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August 11, 2002
David Warsh, Proprietor


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The Future of “Greed”

One of the interesting concomitants of the bear market has been the way that Philadelphia’s Vanguard Investments last month passed arch-rival Fidelity of Boston to take over the top spot among mutual fund companies — at least for now.

What does that signify? Nothing more than that those two exceptional companies have raced over the last 25 years to a draw — each operating according to radically different principles. They will continue to compete for dominance over the next quarter-century.

How they fare — who wins the next leg of the race — will reveal much about the changing values of American society.

Relatively well-known is the story of how a Yankee businessman named Edward Crosby Johnson II took over a sleepy Boston mutual fund called Fidelity in 1943 and slowly built it into the premier firm of a new industry.

Before Fidelity, there were stockbrokers, typified by Merrill, Lynch. They sold individual stocks and bonds to well-heeled investors, what was known in those days as the carriage trade. Afterwards, there were mutual funds, diversified portfolios f stocks or bonds, overseen by professional money managers.

Fidelity didn’t invent the mutual fund, but the company popularized them, with a promise that they would “beat the averages.” A marketing genius, “Mister Johnson” established a star system among his portfolio managers by burnishing the reputations (and the pay checks) of those who got the best results.

Joe Nocera’s 1994 book” A Piece of the Action: How the Middle Class Joined the Money Class” chronicles how this “cult of performance” helped revolutionize personal investing. Gerry Tsai, Fidelity’s gunslinger-in-chief, gained 50 percent for his fund-holders in 1965, while the Dow Jones Industrial Average rose only 15 percent. After that, it became chic to invest in mutual funds.

Even better known is Fidelity’s chapter two. How Tsai quit when it became apparent that Mister Johnson was determined that control of the business should pass to his son. How young “Ned” cut his teeth on computer applications in the early 1970s, then demonstrated a marketing genius surpassing even that of his father.

Whether taking his mutual funds directly to the public, inventing a money market fund with check-writing privileges (and thus improvising his way around the central position of the banks,) investing in massive advertising campaigns or perfecting his back-office operations as a strategic weapon, Ned Johnson was one of the premier businessmen of the late 20th century, with a host of imitators..

Building mutual funds into the dominant investment medium for American families turned out to be hugely profitable, too, thanks to management fees of a percent or so and other operating expense charged against fund returns. Today Johnson’s net worth may be only somewhat less than that of Bill Gates. His well-paid fund managers have done well too.

Far less well known is the Vanguard story. How a young Princeton graduate named John Bogle rose quickly to become in 1965 second-in-command of Wellington Management, one of the oldest and most respected families of mutual fund. How Bogle acquired the go-go Boston firm of Thorndike, Doran, Paine and Lewis the following year to add a touch of glamour to the business, only to find himself fired by his partners when the market turned down in 1974 — but only partly fired.

In desperation, Bogle managed to persuade his board to let him stay on as a kind of internal watchdog for Wellington shareholders, with a sharp eye on the practices of the managers of the fund itself. It was enough. Bogle renamed his small administrative oversight Vanguard — after Nelson’s flagship at the Battle of the Nile — and quickly zeroed in on the expenses of management of the fund itself.

Prohibited from any kind of active management, within two years he formed an index fund — the world’s first. It represented an approach precisely opposite to that of the whiz-kid active managers who had turned him out. Instead of attempting to pick winners, Bogle’s fund would simply model the companies represented by the Standard and Poor’s 500 Index, rising and falling with the broad market itself.

Why? Because experience showed that the average mutual fund had trailed the performance of the S&P 500 by an annual average of 1.5 percent — 9.5 percent v. 11 percents. That 1.5 percent or so differential Bogle attributed to the cost of keeping portfolio managers in colorful suspenders. The investor, not the manager, should capture that extra return.

Vanguard’s index fund appeared at the very moment that an avalanche of theoretical work appeared in the finance literature to argue that almost no one — perhaps no one at all — could expect to beat the market averages over time, since markets were more efficient in processing information that even the best informed or most intuitive individual. Why pay high fees to stock-pickers under those circumstances?

Moreover, because Bogle early on had “mutualized” his funds, buying in their shares from management owners and public stockholders of the management company, investors were also the owners of the funds. The substantial profits realized from Vanguard’s rapid growth reverted to the funds themselves, and became part of their yearly returns.

Good news gets around. Vanguard’s low-cost approach has generated consistently better results year after year than Fidelity’s more sporadically spectacular results — just a little, to be sure, but as Bogle says, 1 percent or so a year adds up mighty fast over time. Vanguard’s Index 500 fund surpassed Fidelity’s Magellan Fund in the mid-1990s as the largest US mutual fund.

And last week, David O’Leary, president of Alpha Equity Research, told Julie Earle of the Financial Times that big flows out of stock funds and into index and bond funds had caused Vanguard to vault past Fidelity for the first time in terms of total assets under management, both stocks and bonds.

Vanguard put its assets at the end of July at $447.3 billion, according to O’Leary. Fidelity possessed $428 billion, he said. Fidelity will release its own numbers later this month, but few doubt that the company’s earnings have fallen sharply. The pressure from discount and online brokers as well as index funds is intense.

The real question for the next 25 years, then, is whose “greed” will prevail — more delicately, whose determination to realize the best investment return? Money managers? Or their individual investors?

Fidelity built a great powerhouse over 60 years through clever marketing. Investors’ high hopes that their champions would possess the hot hand did the rest. Vanguard essentially reversed to process, settling for the market return itself in expectation that over time active management was little better than gambling, by professionals, for professionals, in a game that the house would always win.

For this month at least, Vanguard is the largest mutual fund organization in the world.

* * *

My former best friend Rafe Needleman informs me that after eight months as an independent web columnist, he’s signed on with a business magazine. Some readers will remember that last week I described Needleman’s independent online column as an enterprise similar to mine.

“It was a fun ride,” he writes of the short two-to-four-times weekly column he had written since January — “just not a profitable one.”

So as of August 17, the former Red Herring columnist will be writing “What’s Next” (www.business2/whatsnext) for Business 2.0, an AOL-Time Warner magazine with deeper pockets than Needleman’s former employer, Red Herring magazine.

Perhaps this is typical of the life of an Indie on the Web — at least a typical happy ending. Never mind how common such outcomes are. Those big advertising-driven corporations look mighty comfortable from the outside.

Then again, you never know — until you try. Sunday columns here continue unabated. Look for a second weekly dispatch to begin in the fall.

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