Unlikely Cousins

More Similar Than Different
Fund-industry giants Vanguard and American Funds would seem to be polar opposites. Vanguard is known for indexing, selling directly to investors, and impressing financial reporters. American Funds, in contrast, has no index funds, distributes almost solely through financial advisors, and is notoriously media shy. Vanguard has long since diversified away from its starting point of running retail equity mutual funds. It now is a bond-fund powerhouse with millions of 401(k) shareholders and a stable of exchange-traded funds. American Funds, in contrast, mostly just runs stock funds, has less than 1% market share in the 401(k) industry, and is not in the ETF business.

In other words, Vanguard has mostly been on the right side of history and American Funds has not. (The exception being distribution, where there is no right side of history, as companies have been able to succeed both as direct marketers and by working through advisors). The money tells the story. Over the past three years, Vanguard has led the United States (and indeed the world) in incoming fund assets, enjoying more than $350 billion of net inflows into its mutual funds and ETFs. No other company has been close; at $160 billion, PIMCO has been a distant second. Poor American Funds, on the other hand, has been by far the industry's biggest loser over that time period, with almost $200 billion exiting its doors.

Ironically, though, the two companies are much alike, as they share several attributes that distinguish them from the rest of the fund industry:

1) Long employee tenure--Vanguard's portfolio managers aren't always veterans, but senior investment management is generally made up of Vanguard lifers. For its part, American Funds not only has many portfolio managers with more than 10 years on the job, but a staff of career analysts. Historically, it has not been a place that employees leave.

2) Staid funds--Vanguard has done well over the years by avoiding trendy fund launches. It hasn't had to apologize for putting out a technology fund in the late 1990s, or a real estate fund a decade later, or for offering tricked-up bond funds that posted high yields but weak returns. American Funds has been more conservative yet. Over the past 25 years, the firm has created exactly zero new U.S. stock funds, and it doesn't have a sector fund. American Funds makes Vanguard look stylish.

3) Low portfolio turnover--Both companies favor slow-trading investment strategies.

4) Multiple investment managers--Vanguard founder Jack Bogle was the first to divvy up a fund's assets among several subadvisors, as opposed to the standard approach of giving the whole asset pool to a single investment manager. American Funds does not outsource its portfolio management, but it does slice the fund into multiple parts and hand each part to a different manager (or management team).

5) High diversification--Both companies' funds tend to spread their investments over an unusually large number of assets.

6) Risk aversion--Both Vanguard and American Funds tend to run funds conservatively. For example, Vanguard's sector funds are among the most cautiously managed of sector funds, owning many blue chips and interpreting their charters broadly, so as to get better diversification. Similarly, when American Funds offers emerging-markets funds, it does so via watered-down versions that favor giant multinationals, including some from developed countries.

7) Strong market correlations--Because of their conservative construction, mainstream assets, and high diversification, both Vanguard's and American Funds' funds tend to act much like their benchmark indexes. These funds rarely deliver surprises, for good or ill.

It's odd that two fund families with similar investment habits are viewed so differently in the marketplace. Tomorrow, we'll see if we can find the answers to that puzzle in the investment results.  

If You Throw It, Will It Stick?
In contrast with Vanguard and American Funds, there are the many fund companies that are creating exotic ETFs, in the hopes that they will be first to market with something. Last Wednesday's column noted that the Winklevoss twins filed to launch a bitcoin ETF. (Chuck Jaffe bravely attempts to defend the fund. Full points for contrarianism, Chuck!) On the same day, The Wall Street Journal covered the trend in "The Hunt for the Never-Been-Done ETF" (subscription required). Among the funds mentioned were a dynamic insurance portfolio, a daily South Korea bull 3-times fund, and a Central Asia and Mongolia index portfolio.

Some of these specialized, narrow funds do attract buyers, mostly because the market that they index performs. Most, however, will languish with small asset bases and may eventually be shut down by their sponsors. (The Journal article notes that ETFs are closing down at record rates.) As strategies go, this one would not seem to be particularly friendly to investors: Entice them to buy into hot sectors, and fold the funds that hold unpopular but potentially cheap securities. 

One could interpret this sales tactic as not being in the best interests of investors--but that can't be the case, because index funds are good for investors, and actively managed funds like American Funds' are gimmicky and bad. So people tell me.

The First Rule of Marketing
Get them to pay attention. Well, Frank Eliel did just that. His hand-written and stamped letter caught my eye. I opened. Here, with "everything on one CD," was the "complete method" for making the "four wealthy building, wealth saving decisions" and to "make them the visual way." Yes, this CD is my guide for conducting … Mutual Fund Proctology.

Whatever the second rule of marketing may be, Mr. Eliel's pitch surely must lie in violation.

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.