Great Expectations
Vanguard founder talks about the current market, speculation and how investors need to adjust their expectations.
By Aleksandrs Rozens November 17, 2008
John Bogle founded the Vanguard Mutual Fund Group in 1974. He served as its chairman and chief executive until 1996 and remained on as senior chairman until 2000.
Recently, he wrote "Enough: True Measures of Money, Business and Life," which was published by John Wylie & Sons.
To call it a business book—a how-to or memoir—would be too simplistic. In fact, it is far from the typical business book because it offers some interesting life lessons on dealing with people, especially clients and customers.
John Bogle
When it comes to clients, Bogle refers to "The Odyssey," where Homer suggests that "Take it to heart, and pass the word along: Fair dealing brings more profit in the end."
In his volume, Bogle also reveals how he started Vanguard. (He named it after one of Lord Nelson's flagships, in a nod to his first place of employment, Wellington, which shared the name of the famous British general who defeated Napoleon).
Bogle spoke with IDD last week, offering his thoughts on long-term investing and how it may come back—as opposed to rapid-fire maneuvers in and out of a company's shares—and his thoughts on PE fund managers as well as hedge funds. Not surprisingly, they are not positive.
As Bogle sees it "we have made Wall Street too much of a casino. It is totally dominated by speculation ... we are engaged in an orgy of speculation the likes of which has never been seen in the history of this country."
His rule of thumb for investors: your bond position should equal your age. "I'm about 80% bonds. I started 65% about 15 years ago," says Bogle.
Following are excerpts from the interview:
IDD: How do you think the credit crisis will play out?
BOGLE: The market can't bail itself out of this mess. Wall Street has a lot to answer for to Main Street and yet Main Street, which is really where the tax base is, is going to have to bail out Wall Street for Wall Street's errors. And that is, of course, a tragedy--an economic tragedy. But I am persuaded because I respect people like Larry Summers, I certainly respect Ben Bernanke. I am not so sure about Hank Paulson. I suppose I respect him in a way, but his issue is that he is an investment banker. So it should come as no surprise to anybody that he looks at these things from an investment banker's perspective. How else can he look at them? It [the bailout] has to happen. I think it is too bad it has to happen, but I think we ought to get ready for building a better financial system, which means building a smaller financial system because what is going on on Wall Street is a casino and our croupier has raked too much off of the table before we get paid.
IDD: When you say our financial system gets smaller, what do you mean by that?
BOGLE: Revenues will be less for a whole bunch of reasons. First, they are never going to be allowed—with the government being part owners of them—to have 35-to-1 leverage. Number two, we're going to have better disclosure about what is on that balance sheet. When you think about it, if you are leveraged 35 to 1 and all your assets are Treasury bills I don't see that as much of a problem. The problem is that none of them are Treasury bills. They are toxic mortgages and we need much better disclosure of that. The third thing is that they are going to have to be content with less revenues.
IDD: You like the idea of keeping things simple in business and investments; what do you think about the credit default swaps market?
BOGLE: It's a modern day version of quantitative insanity. A completely obvious example of the way that speculation has over run financial investment in our financial markets. An easy way to look it at is this. Suppose you have a house and you insure it against fire for $200,000. Now, suppose that you have 130 neighbors, 65 of whom are betting that it will burn down and 65 of whom are betting that it won't. And, that's approximately the ratio we have got here. It's supposed to be about $2 trillion debt instruments covered by CDS and $62 [trillion] or $65 trillion of credit default swaps. Half of them are in one side and half of them are in the other. So, you could say "well what's the matter with having your neighbors insuring or betting your house will burn down or betting it won't burn down?" What's the matter is you have to keep a close eye out for arsonists. So, we have arsonists out there playing the CDS market, to sink your firm, make money for themselves and their hedge funds. They want those premiums to go way up and playing games like that—we don't know how much because the market is totally opaque and volume is not recorded—and these are the things that have to change.
IDD: I thought your observation that the stock market is a giant distraction to people was interesting.
BOGLE: It is a giant distraction to the business of investing. And the word "business" was not lightly chosen. Investing is owning businesses and hanging on to them so they can earn a return on your capital.
IDD: This runs counter to the short term idea of playing in the CDS market?
BOGLE: Absolutely.
IDD: I noticed that you traced the history of the introduction of futures and options on stocks. It seems like another toy to tinker with taking away from the true essence of buying into a business and its future.
BOGLE: When you buy an option or a future you are making a bet on the future price of the stock or the derivative or the index.
IDD: Is there no room for that kind of financial tool?
BOGLE: We do need speculators. The market might not trade every day. I'm not sure how bad that would be. That's another story. But if nothing traded you would not have a way to value securities or anything else. The reality is not that speculation is inherently bad or investment is inherently good, but rather we have lost the balance. If I had to guess, it would be my druthers that the market be 80% investment and 20% speculation, or something like that. That's really what it was when I came to this business. The turnover of the market wasn't that 345% [of] this year. It was about 30% a year for 15 years.
[In his latest book Bogle points out that the annual rate of turnover of stocks—that is, the number of shares traded as a percentage of shares outstanding—was about 25%. In 1998 this turnover rate rose to above 100% and last year it rose to 284%.]
IDD: I found the data interesting, how much paper was held for the long term and how, today, 100% or more of the shares are changing hands.
BOGLE: The turnover rate is now 345%. That is astonishing.
IDD: What do you think about this idea of computer program trading? It sort of goes counter to what you say about not relying too much on past events or history for expectations about the future.
BOGLE: Any kind of algorithm or any kind of trading based on a single philosophy is only its worst enemy. I talk the same way about indexing based on earnings and revenues rather than indexing based on market cap. The problem with it is a very simple one. If it works, it won't work. There will be periods of time where it did better and there will be periods of time where its done worse. The algorithm guys, the quants are having bad years this year.
IDD: What is your view on the idea that Wall Street has prop desks active in equity and bond markets? Did you and your colleagues change the way you view Street firms because of this?
BOGLE: The only thing I can say is there is a quote from Mr. Buffett and that is: "any new idea goes through three phases: first the innovator, then the imitator and then the idiot." You know where Wall Street is on that scale.
IDD: They are late in the game then?
BOGLE: Yes. We always copy what's done well in the past and I don't know how we can be so dumb to be honest with you.
IDD: There is a number in your book that was interesting. In 2001 we had over 6,000 mutual funds and by 2008 half of those are still around. What's the common denominator behind their fall? Is there a common theme behind this and should we expect that to accelerate now because of what is going on this year and last year?
BOGLE: It will accelerate, inevitably. If you have a fund that can't perform or doesn't beat the market, people forget about it pretty quickly. Or a fund that performs and can't beat the market and does not get very big, the economics of this business are [such that] a $10 million fund is not really worth running. So, [with] the combination of limited size and bad performance the manager says "I thought it was a good objective in the first place, but it is just not working for the company and not working for investors."
That's a really bad fund that doesn't work for investors [and] it does not work for the managers either.
IDD: One of the suggestions you make in "Enough" is that investors should go for not-for-profits because their interests are aligned with the investors.
BOGLE: Exactly. Just read [David] Swensen on that point. He [Swensen is the chief investment officer of the Yale University Endowment] is probably the most respected investor for his personal integrity, his unwillingness to get paid what he could earn somewhere else, his success up at Yale and doing all this hard work to improve the quality of education in New Haven, Conn., first, but also ultimately in America.
IDD: Where do you think the S&P 500 ought to be or do we have a further way to go down for the S&P 500 and the DJIA? Do you have an outlook on where they may be by year end and when do we see a turnaround in either one of those indexes?
BOGLE: I have absolutely no idea because the market is being driven by emotion. In the long run—I think we discussed the fact that I think stocks ought to be able to produce the returns of 8 or 9% over the next decade—and I think the probability for that is good.
But where it will be by the end of the year has nothing to do fundamentals and reminds me—I think this phrase may be in the book—the daily moves in the market are like a tale told by an idiot full of sound and fury, signifying nothing. So, there is no point in predicting. If you are investing between now and the end of the year, I would say get out even though it may go up a lot, who knows? Between now and the end of the year, what will drive the stock market is speculation. It is investment that drives the stock market and speculation contributes zero to the long-term returns in the stock market.
IDD: What do you think about PE firms? Basically these are people that are not in it for the long term. Some of them have run into trouble because they leverage up their companies. I'd say their methods of investment run counter to your ideals.
BOGLE: I think David Swensen has in his book some data that shows they don't add much value. If they do, it is simply by leverage. If you put enough leverage on a moderately performing company, it becomes a high performing company so long as times are good. I don't want to gamble on that.
IDD: Today the credit markets are shut and banks are not lending. Loan officer surveys are showing they have become very restrained.
BOGLE: The system may be getting some sense after all this time.
(c) 2008 Investment Dealers' Digest and SourceMedia, Inc. All Rights Reserved.
