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The Soul of Capitalism: John Bogle Interview

One of my favorite books this year is The Battle for the Soul of Capitalism: How the financial system undermined social ideals, damaged trust in the markets, robbed investors of millions—and what to do about it by John C. “Jack” Bogle, the founder of Vanguard (i.e. the pioneer of no-load index funds, which revolutionized the industry). This ambitious book requires your full attention. Bogle draws from his authority as a key player in the world of finance over the past 50 years, who has revolutionized the investment industry, witnessed huge changes, and never backed down from a fight. His book takes on the whole rotten system, and bears reading for a number of reasons.

Battle tackles the systematic rot gnawing at the effectiveness of large corporations, the power of small investors to beat the system, and the integrity of enterprise as many of us see it. Bogle cites isolates trends that other writers have noted, such as out-of-control CEO compensation, the dereliction of duty by boards, the systemic siphoning of profits away from investors by conglomerate-owned managed funds, and weaves them all together into a compelling overall argument. Not only that, but he writes wonderfully, to boot. It’s hard to argue with a book so smart and persuasive. The first chapter is available online as an excerpt. Here’s a nugget that I particularly enjoyed:

Over the past century, a gradual move from owner’s capitalism—providing the lion’s share of the rewards of the investment to those who put up the money and risk their own capital—has culminated in an extreme version of managers’ capitalism—providing vastly disproportionate rewards to those whom we have trusted to manage our enterprises in the interest of their owners. Managers’ capitalism is a betrayal of owners’ capitalism, a system that worked, albeit imperfectly, with remarkable effectiveness for the better part of the past two centuries, beginning with the Industrial Revolution as the eighteenth century turned to the nineteenth.

Earlier this fall I had the chance to do a question and answer with the man called Jack. Here’s what he said.

Q: Jack, you are one of the most influential investment figures of the past 50 years. Why have you written this book?

A: This is meant to be a lot more than a business book. It addresses this country’s role in the world, and our faltering practice of capitalism. We have turned a system of owners’ capitalism (where the idea is to earn the maximum return on the capital invested by the owners) into managers’ capitalism. In corporate America, the investor-owner is now at the bottom of the food chain, and managers are at the top. And there’s a very simple equation at stake here: the more that managers of America take, the less that investors make. This formula may not be up there with “e=mc squared,” but it is tautologically true. I say in the book that if investment returns are 7 percent annually and the system takes 2.5 percent then you are left with only 4.5 percent.

One key problem is that we’ve gone from an own-a-stock society to a rent-a-stock one, which has a terrible impact on the shareholders. When, as Larry Summers asked, was the last time you washed a rental car? Likewise, when was the last time someone voted a rental stock? The typical fund manager with all that turnover doesn’t care about real business value. And index managers, on the other hand, can’t follow that threadbare rule of ‘if you don’t like the manager sell the stock.’ Instead, they should be advocating a model of ‘if you don’t like the management then change the manager.’ They should be an activist in corporate proxies, by putting proposals in the proxy to limit compensation, for example, and by nominating directors. But you can’t find a fund manager like this. When was the last time there was any proxy proposal raised by a mutual fund? Isn’t that amazing for an industry which owns 28 percent of corporate America?

It’s very clear from a statistical standpoint that all this high turnover is to the disadvantage of fund shareholders. When I came into this industry, turnover was around 15-16 percent annually, and now it is 100 percent. This just doesn’t work in the long run. Fund shareholders will eventually gravitate toward more intelligently run mutual funds. They will encourage funds to focus more on the long run than the short run. People laugh at me, but it is going to happen. These ideas are on the right side of history. They are so fundamentally common sense.

Q: Your book takes on more than fund management however. It critiques the way corporate boards govern and how CEOs manage their companies. Why take such a systematic approach?

A: It’s all of a piece. You have the CEO compensation issue, where the game becomes not to build the company but to build the price of the stock, and then to capitalize on stock options. The fact of the matter is that everyone knows that the value of the stock is the discounted future cash flow, plain and simple. That’s it. And yet we have this industry practicing witchcraft. You have CEOs promising earnings growth of 11 percent annually and delivering six. You wonder why they don’t get fired! The real question that motivates them is ‘how do I drive the stock up?’ And they do this by making outrageous projections and then doing whatever they can by hook or by crook to achieve these projections. And to accomplish this they bring others into the system. One of the most egregious examples of course is Enron, which involved conspiracy with the accountants. And why do the accountants conspire? Because on a basic level, the companies pay them. The companies pay five times as much for consulting services than for accounting, so, naturally, the accounting firms did not want to lose the consulting business. Then in the mutual fund business you have the failure of directors who are captive to the fund managers who sit on the other side of the table. These executives are generally the kind of men you’d like your daughter to marry—I’ve never met a corrupt person in the industry. But the industry itself is corrupt because it is taking too much money out of the returns and is ignoring its fiduciary duty to fund owners.

In the old days, directors answered directly to the stockholders. But we no longer have direct representation. That ended in 1981, which was the last year that more than 50 percent of public equities was owned by direct investors. We went from 92 percent of individual ownership in 1950 to 32 percent today. And what has emerged at the same time are financial agents whose ownership rose from 8 percent to 68 percent. Astonishing! But these agents don’t represent the interests of the principals . . . largely mutual fund shareholders and pension beneficiaries. Today the money management companies are largely owned by giant conglomerates, and their goal is to earn a return on their capital, not on your capital as a fund shareholder. They have a fiduciary responsibility to shareholders, and they also have to make as much money as possible for their owners. They are serving two masters. And what necessarily happens is that they serve the one that is paying their compensation. So you see it’s all of a piece.

Q: How do you change it?

A: I don’t think that change is going to be easy. The book is my attempt to give a little impetus to the changes that we have to make. When I say investors of the world unite, I mean it. There are several key things we must change. The biggest risk to our financial system is the failure of our retirement system. Right now half the savings assets of the American economy—nearly $10 trillion—are in retirement plans, which are failing badly. The problem is that over an investment lifetime only about 25 percent of the rewards go to the investors and 75 percent go to the intermediaries. We have to change this. We need to have a federal blue ribbon commission to study the entire system. Right now we have a whole series of isolated pockets of retirement savings when we need an integrated system—something that would be linked, for example to corporate 401k plans and corporate pension plans, which would be integrated with the social security system. But in order to do so we need to make sure that there is a federal standard of fiduciary duty. We need to codify that standard and state what it means. We also need to have a massive education campaign so that investors understand simple investment fundamentals, and the confiscatory power of trading costs and fund expenses. The sooner investors look after their own economic interests the better off they will be.

Q: You continue to advocate index funds. Couldn’t your prescriptions be seen as somewhat self-serving?

A: I don’t see how. Vanguard index funds are the core of what I am talking about today: giving the investor no more and no less than his or her fair share of whatever returns the financial markets are kind enough to deliver. That’s just what I said in my senior thesis from college in 1951 and have said ever since. I have no vested interest in whether or not Vanguard gets bigger.

I do believe that we are seeing some positive change. The best investors today are accepting the message of index funds and low-cost investing. Peter Lynch said years ago that most investors would be better off with an index fund. How could he be wrong? The numbers are there. Jack Meyer, who is leaving Harvard, says the investment industry is a giant scam. And David Swensen of Yale calls the mutual fund industry a colossal failure for individual investors. You can even go back to the legendary Benjamin Graham, who in a late interview in 1976 seemed to indicate that indexing was the best strategy. Nobel Laureate Paul Samuelson challenged those who had brute evidence that management worked in favor of the investor to prove it. He’s still waiting. Warren Buffett has recommended low cost index funds for decades. If those investors are all agreeing, then sooner or later people will sit up and take attention. When the dumb investor realizes how dumb he is and buys an index fund, he immediately becomes a smart investor.

For investors to gain the almost universally accepted benefits of maximum diversification, they must have intermediaries, whether pension funds or other managed funds, to pool their resources and own literally hundreds of stocks and bonds. So agents are necessary; we have an agency society. And the whole darn book can be summed up by the fact that these agents aren’t representing their principals. We need a fiduciary society where we enjoin the agents to represent their principals, a society in which stewardship and trusteeship are the watchwords.