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It's the Destination, Not the Vehicle

Vanguard's Bill McNabb and Invesco's Marty Flanagan discuss the future of advisory services, their stances on new products, and their strategies for meeting client needs.

Dan Culloton, 08/23/2011

This article first appeared in the August/September 2011 issue of Morningstar Advisor magazine. Get your free subscription here.

To say that the business of giving financial advice to people has changed dramatically over the past several years is a dramatic understatement. Not only are the ranks of fee-only advisors swelling, but so is the array of products and providers seeking to serve them.

To explore these changes, we invited two executives who are addressing the advisor market from different vantage points. Marty Flanagan has dealt with advisors of all stripes his entire career, first at Franklin Templeton and now as CEO of Invesco. Vanguard, primarily seen as a shop for do-it-yourself investors, has taken increasing interest in fee-only advisors under Bill McNabb and his predecessor.

Both firms have broad mutual fund lineups, but they also are fighting for market share in the exchange-traded fund space--Vanguard with a stable of broad-based index ETFs and Invesco PowerShares with a lineup that has pushed the boundaries of passive investing. What follows is an edited transcript of Flanagan and McNabb's discussion on June 25 on the best way to serve advisors and their clients.

Dan Culloton: Given the changes in the advisor market, what are the challenges of reaching advisors in this environment?

Marty Flanagan: I think a lot of the changes in the advice channel have been positive ones. The movement away from commission-based compensation to asset-based compensation is very, very good for investors. There's been obviously quite an emergence of independent financial advisors. Our focus is a pretty simple one: All we do is manage money. And so, first and foremost, our focus is making sure that we're meeting the needs of the advice channel through the depth and breadth of the investment capabilities we have.

But also I think what's happened over the years--and I think importantly--is the movement of [us asking], How do you help advisors be successful? At one level, it's understanding our investment-management capabilities and how should you expect them to perform in different markets. But it's also trying to be very, very thoughtful with advisors and understanding what their needs are. Everybody has relative strengths, and understanding the relative strengths of the different advisors is very important. I think investors are vastly better off than they were 10, 15, 20 years ago.

Bill McNabb: We have served independent advisors for more than 25 years, but it was a relatively small segment of the marketplace. As we began to see the business model for advisors change from transaction-based to fee-based, the big "Aha!" for us was: How would advisors react if we treated them the way we treat many of our institutional clients?

For that constituency, our goal is to offer high-quality, low-cost investments. Obviously, indexing is an important part of that, but not the only part. Could we bring the same to the advisor market under these new rules of engagement? Treating advisors like institutions for us meant more than just product. There is the critical element of service, in terms of helping advisory firms achieve their goals, build robust client bases, and serve their end clients extremely well.

We also have a tremendous depth of research. The advisor community is really, really hungry for ideas. We've had considerable success in sharing with advisors our various research pieces, and having them make use of them for building up their own practices and assembling portfolios for their clients.

I agree with Marty: This overall development is very good for the end user of the service, in that there's much more focus on transparency on the product side as opposed to the advice side. Where we're having the most success is with advisors who really want to be clear, saying, "This is what you're paying me for, and this is what the underlying cost of the product is." In those situations, the total cost, if you will, to the end consumer is pretty important. That's where Vanguard helps the equation.

Flanagan: The investor is so much better off because the sophistication across the spectrum has gone up quite dramatically. You're seeing the likes of CFAs in the field matching off against the advisor channel. And, by the way, many of the independent financial advisors are CFAs themselves, and Certified Financial Planners. I think that's a great thing.

Stock-Pickers or Asset-Allocators?
Bill, Vanguard has also put out research recently that implies advisors might be better off not trying to choose securities or do asset allocation with the goal of trying to beat the market--which for a long time has been the goal of many advisors. Are advisors better off trying to do the security selection on their own, or are they better off focusing on the broader planning topics?

McNabb: Marty and I may end up differing on this, I don't know. Vanguard believes very strongly that the real value-add is in the discipline and getting the client to the right strategic asset allocation. We've done a fair amount of work over the last decade, re-evaluating the [Gary P.] Brinson work and updating the data. We still come to the same conclusion--asset allocation overwhelms everything else when it comes to long-term performance. The research that you're describing we refer to as "the advisor's alpha." What we've tried to convey to advisors is that going out and telling your clients you're going to pick superior-performing funds and underlying investment strategies is a very, very difficult task, and one in which the odds are stacked against you.

On the other hand, telling your clients that you're going to make life really easy for them--you're going to get them to the right strategic asset allocation and, oh, by the way, you add a ton of value just by the fact that you will keep them to that asset allocation by rebalancing periodically in a strategic way. The rebalancing itself more than likely pays for most of the advisor's fee. Everybody knows it, but we've all dealt with investors when times are particularly challenging. [They say] "Well, I know I should be 60/40, but I'm feeling really good about the stock market right now. I'm going to let it ride" and all of a sudden they're 65/35 or 70/30, and they push their advisor to let them do that, or vice versa.

As we came through the crisis, there was tremendous pressure--"I just can't take it anymore, I don't want any equity exposure." And the advisors who served their clients best were those who kept them on a long-term strategic asset-allocation plan. To me, that is where the value gets added. So, you're right, that's the approach we're emphasizing. I think there are certainly other people out there who take a different approach.

Flanagan: The absolute right answer is that the financial advisor should be meeting the investor's goals. And I think that's where we, as an industry, miss it at times.

The asset allocation matters a lot. And from my point of view it comes out of this process of understanding the client's needs. What is their investment objective? What's their time horizon? What's their risk tolerance? And my view, where it might be a little bit different, is that building a portfolio can be achieved with multiple vehicles. The vehicle is not the answer. It's really the asset allocation inside, and really the investment quality.

I started my career working for John Templeton, so my core is an active mind-set. But the truth of the matter is that there's a place for both. And both are very, very important. And I would say that would be sort of a personal maturing in my career. I once had a passionate belief about deep value investing, but I've learned over time that there are many ways to meet investment objectives. And you need all of the skills to pull that off.

McNabb: I certainly don't disagree that there are many ways, from an investment strategy standpoint, to get there. Vanguard also believes strongly that active can play a role. Our general point has been that it's fine to do that, but at the end of the day, you are trying to [reach] a set of goals.

The goal is key. For most people, getting the asset allocation right first goes a long way toward the goal. As you get more refined, that's where you can get into some of the more subtle distinctions: Do you have a passive core and active satellites? Or, do you take a little bit more active risk because you've saved so much more than you're ever going to be able to spend? You can get into some really interesting nuances. But for the primary set of goals, getting the right asset allocation is going to drive whether you're successful or not. And that's the point of the "advisor's alpha" concept.   

Flanagan: I look at the world pretty simply. And I generally think the world's more complex, not less complex. People have less time, not more time. So, the value of advice for individuals is just so important. And we've seen so many times people that aren't working with a good financial advisor, that don't have a disciplined investment plan in place, they just naturally do the wrong thing. That's human nature.

As Bill was referring to the crisis period, there are probably many individuals who were not disciplined. Exactly at the wrong time--by February of 2009--they said, "I can't take it anymore," and they probably went all to cash. That's really the value of advice and being very thoughtful and understanding for investors.

Culloton: Bill, is there a tension or conflict between serving advisors and serving direct investors in terms of how you approach those markets? How do you see investors and advisors behaving with your funds?

McNabb: It's a question we get asked frequently. I was meeting with the team that serves advisors this morning, and that was the first question from the audience. I don't actually think it's a conflict at all. There is a proportion of the population who really wants to do it themselves. They want to go to the Morningstars of the world and learn as much as they can. They need really good tools, so we provide those tools on the web, assistance from our phone associates, and some basic advice programs.

However, the self-directed segment has been about 25% of the investing public, I think, for going on 35 years. Vanguard went no-load in 1977. There were several no-load companies before us. And the best I can cobble together from the industry data, backing out 401(k) plans and just looking at retail investors, it's always been about that percentage. It's a very important constituency to us, and we want to serve those folks incredibly well. The other side of the equation is where people are looking for a professional to walk them through the process and actually manage the process for them. We want to give advisors the same support that we're providing to our other client segments, so that they can achieve their goals more effectively.

Our investment philosophy is not any different. Our service mentality is not any different. We don't feel conflicted, largely as a result of the transparency brought about by the change in the market structure and compensation. There would have been a conflict for us, to speak bluntly, if we were part of the old commission-based structure. I do not believe that we could ever run no-load funds on one side and load funds on the other. Philosophically, such a model would have been just totally anathema to us, and not something we would ever contemplate. But the way the market has evolved, we've chosen to try to serve this constituency the same way we serve plan sponsors, endowments, foundations, and so forth. We just keep trying to bring that mentality to it.

Culloton: Both of your firms offer ETFs and traditional mutual funds. What do you see advisors buying most from you, ETFs or traditional funds?

McNabb: This year, ETFs are running ahead of traditional mutual funds for our advisor business. In 2009, funds were actually stronger. Last year and year-to-date 2011, ETFs have been a bigger part of the flow.

Flanagan: For all of our clients, our fundamental focus is understanding what their investment need is, and then whether we have investment capability to meet that need.

We look at the vehicle as a delivery mechanism. So, I really don't get focused on whether it's an ETF, a mutual fund, or any of the different vehicles. Our goal is to meet the investment objective of our clients.

That said, we've seen the same thing Bill has said. I personally have not declared a vehicle as a winner in the long-run. Mutual funds and ETFs both have a very, very important place in the world.

Culloton: I've heard Gus Sauter say he views ETFs and mutual funds as just different distribution vehicles for really the same thing.

McNabb: That was the exact quote I was going to throw out. In our case, it's really true because of the share-class nature of our ETFs. And I'm sure it's not lost on you guys that for the Admiral Shares of our index funds, which are for retail investors with $10,000 or more to invest, the expense ratios are identical to those of the ETF shares in most cases. We believe very strongly that clients, whether it's through the advisor channel or directly, pick the structure that works best for their investment needs. We're indifferent from a price standpoint and from a support standpoint because we're going to support them equally.

Handle With Care
How are advisors using ETFs? If you saw a broker or an advisor using your mutual funds or ETFs in a harmful way, or in a way that could potentially be harmful, what would you do?

Flanagan: If we found that somebody was misusing a product or didn't understand a product, we would engage very, very quickly, because it's not in the investor's best interest, it's not in our firm's best interest, and it's not in the industry's best interest. We are fiduciaries, and you just don't want people to have bad experiences. So, I think that's something that's just a must, and I think the industry tries very hard to do a good job of it. And we do, too.

Culloton: How are advisors using ETFs?

Flanagan: We've always been in the advice channel. That's really our core. That's our bread and butter. It's what we believe in. But what we observed in 2005, when we purchased Invesco PowerShares, was that ETFs were evolving beyond the traditional cap-weighted indexes to fundamental and intelligent indices. We thought it was very complementary to what we were doing. But we were also seeing an evolution in the advice channel. What we were seeing was the beginning of mutual funds and ETFs being used together, and that you could take a core U.S. equity fund, and you can modify your exposure by using ETFs, core/ satellite concepts, and the like. That has continued extensively in the advice channel. We continue to see greater and greater evolution around asset allocation with ETFs.

McNabb: If we see investors using any of our funds or ETFs in a potentially harmful way--everything [at Vanguard] is nautical, so we like to say that we make them "walk the plank." Seriously, we will cut off relationships where we see a conflict with our core values. We've done it numerous times in our history--a few times it's actually been played out in public. Not that we wanted it to be, but for whatever reason people thought that it would make an interesting story.

So, we're really strong on philosophical alignment, and we're going to continue to be really strong on it. Obviously, you get into gray areas. If somebody is overweighting emerging markets by 20% versus how you think a global portfolio should be structured, is that an abuse? Probably not. If somebody is day-trading sector ETFs--a broker or a retailer investor, for example--that is abuse. We're not interested in that kind of business.

On how people are using them . our focus on the advisor side is to provide the basic building blocks. We want to give advisors core holdings that can serve as a great foundation for any portfolio. We are less interested in the esoteric ideas out there, some of which are, frankly, not all that well thought out, and some of which are legitimate, but again, not something that we have a particular interest in doing.

Interestingly, this year we've seen incredible diversification among our funds and ETFs. It's been the most diversified set of flows I've seen in years into the ETFs. I think it's because we're becoming even more established with a greater number of advisors.

Our emerging-markets ETF continues to attract a decent amount of attention, both from advisors as well as from institutions. Dividend Appreciation VIG, MSCI EAFE VEA, REIT Index VNQ, and the broad domestic stock market--both Total Market VTI, and S&P 500 VOO--have all attracted a fair--I won't say equal, but within spitting distance--amount of money. The data is telling just what we hoped--these products are being used as foundation-builders. PAGEBREAK  

Culloton: When providing ETFs or funds as building blocks, is it possible that the blocks could get too small, too narrow, too splintered to be useful or perhaps even dangerous?

McNabb: I'll say yes. But again, this is an area where there's a lot of room for reasonable debate.

Flanagan: Right.

McNabb: We've had a number of discussions internally about this issue. And in the marketplace, other folks have taken a different tack, where they've said: "Let's carve things up as granularly as possible and let people put the pieces together." Our view is if you're going to get broad exposure, do it the most efficient way, which would be in bigger chunks.

Flanagan: It all depends on the client again, right? I think broadly in the advice channel, it depends on who the client is, the sophistication, their broader portfolio. But you're also seeing some very sophisticated financial advisors and, frankly, some of the institutions, capable of going more narrow and meeting their exposures with ETFs. But I agree with Bill. You can absolutely take it way too far.

Culloton: How far is too far? The PowerShares lineup can get pretty narrow in some cases, with clean-energy ETFs and other things.

Flanagan: If you look at the PowerShares lineup today and where we started as a firm, you would see an evolved ETF complex that has a wide range of exposure, income, alternative, and intelligent equity offerings to meet our diverse set of clients' needs. I think that over the last number of years the lineup has matured quite substantially. That said, some of the clean-energy [offerings] and the like are very narrow. But you've seen a lot of institutions and advisors move toward it. Again, I think it's a much broader lineup these days, and we think it's very appropriate.

Culloton: Bill, Vanguard's lineup has gotten a little bit more granular in recent years, too, with, for example, the sector ETFs and fixed income. Is that arguably too narrow?

McNabb: One of the reasons that we went a little more granular on the fixed-income side than you might have anticipated is we're concerned--I don't know if concerned is too strong a word. But the nature of the fixedincome markets has changed quite a bit. Look at the total bond market right now--the composition of the Barclays Aggregate Bond Index versus its composition three or four years ago is dramatically different.

Our view was that advisors might want to put fixed-income portfolios together a little bit differently than the broad total market, given how much intervention there's been. We see enough sophistication among that clientele and among our institutional investors for that to make sense. For the average small investor who was buying an ETF through a brokerage platform at Vanguard or at Schwab or somewhere else, I wouldn't say it's that appropriate for them.

Fundamental Issues
Marty, there's a lot of debate over whether fundamental indexing should be called "indexing" in general, because of the construction and the methodology behind it. Should it be called indexing?

Flanagan: If you look at the range from passive to active, there is that spectrum. My view is that we are meeting investment needs with the fundamental indexes. And we think there's a role; we think it is a very good thing in the portfolio.

Culloton: Regardless of the vehicle, is fundamental indexing an index, or is there an active factor?

Flanagan: Well, it's probably no different than following benchmarks, right? It's a rules-based investment approach. I think there's something very attractive to that to a number of investors.

Culloton: And Bill, is fundamental indexing actually indexing?

McNabb: I've got to respectfully take the other side of the argument.

Flanagan: I hope so. (laughter)

McNabb: To me, indexing is matching a clearly defined, market-cap-weighted broad market or a market segment that's clearly defined. There's another really important element to this, and it's what indexing means to the investor. The reason indexing is such a powerful, powerful argument is the cost differential. And it's essentially that there is a zero-sum game going on here.

You take all your active managers in the world and add them up--they are the market. So, you're going to get the market. And if you take all your index managers and add them up, obviously you get the market as well. And then the sole difference is, What are the implicit and explicit fees that go along with that? And that's why indexing over long periods of time tends to outperform active management, because at the end of the day active management is a zero-sum game. Now, one could argue and say, well, it doesn't have to be a zero-sum game, because there aren't two constituents; there are multiple constituents out there. There are individual stock shareholders who are getting crushed by the active managers. So, it's actually possible to consistently beat the market.

But I think individual ownership of equities has shrunk very dramatically. And, again, the data all supports that when you add up all your active managers, it looks like the market minus the costs. You guys have actually done some fabulous work on that over the years at Morningstar. A fundamental strategy does not guarantee that same kind of result, because it is, by definition, a set of factor bets.

And we've lived in a world where small-cap--and small- and mid-cap in value--have been outperforming for a pretty prolonged period of time, so those factor bets have really paid off. But they are just that, they are factor bets. In the long run, when we go through a full cycle, there will be a period of time where growth and large cap actually do outperform again, and I think there's going to be a lot of disappointment [with fundamental indexing].

Actives and Alternatives
Culloton: Both of your firms offer active strategies and passive strategies. Is there a future for active ETFs? Could you see your firm pouring more of your active strategies into ETFs?

Flanagan: We do have three active ETFs. If you look at the amount of conversation [about active ETFs] you would think there's a trillion dollars in active ETFs. The concept really has not taken off in the marketplace. That said, I do think there's a place for them. Where we have taken them to the market is fixed income, quantitative equity, and real estate. It is not going to take over the world. I think it is probably not an appropriate vehicle for lots of equity investing. The fundamental idea that an active manager has to publish their portfolio every day, I don't think it's in the client's best interest as they're building those positions. So, it will evolve. It will probably have a place. I just don't see the revolution around it that has been declared, personally.

McNabb: I would second all of that. Again, if you step back and think about how we've created ETFs, in theory, we could add a share class to any of our active funds. In a sense, I could make the exact same argument to you that I made about our index funds. We want the product structure that works best for the end client, and we don't really care whether it's a traditional open-end fund or an ETF.

Every active manager I talk to on our equity side is extremely concerned about what it would mean to their portfolio and how people would react to seeing it published each and every day. They really feel that they'd be giving up quite a bit of their advantage. Many of our active fixed-income managers feel the same way. We filed for an active TIPS ETF, because, frankly, in the TIPS market we shouldn't be trying to add a lot of alpha. (laughter) Even though the strategy is technically active, there are no trade secrets in that marketplace.

Culloton: What is the role and what are the perils for alternatives in portfolios?

Flanagan: Well, we have alternatives; right now real estate is our biggest alternative, direct real estate in particular, then distressed private equity investing through WL Ross. I think you have to step back and say, This is a client. What's their investment horizon? What's their risk tolerance? What are their liquidity considerations? This, I think, often gets missed in this whole alternative conversation.

If you go back through the crisis--and this tends to be more applicable to the institutional world--everybody was so absolutely enamored with alternatives. And you saw some foundations and pensions just get literally humbled and found themselves in very difficult situations because they extrapolated returns of "alternatives" that were very illiquid. No one thought that tail risk would ever come. And so I think, yes, you can get some attractive returns. But it is not the be-all and end-all. There's a level of sophistication and all the other fundamentals you have to consider when you're looking at them. I think for some people it's just not appropriate at all.

McNabb: We continue to look at it, and I think some investors moved to alternatives because they were intrigued by the perceived higher returns. From our perspective, the whole value of nontraditional investments is their diversification effect.

We've been looking for ways to further diversify portfolios without giving up too much in return. If we can find vehicles that help us do that in a cost-effective manner, we're interested in it. Hence, the experiment--by the way, not with other people's money, but with an internally managed portfolio--with what we've been thinking about for the managedpayout funds. But the more I study this space, and the deeper we get, the more skeptical I am that there are many great answers out there.

Flanagan: When you hear people say, "I'm a hedge fund investor," it gets back to this vehicle conversation. Who cares? Vehicle has nothing to do with meeting an investment need. I think really understanding what you're trying to accomplish matters a great deal.

Dan Culloton is an associate director of fund analysis with Morningstar.

Dan Culloton is an associate director of fund analysis for Morningstar and editor of Morningstar's Vanguard Fund Family Report, a monthly newsletter that offers independent, no-holds-barred guidance on the pros and cons of this dominant fund family. Click here for a free issue of the Vanguard Fund Family Report.

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