Can Vanguard Keep the Faith While Expanding Even Further?

Morningstar recently issued a new Stewardship Grade for Vanguard. The firm's overall grade--which considers corporate culture, fund board quality, fund manager incentives, fees, and regulatory history--is an A. What follows is Morningstar's analysis of the firm's corporate culture. This text, as well as analytical text on the other four Stewardship Grade criteria, is available to subscribers of Morningstar's software for advisors and institutions: Morningstar Principia®, Morningstar Advisor Workstation(SM), Morningstar Office(SM), and Morningstar Direct(SM).

Vanguard's total assets under management recently passed the $2 trillion mark. In nearly every category of core-oriented mutual funds--from municipal bonds to domestic and international equities to allocation funds to exchange-traded funds--the firm is number one or number two in market share. Overall, performance is strong.

But even for one of the United States' largest and most-successful mutual fund managers, there's more work to be done. And for a firm that's already entrenched in its home market and also committed to pursuing the righteous path of keeping investments simple, one attractive avenue is the building of a more-global business. While the concern that Vanguard could grow bigger still without getting bogged down in bureaucracy and without losing its character remains a legitimate one, the firm has dealt well with this issue and has grown quite gracefully to this point.

Although Vanguard long ago began overseas operations, thus far its international pursuits are small potatoes (relatively speaking) for a firm largely built on passive investing in the U.S. In 2012 just 7% of Vanguard's assets under management came from overseas accounts, gathered primarily through a few handfuls of ETFs in a few markets. But there are developments in other markets that work in Vanguard's favor. First, there's the shift to defined-contribution retirement accounts from defined-benefit arrangements, which can create a do-it-yourself, or at least a more engaged, investor base. And much as the U.S. has been going the way of fee-based investment advice and of the often-indexed assets that go along with it, some overseas markets are also moving in that direction. Of particular note is recent legislation in the United Kingdom and Australia, which affects how financial advisors do business and could encourage more fee-based versus commission-based accounts.

But Vanguard will have challenges, too. For starters, it's still a relative newcomer to global markets and may not yet enjoy the same kind of name recognition and high regard that it does in the U.S. and that some of its competitors already experience. To be sure, the ETF and passive investing trends are newer and growing overseas. Being a part of a swell will help--and Vanguard will easily be able to prove its prowess in indexing. But while Vanguard faced and overcame some of the same hurdles when it was founded in the mid-1970s, it had its charismatic and outspoken founder Jack Bogle making the case for his firm (and indexing generally). Today the organization itself is the missionary.

Vanguard has worked hard to build a team-oriented outfit. The public face of Vanguard used to be former chief investment officer Gus Sauter; 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 (who was recently appointed to lead Vanguard's Active Equity group), economist Joe Davis, and investment strategy group leader Fran Kinniry--disseminate the family's research and opinions. CEO Bill McNabb, the firm's third, has been in his office since 2008. Otherwise, Vanguard often rotates senior managers among assignments--in fact, it recently shuffled a number of managers in the wake of Sauter's retirement at the end of 2012 and several months after now-CIO Tim Buckley assumed his post. Vanguard does this in part because it values fresh perspectives, but also to build its managers' repertoire. Its senior management team has grown over the past year to 11 members from nine, as the firm added roles for its financial advisor and international leaders, reflecting the growing importance of those areas.

Now a larger organization and one that aims to spread further around the globe, Vanguard is turning its attention to processes to help keep its character intact as it grows. McNabb says, for example, that there are a couple of large technology initiatives under way. He also notes the challenge in developing the next generation of Vanguard's leadership around the world and will depend not only on consistent processes but also on Vanguard's culture carriers, or those who share the firm's missionary zeal.

Much may hinge on Tim Buckley. As Vanguard's CIO, his experience with investments is more limited than some others' in the ranks. But Buckley does have experience in leading the firm's technology efforts, as well as some other areas at the firm, and he's a firm believer in process. He's also considered one of the firm's culture carriers, having spent his entire career at Vanguard, beginning in 1991 as the assistant to the chairman (then Bogle). About Vanguard and its potential challenges overseas, he is cool, professing simply, "We have a better way of investing." When asked whether he's an active or a passive investor, he says he's a "low-cost" investor, covering his bases but also highlighting one of Vanguard's most important values.

It will likely be a long time before Vanguard's international assets are a really significant piece of its assets-under-management pie, and that's largely because the firm continues to grow in the U.S. as well. Vanguard has continued to dominate in investor inflows thanks to the growing popularity of ETFs and passive investing, as well as its success among its actively managed subadvised funds.

The family's dominance is more than a happy accident. It spent decades establishing itself as the go-to shop for low-cost index and actively managed funds, and it defends its turf as fiercely as anyone in the industry. In recent years it has gotten more assertive, launching a steady stream of new ETFs and mutual funds--in 2013, it will finally launch an international-bond index offering for U.S. investors, in part based on financial-advisor demand. And it has continued to bolster its salesforce to win over more fee-only financial advisors. Throughout 2012 it more than doubled its salesforce to more than 200, including 65 salespeople located all around the country rather than being based out of a centralized location.

Martha King, who leads Vanguard's financial-advisor business, notes that Vanguard's expansion into the financial-advisor market has required a different philosophy on sales. The firm still tries to be consultative, recognizing that it may not have the right funds for everyone, but financial advisors expect Vanguard to know and discuss the competitive landscape, not just Vanguard's suite of offerings. King also acknowledges that it will take some time before she can assess whether or not the salesforce expansion is paying off, as new folks build their relationships. Eight regional managers will help assure Vanguard's wholesalers are selling in a Vanguard way, and Vanguard will continue to reward its salespeople based on team versus individual sales. Nonetheless, there is some risk that not everyone out there representing Vanguard to its financial-advisor constituency is a cultural fit, which includes being receptive to ongoing coaching.

Vanguard's ETF business is worth further comment. Bogle himself, after retiring from the firm he founded, has railed against how some investors use ETFs, which, unlike mutual funds, can be bought and sold throughout the day, to rapidly trade. Yet, in the past decade-plus, Vanguard has gone from late entrant to quick up-and-comer in the field. BlackRock's iShares has a commanding hold as the largest ETF provider, but Vanguard continues to gain on second-place State Street. The ETF industry is also one area at Vanguard where investor demand can play more of a part in the firm's decision to launch funds. For example, the firm introduced a handful of both S&P and Russell index ETFs in September 2010 in response to financial-advisor requests. And Vanguard's recently announced international-bond offerings, which had been contemplated at the firm for more than 10 years, will also satisfy investor demand.

Vanguard does not churn out flavor-of-the-month funds, but it has introduced many new funds over the past several years, including some more-esoteric or sophisticated options such as its managed-payout funds. Overall, its roster is large and diversified but still sensible. Like most fund families, when Vanguard evaluates whether to start a new fund, it wants to offer it in a competitive way and for it to be one of the best in its category, but it also must have an enduring place in a portfolio. Those criteria have helped Vanguard's success ratios, which report what percentage of a fund family's offerings both survive and outperform their category averages. As of the end of March 2013, Vanguard's success ratios stand at 77% over the past three years, 78% over the past five, and 74% over the past 10; these are among the highest among the largest 20 mutual fund families. Well more than half of Vanguard's fund and ETFs assets are in funds that earn a medal from Morningstar--that is, they receive a Gold, Silver, or Bronze Morningstar Analyst Rating.

Vanguard's new endeavors certainly warrant scrutiny--the firm doesn't get a pass just because it is reputable and has done the right things so far--but Vanguard has a unique cultural anchor that stacks the odds in investors' favor. Its mutual ownership structure reduces many of the conflicts inherent in the money management industry. Virtually every other fund family has to balance making money for its owners with serving fund owners. Vanguard's shareholders are its fundholders, so it has a structural incentive to operate at-cost and to put investors first.

The firm's average fee level is the lowest among fund families. The 0.17% average expense ratio of its funds (including ETFs) is down from last year and just a fraction of the industry average, and Vanguard has consistently sought ways to preserve and widen that gap. For example, it recently took a risk by moving away from funds that track the popular MSCI indexes, projecting that the move will save a lot of investors a great deal of money. In 2010 it expanded access to its low-cost Admiral mutual fund share classes, and it frequently shaves individual fund fees as assets grow.

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 and  Vanguard Capital Value from 2009 to 2010. It also restricted inflows at other funds, such as  Vanguard Wellington (VWELX) in 2013. But it has also tried to manage capacity at other large offerings, such as  Vanguard Explorer (VEXPX) and  Vanguard Windsor II (VWNFX), by adding more subadvisors, which risks making them more marketlike. 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.

Even a mutually owned company that provides services at cost and that has conducted itself honorably in the past can become bureaucratic and self-serving as it grows. And just because the firm operates at cost doesn't mean it doesn't have to make tough decisions on whether and where to spend its shareholders' money. For example, for now, the U.S. funds' shareholders will subsidize Vanguard's international efforts, which do put investor capital at risk (though McNabb says those operations should start contributing sooner rather than later, a reflection of the highly scalable passive asset-management business). Whether Vanguard's spending in new areas is in the interest of its shareholders lies largely with its corporate board of directors--which is also the funds' board of directors.

There's reason to trust the firm, which earns an A grade for its culture in Morningstar's Stewardship methodology. When Vanguard talks of moving overseas, it is not only to help diversify the firm's assets and to attract global talent--both of which help ensure the organization can thrive--but also to earnestly help investors around the world to achieve better results through diversification, low costs, and rebalancing. Vanguard's mantra is no different today or in other regions, and that has served investors well over the firm's 40-year existence.

Click here to see Morningstar's Stewardship Grade methodology.