The Vanguard Anomaly

Capitalist Pigs
The nation's (and world's) largest and most praised fund company is run as a nonprofit. I speak, of course, of Vanguard, founded by Jack Bogle as a nonprofit organization to be owned by its funds' shareholders. In his latest speech, "Big Money in Boston: The Commercialization of the 'Mutual' Fund Industry," Bogle sounds a familiar theme in lambasting fund companies that are run for commercial reward.

Effectively, Bogle argues that fund companies play a zero-sum game. They can give more to owners of their funds, or they can give more to owners of the fund companies, but they cannot give more to both. They cannot use their profits to do what profits normally enable, that is hire better people, purchase better equipment, and invest in better research so as to make better products and deliver better service. Instead, profits are monies funneled from fund shareholders to the owners of fund companies.

This, of course, is not as Adam Smith wrote. (Vanguard's claim of being client-owned makes me think of my onetime neighbor, the openly collectivist Hyde Park Co-Op supermarket--a dirty, expensive dog that was. But as my Morningstar colleagues remind me, Vanguard's success owes not to any starry-eyed vision, but rather to its hard-headed operational excellence. Vanguard's spiritual leader is Walton, not Marx.) As a nonprofit entity that beats for-profit businesses, Vanguard upsets mainstream economic theory.

Another way of putting the matter is that hedge funds allegedly outperform mutual funds (the truth may be otherwise, but that's a subject for another column) because hedge fund managers have the possibility of making billions over the years, rather than the mere $50 million or $100 million that a top active mutual fund manager might expect. By that logic, Vanguard with its lower salary and bonus structure would attract lower-quality employees yet.

The Vanguard anomaly, I think, owes to three conditions. One, the industry's product is improved by being cheap. A car does not improve because it costs less, nor does a haircut, hotel room, or stage production. But all things being equal, a fund that sells for less is better than a fund that sells for more. The cheaper fund has a higher total return; it is a better product. Second, the industry accommodates low-cost distribution. Vanguard's model would not succeed with soda, where massive levels of advertising are needed to support the brand. Third, mutual funds operate in a well-lit playing field, where consumers can easily measure results and make their own decisions, as opposed to being led by branding.

The main lesson I draw from Vanguard's success is the danger of saying never. There are few precepts that do not admit exceptions. The motivation of becoming extremely rich (most fund company executives), as opposed to just very rich (Vanguard executives), is not among those rare few.

Public or Private?
Bogle's speech also argues for the superiority of private partnerships. Before 1958, fund advisors could not be acquired by a larger entity or spun off as publicly traded shares; the SEC considered such actions to be violations of fiduciary duty because they were sales of fiduciary office. However, in 1958, a court of appeals ruled that such sales were acceptable. In his usual understated way, Bogle calls that decision a "baneful development" made on "a day that will live in infamy." (He did not, however, state that the only thing that fund investors need fear is fear itself.) He argues that when private partnerships are sold, the new buyers seek to squeeze higher margins from the fund companies. Thus, while a nonprofit is the best fund company structure per Bogle, a private partnership is next in line.

That sounds right to me. No, things are not quite as black and white as portrayed by Bogle.  T. Rowe Price (TROW) is publicly traded, and it's a sober, methodical, and careful steward of investor assets. (Bogle once cited T. Rowe Price funds as being the best alternative if somebody were foolish enough not to buy from Vanguard.) Over the years, Morningstar analysts have seen a number of boutique firms swallowed by bigger fish, and some have retained their character. However, it must be said that a disproportionate number of excellent fund companies are structured as private placements. Three notable examples are Capital Research (American Funds), Dodge & Cox, and GMO.

Do as I Say, Not as I Do
A recent Ignites poll finds that 42% of mutual fund professionals have a "significant" chunk of their assets invested in index funds, while another 24% own a "moderate" amount of index funds. Thus, two thirds of fund professionals have meaningful exposure to the investment type.

Probably two thirds of their companies also offer an index fund of some type. But in most cases not enthusiastically, nor do those funds have many assets. It appears that about half of fund professionals are eating rather differently than the diets prescribed by their companies.

Not Jack's Fault
Thursday's The Wall Street Journal carried an article (subscription required) about an active fund manager, Wally Weitz, whose flagship fund is suffering net redemptions despite strong performance. Or so the Journal'sstory goes. The truth is, while  Weitz Value (WVALX) does have a fine record over the decades and has beaten the S&P 500 over the past three years, it lags both the index and its peers over the trailing 10 years. This occurred because the fund underperformed exactly when you would not want a fund to lag--that is, from peak to trough in 2007-08--so the fund can't be defended on the grounds that it carries lower risk.

It's certainly not a bad fund, but that it would be receiving redemptions even as index funds are enjoying inflows is not, as the article seems to suggest, due to active managers being unfashionable. Investors are being perfectly logical; why pay more to accept uncertainty when there's not a strong reason to do so? 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.