The Best Investment Advice
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The best investment advice you'll never get For 35 years, Bay Area finance revolutionaries have been pushing a personal investing strategy that brokers despise and hope you ignore. Mark Dowie http !!www.sanfran"ag.co"!story!best#invest"ent#advice#youll#never#get As Google’s historic August 2004 IPO approached the co"pany$s senior vice president, %onathan &osenberg, reali'ed he was about to spawn hundreds of i"petuous young "ulti"illionaires. (hey would, he feared, beco"e the prey of )all *treet brokers, financial advisers, and wealth "anagers, all offering their own get#even#richer invest"ent sche"es. *cores of the" fro" fir"s like %.+. Morgan ,hase, -B*, Morgan *tanley, and +residio Financial +artners were already circling co"pany head.uarters in Mountain /iew with hopes of presenting their wares to so"e soon#to#be#very#wealthy new clients. &osenberg didn$t turn the suitors away0 he si"ply placed the" in a holding pattern. (hen, to protect 1oogle$s staff, he proposed a series of in#house invest"ent teach#ins, to be held before the invest"ent counselors were given a green light to land. ,o"pany founders *ergey Brin and 2arry +age and ,34 3ric *ch"idt were e5cited by the idea and gave it the go#ahead. 4ne by one, so"e of the "ost revered na"es in invest"ent theory were brought in to school a class of brilliant engineers, progra""ers, and cybergeeks on the fine art of personal investing, so"ething few of the" had thought "uch about. First to arrive was *tanford -niversity$s )illia" 6Bill7 *harpe, 899: ;obel 2aureate econo"ist and professor e"eritus of finance at the 1raduate *chool of Business. *harpe drew a large and enthusiastic audience, which he could have wowed with a +ower+oint presentation on his <gradient "ethod for asset allocation opti"i'ation= or his <returns#based style analysis for evaluating the perfor"ance of invest"ent funds.= But he spared the young geniuses all that co"ple5ity and offered a si"ple for"ula instead. <Don$t try to beat the "arket,= he said. +ut your savings into so"e inde5ed "utual funds, which will "ake you >ust as "uch "oney 6if not "ore7 at "uch less cost by following the "arket$s natural ebb and flow, and get on with building 1oogle. The !ollo"ing "ee# it "as $urton %al#iel for"erly dean of the ?ale *chool of Manage"ent and now a professor of econo"ics at +rinceton and author of the classic A Random Walk Down Wall Street. (he book, which you$d be unlikely to find on any broker$s bookshelf, suggests that a <blindfolded "onkey= will, in the long run, have as "uch luck picking a winning invest"ent portfolio as a professional "oney "anager. Malkiel$s advice to the 1oogle folks was in lockstep with *harpe$s. Don$t try to beat the "arket, he said, and don$t believe anyone who tells you they can@not a stock broker, a friend with a hot stock tip, or a financial "aga'ine article touting the latest "utual fund. *easoned invest"ent professionals have been hearing this anti#industry advice, and the praises of inde5ing, for years. But to a class of A:#so"ething .uants who$d grown up listening to stories of tech stocks going through the roof and were eager to test their own ability to outpace the averages, the discouraging "essage ca"e as a surprise. *till, they listened and pondered as they waited for the following week$s lesson fro" %ohn Bogle. <*aint %ack= is the living scourge of )all *treet. (hough a self#described archcapitalist and lifelong &epublican, on the sub>ect of brokers and financial advisers he sounds "ore like a seasoned Mar5ist. <(he "odern A"erican financial syste",= Bogle says in his book The Battle for the Soul of Capitalism, <is under"ining our highest social ideals, da"aging investors$ trust in the "arkets, and robbing the" of trillions.= But "ost of his ani"us in Mountain /iew was reserved for "utual funds, his own field of business, which he described as an industry organi'ed around <sales"anship rather than stewardship,= which <places the interests of "anagers ahead of the interests of shareholders,= and is <the consu""ate e5a"ple of capitalis" gone awry.=
Bogle$s closing advice was as si"ple and direct as that of his predecessors those brokers and financial advisers hovering at the door are there for one reason and one reason only@to take your "oney through e5orbitant fees and transaction costs, "any of which will be hidden fro" your view. (hey are, as ;ew ?ork attorney general 3liot *pit'er described the", nothing "ore than <a giant fleecing "achine.= Bgnore the" all and invest in an inde5 fund. And it doesn$t have to be the /anguard 5:: Bnde5, the inde5ed "utual fund that Bogle hi"self built into the largest in the world. Any passively "anaged inde5 fund will do, because they$re all basically the sa"e. )hen the industry sharks were finally allowed to enter the inner sanctu" of 1oogle, they were barraged with .uestions about their co""issions, fees, and hidden costs, and about inde5ing, the al"ost cost#free invest"ent strategy the 1oogle e"ployees had been told delivers higher net returns than all other "utual fund strategies. (he asse"bled )all *treeters were surprised by their reception@and a bit discouraged. Brokers and financial planners don$t like inde5ed "utual funds for two basic reasons. For one thing, the funds are an affront to their ego because they discount their ability to asse"ble a winning portfolio, the very talent they$re trained and paid to offer. Also, inde5 funds don$t "ake brokers and planners "uch "oney. Bf you have your "oney in an account that$s following the natural "ove"ents of the "arket@also called passive investing@you don$t need fancy "anagers to watch it for you and charge big bucks to do so. Brin and +age were proud of the decision to prepare their staff for the )all *treet predation. And they were glad to have launched their co"pany where and when they did. )hat took place in Mountain /iew that spring "ight have never happened had 1oogle been born in Boston, ,hicago, or ;ew ?ork, where "uch of the financial co""unity re"ains at war with insurgency forces that first started gathering in *an Francisco 35 years ago. It all started in the early &'(0s with a group of "averick invest"ent professionals working at )ells Fargo bank. -sing the vast new powers of .uantitative analysis afforded by co"puter science, they gradually ca"e to the conclusion that the traditional practices guiding institutional investing in A"erica were, for the "ost part, not delivering on the pro"ise of better#than# average returns. As a result, the fees that average A"ericans were paying brokers to engage in these practices were akin to highway robbery. *ure, so"e highly paid hotshot portfolio "anagers could occasionally put together a high#return fund. But generally speaking, trying to beat the "arket@also called active investing@was a fruitless venture. (he insurrection these "avericks would create eventually caught on and has spread beyond the Bay Area. But *an Francisco re"ains ground 'ero of the de"ocrati'ing challenge to A"erica$s vast and lucrative invest"ent industry. -nder threat are the billions of dollars that "utual funds and brokers ski" every year fro" often#unwary investors. And every person who has "oney to invest is affected, whether she$s patching together her own portfolio with a broker, saving for retire"ent or college, or >ust "aking s"all contributions each year to her C:8D. Bf the "ove"ent succeeds, not only will "ore and "ore people have a lot "ore "oney in their pockets, but the personal invest"ent industry will never look the sa"e. I "as once a port!olio manager mysel! and like the industry folks 1oogle was protecting its e"ployees fro", B was certain B could outperfor" "arket averages and confident that B was worth the salary paid to do so. Eowever, B left the invest"ent business before this revolt began to brew. Bn the intervening years, B never stewarded "y own invest"ents as >udiciously as B$d "anaged those of "y for"er e"ployers@Bank of A"erica, Bndustrial Bnde"nity, and the Bechtel fa"ily. B was unhappy with the )all *treet fir"s B had been using, which had churned "y account to "ake lots of "oney on the sales, and, despite instructions to the contrary, placed "y "oney in their own funds and underwritings to "ake even "ore at "y e5pense. *o a couple of years ago, when it finally ca"e ti"e to get "y own house in order, B knew B wanted help fro"
an independent adviser, so"eone who was doing things differently fro" the big brokerage fir"s. 3ventually B found a s"all financial "anage"ent fir" in *ausalito called Aperio 1roup that, after only seven years in business, already had a stellar reputation. <Aperio= in 2atin "eans <to "ake clear, to reveal the truth.= Bndeed, truth#telling is key to Aperio$s "ission, even if that "eans bad"outhing its own industry in the process. 4ne of the co"pany$s founders, +atrick 1eddes, aged CF, is a renegade fro" the top echelons of his field. For several years he served, first as director of .uantitative research, then as ,F4, at Morningstar, the nation$s leading co"pany for researching and appraising "utual funds. But when he left, not only was he disenchanted with his own co"pany$s corporate environ"ent, he was also beco"ing uneasy with the "oral underpinning of the entire industry. <2et$s be straight,= says 1eddes in his soft#spoken but 'ealous way. <Being unethical is a good precondition for success in the financial business.= Eis partner, a bright, high#energy ;orwegian A"erican na"ed +aul *olli, C9, is another finance guy who didn$t have the gene for corporate culture. After graduating fro" Dart"outh$s business school, he tried invest"ent banking but didn$t like it. Ee went out on his own, starting an invest"ent advisory business, but says he flailed about, searching for a business "odel that would support his desire to <live deliberately= in the (horeauvian "anner. *olli and 1eddes consider the"selves heirs to the )ells Fargo insurgency and, as such, part of a "ove"ent that includes acade"ics, so"e institutional investors, a couple of large inde5 fund co"panies, and a handful of s"all fir"s like their own that are dedicated to bringing the inde5ing philosophy to badly advised investors like "yself. And unlike "ost "utual fund invest"ent fir"s, which have G5 "illion and G8: "illion "ini"u"s, Aperio was willing to take on a "essy si5#figure portfolio. *olli took one look at "y unke"pt collection of "utual funds and said, <?ou$re being robbed here.= Ee pointed to funds B had purchased fro" or through +utna", Merrill 2ynch, Dreyfus, and @yes@,harles *chwab 6which referred "e to Aperio7 and asked, <Do you know that you$re paying these guys to do essentially nothingH= Ee carefully e5plained the "any ingenious ways fund "anagers, brokers, and advisers had found to chip away at investors$ returns. (urns out that B, like "ore than 9: "illion other suckers who have put close to G9 trillion into "utual funds, was paying annual fees, co""issions, and transaction costs well in e5cess of A percent a year on "ost of "y "utual funds 6see <)hat Are the FeesH= page I57. <Do you know what that adds up toH= *olli asked. <At the end of every 3J years, you will only have "ade half of what you could have, through no fault of your own. And these are fees you needn$t pay, and won$t, if you switch to inde5 funds.= All inde5ing calls for, *olli e5plains, is the selection of a particular stock "arket inde5@the Dow %ones Bndustrial Average, *tandard and +oor$s 6*K+7 5::, the &ussell 8:::, or the broader )ilshire 5:::@and the purchase of all its stocks and bonds in the e5act proportions in which they e5ist in that inde5. Bn an actively "anaged fund, "anagers pick stocks they think will outperfor" a particular inde5. But the pre"ise of inde5ing is that stock prices are generally an accurate reflection of a co"pany$s worth at any given ti"e, so there$s no point in trying to beat that price. (he worth of a client$s invest"ent goes up or down with the ebb and flow of the "arket, but the idea is that the "arket naturally tends to increase over ti"e. Moreover, even if an inde5 fund perfor"ed only as well as the e5pensively "anaged Merrill 2ynch 2arge ,ap "utual fund that was in "y portfolio, B would earn "ore because of the lower fees. *tewarding this kind of invest"ent does not re.uire a staff of securities analysts working under a fund "anager who "akes GA: "illion a year. Bn fact, a desktop co"puter can do it while they sleep. (here are always e5ceptions, of course, *olli says, <a few funds that at any given "o"ent outperfor" the inde5es.= But over the years, he e5plains, their perfor"ances invariably decline, and their highly paid cover#boy "anagers slide into early obscurity, to be replaced by a new hotshot "anaging a different fund. Bf a "utual#fund investor is able to stay abreast of such changes, "ove their "oney around fro" fund to fund, and stay ahead of the averages 6factoring
in higher co""issions and "anage"ent fees7 it will be by sheer luck, says *olli, who then offers "e pretty "uch the sa"e advice %ohn Bogle and his colleagues offered 1oogle. *ell the hyped but fee#laden funds in "y portfolio and replace the" with boring, low#cost funds like those offered by Bogle$s /anguard. Bt took *olli a couple "ore painful "eetings and a few do'en trades to clean the parasites out of "y account and reinvest the proceeds in inde5 funds, the lifeblood of his business. )ithout e5ception, he "oved "e into funds that have outperfor"ed the ones B was in, like the /anguard &3B( Bnde5 Fund, so"e +i"co bond and stock funds, and Artisan Bnternational. And he did it for an annual fee of .5 percent of "oney under "anage"ent, saving "e over a full percent in overall costs and a lot of ta5es in the future. (hen he did so"ething B doubt any other financial "anager would have done. Ee fired hi"self. <?ou really don$t need "e any"ore,= he said, and closed "y Aperio account that day, ending his fees, but not our relationship. B was curious. )ho was this guy who was so open about the less#than#dignified ways of his own businessH <?ou have to have lunch with "y partner,= he said. I! )olli is an industry gad!ly 1eddes, a "odest, unassu"ing son of a -nited ,hurch of ,hrist "inister, is its chainsaw "assacrer. <)e work in the "ost overco"pensated industry in the country,= 1eddes ad"itted before the water was served, <and inde5ing threatens the revenue flow fro" "anaged funds to brokerage houses. (hat$s why you$ve been kept in the dark about it. (his truly is the great secret sha"e of our business. <(he industry knows they are peddling bad products,= 1eddes continued, <and a lot of people "aking the "ost "oney and getting the "ost prestige are doing so by gouging their custo"ers.= And 1eddes is .uick to differentiate between <illegal theft=@the sort of industry scandals *pit'er has uncovered, such as illicit sales practices, undisclosed fees, kickbacks, and after#"arket trading@and <legal theft,= the stuff built into the cost of doing business that no attorney general can touch, but which in dollar a"ounts far e5ceeds investor losses to illegal activity. 1eddes wasn$t always full of such tough talk about the industry. ;ot that he had any .ual"s about speaking his "ind0 in fact, he was let go fro" Morningstar in 899J for being openly critical of the co"pany$s internal culture. <B still think of Morningstar as a potentially positive force in the industry,= he says. <But let$s >ust say they were weak at conflict "anage"ent, especially at the senior levels.= Bt wasn$t until he took a freelance consulting >ob for ,harles *chwab that he really saw the light about inde5ing. <My >ob was to co"pile all the acade"ic research on "utual funds, and that$s when it really beca"e clear that active "anage"ent doesn$t add any value,= he says. )hen he finished the pro>ect, 1eddes started teaching a finance class through the -niversity of ,alifornia e5tension, where he started preaching his anti#industry gospel. <B had to be careful, because there were a lot of brokers in the class. B started noticing that so"e of the" would get sort of irritated with "e.= Around this ti"e is when he "et *olli. *olli had a client, a doctor who was looking to learn about portfolio "anage"ent and asked *olli what he thought of 1eddes$s -, course. )hen *olli looked into it, he was bowled over. <Eere was this guy who$d been ,F4 at Morningstar and had this incredible background, and B thought, what the hell is he doing at Berkeley teaching this course to guys like "y clientH (his is too good to be true@B have to "eet this guy.= *lowly, inadvertently even, Aperio was born. But the fit was perfect. 1eddes brought what he calls <the .uant piece= to the table0 *olli had the strategic vision. After a few "onths of brainstor"ing, they set out to see if a couple of guys who held the"selves to high ethical standards could "ake it in the cutthroat financial industry. And >ust how do these guys "ake "oney if they keep kicking out clients like "e once they switch us into inde5 funds, while alienating others with their irreverent criti.ue of the entire
"utual fund ga"eH 1eddes does take referrals fro" invest"ent fir"s like ,harles *chwab, which thrive on the sale of "anaged "utual funds. *o why the rantH Bsn$t he, too, in business to "ake a buckH <Absolutely,= he ad"its. <B$" not Mother (eresa0 B$" a capitalist who wants to succeed and "ake "oney. B >ust think the best way to do that is by building trust in a clientele by revealing to the" honestly how this business works.= 1eddes also offers a custo"i'ed version of inde5ing 6on ta5able returns7 for wealthier clients, a service that re.uires an ongoing relationship and supplies Aperio a steadier source of inco"e than "y low#si5#figure portfolio did. Aperio now has about GF:: "illion under "anage"ent. Bt$s a paltry su" co"pared with those of the big brokerage fir"s, which deal in the billions or even trillions, but 1eddes is fine with that. <Bf B were "aking what B could be "aking in this business, B >ust wouldn$t like the person B$d have to be.= *)an +rancisco "as the only place in the country where this could have happened,= says Bill Fouse, a >a'' clarinetist in Marin ,ounty who was present when the first shots were fired in the invest"ent rebellion. Bt was 89I:, and revolution was in the air. )hile hippies, dopesters, and antiwar radicals were filling the streets of A"erica$s "ost tolerant city with rage, sweet s"oke, and resistance, a .uieter protest was brewing in the lofty, paneled offices of )ells Fargo. (here, a young engineer na"ed %ohn Andrew <Mac= McLuown, Fouse 6who like "any "usicians also happens to be a brilliant "athe"atician7, and their self#described <skeptical, suspicious, careful, cautious, and slow#to#change= boss, %a"es /ertin, were taking a hard look at the conventional wisdo" that for a century had driven A"erican portfolio "anage"ent. Bank trust depart"ents across the country were staffed by portfolio "anagers who, as B did at the ti"e, believed that they alone possessed the invest"ent for"ula that would enrich and protect the security of their custo"ers. <;o one argued with that pre"ise,= Fouse recalls. But McLuown suspected they were pretty "uch all wrong. Ee had "et )ells Fargo chair"an &anso" ,ook at an invest"ent foru" in *an %ose, and at a later "eeting at co"pany head.uarters, persuaded hi" that traditional portfolio "anage"ent was "erely an invest"ent variation of the 1reat Man theory. <A great "an picks stocks that go up. ?ou keep hi" until his picks don$t work any"ore and you search for another great "an,= he told ,ook. <(he whole thing is a chance#driven process. Bt$s not syste"atic, and there$s lots we still don$t know about it and that needs study.= ,ook offered McLuown a >ob at )ells and a generous budget to conduct research into the 1reat Man (heory and other sche"es to beat the averages. McLuown accepted, and a few years later Fouse ca"e on as well. (hey couldn$t have been "ore different Fouse, a di"inutive, "ild#"annered "usician, and McLuown, a burly, boisterous *cot. (he two were like oil and water@McLuown even tried to have Fouse fired at one point@but their boss, /ertin, was the one who really was in the hot seat. <?ou have to understand, /ertin$s career was on the line,= Fouse recalls. <Ee was, after all, running a depart"ent full of portfolio "anagers and securities analysts whose "ission was to outperfor" the "arket. 4ur thesis was that it couldn$t be done.= +roof of McLuown$s theory could lead to the end of an e"pire, in fact "any e"pires. <(he poor guy was under siege,= says Fouse. <Bt was a nerve#racking ti"e.= /ertin$s "e"ory of those ti"es is no less vivid. <Mac the knife was going to own this thing,= he once told a reporter. <B could >ust see the fin of the shark cutting through the water.= 3ventually, the research McLuown and Fouse produced beca"e so strong that /ertin could not ignore it. <Bn effect it said that al"ost everything that every trust depart"ent in A"erica was doing was wrong,= says Fouse. <But %i" eventually accepted it, even knowing the conse.uences.=
Bn %uly 89I8, the first inde5 fund was created by McLuown and Fouse with a GJ "illion contribution fro" the *a"sonite 2uggage pension fund, which had been referred to Fouse by Bill *harpe, who was already teaching at *tanford. Bt was *harpe$s acade"ic work in the 89J:s that for"ed the theoretical underpinning of inde5ing and would later earn hi" the ;obel +ri'e. (he s"all initial fund perfor"ed well, and institutional "anagers and their trustees took note. By the end of the decade, )ells had co"pletely renounced active "anage"ent, had relieved "ost of its portfolio "anagers, and was offering only passive products to its trust depart"ent clients. And it had signed up the ,ollege &etire"ent 3.uities Fund 6,&3F7, the largest pool of e.uity "oney in the world, and Earvard -niversity, the largest educational endow"ent. By 89F: G8: billion had been invested nationwide in inde5 funds0 by 899: that figure had risen to GAI: billion, a third of which was held at )ells Fargo bank. 3ventually the depart"ent at )ells that handled inde5ing "erged with ;ikko *ecurities and was later bought by Barclays Bank, which created the *an Francisco subsidiary Barclays 1lobal Bnvestors. Bts ,34, +atricia Dunn, the scandal#tinged for"er chair"an of Eewlett#+ackard who had worked for A: years at )ells Fargo, had been heavily influenced by inde5ing. &unning Barclays, she beca"e the world$s largest "anager of inde5 funds. Fouse, now retired in *an &afael, e5plains why all this could have happened only in *an Francisco. <)hen we started our research, al"ost all the trust clients out here were individuals with s"all accounts. Anywhere else, particularly on the 3ast ,oast, trust depart"ents handled very large institutions@pension funds, university endow"ents, that sort of thing. Bf Mellon, ,hase, or ,itibank had done this research and co"e to the sa"e conclusion, they would have in effect been saying to their large, sophisticated, and very lucrative clientele M)e$ve been doing things wrong for a century or "ore.$ And thousands of very co"fortable invest"ent "anagers would have been out of work.= But even in *an Francisco, as in the country$s other financial centers, Fouse and McLuown$s findings were not a welco"e develop"ent for brokers, portfolio "anagers, or anyone else who thrived on the industry$s high salaries and fees. As a result, the counterattack against inde5ing began to unfold. Fund "anagers denied that they had been gouging investors or that there was any conflict of interest in their profession. )orkout gear appeared with the slogan <Beat the *K+ 5::,= and a Minneapolis#based fir", the 2euthold 1roup, distributed a large poster nationwide depicting the classic -ncle *a" character saying, <Bnde5 Funds Are -nA"erican,= i"plying that anyone who was not trying to beat the averages was nothing "ore than an unpatriotic wi"p. 6(hat poster still hangs on the office walls of "any financial planners and fund "anagers.7 *avvy invest"ent consu"ers, however, were apparently catching on. As they began to suspect that the fa"ous fund "anagers they were reading about in Business Week and Money "aga'ine were taking the" for a ride, inde5 funds grew in si'e and nu"ber. And actively "anaged funds shrank proportionately. 3ven so"e highly placed industry insiders started beating the dru"s for inde5ing. Fro" her perch at Barclays, ,34 Dunn gave a speech at a A::: annual industry "eeting in ,hicago. As reported in Business Week at the ti"e, she started out with so"e tongue#in#cheek co""ents about fund "anagers$ <rare gifts and genius,= and then shocked the crowd by going on to denounce the industry$s high fees. According to the article, she even included this 'inger <NBnvest"ent "anagers sellO for the price of a +icasso NwhatO routinely turns out to be paint#by#nu"bers sofa art.= Bt$s not as if Merrill 2ynch, +utna", Dreyfus, et al, were being put out of business by this new consciousness, but like any industry threatened with bad ink, the financial co""unity continued to strike back at every opportunity. Bn May A::3, Matthew Fink, president of the Bnvest"ent ,o"pany Bnstitute, a "utual funds trade association, told convening "e"bers that his industry was s.ueaky clean and has <succeeded because the interests of those who "anage funds are well#aligned with the interests of those who invest in "utual funds.= At the sa"e convention, Fink$s re"arks were echoed by B,B vice chair"an +aul Eaaga %r., who, in his keynote address,
pronounced that <our strong tradition of integrity continues to unite us.= Bndeed, integrity had been the the"e of every B,B "e"bership "eeting in recent "e"ory. Eaaga then attacked his industry$s critics, including for"er *3, chair"en, "e"bers of ,ongress, acade"ics, >ournalists, even <a saint with his own statue= 6%ohn Bogle7. <N(heyO have all weighed in about our perceived failing,= la"ented Eaaga. <Bt "akes "e wonder what life would be like if we$d actually done so"ething wrong.= Ee didn$t have long to wonder. Four "onths later, the nation$s first big "utual fund scandal broke when 3liot *pit'er brought civil actions against four "a>or fund "anagers for allowing preferred investors to buy and sell shares on news or events that occurred after "arkets had closed. *pit'er co"pared the practice to <allowing betting on a horse race after the horses have crossed the finish line.= Multi"illion dollar fines were issued against the fir"s, which were also re.uired to co"pensate custo"ers da"aged by what were called "arket#ti"ing practices. (he "arket#ti"ing scandals alone are esti"ated to have cost fund investors about GC billion, and other industry violations were uncovered after that. But now "ore e5perts are convinced that the a"ount pales in co"parison to the tens of billions lost every year >ust to the fees and transaction costs by which "utual funds live and die. After the "utual fund scandals broke, *enator +eter Fit'gerald 6&#Bll.7 called a hearing before the *ubco""ittee on Financial Manage"ent, the Budget, and Bnternational *ecurity, and said this in his opening state"ent <(he "utual fund industry is now the world$s largest ski""ing operation@a GI trillion trough fro" which fund "anagers, brokers, and other insiders are steadily siphoning off an e5cessive slice of the nation$s household, college, and retire"ent savings.= ,o one running a university endow"ent, independent foundation, or pension fund could "atch his nu"bers during his tenure over the last A8 years, chief invest"ent officer David *wensen has averaged a 8J percent annual return on ?ale -niversity$s invest"ent portfolio, which he built with everything fro" venture capital funds to ti"ber. Ee$s been called one of the "ost talented investors in the world. But lately he$s beco"ing perhaps even "ore fa"ous for his advice to individual investors, which he first offered in his A::5 book Unconventional Success. <Bnvest in nonprofit inde5 funds,= he says une.uivocally. <?our odds of beating the "arket in an actively "anaged fund are less than 8 in 8::.= And there$s "ore. A recent entry on the Motley Fool, the popular invest"ent advice website, "ade the following blanket state"ent <Buy an inde5 fund. (his is the "ost actionable, "ost "athe"atically supported, short#for" invest"ent advice ever.= As long as 8: years ago, in his annual letter to his shareholders, )arren Buffett advised both institutional and individual investors <that the best way to own co""on stocks is through an inde5 fund that charges "ini"al fees. (hose following this path are sure to beat the net results 6after fees and e5penses7 delivered by the great "a>ority of invest"ent professionals.= 4ne would think, with that kind of advice floating about, that the whole country would by now be in inde5 funds. But in the three decades since )ells Fargo kicked things off, only about C: percent of institutional "oney and 85 percent of individuals$ "oney has been invested in inde5 funds. *o why is inde5ing catching on so slowlyH A big reason, according to 1eddes, is that putting investors into inde5 funds is si"ply not in the interest of the industry that sells securities. <(hey >ust won$t accept inde5ing$s "inuscule fees,= he says. By now, "ost "a>or brokerage fir"s offer inde5 funds in addition to traditional "utual funds, but "oney "anagers typically don$t "ention the" at all. ?ou usually have to ask about the" yourself. And it "akes a certain kind of sense. Bf a naive investor calls a broker with G8::,::: to invest, would the broker be likely to reco""end the /anguard 5:: Bnde5 with its .89 percent annual fee, of which he receives nothing and collects but a s"all portion of his fir"$s appro5i"ately G8:: transaction feeH 4r "ight he suggest the client buy +utna"$s *"all ,ap 1rowth Fund B *hares, which carry a A.3 percent annual fee, 8 percent 6G8,:::7 of which goes to hi"H And will
he tell his client about the hidden transaction charges that further reduce the return on invest"entH Bt$s si"ply not to his advantage to do so. Bt$s hard to find active fund "anagers who are willing to talk about these issues. B spoke to several, but no one was co"fortable discussing the high cost of their practice, and few were willing to talk on the record. &on +eyton, president and ,34 of ,allan Associates, a *an FranciscoPbased institutional invest"ent consulting fir", offered a list of advantages of active "anage"ent, which essentially boiled down to the fact that it$s "ore fun. <(hey can raise and lower cash positions Nread buy and sell whatever stocks e5cite the" at any given "o"entO and go into fi5ed#inco"e or foreign securities Nread look for invest"ents wherever they wantO.= B know fro" e5perience that he$s right, but it$s kind of beside the point. (he "ost forthright co""ents ca"e fro" Baie ;et'er, a research analyst in the 4rinda office of 2it"an!1regory ,o"panies, a *an FranciscoPbased invest"ent "anage"ent fir" speciali'ing in "utual funds. ;et'er told "e outright, <3ighty percent of active "anagers underperfor" the "arket. But we do believe that so"e "anagers add value, and those are the ones we look for.= *till, if you factor in fees and transaction costs, you have to wonder how "uch that re"aining A: percent would slip. But even if the nu"ber of active "anagers who consistently beat the "arket is s"all, *tanford$s Bill *harpe still sees a real need for their services. )hile he is a strong partisan of inde5 funds, he is neither as surprised nor as concerned as 1eddes that they don$t represent a higher proportion of overall invest"ent. <Bf you$d told "e 35 years ago that inde5ing would one day represent C: and 85 percent of invest"ents, B would have asked you what you were s"oking,= says the personable *harpe with his characteristic chuckle. Bf everyone invested in inde5 funds, he points out, the "arket itself would die a natural death. <)e need active "anagers,= he says. <Bt$s buyers and sellers who keep prices "oving, which is what drives the "arket. Bnde5 funds si"ply reflect what the "arket is doing.= Ee believes we$d even start to see a decline in "arket efficiency if inde5 funds rose to 5: percent of total invest"ents. Does this "ean that, when we look at "utual funds, half our options would still be burdened with unconscionable fees and hidden costsH Eopefully not. )ith the call getting louder fro" financial e5perts and industry watchers to refor" and regulate "utual funds, it$s hard to believe that the fee syste" can last "uch longer, particularly with strong &epublican voices like +eter Fit'gerald$s in ,ongress. But while )all *treet has considerable soul#searching to do, full bla"e for the gouging of naive investors does not lie with the invest"ent "anage"ent industry alone. (here is an innate cultural i"perative in this country to beat the odds, to do better than the %oneses. Bn so"e ways the 2euthold 1roup was right when it said that inde5 funds are un#A"erican. Bt$s si"ply difficult for "ost of us to accept average returns on our "oney, or on anything for that "atter. (he ulti"ate e5a"ple of the nation$s attraction to the big score is, of course, right now under our noses. Bf on August 8F, A::C, you had invested G8::,::: in 1oogle, that stock would now be worth G55:,:::. *o while evidence "ounts that it$s al"ost i"possible to hit the >ackpot with cost#burdened "utual funds@and that for every 1oogle, there$s an 3nron@we si"ply refuse to stop trying. +erhaps *olli and 1eddes had it right when they selected the na"e for their co"pany. (he real purpose of this whole revolution is <to "ake things clear, to reveal the truth.= As *olli puts it, <As long as people know what they$re dealing with, they can invest their "oney with full awareness. )hether it$s playing it safe with inde5ing or taking a flier on a hedge fund@at least they$re the ones in control.= )hat about hedge fundsH *o, the bulk of your savings is safely tucked away in a sensible inde5 fund or two. )hy not set aside 5 or 8: percent and take a chance on the post#dot#co" insider$s invest"ent cra'eH
Bt$s certainly te"pting. (he "ost high#profile "anager, 3dward <3ddie= 2a"pert, has reportedly earned investors in his 3*2 Bnvest"ents hedge fund an average return of A9 percent a year since 89FF. After successfully buying D"art with his investors$ "oney, 2a"pert turned the "erged retailer around and in A::C personally took ho"e G8 billion. Another of the world$s "ost successful funds is *an Francisco$s Farallon ,apital Manage"ent, which has a"assed assets of G8A.5 billion over two decades by delivering post#fee returns of 8I percent a year on its flagship fund, according to a A::5 article in nstitutional nvestor "aga'ine. Forty#eight#year#old (o" *teyer$s investors include universities, pension funds, and individuals0 at any one ti"e, the "aga'ine said, the "anagers there "ight be nursing 3:: to 5:: invest"ents in everything fro" real estate@Farallon recently bought into the Mission Bay develop"ent@to international finance. But the road fro" )all *treet is scattered with the bones of bitter hedge fund investors. *ince 8995, "ore than 8,F:: known hedge funds have folded co"pletely. Bn the last few "onths alone, two large funds@Mother&ock and A"aranth Advisors@have gone south. The high !ailure rate should come as no surprise given how hedge funds operate. (here$s no working "odel, so they vary widely, but the basic idea is that they rely on risky, untraditional invest"ent strategies@ranging fro" arbitrage to taking over floundering co"panies, as 2a"pert did@to "ake big "oney fast. (he industry is largely unregulated, and "ost funds involve private partnerships that operate in strict confidence. (hey$re also e5tre"ely e5pensive, which li"its their user profile. (hough fees average >ust A percent of the invest"ent, the sa"e as in a typical *ilicon /alley venture fund, "anagers also withhold a si'able chunk 6averaging A: percent, but so"eti"es going as high as 5: percent7 of whatever profit the funds produce. (he typical "ini"u" re.uired to get into a fund is between G8 "illion and G5 "illion. (he *3, periodically considers applying "ini"al rules to hedge funds, such as prohibiting pension funds fro" investing in the". 2ast 4ctober, the call for refor" ca"e fro" ,ongress when *enator ,harles 1rassley, chair"an of the *enate Finance ,o""ittee, asked ad"inistration officials and ,ongress "e"bers for their views on how to i"prove hedge fund transparency. But so far, the hedge fund lobby has "anaged to keep all regulators at bay. %ar# .o"ie )hat are the feesH 3very fee that a "utual fund charges should be outlined so"ewhere in its prospectus. But "any people don$t even think to look for it, and you can$t necessarily trust your broker to bring it up. <(he first step is si"ply getting people to pay attention to fees,= says +atrick 1eddes, chief invest"ent officer of Aperio 1roup, in *ausalito. /ang tough in as#ing your bro#er !or the !ull brea#do"n of what those fees will cost you each year. Bf you need help, the ;ational Association of *ecurities Dealers has a useful tool for co"puting fees, called the Mutual Fund 35pense Analy'er, on its website 6http !!apps.nasd.co"!investorQBnfor"ation!ea!nasd!"fetf.asp57. ?ou put in the na"e of the fund, the a"ount invested, the rate of return, and the length of ti"e you$ve had the fund, and it tells you e5actly how "uch you$ve been charged. ?ou can also co"pare past fees for different funds before you invest. For e5a"ple, if you had put G8::,::: into +utna"$s *"all ,ap 1rowth Fund ,lass B *hares and held it for the past five years, you would find that +utna" would have charged you G83,F:9 in fees during that ti"e. /anguard$s (otal *tock Market Bnde5 Fund, on the other hand, would have charged only G8,8J5 for the e5act sa"e invest"ent. -$yron Perry )hich inde5 fundH Bn so"e ways inde5ing is a no#brainer invest your "oney and let it do its thing. *till, there are
varieties. Aperio 1roup$s +atrick 1eddes pushes two rules in choosing a fund *The broader the better and the cheaper the better01 )hen you invest in a broad do"estic fund, you$re investing in the entire -.*. econo"y, or <owning capitalis",= as it were, 1eddes says. (he /anguard (otal *tock Market Bnde5 Fund, which represents about 99.5 percent of -.*. co""on stocks, is a great one to start with. Bf you choose a narrower fund, like a tech or energy inde5, you$re basically >ust speculating 6though you$ll "ost likely still fare better than if you tried to pick the ne5t 1oogle7. ;arrow inde5 funds also typically co""and higher fees. )ith inde5ing gaining in popularity, everyone$s trying to get into the ga"e and sneak in unnecessarily high fees. 1eddes says there$s no good reason to pay "ore than .89 percent. -$yron Perry Mark Dowie! who mana"ed the municipal #ond portfolio at Bank of America and all none$uity investments for ndustrial ndemnity! and advised the Bechtel family on economic and investment strate"y! now watches his modest portfolio of inde% funds "row from his home near &oint Reyes Station'
Bogle$s closing advice was as si"ple and direct as that of his predecessors those brokers and financial advisers hovering at the door are there for one reason and one reason only@to take your "oney through e5orbitant fees and transaction costs, "any of which will be hidden fro" your view. (hey are, as ;ew ?ork attorney general 3liot *pit'er described the", nothing "ore than <a giant fleecing "achine.= Bgnore the" all and invest in an inde5 fund. And it doesn$t have to be the /anguard 5:: Bnde5, the inde5ed "utual fund that Bogle hi"self built into the largest in the world. Any passively "anaged inde5 fund will do, because they$re all basically the sa"e. )hen the industry sharks were finally allowed to enter the inner sanctu" of 1oogle, they were barraged with .uestions about their co""issions, fees, and hidden costs, and about inde5ing, the al"ost cost#free invest"ent strategy the 1oogle e"ployees had been told delivers higher net returns than all other "utual fund strategies. (he asse"bled )all *treeters were surprised by their reception@and a bit discouraged. Brokers and financial planners don$t like inde5ed "utual funds for two basic reasons. For one thing, the funds are an affront to their ego because they discount their ability to asse"ble a winning portfolio, the very talent they$re trained and paid to offer. Also, inde5 funds don$t "ake brokers and planners "uch "oney. Bf you have your "oney in an account that$s following the natural "ove"ents of the "arket@also called passive investing@you don$t need fancy "anagers to watch it for you and charge big bucks to do so. Brin and +age were proud of the decision to prepare their staff for the )all *treet predation. And they were glad to have launched their co"pany where and when they did. )hat took place in Mountain /iew that spring "ight have never happened had 1oogle been born in Boston, ,hicago, or ;ew ?ork, where "uch of the financial co""unity re"ains at war with insurgency forces that first started gathering in *an Francisco 35 years ago. It all started in the early &'(0s with a group of "averick invest"ent professionals working at )ells Fargo bank. -sing the vast new powers of .uantitative analysis afforded by co"puter science, they gradually ca"e to the conclusion that the traditional practices guiding institutional investing in A"erica were, for the "ost part, not delivering on the pro"ise of better#than# average returns. As a result, the fees that average A"ericans were paying brokers to engage in these practices were akin to highway robbery. *ure, so"e highly paid hotshot portfolio "anagers could occasionally put together a high#return fund. But generally speaking, trying to beat the "arket@also called active investing@was a fruitless venture. (he insurrection these "avericks would create eventually caught on and has spread beyond the Bay Area. But *an Francisco re"ains ground 'ero of the de"ocrati'ing challenge to A"erica$s vast and lucrative invest"ent industry. -nder threat are the billions of dollars that "utual funds and brokers ski" every year fro" often#unwary investors. And every person who has "oney to invest is affected, whether she$s patching together her own portfolio with a broker, saving for retire"ent or college, or >ust "aking s"all contributions each year to her C:8D. Bf the "ove"ent succeeds, not only will "ore and "ore people have a lot "ore "oney in their pockets, but the personal invest"ent industry will never look the sa"e. I "as once a port!olio manager mysel! and like the industry folks 1oogle was protecting its e"ployees fro", B was certain B could outperfor" "arket averages and confident that B was worth the salary paid to do so. Eowever, B left the invest"ent business before this revolt began to brew. Bn the intervening years, B never stewarded "y own invest"ents as >udiciously as B$d "anaged those of "y for"er e"ployers@Bank of A"erica, Bndustrial Bnde"nity, and the Bechtel fa"ily. B was unhappy with the )all *treet fir"s B had been using, which had churned "y account to "ake lots of "oney on the sales, and, despite instructions to the contrary, placed "y "oney in their own funds and underwritings to "ake even "ore at "y e5pense. *o a couple of years ago, when it finally ca"e ti"e to get "y own house in order, B knew B wanted help fro"
an independent adviser, so"eone who was doing things differently fro" the big brokerage fir"s. 3ventually B found a s"all financial "anage"ent fir" in *ausalito called Aperio 1roup that, after only seven years in business, already had a stellar reputation. <Aperio= in 2atin "eans <to "ake clear, to reveal the truth.= Bndeed, truth#telling is key to Aperio$s "ission, even if that "eans bad"outhing its own industry in the process. 4ne of the co"pany$s founders, +atrick 1eddes, aged CF, is a renegade fro" the top echelons of his field. For several years he served, first as director of .uantitative research, then as ,F4, at Morningstar, the nation$s leading co"pany for researching and appraising "utual funds. But when he left, not only was he disenchanted with his own co"pany$s corporate environ"ent, he was also beco"ing uneasy with the "oral underpinning of the entire industry. <2et$s be straight,= says 1eddes in his soft#spoken but 'ealous way. <Being unethical is a good precondition for success in the financial business.= Eis partner, a bright, high#energy ;orwegian A"erican na"ed +aul *olli, C9, is another finance guy who didn$t have the gene for corporate culture. After graduating fro" Dart"outh$s business school, he tried invest"ent banking but didn$t like it. Ee went out on his own, starting an invest"ent advisory business, but says he flailed about, searching for a business "odel that would support his desire to <live deliberately= in the (horeauvian "anner. *olli and 1eddes consider the"selves heirs to the )ells Fargo insurgency and, as such, part of a "ove"ent that includes acade"ics, so"e institutional investors, a couple of large inde5 fund co"panies, and a handful of s"all fir"s like their own that are dedicated to bringing the inde5ing philosophy to badly advised investors like "yself. And unlike "ost "utual fund invest"ent fir"s, which have G5 "illion and G8: "illion "ini"u"s, Aperio was willing to take on a "essy si5#figure portfolio. *olli took one look at "y unke"pt collection of "utual funds and said, <?ou$re being robbed here.= Ee pointed to funds B had purchased fro" or through +utna", Merrill 2ynch, Dreyfus, and @yes@,harles *chwab 6which referred "e to Aperio7 and asked, <Do you know that you$re paying these guys to do essentially nothingH= Ee carefully e5plained the "any ingenious ways fund "anagers, brokers, and advisers had found to chip away at investors$ returns. (urns out that B, like "ore than 9: "illion other suckers who have put close to G9 trillion into "utual funds, was paying annual fees, co""issions, and transaction costs well in e5cess of A percent a year on "ost of "y "utual funds 6see <)hat Are the FeesH= page I57. <Do you know what that adds up toH= *olli asked. <At the end of every 3J years, you will only have "ade half of what you could have, through no fault of your own. And these are fees you needn$t pay, and won$t, if you switch to inde5 funds.= All inde5ing calls for, *olli e5plains, is the selection of a particular stock "arket inde5@the Dow %ones Bndustrial Average, *tandard and +oor$s 6*K+7 5::, the &ussell 8:::, or the broader )ilshire 5:::@and the purchase of all its stocks and bonds in the e5act proportions in which they e5ist in that inde5. Bn an actively "anaged fund, "anagers pick stocks they think will outperfor" a particular inde5. But the pre"ise of inde5ing is that stock prices are generally an accurate reflection of a co"pany$s worth at any given ti"e, so there$s no point in trying to beat that price. (he worth of a client$s invest"ent goes up or down with the ebb and flow of the "arket, but the idea is that the "arket naturally tends to increase over ti"e. Moreover, even if an inde5 fund perfor"ed only as well as the e5pensively "anaged Merrill 2ynch 2arge ,ap "utual fund that was in "y portfolio, B would earn "ore because of the lower fees. *tewarding this kind of invest"ent does not re.uire a staff of securities analysts working under a fund "anager who "akes GA: "illion a year. Bn fact, a desktop co"puter can do it while they sleep. (here are always e5ceptions, of course, *olli says, <a few funds that at any given "o"ent outperfor" the inde5es.= But over the years, he e5plains, their perfor"ances invariably decline, and their highly paid cover#boy "anagers slide into early obscurity, to be replaced by a new hotshot "anaging a different fund. Bf a "utual#fund investor is able to stay abreast of such changes, "ove their "oney around fro" fund to fund, and stay ahead of the averages 6factoring
in higher co""issions and "anage"ent fees7 it will be by sheer luck, says *olli, who then offers "e pretty "uch the sa"e advice %ohn Bogle and his colleagues offered 1oogle. *ell the hyped but fee#laden funds in "y portfolio and replace the" with boring, low#cost funds like those offered by Bogle$s /anguard. Bt took *olli a couple "ore painful "eetings and a few do'en trades to clean the parasites out of "y account and reinvest the proceeds in inde5 funds, the lifeblood of his business. )ithout e5ception, he "oved "e into funds that have outperfor"ed the ones B was in, like the /anguard &3B( Bnde5 Fund, so"e +i"co bond and stock funds, and Artisan Bnternational. And he did it for an annual fee of .5 percent of "oney under "anage"ent, saving "e over a full percent in overall costs and a lot of ta5es in the future. (hen he did so"ething B doubt any other financial "anager would have done. Ee fired hi"self. <?ou really don$t need "e any"ore,= he said, and closed "y Aperio account that day, ending his fees, but not our relationship. B was curious. )ho was this guy who was so open about the less#than#dignified ways of his own businessH <?ou have to have lunch with "y partner,= he said. I! )olli is an industry gad!ly 1eddes, a "odest, unassu"ing son of a -nited ,hurch of ,hrist "inister, is its chainsaw "assacrer. <)e work in the "ost overco"pensated industry in the country,= 1eddes ad"itted before the water was served, <and inde5ing threatens the revenue flow fro" "anaged funds to brokerage houses. (hat$s why you$ve been kept in the dark about it. (his truly is the great secret sha"e of our business. <(he industry knows they are peddling bad products,= 1eddes continued, <and a lot of people "aking the "ost "oney and getting the "ost prestige are doing so by gouging their custo"ers.= And 1eddes is .uick to differentiate between <illegal theft=@the sort of industry scandals *pit'er has uncovered, such as illicit sales practices, undisclosed fees, kickbacks, and after#"arket trading@and <legal theft,= the stuff built into the cost of doing business that no attorney general can touch, but which in dollar a"ounts far e5ceeds investor losses to illegal activity. 1eddes wasn$t always full of such tough talk about the industry. ;ot that he had any .ual"s about speaking his "ind0 in fact, he was let go fro" Morningstar in 899J for being openly critical of the co"pany$s internal culture. <B still think of Morningstar as a potentially positive force in the industry,= he says. <But let$s >ust say they were weak at conflict "anage"ent, especially at the senior levels.= Bt wasn$t until he took a freelance consulting >ob for ,harles *chwab that he really saw the light about inde5ing. <My >ob was to co"pile all the acade"ic research on "utual funds, and that$s when it really beca"e clear that active "anage"ent doesn$t add any value,= he says. )hen he finished the pro>ect, 1eddes started teaching a finance class through the -niversity of ,alifornia e5tension, where he started preaching his anti#industry gospel. <B had to be careful, because there were a lot of brokers in the class. B started noticing that so"e of the" would get sort of irritated with "e.= Around this ti"e is when he "et *olli. *olli had a client, a doctor who was looking to learn about portfolio "anage"ent and asked *olli what he thought of 1eddes$s -, course. )hen *olli looked into it, he was bowled over. <Eere was this guy who$d been ,F4 at Morningstar and had this incredible background, and B thought, what the hell is he doing at Berkeley teaching this course to guys like "y clientH (his is too good to be true@B have to "eet this guy.= *lowly, inadvertently even, Aperio was born. But the fit was perfect. 1eddes brought what he calls <the .uant piece= to the table0 *olli had the strategic vision. After a few "onths of brainstor"ing, they set out to see if a couple of guys who held the"selves to high ethical standards could "ake it in the cutthroat financial industry. And >ust how do these guys "ake "oney if they keep kicking out clients like "e once they switch us into inde5 funds, while alienating others with their irreverent criti.ue of the entire
"utual fund ga"eH 1eddes does take referrals fro" invest"ent fir"s like ,harles *chwab, which thrive on the sale of "anaged "utual funds. *o why the rantH Bsn$t he, too, in business to "ake a buckH <Absolutely,= he ad"its. <B$" not Mother (eresa0 B$" a capitalist who wants to succeed and "ake "oney. B >ust think the best way to do that is by building trust in a clientele by revealing to the" honestly how this business works.= 1eddes also offers a custo"i'ed version of inde5ing 6on ta5able returns7 for wealthier clients, a service that re.uires an ongoing relationship and supplies Aperio a steadier source of inco"e than "y low#si5#figure portfolio did. Aperio now has about GF:: "illion under "anage"ent. Bt$s a paltry su" co"pared with those of the big brokerage fir"s, which deal in the billions or even trillions, but 1eddes is fine with that. <Bf B were "aking what B could be "aking in this business, B >ust wouldn$t like the person B$d have to be.= *)an +rancisco "as the only place in the country where this could have happened,= says Bill Fouse, a >a'' clarinetist in Marin ,ounty who was present when the first shots were fired in the invest"ent rebellion. Bt was 89I:, and revolution was in the air. )hile hippies, dopesters, and antiwar radicals were filling the streets of A"erica$s "ost tolerant city with rage, sweet s"oke, and resistance, a .uieter protest was brewing in the lofty, paneled offices of )ells Fargo. (here, a young engineer na"ed %ohn Andrew <Mac= McLuown, Fouse 6who like "any "usicians also happens to be a brilliant "athe"atician7, and their self#described <skeptical, suspicious, careful, cautious, and slow#to#change= boss, %a"es /ertin, were taking a hard look at the conventional wisdo" that for a century had driven A"erican portfolio "anage"ent. Bank trust depart"ents across the country were staffed by portfolio "anagers who, as B did at the ti"e, believed that they alone possessed the invest"ent for"ula that would enrich and protect the security of their custo"ers. <;o one argued with that pre"ise,= Fouse recalls. But McLuown suspected they were pretty "uch all wrong. Ee had "et )ells Fargo chair"an &anso" ,ook at an invest"ent foru" in *an %ose, and at a later "eeting at co"pany head.uarters, persuaded hi" that traditional portfolio "anage"ent was "erely an invest"ent variation of the 1reat Man theory. <A great "an picks stocks that go up. ?ou keep hi" until his picks don$t work any"ore and you search for another great "an,= he told ,ook. <(he whole thing is a chance#driven process. Bt$s not syste"atic, and there$s lots we still don$t know about it and that needs study.= ,ook offered McLuown a >ob at )ells and a generous budget to conduct research into the 1reat Man (heory and other sche"es to beat the averages. McLuown accepted, and a few years later Fouse ca"e on as well. (hey couldn$t have been "ore different Fouse, a di"inutive, "ild#"annered "usician, and McLuown, a burly, boisterous *cot. (he two were like oil and water@McLuown even tried to have Fouse fired at one point@but their boss, /ertin, was the one who really was in the hot seat. <?ou have to understand, /ertin$s career was on the line,= Fouse recalls. <Ee was, after all, running a depart"ent full of portfolio "anagers and securities analysts whose "ission was to outperfor" the "arket. 4ur thesis was that it couldn$t be done.= +roof of McLuown$s theory could lead to the end of an e"pire, in fact "any e"pires. <(he poor guy was under siege,= says Fouse. <Bt was a nerve#racking ti"e.= /ertin$s "e"ory of those ti"es is no less vivid. <Mac the knife was going to own this thing,= he once told a reporter. <B could >ust see the fin of the shark cutting through the water.= 3ventually, the research McLuown and Fouse produced beca"e so strong that /ertin could not ignore it. <Bn effect it said that al"ost everything that every trust depart"ent in A"erica was doing was wrong,= says Fouse. <But %i" eventually accepted it, even knowing the conse.uences.=
Bn %uly 89I8, the first inde5 fund was created by McLuown and Fouse with a GJ "illion contribution fro" the *a"sonite 2uggage pension fund, which had been referred to Fouse by Bill *harpe, who was already teaching at *tanford. Bt was *harpe$s acade"ic work in the 89J:s that for"ed the theoretical underpinning of inde5ing and would later earn hi" the ;obel +ri'e. (he s"all initial fund perfor"ed well, and institutional "anagers and their trustees took note. By the end of the decade, )ells had co"pletely renounced active "anage"ent, had relieved "ost of its portfolio "anagers, and was offering only passive products to its trust depart"ent clients. And it had signed up the ,ollege &etire"ent 3.uities Fund 6,&3F7, the largest pool of e.uity "oney in the world, and Earvard -niversity, the largest educational endow"ent. By 89F: G8: billion had been invested nationwide in inde5 funds0 by 899: that figure had risen to GAI: billion, a third of which was held at )ells Fargo bank. 3ventually the depart"ent at )ells that handled inde5ing "erged with ;ikko *ecurities and was later bought by Barclays Bank, which created the *an Francisco subsidiary Barclays 1lobal Bnvestors. Bts ,34, +atricia Dunn, the scandal#tinged for"er chair"an of Eewlett#+ackard who had worked for A: years at )ells Fargo, had been heavily influenced by inde5ing. &unning Barclays, she beca"e the world$s largest "anager of inde5 funds. Fouse, now retired in *an &afael, e5plains why all this could have happened only in *an Francisco. <)hen we started our research, al"ost all the trust clients out here were individuals with s"all accounts. Anywhere else, particularly on the 3ast ,oast, trust depart"ents handled very large institutions@pension funds, university endow"ents, that sort of thing. Bf Mellon, ,hase, or ,itibank had done this research and co"e to the sa"e conclusion, they would have in effect been saying to their large, sophisticated, and very lucrative clientele M)e$ve been doing things wrong for a century or "ore.$ And thousands of very co"fortable invest"ent "anagers would have been out of work.= But even in *an Francisco, as in the country$s other financial centers, Fouse and McLuown$s findings were not a welco"e develop"ent for brokers, portfolio "anagers, or anyone else who thrived on the industry$s high salaries and fees. As a result, the counterattack against inde5ing began to unfold. Fund "anagers denied that they had been gouging investors or that there was any conflict of interest in their profession. )orkout gear appeared with the slogan <Beat the *K+ 5::,= and a Minneapolis#based fir", the 2euthold 1roup, distributed a large poster nationwide depicting the classic -ncle *a" character saying, <Bnde5 Funds Are -nA"erican,= i"plying that anyone who was not trying to beat the averages was nothing "ore than an unpatriotic wi"p. 6(hat poster still hangs on the office walls of "any financial planners and fund "anagers.7 *avvy invest"ent consu"ers, however, were apparently catching on. As they began to suspect that the fa"ous fund "anagers they were reading about in Business Week and Money "aga'ine were taking the" for a ride, inde5 funds grew in si'e and nu"ber. And actively "anaged funds shrank proportionately. 3ven so"e highly placed industry insiders started beating the dru"s for inde5ing. Fro" her perch at Barclays, ,34 Dunn gave a speech at a A::: annual industry "eeting in ,hicago. As reported in Business Week at the ti"e, she started out with so"e tongue#in#cheek co""ents about fund "anagers$ <rare gifts and genius,= and then shocked the crowd by going on to denounce the industry$s high fees. According to the article, she even included this 'inger <NBnvest"ent "anagers sellO for the price of a +icasso NwhatO routinely turns out to be paint#by#nu"bers sofa art.= Bt$s not as if Merrill 2ynch, +utna", Dreyfus, et al, were being put out of business by this new consciousness, but like any industry threatened with bad ink, the financial co""unity continued to strike back at every opportunity. Bn May A::3, Matthew Fink, president of the Bnvest"ent ,o"pany Bnstitute, a "utual funds trade association, told convening "e"bers that his industry was s.ueaky clean and has <succeeded because the interests of those who "anage funds are well#aligned with the interests of those who invest in "utual funds.= At the sa"e convention, Fink$s re"arks were echoed by B,B vice chair"an +aul Eaaga %r., who, in his keynote address,
pronounced that <our strong tradition of integrity continues to unite us.= Bndeed, integrity had been the the"e of every B,B "e"bership "eeting in recent "e"ory. Eaaga then attacked his industry$s critics, including for"er *3, chair"en, "e"bers of ,ongress, acade"ics, >ournalists, even <a saint with his own statue= 6%ohn Bogle7. <N(heyO have all weighed in about our perceived failing,= la"ented Eaaga. <Bt "akes "e wonder what life would be like if we$d actually done so"ething wrong.= Ee didn$t have long to wonder. Four "onths later, the nation$s first big "utual fund scandal broke when 3liot *pit'er brought civil actions against four "a>or fund "anagers for allowing preferred investors to buy and sell shares on news or events that occurred after "arkets had closed. *pit'er co"pared the practice to <allowing betting on a horse race after the horses have crossed the finish line.= Multi"illion dollar fines were issued against the fir"s, which were also re.uired to co"pensate custo"ers da"aged by what were called "arket#ti"ing practices. (he "arket#ti"ing scandals alone are esti"ated to have cost fund investors about GC billion, and other industry violations were uncovered after that. But now "ore e5perts are convinced that the a"ount pales in co"parison to the tens of billions lost every year >ust to the fees and transaction costs by which "utual funds live and die. After the "utual fund scandals broke, *enator +eter Fit'gerald 6&#Bll.7 called a hearing before the *ubco""ittee on Financial Manage"ent, the Budget, and Bnternational *ecurity, and said this in his opening state"ent <(he "utual fund industry is now the world$s largest ski""ing operation@a GI trillion trough fro" which fund "anagers, brokers, and other insiders are steadily siphoning off an e5cessive slice of the nation$s household, college, and retire"ent savings.= ,o one running a university endow"ent, independent foundation, or pension fund could "atch his nu"bers during his tenure over the last A8 years, chief invest"ent officer David *wensen has averaged a 8J percent annual return on ?ale -niversity$s invest"ent portfolio, which he built with everything fro" venture capital funds to ti"ber. Ee$s been called one of the "ost talented investors in the world. But lately he$s beco"ing perhaps even "ore fa"ous for his advice to individual investors, which he first offered in his A::5 book Unconventional Success. <Bnvest in nonprofit inde5 funds,= he says une.uivocally. <?our odds of beating the "arket in an actively "anaged fund are less than 8 in 8::.= And there$s "ore. A recent entry on the Motley Fool, the popular invest"ent advice website, "ade the following blanket state"ent <Buy an inde5 fund. (his is the "ost actionable, "ost "athe"atically supported, short#for" invest"ent advice ever.= As long as 8: years ago, in his annual letter to his shareholders, )arren Buffett advised both institutional and individual investors <that the best way to own co""on stocks is through an inde5 fund that charges "ini"al fees. (hose following this path are sure to beat the net results 6after fees and e5penses7 delivered by the great "a>ority of invest"ent professionals.= 4ne would think, with that kind of advice floating about, that the whole country would by now be in inde5 funds. But in the three decades since )ells Fargo kicked things off, only about C: percent of institutional "oney and 85 percent of individuals$ "oney has been invested in inde5 funds. *o why is inde5ing catching on so slowlyH A big reason, according to 1eddes, is that putting investors into inde5 funds is si"ply not in the interest of the industry that sells securities. <(hey >ust won$t accept inde5ing$s "inuscule fees,= he says. By now, "ost "a>or brokerage fir"s offer inde5 funds in addition to traditional "utual funds, but "oney "anagers typically don$t "ention the" at all. ?ou usually have to ask about the" yourself. And it "akes a certain kind of sense. Bf a naive investor calls a broker with G8::,::: to invest, would the broker be likely to reco""end the /anguard 5:: Bnde5 with its .89 percent annual fee, of which he receives nothing and collects but a s"all portion of his fir"$s appro5i"ately G8:: transaction feeH 4r "ight he suggest the client buy +utna"$s *"all ,ap 1rowth Fund B *hares, which carry a A.3 percent annual fee, 8 percent 6G8,:::7 of which goes to hi"H And will
he tell his client about the hidden transaction charges that further reduce the return on invest"entH Bt$s si"ply not to his advantage to do so. Bt$s hard to find active fund "anagers who are willing to talk about these issues. B spoke to several, but no one was co"fortable discussing the high cost of their practice, and few were willing to talk on the record. &on +eyton, president and ,34 of ,allan Associates, a *an FranciscoPbased institutional invest"ent consulting fir", offered a list of advantages of active "anage"ent, which essentially boiled down to the fact that it$s "ore fun. <(hey can raise and lower cash positions Nread buy and sell whatever stocks e5cite the" at any given "o"entO and go into fi5ed#inco"e or foreign securities Nread look for invest"ents wherever they wantO.= B know fro" e5perience that he$s right, but it$s kind of beside the point. (he "ost forthright co""ents ca"e fro" Baie ;et'er, a research analyst in the 4rinda office of 2it"an!1regory ,o"panies, a *an FranciscoPbased invest"ent "anage"ent fir" speciali'ing in "utual funds. ;et'er told "e outright, <3ighty percent of active "anagers underperfor" the "arket. But we do believe that so"e "anagers add value, and those are the ones we look for.= *till, if you factor in fees and transaction costs, you have to wonder how "uch that re"aining A: percent would slip. But even if the nu"ber of active "anagers who consistently beat the "arket is s"all, *tanford$s Bill *harpe still sees a real need for their services. )hile he is a strong partisan of inde5 funds, he is neither as surprised nor as concerned as 1eddes that they don$t represent a higher proportion of overall invest"ent. <Bf you$d told "e 35 years ago that inde5ing would one day represent C: and 85 percent of invest"ents, B would have asked you what you were s"oking,= says the personable *harpe with his characteristic chuckle. Bf everyone invested in inde5 funds, he points out, the "arket itself would die a natural death. <)e need active "anagers,= he says. <Bt$s buyers and sellers who keep prices "oving, which is what drives the "arket. Bnde5 funds si"ply reflect what the "arket is doing.= Ee believes we$d even start to see a decline in "arket efficiency if inde5 funds rose to 5: percent of total invest"ents. Does this "ean that, when we look at "utual funds, half our options would still be burdened with unconscionable fees and hidden costsH Eopefully not. )ith the call getting louder fro" financial e5perts and industry watchers to refor" and regulate "utual funds, it$s hard to believe that the fee syste" can last "uch longer, particularly with strong &epublican voices like +eter Fit'gerald$s in ,ongress. But while )all *treet has considerable soul#searching to do, full bla"e for the gouging of naive investors does not lie with the invest"ent "anage"ent industry alone. (here is an innate cultural i"perative in this country to beat the odds, to do better than the %oneses. Bn so"e ways the 2euthold 1roup was right when it said that inde5 funds are un#A"erican. Bt$s si"ply difficult for "ost of us to accept average returns on our "oney, or on anything for that "atter. (he ulti"ate e5a"ple of the nation$s attraction to the big score is, of course, right now under our noses. Bf on August 8F, A::C, you had invested G8::,::: in 1oogle, that stock would now be worth G55:,:::. *o while evidence "ounts that it$s al"ost i"possible to hit the >ackpot with cost#burdened "utual funds@and that for every 1oogle, there$s an 3nron@we si"ply refuse to stop trying. +erhaps *olli and 1eddes had it right when they selected the na"e for their co"pany. (he real purpose of this whole revolution is <to "ake things clear, to reveal the truth.= As *olli puts it, <As long as people know what they$re dealing with, they can invest their "oney with full awareness. )hether it$s playing it safe with inde5ing or taking a flier on a hedge fund@at least they$re the ones in control.= )hat about hedge fundsH *o, the bulk of your savings is safely tucked away in a sensible inde5 fund or two. )hy not set aside 5 or 8: percent and take a chance on the post#dot#co" insider$s invest"ent cra'eH
Bt$s certainly te"pting. (he "ost high#profile "anager, 3dward <3ddie= 2a"pert, has reportedly earned investors in his 3*2 Bnvest"ents hedge fund an average return of A9 percent a year since 89FF. After successfully buying D"art with his investors$ "oney, 2a"pert turned the "erged retailer around and in A::C personally took ho"e G8 billion. Another of the world$s "ost successful funds is *an Francisco$s Farallon ,apital Manage"ent, which has a"assed assets of G8A.5 billion over two decades by delivering post#fee returns of 8I percent a year on its flagship fund, according to a A::5 article in nstitutional nvestor "aga'ine. Forty#eight#year#old (o" *teyer$s investors include universities, pension funds, and individuals0 at any one ti"e, the "aga'ine said, the "anagers there "ight be nursing 3:: to 5:: invest"ents in everything fro" real estate@Farallon recently bought into the Mission Bay develop"ent@to international finance. But the road fro" )all *treet is scattered with the bones of bitter hedge fund investors. *ince 8995, "ore than 8,F:: known hedge funds have folded co"pletely. Bn the last few "onths alone, two large funds@Mother&ock and A"aranth Advisors@have gone south. The high !ailure rate should come as no surprise given how hedge funds operate. (here$s no working "odel, so they vary widely, but the basic idea is that they rely on risky, untraditional invest"ent strategies@ranging fro" arbitrage to taking over floundering co"panies, as 2a"pert did@to "ake big "oney fast. (he industry is largely unregulated, and "ost funds involve private partnerships that operate in strict confidence. (hey$re also e5tre"ely e5pensive, which li"its their user profile. (hough fees average >ust A percent of the invest"ent, the sa"e as in a typical *ilicon /alley venture fund, "anagers also withhold a si'able chunk 6averaging A: percent, but so"eti"es going as high as 5: percent7 of whatever profit the funds produce. (he typical "ini"u" re.uired to get into a fund is between G8 "illion and G5 "illion. (he *3, periodically considers applying "ini"al rules to hedge funds, such as prohibiting pension funds fro" investing in the". 2ast 4ctober, the call for refor" ca"e fro" ,ongress when *enator ,harles 1rassley, chair"an of the *enate Finance ,o""ittee, asked ad"inistration officials and ,ongress "e"bers for their views on how to i"prove hedge fund transparency. But so far, the hedge fund lobby has "anaged to keep all regulators at bay. %ar# .o"ie )hat are the feesH 3very fee that a "utual fund charges should be outlined so"ewhere in its prospectus. But "any people don$t even think to look for it, and you can$t necessarily trust your broker to bring it up. <(he first step is si"ply getting people to pay attention to fees,= says +atrick 1eddes, chief invest"ent officer of Aperio 1roup, in *ausalito. /ang tough in as#ing your bro#er !or the !ull brea#do"n of what those fees will cost you each year. Bf you need help, the ;ational Association of *ecurities Dealers has a useful tool for co"puting fees, called the Mutual Fund 35pense Analy'er, on its website 6http !!apps.nasd.co"!investorQBnfor"ation!ea!nasd!"fetf.asp57. ?ou put in the na"e of the fund, the a"ount invested, the rate of return, and the length of ti"e you$ve had the fund, and it tells you e5actly how "uch you$ve been charged. ?ou can also co"pare past fees for different funds before you invest. For e5a"ple, if you had put G8::,::: into +utna"$s *"all ,ap 1rowth Fund ,lass B *hares and held it for the past five years, you would find that +utna" would have charged you G83,F:9 in fees during that ti"e. /anguard$s (otal *tock Market Bnde5 Fund, on the other hand, would have charged only G8,8J5 for the e5act sa"e invest"ent. -$yron Perry )hich inde5 fundH Bn so"e ways inde5ing is a no#brainer invest your "oney and let it do its thing. *till, there are
varieties. Aperio 1roup$s +atrick 1eddes pushes two rules in choosing a fund *The broader the better and the cheaper the better01 )hen you invest in a broad do"estic fund, you$re investing in the entire -.*. econo"y, or <owning capitalis",= as it were, 1eddes says. (he /anguard (otal *tock Market Bnde5 Fund, which represents about 99.5 percent of -.*. co""on stocks, is a great one to start with. Bf you choose a narrower fund, like a tech or energy inde5, you$re basically >ust speculating 6though you$ll "ost likely still fare better than if you tried to pick the ne5t 1oogle7. ;arrow inde5 funds also typically co""and higher fees. )ith inde5ing gaining in popularity, everyone$s trying to get into the ga"e and sneak in unnecessarily high fees. 1eddes says there$s no good reason to pay "ore than .89 percent. -$yron Perry Mark Dowie! who mana"ed the municipal #ond portfolio at Bank of America and all none$uity investments for ndustrial ndemnity! and advised the Bechtel family on economic and investment strate"y! now watches his modest portfolio of inde% funds "row from his home near &oint Reyes Station'
