The Knockoff Economy (20 page)

As with comedians, when the law fails magicians, their norms step in. The exposure of tricks doesn’t occur often. But when it happens, the magic community retaliates. In the 1997–98 television season, Fox broadcast a four-part show titled
Breaking the Magician’s Code: Magic’s Biggest Secrets Finally Revealed.
In the show a character identified only as the “Masked Magician” performed a series of small tricks and large-scale illusions before revealing the secrets that made them possible. The turncoat magician was ultimately revealed to be a relatively obscure Las Vegas performer named Val Valentino.

The magic community’s response was swift and pitiless. Valentino was branded a traitor and shunned by magicians everywhere. “I’m sort of excommunicated now from the magic fraternity’s world,” Valentino admitted.
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Largely shut out of work in the United States, Valentino spent a lot of time performing abroad. In subsequent years, he helped to produce a reprise of
Breaking the Magician’s Code,
which aired in the United Kingdom and on US TV stations connected with Fox affiliate MyNetworkTV.

It’s been more than a decade since the first appearance of the Masked Magician, but the magic community’s dislike of Valentino persists. In the fall of 2010, well-known magician Criss Angel spotted Valentino in a Las Vegas casino and had him removed by security. Valentino told the press that Angel “looked at me and yelled, ‘Get that piece of [expletive] out of here.’ It was bizarre, so unprofessional. I was so disappointed in him.” When Valentino and his companion went to a different lounge in the casino, Angel found them and had them removed again.
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What can we learn from stories such as these? Magicians need protection, but not the sort that legal rules against copying are likely to provide. Magicians’ social norms provide a sort of “super-trade-secret” protection, where
magicians are subject to community sanction for disclosing secrets in situations that the formal law would ignore. Exposing tricks is rarely against the law, yet the norms system punishes those who do so. And while the law does not distinguish between sharing with fellow magicians and with ordinary people, the norms system treats the two as entirely different.

And like comedy, the world of magic offers some important lessons about innovation. Social norms can serve as an alternative or supplement to legal protection, especially when legal rules are costly or cumbersome to use. And these norms can evolve, as the story of comedy shows. Is a private, norms-based system preferable to a legal system of copyright, patent, and trade secret rules? This question is impossible to answer as a general matter. Each system comes with its own costs and benefits. On the one hand, the norms system is cheap to enforce and appears to incentivize plenty of innovation. We don’t lack for comedy or magic today, either in terms of quantity or variety. But on the other hand, the system presents the danger of mob justice (including gossip and the inability to appeal), does not recognize the full range of forms of ownership and transfer found in the formal law, and lacks a clear fair use standard and reasonable time limitations on the right of ownership.

Of course, all weaknesses are relative. Ordinary IP law offers comedians and magicians little help, and it is unclear whether rewriting legal rules would be possible. More to the point, it does not seem necessary to rewrite the legal rules to better serve comedians and magicians: they are thriving without it.

In 1950, 20-year-old John Bogle was working late in the Princeton University library researching his senior thesis in economics. Bogle was interested in the growing investment management industry. In particular, he wanted to understand whether people who trusted their money to mutual funds run by professional fund managers were making a good decision. Mutual fund managers charged high fees for their investment funds. Were they worth it? Bogle wondered.

To find the answer, he combed through price reports for hundreds of funds. What Bogle found surprised him. It wasn’t just that actively managed mutual funds were failing to beat the market by enough to justify their managers’ high fees. They were failing, on average, to beat the market
at all.
Investors would be better off, Bogle argued in his thesis, titled
Mutual Funds Can Make No Claim to Superiority over the Market Averages,
if they could find a low-cost way simply to mimic the market’s return.

Bogle’s interest in investing, and his skepticism about Wall Street, started in his youth. His father was ruined in the stock market crash of 1929 and was forced to sell the family home. Bogle has said that this experience made him
a financial conservative, a perspective that fueled his skepticism about whether actively managed mutual funds delivered for their investors.

Bogle’s senior thesis earned him an A+. It also caught the attention of Walter Morgan, the head of the Philadelphia-based Wellington Management Corporation, then, as now, a leading investment management company. Morgan hired Bogle right out of Princeton in 1951. Bogle rose through the ranks and eventually was made head of the firm, but was fired in 1974 following a number of years of below-par performance at Wellington’s actively managed funds and a trouble-plagued merger with a Boston-based rival.

Finding himself out of a job in his mid-40s, Bogle picked up where he’d left off as a Princeton senior. He decided to put the ideas in his senior thesis into practice. Immediately after his firing from Wellington in 1974, Bogle founded The Vanguard Group. Vanguard’s initial business was providing administrative services to Bogle’s old firm, Wellington. But by 1976, Vanguard had introduced its first index fund, the Standard and Poor’s 500 stock index.

Veteran investors scoffed, calling the fund “Bogle’s folly” and refusing to believe that Americans could be happy with investment returns that were purposefully aimed to achieve the market’s average return. They were quickly proven wrong. The Vanguard Group, which started with a paltry $11 million in investment, grew explosively on the wide appeal of its low-cost index funds. Vanguard’s flagship 500 Index fund crossed the $100 billion milestone in November 1999, and surpassed the actively managed Magellan fund in 2000 to become the largest mutual fund in existence.
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Vanguard itself is now the largest mutual fund company in the United States. And the firm is not just big and rich, it is also innovative. Vanguard was the first firm to introduce bond market index funds, and the first to offer stock market index funds aimed at stocks of particular market capitalization (i.e., small-cap or large-cap stocks), and particular profiles (i.e., value stocks vs. growth stocks). Today these are commonplace ways of structuring mutual funds that investors take for granted. When the new index funds were introduced, however, there was widespread criticism from Wall Street experts. Yet in each case there turned out to be a sizable market for Vanguard’s innovations.

John Bogle never tried to patent the idea of the index fund. Even if he had tried, he almost certainly would have failed: at the time the index fund was invented, most courts held that new methods of running a business were not patentable. The idea of a mutual fund that holds a representative index of
stocks on behalf of investors would have been treated as an unpatentable business method.

In the years since, business methods have become patentable. At the time Bogle introduced the index fund, however, competitors were perfectly free to copy his idea. They didn’t do so right away. Vanguard’s first index fund competitor, the Wells Fargo Stagecoach Corporate Stock Fund, arrived only seven years later.

Why did Wall Street not copy Bogle’s innovation, even as Vanguard’s business boomed? Perhaps because the investment managers who run actively managed mutual funds saw little upside. Index funds don’t require much management—that’s the whole point—and therefore they limit the amount of money that can be made from investors in the form of management fees. (Unless of course the fund grows to be enormous, as Vanguard’s ultimately did.) As clients flocked to Vanguard’s funds, though, Wall Street’s resistance broke down. In the 1980s, fund giant Fidelity introduced index funds, and by 1990, a number of smaller competitors had followed suit. By the end of the ’90s, there were more than 270 index funds competing in the market, 40 of which were benchmarked to the S&P 500, exactly as Bogle’s had been almost 30 years earlier. By 2001, over 400 index funds were in existence, and today, there are more than a thousand.

So John Bogle invented the index fund, but the absence of patents meant that Vanguard’s rivals were free to copy Bogle’s innovation. And eventually they did. This was a smart move for Vanguard’s rivals, who got to market their own version of an investment product that people wanted. This was also a great development for consumers. Many people are locked into employer-administered retirement accounts that force them to use funds from companies other than Vanguard. Only after the widespread imitation of index funds were these people able to get the same access to low-cost index funds that Vanguard had been alone in providing for years.

And yet, here’s the puzzle: even though any firm is free to market index funds, and many dozens do,
Vanguard is today still by far the biggest provider of index funds.
The firm has done very well from its innovation. And even in the face of widespread copying of its central innovation, it has managed to stay on top.

Vanguard is not an isolated example. Like fashion, food, and stand-up comedy, finance is an innovative industry that operates with a surprisingly limited focus on intellectual property protection. In this chapter, we briefly look at finance, and we also present a number of snapshots of other creative
endeavors in which copying is common and, for the most part, legal. Each has its own story, its own creative culture, and its own way of maintaining that creativity despite copying. We will sketch out the basics of these industries and show how they add to our understanding of innovation. Along the way, we will explore the importance of a key aspect of the creativity-copying relationship: tweaking, or the freedom to rework and refine an innovation into something bigger and better.

We will start with
football,
which has a rich history of innovation without the use of patents, copyrights, or any other form of legal protection. We’ll then move on to the very different world of typefaces—or, in more modern argot,
fonts.
The shapes of letters are not copyrightable, and for that reason, font designers cannot prevent rivals from copying their work. And yet production of new fonts has boomed. We’ll then return to where we started—with innovation in the
financial services industry.
As it turns out, John Bogle’s story is not unique. The financial services industry has a long record of innovating despite imitation. We’ll examine how. We finish with a quick look at
databases.
In a landmark case called
Feist,
the Supreme Court held that facts, including facts collected in databases, could be freely copied. Immediately thereafter, the European Union went the other way and banned the copying of databases. And yet since the European rule went in effect almost two decades ago, the United States has
increased
its lead over Europe in the number and value of databases produced. How did this happen?

Each of these industries is different from the others. Finance is an economic powerhouse; databases are big and growing; football is smaller but still quite significant economically, and fonts are a tiny market. The four differ in many other (and obvious) ways. But each tells us something about the variety of ways in which creative cultures can be organized to help innovation co-exist with and even benefit from imitation.

Football in the late 19th and early 20th centuries was a pure running game—big running backs bashing their way through a scrum of defensive linemen. And in an era where players wore little protective equipment, the results were not pretty. As we noted in the Introduction to this book, 18 college football players were killed in 1905, and many more seriously injured. (Football was predominantly a college game in those days, and of
course college football remains hugely important today.) The national outcry over gridiron carnage led the White House to intervene, resulting in the formation of a college cartel that would eventually become the National Collegiate Athletic Association, or NCAA.
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Perhaps of equal importance, however, the outcry led to a rethinking of the rules of football. The most noteworthy change was the introduction of the forward pass.

The great allure of the pass was that it was thought to be less dangerous to players than the run. Yet it had an effect on the game that went far beyond safety. The pass catalyzed a process of change that continues today. It made football a much more complex and interesting game, with an enormous variety of new plays and formations. And over time the importance of passing has only grown, to the point that few teams succeed without a strong passing game.

Some stats from the first 11 games of the 2011 National Football League (NFL) season make the point. During that period, the Jacksonville Jaguars went an unimpressive 3-8. The Jaguars were simultaneously the worst passing team in football and one of the better teams at the run (number 12 of 32). Yet they gained
more
yardage passing (1,444) than running (1,306). And those figures underplay the value of the pass to even teams with a very weak passing offense. The Jaguars gained 5.2 yards per passing attempt (pretty anemic actually—good passing teams average over 7 yards) versus only 3.8 for the run. In a game of inches, that’s a big difference. The fundamental problem that keeps the Jaguars from scoring more points is that they are so bad at passing the ball.
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Passing is critical today, and has been for a long time. As football shifted its offensive focus from running to passing, teams developed an array of new plays and formations. In turn, defenses mutated to counter the aerial game. The result was a long-standing dynamic of innovative offensive strategies and defensive counterstrategies that has continually renewed the game. No other
major sport has changed as profoundly or frequently as has football. The closest baseball comes is the designated hitter rule; in basketball, the shot clock and the three-point shot. These are important innovations and certainly controversial in some quarters. But none transformed their respective games as much as passing transformed football. Forward passing added a range of complexities to the gridiron. The result has been a continuous wave of innovation aimed at effectively deploying, and countering, the ability to pass the ball.