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Rekenthaler Report

Jack Bogle's (Somewhat) Accidental Legacy

The leader of the low-cost and index-fund revolutions probably will not be remembered for his favorite innovation.

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Serendipity
At first glance, Jack Bogle’s career appears to have been fully by design. After all, the man wrote his undergraduate thesis about the mutual fund industry. If there ever was somebody who had his life’s work planned from an early age, it would seem to be John Clifton Bogle.

Not so. After college, Bogle planned to enter banking--until a mutual fund company, Wellington Management, contacted him to schedule an interview. Several years later, when still at Wellington, Bogle orchestrated a merger with another fund company that became unsuccessful, leading him, as he was later fond of saying, to be “fired with enthusiasm.”

The year was 1974, and Bogle was an ex-CEO receiving severance payments. An unlikely revolutionary! Necessity, however, mothered invention. Seeking to remain with Wellington Fund, Bogle proposed to the fund’s directors that Wellington Management continue as the fund’s investment advisor, but that a different company serve as the administrator. They agreed. So began The Vanguard Group, with Bogle as its head.

The Ownership Argument
Although separating the fund’s administrative and investment-management functions occurred mostly by happenstance, another Vanguard feature was premeditated: its ownership structure. Long before Bogle was terminated by Wellington Management, he had suggested that mutual fund companies should be owned by their funds’ shareholders. The resulting organization would, in effect, behave as a nonprofit organization.

Therein lay Bogle’s primary affection. He spent the rest of his life arguing that what mattered for a mutual fund sponsor was how it was owned. Worst were publicly traded companies, or subsidiaries of larger firms, when outside shareholders expects steadily rising earnings. Better were private partnerships, where the desire for profits was tempered by patience. Best, however, are organizations that avoid the profit temptation entirely. Such firms must satisfy only one set of shareholders, not two.

Bogle never stopped beating that drum. Partially, to be sure, because Vanguard remained the only mutual fund company to claim that structure. Bogle was an evangelical, but of a practical bent. He knew which sermons were best for business. But the belief was genuine. In the final year of his life, this past June, Bogle maintained to a group of mutual fund observers that Vanguard’s ownership arrangement made everything else possible. He meant it.

An Unstoppable Trend
With respect, I disagree. Vanguard’s structure accelerated the movement toward lower-cost investing. Because the company was not concerned with generating profits, as they are conventionally measured, it could readily slash its funds’ current expenses, in the expectation that, over time, the ensuing performance advantage would attract additional buyers. Vanguard sold to retail investors, but it thought like an institutional manager.

But either way, the movement to low-cost funds was inevitable. Unless higher fund expenses lead to higher gross returns, which in aggregate they do not, such costs directly harm shareholders. Every dollar that exits a fund, for any reason, is one dollar less that shareholders now possess. That math is easily understood. It was just a matter of time before the broad investment public concurred. Today’s mutual fund cost wars were inevitable.

To be sure, without Bogle’s innovation of the mutual-ownership structure, the movement toward low-expense funds would have occurred more slowly. But ultimately, the cost battle was coming. Consumers would have forced the issue, and the marketplace would have responded to meet the demand.

Gaining scale by becoming an industry’s low-cost provider is a common business strategy. In most sectors, the CEO who devises that strategy is motivated by profit (for example,  Amazon.com’s (AMZN) Jeff Bezos). They require no innovative ownership structure to forgo today’s margins for tomorrow’s scale. They recognize that the potential payoff is huge. They have a longer-term outlook than do their rivals.

That was Bogle’s first bequest to retail investors: the vision to realize that dramatically lower fund costs would be a win-win. Fund shareholders would benefit immediately, through higher returns. Vanguard would take longer to prosper, because sales would materialize only after the performance was posted, but sooner or later those assets would arrive. Bogle bet that retail investors, in the final analysis, were rational--and he was correct.

In founding Vanguard, Bogle created a useful ownership structure, but what really mattered was his conviction that if he rewarded Vanguard’s shareholders, they eventually would reward Vanguard in return.

The First Indexer
The other contribution for which Bogle is noted is, of course, the invention of the retail index fund. Being so highly recognized for that achievement might well have surprised his younger self. To some extent, the launch of the  Vanguard 500 Index Fund (VFINX) owed to chance. As Vanguard was established as an administrator, the company initially was reluctant to launch funds that would be run in-house. An index fund, though, was different. Its portfolio would be unmanaged, and thus suitable for Vanguard’s mandate.

Thus, while Bogle was the most logical person to devise the first retail index mutual fund--because he had long followed the academic research and was aware that most active U.S. stock-fund managers had not beaten the S&P 500 after their funds’ expenses were paid--there was an element of chance associated with that event. Vanguard was not established to provide index funds. It just happened to create one in 1976. It would be more than a decade before Vanguard launched another.

Bogle’s view of index funds differed from those of many of his disciples. He had no particular preference for passive strategies, as opposed to active management. Either was fine. What concerned him was cost. Yes, a cheap index fund is better than an expensive actively managed fund, but the reverse also holds true. Index funds aren’t good because they index. They are good because, for the most part, they are cheap.  

Wrapping Up
Perhaps the future will bring converts to Vanguard’s corporate structure, so that Bogle’s “great idea” remains in investors’ memories. But it has been more than 40 years since Vanguard’s inception, and there have been no takers yet. That event seems unlikely. What is certain, though, is Bogle’s position as the fund executive who most helped investors, by pushing the industry toward offering lower-cost investments, and by sparking the index fund rebellion. History will not soon forget those contributions.

Addendum: Some of the details about Bogle’s early background, and Vanguard’s creation, come from “John Bogle and the Vanguard Experiment,” by Robert Slater.

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.