As with the last post, this was originally published in the Mutual Fund Observer.
Vanguard is eating everything. It is the biggest fund company in the U.S., with over $3 trillion in assets under management as of June-end, and the second biggest asset manager in the world, after BlackRock. Size hasn’t hampered Vanguard’s growth. According to Morningstar, Vanguard took in an estimated $166 billion in U.S. ETF and mutual fund assets in the year-to-date ending in August, over three times the next closest company, BlackRock/iShares. Not only do I think Vanguard will eventually overtake BlackRock, it will eventually extend its lead to become by far the most dominant asset manager in the world.
With index funds, investors mostly care about having their desired exposure at the lowest all-in cost, the most visible component of which is the expense ratio. In other words, index funds are commodities. In a commodity industry with economies of scale, the lowest-cost producer crushes the competition. Vanguard is the lowest-cost producer. Not only that, it enjoys a first-mover advantage and possesses arguably the most trusted brand in asset management. These advantages all feed on each other in virtuous cycles.
It’s commonly known Vanguard is owned by its mutual funds, so everything is run “at cost.” (This is a bit of a fiction; some Vanguard funds subsidize others or outside ventures.) “Profits” flow back to the funds as lower expense ratios. There are no external shareholders to please, no quarterly earnings targets to hit. Many cite this as the main reason why Vanguard has been so successful. However, the mutual ownership structure has not always led to lower all-in costs or dominance in other industries, such as insurance, or even in asset management. Mutual ownership is a necessary but not a sufficient condition for Vanguard’s success.
What separates Vanguard from other mutually owned firms is that it operates in a business that benefits from strong first-mover advantages. By being the first company to offer index funds widely, it achieved a critical mass of assets and name recognition before anyone else. Assets begot lower fees which begot even more assets, a cycle that still operates today.
While Vanguard locked up the index mutual fund market, it almost lost its leadership by being slow to launch exchange-traded funds. By the time Vanguard launched its first in 2001, State Street and Barclays already had big, widely traded ETFs covering most of the major asset classes. While CEO and later chairman of the board, founder Jack Bogle was opposed to launching ETFs. He thought the intraday trading ETFs allowed would be the rope by which investors hung themselves. From a pure growth perspective, this was a major unforced error. The mistake was reversed by his successor, Jack Brennan, after Bogle was effectively forced into retirement in 1999.
In ETFs, the first-movers not only enjoy economies of scale but also liquidity advantages that allows them to remain dominant even when their fees aren’t the lowest. When given the choice between a slightly cheaper ETF with low trading volume and a more expensive ETF with high trading volume, most investors go with the more traded fund. This makes it very difficult for new ETFs to gain traction when an established fund has ample trading volume. The first U.S. ETF, SPDR S&P 500 ETF SPY, remains the biggest and most widely traded. In general, the biggest ETFs were also the first to come out in their respective categories. The notable exceptions are where Vanguard ETFs managed to muscle their way to the top. Despite this late start, Vanguard has clawed its way up to become the second largest ETF sponsor in the U.S.
This feat deserves closer examination. If Vanguard’s success in this area was due to one-off factors such as the tactical cleverness of its managers or missteps by competitors, then we can’t be confident that Vanguard will overtake entrenched players in other parts of the money business. But if it was due to widely applicable advantages, then we can be more confident that Vanguard can make headway against entrenched businesses.
A one-off factor that allowed Vanguard to take on its competitors was its patented hub and spoke ETF structure, where the ETF is simply a share class of a mutual fund. By allowing fund investors to convert mutual fund shares into lower-cost ETF shares (but not the other way around), Vanguard created its own critical mass of assets and trading volume.
But even without the patent, Vanguard still would have clawed its way to the top, because Vanguard has one of the most powerful brands in investing. Whenever someone extols the virtues of index funds, they are also extoling Vanguard’s. The tight link was established by Vanguard’s early dominance of the industry and a culture that places the wellbeing of the investor at the apex. Sometimes this devotion to the investor manifests as a stifling paternalism, where hot funds are closed off and “needless” trading is discouraged by a system of fees and restrictions. But, overall, Vanguard’s culture of stewardship has created intense feelings of goodwill and loyalty to the brand. No other fund company has as many devotees, some of whom have gone as far as to create an Internet subculture named after Bogle.
Over time, Vanguard’s brand will grow even stronger. Among novice investors, Vanguard is slowly becoming the default option. Go to any random forum where investing novices ask how they should invest their savings. Chances are good at least someone will say invest in passive funds, specifically ones from Vanguard.
Vanguard is putting its powerful brand to good use by establishing new lines of business in recent years. Among the most promising in the U.S. is Vanguard Personal Advisor Services, a hybrid robo-advisor that combines largely automated online advice with some human contact and intervention. VPAS is a bigger deal than Vanguard’s understated advertising would have you believe. VPAS effectively acts like an “index” for the financial advice business. Why go with some random Edward Jones or Raymond James schmuck who charges 1% or more when you can go with Vanguard and get advice that will almost guarantee a superior result over the long run?
VPAS’s growth has been explosive. After two years in beta, VPAS had over $10 billion by the end of 2014. By June-end it had around $22 billion, with about $10 billion of that growth from the transfer of assets from Vanguard’s traditional financial advisory unit. This already makes Vanguard one of the biggest and fastest growing registered investment advisors in the nation. It dwarfs start-up robo-advisors Betterment and Wealthfront, which have around $2.5 billion and $2.6 billion in assets, respectively.
Abroad, Vanguard’s growth opportunities look even better. Passive management’s market share is still in the single digits in many markets and the margins from asset management are even fatter. Vanguard has established subsidiaries in Australia, Canada, Europe and Hong Kong. They are among the fastest-growing asset managers in their markets.
The arithmetic of active management means over time Vanguard’s passive funds will outperform active investors as a whole. Vanguard’s cost advantages are so big in some markets its funds are among the top performers.
Critics like James Grant, editor of Grant’s Interest Rate Observer, think passive investing is too popular. Grant argues investing theories operate in cycles, where a good idea transforms into a fad that inevitably collapses under its own weight. But passive investing is special. Its capacity is practically unlimited. The theoretical limit is the point at which markets become so inefficient that price discovery is impaired and it becomes feasible for a large subset of skilled retail investors to outperform (the less skilled investors would lose even more money more quickly in such an environment—the arithmetic of active management demands it). However, passive investing can make markets more efficient if investors opting for index funds are largely novices rather than highly trained professionals. A poker game with fewer patsies means the pros have to compete with each other.
There are some problems with passive investing. Regularities in assets flows due to index-based buying and selling has created profit opportunities for clever traders. Stocks added to and deleted from the S&P 500 and Russell 2000 indexes experience huge volumes of price-insensitive trading driven by dumb, blind index funds. But these problems can be solved by smart fund management, better index construction (for example, total market indexes) or greater diversity in commonly followed indexes.
Why Vanguard Might Fail
I’m not imaginative or smart enough to think of all the reasons why Vanguard will fail in its global conquest, but a few risks pop out.
First is Vanguard’s relative weakness in institutional money management (I may be wrong on this point). BlackRock is still top dog thanks to its fantastic institutional business. Vanguard hasn’t ground BlackRock into dust because expense ratios for institutional passively managed portfolios approach zero. Successful asset gatherers offer ancillary services and are better at communicating with and servicing the key decision makers. BlackRock pays more and presumably has better salespeople. Vanguard is tight with money and so may not be willing or able to hire the best salespeople.
Second, Vanguard may make a series of strategic blunders under a bad CEO enabled by an incompetent and servile board. I have the greatest respect for Bill McNabb and Vanguard’s current board, but it’s possible his successors and future boards could be terrible.
Third, Vanguard may be corrupted by insiders. There is a long and sad history of well-meaning organizations that are transformed into personal piggybanks for the chief executive officer and his cronies. Signs of corruption include massive payouts to insiders and directors, a reversal of Vanguard’s long-standing pattern of lowering fees, expensive acquisitions or projects that fuel growth but do little to lower fees for current investors (for example, a huge ramp up in marketing expenditures), and actions that boost growth in the short-run at the expense of Vanguard’s brand.
Fourth, Vanguard may experience a severe operational failure, such as a cybersecurity hack, that damages its reputation or financial capacity.
Individually and in total, these risks seem manageable and remote to me. But I could be wrong.
Vanguard’s rapid growth will continue for years as it benefits from three mutually reinforcing advantages: mutual ownership structure where profits flow back to fund investors in the form of lower expenses, first-mover advantage in index funds, and a powerful brand cultivated by a culture that places the investor first.
Future growth markets are huge: Vanguard has subsidiaries in Australia, Canada, Hong Kong and Europe. In these markets passive investing has low market share and correspondingly high fees. Arithmetic of active investing virtually guarantees Vanguard funds will have a superior performance record over time.
Vanguard Personal Advisor Services VPAS stands a good chance of becoming the “index” for financial advice. Due to fee advantages and brand, VPAS may be able to replicate the runaway growth Vanguard is experiencing in ETFs.
Limits to passive investing are overblown; Vanguard still has lots of runway.
Vanguard may wreck its campaign of global domination through several ways, including lagging in institutional money management, incompetence, corruption, or operational failure.