JOHN BOGLE: "TURNING OVER FUND PORTFOLIOS AT 85% A YEAR IS DEPLORABLE"

The mutual fund industry has no business investing Social Security funds as part of the much ballyhooed efforts to privatize the system — its costs are too high.

That’s just one of John C. Bogle’s contrarian opinions on the future of the investment business. But going against the grain is nothing unusual to the founder and senior chairman of the Vanguard Group in Malvern, Pa. Mr. Bogle’s shareholder-owned corporation pioneered no-load and indexed mutual funds. Now, the low-cost leader is fast closing the asset gap between itself and industry No. 1 Fidelity Investments.

Q What do you see as the outcome of the debate on reforming Social Security?

A There is a lot of opinion about whether equities should be part of the program or not. That’s clearly a sign of the bull market. In 1987, no one would have recommended equities. But I believe it will happen. I think on balance, and I’m not an expert on all the mechanics, changing the retirement age will come. Changing the contribution level, I think, will not come. Raising the Social Security wage base will happen, which I think is too bad because it’s another form of taxation.

Q What shape will the investment in equities take?

A You probably make an opportunity available to switch 2% to 2.5% a year of the Social Security contribution into your own individual account, and I think that’s the way it will come out.

Q Your 2%, is that 2% of the 6.45% employee contribution?

A No, 2% of the 12.9%. It’s 1% from the employee and 1% from the employer. Then you get the question, how should it be invested? The strongest feeling I have on this is: Under no circumstances under the sun should those investments be entrusted to the mutual fund business.

Q Why not? It seems well positioned to manage the assets.

A My reasoning is this: We know what net return all the investors in aggregate, using the new Social Security self-directed option, will get — the market return. There is no other way. However, they are going to get it less cost.

Administering these tiny plans is going to be much more expensive than anything this industry has ever done. It could even be five percentage points.

Let’s take 3.5% as a sort of modest global number. It’s going to take, in a 6% return bond market, or 5% government long-bond market, an 8% stock market return down to 5%. The two, stock returns and bond returns, are going to be indifferent, actuarially speaking. Yet one will involve very large risk, and one will not.

What’s three-and-a-half percent a year? But if the risk premium is three-and-a-half percent, which happens to be the long-term average risk premium, you have consumed 100% of the risk premium for equities through distribution costs and management costs.

Q How would you do it?

A I would let you pick a stock fund or a bond fund, or both — a balanced fund — overseen by a completely independent federal agency, not even a federal agency, a federal board, and they could deal with the awesome political decisions like whether to include tobacco stocks.

Q How would you keep costs down?

A I wouldn’t put bells and whistles on like the fund industry puts on it. I’d just have a little book entry system. You can confirm to people once a year.

This idea of calling up at 1 o’clock in the morning and saying I want to move my money from stocks into bonds is lunacy, and this business of turning over fund portfolios at 85% a year — the average turnover for stock funds — is deplorable.

I think the federal government could run that at 10 basis points. They have the accounting system right there in Social Security.

Q How will the money management business look in 15 years?

A I think the mutual fund companies should be, but are not, in an almost impregnable position. For example, in August when one read in the paper that almost $11 billion was taken out of equity funds, this industry’s cash flow was almost $43 billion, just about what it was in the previous six months. The cash flow doesn’t seem to change very much. The distribution of that cash flow between stocks, bonds and cash does change. But this industry should be a bulletproof industry, because, what is an investor going to do, other than when he needs the money to spend?

Q You said “should be impregnable.”

A We don’t have the same kind of a lock on it as the insurance companies had. The industry’s problem is that its lock is not the right lock. It’s too expensive.

And unless this industry eventually steps up to the plate and gives the investor a fair shake, people are going to create other investment alternatives.

Marketing costs are terrible. This industry gets around $55 billion in revenue every year. The operating expenses of running a fund –accounting, reports, telephone calls, controls, legal etc. — are probably something like 25 basis points, or about $18 billion.

The profit margin after all costs is probably 45%, say $22 billion in round numbers. And there’s probably $5 billion for investment management and $10 billion for marketing. I have recommended that the SEC do a study and give us the answer to that question, and also to have funds required to report those numbers.

Q What about the role of private investment counseling firms?

A The accounts that really matter to counselors are the accounts run for taxable investors because taxable investors have the most money. There are very, very wealthy families in this country. The bank trust departments know how to do it and they don’t do a lot of trading. They’re very tax conscious. Any wealthy individual is very tax conscious. Look at Warren Buffett. He buys General Re in part for tax reasons. Counselors can give you, above everything else, a tax-managed account.

Q How would you do it?

A I designed a fund that just would have bought America’s 50 largest growth stocks and held them forever. Not an index fund because you don’t sell them, period. If they drop out of the index you don’t sell them, you don’t care, you don’t replace them. You get extraordinary — maybe a point and a half — extra tax efficiency that way.

You have a redemption fee. You want to get out, you have to pay 2%. That’s what we do in our tax-managed funds.

The industry’s liquidation ratio is 33% to 36% per year. I’m counting not just liquidations, but exchanges out of equity funds. That means the average mutual fund shareholder holds his funds for three years. Take it to the fund of funds level. The shareholder of a fund-of-funds turns over his account every three years. The fund-of-funds turns over its account every year-and-a-half, and the funds in the funds-of-funds turn over their accounts every year. What a multiple!

My fund, you run it for 15 basis points.

There’s one other thing you do. You can redeem in kind. When the shareholders do leave, the fund doesn’t realize any capital gains. It’s complicated to do, but it could be built into the system.

Q Are you going to offer this product?

A I can’t get anybody here interested. I can’t go in any more and say: This is what we’re going to do today. Things really worked pretty well when I could, but the ideas were not always popular.

Q Do you think there will be a shakeout in the fund industry?

A There’s a lot of hyperbole in the number of funds. It’s far too many, but a lot of the fund counters count A share, B share, C share and D share. But when you get down to stock funds the number is about 3,000. I think that’s just insanity, and I think that probably a quarter of them, maybe a third of them will be gone 10 years from now.

It’s no secret that funds that do badly get merged into other funds. I see some fund attrition in a different environment, with fewer funds being created. After all, there are 130 or 140 index funds out there, and the world, as anybody who has thought about it for 30 seconds must know, needs one index fund.

Q What do you think about financial planners? Are they good for individual investors?

A Those who think they need help, and many really do need help, should go to a financial planner. I happen to believe the best way is through a fee-only financial planner. And given our structure we like to work with them a lot. I think they will continue to do better, probably at the expense of the broker-dealers.

I think they should put more pressure on the funds.

The only thing that’s going to change this industry is when the buyers speak, and the two buyers who have the heft to do it are the 401(k) administrators and the financial planners.

Similarly with the registered investment advisers, as that business gets stronger, the real impact is to say: If your fund charges over 75 basis points, you are off our list. I’d actually make the cutoff at 45 basis points, but that may take a bit longer.

Q What do you see as the shape of pensions 15 years from now? We’re heading to a mostly defined contribution system.

A We have a very good system now. But everybody’s needs are different. The 25-year-old should not be in the same pension plan as a 64-year-old. We have an opportunity to custom-make pension plans, and that makes a heck of a lot of economic sense.

Q Do you like the defined contribution system?

A There is nothing under the sun that can beat an equity-based plan compounding tax free. And there is no way anyone can beat that return. If you do it through an index fund, it makes consummate sense. The index fund guarantees you 99% of the market return. That’s pretty much true with stocks, bonds, money markets. The average mutual fund in those markets has given you 85% of the market return.

If we compound, say, an 8.5% return against a 10% return over 50 years, you have only 50% of the accumulation. It’s the tyranny of compounding.

Everybody talks about the magic of compounding. The tyranny is that cost differential compounds. So if you can capture 99% of the market return you are talking about double the amount of money at retirement, or maybe $2 million instead of $1 million. Investors will get that message.

Vitae

John C. Bogle, 69, founder and senior chairman, Vanguard Group, Malvern, Pa.

Assets under management: $430 billion

Number of funds: 101 in U.S.; 20 overseas

Largest fund: Vanguard S&P 500 index fund, $74 billion

Number of shareholder accounts: 10 million

Personal: Had a heart transplant in February 1996