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» Brennan profile » Oct. 4 interview with Abby Joseph Cohen

GEOFF COLVIN: The fastest growing kinds of mutual funds are index funds, the king of index funds is Vanguard, and the CEO of Vanguard is Jack Brennan. But are index funds the way to go in a bear market? Are the indexes themselves, like the S&P 500, being managed as they should be? And in this environment of scandal, are major mutual fund executives fighting for investors by voting their proxies in favor of good governance? There’s a lot to talk about Jack. Welcome.

JACK BRENNAN: Thank you. It’s great to be here.

COLVIN: Let’s start with this debate on stocks versus bonds. Right now investors are largely bailing out of stocks, bailing into bonds. Are they doing the right thing?

BRENNAN: No. We think it’s a mistake. I think the analysis that Tim and Tom gave was great. You know, there is a lot of risk in the bond market. When will stocks turn around? Was today the start? Who knows? Or yesterday? But chasing past performance is always a curse and it’s always a problem and it’s never a winning strategy. So I think people should be very leery about giving up on stocks because they are a long-term investment, and running into bonds at these yield levels we think is quite dangerous.

COLVIN: Yeah. Index funds in general, we’ve had a lot of people say, or some people say, including on this program, that in a bear market they’re not the way to go. If you had put $1,000 into an S&P index 10 years ago, it would have outperformed actively-managed funds. It would have increased to $2,278, whereas the average actively-managed diversified U.S. stock fund would have increased to $2,163 – somewhat less. However, since the market peak in March of 2000, $1,000 in an S&P index fund would have shrunk to $590, whereas $1,000 in the average actively-managed fund would have shrunk quite a lot, but not quite as much, to $617. Are index funds the way to go even in a bear market like this?

BRENNAN: Oh, sure, because you can’t predict when a bear market is going to start or end. You own a stock fund because you think it will appreciate in value. And we think, frankly, moving forward, where returns will be less than we experienced in the past once they turn around, the diversification value and the expense advantage become more compelling than they were over the past 10 or 20 years. So actually when I look at those numbers, I think it’s remarkable without cash being fully invested that the index funds have fared as well as they have against actively-managed funds, because that’s where active management was supposed to have its big value.

COLVIN: Right. Now there has been some controversy and complaining, even from Vanguard executives, about the structure of some of these indexes, including the S&P 500. What’s the problem?

BRENNAN: Well, there are a couple I think. One is some of them become slightly more managed than they should be. They’re being created subjectively rather than objectively. Some of them are too tightly defined. It assumes that you’re either a value or a growth stock. That’s not the way active managers think about things, and so it becomes too arbitrary. And then frankly when they’re re-balanced, which happens generally once a year, there’s an awful lot of tax-inefficient activity. So we think there are ways that indexes can be improved, and frankly we hope there are some indexes that will come out that will be improvements and that we’ll be able to offer them to our investors.

COLVIN: And the advantages will be lower expenses.

BRENNAN: Lower expenses always in an index fund, but really portfolios that will in a sense mirror active management at a lower cost with broader diversification, better than some of the existing indexes do today.

COLVIN: Now there’s an argument that I have heard against index funds which says the indexes, including big ones like the S&P 500, change the stocks, change the components so often, and they announce a week ahead of time what the change is going to be. So people load up on those stocks, knowing that index funds like yours have to buy them, they have no choice. And therefore there are extra costs that the fund incurs as a result.

BRENNAN: Well, there clearly are trading strategies that people use to try to beat index funds at that reconstitution game. Frankly the best index fund managers know their ways around that, and fortunately I work with a team that does that.

COLVIN: Right. There is another big issue these days. Index funds, mutual funds in general, are huge owners of stocks in general. Over the years, traditionally they haven’t voted their proxies or they’ve simply voted them as management recommends. Now there is a big movement in favor of voting them critically, voting them in favor of good governance, regardless of what management recommends. Where do you stand?

BRENNAN: Well, I stand –- first the generalization is not quite accurate. If you look at the Capital Guardians, the Fidelities, the Vanguards, the T.Rowe Prices, they have full time staffs that do nothing but vote proxies and have for years. For instance, last year, just a number I have, we voted against 66 percent of the compensation proposals put in front of us. So some of the rhetoric is far off base in that regard. That said, all institutional investors should take this issue more seriously, and I think clearly they will. You know, our pattern of behavior is not going to change because we’re already there, as are the best fund companies. But bringing everybody into that tent of taking it seriously, we find it frustrating that silly proposals get approved, and we think, who’s voting these proxies when we see them. So I think it’s a good step forward, but frankly the rhetoric is a little off base in terms of what the fund industry has done.

COLVIN: Now there is some talk in Washington about a requirement that mutual fund companies disclose how they vote on these proxies. Where do you stand on that?

BRENNAN: We think the disclosure of your proxy voting policies in pretty good detail, as we do on our web site, is the right step, and frankly stating affirmatively that you have voted your proxies in the shareholders’ best interests. But we think going to full disclosure of every proxy vote allows third parties and special interest to come in and try to pressure firms like Vanguard, and we don’t think that’s the right step. We think that’s a step too far. I think everybody should be forced to disclose policies and aver that they’ve done it, that they’ve voted correctly, but not go all the way to I think something that would be dangerous for our shareholders, and that’s the only one I’m interested in.

COLVIN: You have a new book out called “Straight Talk on Investing.” As of this afternoon, it is the number one best-selling title on Amazon.com. Congratulations.

BRENNAN: Thank you very much.

COLVIN: It’s very basic, very right-on advice for investors. What do you think is the biggest mistake the average individual investor makes?

BRENNAN: They don’t tune out the noise. People think it’s the sport and they think they have to do something, rather than set a plan, set a simple financial plan of living below their means and sticking with it. The tendency to think you have to do something is I think the single biggest mistake. And you know that’s frankly why I wrote the book, is to try to put in plain English, and pretty bluntly, that it’s not that hard, which is the first chapter title, and if you’re knowledgeable and interested, but not too active, you’ll do well.

COLVIN: That’s terrific. Jack, thank you so much for being with us.

BRENNAN: My pleasure.