welcome to books of our times produced
by the Massachusetts School of Law
today we shall discuss a book that
details underlying reasons that led to
the stock market bubble of the  nineteen
nineties
the collapse of the early 2000's and
huge losses for investors
many of those reasons relating to
corporations and mutual funds
still exist and still threaten us today
unfortunately
the book discussing the underlying
reasons is the battle for the soul of
capitalism
by John Bogle for over 30 years Mr
Bogle  has been one of the Giants of the
mutual fund industry
he is the founder in the early nineteen
seventies and for many years was the head
of the famous Vanguard family of
mutual funds Vanguard is one of the
leaders of the industry
and for decades mister bogle has been a
leading critic perhaps the leading
critic of
practices that widely prevail elsewhere
in the industry
because if his  founding of vanguard the
innovations he wrought there
including so-called index funds and the
constructive criticisms he is regularly
leveled
John Bogle has been called one of the
four most influential investors of 
the entire one hundred years of thue 20th century Mr. Bogle is with me
today to discuss his book
and I am Lawrence R. Velvel  the Dean
of the  Massachusetts school of law
John  thank you for coming up from the
philadelphia area Valley Forge is not
valid forge pennsylvania great to be with you 
famous in history song and story John 
early in your book I think it might be
the very first part of your book 
very first thing in your book you
compare what is happening 
in the american economy to the fall Rome
what are the points of comparison that
you see why did you do that
well I did it in part to catch people's
attention to the fact or 
direct people's attention to the fact that we
have become a great world empire
and there's no evidence that any Empire
last forever so that comes up in the
book right at the beginning
as a warning yeah for what can happen if
you get a little arrogant if you get too self indulgent
a most unpopular thing  to say
to americans by the way
it's very unpopular that's not
my cause  is not popularity
yeah but the fact is the Roman
Empire was the strongest power on earth
as we certainly are they had frontiers
that went
basically to the edge of the water we're 
surrounded by two oceans
 they had a working Constitution
believe it or not in those days
as we have had here and a whole lot of
other things
I mention in  the book that just as the
Roman Empire had its bread and circuses
so do we have our bread and circuses
yeah so it's a warning
that this too shall pass away if we
don't wake up
and repair some other problems in our
corporate system in our  investment system
and in our mutual funds system at lunch
with our faculty you pointed out that you start the book or  early on 
you have a
 perhaps a 10 or 15 line quotation
from
from Gibbons on the Decline and Fall and
you had to change it
only very sparingly to make it perfectly
suitable for the circumstances of the
United States
I think the readers of  the book will be
amazed because I
I took the trouble to put the footnote
showing  the actual quote from your
from Gibbons great decline and fall of the Roman
Empire yeah
right at the bottom of the page my
revise quote is and
the similarities are stunning yes && you
had to change it so little that
you would plainly be  called
plagiarism were it not for the 
fact that you identified who it  was and gave
the whole quote you are exactly right
Indeed indeed Joh I personally have felt 
for quite a while now and have brought
it up from time to time in our
television shows
that the fundamental problem if there is 
is
a fundamental a single fundamental
problem overarching problem
in the  United States is dishonesty in  all
its forms
I get the sense that from what you say your 
stress on integrity and ethics and
morality in business and elsewhere
that you don't wholly disagree
with that
yeah I I'm not so sure about use the
word
dishonesty but there's certainly 
lower ethical standards I've never said
business conduct is today's business
leaders are less ethical tha
business leaders of 100 years ago
fifty years ago I'm not sure they are
but what  I am sure of absolutely  sure of is
the standards of what we consider
ethical
conduct have been greatly debased so
what's ethical now is
what you have to do to meet Wall Street
expectations
and what you must do because everybody
else is doing it
and those aren't ethical standards
ethical standards to me
are absolute standards and not relative
yes yep
will get into a lot of that Jo
because when one talks about
stock options and the funny money
accounting
that was indulged to make them possible
my I think this is a
pluperfect examples of what you're
talking about
I do you feel well
you talk a couple times in your book and
you mentioned at lunch
that you wrote a thesis in 1951 I guess
all seniors at princeton to this day
have to write theses
that's correct and you wrote a thesis on
the mutual fund industry
which by the way I'd like you to explain
became a book
and also I have the sense that when
writing that thesis
you formed ideas about the investment
company
business or the mutual fund business
ideas which largely I guess reflect your
own ethical background
and ideas which you have never really
changed in the last 50 years
want to comment on all of that sure I think that's
very fair
the title of my senior thesis was the 
economic role of the investment
company that is the mutual fund what did it
do for the economy what did it do for the 
investors
and it occurred to me the most important
theme there is
the business must be beholden to its own
shareholders
the role of the mutual fund I think I'm
pretty much quoting directly from the
thesis right here
is to serve to serve both individual
and institutional investors
and we had the the businesses that exist
today
is a business that serves the interest of the 
managers of mutual funds
before it serves the interest of those
shareholders
who own it and like a typical idealistic
young college student my thought was
how do you make this a better industry
and one of the  quotes which I
think I can still remember pretty
directly
is mutual funds must be managed in the
most efficient
honest and economical way possible
i also said mutual funds can make no claim
of superiority over the 
market averages which is in a  way an
early thought
maybe we want an index fund that simply
represents the market averages
yeah so it was very idealistic very
impassioned
and you could argue that it's kinda
sophomoric idealism at its worst
or you can argue it's the design for
the firm I would create a
quarter-century later a
firm called Vanguard well I used to know
a fellow whose
quite a famous guy I don't think I have to 
his name and
he would always worry when he went to
court if he didn't win
didn't win a case he said I lost something off my
fastball
and I don't think you've lost anything off your fast ball
well you know my convictions are which I
think makes them really wonderful
is they're very simple they're the  essence of 
simplicity
and they depend on simple arithmetic
Larry  and I call this I've come to  call this
after a quotation from justice brandeis
yeah the relentless rules  of humble
arithmetic
and if  investors would only understand
as a group they share the market return
and therefore let's say the market goes
up 10 percent and therefore as a group
once they paid the cost of acquiring
that return what we call financial
intermediation cost
they lose to the market by the amount of
the cost so the  central arithmetic of
the investment business is that beating
the stock market
for investors as a group is a zero-sum
game
and beating the stock market after cost
is a loser's game yeah if  people just
understand that they'd 
understand why indexing works yeah
because it takes
less than anybody else yeah
well we'll  elaborate that a let me ask
one other question
go back to one other question your
thesis
is one of  I gather relatively few or very
few
that has ever been published as a book
at princeton university
I'm told they're just been two that
anybody knows of
two  in like a hundred years ya as
long as anybody can remember and yeah
one of them was mine and I should say parent parenthetically
that it did not get published until 2001
I see they made you wait  fifty years they mad me wait  fifty years they did display at
the library
and and the other has to be a an equally
maybe even more idealistic thesis by
Wendy Kopp called teach
America ah yes a thesis for the business she
created
even as my Princeton thesis
turned out to be the basis for
the business I created about bringing
young people out of  college and 
into the areas of American Society that
really need help in teaching right right  the underside of  society the less
privileged  side
right right now john
do you think that that the kind of  non
fiduciary mind said if I might put it
that way
what let's first of all define if you
will for the audience I mean we lawyers
know and you  investment folks know
but explain what a fiduciary mindset
is a fiduciary mindset is simply a
mindset that says my clients come
before I do yeah its service to others
before service to self
it's in the technical sense it's the
role of a trustee of 
a pool of money or of an estate or a
mutual fund for that matter
who says I'm not running this for my
benefit
I'm  putting the interest  of those mutual
fund shareholders the  beneficiaries of that 
estate or whatever it might be
the beneficiaries of  the pension plan in a
corporate sense first
I'm not gonna take excessive amounts of
money out of that I'm  not gonna do things to that
pool of  assets
that hurts those shareholders I'm going to  do
everything I can to help them
now I think the last thing you said
is really  the
the crux of the problem because every
lawyer
every fund manager everybody who runs
money
every architect everybody wants to make
a living
 the real question is do you not 
let
unlimited greed get the better of you do you
not make all the money possible
just because you can make it
but instead
confine yourself limit yourself because
you have this overriding responsibility
to others
you think that's a fair way to look at
it yes it is a fair way to look at it
and we know for example in the mutual
fund industry
just because of these relentless rules of
humble arithmetic
that as a group the more money the
managers take yeah
the less money the investors make yes so
and
in great bull markets which is a big
part of this the kind of super
stock markets the best market in the
history of the nation and for that
matter in the world average gains
over twenty years up 18 percent per year
pretty much year after year let people
still give
all a lotta money that they were
investing went way up in value because it
got overvalued and not because the
underlying stocks did the 
underlying  companies did so well and that
meant you could take a nice
slice off the top and in effect nobody
worried it didn't 
 make much of a difference you know
 because the markets were so
good
right right that's kinda typical of 
bubbles  I think  exactly
john  you know one wonders as I
as I've asked you one wonders how could the
situation have deteriorated to the point
where you see it
in view of the fact that your book has
been blurbed 
as they say by an all-star cast
highly influential highly-placed people
and I don't mean
just highly-placed in the investing
world although that certainly
but even politically highly-placed I
mean
when all these people say this man is
right and he's telling us something
which needs to be said
how have we come to this pass that you
see us at well
I'm afraid it's simple economics and
that is the 
economic interest of our financial system
of our  investment bankers our stockbrokers
our mutual fund managers all the people that 
are enriched
in this bull market but even up to today
who we pay
400 billion dollars a year to are
their powerful economic interests and
they don't want to give it away
you know the old phrase don't let them
take it away how they stand pretty
much United in 
keeping the system the profits to them at
the expense of the investor
keeping it just the way it is yeah yeah
let's talk a little bit
about the corporation now everybody
knows
at least since Enron and Tyco
and worldcom and the rest of
these guys
everybody knows that one of the  problems
which has existed
is that corporation corporate CEO's
and other very high level guys just
made a bundle off of
stock options explain how this happened
and what kinds of funny money
accounting had to be indulged
speaking of low ethics what kind of
funny money accounting had to be indulged
in order to enable these guys to walk
away with two and 
four and eight hundred million dollars in
profits on options
ok well to explain that I've got to take a half a step back and say
in the long run they're kind of  two markets out
there one is the business market and
that is
real businesses with real people making
real progress
real products and real services with
real strategies an spending real money
on those
strategies and earning real profits that
is what investing should be about
that would be like a steel company or
Microsoft or what have you if the company does
well the stock will do well
but overlaid with that is what we call
the expectations market
and that is changing  the expectations about
what those realities
will be in the future and that's what
the stock market measures
so while the  growth of  american business the
economic return
in american business over a hundred
years is not so far from
a straight line upward pays dividends
every year
earnings grow up much more often than
not every year probably 85 percent or 
ninety percent of the time corporate
earnings grow because they've
got more capital in the business but the
market gets way ahead of that as
it did  in 1999 and then way behind that
as it did in 2003
just a big rise an excessive rise and than
excessive
decline because the market is a
speculative
instrument the executives figured out
implicitly at least that it's  a heck of
a lot easier
to build expectations
than is to build companies building a
company
building the intrinsic value of a  company
is really hard work
building the reality of a company building
the illusion
is like rolling of  a log so  you get to
manipulating
your earnings financial engineering we
call it many many ways to do this my
favorite is
saying well I told you our pension fund
would be earning seven percent
in the next 10 years and now I'm gonna
change that
guess to nine and a half percent that's
why I think our pension plan can do in the
next 10 years and all the sudden your
company makes a billion dollars more
because the cost of the pension plan
goes way down
and reverses itself on the company's incomes and may I
 ask you interject something but I don't'
want you to lose your
thread when you increase the discount
rate
the the expected earnings rate that
means the company must put in
less money to fund the pension plan
which means
the money they're not putting in goes
into the bottom line of corporate profits
what happens is the pension plan comes
up short thirty years from now
or even five as we see our airline pension
plans
have gone over  to the pension pension
guarantee Corp
and and pension guarantee T Corp
as a result is I think forty billion
dollars in deficit
and so the problems come back to haunt
you but  CEO's who got paid for all those
earnings
are long gone yeah your in that case
because you making better and bigger
earnings by not putting the money into
the pension plan
the stock goes up the CEO exercises the
option
his his options and makes more money and
where will I i want to  just add if I may  yea
go ahead what we know about stock
options is
almost all of them are sold the moment they're
exercised
they don't hold these options what
kind of a fool would do that
yeah so the idea is because you'd have to pay money for them
you put up the money and you
get lets say you put up dollars a share for
you option
and  you sell it for twenty two dollars
a share and the  companies often
finance this yeah so they just send you a 
difference check of twenty dollars so 
your never really  out of pocket to hold the option you're never out of pocket at all
yeah and so there we've had this canard
this
ridiculous rumor that suggests that
stock options link the interests of the
managers with the interest of the
investors
nothing could be more false than that yeah
but people believed it and part of it 
was because we had this
terrible aberration in our accounting
system forced
forced on us by corporate america
and given
credence by the congress of  America who
demanded the system not be changed tha
stock option cost are not counted as an
expense
in the words of  the compensation
consultants Larry stock options
free free yeah well nothing is free
yeah why are  they an expense John why are they an  expense because they're d
you can  let's say you pay an 
executive a million-dollar bonus
and instead of that you give them a million
dollars in stock options
the company has to go out unless they
want to dilute their earnings and
and buy back those shares that they've  given you at 
a low price
so their cash goes down and to make
matters worse
they're paying a high price so  the company
stockholder
loses not once by  the dilution of  the options
but twice because an effort to make that
dilution 
look like it doesn't exist the
company goes out and  pays these inflated prices of 
late 90's to buy the stock and when you
pay
 let me see if i've got this right in
a way
when the company's paying money to the 
guy who holds the option
the company has less money that means all
the existing stockholders have 
own a company that  has less money and
therefore is worth less yes it's all of  a 
piece
it's all of a a piece what were pro a they
want me to go to break I'm not going to
do it
what we're pro formas and what was their
effect
well we got into what is called pro forma
a pro forma in the old days let me say
this by way of perspective
medicare merged two companies you want
to show the records before
the merger so you had a long continuity
and so you put the record of the two
companies together  and we called it pro forma
here's what would have happened if we
done this from the very beginning
but we got to pro forma to mean
something very different
and what pro forma earnings came to mean
was here's what we  would have
 earned if nothing bad
happened so it's the earnings you would
have had
if you hadn't  had  to pay a lot of executive
salaries it's the  earnings you would have
had if one of the
product lines that you we're offering
didn't go
belly-up it's the earnings you would
have had if you didn't have to
depreciate your assets
it's what if earnings yeah and
there's no
there there I it's a different world
and and the basis have these fictitious
fictitious earnings or where
fictitious alright fictitious earnings
people say oh well this company made ten
dollars a share wow it must be is should sell
for three hundred dollars  share when the
reality is that made three dollars a
share  and should sell for $30
yep so I'll give you  a good example of  this and
it's in the book
 I think the year was 2001
Verizon lost around four hundred million
dollars
in operating and that's the way the
books look
and then they said well let's increase
the return on  our pension plan
from the believed seven percent to 9 and 
half-percent and they all of a  sudden
added 1.6 billion dollars to the
earnings
yeah leaving them with 1.6 billion plus
four hundred million
for a  profit 1.2 billion dollars which
they probably reported
in a year when the value of the pension
plan
fell by two billion dollars yeah now
that's  financial  engineering at its
highest level
right and that's going to come back to
haunt them if it hasn't already
explain the quarterly
earnings problem what I think I i would
like to all the mirabile dictu problem
miracle of miracles that's a good word
we got into asking
chief executives to project for us  why
would we do the work
now the company has a much better idea
what they're earning than we do
so we got in to first we think we can
earn
a dollar fifty next year and then we got
into as the
time went on that wasn't good enough so
we think we can earn
forty cents in the first quarter and 50
cents in the second quarter and
so on during the year
and gave at what we call earnings
guidance guidance that was the key word
yeah and then it became really a very
interesting sidelight to all of this really
an interesting one
 if a company missed its guidance
the value  of the stock might drop by billions
and billions of dollars the stock would take 
a big drop maybe from
forty dollars to thirty two dollars a
share  people  would say oh my god they're in
trouble
and  the  reason they thought that was pretty good
and that is with all the financial
engineering going on if they can do all
that and still not get to what they promised
they must be a troubled company so the
market wasn't actually entirely stupid
but what happens is there are  so many little
things you can do in inventories
in the way your write off debts an the way you account for your pension plan
that you almost always made your
earnings guidance
quarter after quarter after quarter so
you met expectations but
business that's the difference between the
expectations mark remember that its a
very very different thing
and the business markers that you have
to meet  we've been reading about
companies where  the CEOs went nuts
because they were going to miss the
quarterly earnings by a penny
and he foresaw the stock dropping
right through the floor as they missed
it by a penny
and I think you said in the book that
somebody estimated that GE's ability to
hit
its quarterly earnings on the nose for
20 straight years
had the odds against it of  one in
fifty billion
It was  a lot of billions that's exactly right oh man and you know the interesting thing
about  and this is really
this is  really an interesting point GE has
done very well in the last 4 or 5 years
their earnings have grown
Jeff Immelt seems to have done a nice
job managing the company
but the loss in general electric the 
capitalization value of
General Electric stock has dropped by
more
since its high in early 2000
then the  combined loss  of value in Enron
and worldcom which have gone bankrupt
it's something like 250 billion
dollars of  lost market cap 
thats and
expectations loss and not a business loss
all shareholders loss all shareholders
loss
except the  executives who got out by
selling their options at the high
yeah they're gonna send mighty Joe Young
for me any second if I don't
take a break we have to take a break stay
with us we'll be right back with more
from John Bogle
welcome back John
why did  investment banking and brokerage firms and security analysts
go against with all this funny business
I guess  the simple answer is because it
made them rich
I mean I don't mean to be too crass
about this
but think about it a lot of the big
money in Investment Banking and in the 
securities firms is made through
investment banking and investment
banking is
deals underwriting  the securities of 
corporations stocks bonds whatever it
might be
and the so the security analyst for the
firm's
for example are supposed to be looking
at let me say a good example this is
worldcom
and they're supposed to be saying we
know this company well and its a real turkey
however  however which they were saying
privately  absolutely yeah 
but publicly their company
is the investment banker for worldcom so
they say
this stock is going through the roof
it's got good management
our guy our investment banker is on the
inside he even meets with the board
directors
and he knows what a great company this
is and
its just a profound conflict of interest
that permeated wall street yeah this
desire to sell something
and you don't to be this doesn't
intended to be necessarily a negative
comment about Wall Street but Wall
Street is a giant
marketing machine that's what it's
designed to be
it's designed to bring the capital of
investors into connection
with the capital needs of
entrepreneurs
factory builders technology companies
that's what they do so when these
companies need money
they go at through wall street to these
investors so they have to raise money
and the problem i think is to  have
the investment analyst get paid by the
profitability of the underwriting
department
rather than  by how well their recommendations
do  that's  changed somewhat
somewhat after the tremendous
scandals
that were involved with this is not I
want to very be very clear on this as I  
point in the book this is not some
marginal group of  investment bankers that
got into all this trouble
and had to settle for several billion
dollars with attorney general spitzer in
New York
this is 10  of the twelve largest
underwriting firms in america
largest investment banking firms and I
think all the top 8
yeah this is not something you can hide
this was the way the business was
conducted yeah yeah
John it is popular in america today to
say in a variety of contexts it's just a
few bad apples
no it's not please  it's not  and i try to 
document that
Im the first one to in the book I'm 
the first one to admit
that the actual real wild frauds
the worldcoms and  the and Enron's and the Health South
and the Adelphia 's  is I could go on for a
little while longer pretty easily
but that is a few bad apples but the
problem is the whole
barrel  of Apples has some serious issues
in and of itself
for example as I point out we know
right today that at least 1500 firms
were managing their earnings and  doing
financial engineering how do we know
that
because by hindsight they had to restate
those earnings 1500 restatements I think
is the number I've documented in  the book by some ver very large corporations some of  the biggest
corporations
the entire world 2002 to 2005 2002-2005
yessir
yeah and it's not over yet some of them had to
do it for two or three years
and yet one wonders even as one knows
the answers
when a company restates its earnings to a
much lower
lower number how many executives that got
great big bonuses based on those
original earnings now reduced
gave back a penny  of them as far as we
all know
no one gave back a single penny
of those  ill gotten gaines you know john that
brings up something which
I know you feel feel strongly about
and which was discussed at lunch and is
becoming a big topic today when you see
people
doing this making packages up to you
said in one case $800 million you
know
numbers like two and $300 million for
these executives
trip off the tongue
and they don't even have to give it back
and the average worker has the pay of
the average worker  has gone up in  real dollars has
gone up the last 35 years but what did
you say one-third of one percent
0.3 percent roughly a third of one percent per year
in fairness
7 percent for the  25 years I have years yeah but
the compensation of the CEO
has gone up about eight hundred percent
yeah
to something like in real dollars it
it's probably
12 million a year something in nominal
dollars about four and a half billion
yeah in nineteen eighty dollars and so
what those CEOs
telling us is that I have created all the
value
in this company and you our workers
have created virtually nothing
yeah and I will tell you larry i
CEO of these companies for better part of 
30 years maybe more than 30 years and as
as a CEO I know that not to be true
the most valuable asset to any company is
the hard working people who get
their duffel bags out of  bed in the
morning and come to work
give an honest day's work for an honest
day's pay and go home
Friday afternoon for the weekend without
any hope of getting these staggering awards
you know its kind of ironic  and kind of funny John but
because a group of us started the law
school eighteen years ago
because I've been a dean since then and
I was the only educator involved 
at the  that the time people think think seem
to think that I am responsible for
creating and building a law school and  I keep saying
no not true you know we've got another
eight
10 12 14 people here who were vitally
important in  it  and god forbid
you know  one should ever say anything
different from that as far as i'm
concerned.
I agree with everything you said it's not true it's bad for morale it's bad for
it bad bad bad bad all the way through
and yet that's the way some of these egoists
have been on wall street. I think I'll tell you a funny little story about that night
we had the age of the Imperial CEO and I
was on a conference board commission
on public trust in private enterprise
run by the wonderful
pete peterson former secretary of
commerce a
truly great man in america and
I said  to the one of the CEOs a very good one by
the way I'm not faulting him
I said don't you realize you're just an
employee of
the company  and he got red in the face
yeah  and he  he was about to say don't
be silly  he  might have gotten  the first
part out
and all of a sudden he gave a great big sigh and said you know
you're absolutely right because of
course the CEO is an employee of the company
he gets a little arrogant he gets his picture on the cover of magazines yeah
and he gets paid in ways gets airlines
his own private airplane takes him and in
some cases dog a separate plane for
the dog we have that here too and goes
to down to Augusta to play on the Master's 
course
with other CEOs yeah it's not a good
system yeah
John why did congress go along with
this year we
you even point out that they insisted that
Wall Street continue some of these terrible
things well how did that happen
money money money business lobbying
power
yeah dollars and cents yeah powerful
influence that our  corporations hold
I've often  said that there is no
investment
that  corporation makes a that has the same return on capital
as political contributions you know they pay
these little hundred thousand heres 10,000
theres 25,000 2500
and they get a tax break worth a hundred
million dollars yeah I mean it's
infinite
so in one of the  cases that's pretty
well-known
the SEC Securities Exchange Commission
and the Financial
Accounting Standards Board wanted to
require
options to be expensed something you would think was so logical as we talked about
earlier
and led by senator lieberman the
corporations got into lobbying effort
and led by senator lieberman Saint Joe
it's a Joe yeah the United States
Senate
passed by I think it was a
basically 85 to 5 vote or something like
that a very
an overwhelming vote that if they did
that
the FASB would be Financial Accounting
Standards Board  would be put out of business
yeah and so they back down yeah and
the SEC backed down  you know you were saying that I
think I heard you say that
that the lobbying costs were minimal for
the
for the benefit gained  and
I think you said in the book
paraphrasing churchill
never have so few paid so little for
some much
yeah I
yeah you know it's a funny thing I've
seen it in my business
boy you can buy off people sometimes
the phrase is for a bottle of wine
 let's get into intermediation
would you explain in the 
coupla minutes we have left before the
second segment what is
intermediation well it's a kind of
dull term
that is telling us the most important
single story
about what has happened to capitalism
and that is we have moved from
owners capitalism traditional capitalism
where the owners who put up the money
and take the risk get the rewards
yeah to a new system I call it in  the book a
pathological mutation
to a new system  of owners capitalism
yeah were
where the owners have moved into the back
seat and the managers
with the cooperation of other managers
the CEO's  of other corporations and
accountants
have taken over and gotten far too large
a share of the rewards
they control the companies now these
managers do and the investors do not
how could that happen it happened
because we once had
when we had owners capitalism what I call an
ownership society
and in 1950 ninety-two percent of all stock
nearly in nearly all stock was held by
investors
individual investors and 2 percent I'm sorry
8 percent by financial institutions
today financial institutions own 68
 percent of all stock and individuals are
in the minority
so these financial institutions aren't
owners
think about it they're agents for the
owners
they're  agents for the owners and their
interest are not
those interest of the owners their
interest are their own interests
how to keep the corporation's business
in their 401 k plan
how to manage those mutual funds and get
large fees because it
is a fact that pension funds and
and mutual funds own over half of that
fifty percent of
corporate America out of  that
68 percent that 
all institutions together own even  more than 50
percent and they have their own
interests to serve
and to make matters worse they aren't
owners
anyway they're traders and speculators
because  instead of holding stock on
average for six years
as the mutual fund managers did when I
came into this business all those years
ago
they now hold stock for less than one
year on average so we changed an owner
industry
into a rent a  stock industry and
renters
don't care about corporate governance
yeah they don't care about business
their trading so rapidly they're working
in the expectations market
and not in the market  of business reality 
their only concern is that the price
rise within the next few months so they
can sell out and make a bundle
exactly and of course they're selling
out to their other institutions
yeah so there's no gain expect  to the
people in the middle but that's another
story
now let me see if I have some
of this straight
you or I might own shares in a mutual fund
the mutual fund then owns shares in the corporations
so in a sense the mutual fund is
intermediate to use that dull word exactly that's the word
and it is your view which seems very
hard to fault and I know it's being
accepted more and more
that as the intermediate the
 the pension funds and the  mutual funds
ought to
exercise control over the corporations
in order to stop the corporate managers
from raping the corporations and doing
other bad things
but they are not because they benefit
from the corporations they for example
run
for great sums of money the the
corporations pension plans
and other things and so the the
person gets left out
or whose interests get run over is the
original investor who own shares in a
mutual fund or has
an interest in a pension plan yes that's that's certainly one of the major
contributing factors in my judgment of
course the 
mutual fund industry denies  they say they
vote properly no matter what they're in
the funds are not they're not very
active voters they
have the  gall the say that with a straight face they 
do they do have the gall to  say that yes
indeed
but but the other reality is that if
you're a stock renter and not
not a stock owner you don't care about
corporate governance
thats corporate governance can
change the business
but not the expectations so they're
working in this wrong market
and I have a wonderful quote in this
book which really summarizes
the whole thing and as when we have
strong managers which we do
when we have weak directors which we do
and when we have passive owners
which we do don't be surprised when the
looting begins
again yeah and we haven't had very much
real looting as in those cases I mentioned
before
but we have had is not so far I  mean that
the the difference been running the
company in the interest of the
managers being and paying that kind of compensation
giving that stock options huge shares of
partnership it certainly is not looting
let me be clear on that
on the other hand let me be be equally clear it's not
totally different yup
there was a philosophy involved
the a set that goes something as
follows:
well in terms of the corporate democracy
that we allegedly have and we are
supposed to have
forget it don't worry about corporate
philosophy 
corporate democracy or corporate
governance if you don't like the company
sell its stock if you don't like the mutual
fund cash in your shares and buy another
mutual fund
whereas you take the position that this is
very short-sighted in a number of ways
including good governance and reputable
democracy creates
good business results that a fair
statement well that's a fair statement
by i go even further
you know think of  what the executives will
do if they have no one overseeing them
whereas if you lose oversight yeah if you
lose as  I put it in
James Madison kinda terms he said about
government if
men were angels no governance would
be necessary
no government would be necessary and I
would say if CEO's were angels yeah
no corporate governance would be
necessary and
so it's a separation of powers issue
yeah
and the problem is those that have the
power are
dead-set against giving it up and those
that should want the power
are these institutional investors look
the other way
turn their back on wanting it they're
doing nothing to
to have a strong ownership position we
are gonna get into the position
the odd position it's kind of like the strange
career of James Crow 
you know that term by C Vann woodward
the strange position of mutual fund
management companies in american society
right after this break stay with us
right after this break we'll be  back with
the last segment
with John Bogle
welcome back
John explain if you would
a most unusual phenomenon
the structure and relationships
between a mutual fund management
company on the one hand
and the  mutual fund itself on the other
because in reality the mutual fund
is a shell isn't it yeah you use the word
unusual
I would use the word bizarre you kind of
wonder where it all came from
yeah and that is the mutual fund manager
creates the fund
pays its officers selects its
independent directors and its
non-independent directors an awful lot of 
mutual fund directors are working for the
management company
getting paid by the management company provides the funds for all the  services it
needs to exist administrative services
distribution services investment
management services
and all we have for the fund is a shell
that holds the securities in the portfolio
general motors  enron whatever it  might
have been IBM
Microsoft so on and so 
the mutual fund is the captive the
manager
and the manager has great flexibility
in the amount of money the manager
charges
now I wanna be very clear on this there's a law that governs the
operation of the mutual fund
it's called the Investment Company Act
of 1940 it's been amended once or twice
since then but not in the ways
would be subject to these comments and
that act says
mutual funds must be organized operated
and managed in the interest of their shareholders
and not in the interest of  their managers
and distributors
that is what the law says and that is
the diametric 
opposite the 180 degree different
difference
in the way the fund industry actually operates
your rates yeah
so we now  have created these giant mutual fund
management companies
that are a often  owned by  great big
financial conglomerates
and those financial conglomerates as
everybody who knows anything about the 
corporate world
come into the mutual fund business not
to earn a profit for you the mutual fund
shareholder
but to earn a return on their own capital that 
they put into the business
paid a big price for it because
they paid a big premium on 
just a very tiny amount of
book value for that huge amount  of market value
because this is an incredibly profitable
industry
in terms of  profit margins unbelievable 50
percent pre-tax profit margins
forty-percent pre-tax profit margins  and so
on
so we have an industry that belies both
common sense
and the and the policies established by
the congress
and the administration of the United States
yeah yeah and
a lot of a lot of what's gone wrong is
based on
that complete dichotomy now explain
two things
about that which seemed to me at least
as a layman to more or less go to the
heart of the problem
1 is that the management company charges
the mutual fund which is its  complete
captive
on average let us say one-percent
of the funds assets as a management
charge every year
and that is true whether the fund has
ten million dollars in assets a hundred
million dollars
or as some of them  do fifty or eighty billion
dollars
or $500 billion or a trillion
or a trillion
and the cost don't go up proportionately
they do not the economies of scale in 
investment management
are staggering doesn't cost that much
more to run a ten billion dollar fund
then to run a billion dollar fund maybe
your hire three analysts instead of two
yeah and but those economies of scale
have been arrogated to the benefit of the
management company
and not to the benefit of the funds
shareholder I would call that simply put
a breach of fiduciary duty right now the
other thing which is pretty
staggering is that once the SEC head was
forced by the courts to rule
the courts have a long history of  doing bad
things in 1958
that the management company could be
sold because this allegedly was not
a misappropriation of the
value of the fund itself
well the management company which is
getting one percent
on all these assets maybe on
fifty billion dollars worth of assets in
which one percent is $500 million a year
now
the costs are maybe thirty or forty
million a year
it can be sold and is and is sold yeah to these conglomerates
and and the public actually there are only 
among the 50 largest management
companies today
there are only nine  9 that are
privately held
and 41 that are  either publicly owned by
investors or mostly thirty four or five of them
that are managed by financial
conglomerates
these companies are in business to earn a
return on their own capital which is
what a corporation does it's
almost not wrong just wrong in this
business
now do I have the following right
because it's a staggering example of
something
there was a fellow who for many years
when I first started following this was
a very famous
mutual fund manager his name was Richard strong
and he got hit by the SEC I mean his
funds he owned a management company
and was an analyst besides I guess and
his management company just got
hit tremendously by the SEC because they were
doing illegal things
which he was doing because it made money
for him
to the point where he get kicked out of
the business by the SEC he cannot be
involved with securities business
anymore
and he still sold his management fund
for what three four hundred million
dollars well they say it was four hundred million
dollars
400 million dollars well that really tells you
something  when you can be kicked out of the
business
for be for doing illegal things and you
still walk away with four hundred
million dollars because you can sell the
business you've been kicked out of
well you know the crazy thing about it
is that they sold the business
ultimately to Wells Fargo
the bank the banking enterprise
if before all this happened the
directors had said look
dick strong we don't think you doing a
good job we're gonna hire Wells Fargo
they could have hired Wells Fargo for a
tenth of what the were 
paying dick strong yeah they didn't do that then
dick strong in effect sells his company to 
Wells Fargo
and the directors say oh we now love
Wells Fargo he says I love Wells Fargo
you should use Wells Fargo
he gets his $400 million but because all
that money is tied up there wells Fargo
has to charge
the expensive rates to get a return on
their capital
I mean it's all so  transparent yeah and
and also wrong yeah now you have a
phrase in the book which I'd like you to
explain
in detail the phrase is
in this business the investor when
speaking to the investor
quote you get what you don't pay for
that's a classic would you
explain that please
sure easily and that is all investors
are I'm glad you're sitting down average
or less
well no they're average they can't be  less
than average in a 10 percent market
yeah we all as a group divide up 10
percent yeah
in the mutual fund and in 
intermediation generally
we give up about two and a half
percentage points it looks like
to financial intermediation costs around
$400 million dollars a year as I
mentioned earlier and that means that in
a 10 percent market
gross return we actually pocket
seven-and-a-half percent
there's no way around that gross return
on the market
minus the cost of  intermediation is the
net return investors
divide up it follows we've done  lots of
studies in the mutual fund industry
that show that you don't get you know I
don't get what you pay for
you not only don't get what you pay for
and you not only
you don't quite not get what you pay for
you get precisely
what you don't pay for and therefore
if you pay nothing you get everything
and nothing is essentially what you
pay
for a stock index fund that buys the whole
market and holds it forever
yep now a as I understand it John
if you assume that the market is making
11 percent
and a non index fund what they call
what they call an actively managed fund
will make a little less than the market
because
well transaction costs I'll let you
explain that and then
the investor himself or herself will
make
a few percentage points still less I'll
let you explain that
and amounts of money involved that the
Investor does
not make because of these costs are just
utterly
mind-blowing why don't you elaborate on all of this sure
the there precise examples are 
our course in the book but i'll just say very 
roughly in the last 25 years
the Standard & Poor's index 500 stock
index essentially the value of
 what corporate America the market
value of corporate America market
capitalization of corporate America
has been twelve and a half percent a
year not every year but
on average the average mutual fund has
cost around two and a half percent
and is therefore earned about 10 percent a
year but mutual fund investors
what are those costs transaction costs or selling stocks
well
tell you exactly the average equity
mutual fund which i'm talking stock funds
here
has an expense ratio everything one and a
half-percent
when you turn over your portfolio at 100
percent a year which is what they do on
average
the turnover cost paid to wall street are
something like one percent
 than most funds are sold with a sales
commissions and pay a 5 percent sales
commission and hold the fund for five
years
that's another one percent okay I'm already
up to three and a half percent
yeah but I'm only using two and a half
percent I wanna
I want to give the industry of course a
fair shake 
but what happens is that when at the
beginning for example of  this period during
the eighties when stocks were cheap
investors bought almost nothing in the
way of equity funds and certainly not
after 1987 after the big crack
by the time we get into the late 90's the stocks have
boom four or  $500 billion dollars pours into and
equity funds year after year
at a very high level on the market and
when the market drops way down drops
50 percent
almost no money goes into the market so
they have a very bad
record in terms of market timing
they like stocks
and fund investors when they're high and
hate them when they go down and when they're cheap
kinda dumb and at the same time they make
bad fund selections
when that $500 billion or so  went into
the fund industry
in  1999 early 2000 they were buying
internet funds telecommunications funds
technology funds all those new economy
things which went down even more
with the management companies made a
fortune from which they made a fortune
from and they  brought them out like they
were selling new potato chips yeah
and  so the management companies
contributed greatly to all this
yes yeah because of the  marketing business and  in marketing
the idea is that
sell people what they want yeah and they
want what's hot
they shouldn't but they do and the
management companies make that worse
instead of fighting t against it  you have some
examples you talk about a
person twenty-years-old with 60
sixty year life expectancy still
who might start investing now
and if the person makes seven-and-a-half
percent
I think was the figure over the course
of the next 60 years
due to the magic of compounding  which is
a whole other you know Einstein once 
was asked what's the most the
greatest human invention ever  and he said
compound interest due to the magic of
compounding that will be worth
something like a 132
thousand dollars when the person passes
away
but if you subtract cost so that the
what the person is really  making is five
percent a year
it only thirty-seven thousand well that
illustrates doesn't it and I realize that you
might want to spend it you you'll have similar figures for age seventy or age
65
wow people are losing
not just in percentage points but people
don't necessarily  understand that what the
percentage points translate to in real
dollars
and it's staggering well the 
example that you give is pretty close to
what's in the 
book it's an eight percent compound return that grows to grows to about a hundred
forty-five thousand dollars
and I call that the magic of compounding
returns I want to  emphasize the word returns
the reason it drops down to 32 percent
after you pay two and a half percent
cost
thirty-two thousand dollars from a
hundred and forty-five thousand roughly
is that is
because what  I call the tyranny  of compounding costs
and it turns out simple mathematics the
relentless rules of 
humble arithmetic humble
arithmetic again that the tyranny of
compounding costs
overwhelms the magic of compounding
returns it's the 
single message investors should learn is
get
costs out of the system we're quoting the
great Buffet
the investors two greatest enemies two
greatest enemies to the equity investor
or expenses and emotions  and emotions
is like  bad timing and bad fund selection
yeah
I have three or four things things more I'd like to
talk about but I have to wrap it up
thank you for coming from Valley Forge
great to be with you do appreciate it 
ladies and  gentleman you've heard from one of
the Giants of one of our major financial
industries
enlightening is it not
be with us again next time for the next
chapter the next segment of 
books of our time thank you for being with us
today
