"The Battle for the Soul of Capitalism"

Discussion in 'Politics' started by OPTIONAL777, Apr 20, 2011.

  1. Economy by Lisa Scherzer (Author Archive)

    Bogle: American Capitalism Is Doomed
    AT 76 YEARS OLD, John Bogle, the founder of mutual-fund firm Vanguard, describes himself as an idealist. But you wouldn't know it from the first few pages of "The Battle for the Soul of Capitalism," which might give readers the notion that he has transformed into a gloom-and-doom cynic. Throughout his new book, Bogle paints a dire picture of the financial system, starting with a frightening comparison between 21st-century America and the fall of the Roman Empire.

    Perhaps it's a stretch to suggest that the U.S. is at risk of an epic decline. After all, vibrant and transformative companies like Google (GOOG: 521.53, -5.31, -1.00%), XM Satellite Radio (XMSR), eBay (EBAY: 31.15, -0.01, -0.03%) and Craigslist have cropped up in just the past few years.

    But Bogle isn't seduced. He offers a stinging indictment of corporate excess — and a Cassandra-like warning to individual investors. He invokes ancient history to remind us that "no nation can take its greatness for granted." Bogle, creator of the first index fund, pleads with investors to pay attention to what's happening with their money — or risk losing it to corporate managers with dubious motivations.

    For years, says Bogle, the U.S. had a system in which capital was the property of owners. Those who bore the risk reaped the rewards. That system, which he calls the ownership society, has been transformed in the past 50 years into the so-called agency society. Now investors swallow the risk while managers collect more than their fair share of the rewards. Along with that has come the era of phony accounting, stock-option mania and inflated executive compensation.

    A similar transformation has taken place in the mutual-fund world. Bogle frowns on the trend of fund managers flipping stocks to juice their returns — and running up transaction costs in the process. Such activity isn't in the long-term interest of shareholders. And when fund companies then charge investors excessive fees, it chips away at overall returns — undermining the entire investing process.

    "The ownership society is dead," says Bogle, who still keeps an office at Vanguard's Valley Forge, Pa., headquarters even though he long ago gave up the roles of chairman and chief executive. "And the agency society isn't working, so the task — and it's a huge, huge task — is to develop a fiduciary society that honors trustees."

    How to do that? Bogle advocates federal legislation that requires fund directors to serve solely the interests of fund shareholders, an endeavor that will bring about what he calls shareholder democracy. SmartMoney.com spoke with Bogle about what's wrong with investing in America and how to fix it.

    SmartMoney.com: How has capitalism veered in the wrong direction?

    John Bogle: What I tried to do in the book I don't think has been done before. All these systems are interlinked: the systems of corporate America, investment America and mutual fund America. They intersect to put the shareholder in the back seat. He ought to be up front, in the driver's seat....

    Capitalism has changed into a new system, which is not a good system. It's a managers' system. The rewards have to go to the people who assume the risk; that's conventional capitalism. It's been taken over, most notably in mutual fund America. By far too large a share of rewards has gone to the managers. There are lots of reasons for that, but the main reason is that we don't really have an ownership society. It's gone, and it's not coming back. Fifty years ago individual investors directly owned 91% of all stock. In 1985 the balance changed and institutions owned more than 50% of all stock. Now 68% of all stock is held by institutions, and only 32% is held by individuals.

    SM: Why the shift?

    JB: It's because of a single principle, which is as old as the Talmud, and that's diversification. Most people do not have the capacity to diversify on their own. They do it through mutual funds. They're doing the right thing, but the system isn't working. We're becoming an agency society, where agents aren't representing the principals. They're representing themselves. I quote Adam Smith in the book: We can't expect people to look after other people's money with the same care they look after their own money. Interests are conflicted.

    SM: Explain the rent-a-stock industry vs. own-a-stock industry you talk about in the book.

    JB: In 1950, when I started in this business, there was an average six-year holding period for stocks [by a mutual fund]. In the last 10 years turnover [has increased to] 100% annually. It can easily be called a rent-a-stock industry. You know [former Treasury Secretary] Larry Summers' statement: No one has ever washed a rental car. Why would you take the trouble? We aren't owners.

    SM: Why is the increasing concentration of stock ownership such an insidious development?

    JB: The problem is that we have profound conflicts of interest as agents. Money managers — nearly all of them — are managing both mutual funds and pension funds. So there's not much of a distinction out there from an investment standpoint. The 100 largest institutions own about 58% of all corporate U.S. stocks. That's an amazing concentration. They're managing 401(k) plans and pension plans. They don't want to lose their clients. The managers don't want to offend their clients; and they don't want to offend two types of clients — actual and potential. They don't want to offend anybody.
  2. In my time in this business, investment management has gone from a profession with elements of a business to a business with elements of a profession. Now the dominant form of management is the giant financial conglomerate. Companies, in effect, own themselves. Citibank, for example, holds 1% of Citigroup (C: 4.53, +0.11, +2.48%). They're all members of the Business Roundtable [an association of CEOs of leading U.S. corporations]. Members of the Roundtable own each other; corporations own about 12% of corporate shares. Another 11% they arguably control by having moral suasion. That 12% is in their pension plans, the other 11% is in their 401(k) plans. They have enough power to be pretty confident that those 401(k) managers are not going to take them on over any issue.... Agents' and managers' interests are aligned. What I argue in the book is that the ownership society is dead. And the agency society isn't working, so the task — and it's a huge, huge task — is to develop a fiduciary society that honor trustees. That's best done with a federal statute of fiduciary duty.

    SM: In the book you make comparisons between today's executive compensation excesses and the age of the robber barons.

    JB: I talk about the compensation for chief executives. In the book I say the top earners have 430 times the compensation of the average worker. It's like a second Gilded Age.

    We have to allow some form of shareholder democracy. It's still a stock market with the idea of a republic. Just like our nation — we don't vote on every issue, we elect representatives to vote for us.

    SM: How would that logistically be carried out?

    JB: You have to have access to the proxy. We ought to have shareholders who have 5% of stock be able to elect directors for the company. The Business Roundtable hates it. They don't want anybody else nosing into their business. They don't like the notion that a boss of the business shouldn't be boss of the board. The CEO is an employee of the company, employed by the company to do the best he can for shareholders. The SEC has tried to do something like that, but moved away from it.

    In the U.K. a director shouldn't be elected if he doesn't capture a majority of the vote. If we say directors have to have a majority, then simple withholding votes would have an impact.... Under this concept Michael Eisner wouldn't have been elected [to Walt Disney's (DIS: 41.35, +0.15, +0.36%) board]. The cards are stacked in the favor of management and against any form of corporate democracy. In a corporation, even if a majority of shareholders vote for a provision, under laws in most states the votes are nonbinding. The legal word is "precatory," a word I hate. Those votes are only advisory to the corporation. We have to change that.... There need to be structural changes — access to the ballot, requiring corporations to do what shareholders want. It will be hard, but that doesn't mean we shouldn't try.

    We have to wake up our investors, particularly our mutual-fund investors. The industry is a clear case in which if fund investors move their money to those [mutual funds] doing the right things — ones that have low costs, etc. — then the system will change because individual investors will see the light. This is not going to be easy to do. There's an educational issue there. However long this process takes, it is moving in the direction I'm suggesting. Investors will not ignore their own economic interests. It's a glacially slow change because there are forces aligned against change by the oligarchs. I realize it's a bit self-serving, but Vanguard is a manifestation of this. I don't just talk this kind of talk. It's what I did when I created Vanguard in 1974. It was run for owners, not for managers. It's not owned by a giant conglomerate or family.... It's truly a mutual-fund group. Our market share has increased every year for 23 years in a row.

    SM: You criticize the rise of short-term speculation vs. long-term investment. But isn't that just part of investors' strategy to beat the market?

    JB: Yes, but the buck you make is the buck I lose. It's not balanced trade because of the man in the middle. It's tax-inefficient. The records of mutual funds are far worse than they're portrayed, because we look at pretax returns. In a roughly 13% stock market, the average mutual fund earns 10%, and the average mutual-fund investor earns 6.5%. That's not good enough. And I haven't even talked about taxes, which take out another 100 basis points.... That's pretty stunning. This never would've happened if not for the greatest bull market in history. Managers' fees didn't matter because it didn't feel like you were being cheated.

    People understand the magic of compounding returns. But few investors know about what I call the tyranny of compounding costs.... You put up 100% of the capital and take on all the risk, but you get only 20-something percent of the return. That's a system that is destined to fail. People will not be that dumb forever.