David and Tom Gardner recently interviewed Vanguard Mutual Funds founder Jack Bogle on The Motley Fool Radio Show on NPR. Bogle, who is credited with popularizing the index fund, is currently the president of the Bogle Financial Markets Research Center. This is the first of four parts.
TMF: Jack, let's get right to it. In light of the ever-widening scandal, what is wrong with the mutual fund industry?
Bogle: It has a profound conflict of interest between the managers who run the funds and the shareholders who own them.
That is the nub of the late-trading and market-timing scandals. The managers have been doing things that are disgusting, for want of a better word. The late trading is simply illegal and unethical to boot. The International Time Zone trading where they allow certain investors, privileged investors, to time the markets when they know, as Attorney General [Eliot] Spitzer says, "which horse has won the race."
It has been known about for years, at least a decade. Articles have been in The Financial Analyst Journal about it. No surprise there. The general level of mutual fund timing is just plain too high. There is too much trading money sloshing around in this industry that was designed for long-term investors.
TMF: Now, Jack, a lot of our listeners, I think, own mutual funds because they were sold them by a broker or a financial advisor. So let's talk to that listener directly. How big of a problem do you think this is for the average person out there who owns mutual funds?
Bogle: In terms of dollars and cents, these problems are not large. If the managers who have been caught with their hand in the till were to make good on the dilution, the typical shareholder might get a penny a share. I would bet even that might be large. As far as we know, they are not big.
What is big about them is they point to the big conflicts of interest that go on in this industry because of (A) our high cost structure benefiting the managers and hurting the shareholders, and (B) our unbelievably heavy emphasis on marketing. We are always selling the wrong funds to shareholders at the wrong time.
TMF: Let's talk about four of the major areas that you identify as good for mutual fund managers, but bad for the rest of us. Let's start with market timing.
Bogle: Well, I have touched on that a little bit. It is mainly the nibbling away of small amounts of money from long-term fund shareholders in favor of short-term traders. That is the number that I don't think is too large, but that doesn't mean it is ethical. I recently used the example of the young kid who goes to work in a one-man grocery store and he figures out by the second day that the owner wouldn't notice it if he took $5 out of the till every day. He did and the owner didn't. Does that make it right? I don't think so. It is theft.
TMF: How about management fees and what do you think a reasonable fee for a mutual fund is?
Bogle: Management fees in this industry run about 1.6% for the average equity fund. By the time you add in portfolio turnover costs, which nobody discloses, and you add the impact of sales charges and opportunity costs because funds aren't fully invested, and out-of-pocket fees, you are probably talking about another 1.4% of cost, bringing that 1.6% management fee or expense ratio up to 3% a year. That is an awful lot of money.
TMF: That is right. In a world where the market on average goes up 10% a year, to give away three percentage points of that gain is painful.
Bogle: It is very painful and if you compound that over time, what it means is that over 30 years a long-term investor in funds is going to get about half as much as an investor who doesn't have any cost at all. The dollar compounded at 10% is going to grow to about $18.50. A dollar compounded at even 7.5%, assuming a 2.5% cost, is going to grow to $9.25.
TMF: Huge difference.
Bogle: Huge difference. What you are seeing is, I am a mutual fund shareholder and I put up 100% of the capital, I take 100% of the risk and I get 50% of the return. The croupiers or the financial intermediaries put up 0% of the capital, take 0% of the risk, and also get 50% of the returns.
TMF: Big rake. Jack, we are talking about things... well, really, we are talking about good for mutual fund managers, bad for mutual fund investors. Going down our shortlist, you have covered market timing, which we have talked about. Management fees, right there. What about growth in a fund size? Why is that good for them, bad for me?
Bogle: What happens is that people I think very inadvisably often buy mutual funds when they are of moderate or small size and the manager has developed a very excellent record beating the market year after year. It is the nature of this business that people think the past is prologue; it is actually anti-prologue.
But people pour their money into that fund and it gets bigger and bigger and bigger. The management fees grow right up with the fund, but the fund stops doing well. Why? Because turnover costs are higher because opportunities to buy smaller stocks are limited. To have a fund where a stock makes an impact on the portfolio -- it's much more difficult on a $20 billion fund than on a $500 million fund. So it gets tougher and tougher for the fund to do well and it gets easier and easier for the manager to make a large profit.
Tomorrow: Bogle talks about the prevalence of the mutual fund scandal.