But if long-term investing was the paradigm for the classic index fund, trading ETFs can only be described as short-term speculation. And it was only a matter of time until trading overwhelmed diversification as the driving force in the ETF world. Of the 690 ETFs in existence today (including 343 in registration at the SEC), only 12 represent broad market segments, such as the Standard & Poor’s 500, the Dow Jones Wilshire Total (U.S.) Stock Market Index, and the Morgan Stanley EAFE (Europe, Australia and Far East) Index of non-U.S. stocks. With each passing day, the market segments available through ETFs seem to get narrower. (Can you believe that we now have a “HealthShares Emerging Cancer” ETF?)

These nouveau index funds starkly contradict each of the principal concepts underlying the original index fund. If the broadest possible diversification was the original paradigm, surely holding small segments of the market offers less diversification and commensurately more risk. If the original paradigm was minimal cost, then holding market-sector index funds that may themselves be low-cost obviates neither the brokerage commissions entailed in trading them nor the tax burdens incurred if one has the good fortune to do so successfully.

The full piece is available at either of the links below.

Wall Street Journal website

PDF of article

Link to letter on WSJ site (includes a link to original editorial)

Link to PDF of Mr. Bogle’s letter

A video of the event is available here.

But recommendations from proxy advisers, who are paid by institutions for advice on how to vote, are not always heeded — a vivid example of a power shift outlined by Mr. Bogle, in his book, “The Battle for the Soul of Capitalism.” Ownership of American companies, he argued, has moved from a diffuse group of individual shareholders into a handful of powerful financial institutions such as mutual funds and banks. These organizations are “reluctant dragons” when it comes to exercising corporate citizenship, Mr. Bogle wrote.

One reason, he said, “is the clear conflict of interest they face in managing the retirement plan assets of the very corporations whose shares they own and collectively control.”

“Even when a governance or proxy issue involves a corporation that is not a client,” he added, “the reluctance to speak out persists, giving credence to this perhaps apocryphal comment by a pension fund manager: ‘There are only two types of clients we don’t want to offend: actual or potential.’ “

And Alan Murray at the Wall Street Journal weighed in today, too, writing:

Defenders of the current system say CEO pay is set by market forces. But I am skeptical. Who else out there is eager to pay Messrs. McKinnell, Seidenberg, Whitacre and Nardelli upward of $10 million a year for lackluster performance? I’m reminded of the New York Stock Exchange directors who justified increasing Dick Grasso’s pay package — which enabled him to amass $200 million, a good portion of it during his eight-year reign as CEO — by citing fears he might leave to become secretary of the Treasury, a job that pays $175,700 a year.

That kind of logic is only used by those spending other people’s money. And that’s why shareholders deserve a greater say.

My letter to the SEC on the topic is available here.

To the Editor of the Wall Street Journal:

While I greatly respect the major contributions that Professors Fama and French have made to modern portfolio theory, I take strong exception to their recommendation to change the tax code so that mutual fund investors pay taxes only as gains are realized when they sell their shares, rather than be subject to taxes paid as their funds realize gains on their underlying portfolios. (“Keep it Simple,” February 25, 2006.)

First, their proposed system is in fact far more complex. Now, fund shareholders receive from each fund they own a single tax statement providing the information required on the tax return. Under the new system, investors would have to report the amount and date of each share purchase, worry about wash sales, and post multiple gains (or losses) on their returns. What is more, the conversion from the old system to the new would require the complex recreation of prior data of perhaps hundreds of individual purchases and liquidations in each account. Finally, relying on the accuracy of cost information from investors when they sell their holdings of individual stocks has already proven difficult for the Internal Revenue Service to enforce; in the case of mutual funds, it would be even more difficult.

Second, their article completely ignores the fact that traditional open-end funds can easily provide the same tax deferral as do exchange-traded funds. So far, all (or virtually all) ETFs are index funds, providing returns that parallel those of the underlying market indexes, and are barely, if at all, more tax-efficient than regular index funds, many of which are operated at extremely low cost, yet free of the brokerage commissions on purchasing ETFs. Neither Vanguard’s 500 Index Fund and Total Stock Market Index Fund, for example, have paid capital gains distributions since 1999, with annual distributions averaging less than 0.5 percent of asset value during the preceding five years.

The authors also ignore the availability of tax-managed traditional funds for taxable investors. Again, Vanguard’s five tax-managed funds, in nearly 50 cumulative years of operation, have yet to realize a single capital gain distribution, all the while providing superior pre-tax returns, and truly stunning after-tax returns (outpacing, on average, 92 percent of their peers over the past decade).

The real problem is not with the tax code, but (unrecognized by the authors) with the mutual fund managers themselves. They turn over their fund portfolios at a stunning average rate of 91 percent per year—a holding period of barely 13-months for the average stock in their portfolios, reflecting a trading strategy that is far more akin to short-term speculation than long-term investing.

Unsurprisingly, because of all those execution costs, high fund turnover is clearly associated with low fund performance. During the past decade, for example, the highest-turnover quartile of funds (165 percent annually) provided an annual pre-tax return of just 9.8 percent, while the lowest-turnover quartile (13 percent) returned 11.5 percent, an advantage of 1.7 percent per year—a cumulative extra profit of nearly 30 percent. What is more, the high-turnover quartile of funds took nearly 30 percent more risk (standard deviation of 20.6 percent vs. 16.2 percent).

Looking at risk-adjusted returns, then, the low-turnover funds earned 11.6 percent per year compared to just 8.9 percent for their high-turnover cousins. Result: $10,000 invested ten years ago grew by $20,000 vs. $13,300—a 50 percent enhancement in profit even before taxes are considered. After taxes, the enhancement in cumulative profit approached 100 percent, a difference that is truly astonishing.

Like the mutual fund industry that is now vigorously campaigning to change the tax law, Professors Fama and French simply ignore the economic realities described in this letter. It is not the tax code that needs changing; it is the “short-termism” exhibited by the vast majority of mutual fund managers, and the short-sightedness of mutual fund shareholders who refuse, out of naiveté or even ignorance, to look after their own economic interests. “The fault, dear Brutus, is not in our tax code, but in ourselves.”

John C. Bogle

. . . we’re seeing the rise of a narrow oligarchy: income and wealth are becoming increasingly concentrated in the hands of a small, privileged elite.

See the rest of his article here.