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Vanguard's First-Quarter Scorecard

Christine Benz
Bridget B. Hughes, CFA

Christine Benz: Hi, I'm Christine Benz for Vanguard engineered some changes at the top in the first quarter of 2015. Joining me to discuss this and other developments at the firm are two of our research analysts who focus on Vanguard, Bridget Hughes and Michael Rawson.

Bridget and Mike, thank you so much for being here.

Bridget Hughes: Thanks, Christine.

Michael Rawson: Thanks.

Benz: So, Bridget, let's start with these changes. Vanguard is doing some shuffling in its top ranks. What drove the changes? What was the catalyst for them?

Hughes: Well, the catalyst is a very reasonable reason to start these changes, and that's two retirements. Two of the senior managers at the firm. Mike Miller is retiring in the middle of the year. He had been in charge of planning and development for Vanguard. And then Paul Heller, who is in charge of their retail group, is retiring at the end of the year. So, you can imagine when you have two senior managers retire that there are a lot of holes. Well, it seems like two holes, but it turns into sort of a ripple effect. And so they have made a number of changes at the higher levels and the middle levels of the organization.

Benz: So, it sounds like these are kind of behind the scenes, not things that investors will necessarily confront in terms of their dealings with the funds. Are there implications, though?

Hughes: Well, this is something that Vanguard has historically done, these rotations of managers. So, it isn't unusual. It happens every maybe year or two. Every couple of years or so, there'll be some shuffling of maybe just one or two people who are making some changes. But in this case, it's six or seven or so who are making changes.

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Benz: So, part of the idea is to give people breadth of experience--people in the top roles. Is that the idea?

Hughes: Right. Vanguard is not a cult of personality, so to speak, regardless of--or maybe despite--its roots. As we all know, Jack Bogle is quite a personality and leader in the industry. Today, though, Vanguard is really a collaborative, team-oriented group. They focus more on the organization than they do on any one person. So, they do like to give their senior leadership a lot of experience and touch a lot of different parts of the company.

Benz: Mike, one of the people moving around here is Martha King. She had been in charge of Vanguard's relationships within financial advisors. She really grew that business quite a bit. Let's talk about her legacy there as well as her new role.

Rawson: Well, certainly, Martha King is a rising star at Vanguard, in part, due to the success that she has had. If you look at Vanguard as a firm, they follow what's called the direct-distribution model. They've had a 1-800 number and then a website. You call them up and invest in their funds, whereas most other firms use what's called "pay to play," where you buy their fund and you are paying either a load or a portion of your expense ratio--a 12b-1 fee--to the person who sold you that fund. Not the case with Vanguard.

Consequently, Vanguard really never appealed to your financial advisors, particularly the wirehouse financial advisors who sell a product hoping to get paid and compensated in some way. Vanguard didn't compensate them, so they never used Vanguard products. ETFs come along and institutional share classes of index funds come along, and that starts to change.

Now, financial advisors who are following a fee-based incentive model--where they'll charge a fee for the assets under management that they help advise you on or these independent RIAs who are following the fee-based financial model--will use Vanguard funds, in part, because they are so low-cost that when they tack on their fee, it's still, overall, a low-cost product.

So, they are now adopting Vanguard products when they never had in the past. That now accounts for almost a third of their assets, which is really remarkable. Almost a $1 trillion. And she certainly deserves some credit for that success.

Benz: So, let's talk about Martha King's new role. What's she going to be doing, Bridget?

Hughes: So, she is coming from heading up the segment that focused on financial advisors, and she is moving into the segment that heads up the institutional group at Vanguard. Now, Vanguard has long been a player in the institutional marketplace, so this isn't necessarily a role in which you're going to see the kind of growth that you've seen in the financial-advisory segment, where you went from 0% to 33%, as Mike described.

But she did reorganize the sales group and the advisor segment. We haven't spoken with her about what her intentions will be. This is all of pretty new news for us, too. But there could be some opportunity for growth there. And then the man who is heading up the institutional group, Chris McIsaac, is taking over the planning and development group that Mike Miller is vacating.

Benz: Got it. In terms of funds, one fund saw a manager change in the first quarter--Vanguard Convertible Securities (VCVSX). Let's talk about that fund. It is not a widely held fund. But let's talk about what's going on there and whether it affects our outlook for that fund.

Hughes: So, Larry Keele, who is a manager at Oaktree, which is a subadvisor that manages the convertible fund, announced that he is retiring in the middle of the year. So right away, in January, Vanguard added an Oaktree comanager to help Larry Keele on the domestic portion of the fund. There are a couple of other managers also on that fund, also from Oaktree.

We did downgrade the fund's rating from Silver to Bronze, just recognizing that Larry Keele's retirement is a loss for the fund; overall, his experience is very long and tenured. Stu Spangler, his comanager and successor, has been with the firm for a significant amount of time. They have hired a health-care analyst to kind of fill his previous role, and health care is pretty important to the fund. It has been important in the convertibles market. So, we just want to give it a little bit more time and recognize that newness in the fund, and that's what primarily [accounts for] the downgrade.

Benz: Vanguard has also launched a new fund. Mike, let's talk about that new Vanguard Ultra-Short-Term Bond (VUBFX). What is it designed to do and for whom is that type of product appropriate?

Rawson: Sure. Ultra-Short-Term Bond is a mutual fund, so it's not a money market fund, specifically. Money market funds have very strict regulations in terms of what they can invest in, what duration, and what type of credit risk they can take. In fact, regulation is going to get more onerous on these money market funds to the point where a money market fund that's catering to retail clients can really only invest in short-term Treasury bonds or Treasury bills. And as we all know, they are not going to pay much in a way of interest. Net of expenses, it really probably is going to give you nothing.

So, consequently, investors who want to get a little bit of return from their money market fund are going to shift out of money market funds and into these ultra-short-term bond funds or short-term bond funds, which maybe have a duration of around one year and offer a little bit of return--not much, but you're going to get something. So, I think you're going to have more investors switching to these types of funds and away from money market funds just because of the nature of the regulation that's coming.

If you want an ultrasafe fund, you're going to stay with your money market fund. But if you want a little bit of return, you're going to have to take that risk and maybe have a variable NAV, which this fund is, of course, going to have.

Benz: Right. So, there is no implicit guarantee here at all in this ultrashort product.

Rawson: No. Absolutely not.

Benz: Another fund that Vanguard has announced will be coming to market will be a muni-bond index fund. I guess the question is what took so long with this particular product?

Rawson: In bond land, indexing is not as popular as it is in stock land. When you go to build an S&P 500 fund, you go out and buy all 500 stocks. In the bond world, the Barclays U.S. Aggregate Bond Index has something like 10,000 securities; a lot of them don't trade on a daily basis. It's much harder to strictly index. So, most index bond funds use sampling, and that's the case in municipal-bond land also. There are a lot of municipal-bond funds that can't really index, so they go out and buy just a diversified portfolio of bonds. Technically, it's not indexed, though.

But that distinction kind of doesn't really matter at this point. So, Vanguard realizes that they have got a lot of clients who would like to use a municipal-bond ETF. In order to do that, they have to have an index fund, so they are going to come out with a municipal-bond index fund. Essentially, though, you could think of Vanguard's municipal-bond funds as already being indexed. They are so widely diversified; you're getting a very broad swath of the asset class. It's just that now it will be available as an ETF share class. But other than that, I don't think this is really going to change the nature of Vanguard's municipal-bond funds.

Benz: What reason would I have to give the new index fund a look if I maybe already have, say, the intermediate-term muni-bond fund that's actively managed?

Rawson: Knowing Vanguard, you probably won't have a reason because, as we know, many of their index mutual funds have an ETF share class. They don't encourage you to go to one fund or the other. They say if you want to trade, use the ETF. If you are a long-term buy-and-hold investor, you'll probably get the same expense ratio in the mutual fund. So, I imagine it will be a similar experience with the Vanguard municipal active funds versus an index municipal-bond fund.

Benz: Bridget, Vanguard also announced that it's launching a new target-date series geared toward institutional investors. Let's talk about that one. It sounds like they're going even cheaper when it comes to the expense ratios.

Hughes: Right--which, of course, is no surprise for Vanguard. So, this is a new target-date series that will require $100 million investment minimum, primarily for plans. Obviously, that's not the minimum that you and I would be expected it to come up with as part of our plan. It will have an expense ratio of around 10 basis points, which is significantly smaller than the already-small expense ratios on their other target-date series, which are right in the mid-teens level.

Benz: OK.

Hughes: One of the other changes with the target-date series and the funds like the multi-asset funds like the LifeStrategy funds is that Vanguard is increasing its percentage of international-equity exposure from 30% to 40%. Vanguard has long really been at the forefront of adding that international exposure. And the primary reason is really simply that the continued research of the quantitative group shows that it's such a good diversifier for equities that it [makes sense to] add that on. And as you know, Vanguard is all about diversification and trying to offer a good risk-adjusted experience for investors.

Benz: Another topic I'd like to cover is the area of personal financial advice. This has been such an exciting area in the overall investment industry. Vanguard has a new service. The idea is to deliver not robo-advice but actually customized guidance. Let's talk about the growth there, Mike. What are you seeing so far?

Rawson: Well, you mentioned the buzzword, which is "robo-advisor," which is making a lot of headlines because a robo-advisor essentially is an automated type of advice service. It's really geared toward that low-touch client--maybe somebody with less than $100,000 in assets--where if they went to a financial advisor, the financial advisor is going to give a big yawn and really not want to dedicate a lot of their time because there's not much profit to be made off of someone without much in assets.

However, you could automate that, give that person some very good advice about how to allocate a portfolio and how to build a plan, and they're calling that a robo-advisor.

Now, Vanguard has their own take on it, where you are actually dealing with certified financial planners, real humans; but again, it's low touch, it's geared toward someone with at least $100,000 in assets. Right now, they have stated they're going to charge about 30 basis points for it. It's in a pilot program right now. So, they're planning to launch it, full-blown, later this year.

But even though it's in a pilot program, they've actually already gained a lot of assets, in part, because they've been doing this for years, typically for clients with a little bit more in assets, maybe more than $500,000 or more than $1 million.

Now, that will continue. And these price points I mentioned--30 basis points for $100,000--those are likely to change. So, don't hold me to those numbers. But Vanguard has already seen about $5 billion in new money to this program. So, they've already had a lot of success--almost, I think, so much success that they are not really sure what to do with it yet. They're kind of trying to take it as slow as possible, because it really could revolutionize the industry. Here, you have a firm that's dominant in asset management now, all of a sudden, entering this new market where they're competing with advisors; it could be revolutionary.

Just this past week, Charles Schwab launched their own version of a robo-advisor. Again, that's a different model because that's completely automated. When you go through Vanguard, you will be dealing, to some extent, with a human. If you have $100,000 in assets, you'll have access to a pool of advisors. If you are a little bit more of high-net-worth client, you'll get a dedicated advisor; you'll deal with the same person. That person may actually come and deal with you face to face. So, I don't want to use a term robo-advisor too much with Vanguard Personal Advisor Services because it's a human-based model. But this has the potential to be a game changer in the industry. And I think a lot of other players are watching this because if Vanguard brings that low-cost model that they've been so successful with in the fund industry to the advice industry, it could really shake things up.

Benz: So, I guess a natural question is, if you are going to a firm that has its own investment funds and you're working with one of these advisors, you will be recommended a menu of Vanguard funds, correct?

Rawson: That's true. I'd imagine that it's probably not going to change under Vanguard. Even though I'm not sure if they'll be held to the same fiduciary standards, these advisors have to look out for the best interest of the client.

But at Vanguard, they'll probably be able to say, "Well, these funds are in the best interest of the client." So, it'll be interesting to see how they handle that fine line between being too self-promotional and acting in the best interest of the client. That could be a challenge.

Benz: Final question is on flows. This is a story that we've been monitoring for a few years. Mike, you have been someone who keeps track of fund flows. Let's talk about whether this Vanguard juggernaut, in terms of asset inflows, has shown signs of slowing down at all.

Rawson: It hasn't at all. If anything, it has accelerated. We know, over the past five years, about $0.35 in every $1 added to funds has gone to Vanguard, which is incredible because that's way more than what their market share would suggest. So, they have gained market share tremendously, and really there's no close second. You've got firms like DFA and iShares that are pretty far behind. We often talk about how passive has been so successful--a lot of money is going to passive. Well, actually it's just really going to Vanguard. So, maybe we should frame the discussion as Vanguard versus everyone else rather than active versus passive, which we know is a tired debate.

Hughes: The other interesting thing about Vanguard's flows is that their active funds are also getting flows. Not nearly as much as the passive funds, but they are in flow.

Benz: It's not an all-passive story; it's a Vanguard story, maybe. Thank you both for being here today to share your insights.

Rawson: Thank you.

Hughes: Thanks, Christine.

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