Vanguard: A Low-Fee Manifesto

With $250 billion in assets, 8 million shareholders, and over 5,000 employees, the Vanguard Group is the second-largest mutual-fund complex in the United States. As founder and chairman of the company, John C. Bogle is considered an iconoclast within the industry for his outspoken calls for lower costs. Under Mr. Bogle, Vanguard led the way in serving customers through direct-mail sales and services, rather than through brokers. In 1976, Vanguard introduced what has come to be its hallmark: index funds. These "passive" investments mirror the holdings of indexes such as the Standard & Poor's 500, thus reducing management costs and taxes. A graduate of Princeton University, Bogle has an extensive background in finance. He was interviewed by Monitor staff writer Guy Halverson at Vanguard's modern 200-acre headquarters near Philadelphia.

You revolutionized the industry with the index fund. Is there any new product that you envision as its successor - a second wave of competition?

I don't see a second wave of products changing the price structure.... But I do see another source of [potential change] ... independent directors of the funds. I don't think independent directors do the job they should, of standing up for the rights of mutual-fund shareholders whom they've been elected to represent. I think they could do a much better job.... They should be looking for fee reductions in many cases.

How would you make those independent directors - the trustees who are not otherwise employed by the fund company - more responsive?

It would help, for example, if the Securities and Exchange Commission, the chairman of the SEC, were to stand on his bully pulpit and do a little preaching about getting fees down.... The Investment Company Act [of 1940, the industry's governing legislation] is quite specific in saying that the directors must put the interest of shareholders of mutual funds ahead of the interests of management companies. I simply don't believe that that's being done adequately. I think the combination of director responsibility and fund competition will in fact bring fees down.

Have 12b-1 fees, covering advertising, marketing, and distribution costs, been unfair to small investors?

Absolutely. The existing shareholders of the funds are paying higher fees to bring new shareholders in. Now, the question is, does bringing new shareholders in do any good? Well, the argument is advanced that it reduces fund expenses. The fund gets larger. Now in some cases, and by no means all, ... fees might go down.

Vanguard is known for low fees. How important does that continue to be?

Keeping our costs low is certainly "mission critical" here at Vanguard. It's central to what we do. Our funds own the management company and therefore receive all the profits [$1.2 billion] from the management company's operation. [Most fund-management firms are owned privately or by publicly traded corporations, charging funds fees for their services. The funds are legally independent, though they rarely exercise the option of switching management firms.]

How do you keep costs down when so many companies are raising fees?

A huge portion of our low costs comes from the fact that there's not a profit-making company at this end of the line. The mutual funds are in fact mutual funds.... We spend an infinitely small amount on marketing. Our advertising budget is around $6 million. Some of our competitors are spending $100 million.

You say some companies are beginning to see the advantages of reducing costs or that some companies will be forced to do so. Why?

Two reasons. The most important one is competition. There is at least a vestige of cost competition in this business, in the money-market funds.... If you want to have a higher yield you have to lower costs. Sad to relate, the industry isn't fully honoring the spirit of that principle, ... because they have all these temporary fee waivers to make the yield look high for a little while.

The second thing is the index fund.... The reason for the success of index funds is that their costs are so low. There is no other secret. That puts the performance pressure on, because the index ends up doing better than about 85 percent of all mutual-fund managers over time, the last 16 years say. It's actually 87 percent.

What are shareholder expenses on your S&P 500 index fund?

About 0.2 percent - 20 basis points. The average equity fund, according to Morningstar, has an expense ratio of 140 basis point [1.4 percent of assets]. In addition, the average mutual fund is trading a lot, [thus there are commission costs].

So over time the average mutual fund falls about 1.8 percent shy of the Standard & Poor's index. That means that if the index produces about a 10 percent [annual] return, the average fund will produce an 8.2 or 8.3 percent return. Over time, that's a devastating difference in compound rate of return. If you invested $10,000 for 30 years at 10 percent, you'd end up with, let's see here, $174,000. At, say, 8.7 percent, it would be $122,000. That's a $52,000 difference. In fact, more than five times the amount you started with for saving just a few dollars in cost.... Fees make a huge difference.

Are there now too many mutual funds, at 7,000 or more?

Well, I don't think we need any more funds.... For an investor with a 20-year time horizon, for example, he might as well be in one single fund.... And it might as well be an index fund. Now, the world's not about to accept that, so I would say, buy a middle-of-the-road fund, knowing the manager will change.... This should be a buy and hold business.

Are you comfortable about the duration and pace of this continued economic expansion?

The economy, in the broad sense, is the strongest within my recall. We're having solid growth ... and extremely low inflation.... Inflation will heat up some, but it shouldn't be too bad.

Is the market a little overvalued?

It could be significantly overvalued. Right now common stocks are yielding only 2 percent [in dividends], and they've yielded under 3 percent only half a dozen times in the modern history of the United States. At the worst we could be going through a period of somewhat negative [overall] market returns and probably at the best ... returns that are closer to the long-term norm.

So investors should set their sights a little bit lower?

I would be focusing on a [market] return of about 10 percent [a year].

How do you rate the financial press?

I give them a gentleman's C. There's too much lionizing of portfolio managers.... I don't think they've ever given adequate attention to fee increases.