Index we trust
Vanguard has radically changed money management by being boring and cheap
WHEN John Bogle set up Vanguard Group 40 years ago, there was no shortage of scepticism.
The firm was launching the first retail investment fund that aimed simply to mimic the performance of a stock index (the S&P 500, in this case), rather than to identify individual companies that seemed likely to outperform. Posters on Wall Street warned that index-tracking was “un-American”; the chairman of Fidelity, a rival, said investors would never be satisfied with “just average returns”; and the Securities and Exchange Commission (SEC), Wall Street’s main regulator, opposed the firm’s unusual ownership structure. The fund attracted just $11m of the $150m Vanguard had been hoping for, and suffered net outflows for its first 83 months.
“We were conceived in hell and born in strife,” Mr Bogle recalls.
Vanguard now manages over $3.5 trillion on behalf of some 20m investors. Every working day its coffers swell by another billion dollars or so. One dollar in every five invested in mutual or exchange-traded funds (ETFs) in America now goes to Vanguard, as does one in every two invested in passive, index-tracking funds, according to Morningstar, a data provider.
Vanguard’s investors own around 5% of every public company in America and about 1% in nearly every public company abroad. Although BlackRock, a rival, manages even more money, Vanguard had net retail inflows of $252 billion in 2015, more than any other asset manager.
Impressive as they are, however, these statistics still understate Vanguard’s influence. By inventing index-tracking, and providing it at very low cost, the firm has forced change on an industry known for its high margins and overcomplicated products. Delighted investors and disgruntled money managers speak of “the Vanguard effect”, the pressure that the giant’s meagre fees put on others to cut costs. Some rivals now sell passive products priced specifically to match or undercut it.
Ask any employee for the secret of Vanguard’s success, and they will point to its ownership structure. The firm is entirely owned by the investors in its funds. It has no shareholders to please (and remunerate), unlike the listed BlackRock or Fidelity, a privately owned rival.
Instead of paying dividends, it cuts fees. Mr Bogle’s rationale for this set-up is simple: “No man can serve two masters.” The incentives of the firm and its customers are completely aligned, he says. Competitors implicitly agree. “How are we supposed to compete when there’s a non-profit disrupting the game?” complains one.
Bill McNabb, Vanguard’s current CEO, says the ownership structure permits a virtuous cycle, whereby its low fees improve the net performance of its funds, which in turn attracts more investors to them, which increases economies of scale, allowing further cuts in fees. Even as the assets Vanguard manages grew from $2 trillion to $3 trillion, its staff of 14,000 or so barely increased.
Meanwhile, fees as a percentage of assets under management have dropped from 0.68% in 1983 to 0.12% today (see chart). This compares with an industry average of 0.61% (or 0.77%, when excluding Vanguard itself). Fees on its passive products, at 0.08% a year, are less than half the average for the industry of 0.18%. Its actively managed products are even more keenly priced, at 0.17% compared with an average of 0.78%.
The index-trackers account for over 70% of Vanguard’s assets and over 90% of last year’s growth.
Investors are gradually absorbing the idea that, in the long run, beating the market consistently is impossible, Mr McNabb says. That makes being cheap more important than being astute.
Last year investors in America withdrew $145 billion from active funds of different kinds and put $398 billion into passive ones.
“In an industry with serious trust issues, Vanguard has proven an exception to the rule,” says Ben Johnson of Morningstar. Its investors stay with it roughly twice as long as the industry average. The firm actively shuns short-term “hot money” because it brings extra trading costs.
Mr McNabb tells the tale of the CEO of a foundation who wanted to park $40m with a Vanguard fund for a few months. When the fund turned him away, he “went ballistic”, complaining to the SEC, but Vanguard did not budge.
Vanguard also insists on keeping things simple. It offers only 70 different ETFs, compared with 383 at BlackRock. It steers clear of voguish products, such as funds of distressed energy firms.
It refused, presciently, to set up an internet fund in the late 1990s.
But Vanguard’s conservatism can also be a weakness. It has been slow to expand abroad: its customer base is 95% American. It was slow to get into ETFs as well, allowing BlackRock to become the biggest provider, although Vanguard is catching up. BlackRock is also a one-stop shop for all manner of investments, including alternatives such as private equity and hedge funds, whereas Vanguard caters only to the mainstream. This may be one of the reasons why it does less well with the biggest institutional investors, which want lots of investment options and the kind of bespoke service that Vanguard does not offer.
There is always a chance that a clever fintech startup, or a tech giant like Apple, might create a cheaper or simpler way for individuals to invest, luring away some of Vanguard’s customers.
As it is, it is getting harder for Vanguard to keep cutting fees: to shave its average fee by a hundredth of a percentage point, it needs to attract an extra $560 billion in assets under management. And heavier regulation is always a risk. Last year the industry’s giants won an important battle when they convinced regulators that, unlike banks, fund managers should not be subject to more onerous rules simply because they are big. But talk of rules intended to stem panic in collapsing markets has not gone away.
Nonetheless, there is plenty of room for Vanguard to keep growing. Only a third of American equities are held by index-tracking funds, and a smaller share elsewhere. Regulators in America and beyond are discouraging or barring financial advisers from receiving commissions from firms whose products they recommend—a move that should push even more money to Vanguard as advisers lose the incentive to offer expensive products (Vanguard refuses to pay commissions).
As the move from defined-benefit to defined-contribution pensions continues, and as Asia sets up its retirement systems, there will be growing demand for the sort of “DIY” investing that has underpinned Vanguard’s success. With interest rates and investment returns expected to be low for years to come, keeping fees down will be more important than ever. As Tim Buckley, the firm’s chief investment officer, puts it: “The biggest advantage Vanguard has, aside from its structure, is the greed of our competitors.”