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If cooperatives and mutuals are better than other firms, why are they so rare? Vanguard and the mutualist paradox.

Weekly newsletter of Coop Exchange
Weekly newsletter of Coop Exchange
If cooperatives and mutuals are better, why are they so rare? 
This article seeks to provide answers by looking into the amazing story of Vanguard - a customer owned mutual giant that dominates an industry dominated by capitalist firms.

"Nobody knows nothing"
In 1947, a 18 year old Princeton student named John Bogle started his career in the investment industry that he would later go on to transform. One of the first lessons he received also proved to be one he considered as the best words of wisdom he ever received about the world of investment. An industry veteran named Raymond told him: “Bogle, the only thing you need to know is that nobody knows nothing.” (Serchuk, 2018) What he meant was that while all fund managers would promise to deliver above average returns, half would outperform, half underperform and it was impossible to say whether any success or failure is due to a good or back luck rather than skill or lack of it.
Bogle was described by the host of the most popular investment TV host Jim Cramer as “the most anti-wall street wall streeter.” (CNBC, 2019) He was strongly influenced by the left leaning economist Paul Samuelson, who had envisioned an “index fund”. The principle of index funds was simple - instead of trying to pick above average stocks, buy a small portion of all companies in the stock market to get the average return. Instead of trying to beat other investors, an index simply copies them. However, because copying others requires less effort than actively picking stocks, index funds would require lower management costs. Index funds get the same return as other investors on average, but for lower costs - which means the investors can keep more of the returns. Indexing is similar to randomization - index funds provide the same return as you would expect by chance alone if you just randomly bought stocks.
Bogle started a fund management company called Vanguard, which introduced the first index fund in 1976. At first, he was mocked - the perceived purpose of every business in the industry was to provide better returns than the competitors, so giving average returns seemed like a ridiculous idea to many. However, Bogle had what he described as “the relentless rules of humble arithmetic” on his side. Index funds give investors the same return as other investors on average, but due to lower management fees they can keep more of their returns. This simple arithmetic requires them to outperform the rest of the funds on average. Which is exactly what has happened: over a 15 year period only 5% of actively managed funds have managed to generate better returns than a simple index fund.
As a result of this rather unstoppable and indisputable dynamic, Vanguard became the largest company in the mutual funds industry. The Wall Street Journal described Bogle as the “undisputed champion of the long run”(Jenkins, 2016) and Warren Buffett described as having “done more for the American investors than anyone else” (Melloy, 2019). Bogle died in 2019 - which was also a year when Bloomberg announced that “index funds… finally eclipsed old-fashioned stock pickers.” (Gittelsohn, 2019) in terms of assets under management. Not only had Vanguard become the largest in the mutual funds industry, but their competitors were also increasingly mimicking them by also providing index funds.
What makes the success story startling is that Bogle was not doing something more sophisticated than everyone else, but something more simple. In fact, it’s hard to come up with an example of such a simple invention that has shaped the modern world so profoundly as index funds.
John Bogle, the founder of Vanguard
John Bogle, the founder of Vanguard
Vanguards mutualist paradox
However, indexing was only one half of the Bogles equation. Vanguard is unique among mutual funds in being owned as a mutual. Despite their name, mutual funds are not actually mutual enterprises, with the exception of Vanguard. Vanguard is a fund management company owned by the funds, which in turn are owned by the customers who invest in the funds. In the rest of the industry, the mutual funds pay fees to a management company, typically a publicly listed corporation. These management corporations seek to maximise their fees. Vanguard on the other hand distributes all surplus from fees back to the funds that own the management company. 
Bogle believed that this mutualist structure was key to Vanguard’s success, stating:
We have enjoyed an advantage some of our rivals have described as “unfair,” Because the fund shareholders own Vanguard, none of their investment returns have had to be diverted to the owners of a management company… our structure has been an essential element in the returns that our shareholders have enjoyed. That shouldn’t surprise anyone, for as the economist Peter Bernstein has observed, “what happens to the wealth of individual investors cannot be separated from the structure of the industry that manages those assets.” (States and Security, 2004)
Under the most intuitive assumptions of market competition, one would expect the most successful structure to also be most common. This makes Vanguard’s structural exceptionalism so astonishing: the most successful company in the industry uses a structure that far from being the most common, is one of a kind. This anomalous malfunction does not prevail in some fringe part of the economy - but in the mutual fund industry, which is perhaps the purest example of what capitalism should be most efficient in doing; allocating capital.
One could say that while it might be odd that it took so long to discover this structure and for it to be adopted by only one company, the success of Vanguard shows that once discovered, the market economy is rational enough for a more efficient mutual structure to outcompete its competitors. Nothing could be further from the truth: far from being a recent discovery in the mutual fund industry, when the very first mutual fund was formed in 1924, it had a mutual structure. It was also the biggest mutual fund with the lowest fees until 1965 when it was demutualised. After the demutualisation, its fees increased substantially, eating away returns and therefore leading to gradual diminishment (Bogle, 2004). 
Instead of a more efficient structure replacing less efficient ones, in his 2004 essay “Remutualising the Mutual Funds Industry” Bogle points out that the mutual fund industry had become less efficient in delivering value to its customers, despite the tremendous success of Vanguard in providing a more effective alternative:
“…the accelerating trend toward higher fund expense ratios that today seems endemic in the fund industry…. Fund expenses have risen 238 fold(!) since 1965, nearly double the 128-fold increase in equity fund assets. In a field in which, as today’s lone mutually structured fund complex (Vanguard) demonstrates, the economies of scale in fund operations are truly staggering, it is a truly astonishing anomaly.” (Bogle, 2004)
How can cooperatives or mutual businesses possess competitive advantage but be simultaneously a rare type of business in market competition?
This might be because mutualist advantages are attained at the expense of those bearing the initial costs and risks to start the enterprise. If a person wants to start a grocery store, they might gain a pricing advantage if they give away their profits to the customers as in a consumer cooperative. However, it is irrational for a person to take out a loan to start the store and bear all the risks of failure alone, only to give away all the gains to others if it succeeds.
This can lead to a rather paradoxical situation, where cooperatives and mutuals that possess the greatest competitive advantages might be the type of cooperatives that are the most rarely started. This counterintuitive dynamic can occur if attaining the advantages requires founders to take risks that are disproportionate to the rewards they get compared to their competitors, because the rewards are shared to other stakeholders - customers, suppliers, employees, etc. In other words, founders of successful coops might take similar risks as their competitors for smaller rewards. Mutualist advantages might be gained at the expense of the founders - and the greater the advantage generated, the less incentives there are to take the risk to attain them and start such a cooperative or a mutual.
Far from being something specific to cooperatives and mutuals, this is just a very pure example of one of the core problems of the economic system. One could say that the best economic system maximises rewards for those who increase the well-being of others the most and minimises incentives to benefit at the expense of the well-being of others. 
Too often this is not the case. In the UK, the highest paid CEO in 2019 was a founder of an online gambling site (McWeaver, 2019). It is hard to argue that inventing an online casino would have benefited others rather than benefited the casino owners at other peoples’ expense. Nevertheless, the economic system deemed the founder worthy to earn the highest portion of the economic resources as a reward. Reducing the obstacles of starting mutualist enterprises can tackle some of the root causes of our problems in the economy - how to reward people who take risks to increase well-being of others, while reducing risk-taking that happens at other peoples expense.
Towards concentration of economic power
Vanguard now competes with Blackrock on the status of largest asset manager in the world. It’s hard to overstate how much economic power is at stake in this contest - being the largest pool of capital could be argued to be a more powerful position in the capitalist economy than any other.
These two giants represent two different ownership structures - Vanguard is a mutual, and Blackrock a publicly traded corporation. Vanguard spends its surplus to reduce costs, while Blackrock spends its money to raise its share price by boosting its dividends. Their competition for the dominance of the stock market drives it towards unprecedented concentration of ownership, which is increasingly raising concerns among many observers. 
The concerns have to do especially with cross-ownership and concentration of voting power. Blackrock and Vanguard are the largest owners of practically all publicly listed US companies (Fichtner et al. 2017). This includes both Pepsi and Coca-Cola, McDonald’s and Burger King, etc. For example, the OECD has warned that increases in common ownership create “hidden social cost and reduced product competition” (Riding, 2019).
Because the asset managers vote on the behalf of their customers in the shareholder meetings, they also have the biggest say in deciding who gets hired and fired in the boards of directors. Bogle himself acknowledged this problem, stating that corporate America is developing towards a situation where a “handful of giant institutional investors [hold] voting control of virtually every large US corporation” and that this would not be in “national interest” (Bogle, 2018). 
This also puts them in a somewhat contradictory position - the core idea of index funds was always to passively track the stock market. Now they are not only in a position to influence it, but are increasingly the only entities in the economy capable of exercising influence in the shareholder meetings. Far from being silent spectators, they have become the main characters.
The cooperative parallel universe
While stock markets are experiencing an unprecedented drive towards concentration, on the other extreme exists the cooperative economy. Instead of voting power being concentrated, in cooperatives it is shared equally on one-member-one-vote basis. Instead of being owned by two large asset managers, the ownership is distributed between 1.2 billion members worldwide (Cooperatives UK, 2021). 
This parallel economy has a large and growing presence across industries and continents. Together the movement accounts for one third of all agriculture globally and includes market leaders of many major industries of many countries ranging from the second largest bank in France (Credit Agricole, 2021) to the largest grocery store chain in Singapore (NTUC, 2019).
This ecosystem’s potential for growth is demonstrated by the fact that governments have been sometimes forced to intervene to suppress its spread. For example during the 2008 banking crisis, cooperative banks proved to be more resilient than their capitalist competitors. Far from being unable to compete with the big banks, it has been the big banks that have had to rely on bailouts from the government to save themselves from extinction. Not a single one of the 51,000 credit unions around the world received government recapitalisation during the crisis. Across the US, Europe and Japan cooperative banks consistently proved to outperform their competitors using a range of various indicators. During the crisis, they had a lower risk of bankruptcy, and they continued or even increased lending to small and medium sized businesses in a moment of need (Birchall, 2013). In some countries the outperformance has been dramatic - the only major bank in the Netherlands that did not need a bailout to survive was the cooperative Rabobank (Deutsch, et al. 2012). In Greece cooperative banks account for almost a fifth of all lending to small and medium sized, although they account for only around 1% of loans and deposits overall in the banking sector (EACB, 2020). 
Although in some countries cooperative banks have exemptions and restrictions that differ from conventional banks, this outperformance cannot be, at least not fully, explained by favourable legislation such as reduced tax burden. For example, cooperative banks in Germany pay 2 million euros in taxes for every £1 billion in assets, compared to only 300,000 euros for large banks (Bundesbank, 2020). Despite this, half of all banks in the country are cooperatives, their market share is growing, and not a single one has gone bust or needed a government bailout in over 90 years (BVR, 2021).
Typically investment in cooperatives does not give the investor voting power, which has been thought to put them at disadvantage compared to other firms. However, investors who use index funds, the most recommended and popular investment strategy, do not receive voting rights in the businesses they invest in either, but rather give those rights to the asset manager. 
This means that from the perspective of an individual investor, cooperatives are at no disadvantage compared to index funds when it comes to investors voting rights - and as index funds continue to grow in importance, this disadvantage is reduced in importance. In fact, as investors are increasingly concerned about concentration of corporate voting power, many might prefer to grant their voting rights to be shared equally between cooperative members rather than give it to asset managers who already hold concerning amounts of voting power.
The future issues of this newsletter will present some real life success stories and new ideas about how to form ecosystems of investment into cooperatives. Do subscribe!
Sources
Serchuk, (2018). Nobody knows nothing - John Bogle. https://www.youtube.com/watch?v=fLCfkmaqI6k
CNBC (2019). Jack Bogle’s last CNBC interview: Timing markets never works https://www.youtube.com/watch?v=hMjC_TX1Dc0
Jr, H.W.J. (2016). Jack Bogle: The Undisputed Champion of the Long Run. Wall Street Journal https://www.wsj.com/articles/jack-bogle-the-undisputed-champion-of-the-long-run-14728553
Melloy, J. (2019). Warren Buffett says Jack Bogle did more for the individual investor than anyone he’s ever known. https://www.cnbc.com/2019/01/16/warren-buffett-says-jack-bogle-did-more-for-the-individual-investor-than-anyone-hes-ever-known.html
Gittehlson, J. (2019). End of Era: Passive Equity Funds Surpass Active in Epic Shift. Bloomberg https://www.bloomberg.com/professional/blog/end-era-passive-equity-funds-surpass-active-epic-shift/
States, U. and Security, U.S.C.S.C. on G.A.S. on F.M., the Budget, and International (2004). Oversight Hearing on Mutual Funds: Hidden Fees, Misgovernance and Other Practices that Harm Investors : Hearing Before the Financial Management, the Budget, and International Security Subcommittee of the Committee on Governmental Affairs, United States Senate, One Hundred Eighth Congress, Second Session, January 27, 2004. [online] Google Books. U.S. Government Printing Office. Available at: https://play.google.com/books/reader?id=reD1bht9KT4C&pg=GBS.PP4&printsec=frontcover 
Bogle, J. (2004). Re-Mutualizing the Mutual fund Industry-The Alpha and the Omega. Boston College Law Review, Available at: https://lawdigitalcommons.bc.edu/bclr/vol45/iss2/3/ 
McKeever, V. (2019). The UK’s top-earning CEO bags a record $422 million payday. [online] CNBC. https://www.cnbc.com/2019/12/18/uks-top-earning-ceo-of-bet365-denise-coates-bags-422-million-payday.html
Riding, S. (2019). Brussels targets large index fund managers on “common ownership.” Financial Times. https://www.ft.com/content/0308f2e2-9e4a-34bf-b40b-745e62a536bb
Bogle, J.C. (2018). Bogle Sounds a Warning on Index Funds. Wall Street Journal. https://www.wsj.com/articles/bogle-sounds-a-warning-on-index-funds-1543504551
Cooperatives, UK (2021). Quick facts about co-ops | Co-operatives UK.
NTUC, Fairprice. (2019). Our Retail Formats - FairPrice. https://www.fairprice.com.sg/our-retail-formats/
EACB (2020). Key figures of European Co-operative Banks - EACB http://www.eacb.coop/en/cooperative-banks/key-figures.html
BVR, (2021). About us - Our protection scheme - BVR - National Association of German Cooperative Banks.https://www.bvr.de/about_us/our_protection_scheme
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