Jack Bogle: Has capitalism lost its soul?

July 24, 2012, 2:24 PM UTC

FORTUNE — Do investment money managers have your best interests at heart? Beyond Peregrine’s long-running fraud, some money managers may not be investing your money in the way you expect. Reuters reported on Friday that the Labor Department may be looking into a possible breach of fiduciary duty by J.P. Morgan (JPM). The company put “private mortgage debt underwritten and rated by the bank itself” in its Stable Value Fund, a vehicle designed for 401(k) plans that is supposed “to be the most conservative choice for employees — liquid and backed by insurance,” the report stated. And earlier this month, the Wall Street Journal reported that mutual funds and 401(k) advisors put Facebook (FB) into portfolios advertised as value funds, although “Facebook isn’t considered a value stock.” Funds run by Morgan Stanley Investment Management, lead underwriter of Facebook’s IPO “put the highest percentage of their portfolios in Facebook.”

I recently spoke with Jack Bogle, founder of the Vanguard Group and the first index mutual fund, about the state of money management and corporate governance today. Here’s an edited transcript of our conversation.

When we talked six years ago about your book, The Battle for the Soul of Capitalism, there was no financial crisis, no Facebook IPO. We hadn’t seen the scandals at HP, Chesapeake, and Wal-Mart, to name some recent examples. Would you say that battle has been lost?

I don’t think we’ve lost the battle for the soul of capitalism. But right now, our capital system is functioning badly. Long-term investment is being crowded out by short-term speculation. Instead of owners, we have renters of capitalism in the driver’s seat. And individual investors don’t speak up for themselves. Seventy percent of the market is owned by agents [those who invest other people’s money]. And the agency system is not working well.

The battle for the soul of capitalism could be lost, but as long as there are enough of us left that believe the free market system is best, that open markets can work, we can turn this around.  Capitalism has been abused. But capitalism is going to come back. It’s too good not to.

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What do boards need to be doing that they still aren’t?

Boards need to be overseers of management and act in the interest of shareholders rather than as partners of management. Management has all the weapons. They have the data. They can give out what they want to and not share the data they don’t want to.

Two examples now. Today, boards are allowing companies to spend dollars in ways they shouldn’t. One is on political contributions. The other is the absurdly outrageous salaries we see today. Some compensation consultants may be called independent but you aren’t going to be a success if you don’t give management a raise.

In the fund system, we have the same problem. We don’t want to offend actual clients and we don’t want to offend potential clients.

What do fiduciaries [these agents who invest others’ money] need to do that they aren’t? 

Honestly, we are having a revolution going on in the fund industry. Index funds are dominating. In the five years through May, there has been a $600 billion inflow into index funds and $400 billion lost to funds that are actively invested. Index funds make up 28% of industry assets.

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We must have index owners act in a way they aren’t right now, to encourage and push corporate directors to consider shareholder interests, and to use their votes to do that.

How do you see corporate actions affecting our economic strength? Are companies focused enough on the long-term?

No, I don’t think they are. We need to turn back to long-term investing. The market is made up of speculators that don’t vote proxies. Governance means nothing if you are a renter, a short-termer.

Congress, the SEC, the Supreme Court, money managers, and analysts have all let us down. We have to put the markets back in the hands of owners. We have to have a system that cares about governance.

I understand you have written a new book called The Clash of the Cultures: Investment versus Speculation. What’s it about?

You’ve touched on some of the major themes of the book in your previous questions. The book talks about how short-term speculation has crowded out a focus on long-term investment and intrinsic value.

Capitalism works when it put capital to work at its highest and best use. As an average over the last five years, we raise $250 billion a year in the markets in IPOs and secondary offerings while $33 trillion a year is traded. That means that over 99.2% is speculative, and .8% is invested. I recommend we institute transaction taxes along with other measures to turn that around.

In our capital markets, we have an agency system that is really a double agency system. We have the agents for owners [an example is mutual funds] and we have the agents for shareholders [those are directors]. And they operate in a happy conspiracy that is too focused on price rather than value.

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So companies give earnings guidance and use accounting tricks to boost price. And we have problems with governance, with political spending, and high compensation.

In 1951, when I began in the business, the culture at mutual funds was stewardship versus salesmanship. Those who ran mutual funds used to be professionals who acted in the best interest of owners. Today, they are businesses that act in the interest of themselves. In that time, the funds have grown from $2 billion to the $12 trillion we see today. And rather than 15-16% turnover, these funds now are running at 100%.

Today, only seven are privately held. Vanguard is one of them [it’s a mutual company] and the privately held ones are doing better than the publicly traded ones. Forty three are publicly held and 36 are conglomerates.

What is the single most important action we need to be taking now?

We need to have a federal statute of fiduciary duty, which would require that fiduciaries place the interest of clients ahead of their own. Conflicts of interest like conglomerates would be disallowed. You can’t serve two masters. The statute would outline the rights and responsibilities of corporate governance. It would include providing services at low costs, putting the interest of shareholders (i.e. their customers) ahead of their public shareholders.

Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance (http://thevaluealliance.com), a board advisory firm.