Investment has long been beset by agency issues. The rise of public corporations meant that an agent had to be hired to manage the enterprise. These agents could have agenda’s that were not in alignment with the best interests of the corporation and could use their positions to enhance their own wealth at the expense of the corporation and its investors. This agency problem was supposed to be controlled by holding directors responsible by means of tying compensation to performance. Influential economists created the notion that the best indicator of performance should be maximizing the wealth of the corporation. Given perfect markets, that wealth would be represented by the share price. Executives had marching orders to maximize the share price, and it was assumed that shareholders would keep them and their Boards of Directors honest. The use of potentially volatile share prices as a measure of wealth, and as a determinant of executive compensation, forced attention on meeting short-term market expectations. This could be accomplished by financial engineering if necessary, even if at the long-term expense of the company.
In the days when shares were mostly owned by individual investors, the assumption was that the investors were in for the long haul and expected the company to be focused on long-term growth and prosperity. The ability of these individuals to impact company policy was always minimal, but the rise of institutional investing created another agency issue. About 70% of corporate shares are now owned by institutional investors, mainly mutual funds and pension plans.
Bogle describes how the mutual fund industry evolved from one focused on investing for long-term gains, to one more interested in attaining short-term gains. He describes developments over the 60 years of his experience in the business:
The new mutual fund environment also focused on short-term gains, and as principal "owners" of corporations, this view supported the short-term focus of company executives.
Bogle refers to this conspiracy between corporate management and institutional investors as a "double agency" problem. Indeed, his description of the mutual fund industry as it exists today suggests that there is a third agency issue, one critical to fund investors.
If fund managers were compensated based on a metric dominated by fund performance, then a long-term approach to investment for consistent gains could be appropriate. But that is not the way the system works. Fund managers are paid according to how much money they control. A typical fee is about 1.5% annually on all funds under management; and that is independent of performance. The focus of managers then is to use fund performance as a marketing tool to attract more money. Fund performance is the bait for attracting more investors, but it drives the funds into a highly speculative mode in order to better the competition. This doesn’t, and can’t work in the long term, and investors suffer the consequences.
Fund managers require money to pay themselves lofty salaries, to cover the transaction costs involved in churning stocks in order to try to gain that extra advantage, and money to pay for the marketing required to attract more money. If publicly owned, the fund manager must also extract funds from its investor-clients to provide profit for its investor-owners. How about that for a conflict of interest?
As mentioned, fees have grown to average about 1.5%. A fund portfolio that actually increases in value by 5% annually, would deliver only 3.5% annually to the investor. The difference between 5% compounded annually and 3.5% compounded annually becomes enormous over the years.
To Bogle, the system is not only wasteful, but also shameful.
"Such enormous costs seriously undermine the odds in favor of success for citizens who are accumulating savings for retirement. Alas, the investor feeds at the bottom of the costly food chain of investing, paid only after all the agency costs of investing are deducted from the markets’ returns...."
Bogle is famous for having invented the index fund which tries to track an entire market or market segment, thus avoiding speculation and guaranteeing gains equal to the market. Such a construct has no justification for high fees and can be found in the range of 0.25% or less. As an exercise try compounding money at 4.75% rather than at 3.5% over an investment lifetime.
More on Bogle’s book and his investment advice can be found in Investing in Wall Street’s Casino: The House’s Take.