John Bogle on the Future of Investing: The Rise of the Shareholders

The Wall Street Journal
FILE - This July 16, 2013 file photo shows a Wall Street street sign outside the New York Stock Exchange in New York. Asian stock markets were mostly lower Monday, July 7, 2014, as investors looked ahead to U.S. corporate earnings following last week's strong job numbers. (AP Photo/Mark Lennihan, File)
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One major principle has shaped my 63- year career in investments: "When there is a gap between perception and reality, it is only a matter of time until reality takes over." In considering the future of investing over the coming decades, that's a good place to begin. So what's ahead?

Investors will increasingly "see the light" and choose low-cost, low-turnover, middle-of-the-road strategies, buying and holding their investment portfolios for the long term. The reality is that hyperactive trading strategies offer incomprehensible complexity that ultimately destroys value. As investors continue to favor value-creating simplicity, and realize that their positive perception of finance conflicts with that reality, they will demand a smaller and less-costly financial system.

Today, our nation's financial system is generally perceived as a smoothly functioning national asset. But the reality is that its cost has soared from a low of 4% of gross domestic product in 1950 to an estimated 10% of GDP in 2013—$1.6 trillion.

The wealth generated for the system's insiders—senior financial executives, mutual-fund managers, hedge-fund operators, entrepreneurs and financial buccaneers—has grown to epic levels.

Simply put, I predict that the wealth arrogated to itself by our bloated financial system will be rejected by the largest set of participants in finance—our investors.

As investors come to recognize the long-term financial penalty of excessive trading activity, they will begin to demand their fair share of the value created by our publicly traded corporations. The perception held by too many investors that they can beat the market will give way to the reality that, on balance, trading grotesque trillions of dollars with one another—last year alone, a record $56 trillion—is to no avail.

In fact, America's corporations are the true value creators. Wall Street firms, with their excessive intermediation costs, are value destroyers. Investors are simply the residual beneficiaries. That's the ultimate reality. The perception that short-term speculation can add value will fade, if only slowly.

Looking ahead, the trend of investors moving away from actively managed mutual funds and toward passive index funds will strengthen. Index funds now account for 34% of U.S. equity mutual-fund assets. Since 2007, investors have added $930 billion to their investments in passively operated U.S. equity index funds, and they have withdrawn $240 billion from their holdings in actively managed equity funds. That's a swing of more than $1.17 trillion in investor preferences. In the years ahead, that trend will accelerate.

The "secret" of the traditional index fund is a combination of low cost, broad diversification and a long-term horizon. Investors can enjoy the magic of compounding long-term returns, while avoiding the severe penalty inflicted by compounding costs. Broad-market index funds can cost as little as 0.05% a year, compared with the 1% to 2% annual drag from the costs of active management.

As investors increasingly see the benefits of the index fund, their perception that active fund managers as a group are able to add value will fade. In the coming era, active managers will have to make hard choices about their fees, their strategies, their portfolio turnover, their tax inefficiency, and their susceptibility to large capital inflows—and outflows—depending on their returns.

Over the coming decades, institutional money managers will become far more active in engaging the managements of the corporations whose shares are held in their portfolios. The perception is that the giant money managers that dominate today's intermediation society represent a powerful force in corporate governance. The reality is that their latent power remains unexercised. For example, asset managers regularly endorse management's nominees for directors and shy away from supporting proxy proposals by minority shareholders.

Both our corporate and financial manager/agents have too often placed their own interests before the interests of their shareowner/principals. We now operate in an unprecedented "double agency" society, a tacit conspiracy between these two sets of agents—corporate managers, and institutional asset managers—leaving our system of capitalism largely bereft of the checks and balances demanded by elementary principles of sound governance.

The 300 largest institutional money managers—largely mutual funds and pension funds—now own some 65% of all U.S. stocks by market capitalization. (The largest 10 managers alone own 32%.) They therefore hold absolute power over our nation's corporations, a share that is likely to increase over time. That largely unexercised power will be exercised in the coming era, aided by a federal standard of fiduciary duty for these trustees of Other People's Money. As we become a Fiduciary Society, our corporate and financial system will finally place first the interests of investors.

In 1949, writing in "The Intelligent Investor," Benjamin Graham said that, in theory, "stockholders as a class are king. Acting as a majority they can hire and fire managements and bend them completely to their will." The behavior of stockholders has long suggested that such power is largely theoretical. But I predict that it must—and will—become a reality in the years ahead, as institutional investors are forced to recognize not only their rights, but their responsibilities of corporate ownership and control.

The four changes that I've outlined here are coming. The financial system will shrink in relative importance; much of today's short-term speculation will gradually be displaced by long-term investment; index funds will rise and active management will fall; and public opinion and public policy will together demand that the managers of Other People's Money act as good corporate citizens.

These challenges to the status quo will be fought aggressively by entrenched special interests of the financial sector. But when investors demand change, money managers will, in their own self-interest, accede to their wishes. After all, as Adam Smith wrote in 1776, the interest of the consumer must be the ultimate end and object of all industry and commerce. In the world of investing, Adam Smith's maxim will finally become reality.



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