Wednesday, November 6, 2019

The Clash of the Cultures

John C. Bogle was passionate about helping average investors get their fair share of the wealth produced by the stock market. In his book The Clash of the Cultures, he describes what is wrong with our financial system and what should be done to fix it. Unlike many who shout complaints from the sidelines, Bogle devoted his career to fighting for necessary change.

When it comes to those who invest other people’s money, Bogle “observed firsthand the crowding-out of the traditional and prudent culture of long-term investing by a new and aggressive culture of short-term speculation.”

Bogle devotes much of the book to the history of mutual funds to make his points. Most modern mutual funds have a “double-agency” problem where managers have to serve both the fund investors and the shareholders of the management company. Sadly, investors lose out on the conflicts of interest; management companies can only make money by dipping into investor assets. Stewardship has given way to salesmanship.

“The expense ratio of the average equity fund, weighted by fund assets, rose from 0.50 percent of assets on the tiny $5 billion asset base of 1960, to 0.99 percent for the giant $6 trillion equity fund sector as 2012 began.” Annual expense ratios can be misleading; the corresponding 25-year expense ratios have risen from 12% in 1960 to 22% in 2012. These are U.S. figures; Canadian mutual funds are much more expensive.

“The leaders of the mutual fund industry, and its trade association, the Investment Company Institute, purport to represent mutual fund shareholders. But in fact they represent the management companies that operate the funds.”

To combat this double-agency problem, Vanguard mutual funds actually own their own management company. This is the reason why Vanguard has always kept their fees low. Bogle had hoped that this ownership structure would spread to other mutual funds, but this hasn’t happened.

Short-term thinking is pervasive among companies. “When a corporation’s focus on meeting Wall Street’s expectations (even its demands) takes precedence over providing products and services that meet the ever-more-demanding needs of today’s customers, the corporation is unlikely to serve our society as it should.” This criticism definitely applies to a former employer of mine whose focus on stock price became so all-consuming that making products was barely on the minds of top management.

Bogle bemoans the loss of bright minds from useful pursuits as they head to the investment industry. “‘financial’ engineering, which is essentially rent-seeking in nature, holds sway over ‘real’ engineering, ... which is essentially value-creating.”

We’ve seen a revolution in equity ownership by institutional investors. Their ownership of U.S. stocks has risen from 8% in 1945 to 70% in 2011. Given the extremely high turnover in stocks, institutional investors “act less like owners of stocks than renters.” Collectively, they own a high percentage of publicly-traded companies, and they tend not to oppose company management in proxy votes.

I was surprised to read that “the shift from DB [defined-benefit pension] plans to DC [defined-contribution] plans is not only an inevitable move, but a move in the right direction in providing worker retirement security.” I see the problem with chronically underfunded DB plans, but DC plans force the masses to make their own, often terrible, investment choices. It turns out that Bogle’s optimism about DC plans is conditional on a long list of suggested improvements to mutual funds and the entire system of DC plans. “Our existing DC system is failing investors.” I think we’d be better off with a hybrid system that shifts some of the investment risk from employer to worker, but leaves assets invested at low cost by a pension plan.

The book closes with ten rules for investment success. The first is “remember reversion to the mean.” This means don’t give up on our investments when they go down, because they’ll come back, and don’t shift a higher percentage into stocks when they’re flying because they’ll come down again. The final rule is “stay the course.”

I wouldn’t call this book an easy read, but its broad messages are important, and they come through loud and clear. If you like to pick your own stocks or look for mutual funds that will outperform, you should read this book to see what you’re up against.

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