Focus: The Vanguard way to fund management
Wednesday 05 May 1999
"The greatest 400 hitter in stock market history", as the economist Peter Bernstein describes him, stands head and shoulders above his contemporaries. Last weekend Buffett once again held court at the annual meeting of his company Berkshire Hathaway in Omaha, Nebraska, dispensing wisecracks and his own unique brand of homespun wisdom to thousands of fans.
No mainstream investor in the history of the stock market has ever assembled such a consistent track record of sustained outperformance of the market over such a long period of time. Yet ask the same community of professional investors a different question - "who is responsible for creating the best fund management business in the world?'' - and you will not get anything like the same unanimity of opinion.
Some might make the case for the Johnson family, of Boston, who have built Fidelity into the world's largest independent fund management company. Others might put in a word for Arthur Zeikel of Merrill Lynch, which two years ago bought Mercury Asset Management for the then astounding price of $4.2bn (pounds 2.6bn). Someone might even opt for Schroders in London. There are plenty of other possibilities too.
It partly depends on how you define success: is the objective of an investment management company to manage the most money? Is it to make the most profit for the owners of the fund management company? Or is it to do the best job for the investors who entrust their money to the company's hands?
If the last criterion is the one you choose, as logic suggests it should be, then there is a good case for saying that the answer is not even open to dispute. Jack Bogle, the founder of Vanguard Group, a company that is virtually unknown outside the US, but which is currently leaving most of its competitors in the US market for dead, has a good claim to have created the most successful fund management business of modern times. UK financial services companies take note, for those that are not doing it this way within a five to 10-year time frame - possibly much sooner - will fail.
Founded in 1976, Vanguard is unique among American mutual fund companies, in that it is run as a mutually owned business. It has no controlling shareholders. All the assets of the company are owned by the funds which it manages for its investors. All the services for which most fund management companies charge their investors handsome fees are provided, not with a large profit markup, but at cost.
Vanguard is going through a golden patch. Like its great rival Fidelity, Vanguard is big in the mutual fund business. Like Fidelity too, it has been one of the pioneers in the growth of 401K pensions, the tax-assisted schemes that encourage ordinary Americans to do their own saving for retirement. For the past five years, helped by the extraordinary boom on Wall Street, and the growing popularity of its distinctive low-cost investment approach, Vanguard has enjoyed quite extraordinary levels of growth.
Measured by funds under management, its assets have grown from $250bn three years ago to a fraction under $490bn today. Thanks to this growing popularity, Vanguard now ranks second only to Fidelity in size in the global fund management industry.
In the first four months of this year, Vanguard's funds took in $27bn of new money from investors. In March, Vanguard on its own accounted for more than a quarter of all the money that investors in the United States put into equity mutual funds.
And in a business not widely famed for its quality of after-sales service, the group has won a string of awards for its success in looking after its customers. The company invests heavily in information technology to make sure that investors can keep up to date on the value of their investments and the range of options open to them. Company policy is to answer every call from investors within 20 seconds. Between 50,000 and 150,000 calls a day are handled at one of three national call centres. The evidence that this customer-led approach works is all around at Vanguard's head office campus in Valley Forge, Pennsylvania.
Vanguard has pushed its way from nothing to second place in the US fund management business in little over 20 years despite spending only a tiny fraction of its budget on marketing.
Nor does Vanguard pay any commission to brokers or other types of intermediaries to win business. It has no branches or offices of its own. All its retail business is handled over the phone or on the Internet.
What sells its funds are two things and two things alone: its performance track record, which is one of delivering solid and reliable returns to its investors, based on the lowest cost base of any fund management competitor, and its good quality service to its customers.
As Jim Gately, the managing director responsible for Vanguard's retail business, notes: "People do not expect the company with the lowest costs to provide the best quality service, yet that is what we are doing".
From the outset, 23 years ago, Jack Bogle insisted that the only way to secure enduring competitive advantage in the money management business was through rigorous control of costs.
Whereas the average US mutual fund charges its investors 1.25 per cent of their money each year in management fees and other expenses, the comparable figure for Vanguard is barely a fifth of that, at just 0.28 per cent of assets. No other investment management company comes close to matching this figure.
Furthermore, while Vanguard's costs are coming down in relative terms, those of the industry are going up, so if anything the gap is widening, not narrowing.
Is this not all too good to be true? Rivals are quick to point out that Vanguard's recent success is strongly correlated with the growing popularity of index tracking, of which Vanguard is well known as a leading exponent. Index-tracking funds (also known as passive funds) do not seek to outdo the main market indices, but merely to replicate their performance.
They continue to grow in popularity not just in the United States retail market, but in the pension fund and retail fund business elsewhere in the world as well.
The great attraction of index funds is that they offer investors a combination of above-average performance at below-average cost. The formula is simple but counter-intuitive: how can settling for second best be a winning strategy? Yet indexing is thriving for one very simple reason: it works.
Repeated academic and industry studies have shown that at least three out of four actively managed funds fail to beat the typical stock market index over time. This is not because active managers are lacking in talent, hard work or diligence.It is simply because the costs that active fund managers incur in chasing above-average performance tend to wipe out any edge in performance that they can realistically hope to achieve.
Vanguard is the organisation that has done more than any other to make a commercial success out of transforming this simple (but long resisted) finding of social science into a multi-billion dollar business.
Jack Bogle was the first to see that index funds were the way of the future, but it has been a long haul. When he launched the first index fund in 1976, it look him months to find a bank that was prepared to sponsor the launch: for the first five years, it went nowhere. In fact, more investors took out money than put in new money.
Now, by contrast, so popular has indexing become that Vanguard's flagship tracker fund has become the second largest single mutual fund in the United States, behind Fidelity's Magellan fund.
Vanguard also runs a string of other index funds, including funds that invest in bonds and funds that seek to track a range of international market indices. Ironically, however, although indexing is what Vanguard is best known for, a good deal less than half the money it manages for investors is invested this way.
It runs a variety of actively managed funds as well, for both retail and institutional clients, some of which are contracted out to other fund management groups. In terms of assets, only around $200bn of its near $500bn of assets are indexed. What this shows, observes John Brennan, who succeeded Bogle as the company's chairman and CEO in 1996, is that the defining characteristic of the way Vanguard manages money is actually its devotion to low costs, not to indexing per se.
The average expense ratio for the funds that Vanguard manages in an active manner is just 0.4 per cent, higher than its tracker funds, but still light years below that of many of its competitors. Bogle himself says that he became a fan of indexing because it was the lowest cost way to invest, not for any other reason.
Of course, say the critics, the Vanguard bubble will start to burst when the bull market (and with it, they claim, the indexing phenomenon) finally runs its course. Wall Street's performance at the moment is dominated by a handful of large capitalisation stocks which are almost single-handedly dragging the market higher, distorting the performance statistics, and creating a uniquely favourable playing field for the index trackers.
Vanguard itself has been warning its investors not to expect the current bull market to continue indefinitely for at least three years. It has been working on contingency plans for coping with a serious market correction for almost as long: yet in the words of Jim Gately, as the market continues to power ahead, "the contingency plans are getting rusty".
John Brennan, the man now in charge of the day-to-day running of the company, is unfazed by the sniping from envious rivals. He admits to concern about the continued strength of the bull market, but only because of fears that new investors may be trooping to the Vanguard colours in the naive belief that the returns of the past three years can be sustained indefinitely.
The threat to Vanguard's competitive position of a fall in the market is greatly overstated, he says. The fact that 60 per cent of Vanguard's business is invested outside indexed funds suggests that most of the money which is rolling into the company is coming in for the right reasons - a recognition of the company's low costs and high service quality - rather than from any misguided faith in the permanence of the bull market.
"The biggest danger we face", he says, "is not the market, but our own complacency. My motto has always been that we need to get better, not bigger. Normally companies that do as well as we have done regress to mediocrity. That is the nightmare you face. We are determined to avoid that happening".
Mike Miller, responsible for business development, puts the same point a different way: "The moment you start to think you have won, that is the moment you start to lose".
The biggest issue facing Vanguard now is not whether it can continue to grow, but whether it can sustain its commitment to quality service. Employee numbers have doubled to 10,000 in the past two years, and the challenge facing the management is to ensure that Vanguard's legendary attention to detail does not suffer as the business grows.
Although he is now nearly 70, and retired from day-to-day running of the company, Mr Bogle remains an inspirational figure. He is scathing about many of the practices of the fund management business in the United States, which in his view has lost sight of the fact that its primary responsibility is a fiduciary one to its clients, not the single-minded pursuit of its own profitability.
He says that mutual funds in particular are now fatally obsessed with marketing and winning new business, instead of concentrating on their real function, which is to look after their investors' money.
Despite its track record, Vanguard remains largely unknown outside the United States. Yet according to Mr Brennan, the company has hardly begun to fulfil its long-term potential. Its decision to move into Europe is the first step to try and export its unique formula to overseas markets.
It has also recently added brokerage and financial advice to the services it offers its customers. But, says Mr Brennan, it has no intention of expanding into other areas, let alone try and become an all-singing, all dancing financial services conglomerate.
There is clearly much that Europe can learn from the Vanguard success story. One lesson is simply that fund management does not need to be a high-cost business. Is there any reason why the average expense ratio of UK unit trusts and personal pension funds should be higher than the average mutual fund in the United States? Clearly there is scope for improvement on that score alone.
A second lesson is that the managers of fund management companies here would do well to ask themselves whether their whole-hearted pursuit of new business is really consistent with the best interests of their investors, in whose name they are nominally acting. All the evidence suggests that this is not the case.
Funds under management: $bn
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
Fidelity 76.2 97.8 108.8 142.7 169.6 230.6 264.3 355.9 429.7 521.5 645.5
Vanguard 34.2 47.6 55.8 77.1 98.1 127.2 131.9 180.1 238.7 325.0 433.2
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