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What matters in mutual fund management
Remarks to the Business Advisory Council of the University of Virginia Law School
Charlottesville, Virginia
October 1, 2004
By Michael S. Miller, Managing Director for Planning & Development
Good afternoon. It's my sincere pleasure to be here today. The title of my remarks today is "What Matters in Mutual Fund Management." I've borrowed the "what matters" theme from this year's United Way campaign. At Vanguard, the annual United Way campaign is a very big deal. For me personally, the "what matters" theme clarifies priorities that sometimes get drowned out in our complex and noisy world. The United Way helps people in countless ways. What could matter more?
These days, it's just as important to identify "what matters" in the business world. And the investment management environment has been an extremely noisy place in the past year or so. So I'd like to use my time with you today to share some thoughts on what matters—and what will matter—in the money management business in the future. I'll begin by offering some comments about the last year's events and the present environment.
There's no other way to put it. It has been a brutal 13 months in the money management industry. Numerous fund companies, as well as broker-dealers, hedge-fund advisors, and others, have been implicated in unethical or illegal behavior. The abuses have been particularly startling within the fund industry, which has had a clean reputation for virtually its entire history. I never imagined that the fund industry would be hit with such a rash of scandals.
To date, at least 11 fund firms have agreed to pay nearly $3 billion in fines, restitution, and reduced investment management fees. Without getting into specific cases, it's obvious that some firms and some individuals lost sight of the fundamentals of our business ….the basic precepts of honesty and integrity that 93 million shareholders relied upon when they entrusted their money—today, a total of $7.5 trillion—to mutual funds. [Source: Investment Company Institute]
In our view, New York Attorney General Spitzer, the SEC, and other regulators of our industry deserve a ton of credit for reacting quickly and forcefully to the problems. But it's also fair to say that the fund industry deserves more credit than it's received for its response to the problems. The fund industry was quick to call for tough enforcement and a closing of the gaps that enabled wrongdoing to take root, and over the past 13 months it has taken an active role in the discussions about solutions.
It's been very interesting to observe what has happened to the firms who betrayed the trust of their investors. They've lost clients and market share. Many are shadows of their former selves. According to Morningstar, assets are up just 2 percent among the 21 fund families named in the scandals since the abuses came to light, despite a return of about 13 percent in the U.S. stock market over the past year. Contrast that 2 percent asset growth with the 22 percent growth in assets among fund complexes whose good reputations remain intact.
It's gratifying to see that investors aren't blaming an entire industry for the problems of a relatively small number of firms. But, frankly, we wish the media would 'get it' too. More than one commentator has asserted that these events have taught the entire mutual fund industry a painful lesson. That, of course, is a simplistic view. Not every firm needed to learn a lesson about ethics and integrity.
The majority of the firms in the fund industry do understand their obligations to their investors. And the reservoir of trust among mutual fund investors remains deep and wide, as evidenced by the continued strong cash flows into mutual funds despite the negative headlines about specific firms. Although generally favorable financial markets have no doubt been a factor in our continued ability to attract investors, we think investors have been reassured by the swift action by regulators to right wrongs and punish the wrongdoers and by the fact that the great majority of firms have not been accused of wrongdoing.
So where do we stand now? The headlines about fund firm scandals have faded somewhat from the front pages as the months have passed. Fund firms are busy complying with a wave of stiff new rules on governance, disclosure, and other business practices. Though Vanguard has not been implicated in the scandals, we, too, of course are grappling with these new regulatory requirements.
Because my responsibilities include the oversight of our compliance operations, I have spent many hours on regulatory matters in the past year. Indeed, Vanguard's entire senior staff has devoted substantial time to these issues. But what could be more important than ensuring that we meet the changing and ever-more-demanding regulatory requirements faced by our industry?
It's an interesting question whether these regulatory changes will close all the gaps and prevent future wrongdoing from happening. There's no guarantee, of course. And unfortunately, too many of the new regulations are more a matter of form than substance. Some industry watchers have observed (correctly) that the new rules carry costs, and those costs will ultimately be borne, to some extent, by investors. If the costs come without benefits, that would be a tragedy.
There have, of course, been some needed regulatory changes and new rules that will make a positive difference—most notably, perhaps, the SEC's new compliance rules, including the requirement of a designated chief compliance officer appointed by and responsible to fund boards of directors.
Other regulatory proposals have lost steam, in part because proponents have been unable to resolve all of the complexities. I'm referring here to two proposals in particular: the hard 4 p.m. close for mutual funds to accept fund trades; and the imposition of mandatory redemption fees. The upshot is that to date, regulatory enforcement actions have done more to affect the behavior of fund firms than any regulatory initiatives or new rules. These enforcement actions have forced firms that have had problems to confront their issues; meanwhile, even those firms that have not had problems have moved quickly to tighten up their controls and close any gaps in their compliance systems and operations.
Good controls and good culture
What matters going forward is that both regulators and the fund industry share responsibility for preventing wrongdoing. By and large, the fund industry has always wanted to be regarded as a well-regulated industry that is committed to serving the interests of shareholders. We understand that the trust of the investing public takes a long time to earn, but can be lost in a moment.
I can't think of any other financial business that is as closely regulated as fund firms are. A fund firm like Vanguard wears many hats in the eyes of regulators. The SEC regulates the markets and our funds, as well as our transfer agency activities in processing shareholder transactions. The NASD regulates our sales practices, and advertising and marketing activities in connection with our activities as a fund distributor. State regulators are watchdogs for their respective state securities laws and fraudulent conduct. And all firms have comprehensive Codes of Ethics. In short, we have complex, tiered compliance requirements that are becoming more complex and more comprehensive.
In the past, there was an ongoing dialogue between the industry and regulators about important issues. Though we might disagree about specific regulatory measures, we could discuss the issues. We had a shared understanding of our responsibilities in this area and mutual respect for each other's views. This dialogue provided a framework for regulators and those they regulate. More often than not, we worked cooperatively to develop and implement effective investor-protection measures.
Regrettably, as a result of the past year's events, the relationship between fund firms and regulators has deteriorated. I recently spoke with a senior regulator, who told me he, too, was troubled about this situation. "How do we get the dialogue going again?" he asked. I hope that we can regain the productive working relationship that existed before.
I'm an optimist who believes that the fund industry can weather this challenging time in its history. And if there are lessons to be learned from the past year, perhaps the most important learning for the investing public is that controls and cultures are what matters in mutual fund management.
A fund firm that wants to operate with integrity and ethics can't assume that tight controls alone will prevent wrongdoing. A firm also must possess a strong fiduciary culture—one that's committed to earning the trust, confidence, and faith of its investors. To maintain such a culture, there has to be a commitment at the top to doing the right thing, and it must be communicated clearly throughout the organization. Every employee in the firm must feel a sense of stewardship for the interests of the shareholder. And, of course, tight controls must be in place to ensure that actions match up with words.
Let me explain how culture and controls work together at the organization that I know best. Vanguard is the world's second largest mutual fund company, with about $750 billion in assets under management in our U.S.-based funds, as of September 30, 2004. Vanguard is the only investor-owned mutual fund complex in America. We are known for many things—including our low fees, our commitment to high-quality client service, and our indexing expertise—but I would say the single most defining characteristic about Vanguard is our ownership structure. The Vanguard® funds own The Vanguard Group, which in effect means that the investors in our funds own Vanguard. Unlike other fund firms, we don't have stockholders or a parent company to please. Our mutual ownership structure enables us to focus clearly on the interests of our investors, without the potential conflicts of interest that can occur at other firms.
That client-first orientation also creates clarity on ethical issues. At Vanguard, there is one guiding ethical principle: Do the right thing. Everyone at Vanguard knows there are no gray areas when it comes to doing the right thing. From the first day on the job, every new crew member—we don't use the term employee—at Vanguard learns that ethical behavior is a top priority.
Trade for your personal account based on fund investment decisions or client trades, and you're out. Violate the confidentiality of client information, and you're out. Accept a gift of material value from a client or a vendor in violation of our Code of Ethics, and you're out. Ours is a "no ifs, ands, or buts" policy. As we say in our ethics manual, "A momentary lapse from the straight and narrow could be enough to ruin Vanguard's reputation for many years to come—and perhaps forever in some people's eyes."
Some time ago, we circulated to our crew and our clients a list of our guiding principles. Number one on our eight-point Pledge to Clients is "Put the interests of our clients first at all times." Number two is "Continually seek to earn the trust and loyalty of our clients by adhering to the highest standards of ethical behavior and fiduciary responsibility."
To ensure that we live up to these ideals, we have structured our internal oversight operations carefully. We think of compliance as the four legs of a chair.
The first leg of that chair is the business operation. We believe that the business areas that interact with our clients and prospects are our first line of defense against wrongdoing. They own the responsibility and accountability for conducting business ethically and in compliance with the law and our internal policies and procedures.
Our Legal Department—the second leg—interprets the rules and regulations and makes clear to the businesses what is expected. Our Compliance Department—the third leg—develops procedures and practices and conducts inspections to ensure compliance with the rules. Our Internal Audit Department—leg four—tests our procedures and examines processes and policies to make sure that the results they produce are satisfactory. But ultimately, Legal, Compliance, and Internal Audit play supporting roles. The businesses are, at the end of the day, primarily responsible and accountable. They have to be.
Here's an example of how this works in practice. As a tool to prevent market timing and frequent trading in our funds, Vanguard has long had certain policies and procedures about accepting large purchases. We will ask someone making a large purchase—several hundreds of thousands of dollars, for example—how long they intend to remain invested in the fund. We want investors who are prepared to make a long-term investment in our funds—a year or more, for example—not someone who is hoping to jump in, make a quick profit, and then pull their money out. Frequent traders drive up fund costs and hurt existing, long-term shareholders. We'd rather turn them away than risk harm to our funds and our fund shareholders.
Our "large transaction" policies are not required by regulation, but we want to be sure we have the right controls in place to enforce them for the benefit of our shareholders. Our compliance team works with the business areas to make sure that our phone associates—the folks who interact with shareholders who call to request transactions—are crystal clear about how to handle requests for large purchases. We don't want to discover after the fact that we missed an opportunity to block a frequent trader from our funds.
So in this example, our Client Services Department and phone associates are responsible and accountable for having the right policies and procedures in place, and ensuring that those policies and procedures are strictly followed. Compliance monitors their success and recommends enhancements to procedures when warranted. Internal Audit periodically evaluates our program to determine whether it contains effective controls. And our Legal Department is available to help interpret the regulatory requirements along the way. Working together, we get a far better result than any single group would accomplish alone.
Another important aspect of our controls relates to checks and balances. Legal, Compliance, and Internal Audit report to three different managing directors at Vanguard. Each of us, in turn, reports to our chairman, Jack Brennan. The client-facing business areas report to a fourth managing director.
Risk management and compliance issues are also watched closely by Business Risk Councils in our various business areas, with a centralized corporate Risk Council exercising overall governance and supervisory control. This group of senior Vanguard officers is charged with the oversight of issues that could pose risk to the entire organization. We zero in on business issues and potential areas of concern to ensure that our business practices are appropriately rigorous, consistent, and thorough across all the business areas.
Effective next week, there will be an additional component to our supervisory and compliance systems, when, as newly required by the SEC, we will more directly and formally involve our boards of directors in compliance and fund governance matters by having our chief compliance officer report directly to our boards on a systematic and regular basis. Our directors take a keen interest in compliance. They always have.
In preparation for the chief compliance officer's reports to the boards, we have conducted an exhaustive audit of all the compliance-related rules and regulations and our internal policies and procedures. We have produced a comprehensive listing of each particular compliance function, its business owner, the frequency and method of review to ensure compliance, and the source of the underlying legal or regulatory requirement. It's a rather imposing document, to say the least.
We think our combination of a strong fiduciary culture and strict controls is effective. So does our crew. Every few years, we conduct a comprehensive survey of our crew to find out how satisfied our people are with Vanguard. To encourage candor, anonymity is guaranteed, and the survey is conducted by an outside, independent firm. We were quite pleased (but certainly not surprised) this year to see that ethics was one of the top-ranking themes in the job satisfaction of our folks when we conducted our most recent survey in July.
We asked the crew whether their co-workers, supervisors, and the officers of the company practice ethical conduct. The answers to those three questions ranked among the top ten most favorable responses out of the many dozens of questions on the survey. When compared with responses to similar surveys at other financial firms, we're told that our crew's responses on ethical practices were much higher. [Source: Gantz Wiley Research]
That's the close-up view of how culture and controls operate at one company. Obviously, our business model wouldn't work for every company, and I don't mean to offer it up as the only way to do business. Neither do I suggest that our organizational setup is the only way to ensure regulatory compliance. But I hope I've made an effective case for the assertion that cultures and controls are what matters most in fund management.
Conclusion
Mutual funds have served millions and millions of investors extremely well for the past 75 years. Investors should not lose sight of that fact. You know the benefits and advantages well enough—they include diversification, transparency, professional management, liquidity, and cost. So we very much want to see the fund industry and regulatory authorities correct problems decisively, completely, and effectively so that we prevent future abuses. There's a lot at stake.
If there are lessons to be learned from the scandals of the last year, perhaps the most valuable one is this: Trust is an intangible asset, hard to measure, and fragile too. Image and reputation and actions are what create client trust, and client trust in turn results in client loyalty, which pays powerful dividends to the business. But to ignore or undervalue client trust is to put a firm's future at risk.
Firms that want to succeed in the long run cannot just meet the letter of the law on compliance matters and hope that's enough to meet their obligations to their clients. They must possess both a strong set of conduct rules and the systems for enforcing those rules, and they must also operate within a fiduciary culture of character, integrity, and ethics.
Leaders of the organization must demonstrate their commitment every day through their words and actions, and the organization's enforcement systems must be unremitting. Little slips can lead to major problems, as we've seen so painfully over the past year.
If you are a Vanguard investor, I invite you to hold us accountable for operating within a fiduciary culture and with strong controls. If you invest with another firm, I encourage you to hold that firm accountable. It's what matters.
Thank you for listening. I'd be happy to take questions.
https://global.vanguard.com/international/hAmeEN/research/WhatMatterstEN.htm
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Vanguardia es el único complejo de fondos mutuos de propiedad de inversores en Estados Unidos. Se nos conoce por muchas cosas, incluyendo nuestras tarifas bajas, nuestro compromiso de servicio al cliente de alta calidad, y nuestra experiencia de indexación, pero yo diría que la característica más sobre la definición de vanguardia es nuestra estructura de propiedad. Los fondos de Vanguard ® propia The Vanguard Group, que en efecto significa que los inversores en nuestros propios fondos de Vanguard. A diferencia de las empresas de fondos, no tenemos accionistas o una sociedad matriz a favor. Nuestra estructura de propiedad mutua nos permite enfocar con claridad en los intereses de nuestros inversores, sin los posibles conflictos de interés que puede ocurrir en otras empresas.
“Los dos guerreros más poderosos son paciencia y tiempo.” (León Tolstoi)
