Jonathan Davis: Vanguard shows how structure is the secret of fund success

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The Independent Online

A couple of years ago I noted with interest the planned arrival in Europe of the American fund management group Vanguard. In a world where marketing men have made the unique commonplace, Vanguard is one organisation to whom the term can be genuinely applied. It has a unique ownership structure, a unique track record and a unique philosophy in the investment management business.

A couple of years ago I noted with interest the planned arrival in Europe of the American fund management group Vanguard. In a world where marketing men have made the unique commonplace, Vanguard is one organisation to whom the term can be genuinely applied. It has a unique ownership structure, a unique track record and a unique philosophy in the investment management business.

For a variety of reasons, I have long held the view that the Vanguard business model is far more likely than that of a conventional fund management group to deliver consistent high-quality service to those who entrust their money to it. That is certainly what Vanguard has achieved in the United States, where it now ranks second only to the mighty Fidelity in terms of clients' money invested, and also boasts 15 million accountholders.

Although it also offers a full range of actively managed funds, Vanguard was among the first to embrace the concept of index funds. Its combative and visionary founder, Jack Bogle, has done more than anyone to demonstrate that, nine times out of 10, indexing is the best bet for any risk-conscious investor with a genuinely long-term perspective. The table shows how Vanguard's funds have stacked up against the opposition over the past 10 years. This track record is remarkable for its consistency, but should come as no surprise if you look more deeply at what things ultimately drive returns to fund investors. This list encompasses not just investment returns, but low costs, minimal taxes and quality of service.

Vanguard pays minimal commission to intermediaries, puts out little advertising and reinvests all its profits into the fund management organisation (the company is owned by its own funds and, ultimately, its investors), so it is not really a surprise that it manages to outperform so many competitors. Cost and a commitment to investor education are at the heart of its edge. The average total expense ratio on its family of funds was 0.27 per cent last year, 1 per cent below the average for the mutual fund industry.

This means Vanguard's competitors have to achieve at least an extra 1 per cent better performance each year merely to play on a level playing field. If the difference in costs was going into the pursuit of superior investment returns, Vanguard's competitors might be able to match the net returns its funds achieve. But that is not where the bulk of the extra fees goes in a typical fund management company. That goes on marketing expenses, admin costs and profits that need to be recycled to other groups besides the investors in the funds (including shareholders in the fund management company).

The Vanguard story has been an extraordinary success. Its 15 million account-holders have 8.1 per cent of all mutual fund assets in the US. And so far, although Jack Bogle has retired, there are few signs of any loss of appetite under his equally driven successor, Jack Brennan. Where Vanguard really scores is that its whole philosophy is based on the way financial markets work, rather than on the idealised version of reality that informs the mission statements and business practices of most financial service organisations. The latter's world is a Lake Woebegone one where everyone can legitimately dream of being above average.

The Vanguard approach is based on a set of worldly assumptions; that markets are volatile and unpredictable in the short term; that exceptional fund performance is largely due to changes in style and fashion rather than the brilliance of an individual fund manager; that diversification is the only sure way of managing risk over time, and that high portfolio turnover is demonstrably tax-inefficient and harmful to the best interests of investors. All these are often ignored or breached by most mainstream fund managers, whose business is driven more by what is easiest to sell than by what is in the best interest of clients.

Vanguard's move into Europe is beginning to make slow but steady inroads into the pension fund market, which was its first target. It has $2bn (£1.4bn) of funds under management, which is tiny by the standards of the institutional market, but at least a firm foothold for what Mr Brennan has always seen as being a long hard slog to gain recognition in Europe.

More recently, Vanguard has started to offer funds for retail investors as well, with a range of offshore funds registered in Dublin. With one exception, these are index funds. The range includes a global, European and US equity index fund and three bond index funds (one covering global government bonds, a second European government bonds and a third European investment grade corporate bonds). At present these funds are available only to those with a minimum of $100,000 or 100,000 euros to invest. The average expense ratios range between 0.3 per cent and 0.75 per cent, though these will come down as and when the size of the funds increases, bringing scale economies. These cost ranges are higher than those of Vanguard funds in the US, but still competitive when compared with the best home-grown alternatives.

The bond index funds look an attractive product offering, because most bond funds are overpriced and not engineered to beat their relevant indices. Vanguard's data shows that over five years 96 per cent of actively managed global bond funds have been outperformed by the Salomon world government bond index. Over 10 years the figure is 100 per cent. One reason is that investors have not yet learnt to measure the returns they achieve on their bond funds against a relevant index, although this is now more common in equity funds.

My chart shows how the fashion for telecoms, media and technology stocks in 1999-2000 subtly changed the nature of Europe's market indices, making them more volatile than before. Jeff Molitor, a senior Vanguard executive, says the markets were between 2.5 and three times as volatile last year as in the previous 10 years.

Vanguard spent most of last year warning its investors to reduce their exposure to stocks, but many of its competitors saw this volatility as an opportunity to launch new funds with prospectuses that trumpeted the high historic returns this above-average volatility had produced. That may have been good business in the short run, but it is not the way to build an organisation that really wants to be number one for its customers in the long run.

davisbiz@aol.com

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