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Rekenthaler Report

Where Vanguard’s CEO Sees The Fund Industry Going

Vanguard CEO Bill McNabb gives his take on the fiduciary rule, pricing for advice, expected market returns, corporate governance, and target-date funds.

Looking Ahead
Vanguard CEO Bill McNabb kicked off Wednesday’s session of the Morningstar Investment Conference, discussing, among other topics, the new Department of Labor fiduciary rules, pricing for advice, expected market returns, corporate governance, and target-date funds.

As Vanguard has, by a comfortable margin, been the most prophetic of fund companies, building its business to go where the future was headed, while its competitors mostly managed for the present, McNabb’s words carry considerable weight. Being the leader of the world’s largest, most-successful fund company doesn’t make his beliefs correct—but that would be the sound bet. Disputing with McNabb about the direction the fund industry is like disagreeing with Warren Buffett about the prognosis for corporate America; it can be done, but not lightly.

The bullet points:

Fiduciary Rules
Vanguard was troubled by several provisions in the first version of the Department of Labor’s proposed fiduciary regulations, which it viewed as being burdensome. However, the government agency responded well to the initial criticism, making the final rules substantially better. The standards became “as good as they could be.” Vanguard will have no trouble meeting the new rules, which will become effective in the second half of 2018.

Several financial-services companies (mostly brokers and insurers, not mutual fund providers) have filed lawsuits challenging the regulations. McNabb calls that “an uphill climb;” the legal action might, perhaps, prove successful, but the prudent course is to plan for the change that will probably occur. Unfortunately, there was “an opportunity missed” because the SEC and Finra did not adopt similar measures. It is awkward for both advisors and investors to have the fiduciary rules differ by jurisdiction.

More Advice, Less Cost
Vanguard was “quite taken” with robo-advisers when they first came to market. Vanguard believes that automated advice is a good fit for investors who have $50,000 to $200,000, who want “a little more help than comes with direct investing,” and who don’t wish for a “single-fund solution.” Thus, the company has built its own automated solution, called Vanguard Personal Advisor Services.

The price for that product is 0.30% per year for the minimum investment of $50,000, scaling down as assets grow. McNabb acknowledged that this fee is much less than is typically charged by asset-based financial advisors. The price wars for advice have begun. Investors pay lower fund expenses today than they did 10 or 20 years ago, but not so with financial advice. That is about to change.

In addition to the “high probability” that financial-advice fees will be dropping, McNabb believes that services will likely be increasing. Many activities done by today’s financial advisors will be commoditized by automated solutions. Successful advisors will adapt by changing their activities, delivering services to their clients that are not attempted by robo-advisers.

Managing Expectations
Vanguard excels at preventative communications. The company habitually sends letters to investors in funds that have enjoyed unusually high returns, warning them that the future will not be as pleasant. It is cautious with its marketing promises. It frequently closes growing funds to new investors. As a result of such actions, and also the conservative nature of most of its funds, Vanguard has avoided boom-and-bust asset flows.

McNabb believes that financial advisors should act similarly. “Being very clear with people about the expectations for future asset-class returns” is critically important, he says—one of an advisor’s most important tasks. “Too many investors look to get bailed out by double-digit returns,” rather than save at a higher level. That won’t happen any time soon; the great bull markets of the 1980s and 1990s are behind us.

Vanguard’s forecast for the next decade: 6% to 7% per year (in nominal terms) for stocks, 2% for bonds. That makes for about 4% on a balanced fund, after expenses. Better than cash in a mattress, to be sure, but the magic of compounding will be less spectacular than most investors realize.

Passive Investors, Not Governors
Activist hedge fund managers, who aggressively pressure corporate managements to respond to their suggestions, frequently argue that index funds hamper corporate governance. Index funds are, after all, passive investors. As such, they cannot threaten to punish laggard corporate managers by selling their companies’ stock. They must continue to hold the position, regardless of what the corporations do.

McNabb turns that argument on its head. Yes, activist managers have the weapon of selling stock. That is also an escape route, though; the activist manager who clears out of a position has washed his hands of responsibility. Index funds can take no such refuge. Nor do they care much about short-term gains, as is generally the desire of activist managers. What index funds care deeply about is “long-term wealth creation”—presumably, the goal of fund investors, as well.

Less Is More
Target-date funds offer an important lesson. Nobody “ever thought that target-date funds would become so successful.” When target-date funds debuted, they competed with lifecycle funds that came in various risk flavors, such as aggressive, moderate, and conservative. Fund-industry experts thought the competition would be a horse race. Target-date funds had the advantage of differentiating by age, but lifecycle funds permitted differentiation by risk tolerance. Both, it seemed, were important.

Investors found that to be no contest at all. They did not wish to take quizzes to discover their risk tolerances. Nor, in fact, did they wish to partake in any thinking at all. They wanted the easiest path. And selecting a fund based on the date that they would turn 65 was the easiest path of all. In a few short years, target-date funds swept the field. They are today’s default funds for 401(k) plans  and lifecycle funds are not.

The lesson, says McNabb, is to keep things simple. Vanguard has succeeded in part by offering broadly diversified funds that have been easier to understand, and thus easier to hold, than has the competition. In the future, it will seek to increase its advantage of relative simplicity. Not so much with funds, as Vanguard’s lineup is largely established, but instead with communications and tools.

The fund company that can convey key messages in a simple, easy-to-understand fashion (increasingly, through phone apps) is the fund company that will win the hearts and minds of future investors. The upcoming generation rewards those businesses that use technology effectively, making for a streamlined experience. This lesson will also apply to financial advisors. They, too, will thrive by making their customers’ lives simpler, by applying lessons learned from behavioral research, extended through technology.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for 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.