2017

In his 2017 CNBC interview, Klarman restated his view that the investor's job is not to forecast the market but to evaluate businesses as if the market did not exist. He argued that most participants spend their time forecasting price action rather than estimating value, and that this misallocation of attention is the single greatest source of avoidable loss. His method begins with a conservative estimate of intrinsic value derived from cash-flow analysis, asset value, and any optionality the business possesses. He is explicit that the estimate is a range, not a point, and that the width of the range should be a function of the predictability of the business. Stable, asset-heavy businesses warrant tighter ranges; speculative growth stories warrant ranges so wide that the lower bound justifies a low price regardless. The market price is consulted last, only after the value range is fixed. Klarman refuses to allow the current price to anchor his estimate of value, on the theory that doing so is the surest way to confirm whatever the market already believes. The discipline is to anchor on the fundamentals, then let price tell you whether to act. When the market confirms the analysis, the investor abstains; when the market diverges sharply, the investor engages - and only then.

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

The Modern Corporation and the Public Interest A Speech by John C. Bogle, Founder of the Vanguard Group Before The Public Company Accounting Oversight Board 2017 International Institute * * * Washington, D.C. December 7, 2017 If my title, “The Modern Corporation and the Public Interest” echoes “The Modern Corporation and Private Property,” the title of an influential 1932 monograph by Columbia professors Adolph A. Berle and Gardiner C. Means, please be clear that the similarity is intentional.1 The principal conclusions of their landmark review of the public corporations of the day:  The position of ownership has changed from an active to a passive agent. The typical owner has rights and expectations with respect to an enterprise, but is practically powerless to effect change.  The spiritual values that formerly went with ownership have been separated from it.  The value of an individual’s wealth is determined largely by the actions of the individuals in command of the enterprise—over whom the typical owner has no control. That value is also subject to the vagaries and manipulations characteristic of the marketplace.  Individual wealth has become extremely liquid, convertible into other forms of wealth at a moment’s notice. Note: Mr. Bogle’s comments do not necessarily represent the views of Vanguard’s present management. 1 As an Economics major at Princeton University in 1947-51, I studied their work.

“Puritan Boston and Quaker Philadelphia” John C. Bogle, Remarks before the Society of Friends Philadelphia, PA November 9, 2017 As some of you know, an article in the December 1949 issue of FORTUNE magazine introduced me to an industry I had never heard of before: mutual funds. The article was entitled “Big Money in Boston.” It focused on Massachusetts Investors Trust (M.I.T.), with assets of $275 million, by far the largest mutual fund of its day. Down in Philadelphia, a much smaller fund named Wellington had just crossed the $100 million mark. That article inspired me to write my Princeton senior thesis on the fund industry. And that thesis, in turn, inspired mutual fund pioneer and Wellington Fund founder and president, Walter L. Morgan—my beloved mentor—to hire me. On July 9, 1951, I joined Wellington and the fund industry, the first “full time” job in my long career. In those days, Wellington Fund operated in the manner of the traditional mutual fund: a pool of investor assets, managed for a fee—usually ½ of 1% to 1% of fund assets—paid to an external, separately-owned investment adviser, Wellington Management Company. M.I.T. was run by its own trustees, a structure that bore a vague resemblance to the mutual (fund- shareholder-owned) structure that Vanguard, successor to Wellington, would institute almost a quarter- century later, in 1974. Back when I joined Wellington, Boston was indeed where the “Big Money” was.

January 2018 Dear Fellow Investor, This is the eighth annual letter to owners of the Fundsmith Equity Fund (‘Fund’). The table below shows performance figures for the last calendar year and the cumulative and annualised performance since inception on 1st November 2010 compared with various benchmarks. % Total Return 1st Jan to Inception to 31st Dec 2017 31st Dec 2017 Cumulative Annualised Fundsmith Equity Fund1 +22.0 +261.7 +19.7 Equities2 +11.8 +135.5 +12.7 UK Bonds3 +1.4 +34.2 +4.2 Cash4 +0.4 +4.4 +0.6 1T Class Acc shares, net of fees, priced at noon UK time. 2MSCI World Index, £ net, priced at close of business US time. 3Bloomberg/Barclays Bond Indices UK Gov. 5–10 yr. 43 Month £ LIBOR Interest Rate. 1,3,4Source: Bloomberg. 2Source: www.msci.com. The table shows the performance of the T Class Accumulation shares, the most commonly held class and one in which I am invested, which rose by +22.0% in 2017 and compares with +11.8% for the MSCI World Index in sterling with dividends reinvested. The Fund therefore beat this benchmark in 2017, and our Fund remains the No.1 performer since its inception in the Investment Association Global sector by a cumulative margin of 40 percentage points over the second best fund and 160 percentage points above the average for the sector which delivered +101.2%. However, I realise that many or indeed most of our investors do not use the MSCI World Index as the natural benchmark for their investments.

At the 2017 Berkshire annual meeting, I told the audience that the previous decade, with its enormous expansion of the Chinese economy and the corresponding expansion of the Chinese capital markets, had been the most instructive of my investing life, not because I had made many new mistakes, but because the old mistakes had been repeated by a new generation of investors, at a scale that had produced the largest speculative bubble in Chinese real estate in modern history. The market-psychology point I tried to convey was that the crowd, in its broad patterns, repeats the same mistakes in every cycle, because the incentives facing the participants are the same in every cycle, and the biases facing the participants are the same in every cycle. The investor who recognises the patterns, and who refuses to participate in the new version of the old mistake, has a long-run advantage over the investor who assumes that the new version is different. The mistakes-and-learning element was the one I had most wanted to convey. I had made my own share of mistakes in the previous decade, by being too cautious during the expansion of the Chinese capital markets, and the cost of the caution had, in opportunity terms, been very large. The lesson I drew was that the disciplined investor must be willing to act during an expansion, even when the outlook is unclear, and even when the prices may go lower before they go higher. The 2017 meeting was, in this sense, a confession. I told the audience that the framework had been built, in large part, from my own mistakes, and that the discipline I had extracted was to refuse to wait for clarity, and to act when the prices were attractive, even at the cost of being early. The investor who builds the discipline of acting during the expansion will outperform the investor who waits for clarity. The contrarianism lesson I tried to convey was that the investor who refuses to participate in the speculative bubble, looks unfashionable during the boom, and he is told, repeatedly, that he is missing the opportunity of a lifetime. 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 2017 meeting was, in some ways, the most contrarian I had ever given. I told the audience that the framework had been built, in large part, from my own mistakes, and that the discipline I had extracted was to refuse to participate in the speculative bubble, even at the cost of looking unfashionable during the boom. The investor who builds the discipline of refusal will outperform the investor who participates on the assumption that the new version is different.

Chen Yidan was born in Huizhou, Guangdong, grew up in Shenzhen, and earned a bachelor's in applied chemistry from Shenzhen University (1993), a master's in economic law from Nanjing University (1996), and a Doctor of Business Administration from Singapore Management University (2019).

On June 16, 2017, Amazon announced it would acquire Whole Foods Market for $42 per share in an all-cash transaction valued at approximately $13.7 billion, including Whole Foods Market's net debt. The press release quoted Bezos praising Whole Foods for offering the best natural and organic foods and making it fun to eat healthy. Whole Foods co-founder and chief executive John Mackey framed the deal as an opportunity to maximize value for shareholders while extending the grocer's mission and bringing higher quality, experience, convenience, and innovation to customers. The press release committed to Whole Foods continuing to operate stores under its own brand, with Mackey remaining as chief executive and headquarters staying in Austin, Texas. The acquisition closed later that year and precipitated a broad sell-off in the shares of traditional supermarket chains, marking Amazon's first major move into physical grocery retail.

The Fire Phone, launched in 2014, became one of Amazon's most expensive product failures and a case study in Bezos's commitment to institutionalized learning from failure. The phone debuted at $649, was quickly reduced to $159, and was discontinued after roughly 14 months on the market. In October 2014 Amazon reported a $170 million write-off tied largely to unsold Fire Phone inventory, with additional costs from supplier commitments. Harvard Business School's case study of the episode attributed the failure to a company with too much money building a product nobody needed, with hardware development processes that internal reviewers described as poor. Bezos publicly accepted the failure as part of the cost of invention, and the team that had built the Fire Phone was redeployed to the Echo and Alexa program — a move widely credited with seeding Amazon's eventual dominance of the connected-home market.

In November 2017 David Swensen sat for a conversation on long-term investing with former United States treasury secretary Bob Rubin at the Council on Foreign Relations, an appearance summarised and circulated by the MOI Global community. The conversation covered the philosophy that had guided the Yale Investments Office for more than three decades, the structure of the endowment's portfolio, and the question of how a long-horizon institution should think about the trade-off between risk and return. Swensen used the platform to restate the central principles of the Yale model, including the equity bias, the diversification across asset classes, the allocation to private assets, and the insistence on active management only where the case for it could be sustained. 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. He told Rubin that the office's long holding periods were a function of the structure of the alternative asset classes the office chose to own, and that the willingness to forgo the daily liquidity of the public market was the source of the premium the office earned in those classes. He argued that the premium was not a free lunch but a compensation for the willingness to lock up capital, and that the office's discipline during periods of public-market stress, when the public market offered the appearance of attractive prices, had been a defining feature of the model's track record. He framed the alternative-asset allocation as a structural feature of the portfolio rather than as a tactical bet on any single vintage of returns or on any single manager relationship. 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. He closed the conversation with a reflection on the people who had built the office. He told Rubin that the most durable decision he had made was the decision to staff the office with people who intended to spend their careers at Yale, since the long holding periods of the alternative asset classes meant that the relationships built in the early years of a career would still be producing deal flow decades later. He said he had turned down offers to leave for higher-paying positions and that he considered his role at Yale a public service rather than a commercial proposition. The conversation is treated as a companion to the 2013 Yale School of Management interview and is widely cited in the institutional investment literature on the Yale model. 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.

In 1966, the year he died, some 240 million people watched a Disney movie, 100 million followed a Disney television program, 80 million bought Disney merchandise, and nearly seven million passed through Disneyland's gates, a reach few creative figures before or since have matched. The PBS American Experience documentary frames his achievement as the creation of one of history's most beloved cartoon characters, the conception of the first feature-length animated film, the pioneering integration of media and marketing through thousands of branded products, and Disneyland itself, the first theme park anywhere, built as a walkable, three-dimensional version of his own utopia. The portrait is not hagiography: a driven, restless perfectionist whose attention to detail and quest for innovation meant constant delays and cost overruns, Disney felt unappreciated by the movie industry, was stung when critics panned his productions, and after his employees organized and went on strike, felt betrayed enough to call them communists before the House Un-American Activities Committee.

Cao was born in 1946 in Fuqing, Fujian, into a family that had been wealthy but lost everything fleeing the Chinese civil war, forcing him to leave school at age 14 to help support the family.

In the period following his 2015 detention, Guo Guangchang indicated publicly that he remained actively engaged in leading Fosun and had not contemplated stepping back from the business, a stance that framed his continued operational involvement.

__________________ Substantial portions of this essay were the basis for a speech delivered to the Morningstar Investment Conference in Chicago, Illinois on April 27, 2017. The opinions expressed in the essay do not necessarily represent the views of Vanguard’s present management. The Road Less Traveled An Essay by John C. Bogle Founder of The Vanguard Group (1974) and Vanguard 500 Index Fund (1975) April 26, 2017 I. The Prophesy Almost 43 years ago, in July 1974, one of the most memorable events of my long career took place. I was in Los Angeles at the headquarters of the American Funds, meeting some of the friends that I had gotten to know during my long service as a governor of the Investment Company Institute, and chairman during 1968-1970. During the day, the late Jon Lovelace, head of the firm, came into the conference room where we were gathered and asked me to meet with him privately. He had some important industry issues that he wanted to discuss. Jon, son of Jonathan Bell Lovelace, founder of the American Funds in 1931, had a high reputation for business integrity, independence of thought, and wisdom, and I was eager to meet with him. Following my visit to his firm, however, I had scheduled a dinner meeting before flying back to Philadelphia on the 7:30 a.m. flight the next morning. “That’s fine,” Jon said, “I’ll meet you at the LAX breakfast room counter at 6 a.m.” When I arrived, Jon was already seated at the counter.

In mid-2017 Snapdeal was being negotiated for sale to Flipkart at a firesale price of around $1 billion, less than one-sixth of its peak $6.5 billion valuation from early 2016 — meaning investors were recovering roughly fifteen cents on every dollar they had put in, an outcome that hardened the industry's suspicion of headline-valuations in Indian e-commerce.

In 1982 Dalio made the call that nearly ended his career. A year into Bridgewater's first proper office in Connecticut, and seven years after starting the firm from his apartment, he believed American banks were lending too much money to emerging Latin American countries. The analysis was very controversial among bullish investors, and it turned out to be right about the debt. At the start of 1982 American bankers still hoped their money would kickstart those economies and yield big returns, even though Latin American countries owed 327 billion dollars to the nine biggest money-center banks in the United States. Then Mexico's finance minister met with one hundred international bankers at the New York Federal Reserve to tell them his country was unable to pay its 80 billion dollar debt, of which between 20 and 30 billion was owed to American banks. Oil prices had dropped without warning, the peso had been devalued, and rates were up, crushing Mexico's economic dreams.

Reflections on a Revolution Remarks by John C. Bogle 70th CFA Institute Annual Conference May 23, 2017 In recent years, disruptive innovation has permeated the realms of commerce as never before, and it is destroying many traditional business sectors. Think books. Think retail. Think print media. Think local transportation. Think recorded music. And think investing. The realm of investing has been no exception to the rise of disruptive innovation. The trading of stocks through brokers faces challenges both from electronic competition and displacement by exchange-traded index funds (ETFs). Robo-advisers challenge traditional registered investment advisers. And, traditional active money managers face the challenge of index funds. So far the Index Revolution has claimed no victims among asset management firms, in part because a strong stock market has raised assets of actively managed equity funds from $7.3 trillion to $10.5 trillion over the past decade. (Chart 1) Advisory fees have risen from $73 billion to $86 billion, a mere $13 billion increase at revenues for the advisers to these active funds. But in economics, everything happens at the margin. When we look at the data from a different perspective, the revolution leaps out at us. During the past decade, cash flows into U.S. equity index

At the 2017 Daily Journal meeting, Munger made one of his most explicit pitches for Chinese equities. Some very smart people were wading into China, he said, and he expected more to follow. His core observation was simple and structural: the great companies in China were cheaper than the great companies in the United States. He had been making the same observation privately for years, and at DJCO 2017 he made it on the record. Munger's reasoning was not a macro call. He was not predicting the renminbi, the Politburo's next move, or the exact timing of trade frictions. He was making a relative-value statement about the cost of buying world-class franchises in two markets. A great company in China, on the metrics he cared about - long-run return on capital, durability of the moat, growth runway - was available at a lower multiple than a comparable great company in the United States. That gap, in his view, was an opportunity for the patient investor who could underwrite the Chinese business honestly. The risk, he acknowledged, was real. China had governance, disclosure, and political-risk dimensions that American investors had to take seriously. But Munger's framing was that those risks had already been priced into the cheap multiples - that the market had over-discounted them. The implicit recommendation was to do the work, find the genuine franchises, and pay the cheaper price while other investors were still standing on the sideline. He would, of course, take his own advice in the BYD position - the Chinese EV maker he had championed at Berkshire a decade earlier and that, by 2017, was making real money.

In his 2017 TED talk, titled How to Build a Company Where the Best Ideas Win, Dalio made the business case for the practices that defined Bridgewater: radical transparency and algorithmic decision-making, organized into an idea meritocracy in which people are expected to voice their honest views, and even calling out the boss is fair game. The talk's framing question was what would change if you could see your colleagues' unvarnished opinions of you and of each other. Dalio, introduced as the founder, chair, and co-chief investment officer of the world's largest hedge fund, argued that these strategies helped him create one of the world's most successful funds and that anyone might harness the power of data-driven group decision-making. Bridgewater's own machinery annotates the claim from the firm's record: every meeting recorded and viewable by any employee unless proprietary, a dot collector app logging real-time assessments of people's views, and investment decisions made without considerations of hierarchy, a firm that treats candor as an operating system rather than a value statement.

Buffett described Apple as a business whose economic characteristics — enormous consumer attachment, high margins on hardware that locked in a services ecosystem, and the capacity to return capital through buybacks — made it attractive even though Berkshire owned only a minority stake. He framed the holding in terms of look-through earnings: Apple's retained earnings, though not distributable to Berkshire, increased Berkshire's share of Apple's future cash flows each year Apple repurchased stock below intrinsic value.

On the logic of the Apple holding and look-through earnings.

Acceptance Remarks John C. Bogle 2017 CME Group Melamed-Arditti Innovation Award Naples, Florida November 14, 2017 I’m delighted to share this remarkable Innovation Award with my fellow Scotsman, the quantitative investment pioneer John “Mac” McQuown. I’m especially honored because the CME Group Melamed-Arditti Innovation Award is based, not only on the invention of a financial innovation that has “created significant change to markets, commerce, or trade,” but also on “the practical application of the idea . . . in improving the economic well-being of individuals, an industry, or a nation”—in the public interest. That’s always been the goal of my long career. Surely First Index Investment Trust (the original name of today’s Vanguard 500 Index Fund) was designed to do exactly that. I’m still sort of amazed that it fell to me to create this pioneering index mutual fund way back in 1975. How did it happen? But first, how did it not happen? First Index was not a product of complex algorithms, nor of Modern Portfolio Theory (MPT), nor of the Efficient Markets Hypothesis (EMH). For me, the uneven efficiency of the market makes the EMH an unreliable basis for indexing. Truth told, when I decided to start our index fund, I possessed neither the training nor the talent for applied statistics, and, embarrassingly, I had never even heard of the EMH. Nor was the first index mutual fund a product of the quantitative work done at the University of Chicago and at Wells Fargo.

A Wealth of Common Sense's 2017 summary of Klarman's thinking focused on the difficulty of maintaining a disciplined posture in markets that consistently reward the abandonment of discipline and that penalize the patience that the value tradition treats as a virtue. The piece observed that Klarman's long-term returns, while exceptional on any absolute measure, had been punctuated by long stretches of underperformance during which the firm held cash and refused to participate in the speculative phase of the cycle and during which clients and observers had periodically questioned whether the firm had lost its edge. The summary argued that this pattern was itself the source of the firm's edge, since the willingness to look wrong for extended periods is what allows an investor to act decisively when dislocations arrive and to acquire the assets that the consensus has decided to abandon at prices that finally reflect a margin of safety. The article emphasized that Klarman's view of market psychology is not that crowds are always wrong but that the conditions of euphoria and panic produce predictable distortions that the disciplined investor can exploit and that the undisciplined investor is exploited by. The summary noted that Baupost's track record shows the firm adding capital in periods of acute stress, including 2008 and 2002, when most participants were forced sellers and when the prices of assets that had been unobtainable during the prior euphoria finally reflected the pessimism that the underlying businesses did not actually justify. The pattern underscores Klarman's insistence that risk and return are not always positively correlated, and that the highest-expected-return positions often appear precisely when the apparent risk is at its peak and when the consensus is most convinced that the asset in question should be avoided at any price. The piece also reflected on the cultural conditions that make Klarman's approach difficult to replicate and that have made the firm unusual even within the value-investing community that shares its analytical principles. The summary observed that the structure of the asset management industry actively penalizes the kind of patience that Baupost practices, since clients tend to withdraw capital during periods of underperformance even when the underlying thesis remains intact and even when the underperformance is itself a consequence of the discipline that the client originally sought out. The article closed by noting that the rarity of Klarman's posture is itself evidence of its value, and that the markets remain structured in a way that rewards those who can resist the gravitational pull of consensus during periods of speculative excess and who can sustain the discomfort of looking wrong while waiting for the conditions that the discipline was designed to exploit.

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

funds have totaled a positive $1.3 trillion, while actively managed U.S. equity funds have suffered negative cash outflows of $1.1 trillion, a remarkable $2.4 trillion swing in investor preferences. Index funds garnered positive flows during every year of the decade, while active funds had negative flows in nine of the ten years. (Chart 2) That trend seems to be accelerating. During the first four months of 2017, investors have poured $115 billion into U.S. equity index mutual funds—on pace for the biggest year ever. Active funds are on pace for their second worst year on record. Yes, there’s a revolution underway. If you believe Paul Samuelson, Warren Buffett, and David Swensen (my “murderer’s row”), I’ve been a hero, the leader of this Index Revolution. They may even be right! Whatever the case, in 1975 I started the world’s first index mutual fund. That strategy was importantly motivated by my 1974 creation of Vanguard, with its mutual (fund-shareholder-owned) structure, driven by its charter and its spirit to minimize the costs of investing.

Cao built Fuyao Group into one of the world's largest glass manufacturers, with the company specializing in automotive glass, and holds leadership roles in industry bodies including the China Automobile Glass Association.

Dalio then extrapolated the crisis into a forecast that failed. He expected fifteen other Latin American countries to follow Mexico into default, and he concluded that the debt shock would drag the American economy and the stock market down a lot. Instead, in his own retelling, the economy and stock market went up a lot. The mistake, he told Business Insider's global editor in chief Henry Blodget, was that he had focused so heavily on the Latin American debt crisis that he ignored the information he could not reach, or was simply not weighing, the missing preparation for a broad range of outcomes. He lost money for himself and for his clients, and he was so broke he had to borrow four thousand dollars from his father. The experience was, in his words, very, very painful, and it became the founding trauma of his investment philosophy, the episode he credits with forcing a complete rebuild of how he approached not knowing.

Indeed, when I later read the Chicago version of the origin of the index fund, I realized that I had then never heard of a single one of those star-studded names that graced the Chicago article at the time I created First Index. Mac McQuown, Jim Vertin, Bill Fouse, Fisher Black, Harry Markowitz, Eugene Fama, Dean LeBaron, Jim Lorie, Merton Miller, Myron Scholes, and Bill Sharpe . . . surely a “who’s who” is of the biggest names in the financial academy. This 1951 graduate of Princeton University with a mere A.B. degree was, in a word, ignorant of what was going on in the academy. No, the genesis of First Index was casual and intuitive. Short version, according to Jan Twardowski, Princeton B.S.E.E. degree and recently-minted Wharton M.B.A.28

 Finally, in the corporate system, the “owner” of industrial wealth is left with a mere symbol of ownership. The power, the responsibility, and the substance that had been an integral part of ownership in the past has been transferred to a separate group in whose hands lies control. (Italics added.) Berle and Means cogently identified a problem that continues to plague modern capitalism. For a time, the system worked with reasonable effectiveness, since corporate shareholders with larger investments still had both the legal rights and voting rights to protect their own interests. As ownership was gradually diffused into far smaller shareholdings, however, effective shareholder power declined, even as the latent power of those voting rights remained intact. The Rise of the Institutional Investor While this opus was published 85 years ago, the description of our U.S. corporate system that I have just cited still rings true—passive ownership, seemingly powerless; a decline in spiritual values; the vagaries of the marketplace; the supremacy of management. But one of the two major parties that Berle and Means identified has lost most of its standing. Ownership of stocks by individuals has plunged from 92% of all stocks in 1945 to an estimated 27% today. Diffused ownership of stocks gradually has given way to concentrated ownership. In the early 1950s, holdings of stocks by U.S.

Munger told the 2017 audience that the Daily Journal and Berkshire Hathaway had succeeded, more than anything else, by refusing to attempt to know too much. He kept a too-hard pile on his desk, he said, and most of the problems that crossed his path got shifted onto it. Every once in a while an easy decision came along, and he made it. That, he said, was his entire system. The room laughed, but Munger meant it as a serious investment philosophy. He tied the too-hard pile to the discipline of patience. A normal human life does not have very many great decisions in it. He told the audience that if they actually counted the meaningful decisions made in the history of the Daily Journal Corporation or the history of Berkshire Hathaway, the number per year was not very high. The game was being there all the time, recognizing the rare opportunity when it came, and recognizing that normal human life does not contain very many such moments. He contrasted this with what he called the racetrack tout - the people who sell securities and act as though they have an endless supply of wonderful opportunities. Those people, Munger said, are not even respectable. They pretend to know a lot of stuff they do not know, and pretend to furnish opportunities they are not furnishing. His advice to the audience was to avoid them - unless, he added with characteristic dryness, you happen to be running a stock brokerage firm, in which case you need them. The honest investor's job was to recognize the rarity and to refuse to manufacture the frequent.

Nearly 50% of mutual fund assets were managed by Boston-headquartered firms. Fund assets in the Greater Philadelphia area (largely Wellington Fund) ranked a distant fourth, with a mere 7% of all fund assets. That headquarters map looks very different today. Greater Philadelphia ranks first, with a share of 25% of industry assets (again, almost entirely Vanguard funds), more than triple its 1951 share of 7%. Boston’s share has dropped by more than half, from 50% to 19%, now ranking third.

Those of you who are based in the UK may look to the FTSE 100 Index (‘FTSE’ or ‘FTSE 100’) as the yardstick for measuring your investments and may hold funds which are benchmarked to this index and often hug it. The FTSE delivered a total return of +12.0% in 2017 so our Fund outperformed this by a margin of 10.0%. I will come back to the subject of the FTSE 100 Index later.

In 1998, Chen co-founded Tencent alongside Ma Huateng, Zhang Zhidong, Xu Chenye, and Zeng Liqing, serving as the company's Chief Administrative Officer.

Employee headcount had collapsed to under 2,000 from roughly 6,000 a year earlier; the office spa, creche and gym were shut and the library was the only amenity still functioning — physical evidence of the cash crunch that had taken hold inside a firm that, only twenty months before, had been seen as a credible rival to Flipkart.

After exchanging a few pleasantries, he got right to the point. “I understand that you’re planning to create a new mutual fund complex that will actually be mutual, owned by the fund shareholders.” I responded that, yes, I hope to create a firm with mutual structure. But I was in the midst of a nasty battle to rebuild my shattered career, and its outcome was unpredictable.

Klarman observed that one of the hardest psychological tasks in investing is to act against the consensus while being part of the same information stream that produces it. The investor reads the same news, watches the same interviews, and is exposed to the same narratives as everyone else. The contrarian edge is not access to better information but the willingness to weigh that information differently. He noted that the consensus is not always wrong and that fighting it for its own sake is a form of hubris. The honest contrarian has to admit the possibility that the crowd sees something he does not. The discipline is to demand a margin of safety wide enough that being wrong about the consensus does not produce a permanent loss - not to assume the consensus is always mistaken. This balance is what separates his version of contrarianism from the more theatrical strain. Baupost rarely takes public stands against popular holdings; it simply abstains from situations where price already reflects the consensus optimism, and adds capital where price implies the consensus has given up. The discipline is observable in the trade record: years of relative inactivity in popular sectors, punctuated by concentrated buying during forced selling. The narrative is not that the crowd is wrong but that the crowd has mispriced this specific situation, and we have an independent estimate to back our view.

I should note that the Boston share is actually more like 17%, since some of Boston’s leading managers—including Massachusetts Financial Services (and its one-time flagship M.I.T.) and Putnam— are owned by Canadian conglomerates. As for M.I.T. itself, the focus of that 1949 Fortune article, its market share has fallen from 15% to 3/100 of 1%. “How the mighty have fallen!” (Second Samuel, 1:27) But perhaps the major part of this shift of industry leadership from Boston to Philadelphia can be divined by considering the difference between the two cities, encapsulated in the title of Penn Professor E. Digby Baltzell’s 1979 book: Puritan Boston and Quaker Philadelphia. In his analysis, Dr. Baltzell gave Boston’s Puritans the edge over Philadelphia’s Quakers. He described the Boston style as “communal and organic,” while Philadelphian’s style was “characterized by pragmatism and extreme individualism.” Boston, Baltzell alleged, “favored the democratic ideal,” more consistently than did Philadelphia. But Dr. Baltzell was looking back, unaware that he happened to be writing at the time of a major inflection point in the history of the mutual fund industry, an industry about to enter an era of growth that would carry its assets up 180-fold from $95 billion in 1979 to $17 trillion today.

institutional investors—first mutual funds, then pension funds, then thrift plans—began to grow, and grow rapidly. In 1945, these institutions owned only 8% of all publicly-held stocks. By 1962, 18%. By 1982, 50%. Today, institutional holdings of stocks stand at an estimated 73%. It’s hard to imagine a change more sweeping than this change in the ownership of corporate America . . . well, maybe the index fund! The Double-Agency Society The Berle-Means model no longer explains how our modern corporations are governed. What has emerged instead is a “double-agency” society in which corporate agents (as a practical matter, CEOs) who are duty-bound to represent their shareholders face money-manager agents who are themselves duty-bound to represent their mutual fund shareholders and their other clients, often pension funds.

Last year in order to describe our Fund’s performance for the year I quoted the commentator’s cliché that football is a game of two halves, because in 2016 a strong first half performance by our Fund contrasted with a weaker second half of the year. In 2017 we experienced what stock market commentators often describe as a sector ‘rotation’ in which the sectors in which we are invested mostly fell out of favour and share prices of those companies underperformed, whilst other sectors which we do not own performed well—in particular the bank sector. This ‘rotation’ seems to have occurred as a result of expectations about a pick-up in economic growth leading to a potential recovery in the performance of cyclical stocks, especially after the election of Donald Trump as US President in early November with predictions that his economic policies would stimulate more rapid growth in the US economy. The commentator’s quote I wish to use to describe this year’s performance is from Yogi Berra, the American baseball player, manager and coach, who had some deceptively simplistic or seemingly illogical aphorisms. One of my favourites is ‘You can observe a lot by watching’ which I think some people would do well to consider. However, the one which I think expresses the performance of the Fund and market in 2017 is ‘It’s déjà vu all over again’. What have we experienced in December?

Liu told the Financial Times in 2011 that he was focused on organizing peasant farmers into roughly 100 agricultural cooperatives and setting up underwriting companies to help them obtain loans, framing his business as a tool for rural industrialization.

original crew members of our tiny, shiny new firm named Vanguard. I’ll let Jan tell the story of what happened in mid-1975: “One day you surprised me by asking if I could run an index fund and after a couple days research I said yes . . . I wrote the index fund programs in APL on a time-sharing system, using simple cap-weighting algorithms and public databases. It was, frankly, easy, although I was quite nervous when you sold the idea to underwriters and the road show began. Actual money was going to be managed based on my little set of APL programs!” There was, of course, much more to the story than that simple anecdote.1 So let me take you through a brief time line of the confluence of events and circumstances that made my timing and my 1975 decision almost inevitable: 1. March 1951. The Thesis. I handed in my Princeton thesis focused on the then-tiny ($2 ½ billion) mutual fund industry, which was entitled “The Economic Role of the Investment Company.” After a skimpy statistical analysis, largely anecdotal, I concluded that mutual funds “could make no claim to superiority over the market indexes.” In mid-1975, as I prepared to recommend the formation of the first index fund to the Vanguard directors, I recalled those words. 2. 1960-January 1974. The Learning Experience. Through my experience on the Wellington Fund Investment Committee, I learned first-hand how tough it is to find portfolio managers who could consistently distinguish themselves.

Dalio looks back on 1982 as the best thing that ever happened to him, because it changed his mindset. The lessons, he says, were fear and humility: the fear balancing his natural aggressiveness, and the humility replacing certainty about what he knew with a map of what he did not. He shifted from starting with what he knew to starting from an acknowledgment of ignorance, then determining what he still did not know, which let him hedge his bets more carefully and prepare for a broad range of outcomes. He credits that open-mindedness, more than any specific market insight, with everything that followed: the ability to build Bridgewater into a giant overseeing 103 billion dollars in hedge fund assets, with about 150 billion in total assets under management at the time of the 2017 interview. His summary became a signature line: his success in life has come far more from knowing how to deal with his not-knowing than from anything he knows.

The piece reports SoftBank as the central actor in the failure: the Japanese investor pushed Snapdeal to spend aggressively, declined to make good on repeated promises of fresh capital, blocked other fundraising, and finally cornered the founders into a Flipkart merger — a portrait of how a single large investor can take operational control of an Indian startup's fate.

Cao serves as a member of the Chinese People's Political Consultative Conference representing Fujian, connecting his business role to a formal advisory political body.

Chen stepped down as Tencent's CAO in March 2013 to found the Chen Yidan Charity Foundation, continuing involvement with Tencent as an advisor, sponsor, and honorary chairman of the Tencent Charity Foundation, and later as Lifetime Honorary Consultant.

Indexing, Costs, and Consumerism It is this combination of strategy and structure that has paved the way to Vanguard’s leadership: 80% of the assets of traditional index funds (TIFs)—largely based on buying and holding broad market, low-cost stock and bond indexes such as the S&P 500—and 30% of the assets of ETFs—largely based on active trading of both broad market indexes and narrow market segments, and often appealing to investors who wish to speculate. Combining both TIFs and ETFs, Vanguard holds a dominant 50% share of the U.S. index fund market.

To put it mildly, Jon did not like my idea. I still remember his exact words, “If you create a mutual structure, you will destroy this industry.” Viewed in the light of what would follow decades later, if Jon Lovelace only had added (which he surely implied), “you will destroy this industry as we now know it,” his reputation for wisdom and foresight would have been even further enhanced. II. The Upstart and the Revolution This compelling anecdote begins my story of how an upstart firm, founded at the bottom of a vicious bear market in 1974 (down 50%), overcame the high odds against its survival, let alone its success. The firm had an unprecedented mutual structure. It was compelled to use an external investment adviser with a previous record of failure. It was limited in its ambit to fund administration, and barred from engaging either in portfolio management or share distribution. It would soon stake its future on an unprecedented strategy—a stock portfolio that would require no investment adviser. And, as if those liabilities were not enough of a burden, the firm had a brand-new name. As you now must know, that name was Vanguard; that unprecedented structure was mutual; and that strategy began with the creation of the world’s first index mutual fund. Whether you applaud this novel approach to mutual fund structure and strategy—or maybe even wish that it had failed—that structure and that strategy have changed the nature of the mutual fund industry “as we then knew it.

Asked about the firm's holding periods, Klarman noted that Baupost's average position lasts several years, with some held for a decade or more. He framed this not as a stylistic preference but as the natural consequence of buying assets that are cheap relative to conservative value and waiting for the gap to close. He observed that the closing of the price-to-value gap is rarely a smooth process. Sometimes a catalyst appears - a takeover, a recapitalization, a reorganization. Often the catalyst is simply time, as the business generates cash that ultimately forces the market to re-rate it. The investor who demands a near-term catalyst before acting tends to miss the situations where the catalyst is simply patient compounding. The compounding implication is that the firm's returns are largely earned in the gaps between transactions. Baupost is not, by design, a high-turnover firm. Its edge is in identifying the gap, sizing into it, and waiting. The cost of this style is the years of relative underperformance during bull markets; the benefit is the avoidance of permanent loss during bear markets. Over a multi-decade horizon the compounding math has favored the style, but Klarman has been explicit that the style requires clients willing to accept multi-year stretches of looking wrong.

Assets of U.S. mutual funds have also soared, from $500 billion in 1985 to $16 trillion currently. (Exhibit 2) But the composition of fund assets has fluctuated widely—in 1970, an equity fund business— 87% equity funds, 8% in balanced funds, only 5% bond funds. (Exhibit 3) Then came the 1973-4 stock market crash. It almost killed the equity fund business. Equity fund assets dropped from $56 billion to $29 billion—a near-50% plunge. Bond funds helped to cushion the blow, and then, miraculously—and not a moment too soon— money market funds were created, bailing out the fund industry. By 1981, money market funds accounted

Even more of a lesson: the 1966 merger that brought us Ivest Fund collapsed in 1974. Its managers, who had sown the “Go-Go” era wind, reaped the subsequent whirlwind. These aggressive young managers ruined Wellington Fund, ruined their own fund, and ruined two opportunistic copies of it. All three funds quickly failed the investors. 3. January 23, 1974. The Firing. Despite the failure of the managers, it was I who lost my job as CEO of Wellington Management Company. My new partners ganged up and fired me. It was not a happy moment in my career. 4. January 24, 1974. The Closed Door Begins to Open. The very next day, the Board of the Wellington Funds—largely independent of Wellington Management Company—met in New York City. (You can’t make this stuff up!) I was still Chairman and CEO of the funds, and urged the directors to assert their legal independence, retain me as CEO, and perform their own 1 No I’m not saying that two undergraduate degrees from Princeton and an M.B.A. from Wharton are equal to all those Ph.D.s from Stanford, Chicago, Harvard, and MIT . . . not saying it yet!

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

for 77% (!) of industry assets, bond funds 6%, balanced funds a mere 1%, and only 16% in equity funds. As money market funds faded, bond fund assets rose—to 22% of industry assets currently, with money markets at 17%, balanced at 8%, and equities at 52%. Yes, there has been much fluctuation in the relative positions of stock, bond, balanced, and money market funds since 1960. But, beginning in 1976, there was one constant—the steady rise of the importance of stock and bond index funds. (Exhibit 4) From a 1985 position of less than 1% of all stock fund assets and 0% of bond fund assets, both penetrations have marched steadily upward in market share of industry assets to this year’s high of 23% of bond funds and 41% of stock funds. Yes, there’s an index revolution going on, and it is accelerating! Background to Bonds: “Balance” and Wellington Fund

After the 1949 Communist takeover, Liu was classified by the CCP as a 'nationalist capitalist' and, unlike many other pre-1949 industrialists whose firms were nationalized outright, retained a protected status, later serving as a Shanghai representative to the first National People's Congress.

Fuyao Group became one of the largest glass manufacturers globally, per Wikipedia's characterization, with Cao continuing as chairman.

A fall in technology sector shares and a rise in bank shares in anticipation of the next rise in interest rates by the Federal Reserve Bank (being a stickler for at least attempting to use language correctly, I refuse to use the popular term ‘hike’ to describe the Fed’s actions as the dictionary definition of this in context is a sharp increase. I am fairly confident that is not what we are getting. My concern about correct usage may not be to everybody’s liking but in my view we should use language more carefully than many modern commentators do as it is after all our main means of communication). When judging these events, the fact that we seem to have seen this movie before might lead us to conclude that we know how it will end. I can now trace back five years of market commentary that has warned that shares of the sort we invest in, our strategy and our Fund would underperform. During that time the Fund has risen in value by over 175%. The fact that you would have foregone this gain if you had followed their advice will of course be forgotten by them if or when their predictions that our strategy will underperform the ‘value’ strategy of buying cyclicals, financials and assorted junk pays off for a period.

Strategy and structure have also made Vanguard a hero to Main Street. The letters I get from shareholders almost every day say exactly that. But Vanguard is an anti-hero—dare I say “villain”? —to Wall Street. Our distinction—focusing on serving clients, rather than supplying “products” to intermediaries—is the foundation upon which Vanguard has been built. For investors as a group, lower costs lead to higher capture of whatever returns the stock market gives us, or—let us not forget—takes away from us. There is no rational argument against this tautology. Therein lies the reason that the low-cost, buy-and-hold index revolution is here to stay. Indexing is not a fad; it is not a fashion; it is a fact of life, indeed of elemental arithmetic. Placing the interests of Main Street investors ahead of the interests of Wall Street intermediaries is simply a reflection of the fundamental economic principle enunciated by Adam Smith in the Wealth of Nations in 1776. Paraphrasing: “The producer’s sole duty is to serve the consumer.” Of course it is! That principle is universal; investing other people’s money is no exception. Past Returns, Future Returns The failure of active fund managers in the strong bull market we have enjoyed (on balance!) since 1982 was well concealed by the fact that few fund investors seemed disappointed in their returns. Of course!

Chen co-founded Wuhan College in 2009 as a pioneer of non-profit private universities in China, donating RMB 20 million in 2015 to support the college's library construction and reading-material purchases.

Duty-bound to serve their shareholder/principals or not, corporate managers have relegated the interests of their owners to second place behind their own. They have rewarded themselves with shockingly outlandish salaries, bonuses, and stock options; they engage in vigorous financial engineering of the earnings they report to their shareholders; and they have orchestrated huge stock buy-back programs that are often undertaken to offset the dilution of earnings entailed by the exercise of the stock options that they have awarded to themselves. Corporate managers do all of this because they care deeply about their own financial interests and prestige over their peers. And the money manager/agents, ostensibly overseeing them, have let it all happen without significant protest. These money manager agents don’t seem to care about corporate governance, in part because they have their own conflicts of interest. Most are lavishly compensated, so they don’t dare to cast the first stone at their wealthy fellow agents in corporate America. Further, the portfolio managers of these agents are too often short-term traders in a company’s stock (“renters”) rather than long-term holders of stock (“owners”). Stock renters don’t care—and perhaps shouldn’t care—about corporate governance. When one side cares and fights for itself with a passion, and the other side doesn’t care and prefers low-profile passivity, it is hardly surprising which side wins.

In August 2015 Bahl publicly told Economic Times that Snapdeal would overtake Flipkart on GMV by March 2016; Snapdeal's market share then stood at 26% against Flipkart's 45% and Amazon's 12%, but by mid-2017 its share had more than halved to roughly 12% as both rivals moved to 35–36% each — the bold claim that framed the bet and the underperformance that disproved it.

He would have been unaware, too, that most Boston funds were in the process of changing their structure from largely privately-owned managers serving as trustees to ownership by financial conglomerates focused on building their own profits by amassing assets. Their primary focus was changing from prudent management to aggressive marketing. For Massachusetts Investors Trust, that structural change began in 1969, when its trustees created a new corporation (Massachusetts Financial Services—owned by themselves . . . ahem, that’s Puritan?) to manage M.I.T. and its sister funds. In 1976, the trustees sold their holdings to Canadian conglomerate Sun Life. By remarkable coincidence, almost simultaneously, Vanguard—successor to Wellington—did almost exactly the opposite. I founded the new firm in 1974, structured as a truly mutual mutual fund group, without precedent in industry history, owned not by outsiders but by its own fund shareholders, and thus able to operate at rock-bottom cost. Dr. Baltzell also had to have been unaware that a sea change in investment management was in its beginning stages, one that would revolutionize the field of finance.the

You or they might well counter by saying that this past outperformance is all very well but it does not help you in making a decision on whether to own our Fund from today, which must surely be determined by its future performance or as the legalese goes ‘Past performance is not necessarily a guide to future performance’. I think the key word in that sentence is ‘necessarily’. Let me offer a couple of thoughts on that. The first problem is of course that the commentators upon whom you might rely may simply be wrong.that:

Corporate Managers—Serving Themselves In all those years since Berle/Means, the self-indulgence of our corporate manager/agents has increased sharply, particularly since 1980. The most obvious manifestation of this trend is executive compensation. In 1980, the ratio of the average compensation of CEOs was 42 times that of the average worker. By 2016, the compensation ratio had soared to 335 times. I can find no business rationale for that shocking increase, other than that corporate managers have almost unfettered power, and can use it with abandon to their own advantage. Measured in real (inflation-adjusted) 1980 dollars, CEO compensation has risen at a rate of 6.5% annually, increasing by more than 560% in real terms during the period. In comparison, the compensation of the average worker increased by less than 1% per year, an insignificant cumulative increase of just 14% over 36 years.are

administrative, investment management, and share distribution services, basically terminating the funds’ relationship with Wellington Management. That was a bridge too far for the Board, but they authorized me to provide a study of the options available to them.2 5. September 24, 1974. Vanguard Is Founded. The options that I presented to the Board ranged from the Funds’ acquisition of Wellington Management (my first choice) to having the Funds assume responsibilities for their own administration but retain Wellington Management for their investment management and share distribution (my last choice). They voted for that last choice. But it was better than nothing, and 43 years ago Vanguard—the name that I had chosen— was founded as a truly mutual mutual fund organization, designed to serve its shareholders. Part of our strategy focused on minimizing the management fees paid to our advisers. Now, an index fund would give me the opportunity to start a fund with no management fees. This confluence of opportunity and motive may well be the most powerful single force undergirding innovation. 6. October 10, 1974. “Challenge to Judgement.” That’s when I read Paul Samuelson’s article in the very first issue of the Journal of Portfolio Management. What a coincidence! I felt as if he had written it directly to me. Dr. Samuelson sought “brute evidence” that any mutual fund manager could consistently outpace the S&P 500 Index, but found none.

S&P 500 Index). Indexing would prove to be the apotheosis of that “democratic ideal” of which Baltzell spoke earlier, the democratization of investing for our nation’s average citizen investor. But it didn’t happen in Boston. It would make Vanguard the dominant firm in the fund industry by an unprecedented margin. Vanguard’s novel structure (mutuality and low cost) and pioneering strategy (indexing) were essentially the tools that moved the mutual fund industry’s “Big Money” from Puritan Boston to Quaker Philadelphia. In retrospect, I have come to realize that my design for Vanguard reflects many of the basic Quaker values that William Penn fostered—simplicity, economy thrift, efficiency, service to others, and the conviction, in the words of George Fox, that “the truth is the way.” (I confess that I’m not so strong on some of the other Quaker values, in particular, consensus, patience, silence, and humility.) I take comfort in the fact that Benjamin Franklin too, struggled to balance his pride with humility. Here’s what he wrote in his autobiography: In reality, there is, perhaps, no one of our natural passions so hard to subdue as pride. Disguise it, struggle with it, beat it down, stifle it, mortify it as much as one pleases, it is still alive, and will every now and then peep out and show itself. . . . Even if I could conceive that I had completely overcome it, I should probably be proud of my humility.

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

Morgan Stanley had rated Snapdeal in 2015 as one of India's most capital-efficient startups on a GMV-to-capital-raised ratio of 3.2 — second only to ShopClues at 3.8 and ahead of Flipkart at 2.4 and Amazon India at 1.0 — a metric that flattered the firm at peak but did not anticipate the model's exposure when funding dried up.

In May 2016, Chen founded the Yidan Prize, funded by an independent trust of HK$2.5 billion (US$320 million), to recognize innovators who have made significant contributions to education; in 2018, he donated his Tencent shares to set up a charitable trust further supporting education development.

The S&P 500 Index Fund earned an annual return of 12% per year, a 51-times increase; the annual return of the average large-cap blend fund was 10% per year, an increase of “only” 30 times. But investors in mutual funds looked at their wonderful absolute returns, and disregarded (or were not even aware of) their terrible relative returns. Indeed, they likely applauded their money managers. There is little, if any, chance that 12% annual return on stocks during the era that we have witnessed (or at least heard about) is going to recur during the coming decade. Why? Because as John Maynard Keynes warned us long ago, “It is dangerous . . . to apply to the future inductive arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was.” So let’s look to the sources of stock returns to create rational expectations for the coming decade. What were those sources of that 12% annual return of the S&P 500 on stocks since 1982? A 3.3% dividend yield and 5.4% annual earnings growth, for an Investment Return of 8.7%.that

Built a diversified industrial conglomerate beginning with match manufacturing, then expanding into cement, coal, and wool textiles.

Few, if any, industry leaders contemplated this outcome. They were bound by “presentism.” In a recent issue of The New Yorker, essayist Adam Gopnik tells us that, “of all our prejudices, the strongest is presentism . . . the assumption that what is happening now is going to keep on happening, without anything happening to stop it.” Surely that assumption was held by mutual fund industry leaders (except Jon Lovelace!), who paid no attention to this new fund complex with its new name and a new structure, at once both ridiculous and logical. These leaders tacitly assumed that the existing fund framework would keep on happening. That was a big mistake. The industry thought that a truly mutual structure was not even worth acknowledging. Even 43 years later, it has yet to be copied. And our peers snickered at the index investment strategy that the mutual structure facilitated, even demanded. One leader said, “The great mass of investors aren’t going to be satisfied with average returns. The name of the game is to be the best.” Another asked, “Who wants to be operated on by an average surgeon?” And a popular poster on Wall Street declared, “Help Stamp Out Index Funds! Index Funds are Un-American.” The indexing idea was so absurd that it took until 1988— 13 years later—before the first (and pretty much the last) of the industry’s “Old Guard” reluctantly joined the embryonic index fund movement. III.

He demanded, in effect, that someone, somewhere start an index fund based on the S&P 500. That bolt from the blue set my 1951 idea on the road to reality. 7. September 27, 1975, Morning. Friendly Persuasion. Given Paul Samuelson’s unquestioned credibility, I marked his essay “Exhibit A” in my presentation to the board. The next presentation was my own statistical study showing the average annual return of equity mutual funds compared to the S&P 500 over the previous 30 years ending in mid-1975, which I calculated on a Monroe mechanical calculator. Result: S&P 500 annual edge, 1.6%.3 8. September 27, 1975, Afternoon. The Index Fund Is Born. To resolve that unpleasant political struggle, the newly formed Vanguard was barred by its Board from providing investment management services to our mutual funds. That door was closed to us. But the index fund allowed me to open a window: “This fund is not managed,” I told the Board. Result: the unanimous approval of the Vanguard Board to form the world’s first index mutual fund. (Again, “you can’t make this stuff up.”) 2 The Board was closely divided, and the directors were anything but aligned in their views. Were it not for the leadership of the late Charles D. Root, Jr., chairman of the independent director group, the events that followed would never have taken place. 3 Factoid: I repeated the study for my paper published in the January/February 2016 issue of The Financial Analysts Journal for the 30 years ending 2015: S&P edge, 1.6%.

• The UK would vote for ‘Remain’ in the Brexit referendum • The UK would enter a recession immediately if it voted to ‘Leave’ the EU • Donald Trump would not become President • Narendra Modi would not become Prime Minister of India • Narendra Modi’s economic reforms would fail • Theresa May would have such a resounding victory in the 2017 election that Labour would disintegrate • Angela Merkel would sweep to victory in the German elections • President Trump’s tax reform bill would not be passed by the US legislature In some cases, they have a ‘Full House’ having made all these predictions. The fact that they have been shown to be comprehensively wrong does not seem to stop them from giving us the dubious benefit of further predictions. In this regard they remind me of the broker who was always wrong and who is mentioned in the book ‘Hedgehogging’ by Barton Biggs, the strategist and hedge fund manager. Biggs found him useful to talk to because once the broker had given his views on what would happen or what to do, Biggs knew that the opposite was bound to be correct. For what it’s worth, my diagnosis of the problem for these commentators who seem to emulate this broker is that they are experiencing role confusion. They seem to have forgotten that their role is to report events accurately and have decided that instead they need to influence the outcome to one they desire.

The Opportunity to Speak Now is the time that I’ve chosen to speak out on the fund industry today. But this is not a victory lap. I‘ve been around too long to take victory laps before the game is over. Nor is it a valedictory. I’ve got much more to accomplish in my life and in my career. It begins with the saga of the improbable creation of Vanguard, the firm I founded almost by accident, and the even less probable creation of the index fund. I’ll then describe how Vanguard became a colossus, the most dominant firm in the history of the mutual fund industry—$4 trillion in assets, 23% market share of assets, an incredible $304 billion in 2016 cash flows (an unprecedented 171% of industry cash flows), and of course in costs. Asset-weighted, an expense ratio of just 12 basis points—the industry’s lowest-cost provider. As Psalm 118 tells us: The stone that the builders rejected has become the chief cornerstone. Next I’ll discuss two business strategies that today’s active fund managers might adopt to respond to the new environment, now dominated by index funds.starkly

Liu became one of Republican Shanghai's most prominent industrialists, with holdings across multiple sectors, per Wikipedia and Global Times profiles.

In those days, bond funds were but a tiny factor in the fund industry. Even by 1971, there were but 38 bond funds among the industry’s 361 mutual funds. But I was a contrarian, and when I became CEO of Wellington Management Company in 1965, I couldn’t shake the idea of adding a bond fund to Wellington’s conservative menu. My conviction was reinforced when a sassy new magazine, Institutional Investor, ran a story in 1969 slamming bonds, illustrated with a cover replete with dinosaurs. (Exhibit 5) Title: “Can the Bond Market Survive?” It would be hard to miss the message! The “Go-Go” Era Earlier, in 1966, the fund marketplace had shifted its emphasis from its traditional middle-of-the road, Dow-Jones-Average-type, investment-grade, large-cap stock funds.“Go-Go”

rose from 7.8 times to 26.5 times (Wow!), an annual Speculative Return of 3.4%. Total Return on stocks 12.1%. (Chart 3) That was yesterday. Tomorrow is a different matter. Today, the dividend yield is 2.0%. Guessing at earnings growth, I use a lower figure, 4.0%. Investment return, 6.0%. Were the P/E declined to 19 times (just a guess, but a reasonable one), the annual speculative return would be -2%. Total stock market return 4%.1 Investment Costs Become Even More Important It must be obvious that if future returns on stocks fall well below the extraordinary returns of the Great Bull Market, fund expenses will take an even larger chunk out of returns. In that 12% stock market era, 2% expenses consumed “only” one-sixth of the annual return, although the net cumulative return would have dropped from 5180% to 2710%. In a 4% annual stock market, 2% expenses would consume fully one-half of the annual return, reducing the cumulative return from 295% to 100%. As expenses take on such a dominant role in shaping returns, the index fund cost advantage will become even more obvious. Individual investors who look to the past to tell them about the future are foolish at best. They are courting disappointment, and, given the likelihood of lower returns on stocks, will likely be ill-served if they haven’t revised upwards the amounts they are saving each month. (If returns are higher than I suspect, they’ll simply have built a larger nest-egg.) 1 Feel free to disagree.

William Penn and his fellow Quakers—right up to tonight—have been, and continue to be, a constant inspiration for me. I close with this quotation attributed to Pennsylvania’s founder—a goal that I strive to honor, but with my all-to-human failings, I will never fully reach. You Friends all know it well: I expect to pass through this world but once. Any good, therefore, That I can do or any kindness I can show to any fellow creature, let me Do it now . . . for I shall not pass this way again.

the real builders of corporate intrinsic value? Isn’t this disparity both economically indefensible and morally irresponsible? The Ratchet Effect Our CEO compensation system suffers from a fatal flaw. Compensation is based importantly on comparison with peers, and often gives too much weight to stock price and too little to intrinsic corporate value. When a board finds that its own CEO’s pay reposes in the fourth quartile among his or her peers—“our CEO is better than that!”—it is all too likely to raise the compensation up to the first or second quartile. This leap, of course, drops another CEO into the fourth quartile. Duh! And so the cycle repeats, ratcheting onward and upward as the years pass, almost always on the recommendation of an ostensibly independent executive compensation consultant. The so- called “free market” that sets CEO compensation doesn’t exist. Rather, it is a closed market, one that is essentially created by compensation consultants, who have long since recognized that without generous recommendations on CEO pay, their own business will not long endure. Such a methodology is fundamentally flawed. Warren Buffett pointedly describes the typical consulting firm by naming it, tongue-in-cheek, “Ratchet, Ratchet, and Bingo.” Until we pay CEOs on the basis of corporate performance rather than on the basis of corporate peers, CEO pay will, almost inevitably, continue on its upward path.

He is described by the Yidan Prize Foundation as the 'Father of Internet Philanthropy' and ranked top of the 13th China Charity Ranking in 2016 and as China's top philanthropist on the 2017 Forbes China Philanthropist list.

The founders' big strategic bet was to build an ecosystem of apps and services around the core marketplace — FreeCharge ($400M acquired April 2015), Shoppo, Unicommerce, Exclusively, lending and a WeChat-style messenger — modelled on Facebook's bundling of WhatsApp and Instagram, with Bahl arguing that social was the leading indicator for how Indian e-commerce would evolve.

contrasting strategy designed to serve fund investors. Finally, I’d like to give you a few personal reflections about my long career in this industry. Strange as it may seem, during my career began with my 1951 Princeton senior thesis on “The Economic Role of the Investment Company,” calling out values that have been reaffirmed all through my career.  Mutual funds’ “prime responsibility must always be to their shareholders.”  Funds must operate in “the most efficient, economical, and honest way possible.”  Funds “can make no claim to the superiority over the market [indexes].”  Funds should represent “the great number of inarticulate and ineffective individual clients” in corporate governance. Foresight? I doubt it. Callow? Sure. The new paradigm I created for mutual funds may well have found their genesis 66 years ago in the callow idealism of a prototypical college student. Truth told, I hoped to present the story of Vanguard and its implications for the mutual fund industry at the coming General Membership Meeting of the Investment Company Institute. My credentials: former chairman of the ICI board; a leader who brought three of ICI’s future chairmen into the fund industry (and helped to groom a fourth); founder and long-time CEO of the ICI’s largest member and largest dues payer; a voice that ought to be heard, discussing the new and disruptive trends that those fund executives gathering in Washington D.C.

As a start toward reform, corporate shareholders should demand that CEO compensation be primarily related to a firm’s return on total capital (ROTC) compared to the average ROTC of all U.S. corporations (and to the average ROTC of its peer corporations). The historic average ROTC for U.S. corporations is 12%. Executives would receive long-term compensation awards only to the extent that their firm’s ROTC exceeded 12%. That’s often a tough hurdle, but the managers are well-paid to surmount it. Earnings Guidance and Stock Prices The staggering amount of stock options issued to executives by our generous corporations has turned most of management’s focus from increasing intrinsic corporate value to increasing the stock price.guidance,

Pension funds that fail to take into account lower future returns are courting not merely disappointment, but disaster. Pension plans—public and private alike—are now facing a $1.5 trillion deficit, assuming future returns of 7 ½% per year. In an environment of 4% gross returns on stocks, 3% gross returns on bonds, and even (generously!) 8% gross returns on alternative investments. 7 ½% looks impossible, especially when investment costs are taken into account. Even a 5% net return after costs for pension funds looks like a stretch. Here, the word “crisis” seems appropriate. Challenges to Traditional Indexing The index revolution, like all revolutions—is not without its flaws. The most recent flaw is the focus on the concept of “Smart Beta”—replacing market-cap-weighted portfolios by portfolios weighted by so-called “fundamental” factors: dividends, earnings, book values, assets, etc. As a concept, Smart Beta is not a terrible idea . . . nor is it a world-changing one. But it suffers from the assumption that past data, heavily mined, will identify factors that will provide sustainable performance leadership. Mark me as from Missouri on that one. It ignores the principle of reversion to the mean (RTM) in stock returns, market returns, and mutual fund returns. That’s a huge mistake. Once again (remember the “Go-Go” fund craze of 1965-1968 and the “Nifty Fifty” craze of 1970- 1973?)

In hindsight, the report concludes the ecosystem-of-apps bet was audacious and foolish — the timing was wrong, the execution capability was missing, and Bahl was widely summarised as 'said all the right things but did all the wrong things,' an indictment of strategy that was right in theory but mistimed in practice.

Co-founded Tencent in 1998 and served as Chief Administrative Officer, later launching the Tencent Charity Foundation in 2007.

Remained on the mainland after 1949 and cooperated with the new Communist government rather than relocating his business interests abroad.

They also seem to have missed the point that voicing your views in an echo chamber is not likely to lead to a challenging debate in which to test your opinions. Thankfully, I spend little or no time trying to apply predictions about macro events in order to manage our portfolio. However, that does not mean that I do not think about them. As I have maintained for most of the decade since the Financial Crisis, looking back to the Great Depression for an analogy that would enable us to understand these events and form a view of how they may unfold is probably a mistake. A better analogy may be the Long Depression of 1873–96 when a new industrial power came on stream and caused a wave of deflation as it could manufacture goods cheaper than in the Old World. That industrial power was America after the Civil War. The Long Depression was also preceded by a collapse of part of the banking system. Sound familiar? The wave of deflation we have been experiencing has been caused by a number of factors. These include the rise of China as the world’s greatest industrial power, other cheap manufacturers (South Korea, Thailand, Vietnam, India and Malaysia for example) and the offshoring of manufacturing to cheap manufacturers under free trade agreements, such as Mexico under NAFTA, which so exorcises President Trump.Depression

era—equity funds laced with speculative issues, “story stocks,” and phony accounting. (Shares were bought from corporate insiders by funds at discounts of some 50% from market value, then quickly marked up to market value, creating an immediate, if illusory, 100% return.) In that short-lived era when these speculative “aggressive growth” mutual funds were in the industry’s driver’s seat, both stupidly (from an investment standpoint) and brilliantly (from a marketing standpoint), I merged Wellington Management with Boston’s tiny Thorndike, Doran, Paine, and Lewis, adding a hot “Go-Go” fund to our menu. (Ivest Fund, meteor-like, lit-up the skies for a few years, and then burned out and crashed, its ashes finally deposited in the dustbin of history in 1980.) My new partners at Ivest hated bonds. When I proposed forming a bond fund in 1970, one of them quickly put the kibosh on the idea: “Don’t you realize that bonds are yesterday? Stocks are tomorrow.” But I finally persuaded my colleagues to form an income fund, 60% bonds and 40% dividend-paying stocks. (Today, the assets of Vanguard Wellesley Income Fund total $54 billion.) Then times changed (a little!) and we formed our first “pure” bond fund in July 1973—now Vanguard Long- Term Investment Grade Bond Fund—the first step in our gradual rise to dominance in the bond fund sector of our industry.

9. August 31, 1976. The IPO. First Index was off to a bad—near-fatal—start. The initial public offering, led by Wall Street’s four largest retail brokers, was planned for $250 million. It produced $11.3 million, an abject failure. One of the Wall Street managers of that IPO recently asked: “How is it possible that the worst underwriting in Wall Street history became the greatest innovation in modern finance?” Answer: “It’s a long story.” Afterword The poster announcing this CME award for innovation shows photos of me and Mac McQuown—my friend and enormously deserving co-recipient of this award—with the title of this conference: “Taking the Long View and Never Looking Back.” But looking back, as I have done this afternoon, reminds us how fragile the path to an innovation can be, and yet somehow, against all odds, can result in an index fund, and ultimately an Index Revolution. Surely such a tortuous path to success— one that included a university thesis, a catastrophic merger, a firing, a journal article, a novel corporate structure, a fortuitous (perhaps even disingenuous) reading of an agreement, and yes, an unshakable determination—is an extreme example of what it took to turn a great idea into a reality that changed an industry and served investors. That 1976 First Index mutual fund, with its pathetic $11 million in assets, struggled to gain traction. It didn’t attract its first mutual fund competitor until 1984 (Wells Fargo).

insofar as then there was virtually no international competition in services whereas now in our connected world there is in software (India) and call centres (the Philippines), for example. Plus there is the rise of the so-called gig economy in which the internet, casual employment and the sharing of assets have made price comparisons easier, and have driven down prices and returns in retail (Amazon), transport (Uber) and lodging (Airbnb), for example. If the closest analogy for the events which we have experienced since the Financial Crisis is the Long Depression, we may be barely half way through it simply on the basis of elapsed time. In which case, the period of sluggish economic growth and low interest rates which we have experienced over the past decade may persist for some considerable time. I think this is likely for the simplest of reasons: little or nothing has been done to correct the problems which led to the Financial Crisis. The unsupportable expansion of credit that sparked the crisis has not been resolved. There is in fact more debt in existence now than there was in 2007. Admittedly, some of it is in different hands—China has more debt now and much of the debt in the developed world has been ‘socialised’ and assumed by governments. However, governments are just us collectively, contrary to the fevered imaginings of the ‘magic money tree’ devotees.

It was not until the early 1990s that it started to grow, and grow it did. Today, assets of the Vanguard 500 Index funds total $581 billion. With their sister fund, Vanguard Total Stock Market Index (with 83% of its assets in S&P 500 Index stocks), another $662 billion—in all, $1.24 trillion invested in these TIFs (traditional index funds) at Vanguard alone. Today, all told, the assets of all Vanguard index funds total $3.6 trillion, 74% of Vanguard’s present asset base of $4.7 trillion. During the past quarter-century, index funds have come into their own. More broadly, assets of all U.S. index mutual funds have risen from that pathetic $11 million in 1976 to $93 billion in 1996, a 55% compound annual growth rate—to $6.1 trillion in late-2017, still a respectable 22% annual growth rate. In the past decade alone, U.S. investors have added $2.1 trillion of net cash flow to their holdings of U.S. equity index funds and withdrawn more than $900 billion from their holdings of actively managed equity funds. Such a huge $3 trillion swing in investor preferences surely represents no less than an Index Revolution.

Compounding the operational collapse was a string of senior exits — Saurabh Bansal (category head), Ashish Chitravanshi (SVP operations), Srinivas Murthy (marketing), Abhishek Kumar (corp dev), Farheen Akhtar (comms), Tony Navin (partnerships) and others left between 2016 and 2017 as the focus shifted repeatedly between GMV, order count and customer satisfaction.

, popular fads are driving “product” creation in the fund industry—great for fund sponsors, awful for fund investors. Let me remind you of this time-honored principle: successful short-term marketing strategies are rarely—if ever—optimal long-term investment strategies. Recent experience with “Smart Beta” funds provides a classic example of the pitfalls faced by investors who create strategies through data mining. Renamed “Strategic Beta” by Morningstar, this category has boomed, even though the pioneering RAFI 1000 fund—formed a decade ago—has demonstrated only that its risk-adjusted return and its Sharpe Ratio both lag the S&P 500. Otherwise, it looks more like a closet index fund, with an R2 of 0.97 relative to the S&P 500. Yet the assets of these strategic beta funds have ballooned—from $100 billion in 2006 to $810 billion currently.despite

Liu was granted protected 'nationalist capitalist' status by the CCP and served in national political bodies (NPC delegate, CPPCC member) until his death in 1956.

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

and when earnings flag, the CEO often acts to reduce costs in order to maintain projected profits by limiting employees’ compensation, laying-off experienced and loyal workers, and slashing capital expenditures. But it seems all too likely that these near-term “efficiencies” and these failures to invest adequately for future growth will eventually erode the company’s prospects for the long-term.2 The central issue posed is the harm done when a culture of short-term speculation focused on the price of the stock overwhelms a culture of long-term investment focused on the intrinsic value of the corporation. The GE Story In addition, aggressive accounting is often required to meet aggressive earnings goals. There are few better examples of this “numbers game” environment than General Electric Co. Way back in 1998, when GE had reported earnings that were within 2% of its “guidance” for 20 consecutive quarters, Grant’s Interest Rate Observer calculated the odds of that happening in the real world as 1 in 50 billion. In 2009, GE settled a complaint from the SEC charging the firm, in Grant’s words, with “book cooking and earnings manipulation,” and paid a $50 million fine. Editor James Grant added: “the crimes to which GE allegedly stooped reveal a management besotted with its own share price.

An Industry-Changing Event The ill-begotten merger finally collapsed, and in January 1974, my new partners mustered the votes to fire me. (It’s not fun to be fired!) A painful struggle followed, resolved only when I persuaded the directors of the then-Wellington Funds to retain me as their chief executive, and to operate the funds at cost, on a truly mutual basis. I named the new firm Vanguard—“leader in a new trend.” It was founded on September 24, 1974. The fund directors barred Vanguard from engaging in the investment management of our funds and in the marketing and distribution of fund shares. (They retained Wellington Management to continue to perform those two duties. Given the abject failure of those managers in advising Ivest Fund and Wellington Fund, a truly incredible decision.) We were on our own now. Fortunately, a door opened that gave the new firm an unexpected opportunity. In 1976, Congress passed legislation that allowed mutual funds to “pass through” municipal bond interest income to their shareholders. Municipal bond funds quickly came into being as a new investment category, a permanent factor in our industry. Almost immediately, a score or more fund sponsors answered the call. All were “managed” municipal bond funds, presumably meaning that their managers would shorten maturities just before interest rates rose (and prices fell), and lengthen maturities just before rates fell (and prices rose).

Stepped down as Tencent CAO in March 2013 to dedicate himself full-time to philanthropy, founding the Chen Yidan Charity Foundation and later the Yidan Prize (2016).

What seems to have happened over the past decade is a prolonged experiment in borrowing your way out of a debt problem. Maybe it will work, although I am amongst those who would bet against it, but it certainly is not the sort of circumstance which would suggest that a ‘normal’ economic recovery or a rapid rise or ‘hike’ in interest rates is likely. As an aside, I would suggest that the headlong expansion of credit in much of the western world which preceded the Financial Crisis was an attempt to compensate for the effects of deflation. Instead of accepting that the loss of manufacturing and service jobs to the developing world meant we had to accept lower pay and lower standards of living to compete we opted for an expansion of the state, the mushrooming of non- productive jobs and borrowing to maintain our spending patterns. Secondly, if you nonetheless take the view that our Fund’s strategy has indeed delivered a good performance but that valuations (which I will come to later) for stocks of the sort it owns are high and that this will limit their share price performance at least in the near term, the obvious problem this poses is what you or we might invest in as an alternative. This presents several problems. One is that the valuation of the Fund’s stocks are not all that much higher than the market, especially when their relative quality is taken into account.

the sharp lag in the returns of value funds (Chart 4). In 2016, value stocks rose 16.9% while growth stocks rose only 6.2%. So far in 2017, growth stocks are up 12.2% and value stocks are up but 3.3%. Remember RTM? The Role of the Professional In this new era where indexing is already such a powerful force, what is our role as investment professionals in financial analysis, stock selection, and helping our clients implement their investment programs? In the most recent issue of the Financial Analysts Journal, you’ll find my essay entitled “Balancing Professional Values and Business Values.” In that essay, I cite the ideas of Adam Smith and Benjamin Graham, as well as some of the characteristics and attitudes that I have done my best to help investors develop. I commend this paper to investment professionals in general, and to CFA charterholders in particular. An Investment Lifetime We have moved a long way from a past in which information was precious and where “customers men’” made a (nice) living by trading stocks for wealthy investors; where data on investment returns—absolute and relative—were scarce; where “professional management” was assumed to add value; where no index fund existed to establish the benchmark; where little thought was given to retirement planning. It’s all so different today, and it’s our duty as investment professionals to respond to this new environment. In the coming era, what considerations should investment professionals emphasize?out:

and who care deeply, about the future of this industry—the industry that I have loved for two-thirds of a century. Rejected by ICI, I asked Morningstar for an opportunity to speak at their annual Investment Conference. They immediately opened a slot for me. Thank you, gracious Morningstar leaders! And since my overriding theme today is providing a better, fairer investment experience for mutual fund investors, any audience that includes so many investment advisers to fund investors is far better-suited to hear my story than the audience at the ICI meeting. (I hope that doesn’t sound like sour grapes!) My central message: a call for a better deal for fund shareholders, for Vanguard’s clients and for the clients of the nation’s registered investment advisers. IV. The Background Six months prior to my meeting with Jon Lovelace at the airport in 1974, I had been both the CEO of Wellington Management Company and Wellington Fund, the industry’s dominant balanced fund. But I had been fired from my position at Wellington Management Company, adviser to Wellington Fund and its associated funds, mostly as a result of a disastrous merger with a manager of highly aggressive growth funds. Yet I remained CEO of the Wellington funds. Such a split—retained as head of the mutual funds, fired as head of the funds’ adviser—was unprecedented in our industry’s history.

Chen established Wuhan College, the Chen Yidan Charity Foundation, and the HK$2.5 billion Yidan Prize, and was recognized as China's top philanthropist in national rankings, while retaining honorary ties to Tencent's charity arm.

The article flags that Bahl and Bansal were paid Rs 46.5 crore each in FY 2014-15 including stock options — unusually high for founders of a loss-making startup — and that both sold Rs 80 crore of stock each to Ontario Pension Fund in late 2015, a move that did not go down well with the leadership team, particularly since other senior employees were not allowed to liquidate.

I believed—as any champion of the index fund must believe—that such a flawed premise was nonsense. Where were these experts who could successfully time the bond market? So Vanguard took a different approach. We formed a series of three separate “defined maturity” bond funds—long-term, intermediate-term, and short-term. Each would hold to their particular mandate. With each series focused, not on shifting maturities but on credit quality, investors could decide for themselves what combination of risk and yield would best meet their financial goals.those

It now seems clear that the pioneering creation of that First Index mutual fund in 1975 provided the spark that ignited the index revolution. And it seems reasonable to conclude that my two best-selling books, both focused on index funds—Bogle on Mutual Funds: New Perspectives for the Intelligent Investor (1994) and The Little Book of Common Sense Investing (2007), together with a total of 500,000 sales, and read by an estimated 1.5 million readers, played a major role in fueling the extraordinary revolution that followed. It continues to this day. I’m proud to be counted as one of the principal pioneers of that revolution. Thank you again for the high honor that you have bestowed upon me today, and the privilege of sharing it with fellow pioneer Mac McQuown. * * * PERSONAL NOTE: My relationship with the remarkable Dr. Samuelson began with his Journal of Portfolio Management article, and was reinforced by his Newsweek column of August 16, 1976, “Index Fund Investing.” We met several times thereafter and became a “mutual admiration society” of two. When, in 1993, I asked him to endorse my first book Bogle on Mutual Funds, he graciously turned me down . . . but he quickly offered to write the foreword, and I accepted his offer with surprise and delight. In his foreword, he credited me with having “changed a basic industry in an optimal direction.” On November 15, 2005, Dr.

” Chairman Jack Welch ran GE from 1981 to 2001, and left a legacy of accounting mumbo-jumbo to his successor Jeffrey Immelt, who divested large parts of the GE Capital subsidiary (a primary source of GE’s earnings management) and added several new lines of business. These moves have not yet proved successful. The outcome of the GE story of earnings engineering and management decisions is not a happy one. Consider the change in the value of the firm in the stock market: after growing from $170 billion in 1997 to a high of $580 billion in 2000, its market cap tumbled to $230 billion by 2003. After a few years of stability, GE stock took another tumble in the 2007-2009 bear market, and another tumble of $160 billion in the autumn of 2017. The market cap of what was once the 2 I was a CEO for more than 30 years, and I can assure you first-hand that a committed, well-compensated, and well-trained work force has been a priceless asset throughout my entire career.

The piece frames Nikesh Arora's abrupt June 2016 departure from SoftBank as the moment Snapdeal's safety net was cut: as Arora's mentor relationship with the founders ended, SoftBank's promised follow-on funding stopped, removing the bridge capital that Snapdeal's strategy had been banking on.

Samuelson would put the icing on the index cake in no uncertain terms, in an address to the Boston Security Analysts Society, he said: I rank this Bogle invention along with the invention of the wheel, the alphabet, Gutenberg printing, and wine and cheese: a mutual fund that never made of Bogle rich but elevated the long-term returns of the mutual-fund owners. Something new under the sun. In 2007, with his consent. I dedicated my Little Book of Common Sense Investing to him, “my mentor, my inspiration, my shining light.” Not a moment too soon, for Dr. Samuelson passed on December 14, 2009. The news broke my heart. Yes, this relationship between that “greatest academic economist of the 20th century” (New York Times) and that Princeton graduate with a mere A.B. in Economics may seem strange to you. It seems a bit strange to me, too. But it was among the finest relationships of my long career.

who were seeking a higher yield and were willing to assume the higher price volatility that inevitably accompanies it, the long portfolio, and so on. Changing the Standard for Bond Funds This solution gave Vanguard a large competitive edge. For sorting the funds into three maturities muted much of the “noise” in the performance of “managed” municipal bonds. With comparative performance of the funds sorted by maturities, the lowest-cost funds would be almost sure to win, and Vanguard was already the fund industry’s lowest-cost provider of bond funds. Over time, investors’ perceptions of bond funds changed. The three-tier (or more!) approach became the industry standard—not only in municipal bond funds, but in taxable bond funds as well. Today, with $150 billion of assets, Vanguard’s tax-exempt and taxable bond funds are the collection of bond funds largest in the industry. (Exhibit 6) Six Vanguard muni funds are ranked among the industry’s ten largest. Our taxable bond funds also adopted a similar defined maturity strategy, with assets that now total $836 billion. Three Vanguard funds made the list of the top ten taxable bond funds. Our Total Bond Market Index Fund, with assets of $328 billion, is a mere $229 billion larger than the #2 fund with assets of $99 billion. In all, bond investments under the Vanguard mantle now total just short of $1.1 trillion (See Appendix I), including some $260 billion our balanced funds, LifeStrategy Funds, and Target Retirement Funds.

1) Costs matter. 2) Trading transfers wealth from investors to Wall Street. 3) Focus on investment strategy for an investor’s lifetime. Let me close by focusing on investment strategy. When we evaluate an investment program, we must ask ourselves, “How will this investment serve my client over the course of an investment lifetime?” The perspective of an investment lifetime brings to bear several facts that we might otherwise overlook. For example, consider the survivorship rate of actively managed mutual funds. Only 57% of equity mutual funds in existence ten years ago survived the decade. If we extrapolate that failure rate forward for a four-fund portfolio over an investment lifetime of, say, 60 years, we would expect the client to experience ten fund failures. Then take into consideration the average tenure of active fund managers. The asset-weighted average tenure of active equity fund managers is just under nine years. Again, extrapolating that past experience, an investor with a four-fund portfolio would experience 27 manager changes over the next 60 years. After all those fund failures and manager changes, to say nothing of the onerous annual costs, what are the chances that such a client would even come close to matching the return of the S&P 500? The solution seems too obvious to explain. We are in a new era of professional investing, one in which the rules of best practice are gradually changing.

The idea of splitting the two jobs—the fund role, traditionally titular in nature; the management company job, holding the implicit power to control the funds—seemed sort of, well, weird. But to me, the concept of putting the fund directors—and thus the shareholders to whom they are responsible—in the driver’s seat was a far more rational structure for mutual fund governance than the traditional convoluted structure. We called it “the Vanguard Experiment” in mutual fund governance. By eliminating the profits to an outside firm, Vanguard would quickly become the low-cost provider in an industry where costs are (almost) everything, and where—except for the highly cost- competitive index fund segment—our peers have little interest in competing on costs. (It’s bad for management company profits!) The mutual “at cost” structure would put the fund clients first. A declaration of independence of the funds from their investment adviser. This solution appealed to my logic, my contrarian streak, my determination, and my idealism. But in addition to those (I think) noble motives, I had a less noble motive: I wanted to survive. I wanted to continue my then 23-year career in this wonderful industry.may

largest corporation in the world fell to $160 billion. Net loss in market capitalization since 2000: $420 billion, likely the largest decline in a company’s market valuation in history. Constructive Regulation The issue of earnings engineering has not gone unnoticed by regulators. The SEC recently acted to confront the widespread aggressiveness by corporations in reporting their financial results. Among other things, the Commission emphasized that the presentation of GAAP measures in earnings reports should have “equal or greater prominence” to non-GAAP measurements. The SEC also warned against “cherry-picking” adjustments such as including non-recurring gains and excluding non-recurring charges, in an effort “to achieve the most positive measure.” This reform is long overdue. In addition, the Commission also recently approved the recommendation by the Public Company Accounting Oversight Board of new rules that “would make auditors describe any significant issues they reviewed” with board audit committees, and to “explain any challenging, subjective, or complex judgements.”3 It is high time that the principle of full disclosure reaches this deeply into the complex details of convoluted corporate accounting. There is much more work to be done. Where Are the Stockholders? Even as the manager/agents of our corporations were acting in their own self-interest, our corporate shareholder agents were barely to be seen. Dare I describe it as “the Silence of the Funds”?

Of course, all this may prove is that everything is expensive or at least highly rated, and there are plenty of pundits and fund managers who have indeed suggested that we are in a so-called ‘bubble’ which will end badly with everything falling a long way. So far, they have only managed to demonstrate the difficulty in making predictions and implementing actions based upon them. Even if they are eventually proven right, why will a basket of cyclical stocks and financials prove to perform better in these circumstances than a group of companies which are high quality and defensive in terms of supplying everyday consumables and necessities? The events of 2007–09 suggest that the opposite is true.

well have been my only chance to do so, and I appealed to the board of directors of the Wellington funds depart from their normal presentism mindset and take this drastic step. It would not be easy. The structure that I proposed quickly led to a bitter fight—the fired CEO vs. those who had fired him. The outcome was in doubt until the battle ended, six months after it began. The new firm had perhaps one chance out of ten to survive. But finally, Vanguard was born. In 1975, we made our first strategic move—to create an index fund. While all of our peers had the opportunity to create the first index fund, only Vanguard, with our unique mutual structure, had not only the opportunity, but the motive. The seed of the idea of the index fund was planted in my 1951 senior thesis (remember, funds “can make no claim to superiority over the market [indexes]”). The foundation of our philosophy was my first-hand experience in trying but failing to select winning managers. And a timely and fortuitous inspiration from Nobel Laureate Paul Samuelson then precipitated the creation of the first index mutual fund. Dr. Samuelson’s essay, “Challenge to Judgment,” was published in the first edition of the Journal of Portfolio Management in the fall of 1974. It struck me like a bolt of lightning. By happy coincidence, I read his essay just as the stock market hit bottom and moments after Vanguard was founded.

Yes, this new focus will change our profession, but business values must still be balanced with fiduciary values. Strong ethics and professional competence must still be the bulwark of finance. We must develop a keener awareness of how our financial system works, a profound introspection about how we can make it better, a knowledge of the long history of finance, and a deep involvement in fostering in our profession the high character it requires if we are to serve investors effectively, efficiently, honestly, and prudently in the years ahead. Balancing Business Values and Professional Values I hope you will read my impassioned paper on business values and professional values in the most recent edition of the Financial Analyst Journal, and will consider my perspective. I’ve plied my trade of investing for almost 66 years, and I’ve seen so many of my principles find acceptance—not just on indexing, on the importance of low costs, and on short-term speculation vs. long-term investment, but on investment standards, ethics, and fiduciary duty. Of course I’m pleased to have been alive long enough to see the growing acceptance of these ideas. But we still have far to go— “The trees I planted still are young.” “The songs I sing will still be sung.” I suppose it’s ironic that I close my remarks to this distinguished audience of investment professionals with the word “cash.” But those words are the words of Johnny Cash. Take heed. Thank you.

There is also the fact that the alternative of investing in cyclicals, financials and so- called ‘value’ stocks involves investing in companies, which over time do not create shareholder value by generating returns on capital above their cost of capital and growing by deploying more capital at such favourable returns. We seek to invest in companies which accomplish this. Quoting Warren Buffett, the ‘Sage of Omaha’ and arguably the best investor over the past fifty or so years has in my view become somewhat passé. It is frequently done by acolytes or imitators many of whom seem to have done only the most cursory study of what he actually does, if anything at all. So instead I am going to quote his business partner and Berkshire Hathaway’s Vice Chairman, Charlie Munger: ‘Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return— even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result’ (emphasis added). I have no idea why Mr. Munger chose those particular rates of return but what I do know is that he is not voicing an opinion. What he is describing is a mathematical certainty.

4 One might have expected that as stock ownership moved from a diffuse group of often unsophisticated individual investors to a concentrated group of powerful investment professionals, these new owner/agents would make their will known. Yet until recently, nearly all money managers have been conspicuous by their absence from the corporate governance 3 Quoted from journalist Jason Zweig’s column in The Wall Street Journal, August 21, 2017. 4 The title of my speech in New York before The New York Society of Analysts, October 20, 1999.

We also manage more than $220 billion in money market fund assets. Together, these funds represent by far the largest aggregation of fixed-income assets in the fund industry. Managing Vanguard’s Fixed-Income Funds If the simple decision to create defined-maturity bond funds could be described as “brilliant,” my choice of an external manager to run the new mutual funds was quite the opposite.giant

Citibank, N.A., as the adviser to the funds. Alas, the bank was simply not up to the task. As 1980 began, Vanguard determined to terminate the relationship. At the same time, our large ($420 million) money market funds were paying high fees to their then-manager, Wellington Management Company. This was the moment, I thought, to recommend a giant step: having Vanguard replace Citi as manager of our municipal bond funds,2 and simultaneously have Vanguard build its own in-house management staff to replace Wellington as manager of our money market funds, in part to reduce fees, and in part to obtain “critical mass” for providing economies of scale. The Board meeting, held in September 1980, was contentious. On the one hand, replacing Citibank as adviser to the muni funds was a non-issue. Replacing Wellington with Vanguard as adviser to the money funds would generate substantial savings, largely the result of Vanguard’s “at-cost” structure. But the retention of a new staff of bond professionals at Vanguard carried its own risk. In the end, my recommendation carried, another important step in the expansion of Vanguard’s responsibilities. We also determined to apply the defined maturity concept to our new taxable bond funds, and have our in-house staff manage them. With the board’s approval, we began to build the Vanguard staff to manage our bond assets.

scene, generally endorsing slates of corporate directors and approving management’s proxy recommendations. The dominant money managers of our time run both mutual funds and pension plans. Based on a recent study by Institutional Investor magazine, we can estimate that this group of professional investors oversees some $16 trillion of U.S. equities, a 73% share of the total.5 The mutual funds that they oversee alone hold 37% of total equities, and their other institutional clients hold 36%. This is by far the most dominant stock ownership position in history. If at long last our stock owner/agents are to provide countervailing power to the power of our corporate manager/agents, mutual funds will carry a major portion of the response. This is not a new idea for me. Way back in 1951, in my Princeton University senior thesis, “The Economic Role of the Investment Company,” I noted that the Securities and Exchange Commission, in its 1940 report to Congress, called on mutual funds to serve . . . . . . the useful role of representatives of the great numbers of inarticulate and ineffective individual investors in . . . corporations in which (mutual funds) are also interested. My conclusion, all those years ago: Mutual funds “seem destined to fulfill this segment of their economic role.” (But I didn’t expect to wait 65 years to see it begin!) The fact is that mutual fund managers are charged by law with a fiduciary duty to their fund shareholders.

His credibility was a vital factor in my ability to persuade Vanguard’s board to approve of the creation of the world’s first index mutual fund. Once considered unthinkable, indexing has triumphed, and active managers will have to either join the index revolution and/or expand their range of investment options by developing new active investment strategies. Or do nothing. Whatever the case, active fund management is not going to vanish from the earth. But to think that change stops here would seem like rank presentism. Recent data from Standard & Poor’s reaffirms the tough job facing active managers. For the first time, S&P SPIVA (“Index Versus Active”) produced comparative data for the past 15 years on a broad matrix of funds. S&P calculated the percentage of funds in each category that were outperformed by their relevant market index.funds:

If you invest for the long term in companies which can deliver high returns on capital, and which invest at least a significant portion of the cash flows they generate to earn similarly high returns, over time that has far more impact on the performance of the shares than the price you pay for them. Yet I have been asked far more frequently whether a share, a strategy or a fund is cheap or expensive than I am asked about what returns the companies involved deliver and whether they are good companies which create value or not. Even though Mr. Munger is right it requires a long-term investment perspective to capture that compounding by high return companies, and finding those companies is not easy especially as you need to assess their ability to grow and ward off competition. But the most difficult part of applying the investment strategy suggested by Mr. Munger’s quote, and which we seek to apply, is us. Our inability to take a really long-term view, particularly through the periods when our chosen strategy and companies are not performing as well as less good companies, which are enjoying their period in the sun, is our greatest enemy. I will leave this subject with a sporting analogy. We are often told that life is a marathon not a sprint. So is investing. Most of us will be investors for the majority of our lives. If we start investing in our 30’s with current average life expectancy most of us will be investing for over half a century. It makes Mr.

Percentage of Funds Outperformed by Indexes Fund Category Growth Core Value__ Large-Cap 95% 97% 79% Mid-Cap 97 99 90 Small-Cap 99 95 81 Over the 15-year period, the passive indexes outperformed the average actively-managed funds by 1.5% annually, a cumulative enhancement of almost 25% for capital accumulation, simply by the use of passive market indexes. V. The Optimal Business Strategy for Active Managers So what strategic business options are open to active fund managers? As a group, these managers have lost big chunks of their market share year after year, albeit—given the strong bull market of the recent era—often with assets under management that continued to grow. I’m hardly without experience in actively managed mutual funds. I did sporadic work in the Wellington research department, served for many years on its Investment Committee, and experienced first-hand the frustration of our fruitless efforts to identify portfolio managers who could turn so-so results into superior performance. In 1966, as Wellington’s new, young CEO, I merged Wellington Management Company with a small equity fund manager that jumped on the Go-Go bandwagon of the late 1960s, only to fail miserably in the subsequent bear market. A great—but expensive—lesson. In 1978, after Wellington’s catastrophic decade-long fall from grace under these aggressive managers, I personally reset Wellington Fund’s strategy, and presented the fund’s manager with a 50- stock sample portfolio.

The charge is not express, but it is crystal clear. The Investment Company Act of 1940 declares that “the national public interest and the interest of investors” require that mutual funds are “organized, operated, [and] managed” in the interest of their shareholders, and not “in the interest of directors, officers, investment advisers . . . underwriters, brokers, or dealers.” Such a fiduciary duty must include responsible proxy voting. Governance Activism by Mutual Funds 5 The field of institutional money management is highly concentrated. The ten largest asset managers account for almost half of all institutionally managed assets.

Munger’s 40 year example seem a bit short. So why we should think about what happens over shorter time periods, like quarters or even years is a bit of a puzzle. However, some people behave as though the best way to win this marathon is to engage the services of one hundred and five 400-metre runners (26 miles 385 yards or 42.195 kilometres divided by 0.4=105.5) who could surely run the distance faster than a single marathon runner.whatever

The leader of our new Fixed Income Group was Ian MacKinnon, who put together a team of about six professionals plus a small administrative staff. When we began to manage our municipal bond and money market funds, then combined assets came to about $1.75 billion. As our assets have grown, so has our staff, both in number and in professional skill. Greg Davis led the Fixed Income Group for 3 years until he was named Vanguard’s Chief Investment Officer in July 2017. He was succeeded by John Hollyer, a 28-year Vanguard veteran and a solid bond professional, formerly in charge of Vanguard’s risk management efforts. At present, our Fixed Income Group includes more than 140 professionals, including 62 CFA charterholers, with global offices in Valley Forge, PA; Scottsdale, AZ; London; and Melbourne, Australia. Dare I say that the sun never sets on the Vanguard bond empire? An Index Fund for Bonds The internalization of fixed income asset management in 1981set the stage for Vanguard’s rise to dominance among bond fund managers. But the climactic change was still to come: the creation of the bond index fund. As 1986 came to a close, given the decade-long success of our stock index fund in tracking the returns of the S&P 500 Index, I decided to create a bond index fund, Vanguard Total Bond Market Index Fund. (The SEC staff objected to the name, “Vanguard Bond Index Fund.”) The new bond fund opened its doors to investors on December 11, 1986.

Slow to grow at first, its assets topped the $100 million mark in 1989 and the $1 billion mark in 1995. With current assets of $380 billion, Total Bond Market is now, far and away, the world’s largest bond fund.3 2 We had arguably “broken the ice” in acting as an investment adviser to mutual funds in 1975 when we created Vanguard S&P 500 Index Fund in 1975. Or not. 3 There are actually two such Vanguard funds, with substantially identical portfolios.

change you expect in market conditions. The problem is this; if you choose the one hundred and five 400-metre runner route I presume that to make the contest against the marathon runner realistic you have to carry a baton that you hand over to the next runner. This is the equivalent of you making the decision to sell all your high quality stocks and switch into somewhat cheaper (although maybe not cheap) cyclicals and value stocks. However, I seem to recall that very often that baton gets dropped, or the changeover is not made within the allowed zone and the team is disqualified. I suppose the investment version of this is that you get the timing of your switch wrong or you sell one strategy but remain in cash. The problem in trying to apply this sprint strategy in the real world of investment is even worse. In a relay race the runners for each stage are selected in advance. Whereas in an attempt to apply this technique in investment you would need to select whom you wish to receive the baton as you enter the changeover area each time. After all do you know in advance whether you want to go from high quality consumer staples to financials, commodity stocks or industrials, emerging markets, bonds or some combination of these? The scope for fumbled handovers is endless. And you have to do it many times to succeed with this approach. Moving on to review the outcome for 2017 in terms of our Fund’s strategy.

But mutual funds are hardly a unity. Funds differ substantially in their interest in governance. Considering these four industry segments provides a good starting point: (1) Two classes of passively managed equity index funds. (a) Traditional index funds (TIFs). Broad-market-based, miniscule-cost, passive index funds designed to be held for a lifetime by passive investors. The prototypical TIF remains the world’s first index (S&P 500) fund that I founded in 1975. (b) Exchange-traded index funds (ETFs). Low-cost passive index funds designed to be traded “in real time” by active investors. ETF portfolios are usually more concentrated than TIF portfolios, and often leveraged. (2) Two classes (often blurred) of actively managed mutual funds. (a) Generally, large-cap funds. These funds have average management costs and portfolio turnover typically in the 50% annual range—by today’s standards, long- term stockholders—too often chosen by investors on the basis of outstanding past returns. Of course such returns rarely recur. It’s called “reversion to the mean,” or RTM. (b) Smaller-cap and specialized funds. These funds carry higher costs, and annual portfolio turnover rates that often run in the range of 100% or more. The performance of these funds tend to be more volatile than the large-cap funds, and their investors tend to focus on extraordinary past returns, turning their fund holdings over more rapidly. Here, RTM strikes even more powerfully.

Since then, Wellington has been a remarkably consistent performance leader over its balanced fund peers, largely because of its consistent one-to-two-percentage-point expense ratio advantage and its low portfolio turnover. Vanguard Wellington Fund has regained its rank as one of the nation’s two largest balanced funds. I also selected the managers for the new active funds that we would form. Vanguard’s success in active management continues to this day. With a strong tailwind of low costs, in 2016 Vanguard ranked #1 in cash flow among actively-managed stock and bond mutual funds.

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

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

As you hopefully know by now, we have a simple three step investment strategy: • Buy good companies • Don’t overpay • Do nothing I intend to review how we are doing against each of these in turn. As usual, we seek to give some insight into the first of those—whether we own good companies—by giving you the following table which shows what Fundsmith would be like if instead of being a fund it was a company and accounted for the stakes which it owns in the portfolio on a ‘look through’ basis, and compares this with the market, in this case the FTSE 100 Index and the S&P 500 Index (‘S&P 500’). This year we not only show you how the portfolio compares with the major indices but also how it has evolved over time. Year ended Fundsmith Equity Fund Portfolio S&P FTSE 2010 2011 2012 2013 2014 2015 2016 2017 2017 2017 ROCE 29% 28% 29% 31% 29% 26% 27% 28% 15% 14% Gross margin 54% 58% 58% 63% 60% 61% 62% 63% 44% 41% Operating margin 20% 22% 23% 24% 25% 25% 26% 26% 13% 13% Cash conversion 117% 103% 101% 108% 102% 98% 99% 102% 97% 96% Leverage 63% 15% 44% 40% 28% 29% 38% 37% 52% 46% Interest cover 15x 27x 18x 16x 15x 16x 17x 17x 7x 8x Source: Fundsmith LLP/Bloomberg. ROCE, Gross Margin, Operating Profit Margin and Cash Conversion are the weighted mean of the underlying companies invested in by the Fundsmith Equity Fund and the mean for the FTSE 100 and S&P 500 Indices. The FTSE 100 and S&P 500 numbers exclude financial stocks. The Leverage and Interest Cover numbers are both median.

So, yes, I know the reality: Investing is a hard business. I repeat: Investing is a hard business. So what does an active manager do? Here are some suggestions from respected commentators about business strategies that might help today’s active managers to survive. First, Laurence B. Siegel, CFA Director of Research. Success will come to active managers when they “present convincing evidence, both historically and in the process they intend to use in the future, that they have a good chance of beating the relevant benchmarks after costs.” Second, John Rekenthaler, Morningstar guru, eminence gris, and in my book the industry’s most astute observer of mutual fund trends. He endorses three approaches: (1) Make funds “available for a limited time, until they reach a certain size, at which point they will be closed.” (2) Adopt “niche” strategies that are “capable of very large surprises . . . a fund that holds 25 stocks.” (3) “Ask more of your investors. . . . Educated investors make for better investors . . . with happier investor experiences.” Third, McKinsey & Company. In the “New Era in Asset Management,” firms “will need value propositions that are more closely aligned with the evolving needs of clients; new technology-enabled investment and distribution capabilities, new vectors of growth and productivity . . . strategic agility . . . retool their organizations, change internal mindsets, and take a ‘bifocal’ approach to resource allocation.” Well, sorry, guys.

Citations one and two are reasonable to consider. But I can’t imagine generalizing those ideas to encompass active managers as a group, who, because of their costs, would be unable to match whatever returns the total stock market delivers. It will be a far tougher job if stock returns over the coming decade are well below that grand 50-fold gain in value enjoyed during the 1982- 2017 era—as I expect they will be. As to the third citation, did any of you readers understand that consultant-speak gobbledygook any better than I did? Allow me to disagree with their conclusions. I believe that two different business strategies will emerge for active fund managers. The two strategies will follow from two divergent corporate structures: (1) Closely-held firms (controlled by their founders or inside executives, including some firms with minority holdings by public shareholders), and (2) fund managers owned by financial conglomerates and banks. For the closely held firms, the optimal strategy will be “Don’t do something. Just stand there.likely

Our huge expense ratio advantage accounts for much of Vanguard’s success. (Exhibit 9) The expense ratios of Vanguard’s bond funds are some 40% below our closest competitor (0.27%) and 80%(!) below the industry norm of 0.87%. Bond index funds account for 61% of Vanguard’s bond assets, and some 72% of Vanguard’s taxable bond fund assets, with our actively managed bond funds accounting for but 28%. In reality, “actively-managed” is somewhat of a misnomer, since the firm’s defined-maturity municipal funds, held to rather precise maturity standards and closely tracking comparable muni indexes, represent about one- third of the “active” total. Perhaps “virtual index funds” would be the more appropriate term form them.

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

The companies in our portfolio have consistently had significantly higher returns on capital and better profit margins than the average for the indices. They convert more of their profits into cash and achieve this with a much lower level of borrowing than the average company. Moreover, their average level of borrowing is significantly lower than it was when we started the Fund. The world at large may not have de-geared much but the companies in our portfolio have. Nor is this a one off—they have been achieving these superior results for many years. The average year of foundation of our portfolio companies at the year end was 1916. Consistently high returns on capital are one sign we look for when seeking companies to invest in. Another is a source of growth—high returns are not much use if the business is not able to grow and deploy more capital at these high rates. So how did our companies fare in that respect in 2017? The weighted average free cash flow (the cash the companies generate after paying for everything except the dividend, and our preferred measure) grew by 13% in 2017. We regard this as a very good result given the generally lackluster growth which the world continues to experience. This leads onto the question of valuation. The weighted average free cash flow (‘FCF’) yield (the free cash flow generated by the companies divided by their market value) on the portfolio at the outset of the year was 4.4% and ended it at 3.7% so they did become more highly rated.

However, it is important to bear in mind that this is not a like-for-like comparison as our portfolio did not remain static over the year. In fact the two shares we sold—Imperial Brands and J M Smucker—had by far the highest FCF yields in the portfolio and much higher than the FCF yields of the one we purchased— Intuit. If we had not made these changes the portfolio FCF yield would have remained at 4.0% (although it is worth noting that the growth rate would have been significantly lower—the FCF of both companies fell in 2017) so some of the fall in yield was a result of our action rather than any rise in market valuations. The year end mean FCF yield on the S&P 500 was 3.9% and the median 4.1%. The year end mean FCF yield on the FTSE 100 was 5.6% and the median 4.9%. More of our stocks are in the former index than the latter. To try to cut through all these means and medians, our portfolio consists of companies that are fundamentally a lot better than those in the index and are valued more highly than the average FTSE 100 company and slightly higher than the average S&P 500 company. In the case of the FTSE 100 Index this is because the valuation of the index is dominated by what I would regard as uninvestable companies like Anglo American and Centrica which traded on FCF yields of around 15% as at 31st December 2017. They may be lowly rated but that does not mean that they are necessarily cheap given their poor quality.

” This 36-page document disclosed Vanguard’s voting policies, and categorized in detail how the Vanguard funds voted their 2017 proxies on 38 types of propositions. Yes, most of these votes were cast as “for” votes, consistent with the recommendations of corporate managements. Nonetheless, as it is said, “a journey of 1,000 miles begins with a single step.” A Framework for Reform The power of entrenched managements operating in their own self-interest remains pretty much as it was described by Berle and Means in 1932.abundant

Vanguard’s dominant share of bond fund assets—and the concentration of assets in bond index funds—tells us what has happened in the bond fund marketplace, but it doesn’t tell us exactly why it has happened. Two reasons stand out: One, our remarkably higher yields, so critical for bond investors today, driven largely by our huge expense ratio advantage. Two, the absence of sales loads on our funds, making them far more attractive to individual bond fund buyers and corporate thrift plans, whose administrators have no interest in incurring the unnecessary drag of sales loads. Small wonder, then, that index funds are gradually winning the battle for investor assets in the bond fund arena. While the $1 trillion invested in bond index funds represents a 23% share of all bond fund assets—lower than the 41% presently in stock index funds—that figure seems destined to grow. Since 2011, cash flows into bond index funds have totaled $802 billion, fully 38% of the total flows of $2.1 trillion into bond funds. High Fees, High Loads, and “Compromises” Given the critical advantage of rock-bottom expenses, (relatively) low portfolio turnover, and superior expected risk-adjusted returns, it’s a small wonder that bond index funds are becoming a significant and growing factor in the bond fund marketplace. First, consider fund expense ratios (annual expenses as percentage of fund assets) for bond index funds vs. actively-managed bond funds.

to do nothing, at least in the foreseeable future. These large firms also have the resources to pursue other lines of business beyond investment management, although I don’t see how that strategy could create value for their mutual fund shareholders. They may try to offer new active funds; they may (with great reluctance) put a toe into the traditional index-fund water. But there’s little point in cutting their management fees, for minimal cuts won’t help. (What’s the point of cutting your fees, say, in half from 100 to 50 basis points when index funds cost as little as 4 basis points?) Severe fee cuts would decimate profits—resulting in sharp compensation cuts for insiders that would be hard to tolerate, and for firms with minority public shareholders, a slap in the face for investors who have become used to powerful profit growth. (I continue to have grave reservations about public ownership of fund managers.) Boring as that “do-nothing” strategy might seem, it is far more likely to preserve the profits of managers than slashing fees, or more aggressive marketing, or jumping (likely fruitlessly) on the bandwagon of low-cost traditional indexing. But some of these firms may wish to launch ETFs to capitalize on the popularity of passive indexing by active investors. That might help to maintain their profitability—albeit at far lower profit margins than traditional active funds.

The past may not be a perfect guide but their return on capital has averaged 3% and 6% respectively since 2011 and they have achieved a total shareholder return of -35.3% and -40.7% respectively from 1st November 2010 to 31st December 2017, when our Fund (T Class Accumulation shares) has returned 261.7%. Maybe all this is about to change. It had better if you are thinking of owning them or the FTSE 100 Index.to

information at their fingertips and with substantial holdings in virtually every large publicly-held corporation in our nation. But investment professionals can’t do it alone. They need to work to develop agreement on a broad, national set of principles such as these:6 1. A government requirement that, as fiduciaries, managers must act solely in the long-term interests of their beneficiaries. 2. An affirmation by government that an effective shareholder presence in all public companies is in the national interest. 3. A requirement that all institutional money managers should be accountable for the compulsory exercise of their votes, in the sole interest of their shareholders. 4. A recognition of the right of shareholders to nominate directors and make proxy proposals, subject to appropriate limits. 5. A demand that any ownership structure of managers that entails conflicts of interest be eliminated. Building this framework will not be easy, but it is essential in order to support the independent exercise of the voting power of our money managers.

Opportunistic marketers might develop a niche strategy, inducing narrowly focused ETFs (think lithium ion battery producers, or Israeli tech firms) and hope that they attracts assets. Another strategy might be to translate a quantitative, rules-based active strategy into a proprietary index and sell an ETF that tracks it. This sort of strategy is often referred to as “Smart Beta,” really an actively managed wolf in an index fund sheep’s clothing. Mark me down as dubious as to their long-term staying power. Offering narrow, even speculative ETFs could well be the optimal short-term marketing strategy for attracting cash inflows and generating trading commissions. But it is unlikely to be the optimal long-term investing strategy. For the fund managers owned and controlled by financial conglomerates (including banks), I believe a totally different strategy will emerge. Using the terminology of The Boston Consulting Group, maintain your fund business as the “cash cow” that it is today—delivering high margins and generous profits, albeit likely at a declining rate. Don’t invest more capital. Don’t cut management fees. Nominal cuts won’t help, and severe cuts would eliminate those cash flows. While fund cash outflows are highly likely to continue, a sharply rising stock market, however unlikely, would help offset the outflows, slowing the declines in assets under management, fee revenues, and profits.strategy,

4 Not merely the yield differential itself, but the huge percentage of portfolio yields that is confiscated by the expenses borne by investors in actively managed funds. Let’s examine these differences in three bond categories. In active corporate bond funds (Exhibit 10), the average fund’s gross yield of 3.05% comes with expenses of 0.78%, consuming 26% of the yield and leaving an actual net yield of 2.26%. Compare that outcome with the corporate bond index fund: gross yield 3.22%, expense ratio 0.07%, income consumed just 2%. Net yield 3.15%, 35%(!) higher than the active fund. Similarly, actively managed government bond funds consume 32% of income vs. 3% for the low-cost funds. For active munis, 37% consumed vs. 5% for the low-cost funds. 4 Vanguard’s actively managed bond funds carry expense ratios much lower than the industry average—even those that are managed by outside managers. For example, the GNMA Fund, with $25 billion in assets, is managed by Wellington Management Company for an advisory fee of a mere 0.01%. Its asset-weighted expense ratio is only 0.14%.

The Structure of the Corporation of Tomorrow Pushing governance reform even further, here are some constructive ideas, courtesy of Uwe Reinhardt, professor of Political Economy at Princeton University’s Woodrow Wilson School7: “The cornerstone of the model would be the complete independence of the Board of Directors from the corporation’s management, so that the Board can truly respect its constituency, the shareholders, vis a vis management.” This principle would require that large, publicly held corporations be organized as follows: 6 This list echoes the reforms passionately advocated by long-time corporate governance advocate Robert A.G. Monks. 7 Dr. Reinhardt, a prince of a human being who pulled no punches with his students nor with vested interests, departed this earth on November 14, 2017 at age 80. The world will miss his wisdom, his passion, and his unshakable integrity. So will I!

Mutual fund managers and their boards of directors have a fiduciary duty to their fund shareholders. But when fund expenses are consuming as much as 37% of a bond fund’s yield and comparable index funds are consuming as little as 2%, we have no choice but to ask ourselves: “Have the fund directors who approved the advisory contracts that result in such confiscation breached their fiduciary duty to shareholders? Have fund sponsors who distribute such funds violated their fiduciary duty? Have brokers who sell such funds to their clients failed to place their client’s interests first?” It is high time for industry participants to examine the issue of the excessive fund costs that confiscate such mammoth portions of the investment income earned on the vast majority of active bond funds. Sales loads are another important factor. While nearly all bond index funds are available solely on a “no-load” basis, fully 2,300 share classes of actively managed bond funds require the payment of sales commissions to brokers and investment advisers. Today, those loads run in the range of 1% to 4% for bond funds, averaging about 2 ½%. How much is 2 ½%, you ask? Well, if you pay such a load, you relinquish more than your entire net investment income during the first year that you hold the fund’s shares. Given the obvious hardship imposed on investors by sales loads on active bond funds, leading fund distributors are attempting to compromise. How?

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

enable them to ‘invest in the UK’. Firstly, I have to question why you would want to restrict your investments to the UK. You may live in the UK as most of our investors do, but to quote Arthur Daley ‘The world’s your lobster’. You can invest outside it and it is unlikely that all or even many of the good companies in the world that you might benefit by investing in are headquartered or listed in a country which constitutes about 3% of world GDP. There is also the question of how representative the FTSE 100 Index is of the UK economy. As at 31st December 2017, of the 10 largest market cap (non-financial) companies in the FTSE 100, only three report in sterling. Only numbers 6, 8, 9 and 10 gave any UK numbers in their last reported accounts: • For No. 6, Rio Tinto, the UK is 1% of sales. Australia is bigger. • For No. 8, GSK, the UK is 3.8% of sales. The US is bigger. • For No. 9, AstraZeneca, the UK is 8% of sales. Japan is bigger. • For No. 10, Vodafone, the UK is 14.5% of sales. Germany is bigger. Which is all a clue that investing in the FTSE 100 Index is not investing in the UK. So if you are doing so you have already, perhaps inadvertently, made the decision to invest internationally. If so, you may as well do it properly and look at companies listed abroad. Finally, what sort of companies are in the FTSE 100? An insight into this is provided by the fact that as at 31st December 2017 just 1.8% of the FTSE is in Information Technology. This compares with 23.

1. A Board chairman who is completely independent of management. 2. A Board on which no executives of the corporation, except for the chief executive officer, would serve. (The CEO would be a non-voting member.) 3. A small staff to serve the board, reporting to the chairman. 4. The firm’s public accountants would report directly to the Board. 5. Such a Board structure would mean that the compensation and nominating committee would be composed only of independent directors. In addition, each corporation should be required to provide limited but fair access to its annual proxy statement to stock owners who wish to offer proxy proposals or to nominate directors. Achieving these goals will not be easy. I recognize that many of these proposals for reform are idealistic and out of today’s mainstream. Most CEOs are unwilling to cede part of their imperial power to anyone else. A small staff for the board has also been a non-starter. But where there is a will to reform our flawed governance system, there will be a way. Nor Are the Money Managers Without Sin If only “he who is without sin may cast the first stone,” our nation’s money managers, too, have work to do to mitigate their own flaws so that they can enter the corporate governance arena with clean hands. The fact is that mutual fund managers have their own conflicts. A bizarre industry structure in which even giant fund groups holding $1 trillion of assets or more find it necessary to hire an outside firm to manage them.

9% in the S&P 500 Index, not the technology centric Nasdaq Composite Index. I am not suggesting that Information Technology is the only sector to invest in to capture future growth nor is it immune from becoming over-valued and delivering poor returns to investors from time to time. But if you were to ask which two sets of stocks were more likely to capture the benefit of future growth, one with 1.8% in Information Technology or one with 23.9%, I think the answer would be pretty obvious. So for all those reasons I do not really regard the FTSE 100 as a genuine benchmark for our Fund and neither am I at all concerned about the Fund’s valuation relative to it. However, that should not be taken to mean that we are entirely comfortable with the seemingly ever higher rating which the shares in our portfolio are achieving. It is clearly a finite and reversible source of performance. However, the growth in the free cash flows of the portfolio are providing a greater portion of the performance which is how we would prefer it and what Mr. Munger might have predicted. One aspect of our performance which we have often been asked about in the past is the degree to which it has benefited from the strength of the US dollar as the majority of the stocks we own are listed in the United States. This is a complex subject as currency exposure is driven by where a company derives its revenues rather than where it is headquartered or listed.

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

By offering a large variety of share classes for a single fund. Essentially, brokers and advisors sell to their clients funds with huge loads and lower expenses, or other funds with low or no loads but with higher expenses. Here’s one example5 of this increasingly widespread “compromise” marketing strategy. (Exhibit 11) 5 This firm is one of the largest active managers in the fund industry, struggling to serve two masters: distributors— broker dealers and registered investment advisers (RIAs)—on the one hand, and individual “do-it-yourself” investors on the other.

Note that the confiscation of income is as high as 60% for the 529 C class. Also note that some of the convoluted mathematics involved in deciding which of the 16(!) classes the broker will offer clients from a single sponsor of the same fund with such different costs. Some classes have front-end loads, some have deferred loads, 11(!) have hidden loads paid by the investor in the form of 12b-1 fees for fund distribution. As a result, the net dividend yields received by investors in the 16 classes vary—in this case, from a low of 1% for the 529 C class to high of 2.16% for R6 class of this intermediate-term bond fund. Since the gross (pre-expense) yield of this fund was 2.4%—43% of the yield has been effectively confiscated. If that table tells us anything, it is that the salesmen must be paid. That’s fine for a particular firm, I guess, but investors should make sure that they receive commensurate value in return. The Metamorphosis of an Index Let me close with a few broad thoughts about how the world of bonds might change in the years ahead. As the driver of Vanguard’s dominant 23% share of bond fund assets, Vanguard Total Bond Market Index Fund offers an interesting case study of how bond market indexing works. In 1986, when I first considered the creation of a bond index fund, the sole broad bond index was the Salomon Brothers Investment Grade Bond Index. Then, U.S. Treasury bonds accounted for 50% of its weight, government agency obligations 32%, and corporate bonds 18%.

However, this year there has been a noticeable absence of such questions. Could this perhaps be because in 2017 the best estimate we have is that the weakness of the US dollar cost our Fund some -5.9%. The performance in 2017 was attained despite this headwind.

Let me be clear: I believe that the “stay the course” strategy is the optimal business strategy for today’s largest active fund managers. I also believe that the cash-cow approach is the optimal business strategy for the fund managers owned by financial conglomerates—just one more of their “product lines,” rather than a passionate commitment to our industry. VI. The Optimal Fiduciary Strategy for Mutual Funds But wait a minute. What if the optimal business strategy for fund managers ill-serves the mutual fund shareholders who have entrusted their assets to the funds? We cannot ignore a very different strategy—really a counter strategy—one that serves the interests of fund shareholders. Let’s call it the fiduciary strategy—a strategy that puts fund owners first. Look, I understand that all enterprises face conflicts of one kind or another, and balancing business values with fiduciary values is no easy task. (Even at the only firm in which the fund shareholders own the management company, conflicts exist.) But it is my deeply-held opinion that the flawed structure of this industry has created deep fissures that will, ultimately have to be closed. Far too little introspection on this distinction between business values and fiduciary values has permeated the minds of industry leaders, including the ICI. Managing mutual funds typically remains an insanely profitable business, with pre-tax profit margins often exceeding 50%. How could it be otherwise?

A corporate dichotomy in which these managers are often publicly held and thus have conflicting fiduciary duties in serving two different masters (the fund shareholder and the management company shareholder), with financial incentives that favor the management company master. And a counterproductive set of priorities in which aggressive marketing supersedes professional management. Further, given the fact that so many institutional managers must be considered short-term renters of stocks rather than long-term owners, it’s not at all clear why we should allow full corporate voting rights to the renters. Perhaps we need a sort of tapered voting rights in which holders of stock for, say, at least two years earn full voting rights and holders for less than a year have none.

During 1982-2016, we’ve been blessed with the strongest stock market in history. The S&P 500 enjoyed a 50-fold-cumulative gain (an average return of 12.1%). Few if any mutual funds (except, of course, broad market index funds) earned this return for their shareholders, but no one seemed to notice. Few shareholders were unhappy when they received, say, a 30-fold or 40-fold gain. Yes, absolute returns are far more visible then relative returns, and investors thanked their lucky stars—and their “smart managers”—for their stunning absolute returns. That great 34-year bull market drove our industry’s growth and raised investor expectations of the returns that stocks are likely to achieve in the coming era. But the markets weren’t alone in helping our business grow. While we are good at cursing interference by regulators, we have been blessed by a Federal government that has enabled the formation of tax-exempt municipal bond funds and tax-favored retirement plans—IRAs, pension plans, and thrift plans. Together, these tax-favored structures account for some $7.9 trillion of the present $17 trillion asset base of the mutual fund industry. So our industry has benefitted from two remarkable happenings, manna from heaven that we can take no credit for.

This provision may sound extreme. But if the idea is that the greatest business success comes to corporations that focus on the long-term, it makes considerable sense. Finally, some combination of passively managed traditional index funds (TIFs) and actively managed large-cap funds that invest for the long term will hold the key to corporate governance reform.8 Finally, I confess my surprise (and disappointment) that the growth of TIFs—typically bought and held by passive investors for the long-term—has been eroded by the intercession of ETFs—typically traded in the short term by active investors—often focused on the short-term. My long experience in mutual fund investing has completely persuaded me that great marketing ideas for the fund industry are rarely, if ever, productive investment ideas for its shareholder/clients. Past experience confirms that insight. The average TIF has provided significantly higher investment returns than the average ETF during every year of the past decade, usually by two to three percentage points annually. The cumulative investor returns: TIFs +105%, ETFs +62%. (Even the 71% investor return of actively managed equity funds exceeded the ETF return.) All that is required for the final triumph of the TIF is that ETF investors learn from their own experience. Please don’t be intimidated by this litany of flaws that have come to pervade today’s debased version of capitalism. We can fix them, and we will.

For the year the top five contributors to the Fund’s performance were: Paypal +2.9% Amadeus +2.3% CR Bard +1.8% Novo Nordisk +1.5% Waters Corp +1.4% CR Bard is making an appearance for the second year running, at least partly because it was bid for by Becton Dickinson, another of our portfolio companies. The bottom five were: JM Smucker - 0.3% Imperial Brands - 0.2% Dr Pepper Snapple 0.0% Colgate Palmolive +0.1% Reckitt Benckiser +0.1% We sold our holdings in JM Smucker and Imperial Brands during the year. JM Smucker was a disappointment. One half of the business is in ambient packaged food in which it is a struggle to generate growth—Folgers coffee, Jif peanut butter and Smucker’s jams (jellies if you are American). However, what attracted our interest was when JM Smucker acquired the Big Heart Pet Brands pet food business from private equity. We are keen on businesses which sell to pet owners, such as IDEXX, albeit indirectly, and we had made a very good return on the Big Heart business when it was owned by Del Monte before it was acquired by private equity. However, the outcome in terms of the margins and returns achieved on the business by JM Smucker proved to be disappointing and we were concerned by the management’s reaction to this especially as JM Smucker is a family controlled company. Imperial Brands is the former Imperial Tobacco that we had held since the inception of the Fund.

Move the clock forward from 1987 to 2017, and we see a somewhat different pattern. (A lot can happen over forty years!) U.S. Treasury 36%, agency obligations 38%, and corporates 26%. Clearly, the most significant change in the total bond index (now known as the Bloomberg Barclays U.S. Aggregate Bond Index) is the rise in the weight of corporate bonds from 18% of the total to 26%.

As I look at these changes, I cannot help but wonder: “Is a position of 18%—or even 26%—in corporate bonds the optimal level for an individual investor? Might not some informed investors prefer a portfolio of, say, 65% in investment-grade corporates and 35% in Treasuries and agencies with a slightly higher yield that would come hand-in-hand with slightly higher volatility and a slight reduction in credit quality?” Much as I believe in the bond index fund (and the index it tracks), it occurs to me that the final form of an index fund tracking the bond market may yet be determined. The Future of Bonds . . . and Bond Funds Most of today’s bond investors have experienced only the sharp and unremitting drop in bond fund yields that has occurred over the past 35-plus years—the yield on the Bloomberg Barclays Aggregate Bond Index has plummeted from 14.6% at the close of 1981 to 2.6% today, a decline of a mere 83%. (Exhibit 12) Today’s low rates have led some experts to say that we’re in a bond fund bubble, one which will soon burst and send yields soaring and prices tumbling. Since anything can happen in a financial crisis, these predictions may prove correct. But I believe bursting bubbles is a concern largely for short-term speculators in bond prices, not long-term investors planning for their financial futures. After all, if an investor purchases a 30-year U.S. Treasury bond paying an annual coupon of 2.

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

If presentism leads this industry to believe that such mammoth returns will recur from this point forward, or that the federal government has some further gifts to bestow on our industry, we are fooling ourselves. Indeed, I believe that it is more likely that the administration will act to take away some of these gifts (which tend to favor high-income investors) by limiting the tax deferrals available to corporate thrift plans and individual retirement plans. VII. The Economies of Scale The remarkable growth of mutual fund assets has served the owners of fund management companies bountifully, but it has bypassed the owners of mutual fund shares. All of the economies of scale in investing—and more—have benefitted fund managers. None of these economies were shared by fund investors. Can that allegation really be true? Let’s look at the record. During 1951, the year that I joined the industry, fund assets were $3 billion, the asset-weighted expense ratio was 63 basis points; and total expenses were $20 million ($187 million in today’s dollars). As the industry grew, dominated by equity funds in those early years, the asset-weighted average expense ratio actually declined, to 55 basis points. But then the rise began. By 1980, equity fund expense ratios had risen 120% to 121 basis points, double the 1951 level. In 1980, equity fund assets were $44 billion. By 2016 these assets had soared to more than $8 trillion.

We had become increasingly concerned about the company’s positioning in terms of its lack of exposure to the developing world and to the next generation reduced risk products such as heat not burn devices, all of which has led to volumes falling at a rate that it is difficult to cope with. We were even more concerned by the management reaction which we literally could not understand. Colgate makes the table of our five worst performers for the second year running even though it is our smallest position. It has been facing a tough time with its largest market being Brazil. Turning to the third leg of our strategy which we succinctly describe as ‘do nothing’, minimising portfolio turnover remains one of our objectives and this was again achieved with a portfolio turnover of 5.4%^ during the period. It is perhaps more helpful to know that we have held 13 of our portfolio companies since inception and we spent a total of £1.3m or just 0.011% (1.1 basis points) of the Fund’s average value over the year on voluntary dealing (which excludes dealing costs associated with fund subscriptions and redemptions as these are involuntary).

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

corporation should serve?” Of course, the principal goal of the money management agents must be that the corporations whose shares they hold are managed with the interests of their shareholders as their highest priority. But there can be no doubt that producing long-term growth in the intrinsic value of the firm should remain the optimal goal of the modern corporation. Not the evanescent swings in short-term stock prices, but the durable creation of the intrinsic value of the business. After all, paraphrasing Warren Buffett: When the price of a stock temporarily over-performs or under-performs the business, a limited number of shareholders—either sellers or buyers—receive out- sized benefits at the expense of those they trade with. [But] over time, the aggregate gains made by the firm’s shareholders must of necessity, match the business gains of the corporation. But lest we forget, “the public interest” means the interest of our society as a whole. Princeton’s Uwe Reinhardt nicely sums it up. The goal of our society must be “genuine wealth creation for the economy as a whole. It is not only about financial wealth, but about the total wealth created by all of the nation’s human capital, its physical infrastructure, and its governmental institutions, including national security and the law.” Corporate managers and money managers alike have a vested interest in the preservation of the values shaped by these other contributors to their own wealth and to the wealth of our nation.

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

Why is this important? It helps to minimise costs, and minimising the costs of investment is a vital contribution to achieving a satisfactory outcome as an investor. Too often investors, commentators and advisers focus on or in some cases obsess about the Annual Management Charge (‘AMC’) or the Ongoing Charges Figure (‘OCF’), which includes some costs over and above the AMC, which are charged to the Fund. The OCF for 2017 for the T Class Accumulation shares was 1.05%. The trouble is that the OCF does not include an important element of costs—the costs of dealing. When a fund manager deals by buying or selling investments for a fund, the fund typically incurs the cost of commission paid to a broker, the bid-offer spread on the stocks dealt in and, in some cases, transaction taxes such as stamp duty in the UK. This can add significantly to the costs of a fund yet it is not included in the OCF. We provide our own version of this total cost including dealing costs, which we have termed the Total Cost of Investment (‘TCI’). For the T Class Accumulation shares in 2017 this amounted to a TCI of 1.08%, including all costs of dealing for flows into and out of the Fund, not just our voluntary dealing. We think that figure will prove to be low if or when other funds produce comparable numbers. However, we would caution against becoming obsessed with charges to such an extent that you lose focus on the performance of a fund.

The enterprises that will endure are those that generate growing profits for their owners, something they do best only when they take into account the interests of their customers, their employees, their communities, and indeed the interests of our society. Please don’t think of these ideals merely as foolish idealism. They are the ideals that capitalism has depended upon from the very outset. Hear Adam Smith: “He is certainly not a good citizen who does not wish to promote, by every means of his power, the welfare of the whole society of his fellow citizens.”

But the owners of mutual funds—those whose hope and trust have built this giant industry—are paying their active equity managers at a rate that has increased by 53% since 1960. Given those enormous increases in our industry’s asset base, one can only wonder how this dichotomy could have taken place. My views on this subject are obviously strong. But informed opinion is catching up. In his 2014 text Asset Management, for example, Columbia Professor Andrew Ang opens his chapter on mutual funds with this pungent summary. “Mutual fund managers are talented, but on average none of that skill enriches asset owners. The average mutual fund underperforms the market after fees, investors chase funds with high past returns only to end up with low future returns, and larger mutual funds do worse than smaller funds. While the Investment Company Act of 1940 gives significant protection to ordinary investors, most mutual funds are run for the benefit of mutual fund firms rather than investors.” [Emphasis added.] Simply put, Dr. Ang, now managing director of fund manager BlackRock, is telling us that the master of the mutual fund is the external firm that controls it. But why shouldn’t the master be the shareholders who own the fund? (That is the standard way that all other U.S. corporations operate.) As the King James Version of the Bible tells us, “no man can serve two masters, for he will hate the one and love the other, or hold to the one and despise the other.

income—I believe that the index share of bond fund cash flow and assets will not only continue its historical rise, but even accelerate. And, given the remarkable cost advantages based on its simple mutual, investor-first structure and the staggering economies of scale the firm has achieved for its shareholders, I see no reason that Vanguard cannot continue to build on our present base, lead the field in the bond fund industry, and be an active participant in the issues of the day affecting the bond market. As I look ahead, I’m no Pollyanna. Times will change. Believing that the future will closely resemble the past (“presentism”) and ignoring the inevitable uncertainty of investing—and of life—is to forget the lessons of history. * * * In November 1998, almost exactly 19 years ago—you conferred on me the honor of admission to the FIASI Hall of Fame. Here’s part of what you said: In the mid-1970s, Jack helped pioneer the differentiation of bond funds by maturity, a simple, but important concept which connects investor risk and objectives with fund structure [and helps] investors define and measure risk. Intellectual curiosity, innovation and an independent spirit have all been hallmarks of a long and extremely successful career. And Jack has become one of the most articulate and thoughtful spokesmen for the investment management business today. All of us look forward to many more years of Jack’s ideas and opinions.

It is worth pointing out that the performance of the Fund tabled at the beginning of this letter is after charging all fees which should surely be the main focus. This year I thought I would use the opportunity afforded by this letter to talk about so- called activism and takeovers since we have seen a lot of events in these areas in the past year which have affected the companies we own and follow. Investment is a world in which words get used in confusing ways. Take the words active and activism. Active investors are the opposite of passive investors who simply seek to replicate the performance of an index. At Fundsmith we are active investors— our Fund will only own a maximum of 30 shares (it owned 27 as at 31st December 2017) and we limit it to a few sectors which have the characteristics we seek: consumer staples, some consumer discretionary products, healthcare and technology being the main sectors. So we are far removed from a passive investor. However, we change our portfolio positions very infrequently which I suppose makes us an inactive active investor. You can see why people are often confused. Activists are a different animal. They seek to benefit by causing change in corporations they invest in. Activists are usually active managers but some of them are passive (I’m not making this up) as they seek to improve the returns on their index fund by agitating for change where they feel it is necessary. So I suppose they could be described as passive activists.

No one says it better than Theodore Roosevelt.9 He begins his 1910 speech on “The New Nationalism” by quoting Abraham Lincoln: I hold that while man exists it is his duty to improve not only his own condition, but to assist in ameliorating mankind. . . . Labor is prior to, and independent of, capital. Capital is only the fruit of labor, and could never have existed if labor had not first existed. Labor is the superior of capital, and deserves much the higher consideration. Roosevelt continues with his own words: The material progress and prosperity of a nation are desirable chiefly so long as they lead to the moral and material welfare of all good citizens. . . . The absence of effective . . . restraint upon unfair money-getting has tended to create a small class of enormously wealthy and economically powerful men, whose chief object is to hold and increase their power. The prime need is to change the conditions which enable these men to accumulate power which is not for the general welfare that they should hold or exercise. . . . The right to regulate the use of wealth in the public interest is universally admitted. Wrapping Up If the mission of today’s modern corporation is to serve the public interest, then our giant, ever more powerful institutional investors must educate themselves as to what is real in investing, and what is illusory.

Presenting some ideas and opinions is what I’ve tried to do today. Good luck to all of you bond professionals (including you active bond managers), and to the entire fixed-income community. Yes, having survived defeat, I’m confident that Vanguard and indexing will continue to survive victory.

” While that love/hate pairing is too strong even for me, the point is a valid warning to the mutual fund industry. Hence the question: When the business strategy for the owners of the firm conflicts with the fiduciary strategy for the owners of the funds, whose interests comes first? To me, the answer is obvious. If this industry is to realize its promise to investors, the fund owners must be the master. VIII. Can a Fiduciary Serve Two Masters? In 1985, I gave a speech to a gathering of state financial regulators. It was entitled, “Where Are the Independent Directors?” My concluding words were, “I hope they’ll be back soon.” Today, 32 years later, there is little evidence that the directors have returned. One can only wonder why so many fund boards of directors have seemed to have ignored that “shareholder first” principle, and failed to garner for benefit of the fund shareholders at least a portion of those staggering economies of scale.

Still with me? On the whole we are not fans of activism. Too often it seems to follow a playbook that has the following steps: 1. The activist ‘buys’ a stake in a company. I have put ‘buys’ in inverted commas because often much or all of the stake is held through derivative products which means that the activist can announce a seemingly large position in the company’s stock whilst risking and committing relatively little actual cash.This

We must understand the nature of traditional capitalism; the wisdom of long-term investing and the folly of short-term speculation; the productive power of compound interest to build returns; and the confiscatory power of compound costs to slash those very same returns. In all, the relentless rules of humble arithmetic. We all need to stand back, take a moment for introspection, and finally recognize that these obvious precepts must drive institutional investment management in the years ahead. The arc of investing is bending toward fiduciary duty and the public interest, and its progress is inevitable. 9 Roosevelt’s speech was delivered at the dedication of the John Brown Memorial Park in Osawatomie, Kansas, on August 31, 1910.

methodology also gives some clue as to the activist’s time horizon which may not coincide with ours, as derivatives have an expiry date whereas stocks don’t. 2. Engage in a public row with the target company and seek board representation, a spin-off of part of the business, a merger with or sale to a competitor, raise debt to execute a share buyback (the activist can helpfully tender stock to assist with this) etc. 3. If the company responds by following the activist’s demands they then sell their stake. 4. We and other long term shareholders are left with a company that has incurred fees and diverted time from running the business to respond to the activist and execute the changes, which is now potentially more fragmented, more highly leveraged and has had to install new management. 5. Rinse and repeat with another victim investment. We have many possible objections to this process. In our experience a dialogue in which you seek to change someone’s behavior is best at least started in private. Seeking a public spat at the outset seems to us to be more closely aligned with a desire to seek a certain public profile rather than to effect corporate change. Often the proposals hinge on a misconception or two.

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

We have often been told that if a company has two divisions and one is in a slow growing segment and one is faster growing (like PepsiCo with soft drinks and snacks) then if the two are separated (as Nelson Peltz suggested to PepsiCo) the faster growing one will attain a higher stock market rating once on its own. This is probably true, but won’t that be compensated by a lower rating on the slower growth division? Of course not for the activist who intends to sell out as soon as possible. Thankfully in our view, on this occasion Mr. Peltz was unsuccessful and PepsiCo remains a drinks and snack business, which is not to say that we think everything is fine with PepsiCo’s management or that Mr. Peltz is always wrong, of which more later. Leveraging up the balance sheet to buy back stock is a frequent demand of activists and is invariably described as ‘returning cash to shareholders’ and not only when it is suggested by activists. The correct description for this action should be ‘returning cash to exiting shareholders’ as we remaining shareholders don’t receive any of it and this perhaps best encapsulates the problem we identify with this practice. Those of us who actually seek to own the company and remain shareholders see debt raised to take out shareholders who wish to exit. It is beyond us why we would want that to happen unless the shares purchased are demonstrably cheap.

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

management company was the party that should manage the shareholders’ money in the future . . . sadly, “boardroom atmosphere” almost invariably sedates their fiduciary genes.” My own concern about this issue goes back even further than Mr. Buffett’s. In 1971, as CEO of Wellington Management Company, then a publicly-held manager, I addressed our executives with these words: “It is possible to envision circumstances in which the pressure for earnings growth engendered by public ownership is antithetical to the responsible operation of a professional organization.” That proposition has been proven over and over again. The necessary resolution of this issue would be to roll back conglomerate ownership, came to grips with the public shareholder issue, and at last make it clear that the interests of mutual fund investors must come first. It will not be an easy battle. IX. What Would a Fiduciary Strategy Mean? So yes, the fiduciary duty of fund directors and fund managers must take precedence over the business strategy of fund managers. The Investment Company Act of 1940 clearly demands this fiduciary strategy. Section 1 declares that is in “the national public interest and the interest of investors,” in the words of the SEC, that “funds should be managed and operated in the best interests of their shareholders, rather than in the interests of advisers, underwriters, or others.” This industry has largely ignored that fundamental principle.

However, whilst we question the motivation and methods of activists, and how companies respond to them, we do not always disagree with them. For example, we agreed with Carl Icahn’s view that separation of the two businesses which were part of eBay (the eBay marketplaces business and PayPal the payment service provider) would set PayPal free to grow more rapidly, and as you can see PayPal is the largest contributor to our Fund’s performance over the past year.

Quite a lot happened to affect our portfolio companies and we have seen some takeover activity in the past year. In addition to the bid for CR Bard and the bid approach from Kraft Heinz for Unilever, activists became involved in ADP and Nestlé, which we own, and P&G, which we had already sold, but which remains in our Investable Universe of stocks we would own given certain conditions. I thought it might therefore be helpful to investors if I described our reaction to each of these in turn, since we may not be very active in the sense of changing portfolio positions but we are often engaged in thinking about situations such as these. Automatic Data Processing (‘ADP’) / Pershing Square Payroll and HR services company ADP was approached by activist fund Pershing Square, led by Bill Ackman, who had ‘bought’ an 8.3% stake. The inverted commas are because this stake involved 36.8m shares, 28.0m of which were in fact call options and not actual shares. This did not amount to true ownership in our view since Pershing Square had no right to vote the shares covered by those call options and neither had they expended the cash to purchase the shares. Pershing Square’s approach to ADP became a public row and proxy contest with Pershing Square delivering a 168 page presentation, several letters suggesting ways to improve operating efficiency, which might be summarized as ‘cut costs quickly’, and demanding three board seats. The reaction of the ADP management was interesting.

When that legislative policy is finally honored, a fiduciary strategy for fund owners will emerge. Fund directors will surely demand sharp reductions in management fee rates, perhaps implemented gradually. Discipline in the fund line-up, with funds that are focused on long-term objectives and policies rather than funds formed to capitalize on the fashions of the day. Adding index funds to their offerings. Far fewer dollars spent on marketing. And maybe even the adoption of a truly mutual shareholder structure, with elected fund directors in full control of the mutual funds “managed and operated in the best interests of their shareholders.” And a return to the industry trademark principle from which we’ve strayed, a traditional policy that “we sell what we make,” abandoning our present policy of “we make what will sell.” That particular form of presentism can no longer keep on happening.leaders:

They did not do what so many managements do when faced with an activist by issuing new guidance showing an increase in forecast profits or margins, increasing the dividend and/or share buybacks. Instead they challenged the analysis and assumptions underlying the Pershing Square proposals. We found this direct and refreshingly honest. The stock had significantly outperformed the S&P 500 Index over the past five years even before Pershing Square became involved. Maybe it could have done even better if Mr. Ackman is right, but during this period the management has also had to oversee a transition of the business from one which was mainly paper based to one where its products are delivered by a variety of electronic means, and it is not as though Pershing Square’s suggestions were without risk. We therefore decided to give the ADP management something rather old-fashioned, called the benefit of the doubt, and so voted with them and against Pershing Square’s proposals. We suspect there are far worthier targets for Mr. Ackman to attack even within our portfolio. Nestlé / Third Point Hedge fund Third Point, run by Dan Loeb, purchased a $3.5bn stake in Nestlé and in his June letter to investors Mr. Loeb talked of Nestlé’s ‘unrealized potential for margin improvement and innovation in its core businesses, an un-optimized balance sheet, a number of non-core assets’.

“When students enter business school, they believe that the purpose of a corporation is to produce goods and services for the benefit of society. When they graduate, they believe that it is to maximize shareholder value.” Adam Smith would have concurred with that opening proposition: the purpose of the corporation is to produce goods and services that benefit society. In 1776, in The Wealth of Nations, he articulated the point clearly: “Consumption is the sole end and purpose of all production; and the interest of the producer ought to be attended to only so far as it may be necessary for promoting that of the consumer. The maxim is so perfectly self-evident that it would be absurd to attempt to prove it.” X. A Personal Perspective At the outset, I promised you a personal perspective on some of the thoughts that cross my mind during this 66th year in the fund industry. (Dare I say that few in this audience have even lived that long!) First, this is an extremely happy time in my life and career. To live to see my dream come true of “The Triumph of Indexing”—the title of a small history that I penned and published in 1993—is, well, a nice thing. It’s something that wouldn’t have happened without the heart transplant that I received on February 21, 1996, 21 years ago. Of course I’m thankful for that miracle. If my career means anything, I hope it means that caring counts.

Caring about the millions of honest-to-God, down-to-earth human beings who have trusted Vanguard, and whom we’ve done our best to serve. Caring about the thousands of wonderful, loyal, crew members who are committed to our values, not only of serving our investors, but caring about them. As I often remind Vanguard’s crew, “ideas are a dime a dozen, but implementation is everything.” Caring about those wonderful Bogleheads, whose website is the leading financial forum on the internet. Let me be clear: It was never my intention to build a colossus . . .lowest

Third Point’s approach to Nestlé strikes us as close to the activist playbook which I described earlier in that it calls for ‘improving productivity’; ‘returning capital to shareholders’; ‘re-shaping the portfolio’; and ‘monetizing its L’Oréal stake’.

In respect of productivity, Mr. Loeb said Nestlé should ‘adopt a formal margin target’. He went on to specify the margin level he believes Nestlé should formally target as ‘18–20%’ by 2020. There is more to attaining an improvement in profitability than committing to a target. The approach reminds me of the G20 meeting in 2014 at which the countries committed to attaining GDP growth of more than 2%. If it’s that simple, why not commit 3% or even 4%? Some people seem to believe that GDP growth or profit margins can be conjured up by a commitment. Sadly it may take rather more than that. In respect of returning capital, Mr. Loeb says that ‘capital return in conjunction with a formal leverage target makes sense as well’. He goes on to say that raised leverage would provide share buyback capacity, which would probably be a better use of cash than acquisitions given high valuations (remember that bit please). Mr. Loeb mentions ‘Re-shaping the portfolio’ and invokes the fact that the company has over 2,000 brands, some of which he believes could fetch ‘above-market multiples’ given ‘large synergies to potential acquirers’. He also thinks Nestlé should consider ‘accretive, bolt-on acquisitions in high growth and advantaged categories’ (presumably despite the ‘high multiples in Nestlé’s sector’ he already mentioned).

cost and at the highest level of service. Truth told, very early in our history I worried more about the challenge of managing huge assets than about survival. When Vanguard assets crossed the $4 trillion mark earlier this year, my first thought was the title of an early speech to our crew in which I warned about the perils of giant size. I asked, “Which Axiom?” would prevail: Will it be, “Nothing succeeds like success?” Or will it be, “Nothing fails like success?” So far in Vanguard’s history, it is the first axiom that has prevailed. My worry was, dare I say, premature. For the year was 1984, and our assets had then just crossed the $8 billion mark. While I never sought to build a colossus, I was too stupid to realize that if we merely gave investors their fair share of the returns we’ve enjoyed in the stock and bond markets, we’d become a colossus. By creating the mutual structure and the index strategy, we’ve been the first mover, a huge advantage in fostering our growth. But I’ve also been the most prolific public advocate about these inseparable elements of our growth. In my 2005 book The Battle for the Soul of Capitalism, I cited St. Paul: “If the sound of the trumpet shall be uncertain, who shall prepare himself for the battle?

” My trumpet about the mutual structure and the index strategy has been certain: eleven books, 575 speeches and lectures, 26 articles in academic journals, numerous op-eds, countless interviews, and (literally) daily letter from our shareholders—often deeply touching stories about their lives and their gratitude. I answer every one. I’m not a presentism guy. I’ve always tried to anticipate what tomorrow may hold. Times change. Tastes change. Reputations change. As I so often warned our staff, “There’s a giant in this room. While we can’t see him, he’s carrying a huge sledgehammer and he’s about to slug us right in the nape of the neck.” Today’s known unknowns present ample risks. But the unknown unknowns, like that powerful but invisible giant, are always lurking out there, unseen. Fifty-seven years after my first heart attack in 1960, my health is pretty good, and my voice remains strong—and as opinionated as ever. My scoliosis is severe. “The spirit is willing, but the flesh is weakening.” But I’m still me. I hope that one of my Princeton classmates was right when he recently told me that, “you’re still the kid—the same determined, idealistic, shy, friendly kid—that I knew back in 1951, 66 years ago.” I consider that the ultimate accolade.

His proposal for ‘Monetizing the L’Oréal stake’ is based on his belief that the stake is ‘not strategic and shareholders should be free to choose whether they want to invest in Nestlé or some combination of Nestlé and L’Oréal’. He ended by saying that divestiture ‘via an exchange offer for Nestlé shares…would accelerate efforts to optimize its capital return policies, immediately enhance the company’s return on equity (‘ROE’) and meaningfully increase its share value in the long run as earnings improve over a reduced share count’. Fairly obviously the enhancement of ROE from disposal of a stake which is equity accounted is purely cosmetic but then again some people are impressed by cosmetic changes. We are not amongst them and if I had managed to acquire a 23% stake in the world’s leading cosmetic company, as Nestlé has, I would need some more compelling arguments to persuade me to dispose of it. Nestlé’s first response to Third Point came only two days after Mr. Loeb’s letter. This talked about ‘value creation’. However it did include one specific, namely the announcement of a CHF 20bn share buyback program. A more detailed response came when Nestlé CEO Mark Schneider and other executives presented at the Nestlé investor day on 26th September. The company set a new formal margin target—up 150–250bps from the underlying 16% in 2016 to 17.5–18.5% by 2020; and said that it would accelerate share buyback activity.

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

It also said that as well as the already announced decision to ‘explore strategic options’ for the US confectionery business, it was ‘actively adjusting its product portfolio...as shown by the recent investments in Blue Bottle Coffee, Sweet Earth and Freshly’. However the company defended the L’Oréal stake. On the whole we are not impressed when a company announces new margin targets, share buybacks and acquisitions and/or disposals in response to activists or takeover approaches. The question which always springs to our mind is ‘If these things are possible and desirable, why weren’t you already doing them?Nestlé,

Decision — Ryman Healthcare: NZ$8.60 entry → ~NZ$4.50 exit; formal postmortem. Context: “By far the worst investment I have ever made” — H1 2025 letter. Outcome (known): Loss exit; documented autopsy — a rare public loss postmortem.

however, the CEO Mark Schneider should probably not be criticised for this as he is new in the role so he can’t be blamed for any past dilatoriness. To date Third Point’s approach to Nestlé has not lead to anything we are required to vote on which may be just as well. Procter & Gamble (‘P&G’) / Trian Trian is a fund run by Nelson Peltz whom I have already mentioned in the context of PepsiCo. Although we don’t directly have a dog in this particular fight, as we do not have any P&G in our portfolio, it still resides in our Investable Universe and so an investment is still regularly considered by us, and as we sold our stake because of concerns about P&G’s strategy we are interested in what Mr. Peltz had to say. Trian’s plan for P&G was detailed on 6th September. It called for ‘organizing P&G in a way that promotes accountability, faster decisions and responsiveness to local preferences’; ‘ensuring management’s $12–13bn productivity plan actually delivers’; ‘fixing the innovation machine’; ‘improving development of small, mid-size and local brands, both organically and through M&A’; ‘winning in digital’; ‘addressing P&G’s insular culture’; ‘improving corporate governance, including aligning management compensation with market share gains’. The page after these proposals—i.e. very much to the fore of the piece—details what Trian is ‘NOT’ (they wrote the word in capital letters) recommending.

Among the things which they are not recommending—a break-up of the company, a new CEO, replacement of any directors, taking on excessive leverage, pension benefits cuts, slashing of R&D, marketing or capital expenditure budgets, cost cuts which might impact product quality, moving out of Cincinnati. We like this approach. The next page reminded us that all Trian was seeking was that ‘Nelson become 1 of 11 (or 12)’ directors of P&G and that it is ridiculous to suggest that as one person out of 11 or 12, he would ‘derail’ P&G. The Trian presentation is 93 pages long and is all centred around P&G having a poor organizational structure—‘suffocating bureaucracy and complexity’—which means that no one is accountable, decisions take forever and so forth. When we sold our P&G stake the fact that the company is the overwhelming market leader with Gillette but was ranked no. 50 in online shave clubs struck as illustrating the sort of point Mr. Peltz was making. David Taylor, P&G CEO, went on Jim Cramer’s CNBC programme at one point calling some of Peltz’s proposals ‘very dangerous’. They strike me as more dangerous to Mr. Taylor than to P&G’s shareholders. Mr. Peltz succeeded in his bid to win a board seat even though P&G is said to have spent more than $100m of shareholders’ money to prevent it. We wish him well with his endeavours. His presence makes P&G more interesting to us.

Unilever / Kraft Heinz On 17th February, the story broke that Unilever had received a bid approach from Kraft Heinz, the listed food products company controlled by 3G, the Brazilian entrepreneurs who also control AB InBev, the world’s largest brewer, and Burger King, together with Warren Buffett’s Berkshire Hathaway. On 22nd February, Unilever put out two releases by way of immediate response. The first was entitled, ‘Unilever guidance update’ which said that Unilever ‘now expects core operating margin improvement for 2017 to be at the upper end of its 40–80bps guidance’. The second release said, ‘Unilever is conducting a comprehensive review of options available to accelerate delivery of value for the benefit of our shareholders. The events of the last week have highlighted the need to capture more quickly the value we see in Unilever. We expect the review to be completed by early April, after which we will communicate further.’ On 6th April, Unilever announced the results of this review.

The company said it was: • ‘Accelerating its ‘Connected 4 Growth’ programme and targeting a 20% underlying operating margin, before restructuring, by 2020’ • Combining the foods and refreshment units into one unit, ‘unlocking future growth and faster margin progression’ • Establishing a net debt/EBITDA target of 2x • Launching a €5bn share buyback program • Raising the dividend by 12%—about double the recent rate of increase This approach clearly falls foul of our scepticism when management produces rabbits from a hat when an activist or takeover comes into view. We think we should already have seen the rabbits or at least been told about their existence. To hopefully be clear, we are not fans of Kraft Heinz. We have never owned any shares in Kraft Heinz or its constituent parts. Although 3G has managed to operate the business with efficiency as they have AB InBev, to produce great cost savings leading to operating profit margins of 23% in 2016 and strong gains for owners, well certainly for 3G and Berkshire Hathaway, we have never found a business which can cut its way to growth. Although the Kraft Heinz management are certainly handicapped in this regard by the nature of the company’s brands, which are mostly not in growing areas of the market, the sort of people and approaches you need to grow businesses tend not to flourish in cultures in which the emphasis is on cost cutting.

However, the contrast between their approach and that of Unilever does raise some questions for Unilever’s management which remain unanswered. To give you a simple illustration of this, in 2016 Unilever had €52.7bn of revenues and an average of 169,000 employees, thus revenue per employee of about €312,000. Kraft Heinz had €23.8bn of sales and an average of 41,500 employees, and so revenue per employee of about €574,000. Kraft Heinz has slightly less than half the sales of Unilever but manages to achieve this with less than a quarter of the number of the employees. You don’t have to be a fan of brutal cost cutting to see that Unilever has a case to answer here.

Unfortunately we never got to hear Unilever justify its rather interesting sales/employee ratios because Kraft Heinz withdrew as soon as it became evident that Unilever was hostile to the approach. Warren Buffett is notoriously opposed to hostile takeovers. I hope that has given you all some insight into how we think about and interact with the companies in our portfolio and those we are interested in, and other shareholders, activists and bidders. Finally, I wish you a happy New Year and thank you for your continued support for our Fund. My colleagues and I look forward to seeing many of you at our Annual Shareholders’ Meeting on 27th February 2018 and to trying to answer any questions you may have. Please see the enclosed invitation for details. Yours sincerely, Terry Smith CEO Fundsmith LLP Disclaimer: An English language prospectus for the Fundsmith Equity Fund is available on request and via the Fundsmith website and investors should consult this document before purchasing shares in the Fund. Past performance is not necessarily a guide to future performance. The value of investments and the income from them may fall as well as rise and be affected by changes in exchange rates, and you may not get back the amount of your original investment. Fundsmith LLP does not offer investment advice or make any recommendations regarding the suitability of its product.

This financial promotion is intended for UK residents only and is communicated by Fundsmith LLP which is authorised and regulated by the Financial Conduct Authority. Sources: All data sourced from Fundsmith research and where appropriate using Bloomberg. ^The PTR (Portfolio Turnover Ratio) has been calculated in accordance with the methodology laid down by the FCA. This compares the total share purchases and sales less total creations and liquidations with the average net asset value of the fund.