After meeting with top management in Malvern, Kevin McDevitt, analyst at investment-review service Morningstar, posts his "annual report" on $3.6 trillion-asset mutual-fund and ETF giant Vanguard Group here.
McDevitt repeats the familiar story of Vanguard's rapid and continuing growth -- in "active" as well as index funds -- and pins Vanguard's success to its low fees and unusual structure (a private company, Vanguard is owned by its mutual funds, and controlled by top management and the self-perpetuating board.)
He also raises questions about Vanguard's "agency issues" -- is it really in fund investors' best interest to pay for marketing, foreign expansion and services other investors use? -- and the erosion of its price advantage as cost cuts mount and rivals' fees drop.
HIGHLIGHTS AND EXCERPTS: "Vanguard continues to focus on helping individual investors succeed... Vanguard remains the only firm owned by its fundholders... That has manifested in a sensible lineup of typically core-oriented strategies and a history of sharing economies of scale with clients...
"The 'Vanguard effect' is leading to fee compression across the industry... Vanguard's popularity has exploded... With nearly 22%" of industry assets, it is "more than twice the size of its next-largest U.S. rival... The firm collected an estimated $230 billion in U.S. inflows in 2015 and is slightly ahead of that pace so far in 2016." The rest of the industry is shrinking, McDevitt added.
BEYOND BOGLE "Confidence is understandably running high. As one executive said to us, "Simplicity has won, and it has won big."... Vanguard has stayed true to its principles even as it has evolved well beyond (founder John Bogle's model)...
"Much of the firm's growth during the past five years, for example, has come via ETFs, which Bogle initially saw as tools for rapid trading and speculation. Instead, Vanguard's ETFs... helped Vanguard carve a new distribution channel for itself to investment advisors, especially those in broker/dealers," who collect fees for pushing Vanguard product.
"In the 1990s, Bogle said there was no need for U.S.-based investors to diversify... Today, Vanguard pushes U.S.-based investors, which are 90% or so of its client base by assets... to give equal attention to foreign markets...
"Vanguard manages only about $300 billion abroad and doesn't have the brand recognition it does in the United States..." Still, "with 12 international offices, Vanguard has access to a far larger (24-hour trading and management) talent pool...
A LIMIT TO COST CUTS "The firm's executives acknowledge that what got [Vanguard to the top] won't be enough going forward. Being the low-cost provider won't be sufficient in part because, as the firm grows, it's getting more difficult to move the needle on expenses. It would take more than $500 billion in additional assets to cut the firm's asset-weighted expense ratio by 1 basis point (or 0.01%)...
MORE COMPETITION "Rivals such as BlackRock, Schwab, and Fidelity are competing with Vanguard on cost in a way that wasn't the case five years ago.
"The advent of ETFs and BlackRock's purchase of iShares from Barclays in 2008 changed the competitive landscape. Schwab and Fidelity have also adjusted their lineups to accommodate the growing interest in low-cost, passive vehicles... These firms have been undercutting each other's fees... Schwab recently launched a target-date series composed entirely of passive ETFs that charges just 8 basis points, which is 2 basis points cheaper than the levy on Vanguard's Institutional Target Retirement series...
"Vanguard's offerings... are not always the cheapest. Plus, there are limits as to how low Vanguard funds' expense ratios can go... Its for-profit rivals can theoretically price individual products below cost, making up the lost revenue in other parts of their businesses."
VALUE ADDED? "Perhaps seeing the limits of a strategy built largely around low costs, Vanguard is increasingly exploring ways to use its scale to create value in other ways.
"As financial services become increasingly commoditized, Vanguard is focusing more on building client loyalty through better services. Personal Advisory Services is its most ambitious initiative in this area...
ROBO ADVICE "PAS offers a hybrid [robo-advisor/live customer service] model... lower cost than most traditional advisors. Vanguard charges just 0.30% beginning with a $50,000 account minimum," vs. 0.25% at fully-robo rivals Wealthfront and Betterment.
"Vanguard's scale allows the firm to offer its relatively high-touch service at such an attractive price. But Vanguard has implied that the service is not yet covering its operating expenses."
DOES VANGUARD MARKETING SPEND HELP SHAREHOLDERS? "This points at a tension that exists for Vanguard... How should its scale best be used for shareholders' benefit? As PAS doesn't yet cover its costs, it is implicitly subsidized by fundholders. Arguably, then, there is no benefit to those fundholders who do not use PAS.
"A similar argument could have been made in the past concerning Vanguard's international efforts.... For years U.S.-based fundholders subsidized those operations," which the company says now break even, though it doesn't publish their financials.
"Vanguard argued that U.S. shareholders benefited from the talent and operational advantages Vanguard gained as a global organization. While that may have been true, the link seems less clear with PAS....
AGENCY ISSUES "There are other potential agency issues for Vanguard and its fundholders." Should the company be "focusing efforts on further cost cuts, or reinvesting in the firm's infrastructure and service offerings?...
RUNNING LEAN "There's little evidence that Vanguard's growth has led to bloat. At the end of 2010, Vanguard had 12,600 employees and $1.3 trillion in assets. Six years later, the asset base has more than doubled, but the firm has fewer than 15,000 employees--growth of less than 20%. In comparison, Fidelity has more than 45,000 employees [to handle] $5.4 trillion in total customer assets."
ACTIVE ETFs Besides its leadership in index funds, "Vanguard is the third-largest manager of active funds in the U.S. with $850 billion in assets, trailing only American Funds and Fidelity. As the firm says, the common denominator with its funds is low cost..." He expects Vanguard will soon sell actively-managed ETFs.
THANKS, UNCLE SAM McDevitt says the Department of Labor's new fiduciary rule favors Vanguard by "making it harder to justify investment vehicles with high expenses or commissions."
TOO BIG? "Things won't always go this smoothly. Generally speaking, the biggest threat to Vanguard's success may be its size. Vanguard talks about the advantages of scale, which are certainly real, but there are drawbacks, too.... Size can make it more difficult to deliver a high level of customer service.
"And with size comes greater visibility and scrutiny... As essentially a permanent (index) shareholder, Vanguard can't use the threat of selling its shares as a point of leverage with executives.
"Vanguard has been a model citizen throughout its history, but its size could also attract greater regulatory attention," even a potential designation as a "systemically important financial institution" next time the market tanks.
"Overall, though, Vanguard continues to be a model of fiduciary prudence."
SUMMARY After repeating the company's claims about itself, McDevitt raises a string of useful questions about whether Vanguard can keep cutting costs to stay competitive.
WHAT MORNINGSTAR DOESN'T SAY McDevitt stops short of mentioning the tax, governance, and non-transparency claims raised by ex-Vanguard tax lawyer turned self-described whistleblower David Danon, or the scholars who have reviewed Vanguard's structure, Danon's allegations, and governance, and the impact of index funds generally as they become the ascendant form of stock ownership.
It's good that Morningstar visits fund bosses. But as with professional investment managers who buy company stocks and bonds, it would be great to see Morningstar do more third-party research, for example among Vanguard customers.
SERVICE DECLINE? Initial comments posted to McDevitt's article by Vanguard customers who are Morningstar readers complained of deteriorating or inadequate customer service. How many people really feel that way? In seeking to drive down costs, is the company squeezing too hard?
DO YOU BELIEVE THEM? And wouldn't disclosing executive compensation and expenses make Vanguard's actual spending and management practices more transparent, proving in detail the company's familiar claims its bosses do all for shareholders' best interests?