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Will Size Become an Issue at Vanguard?

Christine Benz
Dan Culloton

Christine Benz: Hi, I'm Christine Benz for Morningstar.

Vanguard is the fund industry's largest firm with assets eclipsing $1.8 trillion earlier this year. Joining me to discuss the firm's growing size as well as other developments at the company is Dan Culloton; he is associate director of fund analysis with Morningstar.

Dan, thank you so much for being here.

Dan Culloton: It's a pleasure to be here, Christine.

Benz: Dan, you just completed a Stewardship Grade for Vanguard. You gave the firm high marks on a few areas, corporate culture, also fund fees, marking them as nice and low as you'd expect.

But one area that you spend a little bit of extra time on was looking at the size issue and discussing what its implications might be for the firm. As we know, firms that are growing rapidly sometimes are focusing on sales at the expensive of what Jack Bogle has called stewardship, and firms can get too large.

So let's discuss what you've look at and what you ultimately concluded about whether size is a red flag for shareholders.

Culloton: Well, growth can be a two-edge sword. It can provide economies of scale that can be passed onto shareholders in the form of low cost, and Vanguard has done this consistently over the years.

Benz: That its argument, partly, for advertising and everything else--that by growing, they are able to bring fees down even lower?

Culloton: Right. That with greater scale, you bring greater efficiencies and lower cost to masses. And that in large part has been true. But growth also brings challenges, both operational and cultural. And I think on the operational side, Vanguard generally has a history of ... dealing with the problem very strongly. They've closed funds when they've gotten too large, they've warned people off of hot asset classes and hot funds and highlighted the perils of chasing performance. They've invested heavily in areas where they are getting a lot of flows, such as in their fixed-income department; they have spent a lot of time bolstering their capabilities there.

Benz: So, do you mean in terms of research and analytics all of those kinds of things?

Culloton: I mean ... CEO Bill McNabb reports that that's been one of their greatest areas of hiring is in the fixed-income department in recent years. Also, the fixed-income department has reorganized itself in order to be more efficient about sharing ideas, and it's also invested in some more higher-level quantitative analytics to help them do their jobs better.

Benz: Okay. So, they have done those investments?

Culloton: Yes. And then the other operational challenges have been internationally. They now have offices in London, in Hong Kong, in Canada, in Australia, and they have really been more assertive about growing internationally in recent years. That's brought about the need to make sure that all of their investment processes are consistent across markets--for example, in the area of index funds, that they are all using the same methods for tracking indexes as closely as possible. I think they are on top of that.

The cultural challenges of growth are a little bit harder to get a handle on. Yet there's still a concern, because everyone knows that nobody stays on top forever. Nobody knows precisely what can knock somebody off of their perch. But there is always that risk that it can happen.

With Vanguard they have an inbred structural, cultural advantage by being mutually owned, so they have this natural incentive to operate as efficiently as possible for their shareholders.

Yet, ... if you look at the insurance industry, even some mutually owned organizations can get so large that they risk operating in the interest of the bureaucracy instead of the interest of their owners or shareholders.

What do you look for warnings signs of that? In Vanguard's case, I think, if they start doing anything that's really, really out of character. Like, they've been advertising more assertively, which, as you said, Vanguard will argue that that helps them build scale, it helps spread the gospel of low-cost investing to the masses, to people who aren't aware of indexing or low-cost yet, but by the same token, if Vanguard were to do something like starting to advertise performance, which they don't do now, if they were to start to advertise their Morningstar fund ratings and start advertising funds that happen to be on hot streaks, these would all be...

Benz: ... one-year performance or six-month performance.

Culloton: One-year performance or even three-year performance or even five-year performance. Right now their advertising is a lot more prevalent, but it's still much more about the brand, much more about the philosophy, much more about their overall approach to investing, which is being balanced long-term and focused on cost. So, if something like that, for example, were to change, then it might be a sign that growth is becoming a priority instead of a byproduct.

Benz: Last, a bit of news I wanted to discuss today, Dan--some sad news that we heard earlier this week. Howard Schow, who is the founder of PRIMECAP Management, or co-founder, and has been also been a longtime co-manager on a number of Vanguard funds--we got news that he passed away over the weekend. Let's talk a little bit about his legacy on some of the funds that he has managed for Vanguard over the years.

Culloton: Vanguard and PRIMECAP and the fund industry in general has lost a quiet giant. He wasn't a manager who sought a lot of attention. In fact, the firm he founded, and the firm where he got started was organized in a way to deflect individual attention away from individual managers. Before he founded PRIMECAP, he was at Capital Group, which is the advisor to American Funds, where they use the multi-manager approach, where the managers run independent slices of portfolios.

Benz: So not a team, but each manager given a slice of the portfolio to oversee as he or she sees fit?

Culloton: Right, right. He put up decades of great performance both at American Funds and American Funds AMCAP, and then later on, from the early '80s on, when he started PRIMECAP and running Vanguard PRIMECAP and Vanguard PRIMECAP Core and eventually Vanguard Capital Opportunity. These have been some of the best funds in the Vanguard stable, and in the domestic equity fund universe, for a long, long time, and his legacy, his returns, stand out there like Nelson's Column.

Benz: Right. So, I guess a natural question after a loss like this--he was an active manager. He was 84 when he passed away, but an active manager on the funds. I guess, as shareholders, we have to wonder, does this affect my outlook for these funds? Should I be concerned?

Culloton: Well, as I alluded to before, I think PRIMECAP is designed to withstand situations like this. They use the multi-manager approach, in which the underperformance or departure of any one manager is minimized by the fact that they are all working independently on separate slices of the fund. More importantly, he built up an organization over time that attracted talented people and retained talented people.

PRIMECAP's managers, the remaining managers on the PRIMECAP and Capital Opportunity funds, have an average of more than 20 years experience at the firm and experience beyond that even. So, they are very seasoned investors. Then, they're backed by an analyst team that has grown over the years in both number and experience. The average tenure at PRIMECAP for the analyst is nearly 10 years.

So, this is a much more experienced team than we usually see industrywide, and I think shareholders of these funds are still in good hands.

Benz: OK, good to know. Thank you, Dan, for sharing your insights. We appreciate you being here today.

Culloton: Thank you.

Benz: Thanks for watching. I'm Christine Benz for