilance with which . . . they watch over their own . . . they very easily give themselves a dispensation. Negligence and profusion must always prevail.” And so negligence and profusion among our corporate directors and money managers have prevailed in present-day America.

Far from it! As Stiglitz’s fellow Nobel Laureate Paul Samuelson observed in the first edition of his classic Economics: An Introductory Analysis—a textbook that I read at Princeton in my sophomore year—the problem with “perfect competition is what George Bernard Shaw once said of Christianity: ‘the only trouble with it is that it’s never been tried.’” Nonetheless, Stiglitz continues, “societies in which there are high levels of trust, loyalty, and honesty actually perform better than those in which these virtues are absent. Economists are just now beginning to discover how non-economic values actually enhance economic performance.” So what’s to be done? While the quest to restore those non-economic but transcendently vital values of trust, loyalty and honesty is hardly for the faint of heart, it’s easy to conceptualize the path we need to follow. If each individual investor out there—not only that minority who hold their stocks directly, but those millions who hold their stocks through mutual funds—would only look after their own economic self-interest, then great progress would be made in restoring the vanishing values of capitalism. Here, I think, Adam Smith’s Invisible Hand would in fact be helpful. For if intelligent investors would only move away from the costly folly of short-term speculation to the priceless (and price-less!)

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.

$0.9 million for 2003, we do not consider present operating results to be a satisfactory investment outcome. Recent earnings of Precision Steel compare unfavorably with oper- ating earnings which averaged $2.3 million, after taxes, for the years 1998 through 2000. Because the steel warehouse business may revert to even more difficult conditions, more decline for Precision Steel may lie ahead. Terry Piper, who became Precision Steel’s President and Chief Executive Officer in 1999, has done an outstanding job in leading Precision Steel through very difficult years. But he has no magic wand with which to compensate for competitive losses among his best customers. Tag Ends from Savings and Loan Days All that now remains outside Wes-FIC but within Wesco as a consequence of Wesco’s former involvement with Mutual Savings, Wesco’s long-held savings and loan subsidiary, is a small real estate subsidiary, MS Property Company, that holds tag ends of appreciated real estate assets consisting mainly of the nine-story commercial office building in downtown Pasadena, where Wesco is headquartered. Adjacent to that building is a parcel of land on which our construction of a multi-story luxury condominium building is nearing com- pletion. We are also seeking city approval of our plans to build another multi-story luxury condominium building, at a later date, on a vacant parcel of land in the next block.

considerable assurance—that America itself will continue to have a population that is growing in age, education, professional status, real income, and asset accumulation—the same five areas in which no-load funds have found their greatest relative strength. I wish I had more time today to deal with the institutional markets of the 1980’s, and their relationship to pricing and product strategy. Let me simply state my conclusion that these markets—pension, endowment, corporate, foundation—should become extremely important to our industry’s future growth. Why? Because a mutual fund group—especially one with a nominal or no sales charge, and with a low expense ratio—offers extraordinary opportunity to such institutions, from the largest to the smallest, in terms of simplicity, efficiency, liquidity, and flexibility—to say nothing of investment performance. One of the great canards of recent years is that mutual funds are somehow “second class citizens” when it comes to performance results. I would like to take a moment to put that ridiculous apprehension to rest right now, because as we approach the 1980’s the information explosion will mean that institutional investors will be even more informed—if that is possible— about relative performance than they are today. And the simple fact is that mutual funds have a significantly better record than any type of adviser to corporate pension accounts.

consistency is crucial, that high portfolio turnover is counter-productive, and that the soundest strategy is not short-term speculation, but long-term investment. Every month, market share data confirm that fund investors increasingly accept these ideas, even as the foxes in the fund industry seem increasingly antagonized by them. But I have yet to see even one of the foxes take the other side, let alone with a compelling, fact-founded rebuttal. There is no debate. Silence, it seems, is golden. Perhaps so… Yet facts are facts. And given the brute evidence of the past, I’d now like to set some new directions for the future as we move into the 21 st century, directions for the foxes in the mutual fund industry that will serve investors and, in the long run, serve fund managers:  Return to prudent management and fiduciary duty, rather than opportunistic marketing and commerce, as our guiding lights.  Emphasize a client-focused approach to serving human beings, rather than simply gathering assets.  Redirect the mutual fund strategy toward long-term investing—owning business and holding them over the years—and away from short-term speculation—trading pieces of paper held for not much larger than a single year.

” In my shameless repetition of this theme in speech after speech, I’m reminded of Wilson, who, when asked how often he used the same idea in his addresses, replied: “You will have to wait a long time for me to be able to answer that question.” (That is, he expected to continue to use the same ideas over and over again.) How much do costs matter? Hugely! Taking into account sales charges, management fees, operating expenses, and portfolio turnover, the average mutual fund deducts about 2½% per year from investor returns. Assuming—an arbitrary assumption indeed—that the manager is able to match an annual stock market return of, say, 10% before costs, 25% of the investor’s return is consumed by costs in a year, 33% in a decade, and—I’m glad you’re sitting down!—fully 48% of his return is consumed in a quarter century. Nearly one-half of the cumulative return generated by the stock market has been confiscated by the costs incurred by the typical mutual fund. It was largely in the context of minimizing costs that I entitled my Woodrow Wilson lecture “The Hedgehog and the Fox.” The title comes from Archilochus’ ancient dictum, “The fox knows many things. But the hedgehog knows one great thing.

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.

No wonder that David Swensen, the integrity-laden and remarkably successful manager of the Yale endowment fund, characterizes such a shortfall as “the colossal failure of the mutual fund industry.” Where is the Public Discourse? It seems obvious that there is an urgent need to face up to these and other failures in the changing world of capitalism. But despite the contentious nature of the issues I’ve just described—broadly reflecting the triumph of the powerful economic interests of the oligarchs of American business and finance over the interests of our nation’s 100 million investors—it is remarkable that so little public discourse has been in evidence. In the investment community, I have seen no defense of the inadequate returns delivered by mutual funds to investors, nor of the industry’s truly bizarre, counterproductive ownership structure; no attempt by institutions to explain why the rights of ownership that one would think are implicit in holding shares of stock remain largely unexercised; no serious criticism of the virtually unrecognized turn away from the once-conventional and pervasive investment strategies that relied on the wisdom of long-term investing, toward strategies that increasingly rely on the folly of short- term speculation; and, until recent weeks, almost no discussion of the profound problems we are facing in our systems of retirement plan funding.

Affiliated Fund* Assets (million) Mgmt. Fee Rate Other Expenses Expense Ratio Mgmt. Fee Dividend Shares* Fidelity Fund Incorporated Investors* Mass. Inv. Trust Wellington Fund* Average $116 $142 0.41% 0.50 0.50 0.50 0.33 0.40 0.44% 0.31% 0.24 0.16 0.05 -0- 0.20 0.16% 0.72% 0.74 0.66 0.55 0.33 0.60 0.60% $476k 410k 215k 485k 1,200k 616k $566k Management Fee Rates and Amounts, 1950 *Now, respectively, Lord Abbett Affiliated, AllianceBernstein Growth & Income, Putnam Investors, and Vanguard Wellington 3. fund is offering a dividend yield of just 0.4 percent. Where did all the income go? It was slashed by fund expenses. The expense ratio of domestic stock funds averages 1.4 percent, reducing the funds’ gross dividend yield of 1.8 percent to 0.4 percent. Unsurprisingly, then, it appears that the average stock fund earns the stock market’s present dividend yield of 1.8 percent and then consumes fully 80 percent of that yield in fees and expenses. It didn’t need to be that way. When I began my research on this industry in 1950 for my Princeton University thesis, an interesting fact came to my attention. The first mutual fund— Massachusetts Investors Trust, founded in 1924—calculated its expenses, not on the basis of a percentage of assets, but as a percentage of its investment income. During its first 25 years, MIT charged investors the then-standard trustee fee of 5 percent of income.

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).

8 percent return the funds reported. Cumulatively, then, these fund investors experienced but a 27 percent increase in their capital over the decade. Yet, simply by buying and holding the market portfolio through an index fund, they would have produced an increase in capital of 141 percent. Thanks to the innovation and creativity of fund sponsors, then, investors lost an astonishing 114 percentage points of return relative to the market itself. So much for the well-being of investors! As to the well-being of managers, we can roughly estimate that the total fees and sales loads (excluded from our calculations, which therefore understates the gap) paid to fund managers and distributors (including brokers) totaled in the range of $20 billion. So yes, to answer the question posed by the title of these remarks, even as in the banking and derivative sectors of our financial economy, innovation has gone too far in the mutual fund sector. And the Beat Goes On One might have hoped that the fund industry would have learned from its past history of over- reaching innovations. But the evidence goes the other way. In recent years, we’ve created “130/30” funds, in which managers implicitly suggest that over-investing the traditional 100 percent long position in stocks by 30 percentage points, offset by a 30 percent short position, will produce higher returns. Maybe yes, maybe no—only time will tell—but the drag of the higher fees on these funds is a certainty.

0.0 0.5 1.0 1.5 2.0 2.5 Vanguard IT Index Fund: 6.65% Leh 5-10 Credit, less 0.20 bps: 6.72 Vanguard Tot Bond Mkt Inst: 6.20% Vanguard Tot Bond Mkt Inv: 6.07% Vanguard IT Inv Grade: 6.43% Avg IT Corp Fund: 5.52% Slope: -1.09 Number of funds: 313 Intermediate-term Corporate Bond Funds 10-Year Returns versus Expenses 3A. Vanguard IT Inv Grade Fund Average IT Inv Grade Fund Volatility (vs index) 85% 75% Quality (A or above) 98% 81% Turnover (5 yr avg) 55% 213% Expense Ratio 0.21% 0.93% 6.44% 5.52% 10-yr Annual Return $8,670 $7,110 Profit on $10,000 Vanguard IT Bond Index Fund 100% 100% 97% 0.17% 6.65% $9,040 3B. Duration 5.2 4.6 5.9 The adjusted annual return of 6.7 percent for the index was more than 20 percent higher than the 5.5 percent return of its average peer. Since the slope of the cost/return line is -1.09 (meaning that each percentage point reduction in cost increases return by 1.09 percentage points), actively managed bond funds as a group in fact earned a lower gross return than either the index fund or the adjusted index. Clearly, relative cost proved to be the principal differentiator in net return. (Chart 3B) Vanguard Intermediate-Term Investment Grade Bond Fund, for example, has an expense ratio of 0.21 percent, less than a quarter of the 0.93 percent expense ratio of its average peer. Similarly, the slightly-longer-duration Vanguard Intermediate-Term Bond Index Fund carries an

The second reason for the debasement of the values of our capitalistic system is that our new investor/agents not only seemed to ignore the interests of their principals, but also seemed to forget their own investment principles. In the latter part of the twentieth century, the predominant focus of institutional investment strategy turned from the wisdom of long-term investing to the folly of short-term speculation. During the recent era, we entered the age of expectations investing, where projected growth in corporate earnings—especially earnings guidance and its subsequent achievement, by fair means or foul—became the watchword of investors. Never mind that the reported earnings were too often a product of financial engineering that served the short-term interest of corporate managers and Wall Street security analysts alike. But when long-term owners of stocks become short-term renters of stocks, and when the momentary precision of the price of the stock takes precedence over the eternal vagueness of the intrinsic value of the corporation itself, concern about corporate governance is the first casualty. The single most important job of the corporate director is to assure that management is creating value for shareholders; yet our new investors seemed not to care when that goal became secondary. While our institutional agents now hold absolute voting control of corporate America, all we hear from these money managers is the sound of silence.

For more information, if you want a very-high-end condominium, simply phone Bob Sahm (626-585-6700). MS Property Company’s results of operations, immaterial versus Wesco’s present size, are included in the breakdown of earnings on page 1 within “other operating earnings.” Other Operating Earnings (Loss) Other operating earnings (loss), net of interest paid and general corporate expenses, amounted to ($0.1 million) in 2007, versus $0.2 million in 2006. The components of the $0.1 million of other operating loss in 2007 were (1) rents ($3.9 million gross in 2007) prin- cipally from Wesco’s Pasadena office property (leased almost entirely to outsiders, includ- ing Citibank as the ground floor tenant), and (2) interest and dividends from cash equivalents and marketable securities held outside the insurance subsidiaries, less (3) gen- eral corporate expenses plus minor expenses involving tag-end real estate. Consolidated Balance Sheet and Related Discussion Wesco carries its investments at fair value, with unrealized appreciation, after income tax effect, included as a separate component of shareholders’ equity, and related deferred taxes included in income taxes payable, on its consolidated balance sheet. As indicated in the accompanying financial statements, Wesco’s net worth, as accountants compute it under their conventions, increased to $2.53 billion ($356 per Wesco share) at yearend 2007 from $2.40 billion ($337 per Wesco share) at yearend 2006.

” I described my 1987 forecast as “a home run,” for, led by 401(k) plans, retirement plan investments in mutual funds had grown some 30 times over—from $30 billion to $900 billion. I predicted (again, perhaps, it was obvious), that “the institutional uptrend should persist.” And so it did. Today, defined-contribution thrift plans hold more than $1.1 trillion of fund shares, and defined benefit pension plans hold some $500 billion. Adding individual retirement accounts (IRAs) of $1.4 trillion brings our retirement plan assets to more than $3 trillion, more than 40 percent of all long-term mutual fund assets. We’ve come a long, long way since that 4 percent asset share that so embarrassed me 20 years ago. As I hope everyone here today recognizes, our industry’s ability—your ability—to handle the complex record-keeping for the nearly 50 million participants in our multi-faceted defined contribution plus plans has been something of a triumph. But the vast menus of funds we provide and the wide array of investment strategies we offer have come nowhere near that high standard. We have too many investors who are too aggressive—401(k) plan participants working for Fortune 100 companies allocate an average of 36 percent to company stock, not only concentrating their investment risk but aligning it with their career risk.

The Becker Securities survey, for example, shows that the equity securities managed for pension funds by banks had a compound rate of total return over the past decade of 3.7% (net off estimated expenses); by insurance companies, the figure was 3.6%; by private investment counselors, the figure was 3.3%. One the same basis, the average annual return of common stock mutual funds was 5.4%—or something like half again as good! We at Vanguard will be presenting, in the coming months, a much more comprehensive analysis of mutual fund performance vs. the results of other institutional managers. For the summary figures above can only hint at the magnitude and consistency of mutual fund superiority. The common stock mutual funds also, for example, beat each of the other institutional management groups in the 1973-74 bear market, and beat each one again in the 1975-76 bull market. And the balanced mutual funds—how long has it been since anyone mentioned that group—have shown the same degree of superiority (perhaps to an even greater degree) over the total pension fund returns provided by the banks, and the insurance companies, and the private counseling firms. In each case, I should note, the results were achieved with a surprisingly similar balance between stocks and bonds (about a 70/30 ratio).

Vanguard’s very first strategic decision, made in 1975, only months after we began, was obvious: To form the first market index mutual fund—an unmanaged portfolio of the 500 stocks in the Standard & Poor’s 500 Index—in history. Derided for years as “Bogle’s folly,” it took, unimaginably, another full decade until a single competitor had the guts—or wisdom—to follow. In the words of The Wall Street Journal, the Vanguard Index 500 Fund has become, heaven forbid, “the industry darling.” With $80 billion of assets, our pioneering index fund is now the second-largest mutual fund in the world, well on its way to becoming the largest before the new century arrives. The decisions that followed over the years took the same direction. Following that first 500 Index Fund, we formed index funds covering our entire stock market, a wide variety of U.S. stock market sectors, international equity markets, and the bond market. We also developed stringently-managed bond funds that offered investors market-like portfolios with clearly-defined quality and maturity standards, entailing little trading and operating with minimal expenses. What is more, we shaped most of our managed equity funds to parallel particular investment styles, focusing on long-term horizons, relatively low portfolio turnover, and, yes again, minimal costs, achieved by negotiating fees at arm’s length with external advisory firms. This hedgehog strategy remains the rock on which our investment philosophy rests.

Lord Keynes’s confidence that speculation would dominate enterprise was based on the then- dominant ownership of stock by individuals, largely ignorant of business operations or valuations, leading to excessive, even absurd short-term market fluctuations based on events of an ephemeral and insignificant character. Short-term fluctuations in the earnings of existing investments, he argued (correctly), would lead to unreasoning waves of optimistic and pessimistic sentiment. While competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, Keynes added, should correct the vagaries caused by ignorant individuals, the energies and skill of the professional investor would come to be largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. He therefore described the market as “. . . a battle of wits to anticipate the basis of conventional valuation a few months hence rather than the prospective yield of an investment over a long term of years.” In my 1951 Princeton senior thesis on the mutual fund industry, I cited Keynes’ conclusions. And I had the temerity to disagree with the great man, arguing that he was wrong.than

I’ll leave it to you to decide. But whatever was truly in my mind all those years ago, the thesis clearly put forth the proposition that mutual fund shareholders ought to be given a fair shake. I threw myself into the task of writing the thesis with abandon, falling madly in love with my subject. I was convinced that the “tiny” $2 billion industry of yore would become huge . . . and would remain “contentious.” I was right on both counts! It is now a $10 trillion colossus, the nation’s largest financial institution. What’s more, the countless hours that I spent researching and analyzing the industry in my carrel at Firestone was rewarded with a 1+, and led to a magna cum laude diploma—a delightful, if totally unexpected, finale for my academic career at Princeton. “Turnabout is fair play!” Fate smiled on me yet again when Walter L. Morgan, Princeton Class of 1920 and the founder of Wellington Fund, read my thesis. In his own words: “Largely as a result of his thesis, we have added Mr. Bogle to our Wellington organization.” One more stroke of luck! Although I agonized over the risks of going into this young business, my research had persuaded me that the industry’s future would be bright. So I cast my lot with this great man and never looked back. He had given me the opportunity of a lifetime. By 1965, Mr. Morgan had made it clear that I would be his successor. At that time, the Company was lagging its peers, and he told me to “do whatever it takes” to solve our problems.

expense ratio of 0.17, explaining almost all of its return superiority over the actively-managed competition (6.65 percent vs. 5.62 percent). In addition, its return benefits from the absence of sales loads. “All bond funds are not created equal.” And that is true of investment grade intermediate-term corporate bond funds, too. The outliers in the chart have usually departed radically from bond market norms. For example, the top performer with that terrific 8.9 percent return (and blessed with no sales loads and a relatively low 0.55 percent expense ratio), held fully 41 percent in credits rated BBB or less, compared to only 2 percent for the index. Overall, the Vanguard managed fund and the Vanguard index fund not only operated at far lower expenses, but maintained significantly higher quality (almost 100 percent A-rated, vs. 81 percent for the average managed fund). In addition, the Vanguard funds exhibited starkly lower portfolio turnover (55 percent and 97 percent, vs. a stunning 213 percent average). That said, both the Vanguard funds were slightly more volatile, carrying a slightly longer duration than the typical managed bond fund (5.2 and 5.9 years respectively, vs. 4.6 years). And so the message echoes. Among intermediate-term taxable bond funds, in terms of maximizing investor return and minimizing quality risk, low-cost funds are superior performers. And over time that annual advantage matters even more!

Status Quo Versus Reality The survival of this industry, as we know it today, depends on the maintenance of the status quo by the foxes. Financial success for the mutual fund manager is represented far less by earning even a market return on the investor’s capital than by earning a staggering return on the manager’s capital. (If you don’t believe that, merely compare the returns that the managers have earned on their own capital to the returns they have earned on the funds they supervise.) Were this not so, managers would not seek huge asset size for their actively managed funds, which clearly impedes the achievement of superior returns, nor spend billions on marketing shares to new investors, the cost of which is borne by existing shareholders who receive no benefit in return—except perhaps the pleasure of seeing their former portfolio manager perform on television with Don Rickles and Lily Tomlin. It goes without saying that despite the pleas in my thesis, non-management—largely marketing—functions have superseded those of management, and the interest of the managers has superseded the interest of the fund shareholders. The foxes, nonetheless, derogate the hedgehog with criticisms, which, as far as they go, may even be valid. But they go too far. Yes, some manager-foxes inevitably beat the market by a solid margin . . . but they are impossible to identify in advance, and, once they reach the pinnacle of performance, almost never remain there.

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

 If index funds are anathema, at least capitalize on the advantages that have given index funds their edge in providing optimal market-related returns to investors—lower fees and costs, lower turnover, higher-tax efficiency, and fully-invested equity portfolios that don’t time the market.  Consider a mutual investor-owned structure—or something that approaches it—for management companies. Funds that required parental support when they were born have now reached their majority. They should be treated as dependent children no longer. There is no reason funds can not directly offer entrepreneurial incentives to managers—at least within reason.  Take action willingly now. Recognize that time is money for fund investors, and “when you give, give with an open hand.”  Managers that act promptly may avoid a decidedly unpleasant later confrontation by fund directors (who may yet honor their fiduciary duty to shareholders—I can dream can’t I?), by the derivative bar, by the Securities and Exchange Commission, by Congress, or even by their own fund shareholders. Or by all of the above. Perhaps surprisingly, I also have a few directions for the hedgehogs:  If you’re style is out of style—and your conviction unshaken—remember reversion to the mean, and stay the course.  If you’re an indexer, don’t get complacent. While the tide is going your way now, it’s just too good to persist. You remember reversion to the mean, too.

Another innovation is a variety of fixed-payout funds in which specific rates of annual withdrawals are offered, along with a warning that these payouts may, over time, exhaust the investor’s capital. (One can only hope that warning is in large boldface type.) Other innovations have included tax-deferred variable annuities that assure continued payouts (as a percentage of a fluctuating asset value), a perfectly good idea—except that the grossly excessive costs, commissions, surrender charges, etc., that burden most of these “products” have proved to erase much of their alleged advantage. And we also see new equity indexed annuities, usually providing only a portion of the stock market’s return while guaranteeing a minimal annual return in the 1 percent to 3 percent range. Even a rudimentary financial analysis suggests that these modest added values are unjustified by costs (and sales practices) that are anything but modest. Of course the major innovation of the recent era is the exchange-traded fund (ETF). I suppose there’s nothing wrong, as such, with an index fund that can be traded (as the advertisements say) “all day long, in real time.” But I have to wonder why any serious investor would want to do such a crazy thing.on

Speculation is clearly evident in the “market timing” that now exists in our industry, and there is little doubt that many of the “new breed” of investors in mutual funds believe it to be a panacea. A plethora of “newsletters” provide timing signals to our shareholders, and we do little to moderate their trading activity. The exchange privilege, originally designed to make possible sensible long-range financial planning without excessive sales commissions, has become overwhelmingly a means to speculate on stock prices, euphemistically described as “taking advantage of changing market conditions,” and sometimes available 24 hours a day. (Dinosaur-like, I find myself wondering just who it is that feels the compulsion to go from stocks to cash at 3 a.m.!) Clearly, many of today’s shareholders demand this flexibility; they know all too well the value of cost-free transactions. And we can pray that they will blame only themselves if their strategy fails. But if portfolio transaction costs are palmed off by these investors on the remaining fund shareholders, a fund has an obligation to suspend its exchange privilege. This, it is fair to say, will not make our marketing departments happy.or,

Not only because they are more likely to be short-term speculators than long-term investors, but also because they are managing the pension and thrift plans of the corporations whose stocks they hold, and thus face a serious conflict of interest when controversial proxy issues are concerned. This conflict is pervasive, for it is said that money managers have only two types of client they don’t want to offend: actual, and potential. And so in corporate America we have witnessed staggering increases in executive compensation not only unjustified by corporate performance but also grotesquely disproportionate to the pathetically small increase in real (inflation-adjusted) compensation of the average worker; financial engineering that dishonors the idea of financial statement integrity; and the failure of the traditional gatekeepers we rely on to oversee corporate management—our regulators, our legislators, our auditors, our attorneys, our directors. And so developed what I described, way back in 1999, as “the happy conspiracy” between our business sector and our investment sector, mutually reinforcing one another, in which traditional values and long standing virtues were undermined. The web is wide, and includes corporate managers, CEOs and CFOs, directors, auditors, lawyers, Wall Street investment bankers, sell-side analysts, buy-side portfolio managers, and indeed institutional and individual investors as well.on

We also have too many investors who are too conservative—investors who have “stable value” and money market funds as an investment option allocate nearly 24 percent to these funds. Too much! What is more, 401(k) investors are notorious for performance-chasing, and we seem not to care. Traditionally, the most popular funds in our retirement plans have been those with extraordinary past performance—but, alas, returns that are destined to revert to the market mean at best, and more likely below it. Magellan Fund, for example, was by far the most popular choice of retirement plan investors during the 1990s, but has since 1993 failed by a wide margin to achieve the average returns turned in by the unmanaged S&P 500 Index—now a thirteen-year failure, trailing the Index over that period by a cumulative total of 91 percentage points. (Amazing! Yet, Magellan remains the third most popular option.) Today’s favorites, of course, also have provided excellent past performance. (What else is new?)$100

” In my remarks, I contrasted the many financial foxes in the money management field—often brilliant, clever, and wily, vulpine to a fault—who trade stocks constantly in a futile effort to beat the stock market, only to be destined finally to failure, dragged down by the heavy costs of their active investment approach.other

The main causes of the increase were net operating income after deduction of dividends paid to shareholders, and appreciation in fair value of investments. The foregoing $356-per-share book value approximates liquidation value assuming that all Wesco’s non-security assets would liquidate, after taxes, at book value.its

If my book helps to open the door to the introspection by our corporate and financial leaders that is so long overdue, and then corrective action, perhaps the needed changes will be hastened. This process must begin with a return to the original values of capitalism, to that virtuous circle of integrity—“trusting and being trusted”—as I mentioned at the outset. When ethical values go out the window and service to those whom we are duty-bound to serve is superseded by service to self, the whole idea of the capitalism that has been a moving force in the creation of our society’s abundance is soured. In the era that lies ahead, the trusted businessman, the prudent fiduciary, and the honest steward must again be the paradigms of our great American enterprises. It won’t be easy, but if we all work long enough and hard enough at the task, we can build, out of a long-gone ownership society and a failed agency society a “fiduciary society,” one in which the citizen-investors of America will at last receive the fair shake they have always deserved from our corporations, our investment system, and our mutual fund industry. Fixing the system is not a task for the faint of heart, for it will not be easy.recommend

Young and headstrong, with self-confidence that belied my lack of wisdom and experience (I was then but 35 years of age), I put together a merger with a high flying group of four “whiz kids” who had achieved an extraordinary record of investment performance over the preceding six years. (Such an approach— believing that past fund performance has the power to predict future performance—is, of course, antithetical to everything I believe today. It was a great—but expensive—lesson!) Together, we five whiz kids whizzed high for a few years. And then, of course, we whizzed low. The speculative fever in the stock market during the “Go-Go Era” of the mid-1960s “went-went.” Just like the “new economy” bubble of the late 1990s, it burst, and was followed by a 50% market decline in 1973-1974. The once happy band of partners had a falling out, and in January 1974 I was deposed as the head of what I had considered my company. I was heartbroken. What’s in a Name?

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

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

Throughout that quarter-century, MIT was the nation’s largest mutual fund, and its growth was substantial. By 1950, its assets had grown to $362 million. The dividend income on its investments grew commensurately, and the 5 percent charge against income was soon producing far too much money for the fund’s trustees to accept. (Imagine that!) So they promptly reduced the annual fee to 2.9 percent of income.4 Since dividend yields were then relatively high (MIT’s stocks were yielding about 5½ percent), the net dividend yield received by MIT’s shareholders was 5.3 percent. (For the record, measured against fund assets, MIT’s expense ratio was 0.33 percent.) For reasons lost in history, few of the mutual funds organized in the years after MIT began followed the pioneer’s precedent. Instead they chose to set their management fees as a percentage of net assets rather than as a percentage of investment income. The typical annual charge was set at ½ percent of assets, typically scaled down to 3/8 of 1 percent on fund assets in excess of $100 million. 5 Modest fee structures, then, for an industry then managing modest amounts of assets. A 1950 snapshot of that tiny mutual fund industry (Chart 3) shows both management fees and total expenses at a reasonably low level, along with a recognition by fund managers that, as their funds grew large (then, “large” meant more than $100 million in assets!)

(Reversion to the mean is alive and well in the mutual fund industry!) Yes, the large-cap Standard and Poor’s 500 Stock Index not only seems high—at an astonishing 29 times earnings it is high—but also seems significantly overvalued relative to the small- and mid-cap stocks that represent the remaining 25% of the market’s $13.5 trillion value . . . but the fundamental theory of indexing is grounded in owning the entire stock market, and that option is available in at least a few index funds. What is more, some 75% of the $2.8 trillion of equity mutual fund assets is invested in those same 500 S&P stocks. So, for the “500” index funds and the industry as a whole, the exposure to market risk is not significantly different. Yes, interim variations in the gap between industry and index returns will surely expand and contract in the future . . . but in the long run the mutual fund industry will have to recognize the inevitability of the failure of its existing investment modus operandi to earn returns that are sufficient to overcome its costs, and add economic value for fund shareholders.Speculation

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

, fund investors were entitled to share in the substantial economies of scale that accompany asset growth (i.e., that it cost little more to manage $200 million in assets than it did to manage $100 million). 4 They did this by capping the number of shares on which the fee would be levied at 6 million. 5 One partial exception was the George Putnam Fund, with a fee of 4 percent of income plus 0.4 percent of assets, both scaled down on assets above $25 million.

With a cumulative final value of an initial investment of $10,000 over the past decade growing by $9,040 in the Vanguard Index Fund, more than 25 percent higher than the $7,110 earned for its average actively managed rival, the index strategy proved to be a winning strategy, outpacing an amazing 297 of its 313 peers over the past decade. Importantly, among the 50 top-performing corporate bond funds in that universe, only a single one is a load fund, whereas among the bottom 50, only 4 are no-load funds. Long-Term Municipal Bond Funds Now let’s consider long-term maturities, with a focus on tax-exempt municipal bond funds. Because of complexities in the construction of municipal bond indexes, there are no pure index funds in this category. But the results of the major index in the field (the Lehman Brothers Tax-Exempt 10-Year Municipal Index) confirm the power of indexing in surpassing the returns provided by the average active bond manager.gross

if we do, take the responsibility of making the investor aware of the hazards involved and administer it with discipline. But perhaps the best example of our industry’s outreach to speculators rather than investors and savers lies in the offering of highly aggressive, often narrowly focused equity funds. This is not the first era of such tactics in mutual fund marketing. During the stock market boom of the mid-1940s, a remarkable 60 percent of industry net cash flow from investors was directed into “specialty funds,” largely those investing in a single industry. Indeed there were then 75 such funds, compared with but 55 diversified equity and balanced funds. They were among the giants of this industry, but few of you here today will remember such names as Group Securities, New York Stocks, and Managed Funds, for their existence was evanescent. In the final analysis, such specialty funds, I fear, are subject to the ultimate criticism: they will not work. The investor churns violently back and forth from one fund to another, often turning over his assets what appears to be at a 500 percent annual rate (an astonishing 25 times the normal 20 percent rate for the industry today). Gradually, he is all too likely to erode his capital to the point where he is no longer part of a desirable, as it were, “target market.

deferred income taxes of $322 million, subtracted in determining its net worth. This interest-free “loan” from the government is at this moment working for Wesco shareholders and amounted to about $45 per Wesco share at yearend 2007. However, some day, parts of the interest-free “loan” may be removed as securities are sold. Therefore, Wesco’s shareholders have no perpetual advantage creating value for them of $45 per Wesco share. Instead, the present value of Wesco’s shareholders’ advantage must logically be much lower than $45 per Wesco share. Business and human quality in place at Wesco continues to be not nearly as good, all factors considered, as that in place at Berkshire Hathaway. Wesco is not an equally-good- but-smaller version of Berkshire Hathaway, better because its small size makes growth easier. Instead, each dollar of book value at Wesco continues plainly to provide much less intrinsic value than a similar dollar of book value at Berkshire Hathaway. Moreover, the quality disparity in book value’s intrinsic merits has, in recent years, continued to widen in favor of Berkshire Hathaway. All that said, we make no attempt to appraise relative attractiveness for investment of Wesco versus Berkshire Hathaway stock at present stock-market quotations. Last year we reported that Wesco had held more than $1 billion of cash equivalents and fixed-maturity investments since early in 2003.

Putting Numbers on Keynes’s Distinction By the late 1980s, based my own first-hand experience and my research on the financial markets, I concluded that the two essential sources of equity returns were: (1) economics, and (2) emotions. What Keynes had described as enterprise I called “economics.” What Keynes termed “speculation,” I found well-defined by “emotions.” The former I defined as investment return— the initial dividend yield on stocks plus the subsequent annual rate of earnings growth. The latter I defined as speculative return—the change in the price investors are willing to pay for each dollar of earnings. (Essentially, the return that is generated by changes in the valuation or discount rate that investors place on future corporate earnings.) Simply adding speculative return to investment return produces the total return generated by the stock market. For example, if stocks begin a decade with a dividend yield of 4 percent and experience subsequent earnings growth of 5 percent, the investment return would be 9 percent.5 If the price-earnings ratio rises from fifteen times to twenty times, that 33 percent increase, spread over a decade, would translate into an additional speculative return of about 3 percent annually. Simply adding the two returns together, the total return on stocks would come to 12 percent. It’s not very complicated! This remarkably simple numeric approach of separating enterprise and speculation—i.e.

narrow market sectors and individual foreign countries. (There are also some ETFs that claim to beat the market; I’ll leave to wiser heads to wonder about the validity of such claims, and how on earth they can call themselves index funds.) As mutual fund managers have become primarily mutual fund marketers. ETFs are enriching the coffers of financial entrepreneurs, fund management companies, and stockbrokers; it remains to be seen whether they’ll enrich the investors who trade them. But Some Innovation Has Served Investors To be sure, not all mutual fund innovation has ill-served fund investors. Indeed, among the greatest innovations is our industry’s history was the money market fund. The first one gingerly began in 1971. But—simply by giving investors the true money market rate (less costs), rather than the regulation- limited rates offered on bank savings accounts—assets had burgeoned to $58 billion by 1979, reaching $237 billion at the peak in 1981, and accounting for fully 80 percent of mutual fund assets! It was money funds that gave the industry breathing room after the 1973-74 bear market until stocks began their powerful and sustained recovery after the 1987 market crash. Money fund assets total $2.8 trillion today, accounting for about 24 percent of industry assets. They remain a major factor in the financial markets and a remarkable service to investors. Yes, money funds have also created huge profits for fund managers.

policies that respond to the failure of our agency society in which direct stockowners have become an endangered species, and (b) to take the steps necessary to ultimately eliminate the frightening shortfall— recently estimated at $1.2 trillion—in the expected future wealth of the vastly underfunded public, private, and individual retirement plans that are the foundation of our national savings. These two problems are directly related, and best solved by the creation of a federal statutory standard of fiduciary duty which will require our intermediaries to truly represent—first, last, and only—the interests of those they serve. But even if that recommendation of a federal approach doesn’t come to pass for a decade or more, Adam Smith’s legendary “invisible hand”—each investor acting in his or her own enlightened self- interest—will gradually bring about these changes. So my second recommendation is to speed-up that process by an intense focus on investor education. If we investors simply have the wisdom to understand how the financial system works, and to move our own money where our own common sense dictates, then the system of financial intermediation that has failed so many investors in the modern era will change. One way or another then,—whether by government fiat or by invisible hand—the soul of capitalism—that traditional owners’ capitalism that served us so well, for so long—will be reclaimed.

1. A commitment to the interest of clients in particular, and the welfare of society in general. 2. A body of theory or special knowledge. 3. A specialized set of professional skills, practices, and performances unique to the profession. 4. The developed capacity to render judgments with integrity under conditions of ethical uncertainty. 5. An organized approach to learning from experience, both individually and collectively, and thus of growing new knowledge from the context of practice. 6. The development of a professional community responsible for the oversight and monitoring of quality in both practice and professional educators. They then add these wonderful words: “The primary feature of any profession (is) to serve responsibly, selflessly, and wisely . . . and to establish (an) inherently ethical relationship between the professional and the general society.” Under this stern definition, it would seem clear that physicians, teachers, engineers, architects, and clergymen would qualify as professionals. At least in the ideal, so would attorneys, accountants, estate planners, and trustees of other people’s money. And yet, profession by profession, the old values are clearly being undermined. The driving force, I think, is the emergence of our “bottom-line” society, in we think we can measure every thing that is important, and that the resultant numbers tell us all we need to know.

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

 Reduce your focus on the Standard and Poor’s 500 Index as the basic indexing standard. Given its extraordinary and unrepeatable margin of superiority over the past five years, S&P 500 Index Funds have clearly drawn huge assets from short-term investors who buy hot past performance, as well from long-term investors who recognize the merits of low-cost, tax-efficient investing in high grade stocks. Begin to implement formalized redemption-in-kind procedures. When the giant growth stocks with their lofty price-earnings multiples revert to, and below, the market mean, as they inevitably will, substantial redemptions could follow. Protect the long-term shareholders.  Remember that while the return on the all-market index fund—the best index standard—will always outpace the returns of all actively-managed accounts as a group, that may not always appear to be the case, since half of all mutual funds are small and mid cap funds. Make sure your investors are aware of this difference.alike:

billion—can replicate the records they achieved when their assets totaled small fractions of these levels. We shall see. However, we can be confident that Vanguard 500 Index, ranking among the top 4 choices, will continue to deliver roughly the stock market’s future return—no more, no less—just what it is guaranteed to do. We also offer too many choices, sowing confusion among participants. We allow too much borrowing, and we now know that, in today’s world of high-employee-turnover, fully 45 percent of those who leave their jobs simply take their money and run. We often also offer participants a self-managed brokerage account, even though it makes it all too easy for employees to invest in a manner that is directly contrary to their own long term interests. Yes, automatic enrollment is a good enhancement, and target retirement funds (properly used) are a wonderful and relatively new option. But we have no monopoly on the affections of retirement plan investors. So it’s in our interest to provide far more investment discipline and far better value in the choices we offer, and to make crystal-clear their importance to plan sponsors and employees. Most important of all, we need to recognize that mutual funds are now a central element in the nation’s overall retirement system, including corporate plans; federal, state, and local government plans; and social security.

But, necessity being the mother of invention, I decided to pursue an unprecedented course of action. The management company directors who fired me composed only a minority of the board of Wellington Fund itself, so I went to the fund board with a novel proposal: Have the Fund and its then-ten associated funds (today there are more than 100), declare their independence from their manager, and retain me as their chairman and CEO. After a contentious debate lasting seven months, we won the battle to administer the funds on a truly mutual basis, under which they would be operated, at cost, by their own wholly-owned subsidiary. With only weeks to go before our incorporation, we still had no name for the new firm. Fate, of course, smiled again. By happenstance, as the battle for the fund board’s approval raged on, I stumbled across a book describing the historic Battle of the Nile, where Lord Nelson sank the French fleet and ended Napoleon’s dream of world conquest. There was Nelson’s triumphant dispatch from his flagship, HMS Vanguard. His words, the proud naval tradition, and the great victory, combined with the leading- edge implication of the name vanguard, were more than I could resist. So on September 24, 1974, The Vanguard Group was born. Ironically, without both the 1951 hiring, which providentially brought me into this industry, and the 1974 firing, which abruptly took me out of it, there would be no Vanguard today.

the outside looking in, and they are a small minority.) Their shared goal: To increase the price of a firm’s stock, the better to please “the Street,” to raise the value of its currency for acquisitions, to enhance the profits executives realize when they exercise their stock options, to entice employees to own stock in its thrift plan, and to make the shareholders happy. How to accomplish the objective? Aim for high long- term earnings growth, offer regular guidance to the financial community as to your short-term progress, and never fall short of the expectations you’ve established, whether by fair means or foul. What’s wrong with that? What’s wrong, as I said in my 1999 remarks, is that when we “take for granted that fluctuating earnings are steady and ever growing . . . somewhere down the road there lies a day of reckoning that will not be pleasant.” I was warning, of course, about the aftermath of the classic “new economy” bubble that had developed, where stock prices were wildly-inflated by unrealistic expectations and, well, irrational exuberance. Finally, the eternal truth re-emerges: The value of a corporation’s stock is the discounted value of its future cash flow. All over again, we learn that the purpose of the stock market is simply to provide liquidity for stocks in return for the promise of future cash flows, enabling investors to realize the present value of a future stream of income at any time. Corporations, we again came to realize, must earn real money.

But in a sector in which the linkage between fund costs and fund returns is not only essentially dollar-for-dollar, but also clearly visible on a daily basis, (simply by comparing relative yields), investors are heavily opting for the lower-cost funds. Nearly one-half of total money fund assets are invested in funds with expense ratios of less than 40 basis points. (Astonishingly, 68 money funds, including that very first fund, get away with ratios of 100 basis points or more.) A Self-Serving Conclusion There are some mutual fund innovations, however, that have well-served fund investors even as they have created no profits for fund managers. I’ll now name six major innovations that meet that standard. (Full disclosure: these comments are self-serving, in that they involve my creation of Vanguard, way back in 1974.) The first is the creation of Vanguard itself, an astonishing innovation in the traditional mutual fund structure, an innovation designed to resolve the dilemma that must be patently obvious after the events that I have chronicled this afternoon: the direct conflict between the interests of fund managers, who make money by gathering assets, no matter what their character or durability; and fund investors, whose interests are ill-served by that strategy. It is a simple truism that, for the fund industry in toto, “the more the managers take, the less the investors make.

Rather, not merely looking after our own parochial interests, we ought to be leading the way to rationalizing the entire retirement services system. So my dream of providing lifetime services to investors includes a vision that our industry leaders at last step forward with proposals and designs to help accomplish “cradle to grave” retirement security for our nation’s citizens. We owe ourselves, to say nothing of our society, no less. 3. A Dream of Long-Term Investment Horizons My third dream is that our money managers turn back the clock, reverting to our traditional focus on long-term investment strategies. My, how times have changed! During my first 15 years in this business, the typical equity mutual fund turned its portfolio over at about 16 percent per year. Result: The average fund held its average stock for an average of about six years. Let’s define that strategy as long- term investing. Today, by way of contrast, we turn our portfolios over with a fury—in fact, six times as rapidly. The average fund portfolio turns over at an annual rate of 100 percent—a holding period of just one year for the average stock. Yes, our larger funds turn over at a somewhat slower rate (perhaps a factor of necessity, given their size), and our index funds portfolios barely turn over at all. Whatever the case, last year our actively managed equity funds, with assets of $4.6 trillion, bought $3.2 trillion of stocks and sold another $3.3 trillion, an amazing total of $6.

Affiliated Fund Assets (million) Expense Ratio Dividend Shares Fidelity Fund Incorporated Inv. Mass. Inv. Trust Average $116 $140 0.72% 0.74 0.66 0.55 0.33 0.60% Growth in Assets and Expenses, 1950 - 2006 1950 $21,200 4,600 7,700 4,100 4,900 $8,500 2006 Wellington Fund $154 0.60% $45,700 Expenses (million) $0.8 0.6 0.3 0.5 1.2 $0.7 1950 $191 $79 2006 $0.9 $114 1950 2006 0.90% 1.32 0.55 1.16 1.09 1.00% 0.25% % of Div. Income 12% 10% 12% 1950 2006 44% 57% 8% 4. But a funny thing happened on the way to 2006. Those old values seemed to vanish. Remarkably, each of those six industry pioneers still exists, but, with a single exception, the idea of sharing substantial economies of scale with shareholders has gone up in smoke. (By 1969, alas, even MIT had abandoned its dividend-based fee rate in favor of the conventional asset-based fee rate. Its expense ratio subsequently more than tripled, from 0.33 percent to 1.09 percent.) Amazingly, despite the truly staggering growth in total fund assets, expenses have grown at an even faster rate, resulting in expense ratios that have actually increased. For five of these six funds, more and more of that priceless component of investment return known as dividend income was consumed by costs, (Chart 4) from 10 percent of income in 1950 to nearly 60 percent in 2006. Even as assets have increased nearly 60 times over, from $770 million to $42 billion, their expenses have increased even faster—more than 100 times over, from $3.

, investment return and speculative return—has been borne out in practice. Indeed I have the temerity (again!) to suggest that Lord Keynes would respect this mathematical extension of his concept. Decade after decade over the past century, we can account, with remarkable precision, for the total returns actually earned by U.S. stocks.6 (Chart 5) 5 I understand that the numbers should in fact be multiplied together, i.e. 1.05 x 1.04 = 1.092, or 9.2 percent. But given the inevitable imprecision of projections, I elect the simple expedient of summing them up, in this case to 9.0 percent. 6 A recent article in Global Investor, Summer 2007, confirmed that the concept works in stock markets all over the globe. “Occam’s Wisdom and Bogle’s Wit,” by professor Javier Estrada.

Einstein surely was on the right track when he said, “Not everything that counts can be counted, and not everything that can be counted counts.” Yet we’ve moved from a world in which, as Protagoras wrote 2500 years ago, “man is the measure of all things,” to a world where “money is the measure of the man.” I doubt that that change can be called progress. Unchecked, the forces of the market not only constitute a strong challenge to our professions; in some cases, these forces have totally overwhelmed traditional standards of professional conduct that it took centuries to develop. That legitimacy, in sad reality, has already been undermined in most of our professions.2 The idea that “the market is self-regulating and morally self-sufficient” to assure the maintenance of professional standards has clearly proved inadequate. Indeed, that misguided idea lies at the heart of some of our major societal failures of recent years, examples that belie the idea that professionals must accomplish their good works with a commitment to use their mastery to fulfill a “mission that inspires passion, a mission that gives beyond the self.” 2 The ideas in this paragraph have been inspired by other articles in the same issue of Daedalus.

3.5 4.5 5.5 6.5 7.5 0 0.5 1 1.5 2 Long-term Municipal Bond Funds 10-Year Returns versus Expenses Vanguard LT Tax-Ex: 5.66% Lehman 10-Yr Muni less 0.20 bps: 5.46% Vanguard Ins. LT Tax-Ex: 5.71% Avg LT Muni Fund: 4.72% Slope: -0.85 Number of funds: 143 Expense Ratio Return 4A. return of 5.66 percent, a comparable index fund, after assumed costs of 0.20 percent, would have provided a 5.46 percent net annual return. By way of comparison, the Vanguard Long-Term Tax-Exempt Bond Fund happened to provide an even higher return of 5.66 percent, net of its tiny expense ratio of 0.15 percent, even less than the costs assumed for the index fund. Once again, low costs lead to higher returns. Each percentage point reduction in costs increases returns by 0.85 percentage points. The 5.66 percent annual return of the long-term Vanguard fund was roughly 20 percent more than the 4.72 percent earned by the average long-term municipal fund, even though many of the actively managed funds were assuming higher risks. The top performing outliers, for example, held barely 50 percent in AAA-rated bonds, compared to 86 percent for the average fund, and 91 percent for the uninsured Vanguard fund. Like the index itself, the Vanguard managed bond fund is broadly diversified and holds a high-quality portfolio: 100 percent rated A or better, even higher than the 86 percent figure for its actively managed peers.

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

Fixing today’s CEO-centered corporate world, the excesses of the financial system, and the faltering mutual fund industry—returning control from managers to owners in a new fiduciary society—is on the way. I hope my book will help. But whether forced to do so by law or regulation, or by the wisdom finally acquired by crowds of investors making intelligent investment decisions as they simply seek to further their own economic interests, so it will be. That’s my ideal, and that’s my idealism. Thank you.

More than any other firm, Vanguard has been the fund industry’s hedgehog, applying its one great thing to pioneer in many of the fund industry’s most productive and investor-friendly innovations: the mutual (investor-owned) structure; the index fund; the tax-managed fund; the money market fund; the management of bond funds in defined asset classes; the direct marketing of shares to investors through no-load funds, without salesmen or commissions; and many others. While we were not always first to adopt these strategies, we have been widely credited as being the driving force in their acceptance, for our single-minded focus on low cost has made them work for investors in an extraordinarily effective way. It was said of Wilson, “he may not have coined all of his vital ideas, but he mined them as no others did.” So too it might be said of Vanguard.

 Think about ways to slow down the high turnover of your fund shareholders. Redemption fees work.  Remind your shareholders about risk—in plain English. When risk is least obvious, it is most in prospect.  Remember that “we never had it so good,” but also that trees don’t grow to the sky. In all, the foxes need to adopt some of the simple strategies of the hedgehog, and the index hedgehogs need some humility. As the millennium rolls into our lives, the mutual fund industry cries out for change, but change that serves its investors. But change in the prevailing ethos of the day is always hard to accomplish. To suggest how difficult it will be to move from the many things the fox knows to the one great thig the hedgehog knows, I close with the wisdom of Plato. In The Republic, Plato presents “The Allegory of the Cave,” describing men shackled to the same spot in a cave, with blinders that limit their vision to a distant light in front of them, rather than the fire burning behind them at a higher elevation: Then . . . one prisoner is freed from his shackles; he walks, looks toward the light, and is pained by the glare and unable to see the objects whose shadows he used to see. He comes into the sunlight, dazzled by a new vision and unable to see what he called realities only moments earlier. He returns to the dark cave, and is laughed at for his vision. But he has seen the reality of beauty and justice, and knows the idols and shadows for what they are.

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

” Meanwhile, the fund itself is incurring heavy trading costs and charging heady advisory fees, to the point where an electronics fund, for example, cannot conceivably match the return of electronics stocks as a group. (At least an “industry index fund” could do that.) If I am correct in this analysis, today’s specialty stock funds, having come and gone once in the 1940s, will come and go again in the 1980s. When the speculator sours on mutual funds—an eventuality that will accelerate when we get the next sharp market correction—what then do we have to offer the investor and the saver? The obvious and, I think, correct response is “back to basics”—back to broadly-diversified, economically-managed funds with sensible objectives. Indeed, I expect that the pendulum will swing even further away from today’s speculation. If the investor wants (and needs) broad diversification among equities, and if the saver wants (and needs) broad diversification among bonds, perhaps unmanaged stock index funds and bond index funds will become important factors in this industry in the decade ahead. There is not much evidence to support this view. Our stock index fund—Vanguard Index Trust— during its first decade has been, as they say, an artistic but not a commercial success.

I’m fond of saying that I left my old job at Wellington in the same way that I began my new job at Vanguard: “Fired with enthusiasm.” Time does not permit me to describe in detail the Vanguard odyssey that was to follow our fortuitous launch. But its parallels to Homer’s Odyssey, while hardly exact, are nonetheless there. We’ve wasted our own time with the Lotus-Eaters. We’ve been enticed by our own wily Sirens. We’ve sailed uneasily between Scylla and Charibdis. We’ve brazenly defied more than one Cyclops. We’ve been threatened by the wrath of our own Poseidon. And we’ve been temporarily entranced by some bewitching Calypsos. But we’ve survived our now-32-year voyage, and returned home, proud and prosperous, for a brief moment of reflection. Of course we know that life is a journey, not a destination, and a new odyssey lies before us. As you might imagine, it’s difficult for me to believe that such a new voyage could have the excitement and challenge of Vanguard’s first one. After all, putting a new name on the map, creating a unique new structure, and establishing a new set of ethical values can’t recur with regularity. True entrepreneurship or not, (1) we created a new form of governance in the mutual fund industry, a mutual structure in which the interests of fund investors take precedence over the interests of fund managers and distributors.

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

In the latter part of 2007 Wesco invested $802 million, net, in marketable equity securities. Of its $3.1 billion of assets at December 31, 2007, $565 million is invested in cash equivalents and fixed-maturity investments. Unless significant additional amounts can be attractively reinvested in acquisitions, equity securities or other long-term instruments of the type that helped cause the long-term growth of Wesco’s shareholders’ equity, future returns on shareholders’ equity will probably be less than those of the past. Due to the current size of Wesco and its parent, Berkshire Hathaway, Wesco’s opportunities for growing shareholders’ equity are unlikely to be as attractive as in the past. The Board of Directors recently increased Wesco’s regular dividend from 371 ⁄2 cents per share to 381 ⁄2 cents per share, payable March 6, 2008, to shareholders of record as of the close of business on February 7, 2008. This annual report contains Form 10-K, a report filed with the Securities and Exchange Commission, and includes detailed information about Wesco and its subsidiaries as well as audited financial statements bearing extensive footnotes. As usual, your careful attention is sought with respect to these items. Shareholders can access much Wesco information, including printed annual reports, earnings releases, SEC filings, and the websites of Wesco’s subsidiaries and parent, Berkshire Hathaway, from Wesco’s website: www.wescofinancial.com. Charles T.2008

For me, the freed prisoner has recognized that the foxes are the shadows and the idols, and the hedgehogs are the reality and the truth. But each of you, like the other prisoners in the cave, will have to decide that for yourselves. Clearly, leaving the darkness of the cave—the safety and comfort of the place one has known—is difficult, unpleasant, and challenging, and the first prisoner who does so will be laughed at. I, more than most investors, know that. But Plato’s allegory is a powerful symbol of the need for a new vision—a vision of true shareholder service that includes not only the information technology that lies at our fingertips, but a focus on a longer-term investment horizon, a cost structure that doesn’t eviscerate shareholder returns, and the needs of the human beings for whom we serve as stewards and trustees. As mutual fund managers and directors come to see the light—and realize that our current notions of serving shareholders are but shadows of the ideal—this industry and the mutual fund investors we serve will, finally, escape the darkness of the cave.

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

Of course we’re all aware, as yet another Daedalus article expresses it, “that pursuing a noble mission is often painful . . . and that not letting the mission get out of hand is possible only for those who truly believe in the mission and have enough self-perspective to remain wary of dangers such as arrogance, megalomania, misguided beliefs, and distorted judgments.” The love of money, again, leads to our ignoring these dangers in our own self-interest, giving credence to Upton Sinclair’s comment, paraphrased here: “it’s amazing how difficult it is for a man to understand something if he’s paid a small fortune not to understand it.” In all, professional relationships with clients have been increasingly recast as business relationships with customers. Again, you’ll have to tell me whether this change has effected the profession of estate planning. But I can tell you that it has pervaded the mutual fund field—once largely a profession of managing other people’s money, now largely a business of gathering assets to manage— with the obvious consequence of putting the manager rather than the investor in the driver’s seat. In a world where every user of services is seen as a customer, every provider of services becomes a seller. Put another way, when the provider becomes a hammer, the customer is seen as a nail. Please don’t think me naive. I’m fully aware that every profession has elements of a business.

4 million to $395 million. Result: expense ratios have nearly doubled, from 0.57 percent to 1.0 percent. This evidence totally contradicts the consistent stand of the industry, articulated over and over again at the annual membership meetings of the Investment Company Institute, that “the interests of mutual fund managers are directly aligned with the interests of mutual fund shareholders.” It’s just not so. But there is a case—just one, and one with which I am well-familiar—in which the ICI was right. That fund’s assets also soared—from $154 million to $46 billion. But while its expenses leaped from $924,000 to $114 million, the expense ratio actually declined by 60 percent, from 0.60 percent of assets to 0.25 percent. Most importantly, after absorbing 12.5 percent of income in 1951, Wellington Fund’s costs actually absorbed even less of the fund’s income—8.0 percent—in 2006. I attribute this obvious success largely to the facts that (a) The Fund is a unit of Vanguard, a unique mutual mutual fund group owned by its fund shareholders, and is operated on an “at cost” basis; and (b) in the 1980s and 1990s, we vigorously renegotiated the advisory fee scale with our external advisor, demanding that our fund’s owners share in the economies of scale. (Today, the annual advisory fee we pay to Wellington Management Company comes to just 3/100 of 1 percent of assets—a measly three basis points.) And now, a dream.

Investment Return: Dividends and Earnings Growth -5 0.8 -3.4 3.3 0.3 -6.3 9.3 -1.0 -7.5 7.7 7.2 0.1 -10 -5 2.9 14.8 -0.8 8.6 20.1 7.6 5.9 17.3 17.8 9.6 9.0 -10 -5 20th Century Stock Returns - by the Decade (%/year) Market Return (S&P 500) 1900s 1910s 1920s 1930s 1940s 1950s 1960s 1970s 1980s 1990s Speculative Return: Impact of P/E Change 8.2 6.3 11.5 -1.1 14.9 10.8 8.6 13.4 9.6 10.6 4.7 3.5 4.3 5.9 4.5 5.0 6.9 3.1 3.5 5.2 3.2 2.0 5.6 -5.6 9.9 3.9 5.5 9.9 4.4 7.4 4.5 5.0 9.5 1900 – 2006 5. The investment return on stocks (top line) proves to be remarkably susceptible to reasonable expectations. The initial dividend yield—a crucial—but underrated—factor in shaping stock returns—is a known factor. And the steady contribution of dividend yields to investment return during each decade has always been a positive, only once outside the range of 3 percent to 5 percent. The secular rate of earnings growth on the other hand, while hardly certain, is relatively stable. There were no long-term Black Swans in investment returns, and even the sharp earnings drop in the Great Depression was but a 2-Sigma event (meaning within the 95 percent probability range). Note that, with the exception of the depression-ridden 1930s, the contribution of earnings growth was positive in every decade, usually running between 4 percent and 7 percent per year. Total investment returns were only once (again, the 1930s) less than 6 percent annually, and only twice more than 11 percent.

This overarching principle—the one great thing that the fund hedgehog knows—is not merely a good strategy for the long-term investor. It is a winning strategy. Here, I am reminded of Occam’s Razor, the principle that advises: When faced with a problem having multiple solutions, choose the simplest one. (This “principle of parsimony”—shaving away all complex solutions—was recently given the attention it deserves by William Safire in his Sunday New York Times Magazine column.) Occam’s Razor is right on the mark in pointing to the solution to the seeming riddle of investment success, for index funds are the essence of simplicity. I should add that, contrary to much of what we read in the financial press, the principle that Sir William of Occam set out in the 14 th century, works—as it must work—in all financial markets. Whether in markets in which fund returns are widely divergent—small stocks or international stocks, for example—or in markets in which fund returns are narrowly-spaced—bonds, for example—there is no longer any question of the power of the universal principle of low-cost indexing. It may threaten the financial interests of the fund industry, but it fosters the financial interests of the fund shareholders. The Hedgehog as Businessman Let me now turn to my second contrast between fox and hedgehog: From the industry’s investment conduct, to its business conduct.hedgehog

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 disgraceful market timing scandals unearthed by Mr. Spitzer and his staff, 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. IV. The Mutual Fund Industry Loses Its Way With this background, I now turn to the very mutual fund industry where I’ve spent my entire career. So it is especially painful for me to acknowledge that the mutual fund industry is in many respects the poster child for the deterioration in business values and investment values that I’ve just described.a

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

” The seminal Vanguard innovation was to reverse that tautology: “the less the managers take, the more the investors make.” And so we created our novel and unique structure. Rather than having the mutual funds run under contract by the investment manager (the industry’s traditional structure), in business to earn a profit on its own capital, at Vanguard the mutual funds would actually own their management company operating to serve solely the interests of its fund investors, offering its services on an “at-cost” basis, and in business to earn a profit on their capital. This structure may not be—and is not—entirely conflict-free. But the proof of the pudding is in the eating: Vanguard today operates at a weighted expense ratio of about 21 basis points, compared to about 95 basis points for the fund industry. Applying this differential of 74 basis points to our present asset total of $1.3 trillion—up from $1.4 billion when we began—means savings of nearly $10 billion  I don’t have time to discuss in depth another promising fund innovation: “Target retirement funds,” in which the investor selects his year of retirement and the fund gradually moves from a heavy equity position to a substantial bond position as retirement nears.

We have consistently matched the Standard & Poor’s 500 Stock Index within on-half of one percent per year, during a period when the Index itself has been a solid performer—usually outpacing about two-thirds of pension equity accounts. Nonetheless, our modest (by today’s standards) $600 million no-load index fund still finds itself without a counterpart. In an industry where mimicry is a way of life, I am almost embarrassed that our competitors have failed to ape our pioneering product. So, undaunted and perversely, we have formed “Vanguard Quantitative Portfolios,” which will seek to harness the incredible power of the computer to manage a diversified equity portfolio, all the while remaining in lock-step with the Index, but trying to eke out a 2 percent to 3 percent annual performance advantage. This approach toward “relative predictability,” you will note, is essentially diametrically opposite to our industry’s direction today. (We dare to be different!) And, we have also just formed the first publicly-available bond index fund—Vanguard Bond Market Fund. The unmanaged bond indexes, like the unmanaged stock indexes, have been formidable competitors for America’s professional money managers, usually outpacing about two-thirds of pension bond accounts. This Fund too will provide substantial relative predictability to investors. Like our stock index fund, our bond index fund will employ no advisor, pay no advisory fee, and operate at an expense ratio in the 0.25 percent range.

5 trillion in transactions. We calculate that turnover rate at about 70 percent, since the accepted turnover formula is to divide the asset base into the lesser of portfolio purchases or sales. Even using this lower turnover rate, however, suggests that our average stock is now held for only 17 months. Surely such a strategy represents, not long-term investing, but short-term speculation. All of this frantic turnover, of course, cannot possibly help our fund shareholders as a group. After all, most fund trading takes place with other funds, and therefore cannot advance the interests of our owners in the aggregate. Indeed, to state the obvious (again), such trading must—and does—dilute the returns of our owners. For the inevitable zero-sum game when stocks are traded from one investor to another becomes a loser’s game after the trading costs assessed by our Wall Street croupiers are deducted. It must be obvious, then, that short-term speculators must lose to long-term investors. So the fund industry’s conversion from yesteryear’s focus on the long-term to today’s focus on the short-term has been, by definition, detrimental to the interests of our shareholders.

(Chart 4B) Befitting its long-term investment horizon, its portfolio turnover is just 12 percent per year—surely an indication of an index-like orientation—vastly lower than the 41 percent turnover of the average actively-managed long municipal fund. And its duration was somewhat below that of its peers.

agreement that it will), relative cost will become a major differentiator, and the “price war” will do what price wars are supposed to do: drive prices down. Greshan’s Law and Mutual Fund Advertising If the general direction of product development in this industry concerns me, the intensity of promotion concerns me even more. I refer principally to advertising that has run amok, advertising that is at once strident, blatant, hyperbolic. If these seem strong words, just open the Sunday New York Times Business Section, or read the most recent MONEY Magazine, or leaf through the last ten pages of any Wall Street Journal. But I urge you not to take it for granted; consider it as if you were a visitor from another planet, trying to decide where to invest the reward you just received for being the first interplanetary traveler. What would you see? Mostly, claims of huge increases in value, achieved (though you are not told this) during one of the great bull markets of this century, often accentuated (nor are you told this) by highly-speculative investment policies. Here is a sampling of the claims advertised in MONEY, February 1987: +1,565 percent, +6,523.50 percent, +504 percent, + 156.32 percent, +348.7 percent, and, of course, $10,000 growing to the magically-precise total of $651,228. (If you believe that, I have a bridge I want to sell you!)

And prosper we did. By the time the SEC finally gave us the green light in 1981, seven long years after we began, the stock market had begun to recover, and our assets had doubled, from $1.4 billion to $3 billion. They would double again with remarkable regularity, about every three years. In 1983, to $6 billion; 1985, $12 billion; 1986, $24 billion; 1989, $50 billion; 1992, $100 billion; 1995, $200 billion; and again to $400 billion in 1998. Remarkable! While it took longer—seven more years—for our assets to double yet again, we crossed the $800 billion mark in 2005. Today we oversee $1.1 trillion of other people’s money. The mighty engine that has driven that amazing growth was powered largely by our simple group of index funds, structured bond funds, and money market funds—each providing a near-causal relationship between low costs and high returns. The assets of these funds now total nearly $800 billion, more than three-quarters of our asset base. What is more, we have also applied their index-like principles—rock-bottom expenses; minimal portfolio turnover; no sales loads; diversified, investment- quality portfolios; and clearly-defined objectives and strategies—to substantially all of the remainder of our assets, largely actively-managed equity funds. Most important, in the marketplace of intelligent long-term investors—individual and institutional alike—our strategies have worked effectively for those we serve.

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.

Vanguard LT Municipal Fund Average LT Municipal Fund Volatility (vs index) 91% 82% Quality (A or above) 100% 86% Turnover (5 yr avg) 12% 41% Expense Ratio 0.15% 1.0% 5.66% 4.72% 10-yr Annual Return $7,340 $5,860 Profit on $10,000 Vanguard Ins LT Muni Fund 88% 100% 18% 0.16% 5.71% $7,420 4B. Duration 5.6 6.1 5.7 3.0 3.5 4.0 4.5 5.0 5.5 6.0 0 0.5 1 1.5 2 Vanguard ST Fed: 5.07% Lehman 1-5 Treas, less 0.20 bps: 4.8% Vanguard ST Treas: 4.95% Avg ST Gov’t Fund: 4.43% Slope: -0.67 Number of funds: 90 Expense Ratio Return Short-term Government Bond Funds 10-Year Returns versus Expenses 5A. Over the past decade, $10,000 initially invested in the Vanguard Long-Term Municipal Bond Fund provided a profit of $7,340, 25 percent larger than the $5,860 earned by its average rival, achieving that extra gain with a higher quality portfolio. With low costs, broad diversification, and no serious attempt to outguess the market in long-term tax-exempt bonds, once again the index-like strategy wins. Both Vanguard Long-Term Tax-Exempt Bond Fund and its close counterpart, Vanguard Insured Long-Term Tax-Exempt Bond, ranked in the top decile of the 143 funds in the category. Once again, load funds were conspicuous by their paucity among the top 20 funds (only 4 with loads) and dominated the bottom-20 fund group (18 with loads). Short-Term U.S. Treasury Bond Funds Our sweep of the bond fund arena concludes with an examination of short-term funds investing in U.S. Government obligations.

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

dollars per year to our fund investors. That’s enough savings to keep our money market and bond funds consistently in the 95 th (or higher) percentile among their peers, and to place our equity funds fairly consistently in at least the 75th percentile in terms of the returns we generate for our shareholder/owners. It is that innovation—based on the common sense observation that costs matter, and that funds should be, well, “of the shareholder, by the shareholder, and for the shareholder”—that has engendered the other major innovations that we have been responsible for over the years. By far the most important of these was our second strategic innovation. Immediately after Vanguard began operations in May 1975, we created the world’s first market index mutual fund, simply tracking the returns of the S&P 500 Stock Index. To do its job, the basic index fund takes diversification to the nth degree. It owns the lion’s share of the entire U.S. market, and thus assures that its investors are guaranteed to capture the gross return of the stock market (or the bond market, or any discrete segment of each). But if this diversification assures that the index fund earns the market’s return, it is rock-bottom costs that assure that it delivers to its investors nearly 100 percent of whatever returns the market may provide. (With its passive strategy, it also virtually eliminates portfolio trading costs, and also provides commensurate tax efficiency.)

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.

” He was not above responding to a statement that there are two sides to every question with a curt, “Yes there are. A right side and a wrong side.” Nor was he beyond telling a colleague, “Do as you think best,” while always leaving underneath the veiled injunction, “but do it this way.” And as he freely admitted, he hardly become easier and more placable with age. “The older I get, the hotter I get,” Wilson said—and he was only 52 then! I confess that my colleagues at Vanguard might see these same traits in me. It was Wilson’s stubborn idealism that stood in the way of accomplishing his final goals while at Princeton—a collegiate campus—and while at the White House—a League of Nations. I can only recall F. Scott Fitzgerald’s statement: “Show me a hero, and I’ll write you a tragedy.” But is tragedy truly the right word? Both developments have now come to pass. And for me, whether one finally succeeds or fails, steadfast commitment to one’s own principles and values is what a man’s life is all about.nor

There’s another great benefit in again becoming an “own-a-stock” industry. We would be forced to recognize that the interest of our shareholders demands that we act as responsible corporate citizens, carefully examining company financial statements, making our views known on matters such as stock options, executive compensation, and corporate governance, and assuring that the corporations whose shares we hold are operated in the interests of their shareholders rather than their managers. In today’s “rent-a-stock” industry, where stocks are treated as mere pieces of paper to trade back and forth rather than as the talisman of ownership, those governance issues are too often ignored. So my dream is that we return to our roots as investors. Not only because it will be to the economic benefit of our clients, but because we can play the determining role in returning corporate America to its own roots of democratic capitalism. 4. A Dream that We Serve Long-Term Investors My fourth dream is that we again serve long-term investors. That is not how it works today. For even as the investment horizons of our fund managers diminished, so, too, have the horizons of mutual fund investors. Small wonder, since we have shaped our business to meet the demands of short-term investors!

Suppose now that industry practice had followed MIT’s early lead, pegging management fees to 5 percent of investment income rather than to fund assets. Further suppose that no economies of scale—none—were shared with fund shareholders, and that the 5 percent fee remained unchanged. On that basis, equity fund expenses last year would have totaled just $5.7 billion, compared to the actual total of $56 billion, a huge potential annual “dividend” of $50.3 billion to fund shareholders.

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.

The returns earned by our funds are consistently ranked near the top of our industry, most recently by Global Investor as #1. It’s fair to say, I think, that Vanguard has represented an artistic success for our fund shareholders, and a commercial success for our firm. So our odyssey has been not only long and arduous; it has been exhilarating and rewarding. Liberal Education, Moral Education When I think of the good fortune that has brought me to where I am today, I give the highest order of credit to a set of strong family values and a faith in God, a fine preparation for college at Blair Academy, and the powerful reinforcement and new awakening I received through a liberal education at Princeton University. A few years ago, former Princeton President Harold Shapiro defined these two aims of a liberal education: “One is the importance of achieving educational objectives, a better understanding of our cultural inheritance and ourselves, a familiarity with the foundations of mathematics and science, and a clarification of what we mean by virtue. “The other is the importance of molding a certain type of citizen,” one who is engaged in “the search for truth and new understanding . . . the freeing of the individual from previous ideas, the pursuit of alternative ideas, the development of the integrity and power of reason of individual goals . . . and the preparation for an independent and responsible life of choice.

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.

1 percent of speculative return, borne of an inevitably period-dependent increase in the price-earnings ratio from 10 times to 18 times, amortized over the century. Despite the Black Swans of market history, ownership of American business has been a winner’s game.might

Today, mutual fund management companies are behemoths, largely owned by giant publicly-held financial conglomerates, run by businessmen whose highest priority is earning the maximum possible return on the capital invested by their firms in the management companies that they acquired. 2. In 1951, the vast majority of equity mutual funds were conservative, broadly diversified among blue-chip stocks, and offered returns that generally paralleled those of the stock market itself, making fund selection by investors fairly straightforward. Today, mutual funds come in a bewildering variety that would shame the mere 28 flavors of ice cream once offered by Howard Johnson’s restaurants. The age-old middle-of-the-road equity funds now account for only about one-tenth of today’s 4,300 such funds, including not only the standard nine-box Morningstar variety (large-, medium-, and small-cap; value and growth styles, and a blend of the two), but also a plethora of specialty funds (technology, internet stocks, energy, gold, etc.) and foreign funds (Japan, Korea, Turkey, emerging markets, etc.), placing a staggering premium on selecting the “right” fund. 3. Conforming to the temper of the times, fund managers led the way in changing their focus, yes, again, from the wisdom of long-term investing to the folly of short-term speculation.

As Warren Buffett says, “When the dumb investor realizes how dumb he is and buys a low-cost index fund, he becomes smarter than the smartest investors.” Our third major innovation was a reverse innovation. Early in 1977, shortly after the index fund began operations, we eliminated the sales loads on all Vanguard Funds, moving from a supply-driven broker-dealer selling system to a demand-driven system dependent on investors’ buying decisions. That change was designed in part to eliminate any incentive to create those fad-and-fashion funds that so devastated the returns of investors in the earlier eras I’ve described. Our fourth innovation, also precedent-breaking, came in the bond fund sector. Up until 1977, bond funds were just that: “managed” portfolios of bonds whose maturities could be extended or reduced depending on the portfolio manager’s outlook for interest rates. But skeptical that bond managers had— or ever could have—such prescience, we again did the obvious. We launched the industry’s first defined- maturity series of bond funds, including a long-term portfolio, a short-term portfolio, and (I’m sure you know what’s next!) an intermediate-term portfolio, all operated at rock-bottom cost. The idea was to hold broadly diversified portfolios of top-quality bonds (first tax-exempt municipals, later taxables), and maintain essentially constant maturities in each category.

(Chart 5A) There are few surprises here. The net return earned by the Lehman 1-5 Year Treasury Index itself (4.8 percent per year, net of an adjustment for an assumed expense ratio of 0.20 percent) outpaces the return of 4.4 percent for average short-term government fund.

When I came into this business all those years ago, the rate of mutual fund redemptions to mutual fund assets was about 6 percent annually, suggesting an average holding period of 16 years for our average shareholder. By the late 1990s, this shareholder turnover rate had soared to nearly 50 percent, suggesting an average holding period of only two years. Think of it! One reason for this huge leap was that funds were widely used as vehicles for illicit market timing and time-zone trading, in which certain fund managers conspired with certain favored short-term speculators (there were 300 hedge funds using this strategy!) to trade against the interests of the funds’ long-term investors. But even with the elimination of much of that abuse, the redemption rate remains at a remarkably high level of 24 percent, suggesting a holding period of a bit more than four years, a far cry from the 16-year holding period of our early tradition. The underlying reason for this excessive rate of investor turnover, I believe, lies in our mad rush to offer investors funds that are designed to be traded rather than funds designed to be held for a lifetime. The contrast of yesteryear’s fund industry—largely market-like portfolios holding blue chip stocks—to today’s could hardly be more stark. We think in terms of sizes and styles, terms more suggestive, when you think about it, of the field of high fashion than of the field of investing.

Bond Funds: Current Yields and Expenses IT Corporate Gross Yield Expense Ratio Net Yield 5.4% 1.1% 4.3% IT Government 5.2% 1.0% 4.2% IT Municipal 4.6% 1.0% 3.6% 5. Well, I can dream can’t I? But in any event, it’s high time that we require mutual funds to disclose to investors and prospective investors the amount of their dividend income that is consumed by costs, and its impact on the fund’s long-term returns. Bond Funds Now a brief word about bond fund expenses. While in bond funds the consumption of income by expenses is lower, the impact on long-term returns is higher. (Chart 5) The average bond fund is presently earning a gross yield of about 5 percent, but after the average expense ratio of 1.0 percent, the net yield averages 4.0 percent. In all, bond fund expense ratios, on average, are consuming about 20 percent of the interest payments the funds receive. (Here, I’ve ignored the impact of sales loads and transaction costs.) But income takes on a special importance in the case of bonds. Why? Because the income yield on a bond fund at the point of purchase establishes the parameters of its future return. 6 Said straight out, today’s yield on a bond fund is an excellent proxy for its total return in the subsequent decade. For example, the initial interest rate on a ten-year U.S. Treasury bond has had a correlation of a mere 0.91 with its returns over the subsequent ten years. (1.00 is perfect correlation.)

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

At the same time, our clients must be provided with an excellent level of service, distinguished not as much by efficiency and automation as by how we treat them. As I have said to our crew 1,000 times over: “Let’s treat our clients as human beings—honest-to-God, down-to-earth human beings with their own hopes, fears, and financial goals.” For what it is worth, at Harvard Business School we have become known as one of the two premier “service-breakthrough companies” in American business. A year ago, I was invited to reveal the secret of our success, such as it may be, to four Harvard classes. I told them that the secret was, hedgehog-like, based on a simple, unitary concept: Treating our clients as human beings—serving them in the same manner as we would have the honest stewards of our assets serve us. I then asked if any of the 300 students I was addressing had ever seen the phrase “human beings” appear in a textbook on business management or corporate strategy. No heads nodded; no hands were raised. But I hope that these future leaders of American business learned something useful, if not priceless. For the hedgehog firm, Occam’s razor shaves away all of the complex, and not entirely straightforward, myths that go into what is called, charitably, “modern marketing,” to say nothing of shaving away all unnecessary costs. Individual human beings—no more, no less—remain the focus.Of

Part IV. The Financial Markets These changes, it seems to me, have had dire consequences for our financial markets. Part of the problem is that the one-time focus on long-term investing has turned overwhelmingly toward short-term speculation, a trend that I’ve witnessed first-hand. In 1950 (and for a decade and a half thereafter), the average equity mutual held its average stock for six years (16 percent turnover); by last year, the average holding period had plummeted to less than one year (turnover of 105 percent). It’s also that the costs of financial intermediation have soared. Last year, we investors paid more than $400 billion to our stock brokers, investment bankers, pension managers, mutual fund managers, hedge fund managers, and financial advisers (and all of their expensive infrastructure, including lawyers, accountants, marketers, and so on). Indeed, we recently learned that if you didn’t make $140 million last year, you didn’t rank among the 25 highest-paid hedge fund managers. (The winning manager was paid $1.5 billion.) Why should the enormous costs we pay for financial intermediation matter to us? Simply because, as investors as a group, we are average. Beating the market is a zero sum game. (In an 8 percent stock market, together we all earn 8 percent. No surprise there!) But that’s before we deduct the costs of playing the game. After the deduction of intermediation costs, beating the market becomes a loser’s game.

” President Shapiro also pointed to the “responsibility of a university offering a liberal education to provide its students with a moral education . . . helping them to develop values that will enrich their lives as individuals and as members of society.” During my four years there, I did my imperfect best to acquire these values, and to manifest them in my actions in the years that followed. As I look back in hindsight through glasses that inevitably have a rosy hue, I can only say that the liberal and moral education that was placed before me at Princeton may well have ignited some deep and unimagined spark that began to influence my life and my career in the mutual fund field. This spark, nurtured by time and experience, has erupted into some sort of flame, one that has permeated my ideas about the proper nature of the mutual fund. The flame will spread one day to the industry and become a blaze, one that will not be easy to extinguish. It is my prayer that my mission—my crusade, if that is not too lofty a characterization of the course of my career—will help an industry to rethink its values, and accordingly be of greater service to growing millions of American investors.are

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

influence changes in the business economy (enterprise). But when I learned of the work of the great American economist, Hyman Minsky (1919-1996), who dedicated his career largely to what he described as the “financial instability hypothesis,” I recognized that yet another element of risk—here, clearly, meaning uncertainty—existed.7 “In 1974, Minsky observed a fundamental characteristic of our economy that linked finance and economics: ‘The financial system swings between robustness and fragility, and these swings are an integral part of the process that generates business cycles.’ Moreover, according to Minsky, the prevailing financial structure is a central determinant of the behavior of the capitalist economy. Likewise, the dynamism of profit-driven motives influence economic activity within the context of a given institutional structure in that the structure itself changes in response to profit seeking. Resonating with the ideas of economist Joseph A. Schumpeter, Minsky emphasized that: Financial markets will not only respond to profit-driven demands of business leaders and individual investors but also as a result of the profit-seeking entrepreneurialism of financial firms. Nowhere are evolution, change, and Schumpeterian entrepreneurship more evident than in banking and finance, and nowhere is the drive for profits more clearly the factor making for change.

That simple concept of defined-maturity segments revolutionized the bond fund sector, and the three-tier bond portfolio quickly became the industry standard. Our fifth major innovation came in 1992, when we determined to share the obvious economies of scale generated by our largest shareholders. It began with the creation of Vanguard “Admiral” funds, which slashed expenses for large shareholders in our newly created series of U.S. Treasury bills, notes, and bonds, a concept which would later spread to similar Admiral share classes in most of our other funds, to the benefit of these key owners. The sixth major Vanguard innovation—my final example today—is one that, like our bond innovation, would quickly be widely imitated (except, of course, for the low costs): Our creation in 1993, of the industry’s first series of tax-managed funds. Unnecessary taxes are this industry’s Achilles Heel, and we determined to create three funds that would serve the industry’s taxable investors, incorporating both minimal costs and maximum tax efficiency. This series of funds is one more innovation that has sprung from our unique organizational structure. But despite the power of our early innovation, the unremitting growth in our market share, and the growth in Vanguard assets to $1.3 trillion, that structure has yet to be emulated by a single one of our competitors. (Think about why that might be.)

Morningstar has popularized nine style-boxes—one axis focused on large- or medium-, or small-cap U.S. stocks; on the other axis, funds focused on growth stocks, or value stocks, or a blend of the two. In addition, we offer hundreds of funds focused on industry segments—technology, precious metals, telecommunications, etc.—as well as international stocks, including the total non-U.S. market (which is fine; it represents about half of the world’s market capitalization), but also scores of funds whose investments are concentrated in individual regions and countries. It is no secret that this radical change in our focus reflects the rise of gathering assets as our highest priority. Once an industry that sold what we made, we became an industry that made what would sell, giving the public what it wants. And the public seems to like the exciting and the new rather than the tried and the true. Most recent result: in the “new economy” speculative market blow-off of the late 1990s, we created some 240 new technology-based funds. These preferences have jeopardized the financial goals of our fund shareholders. That failure can now be measured statistically. Financial services firms are at last beginning to differentiate the rate of return that funds report (the “time-weighted” return) from the rate of return that fund investors actually achieve, (the “dollar-weighted” return), providing clear evidence that investors have chosen unwisely among the funds we have unwisely created.the

This cause-and-effect proposition among bond mutual funds is demonstrable. (Chart 6) The table below compares the yield of various types of bond funds as of December 31, 1996, with their returns during the following decade, ended December 31, 2006. On average, the actual yield of 5.9 percent a decade ago resulted in a total annual return averaging 5.2 percent per year. (That gap reflects those other bond fund costs coming into play.) 6 I’ve always thought that this issue should be explored by academics. It has rarely, if ever, been discussed.

course, our mission of service to investors requires good communications, advanced technology, and financial controls. They are conditions necessary, but not conditions sufficient to reaching our goals. Finally, the one great thing we recognize is the primacy of the individual human being. Reinforcement . . . from a Surprising Source You may be surprised to learn that none other than Woodrow Wilson came at his presidential mission with the same focus. He believed that productive relationships among human beings were required for serving the nation’s citizenry. In 1913, he delivered his first State of the Union address in person, renewing a custom that had lapsed with John Adams more than a century earlier. Wilson did not decide to renew that custom—one that we all now take for granted—inadvertently. Right at the start of his address, he pointed out that that a President must demonstrate that he is, “a person, not a mere department of Government, speaking naturally and with his own voice, that he is a human being trying to cooperate with other human beings in a common service.” I could hardly have said it better. Once the leader determines to treat those whom he serves as human beings, treating all of those with whom he serves as human beings quickly follows. In the ideal, some concept of the leader as servant and the servant as leader—each of whom can lift one another to a higher standard of moral and ethical service—can change the very nature of an enterprise.

Her greatest victories have been the victories of peace and of humanity. And in days quiet and troubled alike, Princeton has stood for the nation’s service.” Continuing his vision—and remember, this address was given in 1902, nearly a century ago—he added this profound prophecy: “A new age is before us, in which, we must lead the world . . . the spirit of the age will lift us to every great enterprise, but the ancient spirit of sound learning will also rule us . . . and the men who spring from our loins shall take their lineage from the founders of the republic.” And so in the United States of America the spirit of the age remains, this very evening.

Bad advertising—advertising that panders even as it produces results—is driving out good advertising— advertising that talks sense, explains costs, describes risks. Too many in this industry are advertising past performance—total returns and yields—that they must know as a certainty cannot be sustained, and will not soon recur. A philosophy that “everyone else is doing it” seems all to pervasive even among the responsible organizations, and the meaning of the phrase “lowest common denominator” has seldom been more clearly demonstrated. I believe that those kinds of zealous, simplistic advertising techniques have no place in this industry. By adopting the customary and time-tested techniques used to sell cosmetics, aspirin, and frozen foods, too many firms have come to view themselves as businessmen selling hot products, not as fiduciaries offering trust services. But our investment services are too important to the investor’s financial well-being, too market sensitive and too unpredictable, too complex and too easily misunderstood to be offered under the loose standards and banal simplicity of most consumer product  I recently received a “Tell-a-gram” updating this number through December 31, 1986. It is $679,958.

Vanguard ST Treasury Fund Average ST Gov’t Fund Volatility (vs index) 93% 100% Quality (A or above) 100% 99% Turnover (5 yr avg) 119% 155% Expense Ratio 0.26% 0.88% 4.95% 4.43% 10-yr Annual Return $6,200 $5,400 Profit on $10,000 Vanguard ST Federal Fund 90% 100% 81% 0.20% 5.07% $6,400 5B. Duration 2.2 2.4 2.2 While the Vanguard Short-Term Federal and Treasury funds are not, technically speaking, index funds, they track the index return with remarkable precision, turning in net average annual returns of 4.95 percent and 5.07 percent over the past decade, slightly higher than the index net return of 4.8 percent and outpacing 71 of the 90 short-term government funds. The low-cost, no-load option wins again. Treasurys being Treasurys, investment quality is virtually uniform. (Chart 5B) Both the Vanguard funds and the index itself hold 100 percent of their portfolios in short-term U.S. Government notes, and the actively managed funds hold 99 percent. With its towering 0.88 percent average expense ratio, however, the average short-term bond fund has a lot to overcome. It doesn’t succeed—it can’t succeed—in overcoming that handicap, even by assuming somewhat more volatility risk than the index and the Vanguard funds. The other outliers earning above- market returns did so simply by holding longer maturities, with the highest-returning funds carrying 3.3- to 3.9-year durations, compared to the duration of 2.2 years for the Vanguard funds.

Using Justice Brandeis’ formulation, these are “the relentless rules of humble arithmetic.” And cost matters. If the market delivers an annual return of 8 percent, when we deduct costs estimated at 2 ½ percent per year, we together earn 5 ½ percent, less than seventy percent of the total. Compounding the 8 percent return over an investment lifetime (I’m assuming 50 years), $1,000 would grow to $47,000—the magic of compounding returns. But with a net return of 5 ½ percent, the investor who puts up $1,000 sees his capital grow to but $14,000—the tyranny of compounding costs. The investor put up 100 percent of the capital and assumed 100 percent of the risk, but captured only thirty percent of the total market return. That’s simply not good enough. The oppressive impact of investment costs is eternal and meaningful, to be sure. But that impact varies with the level of returns the markets produce. So now let’s think for a bit what returns we might reasonably expect in the years ahead, and the drain that excessive intermediation costs might impose upon them. Of course no one knows what lies ahead, but there are ways to establish reasonable expectations. Before I discuss them, I’d like to present some very subjective comments.

As the late Robert Greenleaf, founder of the servant-leadership movement has said, “it is not superior technology, nor more astute market analysis, nor a better financial base that distinguishes a superior company, but an unconventional thinking about its dream, how it organizes to serve . . . a powerful liberating vision that must be difficult to deliver.” I am well aware that both conducting our investment strategy with the simplicity exemplified by index funds and conducting our business strategy with the simplicity of the Golden Rule are idealistic to a fault, perhaps even stupidly and naively idealistic. So be it. I for one am prepared to rise and fall on these hedgehog-like strategies, even as I am well aware that they form a mutually-reinforcing set of values, the key to success for any enterprise. If the application of low cost to policies of prudent investing is key to investment success, a firm requires both a structure and an attitude that bring about low cost. So positioned, the hedgehog’s spines are well-honed, his defenses ready to engage in a life- long competition with the clever foxes of the investment profession and the wily foxes of the world of commerce, breeds that are more sophisticated and worldly-wise, and surely more brilliant, than I could ever imagine being.Wilson,

flare out. There is no evidence that this sea change in investment approach has been advantageous for mutual fund shareholders. To the contrary. 5. In 1951, fund advertisements were limited to dull “tombstone ads” and funds were extremely limited in promoting their performance. For a time, they could not even present their total annual returns. Today, funds that have enjoyed strong returns (usually funds following extreme and/or risky strategies) freely hawk their own wares, bragging about their performance (when it’s good!) in newspapers, magazines, and on television. (Alas, past performance is not only not predictive of the future, but, at least in speculative markets, predictive of quite the opposite.) Ultimately, of course, it is the fund shareholders who pay for all of this promotion. 6. As a result of all of this proliferation and promotion of funds, fund investors, eager to catch the next favorable market trend, move their money around at a frantic rate. Believe it or not, the average holding period of a mutual fund owner in 1951 was some sixteen years. Today it has shrunk but four years, admittedly, up from only two years in 2000, the peak of the illicit market timing scandals.

Initial Yield Expense Ratio 10-Yr Ann. Return IT Corporate Bond Funds 10 Cheapest 6.6% 6.1% 10 Most Expensive 5.9% 1.9% 4.5% The Relationship Between Expenses and Returns Profit on $10,000 $8,100 $5,500 0.2% Low Cost Advantage +11% (89%) +35% +47% 7. Intermediate-Term Corporate Municipal Treasury 12/96 Yield 6.2% 4.7 6.2 10-Yr Ann. Return Through 12/06 5.2% 4.3 4.9 Long-Term Corporate Municipal Treasury 6.9% 5.1 6.1 6.1% 4.4 6.9 Current Yields and Future Returns Note: Yields and Returns exclude impact of sales charges. 6. If investors were more aware of this relationship, surely they’d seek out the lowest-cost—and, therefore, generally highest-yielding—bond funds. For example (Chart 7), here are the returns earned by today’s ten lowest-cost intermediate-term corporate bond funds—expense ratios averaging 20 basis points—and the ten highest-cost funds—expense ratios averaging an amazing 190 basis points—their yields a decade ago, and their returns over the subsequent 10 years. The low-cost group provided an enhancement of fully 35 percent to the investor’s annual return, and a compounded enhancement of almost 50 percent, with zero increase in risk. Investors are largely unaware of these clear relationships between bond fund costs and yields, and between today’s net yield and tomorrow’s total return. Expenses are the principal determinant of relative yields, and yields are highly predictive of future returns.

The tracking of their benchmark, their quality parity, and their extremely low expenses mark the Vanguard Short-Term Treasury Bond Fund and the Short-Term Federal Fund—its counterpart which holds largely agency securities—as the functional equivalents of the Lehman 1–5 Year Treasury Bond Index. While there are no bond funds that track this index, those Vanguard funds are the virtual equivalent of an index fund. (Most of the actively-managed funds carry fees and sales charges (averaging 3 percent), which are incorporated into the rates of return shown.)

largest inflows of investor capital during 1997-2000, the average annual return earned by investors was 6.4 percentage points per year below the return reported by the funds, a cumulative loss of 107 percentage points over ten years. (Only two of the 200 funds defied this pattern.) Perhaps unsurprisingly, the more specialized the funds, the larger the shortfall. Yet in recent years, we’ve taken our focus on a bewildering array of highly specialized fund choices to new heights. The stampede into exchange traded funds (ETFs) has been dominated overwhelmingly by highly specialized funds that, in the words of an ETF advertisement, “can be traded in real time, all day long.” Among 690(!) ETFs today, 678 are narrowly focused, some on individual foreign countries (Korea, Germany, whatever you wish) or industry sectors (technology, small-caps, even most recently, HealthShares Emerging Cancer). Only 12 of the 690 ETFs are highly diversified index funds holding the entire U.S. stock market or the entire non-U.S. stock market, close cousins to our diversified blue-chip funds of yore. Of course such ETFs, held for the long term, are perfectly fine investments. But actively pursuing these narrow strategies, too often chasing past performance, will surely be hazardous to the wealth of our investors and in the long-run, that can’t be good for our industry.

Wrapping Up Whether in banking or mutual funds, innovation has always been—and remains—a two-edged sword. I am not alone in this view. Consider these prophetic words of the eminent financier Henry Kaufmann, from his fine book On Money and Markets, published in 2001. “Only by improving the balance between entrepreneurial innovation and more traditional values—prudence, stability, safety, and soundness—can we improve the ratio of benefits to costs in our financial system.” So yes, our financial system surely provides ample “fresh thinking that creates value,” just as that Economist article on innovation that I mentioned at the outset suggested. But while financial innovations nearly always create value for those who devise, construct, promote, and market them, far too many of these innovations have subtracted value from investors who have trusted their creators and sponsors and invested in them, with damage that has now gone even further, into our society at large. It is time to face up to these realities.

contributing to the highest values of our system of capital formation even as they strive to take personal responsibility for the security of their own financial futures, has been a marvelously worthwhile life’s work. I am infinitely blessed. Returning Full Circle It is wonderfully ironic that the very same 1949 issue of Fortune that inspired my thesis included a feature essay entitled “The Moral History of U.S. Business.” Alas, I have no recollection of reading it at that time. But I read it a few years ago, a half-century later. As I reflect on Vanguard’s two guiding principles of prudent investing and personal service, both seem to be related to the kind of moral responsibility of business that was expressed in that ancient Fortune essay. It began by noting that the profit motive is hardly the only motive that lies behind the labors of the American businessman. Other motives include “the love of power or prestige, altruism, pugnacity, patriotism, the hope of being remembered through a product or institution.” Yes, all of the above. Even as I freely confess to all of these motives—life is too short to be a hypocrite—I also agree with Fortune on the appropriateness of the traditional tendency of American society to ask: “what are the moral credentials for the social power (the businessman) wields?

advertising. One industry participant recently said, “selling mutual funds is just like selling perfume; we’re selling hope.” I pray that that is a minority view. A $700 Billion Trust At the 1936 General Membership Meeting of the Investment Company Institute, there was a huge banner reading “Mutual Funds: A $600 Billion Industry.” My hope today, as I come full circle in these remarks, is that this year’s banner will read “Mutual Funds: A $700 Billion Trust.” For we are much more than a mere “industry.” And we must hold ourselves to higher standards, standards of trust ;and of fiduciary duty. If we fail to do so—if we follow the lead of marketing companies in conventional consumer businesses, if we continue to create investment expectations we cannot possibly meet, often overlaid with high risks and laden down with exorbitant costs—the future of mutual funds is not bright. But if we return to the philosophy that a fully-informed investor paying a fully-disclosed cost for a sensible investment program is the best possible base for building an ever more successful business, our finest hours lie yet ahead. Dealing with this dichotomy—between an industry and a trust—is surely the critical challenge of change that we face. Indeed, what I have presented today is more accurately described as “the challenge to change.

In our omniscient financial markets—dominated by smart, sometimes brilliant, professional investors—largely employed by financial institutions that just happen to be investing other people’s money—we are told, “Don’t think you know more than the market. Nobody does.” And yet I continue to believe, after Pascal, that we should consider not only the probabilities that the things that might go wrong actually come to pass, but their consequences. Even if our stock market professionals, with their intense focus on the short term, are unconcerned about the impact of these issues on the investors they serve, long-term investors, depending on accumulating assets for their retirement years, cannot afford to ignore them. It is here that I have serious concerns. (Full disclosure: while I’m an eternal optimist, I’m a conservative investor, believing that virtually every portfolio should have a portion in fixed-income securities as well as equity securities.) I can hardly contemplate the most dire consequences of, for example, the war in Iraq, nuclear proliferation, fragile sources of energy, the spread of religious fundamentalism, global warming, enormous federal budget deficits (with a political system unwilling to deal with them), and the massive potential shortfalls in the ability of our corporations, our cities and our states (to say nothing of our federal government) to fund their pension liabilities.

“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.

who said in September 1919, only days before suffering the stroke that ended his political effectiveness. “Sometimes people call me an idealist. Well, that is the way I know I’m American. America is the only idealistic nation in the world.” Liberal Education, Moral Education When I think of the good fortune that has brought to me the extraordinary award that Princeton University bestows on me today, I give the highest order of credit to a set of strong family values and a faith in God, a fine preparation for college at Blair Academy, and the powerful reinforcement and new awakening I received through a liberal education at this remarkable place. In a recent essay in the Princeton Alumni Weekly, President Shapiro defined these two aims of a liberal education: “One is the importance of achieving educational objectives, a better understanding of our cultural inheritance and ourselves, a familiarity with the foundations of mathematics and science, and a clarification of what we mean by virtue . . . the other is the importance of molding a certain type of citizen.” He went on to emphasize, “the search for truth and new understanding . . . and the freeing of the individual from previous ideas, the pursuit of alternative ideas, the development of the integrity and power of reason of individual goals . . . and the preparation for an independent and responsible life of choice.” During my four years here, I did my best to acquire these traits.

” For change we must—surely in the operations that we focus on at this meeting, but also in our communications, our pricing structure, our product line, our promotional techniques—if we wish to be not just another multi-billion dollar “industry” but rather a multi-billion dollar “trust.” We are challenged, in a sense, to regain our bearings, to return to the sound and sensible principles that got us to our present eminence in the first place. Let me conclude with a challenge to you of The National Investment Company Services Association. Ten years ago, I looked ahead with you, with mixed success—some hits, some errors, some misses. Today, I have tried to look ahead again; and I anticipate with excitement, curiosity, and enthusiasm the new chapter in our history that will be written in the coming decade. When it ends, you shall be celebrating your 35 th anniversary, and I my 50 th year of observing this marvelous industry. My challenge to you is this: invite me back in 1997. It would be fascinating, to say nothing of amusing, to review together how we rose both to the challenge of change, and the challenge to change!

The growing role of institutional investors fostered continued financial-system evolution by providing a ready pool of buyers of securitized loans, structured finance products, and myriad other exotic innovations.” 7 In the following four paragraphs, I quote investment adviser Frank K. Martin, CFA, writing in the 2006 annual report of his firm, Martin Capital Management.

That we’ll somehow “muddle through” challenges like these—now on a global scale in our “the earth is flat” modern world— seems to be the prevailing expectation of our money managers. While risk abounds, however, stocks are selling at valuations that are in fact somewhat higher than long-term norms, implying optimism on the part of investors. Over the past century, stocks have sold at about 14 times corporate earnings; today they’re selling at about 18 times, reflecting a more confident outlook about what lies ahead. What’s more, as we’ll soon see, stocks currently offer a risk premium over bonds that is extremely low by historical standards. And as former Federal Reserve chairman Alan Greenspan has said, “History has not dealt kindly with the aftermath of protracted periods of low risk premiums.” But whatever may come to pass in the world, in America, and in our robust economy, please don’t forget this unfailing principle: in the long run it is the reality of business—the investment return on stocks, consisting of the dividend yields and earnings growth generated by our corporations—that drives the returns generated by the stock market itself. Over the past century-plus, for example, the nominal investment return earned by stocks was 9.5 percent, consisting of an average dividend yield of 4.5 percent and average annual earnings growth of 5.0 percent. (Chart 1) Speculative return, which added a mere 0.on

A $10,000 investment in the average short-term government fund produced a profit of $5,400, compared to $6,400 for Vanguard’s Short-Term Federal Fund and $6,200 for Vanguard’s Short-Term Treasury fund. It’s simply unbelievable that, given the constraints on maturity in the short-term arena, the need for virtually no credit analysis and the inability to deliver extra value (except by extending maturities), fully 27 of the 90 short-term investment funds carry annual expense ratios of 1 percent or more. Numbers Games Now let’s look behind the figures presented in the foregoing analysis of bond funds in the long-, short-, and intermediate-term maturity groups, and in corporates, municipals, and Treasuries, and play some numbers games. First, the data uniformly point to the compelling advantage of low cost bond funds, and, where available, low-cost bond index funds. And yet cost competition among fund managers is conspicuous by its absence. One can only be appalled, for example, with the fact that there are only 9 long-term municipal bond funds in our list of 143 funds with annual expense ratios of 0.50 percent or less, and perhaps even flabbergasted that there are only two of them with ratios below 0.40 percent. Of course, they are the Vanguard Long-Term and Insured Long-Term Funds, with respective ratios of 0.15 percent and 0.16 percent. By contrast, there are 65 such funds with ratios of 1.00 percent or more, including the, well, champion, coming in at a truly astonishing 1.

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

But as a group, bond fund managers are unwilling to reduce their fees to enhance the returns earned by their shareholders. Since I don’t see how regulation can solve this problem, it’s high time that bond funds, too, be required to put their prospective investors on notice by disclosing these relationships. As in the case of stock fund costs, failure to disclose could hardly be said to represent “fair dealing with investors.” 2. Fund Returns vs.Returns

Then, too many fund managers—including, as I noted earlier, some of the industry’s largest firms—conspired with favored hedge fund clients to allow rapid short-term trading in fund shares that diluted the returns of their long-term shareholders—a classic example of the change from the days “when there were some things one just didn’t do,” to “everyone else is doing it, so I can do it too.” And I’ve seen both, first-hand. 7. Importantly, fund costs have increased by staggering magnitudes since I joined the field all those years ago. In 1951, with fund assets at $2.5 billion, the average equity fund carried an expense ratio (expenses relative to assets) of 0.77 percent. Last year, with equity fund assets at $6.3 trillion, the average fund carried an expense ratio of nearly double that amount: 1.43 percent. Result, expressed in dollars: fund expenses rose from $15 million to $51 billion—260 times as large.5 Not only have basic fee structures risen, but the staggering economies of scale in managing other people’s money have been arrogated by fund managers to their own benefit. Exceptions to this pattern are rare: Among seven of the eight largest funds of 1951, the average expense ratio has actually increased from 0.60 percent to 1.10 percent. Only one fund actually reduced its costs to investors, from 0.60 percent to 0.32 percent. (That fund would be Vanguard’s Wellington Fund.)

” The article quotes the words of Quaker businessman John Woolman of New Jersey, who in 1770 wrote that it is “good to advise people to take such things as were most useful, and not costly,” and then cites Benjamin Franklin’s favorite words— “Industry and Frugality”—as “the (best) means of producing wealth and receiving virtue.” Moving to 1844, the essay cites William Parsons, “a merchant of probity,” who 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.” Those demands, uttered more than 160 years ago, were not only inspiring, but seemed directed right at me. As for the mind, I still strive every day—I really do!—to improve my own mind, reading, reflecting, 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 six days ago, after all, I marked the eleventh (!) anniversary of the amazing grace represented by the incredibly successful heart transplant that I received in 1996.

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.

95 percent. However, it is not only the burden of expense ratios that most bond funds must overcome. It is the burden of sales charges as well. While the earlier data showing the ten-year results of a $10,000 initial investment in fact included the impact of sales charges on those funds charging sales commissions, it is in the nature of that data to amortize, in effect, the front-end sales charge over the full decade. But it turns out that bond funds are typically held by investors for only a relatively small fraction of a decade—actually only about three years on average. So all of those returns for the average bond fund I’ve shown earlier are overstated. One might think that, because of the sunk cost represented by the front-end load, investors in such funds would hold them for an extended period, lengthening the amortization period in order to reduce the negative impact on return. Wrong! (Chart 6) In fact, the holding period for load and no-load funds differ only slightly in the corporate area (about 2.8 years).But

Total Returns on Stocks, Past and Future 4.5% 3.4% 2.0% 5.0% 6.4% 6.0% -1.0% 2.7% 0.1% -2% 0% 2% 4% 6% 8% 10% 12% 14% Last 100 Years Last 25 Years Next 10 Years 9.6% 12.5% 7.0% Earnings Growth Dividends P/E Change Investment Return Speculative Return 1. stocks to 9.6 percent per year. In the long run, then, investment returns are driven almost entirely by economics. But in the shorter-run, emotions—reflected in speculative return—can add to, or subtract from those economics that generate long-term returns, often by substantial magnitudes. During the past 25 years, for example, the annual investment return earned in the U.S. stock market was 9.8 percent, relatively close to the historic 9.5 percent historical norm. But speculative return contributed another 2.7 percent, reflected in the willingness of investors to increase the amount they paid for each dollar of corporate earnings from 9 times to 18 times, based on the trailing 12-month reported total earnings of the S&P 500, a 100 percent increase, spread over a quarter century. (Early in 2000, the P/E ratio actually reached an astonishing 32 times, only to plummet to 18 times as the new economy bubble burst.) Net result: during the past 25 years, speculative return enhanced the market’s annual return by nearly 30 percent. Did it matter? You better believe that it did! Compounded over the full quarter-century period, that enhancement was little short of astounding. The annual investment return of 9.

It is but a truism to state of this industry in the aggregate: “The more fund managers take, the less fund investors make.” I am convinced that the coming of public ownership of fund management companies in the late 1950s bears an important share of the responsibility for many of the problems I’ve described in my remarks today: rising costs for investors, and the failure to deliver our huge economies of scale to shareholders; the failure to make the most of our opportunity in retirement planning; the move away from long-term investment in favor of short-term speculation; the asset-gathering mentality and the focus on fads like size and style, all of which have meant staggering profits for fund managers and substantial cumulative shortfalls to returns in the financial markets for fund shareholders. Just check the record. So what’s to be done? Shareholder education is glacially slow, yet time is money. The conglomerates that dominate the industry today—owning 40 of the 50 largest fund complexes—will not soon accept eroded returns on their capital, nor will they willingly return their profits to their clients. So I see no recourse but to put fund shareholders in the driver’s seat of fund governance, thereby at last honoring both the letter and the spirit of the 1940 Act. 5 SEC Decision “In the Matter of the Vanguard Group” February 28, 1981, page 6.

President Shapiro also pointed to the “responsibility of a university offering a liberal education to provide its students with a moral education . . . helping them to develop values that will enrich their lives as individuals and as members of society.” This aging hedgehog, looking back in hindsight through glasses that inevitably have a rosy hue, can only say that the liberal and moral education placed before me at Princeton may well have ignited some deep and unimagined spark that began to influence my life and my career in the mutual fund field. This spark, nurtured by time and experience, has erupted into some sort of flame that has permeated my ideas about the proper nature of the mutual fund. The flame will spread one day to the industry and become a blaze, one that will not be easy to extinguish. It is my prayer that my mission—my crusade, if that is not too lofty a characterization of the course of my career—will help an industry to rethink its values, and accordingly be of greater service to growing millions of American investors. Serving these new owners of American business, who are contributing to the highest values of our system of capital formation even as they strive to take personal responsibility for the security of their own financial futures, has been a marvelously worthwhile life’s work.

So, yes, it’s fair to say that the idealistic principles I expressed in my ancient thesis—that funds “should be operated in the most honest, efficient, and economical way possible . . . that the industry should focus on reducing sales charges and expense ratios,” and that “the principal role of the mutual fund should be to serve its shareholders”—have not only not been realized, but have been violated. Accordingly, the earlier business values and investment values of our industry became vanishing treasures. V. Grounds for Hope Had I not found agreement with this harsh indictment of the present-day capitalism from some of the most respected names in investing, I might be a little less certain of my ground. But leaders of great repute in the business community and the investment community have stood up and spoken out, making a positive difference. Consider, for example, the eminent financier, economist, and historian Henry Kaufman. In his remarkable 2000 book On Money and Markets, here’s what he said: 5 Asset-weighted expense ratios of equity funds rose from 0.60 percent to 0.80 percent.

-$50,000 -$30,000 -$10,000 $10,000 $30,000 $50,000 $70,000 $90,000 $110,000 $130,000 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 1000 1200 1400 1600 Net New Cash Flow S&P 500 The Timing Penalty: Equity Fund Cash Flow Follows the Stock Market 8. millions I now turn to the issue of the returns actually earned by fund shareholders. When we were an industry that sold what we made, those returns closely paralleled the returns reported by the funds themselves. But when we became an industry that focused on making what would sell, those two returns sharply diverged, with great detriment to fund shareholders. This departure began in the “Go-Go” era of the mid-1960s, when we created scores of risky funds, seeking high returns by rapid trading, investing in small and often risky companies, and following new “investment concepts.” Many of these funds reported past returns that were achieved by dubious means, including buying “letter stocks” from insiders at substantial price discounts and marking-up their prices to the higher market price. The investment records of many of these “incubation funds” that were later taken public were little short of fraudulent. These funds were “hot,” the money flowed in, and then they turned cold. Fund investors paid a high price for our folly. In the recent era, while the conditions were different, the outcome was the same.

0% 20% 40% 60% 80% 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 Share of Corporate Equities Held by Institutions Source: Federal Reserve 6. I’ve written a book about these issues,8 and I express my conclusion bluntly. Using words remarkably close to those of Minsky, I describe how capitalism has changed for the worse. In a half- century we’ve moved from an ownership society where individual shareholders owned 92 percent of all stocks and financial institutions owned only 8 percent (Chart 6) to an agency society in which institutional shareholders now own 74 percent of all stocks. But we haven’t changed the rules. These mutual fund and pension fund managers have largely ignored the interests of their principals—fund shareholders and pension beneficiaries. To restore balance to the system, we need a new fiduciary society in which the interests of these 100 million principals—the last-line investors of America—come first. The Rise of the Financial Economy I’ve taken you on this long trip through risk and uncertainty, not only because I find these ideas both important and intellectually stimulating, but because they set the stage for my discussion of the concerns I hold today regarding our financial system and our society. I recognize that some of these ideas are complex, so let’s summarize the ground we’ve covered so far: 1. Black Swans—extreme and unexpected outcomes—are part of investing, and can’t be predicted in advance. 2.

Remember always that even one person can make a difference. And do your part ‘to begin the world anew.’” A single turn of the page takes you to five epigraphs (count ‘em, five!), the first of which comes from St. Paul: “if the sound of the trumpet shall be uncertain, who shall prepare himself to the battle?” And in my acknowledgments, I get right to the point in the very first paragraph: “Capitalism has been moving in the wrong direction.” The introduction that follows doesn’t let up. I start off with a remarkably light revision of the classic first paragraph of Gibbon’s The Decline and Fall of the Roman Empire, adapted to the present era. Compare the two first sentences. Gibbon: “In the second century of the Christian Era, the Empire of Rome comprehended the fairest part of the earth and the most civilized portion of mankind.” Battle: “As the twentieth century of the Christian era ended, the United States of America comprehended the most powerful position on earth and the wealthiest portion of mankind.” So when I add Gibbon’s conclusion—“(Yet) the Roman Empire would decline and fall, a revolution which will be ever remembered and is still felt by the nations of the earth”—I’m confident that thoughtful readers do not miss the point. But of course I hammer it home anyway: “Gibbon’s history reminds us that no nation can take its greatness for granted. There are no exceptions.

In the late 1990s, fund investors again paid a high price for our focus on the promise of the technology-driven information age, and on the promised land of the great bull market. The price they paid can be measured by the errors that fund investors made in the timing of their fund purchases and the selection of the funds they chose. The next two charts reflect those destructive patterns. The timing penalty (Chart 8) was evidenced by the fact that fund investors placed little money into equity funds during the cheap markets of the late 1980s and early 1990s (less than $10 billion per year), but invested more than $500 billion at the peak market levels of 1998-2000. The selection penalty (Chart 9) made a bad situation worse. Investors poured the lion’s share of that $500 billion into those “New Economy” growth funds, technology funds, telecommunication funds, and even internet funds. It was these funds that led the market upward, and then led the market downward, with late-to-the party fund investors paying an awful price. Ironically, at the height of the bubble, investors were actually liquidating their stodgy old value funds, which would provide excellent downside protection during the bear market that followed.

8 percent produced a 935 percent cumulative gain. But the total annual return of 12.5 percent on stocks grew to a cumulative return of 1,800 percent. That seemingly modest incremental speculative return of 2.7 percent per year produced an extra enhancement of 865 percent for equity investors. But we can’t count on a recurrence of this remarkable bonus. For this simple methodology tells us that we’re facing an era of subdued returns in the stock market. First, today’s dividend yield on stocks is not 4.5 percent (the historical norm), but slightly below 2 percent.dead-weight

What is necessary is that the governance of mutual funds comports with just what the Act calls for: a board of directors that is beholden first and foremost to the shareholders who elected them. We must eliminate the blatant conflict of interest that exists when the chairman of the fund board is the same person as the chairman of the management company board. (As Warren Buffett says, “negotiating with one’s self seldom produces a barroom brawl.”) For the same reason, we need a board wholly independent of the manager. (The requirement that 75 percent of the directors must be independent is a good beginning, but at Vanguard our outside advisers have zero board representation, obviously without adverse consequences for our shareholders.) Regulations already require an independent legal counsel and a chief compliance officer for the funds themselves, and I strongly favor, at least for the larger fund complexes, a fund staff, responsible to the board, that provides the board with objective and unbiased information on fund costs, performance, marketing, etc. So my dream of fund independence means not only that today’s pending board reforms will be preserved by the SEC, but that groundwork will be laid for an industry that at last acts under the spirit of our federal statute that demands that fund shareholders, through their elected representatives, are placed in the driver’s seat of fund governance.

As Karl Popper recognized, not only our market, but science itself, depends not on observations confirmed by verification, but on wild conjectures sharpened by falsification (proof that the theory is wrong). 3. Frank Knight focused on a critical distinction between risk—which is subject to measurement—and uncertainty—which is not. 4. Stock market returns, in the short-term, are not normally distributed, but are explained by the fractal patterns discovered by Mandelbrot. We can’t ignore the possibility—indeed, the virtual certainty—that such extreme patterns will persist, and we never know when. 5. Keynes’s insight was to separate stock returns into two elements, enterprise—subject to a reasoned financial analysis and speculation—the madness of crowds—which, he argued, would become increasingly dominant. 6. Bogle (if you will) applied numbers to Keynes’s insight, showing that future investment returns were subject to reasonable expectations, and that even speculative returns tended, over time, to move toward zero. 7. Minsky added a sobering note: the financial economy, focused on speculation, was not separate and distinct from the productive economy, focused on enterprise. Rather, the former would come to overwhelm the latter. 8 The Battle for the Soul of Capitalism, Yale University Press, 2005.

Returning Full Circle I now close, surprisingly enough, by returning, full circle, to where I began my remarks: Finding Fortune, as it were, a half-century ago. Of course, I had kept a copy of my thesis, and I obtained years ago a copy of that original mutual fund article from which so much innovation was to emerge. What is more, thanks, to an enterprising Vanguard crew member, I received just weeks ago a mint-condition copy of the entire December 1949 original edition of Fortune. One more mystically fortuitous event occurred: the feature essay was entitled “The Moral History of U.S. Business.” I have no recollection of reading it in 1949. But I read it a few weeks ago, nearly 50 years later. As I reflect on Vanguard’s two guiding principles of prudent investing and personal service, both seem to be related to the kind of moral responsibility of business expressed in the Fortune essay. It began by noting the non-profit motives that lie behind the labors of the American businessman: “the love of power or prestige, altruism, pugnacity, patriotism, the hope of being remembered through a product or institution.” Even as I freely confess to all of these motives—life is too short to be a hypocrite—I also agree with Fortune on the appropriateness of the traditional tendency of American society to ask: “what are the moral credentials for the social power (the businessman) wields?

2.75 2.26 4.67 2.80 2.95 3.74 0.5 1.5 2.5 3.5 4.5 Corporate Government Municipal Load No Load Bond Fund Holding Periods (years)* 6. holding periods for load funds are in fact shorter among the government funds (2.3 vs. 3.0 years), and only slightly longer in the municipal area (4.7 vs. 3.7 years). All of these holding periods, of course, are incredibly short—a problem for load-fund investors but indifferent (in performance impact) for no-load investors. How much is that overstatement? If the typical 4 percent front-end sales charge on bond funds were spread over ten years, the reported rate of return would be reduced by just 4/10 of 1 percent per year. But if the same charge were spread over just three years, the hit, as it were, would come to fully 1.4 percent per year. Tacked on to an expense ratio averaging about 1.1 percent for load funds, that total of 2.4 percent would now consume about 50 percent—one half!—of the 4.7 current yield on the 10-year Treasury. (Even a higher fraction—virtually expropriation—for municipal fund investors, but a slightly lower fraction for corporates.) I can’t help but wonder whether (and to what extent) any of you bond professionals here tonight would invest in a bond fund with such a confiscatory handicap. A Word about Vanguard Of course, you may regard me as biased in my presentation this evening.fees,

“Unfettered financial entrepreneurship can become excessive—and damaging as well— leading to serious abuses and the trampling of the basic laws and morals of the financial system. Such abuses weaken a nation’s financial structure and undermine public confidence in the financial community . . . Only by improving the balance between entrepreneurial innovation and more traditional values—prudence, stability, safety, soundness—can we improve the ratio of benefits to costs in our economic system . . .When financial buccaneers and negligent executives step over the line, the damage is inflicted on all market participants . . . and the notion of financial trusteeship too frequently lost in the shuffle.” Dr. Kaufman is not alone. Felix Rohatyn, the widely-respected former managing director of Lazard Freres, is another of the wise men of Wall Street who have spoken out. Here’s what he wrote in The Wall Street Journal a few years ago: “I am an American and a capitalist and believe that market capitalism is the best economic system ever invented. But it must be fair, it must be regulated, and it must be ethical. The last few years have shown that excesses can come about when finance capitalism and modern technology are abused in the service of naked greed. Only capitalists can kill capitalism, but our system cannot stand much more abuse of the type we have witnessed recently, nor can it stand much more of the financial and social polarization we are seeing today.

-$60 -$40 -$20 $0 $20 $40 $60 $80 $100 $120 $140 $160 Q1'98 Q4'98 Q3'99 Q2'00 Q1'01 Q4'01 Q3'02 Q2'03 Q1'04 Q4'04 Q3'05 Q2'06 Q1'07 1000 1500 2000 2500 3000 3500 4000 4500 5000 Growth Value Nasdaq Close Source: Strategic Insight Net Flow (bil) Nasdaq The Selection Penalty: Quarterly Flow into Growth and Value Funds, and the Nasdaq’s Close 9. -30% -20% -10% 0% The Gap Between Annual Time-Wtd. and Dollar-Wtd. Returns 1996 - 2005 Covers the 200 funds with largest cash flows during 1996-2000. 10. We are only now beginning to calculate the devastation that these two patterns dealt to the wealth of mutual fund investors. But the data showing investor returns—resisted by the industry ever since I first mentioned it in a speech to the financial writers in Chicago eleven years ago—can no longer be hidden. We can now readily compare the returns earned by the fund itself—as reported in its shareholder reports and prospectus—to the returns actually earned by its investors. The technical distinction is between time-weighted and dollar-weighted (or asset-weighted) returns. The results are not pretty. Begin with the fact that during the 25-year period 1980-2005, when the S&P 500 Index rose at a 12.3 percent annual rate, the return of the average fund averaged 10.0 percent annually, or 2.3 percentage points less. But the returns earned by fund investors fell far short of that 10.0 percent return.

” As one of two reviews—both very generous—of The Battle that appeared in The New York Time noted, “Subtle Mr. Bogle is not.” No, I’m not writing off America. But my certain trumpet is warning that we must put our house in order. “The example of the fall of the Roman Empire ought to be a strong wake-up call to all of those who share my respect and admiration for the vital role that capitalism has played in America’s call to greatness. Thanks to our marvelous economic system, based on private ownership of productive facilities, on prices set in free markets, and on personal freedom, we are the most prosperous society in history, the most powerful nation on the face of the globe, and, most important of all, the highest exemplar of the values that, sooner or later, are shared by the human beings of all nations: the inalienable rights to “life, liberty, and the pursuit of happiness.” Something Went Wrong But something went wrong. “By the later years of the twentieth century, our business values had eroded to a remarkable extent”—the greed, egoism, materialism, and waste that seem almost endemic in today’s version of capitalism; the huge and growing disparity between the “haves” and the “have-nots” of our nation; poverty and lack of education; our misuse of the world’s natural resources; the corruption of our political system by corporate money—all are manifestations of a system gone awry. And here’s where the soul of capitalism comes in.

” The fact is that, in some important respects, the Invisible Hand of capitalism has failed us. Here are the familiar sentences that Adam Smith wrote in The Wealth of Nations. “It is not from the benevolence of the butcher, the baker, or the brewer that we expect our dinner, but from their regard to their own self-interest. By directing (our own) industry in such a manner as its produce may be of the greatest value, (we) intend only our own gain, and (we are) led by an invisible hand to promote an end which was no part of (our) intention.” Writing in Daedalus in the summer of 2004, Nobel Laureate (in Economics) Joseph E. Stiglitz puts the Invisible Hand into perspective. Under the assumption of “perfect competition, perfect markets, and perfect information . . . selfishness is elevated to a moral virtue.” But those assumptions are false. As Stiglitz’s fellow Nobel Laureate Paul Samuelson observed in the first edition of his classic Economics: An Introductory Analysis—a textbook that I read right here in 1948-49—the problem with “perfect competition is what George Bernard Shaw once said of Christianity: ‘the only trouble with it is that its never been tried.’” Nonetheless, Stiglitz continues, “societies in which there are high levels of trust, loyalty, and honesty actually perform better than those in which these virtues—virtues—are absent. Economists are just now beginning to discover how non-economic values—values—actually enhance economic performance.” So what’s to be done?

and low portfolio turnover. Whatever my bias, I assure you that I have no economic stake in the growth of our bond funds. I believe in them, not because their growth might enrich me (it doesn’t, and it won’t), but because the relentless rules of humble arithmetic on which that strategy is based will enrich investors. Yes, of course I know that many industry participants argue that since Vanguard’s Fixed Income Group manages most of our bond funds—and does so at our actual cost—we have some sort of unfair advantage over our peers. (To whom?, one might ask.) Well, yes and no. Yes, at Vanguard we now directly manage some $300 billion in fixed-income assets, including our bond index funds. We obviously enjoy huge economies of scale, and our advisory fees come to less than 0.01 percent (one one-hundredth of one percent), representing not a fee, but the actual costs incurred in the Fixed Income Group. On the other hand, there can be little doubt that the $27 million in investment supervisory and research costs we incur is among the largest expenditure on professional talent, expertise, experience, and implementation of any group in our field. The secret, as it were, is that while it takes lots of dollars to attract and retain investment professionals, if you manage enough assets, it can cost investors only a tiny fraction of basis points deducted from the returns they earn.

Total Returns on Bonds * , Past and Future 11.9% 4.6% 6.3% 7.8% 10.4% 4.6% 6.1% 7.2% 0% 2% 4% 6% 8% 10% 12% 14% 1980s 1990s 2000 - 06 Next 10 Years 2. Initial yield Return over following period *Intermediate-term U.S. Government Bonds. Est. loss of 2.5 percentage points per year in the contribution that dividend income makes to investment return. Next, let’s assume that corporate earnings will continue to grow (as, over time, they usually have) at about the pace of our economy’s nominal growth rate, say 6 percent per year over the coming decade. (That may be a bit optimistic.) If these assumptions are correct, then the most likely investment return on stocks would be in the range of 8 percent. Now let’s consider speculative return in the coming decade. The present price/earnings multiple on stocks now looks to be about 18 times. If the P/E ratio remains at the present level a decade hence, speculative return would neither add to nor detract from that possible 8 percent investment return. My guess (it is little more than that) is that the P/E might ease down to about 16 times, reducing the market’s return by about 1 percentage point a year to an annual rate of 7 percent. (You don’t have to agree with me. If you think the P/E will leap to 25 times, add 3 percentage points to the investment return of 8 percent, bringing the total return on stocks to 11 percent.

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?

” The essay begins with the example of Quaker businessman John Woolman of New Jersey, who in 1770 wrote that it is “good to advise people to take such things as were most useful, and not costly.” It then cites Benjamin Franklin’s favorite words—“Industry and frugality”—as “the (best) means of producing wealth and receiving virtue.” Moving to 1844, the essay cites the words of William Parsons, “a merchant of probity,” who 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, a character to form.” Woodrow Wilson on the Moral Impulse As for the mind, I still strive every day—I really do!—to improve my own. As for the heart, no one—no one!—could possibly revel in the opportunity to cultivate it more than I. Tomorrow, after all, just happens to be the anniversary of the amazing grace represented by my incredibly successful heart transplant just three years ago. 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 firm I founded 25 years ago.far

0% 5% 10% 15% 20% 25% 30% 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Financial Sector’s Share of S&P 500 Earnings, 1980 – 2007 7. Source: Standard & Poor’s Corporation Was Minsky right? Has a new element of uncertainty been introduced into our economy? I’m inclined to agree. Indeed, I express the secular changes in the economy in a way quite similar to Minsky. Over the past two centuries, our nation has moved from being an agricultural economy, to a manufacturing economy, to a service economy, and to what is now predominantly a financial economy, and a global one at that. But the costs that we incur in our financial economy, by definition, subtract from the value created by our productive businesses. Think about it. When investors—individual and institutional alike—engage in far more trading— inevitably with one another—than is necessary for market efficiency and ample liquidity, they become, collectively, their own worst enemies. While the owners of business enjoy the dividend yields and earnings growth that our capitalistic system creates, those who play in the financial markets capture those investment gains only after the costs of financial intermediation are deducted. Thus, while investing in American business is a winner’s game, beating the stock market—for all of us as a group—is a zero-sum game before those costs are deducted. After intermediation costs are deducted, beating the market becomes, by definition, a loser’s game.

If you think the P/E will drop to 12 times, subtract 4 percentage points, reducing the total return on stocks to 4 percent.) Now let’s look at bonds. Here the arithmetic is much easier. The long-term returns on bonds are largely—if not entirely—produced by the interest payments that they generate. Unlike earnings and dividends, the interest payments on bonds are fixed, and speculative return—reflected in the change in the level of interest rates—however important in the short-term, has far less impact over time. (A ten-year U.S. Treasury bond for example, is retired at par at the end of the period.) As a result, the current interest rate proves to be an excellent predictor of returns in the subsequent decade, with an historic correlation of an astounding 0.91—almost perfect. This relationship clearly prevailed in the 1980s (initial interest yield 10.4 percent, subsequent 10-year return, 11.9 percent), in the 1990s (7.8 percent and 7.2 percent), and so far in the first decade of the 21 st century (6.3 percent and 6.1 percent). (Chart 2) With the yield on the 10-year Treasury currently at 4.6 percent, reasonable expectations suggest a likely return in the range of 4.6 percent for such bonds over 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.

We can’t be sure of exactly how far short, but an analysis of the past decade suggests that the gap was huge. (Chart 10) For example, the 200 funds with the largest cash inflows during the five-year period 1996-2000— essentially the duration of late, great bull market—reported an average return of 8.9 percent for the ten years 1996-2005. But the dollar-weighted returns of those 200 funds—the returns actually earned by their shareholders—was just 2.4 percent, only 25 percent of the annual return reported by the fund themselves.

The rise of the financial sector to pre-eminence is one of the seldom-told tales of the recent era. Twenty–five years ago, financials accounted for only about 5 percent of the earnings of the 500 giant corporations that compose the Standard & Poor’s 500 Stock Index, rising to 10 percent twenty years ago, then to 20 percent in 1997, and to a near-peak level of 27 percent in 2007. (Chart 7) If we add to this total the earnings of the financial affiliates of our giant manufacturers (think General Electric Capital, for example, or the auto financing arms of General Motors and Ford) financial earnings now likely exceed one-third of the annual earnings of the S&P 500. In fact, the finance sector is now by far our nation’s largest generator of corporate profits, larger even than the combined profits of our huge energy and health care sectors, and almost three times as much as either industrials or information technology.8)

The book reads, “The human soul, as Thomas Aquinas defined it, is the ‘form of the body, the vital power animating, pervading, and shaping an individual from the moment of conception, drawing all the energies of life into a unity.’ In our temporal world, the soul of capitalism is the vital power that has animated, pervaded, and shaped our economic system, drawing all of its energies into a unity. In this sense, it is no overstatement to describe the effort we must make to return the system to its proud roots with these words: the battle to restore the soul of capitalism. (One reviewer thought that the title was, well, “inflated,” but liked the book anyway.) This idealism doesn’t let up. The reader doesn’t even finish the first page of Chapter I (“What Went Wrong in Corporate America?”) before reading: “At the root of the problem, in the broadest sense, was a societal change aptly described by these words from the teacher Joseph Campbell: ‘In medieval times, as you approached the city, your eye was taken by the Cathedral. Today, it’s the towers of commerce. It’s business, business, business.‘bottom-line

(Including the costs of administration, finance, legal, and shareholder recordkeeping, the total expense ratios on our internally managed bond funds average about 17 basis points.) Of course that’s a powerful economic advantage for our clients. But the advantage is not limited to bond assets managed at Vanguard by our internal staff. Our external bond fund adviser, Wellington Management Company, manages about $38 billion of total assets in three of our bond funds. Of course we negotiate the best fees we can with Wellington. So, some 12 years ago, anticipating the almost inevitable growth of the bond funds they manage for us, we negotiated sharply sliding fee scales. As assets grew, fee rates would fall. For example, the fee rate on our GNMA fund begins at 2 basis points on the first $3 billion of assets, and declines to 0.8 basis points on assets in excess of $6 billion. With the GNMA Fund’s assets now at $23 billion, Wellington is paid a handsome $2.3 million per year, not bad for a fund investing in U.S. Government-guaranteed mortgage-backed certificates, providing an effective annual fee rate of just one basis point (essentially the same as our internally-managed funds).Bond

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

While the quest to restore these values and these virtues is hardly for the faint of heart, it’s easy to conceptualize the path we need to follow. If each individual investor out there—not only those who hold their stocks directly, but those who hold their stocks through mutual funds—would only look after their own economic self-interest, then great progress would be made in restoring the vanishing treasures of capitalism. Here, I think, Adam Smith’s Invisible Hand would be helpful. For only if intelligent investors move away from the costly folly of short-term speculation to the priceless (and price-less!) wisdom of long-term investing—abandoning both the emotions that betray sound investment strategy and the expenses that turn beating the market into a loser’s game—will they achieve their financial goals. 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.(My

-100% -80% -60% -40% -20% 0% 20% The Amazing Gap Between Cumulative Time-Wtd. and Dollar-Wtd. Returns 1996 - 2005 Covers the 200 funds with largest cash flows during 1996-2000. 11. 1996 to 2000 2001 to 2005 1996 to 2005 1996 to 2005 Dollar-wtd minus Time-wtd Q1 149% -8.5% 50.8% 0.03% -50.7% Q2 106% -5.8% 39.3% 0.05% -39.3% Q3 92% 2.5% 40.3% 0.18% -40.1% Q4 70% 2.3% 31.6% 0.13% -31.5% Avg. 103% -2.4% 40.4% 0.10% -40.3% Time-Wtd. Returns $-Wtd High Fund Performance Produces Low Shareholder Returns Cumulative Returns 12. The consistency of this pattern is remarkable. Among those 200 funds, the shareholders of 198 funds actually earned less money than the funds reported. In only two cases did the shareholders do better; in the best case, by just 0.5 percent per year (fifty basis points); in the other case, by a minuscule five basis points per year. When we compound these shortfalls, the results are little short of astounding. (Chart 11) For fully 76 of the 200 funds, that cumulative shortfall ranged from minus 50 to minus 95 percentage points (!) Unsurprisingly, given the marketing ethos of today’s mutual fund business, the funds that reported the highest returns during the bull market experienced the largest gap between fund returns and shareholder returns, and vice versa.

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

To an important extent, the wonderful life and the modest success I’ve been blessed to enjoy in an opportunity-laden career began right here, on this magnificent and tradition-bound campus. I fell in love with this place when I first arrived as a freshman member of the great Class of 1951. Now, more than fifty years after my arrival here in 1947, the honor of receiving the 43rd Woodrow Wilson Award “for the alumnus whose achievements exemplify the spirit of Princeton in the nation’s service” is the ultimate reward. It will serve as a challenge to me to carry on the work I have begun. Thank you.

2.2% 2.5% 2.3% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% The Impact of Expenses and Inflation on 7% Equity Return 7.0% Nominal Return Inflation Expenses Net Real Return 3. Yes, under these (likely) circumstances, the risk premium for holding stocks vs. Treasuries would be just 2.4 percent annually, only about one-half of the long-term annualized risk premium of 4.6 percent (9.6 percent for stocks; 5.0 percent for bonds). But when rational expectations belie historical experience, it is current reality that must lead the way. (As Lord Keynes wrote: “when the facts change, I change my mind. What do you do?”) Now, let’s assume that 7 percent is a rational expectation for future nominal returns in the stock market, and 4.6 percent in the bond market. While the marketers whose job it is to gather assets for their financial services firms can afford—in their own self-interest—to ignore the reality of inflation and do their sales presentations using nominal dollars, investors have no such luxury. Unless we focus on real, inflation-adjusted returns, we will seriously jeopardize our future financial security. The financial markets are telling us that inflation is expected to be about 2.3 percent over the coming decade. Thus, the real return on stocks would average 4.7 percent.

0% 5% 10% 15% 20% 25% 30% Telecom. Materials Utilities Cons. Staples Cons. Disc. Health Care Industrials Info. Tech. Energy Financial Share of the S&P 500’s 2006 Earnings, by Sector 8. Source: Standard & Poor’s Corporation Estimated Costs of Securities Intermediation, 2007 (billions) Investment Banking and Brokerage $308 Mutual Fund Operating Expenses 100 Hedge Funds 45 Variable Annuities 30 Pension Fund Advisory Fees 15 Legal / Accounting Fees 15 Financial Advisers 10 Bank Trust Departments 5 Total $528 billion 9. In any event, we’re moving, or so it seems, toward becoming a country where we’re no longer making anything. We’re merely trading pieces of paper, swapping stocks and bonds back and forth with one another, and paying our financial croupiers a veritable fortune. We’re also adding even more costs by creating ever more complex financial derivatives in which huge and unfathomable risks have been built into our financial system. The Soaring Costs of our Financial System Turning first to the costs of our system, they have soared to staggering proportions. Led by Wall Street bankers and brokers and mutual funds, followed by hedge funds and pension fund managers, plus advisor fees and all the other costs incurred by financial market participants have risen from an estimated $2.5 billion as recently as 1988 to something like $528 billion this year, or some 20 times over. (Chart 9) But don’t forget that these costs recur year after year.

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.

society.’ But our society came to measure the wrong bottom line: form over substance, prestige over virtue, money over achievement, charisma over character, the ephemeral over the enduring, even mammon over God.” That may seem a harsh indictment, but I don’t back away from it. Indeed, as International Herald Tribune columnist William Pfaff described it, what went wrong as “a pathological mutation in capitalism.” The classic system—owners’ capitalism—had been based on serving the interests of the corporation’s owners, maximizing the return on the capital they had invested and the risk they had assumed. But a new system had developed—managers’ capitalism—in which, Pfaff wrote, “the corporation came to be run to profit its managers, in complicity if not conspiracy with accountants and the managers of other corporations.” Why did it happen? “Because the markets had so diffused corporate ownership that no responsible owner exists. This is morally unacceptable, but also a corruption of capitalism itself.” As you know from reading the book, 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. Since 1950, direct ownership of U.S. stocks by individual investors has plummeted from 92 percent to 32 percent, while indirect ownership by institutional investors has soared from 8 percent to 68 percent.

If the present level holds for the next decade (I’m guessing that it will grow), total intermediation costs would come to a staggering $5 trillion. Then think about these cumulative costs relative to the $16 trillion value of the U.S. stock market and the $12 trillion value of our bond market. Those costs would represent an astonishing 18 percent of that value.

Our old ownership society is now gone, and it is not going to return. In its place we have a new “agency society” in which financial intermediaries now hold effective control of American business. Agents vs. Principals But these new agents haven’t behaved as owners should. Our corporations, pension managers, and mutual fund managers have too often put their own financial interests ahead of the interests of their principals, those 100 million families who are the owners of our mutual funds and the beneficiaries of our pension plans. As Adam Smith wisely put it 200-plus years ago, “managers of other people’s money (rarely) watch over it with the same anxious vigilance with which . . . they watch over their own . . . they very easily give themselves a dispensation. Negligence and profusion must always prevail.” And so negligence and profusion among our corporate directors and money managers have prevailed in present day America. The second reason is that our new investor/agents not only seemed to ignore the interests of their principals, but also seemed to forget their own investment principles. By the latter part of the twentieth century, the predominant focus of institutional investment strategy had turned from the wisdom of long- term investing to the folly of short-term speculation.

0 percent, bringing a profit of $28,700 on the initial stake. In stark contrast, a similar investment in the average taxable bond fund carried a return of just 5.9 percent,1 producing a final value of $31,200, or a profit of $21,200. The Index fund profit, then, was fully 35 percent higher. 1 The average return on net asset value was 6.3 percent. Adjusting for the impact of sales loads on 70 percent of the funds, and assuming a holding period of 3 years—a total added cost of 0.4 percent per year— decreased the average return to investors to 5.9 percent.

This chart (Chart 12), showing the relationship between the various quartiles of reported performance and the actual shareholder performance, makes it clear that the higher the performance quartile in the bull market, the lower the returns earned by investors. As it might be said in Biblical terms, “and the first (in reported returns) shall be the last (in shareholder returns).” The fund industry, naturally, argues that it bears little responsibility for this state of affairs. Rather, it is the foolishness of the investing public that is to blame for these disastrous results. But the industry surely bears a heavy responsibility—I would argue, the largest share—for the harm that has been done.facts:

It is the inner man shaped by the society in which he exists, even the soul, who gives us our highest calling. In Smith’s words, “It is reason, principle, conscience, the inhabitant of the breast, the man within, the great judge and arbiter of our conduct.” This Impartial Spectator, Smith tells us, “calls to us, with a voice capable of astonishing the most presumptuous of our passions, that we are but one of the multitude, in no respect better than any other in it; and that when we prefer ourselves so shamefully and so blindly to others, we become the proper objects of resentment, abhorrence, and execration. It is from him only that we learn the real littleness of ourselves. It is this impartial spectator . . . who shows us the propriety of generosity and the deformity of injustice; the propriety of reining the greatest interests of our own, for the yet greater interests of others . . . in order to obtain the greatest benefit to ourselves. It is not the love of our neighbour, it is not the love of mankind, which upon many occasions prompts us to the practice of those divine virtues. It is a stronger love, a more powerful affection, the love of what is honourable and noble, the grandeur, and dignity, and superiority of our own characters.” With these powerful words, Adam Smith—yes, Adam Smith—touches on nearly all of those traditional ethical principles of which I spoke at the outset.

It’s all too easy for sellers of financial products to focus on historical stock market returns rather than looking ahead, to disregard the impact of inflation, and to ignore the impact of investment costs, pretending that those relentless rules of humble arithmetic that I earlier discussed do not exist. But when we think in terms of prospective returns, and then real returns, mutual fund costs take on a whole new level of significance. At their present estimated annual level of 2.5 percent—including expense ratios, sales loads, and the hidden costs of that huge annual portfolio turnover—fund costs would consume more than 50 percent of that projected real return of 4.7 percent for the stock market, leaving a net real return of just 2.2 percent a year during the coming decade. (Chart 3) (I haven’t even dared to mention the cost of taxes, in an industry where tax-inefficiency is rife.)

While our corporate values and investment values may be “vanishing treasures,” those virtues have not entirely vanished. Indeed, there are scores of examples—although never nearly enough—of corporations and financial institutions that have held to their traditional bearings despite the powerful forces that are driving our society away from them. As I express these thoughts this evening, I note a wonderful irony: the very same 1949 issue of Fortune that inspired my Princeton thesis included a feature essay entitled “The Moral History of U.S. Business.” Alas, I have no recollection of reading it at that time. But I read it a few years ago, a full half- century later. As I reflect on the vanishing treasures capitalism—the debasement of the values of businesses and investors—they seem to be related to the kind of moral responsibility of business that was expressed in that ancient Fortune essay. It began by noting that the profit motive is hardly the only motive that lies behind the labors of the American businessman. Other motives include “the love of power or prestige, altruism, pugnacity, patriotism, the hope of being remembered through a product or institution.” Yes, all of the above. As I have said in other forums, I also agree with Fortune on the appropriateness of the traditional tendency of American society to ask: “what are the moral credentials for the social power (the businessman) wields?in

As you look at that imposing long-term record for low-cost bond indexing, you might be surprised to learn that it could have been even more imposing. In its first decade, beginning with a tiny asset base of less than $100 million and ending at $4 billion, the VTBMF tracking error relative to its target, the Lehman Aggregate Bond Index, was about 45 basis points per year, largely as a result of higher (if still low) expenses and implementation costs on a relatively small asset base. Then, with larger asset size and superior implementation, the annual tracking error fell to an average of 14 basis points through 2001. Then in 2002, misfortune befell the Vanguard Total Bond Market Index Fund, providing lessons that tell us as much about the need for rigorous index management and rigorous control as they do about the risks of active bond management. After some bumps in the summer of 2001, the bond market fell into serious disarray early in 2002, largely because of a series of sharp downgrades in credit quality. The problems continued through June and July, when they reached crisis stage before at last stabilizing. In those two months alone, VTBMF lost nearly 140 basis points of tracking error, bringing the fund’s total lag to its target index for 2002 to an incredible 200 basis points, even more significant since it was derived entirely from the corporate sector (not the Treasury and mortgage-backed sector) which represented only 40 percent of VTBMF’s assets. Why did it happen?

0.8% 1.5% 2.3% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% The Impact of Expenses and Inflation on 4.6% Bond Return Nominal Return Inflation Expenses Net Real Return 4.6% 4. Similar arithmetic, of course, prevails in the bond market. Prospective returns will be lower than in the past, inflation will take its toll, and costs will overpower the return that remains. At 2.3 percent per year, inflation would confiscate exactly 50 percent of the bond market’s nominal return of 4.6 percent, leaving a real bond market return of 2.3 percent. And estimated annual costs of at least 1.5 percent for the average bond mutual fund (expenses plus sales loads) would, in turn, confiscate nearly 70 percent (!) of that real return, reducing it to barely 0.8 percent per year. (Chart 4) It’s at this point that the role of the financial professionals and investment fiduciaries intersects with these investment realities. To what extent is it appropriate for investment professionals—including estate planning professionals—to offer high cost “products” to their clients? To what extent are the trustees of our institutionally-managed pension plans and the directors and managers of our mutual funds focused on providing their plan beneficiaries and fund shareholders with their fair share of the future returns—future real returns—earned in our financial markets?

0% 50% 100% 150% 200% 1945 1948 1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 U.S. Stock Market Capitalization as a Share of Gross Domestic Product 10. Does this explosion in intermediation costs create an opportunity for money managers? You better believe it does! Does it create a problem for investors? You better recognize that too. For as long as our financial system delivers to our investors in the aggregate whatever returns our stock and bond markets are generous enough to deliver, but only after the costs of financial intermediation are deducted, these enormous costs seriously undermine the odds in favor of success for our citizens who are accumulating savings for retirement. Alas, as we all know, the investor feeds at the bottom of the costly food chain of investing. This is not to say that our financial system creates only costs. It creates substantial value for our society.

During the recent era, we entered the age of expectations investing, where projected growth in corporate earnings—especially earnings guidance and its subsequent achievement, by fair means or foul—became the watchword of investors. Never mind that the reported earnings were too often a product of financial engineering that served the short-term interest of both corporate managers and Wall Street security analysts. When long-term owners of stocks become short-term renters of stocks, and when the momentary precision of the price of the stock takes precedence over the eternal vagueness of the intrinsic value of the corporation, concern about corporate governance is the first casualty. The single most important job of the corporate director is to assure that management is creating value for shareholders; yet investors seemed not to care when that goal became secondary. If the owners of corporate America don’t give a damn about corporate governance, I ask you, who on earth should?the

 It was we in the fund industry who created those new funds that were to create such havoc for investors. As the market soared ever higher, we introduced those 494 brand- new “New Economy” funds. Only a precious few of the major fund marketers had the courage to stand firm against the market madness, and forbear from creating and offering such funds.  When we had funds whose performance turned “hot,” we marketed them aggressively. Our public relations departments were willing co-conspirators with the press in establishing interviews with our “star” portfolio managers, many of whom, inevitably, turned out to be comets.  The higher a fund’s performance soared, the more we advertised our returns. Example: In March 2000, the month the market hit its high, there were 44 equity funds that advertised their performance in MONEY magazine. The average advertised annual return was +86 percent. Imagine! (During the next three years, these funds were to plummet by 39 percent.) Unsurprisingly, after the fall, in the October 2002 issue of MONEY there were only four funds that did so. I believe that the mandatory and prominent disclosure of shareholder returns alongside fund returns would alert fund investors to the true returns that managers have actually achieved for their shareholders.

Such disclosure, I suspect, would also discourage fund managers—and brokers and financial advisers, too—from following “the fund of the week” syndrome, remind them of the perils of aggressive marketing, and give them some self-discipline regarding the creation and promotion of high- risk funds. 3. Measuring Shareholder Satisfaction —The Redemption Rate In the early years of my career at Wellington Management Company, as I recall, I was asked to prepare a brochure, to be entitled “The Wellington Story,” designed to persuade both potential investors and the stockbrokers who in those days sold the fund’s shares that Wellington Fund was a creditable investment. Of course, I included sections about the fund’s remarkable growth; its conservative objectives (it was a balanced fund, investing in both stocks and bonds); its past investment record; and its management depth. I also created what I called “an index of shareholder satisfaction,” simply calculated by presenting the ratio of the annual dollar amount of the shares of the Fund redeemed to the Fund’s total net assets. The Wellington Fund redemption rate was then less than 4 percent—about half of the industry rate—suggesting an average holding period of 25 years for its shareholders. We believed that we were the industry leader in shareholder satisfaction, and we were determined to emphasize our bragging rights. In those days, (Chart 13) industry redemption rates were far below today’s levels.

At a minimum, it would seem that stock and bond funds alike should be focused on very low costs, be broadly diversified against the potential hazardous consequences that I described earlier, minimize portfolio turnover and its attendant costs, and be considering the reduction or elimination of sales loads. (Shades of my Princeton thesis!) In addition, participants in our system of financial intermediation should bring these attributes to the fore in choosing the funds that you determine to offer to your clients. I was warned that mentioning index funds would not be universally popular with this audience, but in a likely future environment of lower returns on equities, I have no choice.passively-

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.

I’m treading on dangerous ground here, so let me offer Vanguard management’s explanation. From the Fund’s semi-annual report on June 30, 2002: Over the past six months, one of the principal differences between the funds and their indexes resulted from a decision by our portfolio managers and analysts to overweight the telecommunications sector. This decision rested on the belief that the prices of these bonds were cheap relative to those in other sectors. While our exposure to telecoms was diversified, the damage in the sector was widespread. The declines in the value of bonds issued by telephone companies and wireless providers accelerated immediately after WorldCom’s implosion in June. To make matters worse, our funds also held larger stakes than their indexes did in bonds issued by several energy-trading companies, which plunged precipitously in the wake of the Enron scandal. In short, our decision to overweight these sectors hurt the returns for our shareholders. The funds also were hurt by our “corporate substitution” policy—buying corporate bonds instead of Treasury securities in the short-term end of the market. From the Fund’s annual report on December 31, 2002: Our “sampling” approach to indexing . . . is necessary because it would be impractical and very costly to own all the bonds in the target indexes.to

It facilitates the optimal allocation of capital among a variety of users; it enables buyers and sellers to meet efficiently; it provides remarkable liquidity; it enhances the ability of investors who wish to capitalize on the discounted value of future cash flows (stock sellers), and other investors who wish to acquire the right to those cash flows (stock buyers); it creates financial instruments (so-called “derivatives,” albeit often of mind-boggling complexity) that enable investors to divest themselves of a variety of risks by transferring those risks to others. No, it is not that the system fails to create benefits. The question is whether, on the whole, the costs of obtaining those benefits have reached a level that overwhelms them. Once a profession in which business was subservient, the field of money management has largely become a business in which the profession is subservient. Harvard Business School Professor Rakesh Khurana was right when he defined the standard of conduct for a true professional with these words: “I will create value for society, rather than extract it.” And yet money management, by definition, extracts value from the returns earned by our business enterprises. The Dominance of Finance over Business I now turn to the rise to dominance of our financial economy over our production economy, just as Minsky predicted.

idea of financial statement integrity (“If you can measure it, you can manage it,” writ large!); and the failure of the traditional gatekeepers we rely on to oversee corporate management—our auditors, our regulators, our legislators, our directors. In investment America, the agent-owners who now control corporate America don’t seem to care. While our institutional investors now own 68 percent of all stocks, all we hear from these money managers is the sound of silence. Not only because they are more likely to be short-term speculators than long-term investors, but because they are managing the pension and thrift plans of the corporations whose stocks they hold, they are faced with a serious conflict of interest when controversial proxy issues are concerned. As one manager reportedly has said: “There are only two types of clients we don’t want to offend: actual and potential.” And in mutual fund America, an industry lost its way. Once a profession with elements of a business, mutual funds have become a business with elements of a profession—and too few elements at that. Once dominated by small, privately-held organizations run by investment professionals, the mutual fund industry is now dominated by giant, publicly-held financial conglomerates run by businessmen hell- bent on earning a return on the capital of the firm rather than the return on the capital invested by the fund shareholders.

Note that the 7 percent to 8 percent rates that persisted through the 1950s and 1960s didn’t reach 20 percent until the 1980s. Rates soared to 62 percent in the 1987 bear market but then settled down to the 30 percent-40 percent range through 2004, suggesting a remarkably short average holding period of 2 ½ to 3 years by fund shareholders.

I earlier noted that the earnings of the financial sector of the S&P 500 have risen to preeminence, and so has the capitalization of the stock market risen to exceed our Gross Domestic Product, the value of the goods and services that we as a nation produce each year. (Chart 10) In 1975, the stock market had an aggregate market capitalization of $800 billion, about 50 percent of our $1.6 trillion GDP. But while GDP has risen eight times since then, stock valuations have risen nearly twenty times over. Today the $15.7 trillion aggregate value of stocks is actually equal to about 120 percent of our $13 trillion GDP.

Result: over the past twenty years, the typical mutual fund investor has captured only one- quarter—yes, 27 percent—of the compound real (inflation-adjusted) return on stocks that was there for the taking by simply holding the U.S. stock market portfolio through an index fund. (I’m speaking, of course, of the Vanguard 500 Index Fund.) Facing Up to the Reality It must seem obvious that there is an urgent need to face up to these and other failures in the changing world of capitalism. But despite the contentious nature of the issues I’ve just described— broadly reflecting the triumph of the powerful economic interests of the oligarchs of American business and finance over the interests of our nation’s last line investors—it is remarkable that so little public discourse has been in evidence. In the investment community, I have seen no defense of the inadequate returns delivered by mutual funds to investors, nor of our industry’s truly bizarre, counterproductive ownership structure; no attempt by institutions to explain why the rights of ownership that one would think are implicit in holding shares of stock remain largely unexercised; and no serious criticism of the virtually unrecognized turn away from the once-conventional and pervasive investment strategies that relied on the wisdom of long-term investing, toward strategies that increasingly rely on the folly of short- term speculation.

provide our funds with characteristics that are similar to those of their targets. Our portfolio managers and analysts carefully select bonds so that the funds’ weightings among sectors closely match those of the indexes. However, during June and July, the relative performance of some “subsectors”—in contrast to historical experience— diverged widely. At that time, our funds had larger stakes than their indexes in several subsectors. In particular, at a subsector level we had heavier weightings in bonds issued by telecommunications and energy-trading companies. These groups were hit extremely hard by the WorldCom bankruptcy, the Enron scandal, and accounting irregularities at a number of other companies. In recognition of the radical change in the market’s reaction to credit risk, we have made some adjustments to ensure greater diversification and less exposure to lower-quality bonds. Do those comments suggest that active management, reduced diversification, and investing for higher yield had found their way into indexing? I’ll let you make the call. I’m confident that the Vanguard Fixed-Income Group has learned much from the cascade of ill-tidings that led to such a shocking 200 basis point shortfall in the return of VTBMF to its target index, an assumption borne out by the fact that our annual tracking error has returned to its earlier excellence, and in fact looks even better.

While (as we say at Vanguard) “even one person can make a difference,” the task of restoring the vanishing values of business and investing is far larger than one person can handle. We need wisdom and introspection from our business and investment leaders to learn from the lessons of history and to realize that, however profitable the operation of today’s businesses and investment institutions may be to their managers, in the long run today’s practices will be self-defeating. We need investors everywhere to join together to demand the development of that fiduciary society I have described, and we—all of us—need to awaken our fellow citizens to respect that Impartial Spectator who demands virtuous conduct and a return to traditional values by the leaders of our corporate businesses and our investment institutions. Without that, those treasures will indeed vanish.

managed, low-cost, broadly-diversified, and tax-efficient no-load index fund would provide even higher real returns relative to those earned by actively-managed equity funds than the enormous advantage it has achieved over the past quarter century. Like it or not, the index fund remains, if I may take the liberty of citing the subtitle of my new Little Book, “the only way to guarantee your fair share” of whatever returns our markets are generous enough to provide in the years ahead. I conclude by reiterating my theme that the link between fiduciary duty and financial markets is not only an unbreakable one, but that in today’s risky investment world, it is more important than ever. Trusteeship, fiduciary duty, and professional standards are not just idle phrases. They represent the very essence of good business—ethical conduct, fair-dealing, “just and equitable principles of trade” (in the lexicon of NASD regulations)—in which service to clients, and for that matter, service to society, is the paramount value. Writing about professional obligations in the spring edition of the Yale School of Management Quarterly Review, Harvard Business School professor Rakesh Khurana suggests this stern standard as the watchword of the true professional: “I will create value for society, rather than extract it.

$220 $1,200 $12,000 $206 $232 $15,000 $5,000 $0 $2,000 $4,000 $6,000 $8,000 $10,000 $12,000 $14,000 $16,000 1957 1982 2006 S&P Capitalization S&P Futures S&P Options “The Real Market” vs. Derivatives 11. (billions) Even more striking is the truly staggering increase in financial transactions, a global phenomenon whose implications are far from clear. While the world’s GDP is about $60 trillion, the aggregate nominal value of worldwide financial derivatives is said to be $600 trillion, fully ten times as large as all of the net goods and services produced by our entire world. A simple comparison, based solely on U.S. financial centers, makes the point. In 1957, the market value of stocks in the S&P 500 Index was $220 billion, and futures and options markets on the Index didn’t even exist. (Chart 11) By 1982, the value of S&P 500 had soared to $1.2 trillion and the newly created S&P futures outstanding were valued at $206 billion and S&P options at $232 million. But by the close of 2006, with the S&P 500 valued at $12 trillion, futures contracts on the Index had reached $5 trillion and options contracts had soared to $15 trillion, together an “expectations market” valued at almost double the value of the “real market” itself.

During 2003-2006, the annual returns of VTBMF have come within an average of just 8 basis points per year of its target index. Investors have recognized the improvement, and the Fund’s assets have resumed their upward trend. Assets of $21 billion at the end of 2001, which barely held their own over the two years following the implosion, now total in excess of $40 billion, the industry’s second largest bond fund. It’s worth noting that, even with that shortfall, VTBMF’s return of 8.27 percent for 2002 was nearly 200 basis points in excess of the 6.59 percent return of the average taxable bond fund. What’s more, as the earlier data showed, the impact of the serious problems I’ve described on the fund’s long-term record has been miniscule, costing only about 10 basis points per year, almost trivial in the light of the Fund’s 90 basis point annual cost advantage. But, to be clear, if it is trivial in financial impact, it is anything but trivial in its message about the dangers of seeking higher yields by investing in lower quality bonds. “Index shoemaker, stick to thy last.” Summing Up I can’t imagine that much of what I’ve told you bond professionals this evening offends your sense of reason.low

” Markets being markets, and the relentless rules of humble arithmetic being, well, the relentless rules of humble arithmetic, our financial services industry turns out to be not only an extractive industry, but, at least in the part of it which I have spent my long career, one that has lost its traditional professional bearings. I lay my ideas on the line with you today in the hope that you will not only seek ever higher levels of professional conduct in your own careers, but spread the truth about investing not only to your colleagues, but to your clients, those human beings whose success in preserving and enhancing their capital ultimately defines the success you will achieve in your own careers and lives.

24% 33% 5% 41% 62% 0% 10% 20% 30% 40% 50% 60% 70% 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 Equity Mutual Fund Redemption Rates Annual, Percent of Total Assets 13. 0% 20% 40% 60% 80% 100% 120% 140% Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 International Fund Redemption Rates Monthly Annualized, Percent of Total Assets 14. But it turns out that much of that soaring leap in redemption rates was less about plummeting shareholder satisfaction than about a fraud that was being inflicted on the long-term shareholders of mutual funds. Much of that increase in redemptions, in fact, reflected the growing use of mutual fund shares in “market timing” programs, largely by substantial investors and hedge funds. As the years passed, more and more investors became aware of how easy it was to make purchases (or redemptions) of funds after the local markets for the stocks they held had closed. The funds priced their foreign stocks at the closing prices in local markets, which had closed long before the New York Stock Exchange closed at 4 PM eastern time. Periodically, opportunities arose to, as it would later be alleged by Attorney General Spitzer, “bet on the horses after the race was over.” The betting, as it were, was widespread. The SEC later identified some 400 (!) hedge funds that described their strategy as “mutual fund market timing.

If The Battle helps to open the door to the introspection—and then corrective action— by our corporate and financial leaders that is so long overdue, perhaps the needed changes will be hastened. This process, I conclude, must begin with a return to the original values of capitalism, to that virtuous circle of integrity—“trusting and being trusted.” When ethical values go out the window and service to those whom we are duty-bound to serve is superseded by service to self, the whole idea of the capitalism that has been a moving force in the creation of our society’s abundance is soured. In the era that lies ahead, the trusted businessman, the prudent fiduciary, and the honest steward must again be the paradigms of our great American enterprises. I know it won’t be easy, but if we all work long enough and hard enough at the task, we can build, out of our long-gone ownership society and our failed agency society, a new “fiduciary society,” one in which the citizen-investors of America will at last receive the fair shake they have always deserved from our corporations, our investment system, and our mutual fund industry.Conclusion

If that 160-fold increase in instruments based on ownership of the S&P Index over the past half- century—two and one-half times the 60-fold increase in the production of goods and services in the American economy—doesn’t show that our financial system has come to dominate our productive economy, I’m not sure what would. Minsky’s concerns seem to have been realized in full. Risk and Ruin—a Reprise Even as the volume of financial transactions has soared, so has their mind-numbing complexity. The most recent case in point, of course, was the boom in mortgage-backed debt obligation, part of the secular trend in the “securitization” of assets of all kinds. Two trends were at work here: one, the disintermediation of mortgages, once held largely by community banks for local citizens. (The Jimmy Stewart movie “It’s a Wonderful Life” comes quickly to mind.) It hardly offends one’s common sense to learn that lenders, once they pool their loans and send them off to Wall Street, never to be seen by them again, pay far less attention to loan quality. (Nor is it surprising that the creators of these mortgage- backed bonds have little interest or incentive to help mortgagees in distress to work through their financial difficulties and retain their homes.) Nor—given Wall Street’s ever-pressing need to have something, anything, to sell in the way of “new product”—is it surprising that these instruments became ever more complex, with risk even more deeply concealed.

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

International funds, of course, were the prime victims of what became known as “time-zone trading.” (Chart 14) As the chart shows, the problem goes back at least to the late 1990s, when redemption rates on international funds leaped above the industry-wide rate of 30 to 40 percent. But by 1998, as more investors became aware of the, well, opportunity to engage in this essentially risk-free arbitrage, the international fund redemption rate began to steadily increase. It crossed 60 percent in December 1997, 70 percent in September 1998, 90 percent in March 1999, 100 percent (a one-year holding period) in March 2000, and 110 percent in July 2000, reaching an all-time peak of 128 percent in October 2001 and again in October 2002.

And so ends my saga of entrepreneurship that can still be built by focusing on human values rather than on the accumulation of personal wealth. To reiterate, this saga is at least tangentially related to Homer’s Odyssey that, happily, still resonates in our literature—the hero’s journey through triumph and disaster, over and over again. The odyssey of Vanguard, while different, is nonetheless a throwback to today’s misguided bottom-line society as well as a reaffirmation of the inspiring moral values of the 18 th century, values that belie today’s pervasive retreat from yesterday’s solid foundation of capitalism. At the same time, we seem to have lost our bearings as a nation and as a society, focusing more on the tools of success—what we can see and count, facts and figures, courses about the superficial—and ignoring the truly essential tools of higher learning such as intellectual curiosity, the rule (and role) of reason, moral vision, and even generosity of spirit, open-mindedness, self-denial, and integrity. So what’s to be done? We each must do our part. Each of you here tonight can prove that “even one person can make a difference.”2 Returning to the theme of “Vanguard: Saga of Heroes,” Brad McQuaid reminded us, in the final sentence of that New York Times article, that “these games should never be finished.” Nor should your odyssey or mine be finished so long as our minds improve, our hearts beat, and our character strengthens.

Finally, after the Spitzer revelations in the fall of 2003, the time-zone trading practice began to abate, with redemption rates falling below 30 percent by January 2004. It’s remained in the 25 percent range (with a few upward thrusts) through July 2007, a four-year holding period that, although seems to me absurdly short, suggests that time-zone trading has been substantially eliminated. The remarkable fact is that the data showing these extraordinary redemption patterns was not hidden. The amount of redemptions in international funds was published by the industry’s trade association, the Investment Company Institute, in every single one of the 212 months shown in the chart. All that remained was to compare those redemptions with the fund’s assets and calculate the rate. Is it possible that the industry and its leaders weren’t aware of what was going on? Only out of inexcusable ignorance of what the business had become, or because it was a good idea, in the interest of building assets in international funds, to turn a blind eye to the disservice it clearly represented to the long-term shareholders of these funds. But if it was ignorance, it should have been exorcised with the publication of an article in the Financial Analysts Journal of July/August 2003. Written by four NYU professors, it was titled “Stale Prices and Strategies for Trading Mutual Funds.” The authors demonstrated how easy—and how profitable—it was for investors to develop winning strategies.

We need better information for investors of course, reducing that information asymmetry between fund sellers and fund buyers that I mentioned at the outset. But we have to awaken our regulators and get them involved too, at least in their oversight of the marketers of bond funds in the brokerage community. The NASD demands that “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.” Under what interpretation could selling funds in which costs consume half of a bond fund’s return be considered a high standard of commercial honor? A just and equitable principle of trade? Fair dealing with clients? Isn’t there a point at which the overriding interest of the mutual fund client in a fair shake is held as important—even more important—than the interest of the broker-dealer firm and its account executives in maximizing their own profits? If broker-dealers and regulators refuse to face these facts, perhaps bond fund directors will awaken to the past arithmetic—and, even more importantly, to the future arithmetic—of bond fund investing. Gross return in the bond market, minus the costs of investing, equals the net return investors will actually earn.its

While life is life and death is death, we must nonetheless “press on, regardless” while we can, and “stay the course” as long as the race continues, two phrases I’ve repeated ad infinitum to my colleagues at Vanguard. But even as I ask you, as I did my grandchildren in the dedication to Battle, to enlist in the mission of building a better world, I remain eager for the excitement of the chase; the idealism of a cause worth betting one’s life on; and the joy of honoring the values of the past as the key to a brilliant future. So dream your own dreams, but act on them, too. Action, always action, is required on the ever- dangerous odyssey that each of our lives must follow. Be good human beings. Respect tradition and study the great thinkers of our heritage. And not only hear me, but reflect, if you will, on what I’ve said this evening. I close now, with some words from Tennyson’s Ulysses (the Greek Odysseus, rendered in Latin) that may explain to you, far better than could any words of my own, the exciting adventures I’ve enjoyed, the conflicting emotions I’ve endured, and the single-minded determination on which I have reflected this evening, as I await with eager anticipation the still-unwritten final chapters of my long career. Ulysses begins by reflecting on his odyssey: I cannot rest from travel: I will drink Life to the lees: All times I have enjoy’d Greatly, have suffer’d greatly, both with those That loved me, and alone.

In league with SEC-registered rating agencies (which were paid, as I understand it, some $300,000 for placing their imprimatur on each issue), some new issues of bonds were created entirely out of subprime mortgages.the

shareholders, rather than in the interest of its managers and distributors.” If our independent directors—responsible to insure that the interest of shareholders is the highest priority of the funds these directors serve—will only stand up and be counted, bond funds can at last fulfill their role in serving their owners with efficiency, economy, honesty, and honor.

It concluded: “Should mutual funds even worry about trying to prevent these strategies? Because the gains are offset by losses to the other (long- term) shareholders in the funds, the funds have a fiduciary duty to take preventative action . . . Why (don’t they)? . . . because short-term trading increases assets under management and (increases) management compensation . . . and managers may have the perception that (blocking these strategies) puts the fund at a competitive disadvantage.” In short, taking action to limit trading would hurt fund marketing. Rather than being alerted to the problem, the industry ignored it. Worse, the only published response to the article came from a senior executive of an industry leader, who condemned the Journal for publishing the article: “Your article raises serious questions about the policies, oversight and judgment in selecting articles. Publishing (it) is a bad idea in the best of times but is abhorrent in a period when investor confidence is shaken by corporate greed and fraud, bad accounting, and a bear market overall.” That response is a classic “shoot the messenger” reaction. (It was about this time that his firm finally added redemption fees for its international funds, at last curtailing the trading.) But it wasn’t only managers of international funds that participated in this scandalous conduct. One example: in its 2002 annual report, a U.S.

Underlying Investments Bonds Issued 100% B/C/D? 75% AAA 15% A 5% BBB 5% B The New Alchemy 12. bonds was in “tranches” (series) rated AAA, another 15 percent rated at least A, and 5 percent rated BBB. (Chart 12) Only the remaining 5 percent carried a rating of BB. One might call this the new alchemy— turning lead to gold. But that was an illusion. (I’ve seen a lot of financial legerdemain in my day, but none to equal that.) Early this year, when the first wave of mortgage defaults began to snowball, the financial crisis in mortgages was upon us, at a great and growing cost to our citizens and our society, a classic example of the impact of the financial economy on the real economy. Given the nature of our financial system, few of our giant investment banking firms had the courage to summon the discipline to jump off (or even not to jump on) the mortgage-backed bond bandwagon. The issuance of such bonds in the past five years totaled $2 trillion (including both prime and sub-prime mortgages), likely generating some $80 billion of revenues to “the Street,” its investment bankers, its brokers, its rating agencies, its attorneys, and its securities processors. The only thing the banks could not resist was, of course, temptation, and even the biggest and most savvy firms reveled in the party, its rocking music, and its joyous dancing.

I am become a name; For always roaming with a hungry heart Much have I seen and known; cities of men And manners, climates, councils, governments, Myself not least, but honour’d of them all; And drunk delight of battle with my peers. Then he considers what may lie ahead: I am part of all that I have met. How dull it is to pause, to make an end, 2 This phrase appears on the plaque awarded to Vanguard crew members who win our “Award for Excellence.”

To rust unburnish’d, not to shine in use! As tho’ to breathe were life! Life piled on life Were all too little, and of one to me Little remains: But every hour is saved From that eternal silence, something more, A bringer of new things; And this gray spirit yearning in desire To follow knowledge like a sinking star, Beyond the utmost bound of human thought. Old age hath yet his honour and his toil; Death closes all: but something ere the end, Some work of noble note, may yet be done. Then, determined to take on one final mission, Ulysses summons his followers: So come, my friends Tis not too late to seek a newer world. Push off, and sitting well in order smite The sounding furrows; for my purpose holds To sail beyond the sunset, ‘til I die. Tho’ much is taken, much abides; and tho’ We are not now the strength which in old days Moved earth and heaven, that which we are, we are; One equal temper of heroic hearts, Renewed by time and fate, still strong in will To strive, to seek, to find, and not to yield. To each of you, with so much—for you students, nearly all—of your own odyssey lying before you, unknown, this chronicle of my own past may well be irrelevant. Our task is to live, not the lives of others, but the lives of our own. But wherever you are on your own journey, I know it holds the promise of being an exciting and rewarding one, if only you remain “strong in will, to strive, to seek, to find, and not to yield.

growth fund with assets of $530 million reported, as all funds must, its sales and redemptions. Share sales for the year, $3,509,527,000, redemptions, $3,604,272,000. Redemption rate (calculated but not published), 679.2 percent. Average holding period, seven weeks. Is it possible that market timing was going on? You tell me. Tell me too, where the fund directors were, or for that matter, where the SEC examiners were, or even where the press was. A sad anecdote: in the spring of 2006, I spoke at the Union League Club of New York, afterward signing copies of my new book, The Battle for the Soul of Capitalism. One person who asked me to sign his book requested that I endorse it to him. When he told me his name, I recognized him as the man who was in charge of the administration of the fund I just described. He told me that he’d only recently been released from prison for allowing the rapid-fire trading to take place, and then trying to hide the evidence. He said he knew it was wrong, but the firm had always done it, and he felt compelled to go along. “Everyone else is doing it” strikes again. There’s a telling message there.prominently

Charles Prince, chairman of the giant Citigroup, said it as well as any friend—or foe—of the situation could have: “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Epilogue: just last week, Citigroup slashed the value of its mortgage-backed portfolio by more than $3 billion. Not to be outdone, Merrill Lynch followed suit with a $5 billion writedown; UBS wrote down $3.4 billion, and Deutsche Bank has written down a mere $3.1 billion. Following a long age of rife credit availability, and borrowers with high confidence and low collateral, then, we are beginning to pay the price, even as we face a whole plethora of other risks created by our financial system. Stay tuned. Looking Ahead But if systemic risks are increasing, how can it be that risk premiums on stocks are at less than one-half the historic average? Today’s projected equity premium, for one example, is just 2 percent, some 60 percent below the century-long average of 5.2 percent. (Chart 13) Bonds, based on the current yield on investment-grade issues, should return about 5 percent over this period. The stock return over the coming decade is projected at 7 percent, based on today’s dividend yield of about 2 percent and prospective nominal earnings growth of about 6 percent, with a shading for the slightly lower price- earning ratio that I expect a decade hence. And while the spread of high-yield bonds relative to U.S.

” ___________ Note: regarding the penultimate line of the poem: Tennyson wrote, “Made weak by time and fate, but strong in will.” He could hardly have imagined that a heart could be transplanted from one human being to another, renewing the vigor of the soul.

disclose not only the amount of their annual redemptions (as they must today), but their redemption rate as well. Investors would be alerted by high rates—suggesting some combination of shareholder dissatisfaction and excessive market timing—and perhaps encouraged by low rates—suggesting a high level of shareholder satisfaction and a long-term focus among existing fund owners. When I listed Wellington Fund’s modest redemption rates in The Wellington Story all those years ago, that’s precisely what I was trying to accomplish. What’s to be Done? Without full disclosure, it’s hard to imagine that brokers and advisers can measure up to the high standards of commercial honor, equitable principles of trade, and fair dealing with their clients that are demanded by regulatory principles. I’ve already described, in great detail, three of the disclosures that should be mandatory: (1) the amount of investment income consumed by their fees and expenses; (2) the returns actually earned by their shareholders; and (3) the annual rates at which their shareholders are redeeming their shares. But that’s only the beginning: I believe funds should also be required to disclose: (4) Historical returns, not only in nominal terms, but also in real terms, adjusted for rates of inflation. After all, investors saving for retirement ought to be on notice that the kinds of compound returns funds show are not always what they seem.

-10% -5% 0% 5% 10% 15% 20% 1909 1915 1921 1927 1933 1939 1945 1951 1957 1963 1969 1975 1981 1987 1993 1999 2005 Equity Risk Premium for Trailing Ten-Year Periods 13. Average 0% 5% 10% 15% Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Spread Between Yield of High Yield Corporate Bonds and IT Treasurys 14. Average Treasury bonds has risen from 3 percent to about 4 percent after the recent unpleasantness in the mortgage market, it remains below its long-term average of 5 percent. (Chart 14) Our markets, then, seem to be ignoring the warning issued by then-Federal Reserve Chairman Alan Greenspan in 2005: “History has not dealt kindly with the aftermath of protracted periods of low risk premiums.” When participants in the financial services field ignore the lessons of history, yet another series of risks are created. Other Risks There are, I regret to say, other huge, seemingly unacknowledged risks beyond the financial sector, out there in our society. The risks presented by the Social Security and Medicare payments committed to by our national government. For that matter, the staggering string of huge (and in fact understated) deficits in our Federal budget. Our enormous (soon to reach $1 trillion) expenditures on war in Iraq and Afghanistan (with more to come, perhaps in Iran), bleeding the resources of our empire; terrorism; and the threat of global warming and the cost of dealing with it.

You all know about these risks, of course, but there are other more subtle risks too. A political system dominated by money and vested interests; a congress and an administration seemingly focused entirely on the short-term, the long-term consequences be damned. The vast chasm between the very wealthiest among us (the top 1 percent of our citizenry holds more than a third of our total wealth) and those at the bottom of the economic ladder. (Did you know that 20 percent of New York City residents earn less than $8,300 per year?) The implications of our enormous trade deficit and unfettered global competition. Our self-centered “bottom-line” society, focused on money over achievement, charisma over character, and the ephemeral over the eternal. And finally, the paucity of leaders who are willing to, well, lead, to defy the conventional wisdom of the day, and to stand up for what is right and noble and true. So the risks are high; the uncertainties rife. Yet perhaps we’ll all muddle through. After all, America has always done just that, all through our 230-year history. Perhaps, too, our society and our economy will continue to reflect the resilience that they have demonstrated in the past, often against all odds. And perhaps we’ll come to our collective senses and develop the courage to take arms against this sea of troubles and by opposing, end them. The stock market, indeed, seems to be saying just those things, and I hope it’s right.

For the record, a 9 percent nominal return increases capital by 762 percent over a quarter-century; at a real rate of 6 percent, the increase is only 329 percent—barely 40 percent of the putative capital accumulation.) (5) The actual dollar amounts of expenses paid by each fund shareholder each year. This need be neither complicated nor precise. Simply calculate the fund’s expense ratio for the year just ended, and multiply it by the dollar value of the shareholder’s investment at year-end. The actual dollars they spend, I believe, are more meaningful than ratios to investors. (6) The total annual costs incurred by fund investors. Not merely the fund’s expense ratio, but its estimated costs of portfolio turnover, and the annual impact of the initial sales charge. While the industry leaves the self-serving impression that a fund’s expense ratio represents the total cost of owning a fund, that is far from the truth. The fact is that often there is sort of a three-legged stool of costs that drag down fund returns. The expense ratio of the average equity fund is 1.4 percent; the average (hidden) cost of portfolio turnover probably runs between 0.5 percent and 1.0 percent; and, for funds with sales changes, the amortized cost of the typical 5 percent load runs to more than 1.0 percent per year. (The average holding period is now about 4 ½ years). So average total all-in costs may reach as much as 3 percent a year or more.

But we’d best not forget Lord Keynes’s warning of 70 years ago: “When enterprise becomes a mere bubble on a whirlpool of speculation the consequences may be dire. . . When the capital development of a country becomes a by-product of the activities of a casino, the job (of capitalism) is likely to be ill-done.” Whatever the case, some surprising event out there, far beyond our expectations, will surely come to pass, an event that may carry an extreme impact, and one that, once it happens, we’ll quickly concoct an explanation as to why it was so predictable after all. That event, if—perhaps I should say when—it comes, will be just one more Black Swan.

Such costs, to state the obvious, constitute a powerful drag on net returns earned by fund investors, magnified many fold over the long term. (7) I’d also like to see reforms in advertising regulations. Since only funds with exceptional records advertise them (and then only until they turn negative), I’ve come to the conclusion that advertising fund performance is inherently misleading. It should simply not be allowed. (I’d also bar endorsements. Just what could it possibly matter to an investor that Lance Armstrong or Paul McCartney, presumably in return for a healthy fee, is plugging a particular fund family?)

(8) We also ought to disallow the publication of records of incubation funds and funds with hypothetical past returns. Full-page ads bragging about back-tested, cost-free, and entirely theoretical returns that allegedly were earned by funds following today’s “fundamental indexing” fad—now appearing in all their full-page glory—are simply improper, inappropriate, and materially misleading. The practice must be stopped. The “Statement of Policy” Time does not permit me to go into more detail with my litany of reforms designed to assure that fund investors get the straightforward information to which they are entitled, and are protected from deceptive information that can only mislead them. So let me conclude with a constructive suggestion: my recommendation that FINRA adopt a new “Statement of Policy” regarding the sales and sales literature published by fund sponsors, stockbrokers, and financial advisers. Hardly anyone in this business today remembers (although I do!) that from 1950 until 1969, mutual funds operated under a fairly rigorous code of standards for advertising and sales literature. It was called the “Statement of Policy,” and was administered by the NASD.

Under the SOP, it was deemed “materially misleading” to, among other things, combine into a single figure dividends for investment income and distributions from any other source; to present charts showing results of initial investments which include dividend reinvestments; to present charts or tables which do not provide adequate and accurate disclosure of material facts; to make extravagant claims regarding management ability or competency; or to compare a fund’s record with any other fund or market index without pointing out the material differences or similarities between the subjects of the comparison. The SOP, however, proved unduly restrictive, prohibiting, for example, the publication of a fund’s total annual return. (Ironically, total return has become the universal metric for today’s industry.) It also required levels of detail that obscured the clear presentation of returns that included dividend reinvestment. Nonetheless, if we are to protect investors without burdensome regulation, we must educate them in the sunlight of full disclosure. Exactly how to do this, I do not know, for it involves shareholder reports, sales literature, and prospectuses, each of which operates in a different regulatory framework. But if there is a will, I’m sure there’ll be a way. But don’t count on any support from the mutual fund industry nor the brokerage industry, nor likely from most financial advisers.

Should the strong message of these remarks reach the press and public, I can already hear the Investment Company Institute saying, “More disclosure? It will just confuse investors. They already have too much information.” There is, of course, some truth in that allegation. Most investors don’t know about, or don’t use—or perhaps don’t even understand—the abundant information they have today. But publishing the important data to which I urge giving attention today—even on each fund’s website—would cost essentially nothing. And even if only a single investor were to benefit—and I believe that ultimately millions of investors will benefit—the cost-benefit ratio would be, well, infinite.or

lesser degree, speculation, giving rise to a huge depletion of wealth for the 100 million American families who own mutual funds. In that half-century period, we—at least, too many of us—have tried lots of clever, faddish ways to gather more assets from the investing public—option-income funds, “government plus” funds, short- term global funds, adjustable-rate preferred-stock funds, to say nothing of funds investing in “sin” stocks, etc. Nearly all of them have come and gone, and fund failures have now risen to an annual rate of about 5 percent. Not bad? Only until you realize that at that rate, a decade hence, fully one-half of today’s 4700 equity funds will be gone—consigned to the dustbin of history, Yet, I regret to say, the trend toward specialization in mutual funds is not abating. It is actually increasing. In most industries, innovation is an unvarnished asset, but in the fund industry it has proved to be an asset to fund managers but a liability to fund investors. (Remember those sadly deficient returns that fund investors have earned over the past decade.) Some innovation, of course, has been positive.

I think few would disagree that the Vanguard experiment in mutual fund governance; our creation of the first index mutual fund, the first series of defined-maturity bond funds, and the first series of tax-managed funds; our focus on low-costs—not only in expense ratios, but also in eliminating sales charges, and minimizing portfolio turnover costs—has created substantial shareholder value. And surely target-date retirement funds and asset-allocation funds, properly used, also offer substantial potential benefits to investors. But the new wave of innovation is something else again. I’ve long made my position clear that exchange traded funds (ETFs)—index funds that one can trade “all day long, in real time” (as the advertisement says), and overwhelmingly focused on narrow, even minuscule, sectors of the market—are likely to do investors more harm than good. The stolid, simple, classic old index funds—that have, in fact, worked brilliantly—are also being challenged by new funds purporting to be “better” index funds, but in fact are pursuing active investment strategies. Variable annuities are another problem. The original TIAA-CREF annuity was a truly great creation, and with costs that are so low as to barely be believed, deservedly leads the field to this day. But, with rare exceptions, its successors have piled on costs that are totally unacceptable (to investors, although hardly to salesmen).

Equity-linked annuities, where downside protection is provided—at a grossly excessive cost—are but one more way to escape NASD regulations on the technicality that they are actually (exempt) insured products, not securities subject to federal oversight. A Business Week article describes them as “a sucker’s game dressed up to look like a free lunch.” I hope the SEC will demand the investor protection and disclosure that is clearly required. What’s more, we now have 130/30 funds (or 120/20 funds), whose respective ratios speak to the fund’s long and short positions, our sad attempt to challenge the hedge fund industry. When I see these kinds of innovations, I say, “Watch out!” Also on the drawing board are funds that make automatic monthly payouts directly from capital—which I pray will include a “worst case” disclosure—and funds offering “growth and guaranteed income.” Where this innovation will end, knows God. But my long experience tells me that many, perhaps most, of today’s innovations will end badly for investors. For we know that complexity is usually associated with higher—and often hidden—costs, and with higher—and usually undisclosed—risks. As these “new products” (as we are wont to call them) proliferate, the new Statement of Policy I propose must have the flexibility to deal with them.

Again to be clear, not by regulating them (though I’m not at all sure that might not be a good idea), but by requiring the full and fair disclosure of all relevant information, and with “CAVEAT EMPTOR” written on every page.

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.

” Using a similar formulation, I’d suggest that “If fund managers, and stockbrokers, and financial advisers were angels, no regulators would be necessary.” As far as I know, however, this industry has no angels. So we need all of you here today to demand the kind of full disclosure I’ve described, helping to assure that mutual fund and fund distributors operate under “high standards of commercial honor, just and equitable principles of trade, and fair dealing” with the investors of America.