Can Anything Stop Vanguard?
Short of an unlikely breach of investor trust, Morningstar’s Ben Johnson thinks the fund giant will continue its momentum.
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What Will Stop Vanguard?
Vanguard is in a rare position. It has risen to the top of its league and continues to experience above-average organic growth. It is now bringing in roughly $1 billion per business day in new investor money on a run-rate basis. More and more investors are entrusting their hard-earned money to Vanguard. One of the few things I could see reversing this trend would be a breach of trust, but that is an awfully difficult scenario for me to imagine. The firm's ownership structure is designed to minimize virtually all of the most common misalignments of interest that breed distrust and create bad incentives for stewards of shareholders' capital.
Furthermore, Vanguard has stiff secular tailwinds at its back. The move toward fee-based advice, the growth in target-date funds and the expanding ranks of underserved mass affluent households in need of financial guidance all have propelled the firm forward at a steady clip in recent years and show no signs of abating.
Based on our conversations with management, it is clear that Vanguard is not resting on its laurels. Chairman and CEO Bill McNabb said if Vanguard continues to do the same thing, it won't be able to replicate its success. But while the company continues to evolve, its core principles remain intact. The firm continues to return the benefits of scale to its shareholders in the form of lower fees. In fact, on April 27, it announced another round of expense-ratio reductions for a number of funds, including the world's two largest, Vanguard Total Stock Market Index (VTSAX) and Vanguard Total Bond Market Index (VBTLX). That said, the larger Vanguard gets and the lower fees go, the more money it takes to move the needle. The company estimates that a 1-basis-point (0.01%) firmwide reduction in its expense ratio now requires approximately $560 billion in net new assets.
What isn't being passed back to shareholders is getting reinvested into the business. Much of this reinvestment is being directed toward enhancing the firm's service offering with the aim of galvanizing client loyalty and expanding its client base. Recent examples include a refresh of the firm's online brokerage portal and the introduction of Vanguard's Personal Advisor Services, which had 42,000 clients and $36 billion in assets under management as of the end of March.
Vanguard is also expanding overseas. The firm's ex-U.S. funds now have approximately $250 billion in assets under management. Its London operation has grown from one man with a laptop to nearly 300 employees in recent years. The firm's presence in the United Kingdom has grown rapidly, thanks in part to the introduction of regulation that has banned commissions outright in some advice channels. Also, the firm has built out a local trading footprint to be able to plug into local markets during local hours with local talent. This ultimately benefits not just investors in the firm's Europe-domiciled funds but also investors in the international portfolios within its U.S. lineup. While Vanguard has been relatively late and slow to expand its overseas footprint versus many of its peers, early signs are promising that its funds' shareholders will reap a decent long-term return on their investment.
Active vs. Passive
Tom Rampulla, the head of Vanguard's U.S. Financial Intermediaries business, recently wrote on the Vanguard Blog for Advisors: "Why we believe in active and passive--No ifs or buts." This nicely summarizes the firm's take on the topic. While the lion's share of the company's assets are now in index funds, it has a large and largely successful roster of active strategies as well. The common element among them? You guessed it--low costs. Low costs are just one ingredient in the recipe for successful active management as Vanguard sees it, the other two being top talent and patience. But top talent is becoming increasingly difficult to find. Dan Newhall, a principal in Vanguard's Portfolio Review Department tasked with manager selection and oversight, said finding skilled active managers is more difficult than ever. According to Newhall, many top-tier managers have left the fund business or avoided it altogether, opting to work for hedge funds or striking off for Silicon Valley. Furthermore, as index funds' fees have continued to march lower, the bar has been raised for active managers.
"Active management minus the headwinds" was the title of the slide presentation that John Ameriks, the head of Vanguard's Quantitative Equity Group, shared with us--an apt description of factor-focused funds. Ameriks' group represents the brains behind Vanguard's Global Minimum Volatility Fund, which was launched in December 2013. Vanguard's approach to factor funds is differentiated from those of most of its ever-expanding peer group in the strategic-beta arena. First, the group is not interested in tracking newfangled benchmarks, so these strategies are technically active--though just barely so. By retaining an element of active discretion, Ameriks' group hopes to avoid some of the costs associated with regular rebalancing and to fine-tune its factor exposures. At the highest level, it views offering factor funds as a way to take the costs (and some of the idiosyncratic risks) out of traditional active management. The firm recently launched four actively managed single-factor exchange-traded funds in London and has filed to list similar ones in Canada. Odds are that a U.S. bunch is forthcoming, though the regulatory hurdles the firm faces are relatively higher than those it has surmounted or will have to surmount outside the United States. These funds are intended for an institutional and advisor audience. Ameriks emphasized the need for education and appropriate expectations-setting when it comes to introducing investors to focused factor funds and providing them with guidance on how to best use them within their portfolios. Ameriks thinks that there are a handful of factors that have worked in the past. Also, he believes that the economic intuition that underlies them gives them reasonable odds of working in the future. That said, there are no guarantees, and given that there is a question as to whether these factors will persist, Ameriks thinks of factor funds as a new form of active management. In his book, anything with a question mark after it (that is, Will X strategy beat the market?) is active management.
Vanguard has come a long way over the past 40 years, and its growth has only accelerated in the past 10. Its ascendance is rooted in the trust of millions of investors--some 7 million in the U.S. and a growing number outside the U.S. It is difficult for me to imagine what the firm could do to break this trust and set the virtuous cycle that has propelled it higher spinning in the opposite direction. As the firm pursues new growth opportunities, some will pan out and others may flop. But this is to be expected in any enterprise of any scale. What will inevitably be Vanguard’s key differentiating feature in the future and underpin most of its growth is nothing new: It is owned by its fund shareholders and only its fund shareholders. This is a powerful competitive advantage.
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Ben Johnson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.