Can Vanguard Remain Alone?

Solo Act Historically, Vanguard has competed in a league of its own. Its rivals have battled over one segment of the marketplace, while Vanguard has controlled the other all by its lonesome. Only Vanguard treated funds as commodities. If competently run, suggested the company, the performances of funds within a given category converge. What counts are costs. And nobody beat Vanguard for low expenses.

Every other longtime fund company has claimed to possess the secret sauce. Even Dimensional Fund Advisors, long regarded as Vanguard's challenger because it invests according to rules, cites academic sources for its investment approach, and keeps its costs modest, sells performance. In the industry jargon, DFA sells betas (what assets to own) rather than alphas (manager brilliance), but either way, it promises that it knows more than the overall market. Vanguard does not--at least in its passive business, which now accounts for nearly 80% of assets under management.

Cementing Vanguard's position has been its unique corporate structure, by which its funds' shareholders own the firm. In practice, Vanguard employees and the funds' boards make the decisions, not the Coral Gables Vanguard 500 Index VFINX investor, but nonetheless the structure does matter, because it denies equity to Vanguard's executives. Yes, they wish to increase Vanguard's assets, but their rewards for doing so are different and much less affected by profitability.

Rising to the Top These pieces were fully assembled during Jack Bogle's tenure. The mandates for Bogle's next two successors, Jack Brennan (1999-2008) and Bill McNabb (2008-17), were always clear: Follow the path, only even more closely. Vanguard's corporate strategy required no changes, but as Bogle's genius did not extend to operations, which were becoming more complex as Vanguard expanded, the ship required tighter handling. Brennan and McNabb delivered.

The outcome was as close to inevitable as exists in business. A single organization, all the while improving its operations, controlled the industry's growth segment (low-cost, indexed investing) while hundreds of firms battled over the shrinking portion. The contest was, in spirit, Amazon versus the bricks-and-mortar retailers, and the result was similar. It would have been remarkable had it been otherwise.

That era has largely passed. The assignment will be different for Vanguard's current CEO, Tim Buckley. Bogle created, and Brennan and McNabb refined, but Buckley will need to redefine. Not that Vanguard requires an overhaul, because it does not. But it will need to respond to a growing threat: imitation. Across the industry, rivals are challenging Vanguard's brand. It is becoming difficult for casual observers to distinguish between Vanguard and its major competitors.

New Challengers Appear This convergence has occurred for various reasons.

One has been the invention of exchange-traded funds. By definition, ETFs are Vanguard-like, as they are almost entirely indexed, and priced below traditional mutual funds. When Vanguard countered with its own ETFs--it did not create the category--they were not greatly different from others'. This has not prevented Vanguard from becoming the second-largest ETF provider, but there's no doubt that the lines have been blurred. Vanguard's mutual funds differ more from their competitors than do its ETFs.

A related development has been the emergence of nontraditional competitors. As Bogle enjoyed pointing out, conventional mutual fund firms cannot combat Vanguard. Sure, they can cut their prices to counter a competitive danger, by 10%, maybe even 25%. But when their actively run stock fund levies 1% in annual expenses and Vanguard Wellington VWENX is at 0.17%, the conventional firms are stymied. They will not discount by 80%. So, for the most part, they close their eyes and continue on their present course.

But companies that come from other backgrounds do not have fat mutual fund profits to lose. They have a different perspective. BlackRock and State Street, Vanguard's two major ETF rivals (BlackRock has the largest asset base, State Street the third-largest), never sought high margins. They pursued volume sales, at discount expense ratios, from the beginning. The same goes for Charles Schwab, with its mutual fund lineup.

New Tactics In addition, the traditional mutual fund firms have expanded their revenue sources, which permits them greater flexibility when responding to Vanguard. Perhaps a subsidy in one place can assist them in another. (Robbing from Peter to pay Paul may be a metaphor for futility, but it's often a savvy business tactic.) For example, Fidelity's ZERO funds, such as Fidelity ZERO Total Market Index FZROX, generate no revenue themselves (apart from, potentially, interest payments from loaning those securities), but they bring investors into Fidelity's brokerage, from which they can be upsold.

Another example is Schwab's Intelligent Advisory digital-advice program, which carries a slightly lower fee and half the minimum investment of Vanguard's similar Personal Advisor Services. Schwab cannot necessarily recoup that revenue from management fees of the funds this program purchases--its Schwab Total Stock Market Index SWTSX has an expense ratio of just 0.03%--but it offers plenty of higher-margin services for those within the Schwab system.

The result of these industry changes is a volley of attacks on Vanguard's status as the low-cost provider, from several opponents, across several areas. There's no question that, overall, across all funds and all business lines, Vanguard carries the cheapest prices. But that position is nowhere near as obvious as in the past. The waters have been muddied.

Today's Position Finally, Vanguard eliminated its statement that it offers its funds "at cost" and at "no profit" in its latest filing. This action, I think, is symbolic rather than real. In practice, operating across the board "at cost" with "no profit" was never truly possible, because Vanguard, as with any organization. runs new funds at a loss until they become larger, which requires that the company generate extra cash from its established funds. Nor has the company changed its ways. It remains the same old Vanguard.

(Vanguard dodged the reason for the language change, stating vaguely that it was "simplifying and streamlining" its documents. Perhaps it was to prevent future lawsuits that are based on the company's income-tax status, as with this case. Or perhaps, Vanguard may do more subsidizing itself.)

Being the same old Vanguard is just fine, as far as investors are concerned. The more that other companies resemble Vanguard, the better. For CEO Buckley, though, the flattery is less praiseworthy. Vanguard has raised the fund industry to the point where much of its major competitors have reached (or at least neared) its level. Can it raise the stakes further, and if so, how?

I do not know those answers. They are for Buckley and team to discover. If they can arrive at a solution, though, it will not only benefit Vanguard, but also investors.

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.