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The best investment advice you'll never get
Mark Dowie | Photo: SF magazine | January 18, 2008
For 35 years, Bay Area finance revolutionaries have been pushing a personal investing strategy that brokers despise and hope you ignore.
“San Francisco was the only place in the country where this could have happened,” says Bill Fouse, a jazz clarinetist in Marin County who was present when the first shots were fired in the investment rebellion. It was 1970, and revolution was in the air.
While hippies, dopesters, and antiwar radicals were filling the streets of America’s most tolerant city with rage, sweet smoke, and resistance, a quieter protest was brewing in the lofty, paneled offices of Wells Fargo. There, a young engineer named John Andrew “Mac” McQuown, Fouse (who like many musicians also happens to be a brilliant mathematician), and their self-described “skeptical, suspicious, careful, cautious, and slow-to-change” boss, James Vertin, were taking a hard look at the conventional wisdom that for a century had driven American portfolio management.
Bank trust departments across the country were staffed by portfolio managers who, as I did at the time, believed that they alone possessed the investment formula that would enrich and protect the security of their customers. “No one argued with that premise,” Fouse recalls.
But McQuown suspected they were pretty much all wrong. He had met Wells Fargo chairman Ransom Cook at an investment forum in San Jose, and at a later meeting at company headquarters, persuaded him that traditional portfolio management was merely an investment variation of the Great Man theory. “A great man picks stocks that go up. You keep him until his picks don’t work anymore and you search for another great man,” he told Cook. “The whole thing is a chance-driven process. It’s not systematic, and there’s lots we still don’t know about it and that needs study.” Cook offered McQuown a job at Wells and a generous budget to conduct research into the Great Man Theory and other schemes to beat the averages. McQuown accepted, and a few years later Fouse came on as well.
They couldn’t have been more different: Fouse, a diminutive, mild-mannered musician, and McQuown, a burly, boisterous Scot. The two were like oil and water—McQuown even tried to have Fouse fired at one point—but their boss, Vertin, was the one who really was in the hot seat.
“You have to understand, Vertin’s career was on the line,” Fouse recalls. “He was, after all, running a department full of portfolio managers and securities analysts whose mission was to outperform the market. Our thesis was that it couldn’t be done.” Proof of McQuown’s theory could lead to the end of an empire, in fact many empires. “The poor guy was under siege,” says Fouse. “It was a nerve-racking time.”
Vertin’s memory of those times is no less vivid. “Mac the knife was going to own this thing,” he once told a reporter. “I could just see the fin of the shark cutting through the water.” Eventually, the research McQuown and Fouse produced became so strong that Vertin could not ignore it. “In effect it said that almost everything that every trust department in America was doing was wrong,” says Fouse. “But Jim eventually accepted it, even knowing the consequences.”
In July 1971, the first index fund was created by McQuown and Fouse with a $6 million contribution from the Samsonite Luggage pension fund, which had been referred to Fouse by Bill Sharpe, who was already teaching at Stanford. It was Sharpe’s academic work in the 1960s that formed the theoretical underpinning of indexing and would later earn him the Nobel Prize. The small initial fund performed well, and institutional managers and their trustees took note.
By the end of the decade, Wells had completely renounced active management, had relieved most of its portfolio managers, and was offering only passive products to its trust department clients. And it had signed up the College Retirement Equities Fund (CREF), the largest pool of equity money in the world, and Harvard University, the largest educational endowment. By 1980 $10 billion had been invested nationwide in index funds; by 1990 that figure had risen to $270 billion, a third of which was held at Wells Fargo bank.
Eventually the department at Wells that handled indexing merged with Nikko Securities and was later bought by Barclays Bank, which created the San Francisco subsidiary Barclays Global Investors. Its CEO, Patricia Dunn, the scandal-tinged former chairman of Hewlett-Packard who had worked for 20 years at Wells Fargo, had been heavily influenced by indexing. Running Barclays, she became the world’s largest manager of index funds.
Fouse, now retired in San Rafael, explains why all this could have happened only in San Francisco. “When we started our research, almost all the trust clients out here were individuals with small accounts. Anywhere else, particularly on the East Coast, trust departments handled very large institutions—pension funds, university endowments, that sort of thing. If Mellon, Chase, or Citibank had done this research and come to the same conclusion, they would have in effect been saying to their large, sophisticated, and very lucrative clientele: ‘We’ve been doing things wrong for a century or more.’ And thousands of very comfortable investment managers would have been out of work.”
But even in San Francisco, as in the country’s other financial centers, Fouse and McQuown’s findings were not a welcome development for brokers, portfolio managers, or anyone else who thrived on the industry’s high salaries and fees. As a result, the counterattack against indexing began to unfold. Fund managers denied that they had been gouging investors or that there was any conflict of interest in their profession. Workout gear appeared with the slogan “Beat the S&P 500,” and a Minneapolis-based firm, the Leuthold Group, distributed a large poster nationwide depicting the classic Uncle Sam character saying, “Index Funds Are UnAmerican,” implying that anyone who was not trying to beat the averages was nothing more than an unpatriotic wimp. (That poster still hangs on the office walls of many financial planners and fund managers.)
Savvy investment consumers, however, were apparently catching on. As they began to suspect that the famous fund managers they were reading about in Business Week and Money magazine were taking them for a ride, index funds grew in size and number. And actively managed funds shrank proportionately. Even some highly placed industry insiders started beating the drums for indexing. From her perch at Barclays, CEO Dunn gave a speech at a 2000 annual industry meeting in Chicago. As reported in Business Week at the time, she started out with some tongue-in-cheek comments about fund managers’ “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 zinger: “[Investment managers sell] for the price of a Picasso [what] routinely turns out to be paint-by-numbers sofa art.”
It’s not as if Merrill Lynch, Putnam, Dreyfus, et al, were being put out of business by this new consciousness, but like any industry threatened with bad ink, the financial community continued to strike back at every opportunity. In May 2003, Matthew Fink, president of the Investment Company Institute, a mutual funds trade association, told convening members that his industry was squeaky clean and has “succeeded because the interests of those who manage funds are well-aligned with the interests of those who invest in mutual funds.” At the same convention, Fink’s remarks were echoed by ICI vice chairman Paul Haaga Jr., who, in his keynote address, pronounced that “our strong tradition of integrity continues to unite us.” Indeed, integrity had been the theme of every ICI membership meeting in recent memory.
Haaga then attacked his industry’s critics, including former SEC chairmen, members of Congress, academics, journalists, even “a saint with his own statue” (John Bogle). “[They] have all weighed in about our perceived failing,” lamented Haaga. “It makes me wonder what life would be like if we’d actually done something wrong.”
He didn’t have long to wonder. Four months later, the nation’s first big mutual fund scandal broke when Eliot Spitzer brought civil actions against four major fund managers for allowing preferred investors to buy and sell shares on news or events that occurred after markets had closed. Spitzer compared the practice to “allowing betting on a horse race after the horses have crossed the finish line.” Multimillion dollar fines were issued against the firms, which were also required to compensate customers damaged by what were called market-timing practices.
The market-timing scandals alone are estimated to have cost fund investors about $4 billion, and other industry violations were uncovered after that. But now more experts are convinced that the amount pales in comparison to the tens of billions lost every year just to the fees and transaction costs by which mutual funds live and die. After the mutual fund scandals broke, Senator Peter Fitzgerald (R-Ill.) called a hearing before the Subcommittee on Financial Management, the Budget, and International Security, and said this in his opening statement: “The mutual fund industry is now the world’s largest skimming operation—a $7 trillion trough from which fund managers, brokers, and other insiders are steadily siphoning off an excessive slice of the nation’s household, college, and retirement savings.”