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Beware of the Institutional Imperative

Vanguard's culture remains strong, but it can't get complacent.

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Vanguard looks unstoppable. Perhaps it's time to start worrying.

That may seem incongruous to anyone who's paid attention to the $1.4 trillion mutual fund family. Indeed, Vanguard has emerged even stronger from a decade of market turmoil and scandal. As investors burned by other firms have gotten religion about the kind of cheap, index-tracking strategies that are Vanguard's specialty, it has amassed assets. It has been one of the top-two selling fund families in most calendar years since 1993 and has finished seven of the past 10 years as the largest mutual fund complex in the world--a title it still held at the end of November 2010. It also is gaining market share in exchange-traded funds and expanding overseas.

It has been a long time since Vanguard was the iconoclastic upstart sticking its finger in the eye of the money-management industry with "Bogle's Folly"--as some derided Vanguard 500 Index when it launched in 1976. Rather, Vanguard is now a large part of "the Establishment," and that affects its culture. Here, I'll check that culture's vitals.

It's Good to Be the King
Being large has its advantages, paramount among them the ability to pass on economies of scale to investors via lower expenses, which Vanguard has continued to do. Gigantism can be perilous, too, though. Vanguard must beware of the "institutional imperative"--a sardonic law of organizational inertia coined by Warren Buffett to explain why some successful companies run by smart people still do silly and self-destructive things. The institutional imperative causes companies to think bureaucratically, pursue wasteful vanity projects, dismiss dissenting views, and follow the herd.

You can find symptoms of both resistance and susceptibility to this malaise at Vanguard. That it has thus far avoided self-destruction in the bear markets and controversies of the 2000s is testimony to the durability of its culture. The family's fund owners still own it indirectly through their Vanguard funds, which compel the firm to operate at cost and put shareholders' interests first. The low fees, diversified portfolios, and sober, long-term-focused strategies of the family's funds exemplify this--so do the firm's willingness and ability to cut expenses. In October 2010, for example, Vanguard offered a fee cut to nearly 2 million investors by lowering the minimum initial investments of its discounted Admiral shares of more than 50 index and actively managed funds. This came after the family started letting Vanguard brokerage clients trade Vanguard ETFs for free and on top of the firm's already low fees. The 0.22% average expense ratio of its funds is less then one fifth of the industry average. No one is as consistently cheap across its lineup.

Vanguard has done more than keep costs low. To preserve its active fund manager strategies and protect shareholders from performance-chasers, it has closed funds when they have attracted inflows because of hot performance, as it did at  Vanguard Convertible Securities (VCVSX) and  Vanguard Capital Value (VCVLX) from 2009 to 2010. Its regulatory disclosures and shareholder communications are clear and helpful. And the family has bolstered education efforts in recent years by publishing research white papers, blogs, online articles, videos, webinars, podcasts, and other forms of communication. The public face of Vanguard used to be chief investment officer Gus Sauter; founder Jack Bogle; and Bogle's successor, Jack Brennan. Now a host of articulate Vanguardians--including bond manager Ken Volpert, investment counseling and research head John Ameriks, economist Joe Davis, and investment strategy group leader Fran Kinnery--disseminate the family's research and opinions. The firm in 2010, for example, published numerous articles and interviews cautioning against too much enthusiasm or pessimism for the economy and bonds. The pieces were reassuring without being Pollyannaish amid all the hyperventilation about asset bubbles, double-dip recessions, inflation, and deflation.

Vanguard's scale and brand name also allow it to avoid paying for distribution. Its funds don't charge 12b-1 fees, and it has never engaged in revenue-sharing arrangements with third parties to encourage them to sell Vanguard funds. Because Vanguard is practically a household name among even casual investors and has its own online brokerage, it doesn't need outside platforms as much as rivals do. The family also doesn't have to abstain from using soft dollars or using fund brokerage commissions to pay for outside research or services, but it does. Vanguard allows many external subadvisors at its actively managed funds to use soft dollars, but it monitors for what and how they use them.


It's Hard to Be the King
Vanguard is a solid steward, but it, too, could fall prey to Buffett's maxim. As the family continues to grow and attract smart people who need projects to keep them busy and fulfilled, the family could get more hyperactive, pursuing ideas just for the sake of pursuing them or because the competition is doing it. Or the family could focus more on asset gathering to maintain its status. There's no one Vanguard initiative in recent years that confirms such a diagnosis, but some endeavors have raised eyebrows.

The family doesn't advertise past performance and spends proportionally less than its peers on marketing, but it spends more than it used to. Its ads also are much more prevalent than in years past as it aggressively markets its ETFs and tries to turn its name into a verb with its "Vanguarding" campaign.

It hasn't rolled out many narrow, trendy mutual funds and ETFs, but it has launched a lot of funds. It created 21 new funds, most of them index funds with ETF shares tracking S&P and Russell indexes, in 2010 alone. Vanguard launched the new funds, not because the firm thought S&P and Russell had the best benchmarks available (Vanguard still uses MSCI for its largest mutual funds and ETFs), but because it wanted the business of investment advisors and institutional investors who remain loyal to those index brands.

The family has closed and raised minimums for hot funds, but it also has tried to manage capacity at other large offerings, such as  Vanguard Explorer (VEXPX) and  Vanguard Windsor II (VWNFX), by adding more subadvisors (Explorer once had seven), which risks making them more marketlike. The subadvisors selected by Vanguard's internal portfolio-review department have helped the funds they run compete well with their index-fund siblings, but some of the exceptions have been brutal. Vanguard allowed  Vanguard U.S. Growth (VWUSX) to founder for more than a decade before retooling its management earlier this year. It also adopted the aggressive  Vanguard Growth Equity (VGEQX) at the wrong time as growth stocks peaked in March 2000 and fired its original subadvisor just as the firm's style was set to rebound in 2009. One cannot assume Vanguard will always pick the right subadvisors or share your opinion of the best and worst managers.

In recent years, the firm also has launched and investigated strategies it hasn't tried before, including  Vanguard Market Neutral (VMNFX), the endowmentlike Managed Payout funds, and a hedge fund. Each of them is a work in progress. Finally, the firm considered buying the iShares ETF family, which eventually went to BlackRock, in 2009. If consummated, the deal would have been Vanguard's first acquisition and would have quintupled the size of its ETF business in one fell swoop. These arguably are the actions of a firm that has grown more intent on gathering assets.

Still Focused on Investors
Vanguard contends, with justification, that these and other actions aren't inconsistent with its mission and legacy. It advertises to attract assets to make up for outflows, achieve economies of scale, and evangelize those untutored in the virtues of low-cost, diversified investing. Russell's and S&P's indexes may not have the best methodologies, but advisors and institutions who insist on using them now have a cheaper way to do so with a proven index tracker. The firm has tried new strategies, but not before multiyear vetting. The firm looked at market-neutral strategies for nearly 15 years before launching one in 2007, for example; and it has taken a pass, so far, on other ideas it has examined over the years, such as an international bond fund and 130/30 funds. When it has launched funds with more potential for misuse, such as its sector index funds, it has done so with high minimum investments to ward off smaller investors. As for iShares, the fact that Vanguard didn't buy it could just mean it was the low bidder. But the fact that it didn't enter a bidding war lends some credence to CEO Bill McNabb's contention that while the family will consider acquisitions, it won't pursue them to the detriment of fund owners.

Content but not Complacent
Vanguard investors have every right to be happy with their fund family. Lowering its Admiral share minimums, for instance, was one of the most shareholder-friendly acts in recent memory. Still, many of Vanguard's recent enterprises bear watching. Practices that are suspect elsewhere, such as aggressive advertising and marketing, large fund launches, and complicated strategies, do not rise above suspicion simply because a reputable firm like Vanguard engages in them. Vanguard fund shareholders and its independent directors must be vigilant to make sure the institutional imperative doesn't take root.

So, Vanguard still has an admirable culture, but it also faces unique challenges. History has shown that fund companies that look unassailable can be quickly undone. Vanguard need look only to Fidelity Investments, which dominated the 1990s but spent most of this past decade as an also-ran to Vanguard, PIMCO, and American Funds. This isn't a prediction that Vanguard is due for a comeuppance. It's recognition that any successful organization must be careful not to sow the seeds of its own defeat as it pursues more success.

There's evidence that Vanguard is up to the task. Its above-average fund-manager retention rates and tenures show it can hang on to talent, even though it's not known as the highest-paying employer in the financial-services industry. Most of its funds have performed well versus their respective categories over the trailing one-, three-, five-, 10-, and 15-year periods. And although only two members of the firm's nine-member executive management team--chief investment officer Gus Sauter, who used to run Vanguard's equity index funds, and McNabb, who used to run stable value funds--have experience running money, they are all firm veterans who know the money management industry and Vanguard's role in it well. Being led by nonmoney managers, including the founder and his successor, hasn't hurt the family in the past. It shouldn't hurt in the future as long as the family's leaders remain as passionate about Vanguard's unique structure, mission, and market position as did their predecessors. Vanguard's culture and competitive advantages don't guarantee it will shrug off the institutional imperative, but they do give it potent weapons to combat it.

This article appeared in the December 2010 issue of Morningstar's Vanguard Fund Family Report.

Dan Culloton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.