The renowned John Bogle founded Vanguard in 1974 and brought low-cost investing to the public. In return, his firm has grown into the largest mutual fund company in terms of assets; it took in one of every three dollars of new, long-term investor money over the first four months of this year. At 83, Bogle no longer heads Vanguard, but he continues his mission to give investors a fair shake. His latest book, The Clash of the Cultures: Investment vs. Speculation, came out in August.
We all know Bogle's views on costs and indexing, but how does he feel about financial advisors? What advice does he have to offer those in the profession? Financial Planning posed 10 questions to Bogle and, as always, he was candid and passionate in his responses.
Q. There is ample evidence over the past several, volatile years that both advisors and consumers timed the market poorly. What should advisors do to control our own emotions and those of our clients?
A. My advice to advisors is the same as to consumers: Impulse is your enemy and time is your friend. Investors need to not do anything - just stand there. We will look back at recent volatility as a blip that should have been ignored. Advisors should get the right balance in clients' portfolios and stay there.
Q. Would you venture a prediction on the long-run return of stocks and bonds?
A. I think stocks will earn about 7% annually while bonds will return about 3% per year over the coming decade. The stock prediction is based on a formula I've used for a long time. Stock returns will equal dividends plus earnings growth. Dividends are currently about 2%, and I think 5% annual earnings growth is reasonable. While stock repurchases are similar to dividends, I don't put that in my formula because it's unclear whether these repurchases are completely offset by new shares issued to management through options and restricted stock. My research concludes that including stock repurchases does not improve the accuracy of the model.
The 3% bond prediction is based on the current yield. While the Vanguard Total Bond Market Index Fund is yielding only about 2%, the Vanguard Intermediate-Term Investment Grade Fund is yielding nearly 3%. I think it's appropriate to overweight corporate and underweight U.S. government debt.
Q. But isn't the total bond index fund the bond equivalent of the total stock index fund, in that it owns all U.S. investment-grade fixed-rate securities according to market capitalization? By overweighting corporate, isn't that the equivalent in stocks of overweighting small cap or value?
A. I don't think the analogy fits. The total bond market index fund follows the Barclays aggregate bond index. It comprises about 70% U.S. government and government agency debt. A large portion of that U.S. government debt is owned by China and Japan. In fact, the U.S. government itself owns a large portion of U.S. debt. Overweighting corporate debt from the perspective of all U.S.-issued debt is not the same as overweighting it from the perspective of debt owned by U.S. investors.
Q. For a long time, you've recommended against owning international stocks. Your argument states that one has substantial international exposure from owning U.S. stocks and you don't pick up the foreign currency risk. But doesn't the large performance differential between total U.S. and total international stocks over the past 10 years, as well as currency fluctuations not correlated with U.S. stock performance, argue for owning international stocks directly?
A. Let me be clear, I have never argued against owning international stocks. I just don't think one should have more than 20% of their equity portfolio in international stocks. International stocks are dominated by the U.K., France and Japan, which have large problems.
Of course, these problems are known by investors, but international stocks have additional sovereign risks and far less shareholder protection than in the U.S. Thus, international investing is riskier, and I don't think planners should put more than 20% of their client's equity exposure in international stocks.
Q. You brought index funds to the public in part for their simplicity. Is there a conflict, however, that makes it hard to charge the consumer much if they design a portfolio with a few very broad index funds?
A. There can be a conflict, but the goal of the advisor shouldn't be to beat the market by picking stocks or winning funds. Advisors add value by providing the discipline required for successful investing. They add value in areas like tax efficiency, risk management, estate planning and retirement planning.
Q. Many planners use a core-and-explore approach, believing such markets as U.S. large-cap stocks are efficient, but markets such as small-cap stocks and international stocks are not. What do you think of this approach?
A. The case for indexing isn't based on the efficient market hypothesis. It's based on the simple arithmetic of the cost matters hypothesis. In many areas of the market, there will be a loser for every winner so, on average, investors will get the return of that market less fees. With that said, I guess it's OK for either advisors or consumers to take a small part of their portfolio and do a little gambling. But periodically check out how it is working.
Q. Over the past five years, $565billion of new money went into equity index funds while actively managed equity funds lost $280billion. Bond index funds are also gaining ground. Do you think that advisors are accounting for a large portion of the inflow, understanding the impact of costs on client returns?
A. Yes, but I don't have the data to support it. The flow of funds to indexing has been steady. ETFs account for a large portion of the inflow, though some of the ETFs are marketing triumphs rather than a tool for investors to capture their fair share of market returns. I suspect that about a third of the indexing growth is due to the advisor community.
Q. Vanguard is taking in the lion's share of new money. Could Vanguard become too large?
A. Yes. With growth comes bureaucracy and the organization could become too large. With that said, Vanguard can become much larger and deliver even more value. This is an industry where costs matter and Vanguard has a large cost advantage due to scale. It doesn't cost much more to run an index fund when it doubles in size. Thus, the cost savings per dollar invested can be passed on to the investor.
Advisors, however, should appraise Vanguard to make sure it is still striving for the founding principles and values that I worked to create for the company.
Q. Are you optimistic about the future of the financial industry?
A. I'm optimistic that fees will come down and the financial services industry will become smaller. The original purpose of the financial services industry was to direct capital to the highest and best use. Today, only about 0.8% of the financial services industry goes toward directing capital. The rest goes to areas like excessive trading that adds no value to society. That's because the industry insiders profit at the expense of the consumer. As consumers realize this, the financial services industry will shrink. That's a good thing.
Q. What advice do you have for financial planners?
A. First, I think financial advisors provide a valuable service to millions of consumers. As mentioned, I don't think beating the market is where they add value, so I believe charging on a fee-only basis, or a fixed or hourly professional fee, will grow.
The most valuable services advisors can provide are in areas of financial planning like integrating Social Security into one's portfolio. They can help the client set the right asset allocation and then avoid the temptation to change it. Assisting the client in coordinating the will and estate planning aspects of life is a critical area.
Planners can save their clients in taxes by building tax-efficient portfolios with little turnover and the assets located in the right tax vehicles - taxable, tax-deferred or tax-free. Making sure clients have the right and most cost-effective insurance is another key area of value.
Finally, helping the consumer understand how much they need to save to reach their financial goals, applying all of the areas above, is a critical service planners provide to their clients. Planners should be applauded for the role they play.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes the Irrational Investor column for CBS MoneyWatch.com and is an adjunct faculty member at the University of Denver.
