The dramatic growth of specialization in the 20th century has produced some spectacular examples of professions taking advantage of the intrinsic complexity of things to cut sweet deals for themselves. These don’t last forever, but the forces of competition can take a long time to bring them back into line.
Take physicians, for example. The introduction of prepaid, tax-advantaged insurance in the US during World War II created a cost-plus world in which relatively few effective checks were brought to bear on the provision of health care. Doctors treated their patients as they thought best and more or less wrote their own tickets.
Or consider the airlines. The subtle capture of industry regulators by the companies whose business they oversaw led to a half a century of low-stress, high-margin operations that were the next best thing to autonomous. Rich people flew in half-empty airplanes. Poor people took the bus. And airline executives played golf on Wednesday afternoons.
And then there are the mutual finds. For thirty years they have enjoyed every bit as good a deal as the others.
John C. Bogle is founder and longtime chairman of the Vanguard Group — one of the two biggest groups of funds in the US, the other being Fidelity Management and Research. He was at Boston College Law School last week to deliver a lecture on the history of the industry.
As it happens, the very first mutual fund in the United States will turn 80 in March, having been invented as the Massachusetts Investment Trust on March 21, 1924.
The idea was something new under the sun: a pool of funds contributed by investors, mutually owned by shareholders but managed by trustees who held the power to invest its assets at will, and who were to be compensated at what was then the current bank rate for trustees — 6 percent of the investment income earned by the trust.
Everybody gained from the new arrangement. Investors enjoyed the advantages of diversification and professional money management. Managers made a good living, depending on the quantity of funds they were able to attract. And so, as Bogle recalled, the new arrangement was a remarkable success.
The Massachusetts Investment Trust (or MIT as it then was called, the engineering school in East Cambridge in those days being known as Tech) earned 88 percent for its investors between 1926 and 1928. Its assets at the beginning of that period? A total of $3.3 million!
Then came the Crash. Investors saw the value of their shares drop 63 percent.
But the market revived and MIT’s assets grew apace — to $128 million in 1936 to $277 million by 1949. It was the largest stock fund in the industry throughout the period. It would remain so until 1975, when its assets would total $1.15 billion.
“To its enviable status as the oldest and largest mutual fund, MIT added the luster of consistently ranking as the lowest-cost fund,” continued Bogle. “Its trustees soon reduced that original 6 percent fee to 5 percent of income, and then, in 1949, to 3.5 percent.”
Measured as a percentage of fund assets — the now-conventional yardstick known as the “expense ratio” — the costs of managing MIT fell from half a percent in the early years to 0.39 percent in 1949 to a fairly steady 0.19 percent during the 1960s. The fund was offered to the public through stockbrokers by underwriter Vance, Sanders & Co.
Unaffiliated with the distributor, MIT was not so much a business as a bastion of professional management — almost priestly in its devotion to the interests of its investors.
Until 1969. That was the year that trustees asked shareholders to “de-mutualize” their fund and turn it over to the same kind of external management company as all the rest of the funds in what during the 1960s had become a rapidly growing industry.
Managers would earn a fee based on the assets they managed instead of the income they earned — the fee to be paid partly by existing shareholders and partly by newcomers.
Shareholders agreed, and MIT became a part of Massachusetts Financial Services (MFS).
What had happened? Mutual funds had been discovered by the investing public during the 1960s. Those were, after all, the “go-go” years. Thanks to a buoyant market, fund managers discovered that they could charge higher and higher fees for their results.
The reason why is not hard to understand. Almost always, somebody, somewhere, was beating the market, as some relentless flipper of coins somewhere might be consecutively flipping heads for a little longer than the law of averages would lead you to expect. Fund managers who achieved these above-average returns became stars, pursued by investors who didn’t mind paying slightly higher rates. The returns eventually fell back to average, of course, but the fees didn’t.
Was the change for the better? According to Bogle: “We can say unequivocally that, in terms of the fees it generated for its managers, it was good. We can also say unequivocally that in terms of the costs borne by its shareholders, it was bad.
The expense ratio that in 1968 had been 0.19 doubled to 0.39 by 1976. It doubled again to 0.75 in 1994 before going through the roof in the mania of the late 1990s — to 0.97 in 1998 and an astonishing 1.20 percent in 2003.
Long before, the old limit on management fees of 3.5 percent of fund income had disappeared, fees paid to MIT’s managers consumed 80.4 percent of the trust’s income in 2002!
And as if that were not enough, MIT’s average rate of return to investors had steadily declined in the period of its new ownership structure. Its managers lagged the Standard and Poor index by only a little during the period of its demutualization (1969-2003) — 8.4 percent annually instead of 9.7 percent.
But thanks to the magic of compounding costs, MIT’s total returns were much worse — $23.60 in 2003 for each $1 invested in 1969, instead of $38 invested in the index.
Meanwhile, thanks to the series of ultimately happy accidents in the late 1960s and early 1970s that he described in his Boston College lecture last week, Jack Bogle found himself in command of a small investment management company that was enjoined from actively managing. Whereupon he invented the world’s first stock index mutual fund, designed to mirror the performance of Standard and Poor’s 500 Stock Index.
Today that index fund is the largest mutual fund in the world. And Vanguard, operated for the most part along the lines of the old MIT, has become the lowest cost group of funds in the industry.
Whereas most of the rest of the mutual fund industry has become embedded in giant financial conglomerates — of the fifty largest fund complexes, only six privately held firms remain, while seven are publicly traded and 36 are owned by the likes of Citicorp, Deutsche Bank, J.P. Morgan. AXA and Marsh and McLennan. Only Vanguard clings to the original ideal.
Mass Financial Services, owned now by Sun Life Financial of Canada,, was in the news last week. It was reported to be on the verge an agreement with regulators led by New York Attorney General Eliot Spritzer to pay as much as $200 million in penalties for having permitted after-hour trading by hedge fund operators and other favored traders engaged in market timing.
That’s bad, I suppose. The apparently illegal trading racked up big gains for insiders and diluted returns for unsuspecting investors in MFS funds. But what about the $2 billion of pre-tax profits that MFS earned for Sun Life, thanks to that 1.2 percent operating ratio? (The fund complex is the only 11th biggest in the United States, the third biggest in Boston.)
The high fees are completely legal, of course, the same way that high margins are legal on almost any kind of branded goods sold on the basis of its heavily-advertised secret ingredients for as much as the market will bear. And savings are a lot better for your health than cigarettes.
But how much longer before public awareness begins to catch up with the sweet deal that the fund managers have cut themselves? The answer is that it has already begun to happen. As Bogle told his audience last week, “I have no illusions that a return of the industry to its original …model will be easy — not in the face of the powerful forces that are entrenched in this industry and whose economic interests are at stake.
“But I believe that this is the direction in which shareholders, competition, regulation and legislation will move. While we won’t get all the way to that goal in my lifetime, and maybe not even in yours, I am certain that investors will not ignore their own economic interests forever.”