Here's what I think the mutual fund industry fears about retired Vanguard founder and CEO John Bogle: He's one of them. He knows where all the skeletons are hidden. And he's not afraid to reveal those hiding places.

Among the many surprising skeletons Bogle revealed in my recent conversation with him (see “Exclusive Interview with John Bogle: Industry 'Crying Out for Change'; says Fiduciary Rule 'a Turning Point',” FiduciaryNews.com, June 21, 2016) was his admission that, while he tried to make Vanguard a fiduciary business, it remains to this day a marketing business. In doing so, he exposes the ultimate fiduciary dilemma: The client isn't always right.

Before we get to that, though, let's explore the significance of Bogle's executive experience within the mutual fund industry. Remember, before Vanguard went “mutual,” it was a publicly held management company. Bogle led the transition away from serving the public company's shareholders towards serving the investment company's (i.e., mutual fund's) shareholders. In doing so, he rejected the parameters and benchmarks of public companies.

Let's restate what this means. The shareholders of the public company demand, expect, and, indeed, are entitled to a fair and reasonable return on their investment. In the same manner, the shareholders of the investment company demand, expect, and are entitled to a fair and reasonable return on their investment. What happens if the best interests of one constituency conflict with the best interests of the other constituency?

This is not merely some philosophical question. It is the definitive quandary of corporate governance regarding any publicly traded company. Whose best interests should a company like McDonald's serve? Should it be the company shareholders? In this case, it would seek to maximize profits by charging high prices and keeping expenses low. Should it be the company employees? In this case, it would seek to maximize expenses (i.e., employee salaries) by charging high prices and keeping profits low. Should it be the company's customers? In this case, it would seek to charge low prices by keeping both profits and expenses low.

Are you beginning to see the problem here? It's like a tube of toothpaste. You can squeeze the tube to push all the gel to one end, or you can squeeze the tube to pull all the gel to the other end. It's a zero-sum game. The only way you're going to pay Peter is to rob Paul – and vice-versa.

Now, let's say you want to pick one side of this multi-lateral dilemma. In our McDonald's example, we can make it be the customers. We want the customers to enjoy the cheapest prices. In order to make the business “sustainable” (i.e., make enough money to stay in business), we know we cannot give away those hamburgers. The question then becomes, what's the least we can charge and still pay enough to the employees so they stick around and produce enough profits to continue to attract shareholders to buy and hold the company stock.

OK, you have your assignment. So who do you hire to get it done?

You bring on someone with in-depth experience running a publicly traded fast food company. Theoretically, he knows what costs can be cut, what costs are essential, and exactly what threshold the shareholders will bear before dumping the stock. That's the definition of the perfect insider. He knows where all the skeletons are hidden.

Which brings us back to why the industry considers Bogle such as dangerous commodity. In saying mutual funds need to only serve the best interests of mutual fund shareholders, we are telling McDonald's it's only job is to keep prices low for its customers. And if that's the sole objective of investment companies, who better to assign the task of outing all the unnecessary costs than an experienced mutual fund executive (such as John Bogle). It's the same reason why computer security companies hire hackers and the police trying to solve a bank heist often hire former bank robbers as consultants. If you want to disassemble a system, hire the guy who built it.

What does this have to do with the “ultimate fiduciary dilemma”? According to Bogle, mutual fund companies are marketing companies in that they continually offer new mutual funds that no fiduciary would offer. Why do they do this? Because the market demands it. Why must they do what the market demands? Because that's the way they stay in business. In other words, in order to continue to offer the proper “fiduciary” mutual funds and stay in business, they need to offer improper “non-fiduciary” mutual funds.

If your brain hurts, then you understand.

Author's note: I operate my own family of mutual funds. I've chosen a business model that allows the business to sustain itself without straying from the “fiduciary” mutual fund imperative. I enjoy it and our shareholders seem to like it, too (the funds have very little shareholder turnover). There's a trade-off, though. Everything is very small, too small, in fact, to be attractive to most mutual fund companies. I can get away with it because I live in a low cost-of-living region (i.e., greater Western New York) and have only modest material needs (why else would I spend so much time writing?). So, it is possible to have a pure “fiduciary” mutual fund company. It's just not very profitable. (Hmm, isn't that the very thing mentioned in the McDonald's example?)

Instant Insights /

Hackers, bank robbers, and mutual fund managers

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