How Vanguard Found Itself on Top in the 'Lost Decade'

Many call it the lost decade. It began with the Internet boom and bust; ended with a roaring housing and credit market bubble that imploded catastrophically; featured a mutual fund trading scandal and the rise of ETFs in between; and left most equity fund investors with little to show for their pains on Dec. 31, 2009. During all the turmoil, a lot of investors lost their faith in some big fund families, including Putnam, Morgan Stanley, and Janus, which saw the largest net outflows for the decade. Yet fund investors still seemed to trust Vanguard, sending the family money through bull and bear markets, controversy and calm. Why? A close look at the family's fund flows offers some answers.

The story told by Vanguard's fund flows is remarkable but also highly correlated with the market environment. For instance, after investors grew wary of large-cap stocks in the early 2000s, Vanguard's  Total Stock Market Index (VTSMX) appealed to investors wanting broader stock market exposure that included small- and micro-cap stocks. In addition, in the wake of the tech bear market and the mutual fund trading scandal, some investors also grew disenchanted with active management and turned to broad, one-stop equity and bond index funds--Vanguard's forte. As concerns about inflation grew, investors sought out Treasury Inflation-Protected Securities funds, of which Vanguard offered the cheapest option. Then, during the volatile markets of the past couple years, risk-averse investors sought refuge in bond funds, and Vanguard again offered the cheapest access to bond indexes.

So, you can attribute some of Vanguard's success to its broad lineup of funds. It has had one for just about every season. Equally important, however, is that its funds generally have done well and Vanguard has avoided serious scandal. Of the funds in its lineup that have been around for at least a decade, about 74% have 10-year records that rank in the top half of their category. While other fund families are still trying to live down their involvement in the market-timing scandal and other controversies, Vanguard, on a relative basis, has emerged looking like the industry Eagle Scout. Even as the family has grown it has been pretty good about closing hot funds, keeping fees low, and avoiding trendy funds.

If nothing else, Vanguard's fund flows imply that investors appreciate low costs, broad diversification, and sober stewardship. Digging into the fund flow numbers a bit helps reveal other key factors influencing Vanguard's asset growth. As a starting point, Vanguard's total net assets in open-end funds--our numbers exclude ETFs, money market funds, and funds of funds--as reported by Morningstar's fund flows at the beginning of January 2000 was $422 billion, which ranked second among all fund shops back then. Fast forward a decade to Dec. 31, 2009, when Vanguard's total net assets had climbed to $1.07 trillion, making it the biggest fund family in the world. A portion of those assets came from reinvested returns on investments, but an astounding $440 billion of new investor money came in through the Vanguard doors. To put those inflows into perspective, consider that Vanguard brought in more new assets during the past decade than the shop had acquired throughout the previous three decades.

Domestic-equity funds led the way, bringing in $168 billion over the decade, though almost all of it came in prior to 2007. Since then, Vanguard's bond funds and international equity funds dramatically increased in size. Bond funds began the decade with $76 billion in assets and saw $186 billion come through the door, while international-stock funds added $78 billion over the decade.

Asset Class Flows from January 2000 through December 2009

By a long shot, Vanguard's most popular fund for the 10-year period was Vanguard Total Stock Market Index, which had inflows of $78 billion. Most of the fund's assets came in the second half of the decade, and its popularity at that time can be attributed to a handful of factors. For one, investors may have been disenchanted with the S&P 500 as a core equity holding, because it excluded small- and micro-cap stocks, which was a top-performing area early in the decade. In addition, the popularity of Total Stock Market Index may suggest that investors have embraced a purer form of indexing that seeks to own the whole U.S. equity market. The inception and growth of Vanguard's target-date funds in June 2006 also helped boost the fund's assets. Total Stock Market Index is a key holding in Vanguard's target-retirement funds, which take in a lot of steady and sticky assets from 401(k) plans. Indeed, all six of the underlying holdings in the Vanguard target-date funds were among the 20 Vanguard funds that received the most inflows over past 10 years, and four were in the top 10.

On the fixed-income side, investors put $47 billion in  Vanguard Total Bond Market Index (VBMFX) over the decade. The fund benefited from sitting in the Vanguard target-date portfolios, as well as being a cheap, core bond fund when investors' fixed-income appetites grew. Another fund that appealed to a growing number of risk-averse investors was  Vanguard Inflation-Protected Securities (VIPSX), which provides the market's cheapest access to TIPS. The fund was founded in mid-2000 and by the end of December 2009 had inflows of nearly $24 billion.

It wasn't a banner decade for all Vanguard funds. Several large-cap funds and a couple bond funds have experienced notable outflows. Both  Vanguard Windsor (VWNDX) and  Vanguard Windsor II (VWNFX) faced a difficult decade of outflows, but Windsor faced the brunt of investors' distaste. The fund saw outflows nearly every month of the decade, resulting in net outflows of more than $10 billion. Part of the trouble here is that the fund has seen some manager changes and has performed more erratically than the typical large-value fund. That said, it has been on a tear recently under new manager Jim Mordy, who runs about 60% of the fund's assets.

Among the other funds suffering from outflows,  Wellesley Income (VWINX) suffered outflows of more than $2 billion. This conservative-allocation fund may have frustrated investors with its tortoiselike pace amid the go-go growth market in the late 1990s. In fact, the fund experienced negative returns in 1999 when more aggressive funds soared higher. Throughout the following year, the fund witnessed outflows each month, just as the fund's steady-Eddie approach proved its worth amid the ensuing bear market. Despite investors pulling their money away from the fund at that inopportune time, the 10-year Investor Returns (a measure of how the typical investor in the fund fared) rank in the top 3% of the category.

Vanguard went from second fiddle to first violin in the past decade for lots of good reasons. But it shouldn't rest on its laurels. The family's arch rival, Fidelity, ended the 1990s on top and looked unbeatable. After a decade that was generally hostile to its aggressive-growth-oriented style, Fidelity's star has faded somewhat. When asked to reflect in a recent interview with Morningstar on what could possibly trip up Vanguard in the future, CEO Bill McNabb said doing anything to violate investors' trust would put it in a precarious position. The firm would do well to remember that because it has a lot more to lose now.

Fund Flows from January 2000 through December 2009

Associate director of fund analysis Dan Culloton contributed to this report.