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What's Next for Vanguard?

Here’s how the behemoth plans to continue to innovate.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Vanguard is the world's largest retail fund family. But how can this one-time disruptor keep from becoming the disrupted? Joining me today to discuss where Vanguard is headed is Alec Lucas. Alec is a strategist with Morningstar's Manager Research Group.

Thanks for being here today, Alec.

Alec Lucas: Thanks for having me.

Dziubinski: Now, you recently wrote an article for that did a deep dive into Vanguard. And you point out that Vanguard does face significant competition. Who do you think is the biggest competitor today?

Lucas: Yeah, it's a great question. Vanguard definitely faces competition from a price standpoint from some of the industry's biggest players. So, I think Fidelity, BlackRock, Schwab. I think rather than picking one, it's probably better to think in terms of each firm has a particular business or line of business that competes with Vanguard in one respect or another. So, BlackRock, for example, its iShares ETF business, is an alternative to Vanguard's ETFs; Fidelity has very strong actively managed funds, some of them which can compete with Vanguards. And then with Schwab, you've got a brokerage platform that in some cases has options that are not available on Vanguard's brokerage platform. In other cases, we'll have an option with a lower investment minimum than the same one on Vanguard's platform.

Dziubinski: Now, but Vanguard is, of course, not sitting on its laurels. It's pursuing some different initiatives that again, you talked about in this article, an attempt to really transform itself and the industry. And one of those initiatives is to make advice more accessible. What exactly does that mean, and what are they doing?

Lucas: Yeah, it's interesting that Vanguard is emphasizing advice to the extent that they are. Historically, Vanguard started its business by going direct-to-consumer, if you will, so sort of bypassing advice at the time. Advice has been something that's been a feature of Vanguard's business since the 1990s. But it really took a significant turn in May 2015 with the launch of Vanguard Personal Advisor Services. It's a discretionary asset-management business that's available for investors for at least $50,000. And it starts at 30 basis points, or 0.30%, per year as an asset-based fee. And then in May of 2020, they launched Vanguard Digital Advisor. So, whereas PAS is a hybrid system, it's humans as well as it's digital advice. Digital advisors, obviously only digital, and it's for investors with $3,000 minimum, and it uses four ETFs. And it gives them--it assesses their goals, risk tolerances, and there is over 300 different glide paths.

So, both options, and it's 20 basis points including underlying fund fees, both options are cheap. Both options offer your average retail investor an ability to get best-in-class asset management for a very competitive price.

Dziubinski: Now, you did point out in your article, there is a little bit of a wrinkle that Vanguard's asset-based fees, the model there, can be costly for some investors. Who would those investors be?

Lucas: It would be very high-net-worth clients. So, as a reminder, a 30-basis-point fee works out to $30 for every $10,000 invested. And if you have $25 million or more, that asset base fee drops to 5 basis points, or 0.05% for every $10,000 invested. So, you're only paying $5 per $10,000 invested. But if you have a lot of money that can still add up. So, an account that has $100 million at Vanguard, you would pay $77,500 in fees per year. And if you don't need an overhaul every year, it stands to reason that maybe you shouldn't be paying a salary's worth of fees to Vanguard, if you will. And so, they stopped short of offering flexible pricing models. I think that would be complicated for them to do, and that's one reason perhaps they didn't do it. But definitely, if they were to introduce flexible pricing models that would be a help and a service to investors who are very high-net-worth.

Dziubinski: Now, another initiative that Vanguard is pursuing is investing more in its active equity business, which again seems a little ironic from Vanguard. And just in fact, about a week ago in late August, they announced that they are launching three new active equity funds via the Personal Advisor Service. Why strategically is investing in active important to Vanguard?

Lucas: Yeah, it's become increasingly important because as Vanguard really has become known for indexing--it started off with an active managed business that's less well known--but as it's had such tremendous success with indexing, index products, broad market exposure has somewhat become a commodity. Fidelity, BlackRock, Schwab all have offerings that either match or undercut Vanguard on fees for broad market exposure. And so, as that's increasingly become the case, a standout active lineup can become an important differentiator. And Vanguard historically has done a lot of its actively managed funds combined multiple subadvisors, they have different styles, it reduces risk in terms of volatility, and it offers the possibility, and in many cases, the actuality of benchmark-beating returns. But over long periods of times, those benchmark-beating returns tend to be pretty modest.

If you have a high-conviction actively managed strategy, if it does well--and that's the big if--then it can really offer material outperformance that can change an investor's experience of retirement, for example. And so, they've launched three funds for advisory clients that are very high conviction in their approach. One is a dividend growth approach run by Don Kilbride of Wellington Management. Another is a global value approach run by David Palmer of Wellington Management. And then Lawrence Burns and James Anderson of Baillie Gifford are running an international growth strategy.

Dziubinski: And what do we think? I mean, in general, we think pretty highly of those subadvisors, right?

Lucas: Yeah, the Admiral share class of--so Vanguard Dividend Growth doesn't have an Admiral share class, it's a Gold-rated fund and long has been. And the Admiral share classes of Vanguard International Growth and Vanguard Windsor are both Silver-rated by us. So, we think highly of all three managers. Don Kilbride, for example, has run a version of the concentrated strategy that he'll be running in this new fund. He has run that since early 2008. And it's had excellent results. And it's very concentrated. His normal Vanguard Dividend Growth strategy has about 50 stocks in its portfolio; this new one will have about 25. So, he has to pick well, and historically he has done that. But he has rewarded investors for that added risk.

Dziubinski: And the third initiative that Vanguard is pursuing is democratizing private equity. What are the pros and cons, in general, of private equity investing?

Lucas: Yeah, the big pro is that you can, even after significant fees, get market-beating returns over long periods of time, and it is returns that aren't tightly correlated with the public equity market. The con, of course, is there is a wider range of outcomes, so you can lose money. And even if you make money, your capital is tied up for long periods of times. And so that's the big con: It tends to be that you have to be a very high-net-worth individual--a qualified investor is the lingo to access private equity. But Vanguard, in sort of rolling out private equity, has a goal eventually to perhaps introduce it to target-date funds and make it more readily accessible. And there's challenges to that. There's a lot of capacity constraints in the private equity world that would make it difficult to roll it out more broadly, but Vanguard is certainly thinking about doing that.

Dziubinski: And what are some of the things that you think Vanguard is doing right when it comes to private equity right now?

Lucas: So, they've partnered with a proven fund-of-funds manager in HarbourVest, so you're getting about as much diversification in private equities as you can. They're rolling it out slowly. The allocation to clients is being rolled out slowly. So, even if it turns out we're at a private equity top right now, the investors won't be fully allocated in that respect for several years now. So, they'll be gradually buying in. They're taking a long-term horizon as they do with all their investing. And they've structured the partnership so that it doesn't become really economically beneficial to HarbourVest until they hit an 8% hurdle rate. So, investors are--they're not guaranteed an 8% return, but certainly HarbourVest is incentivized to produce results at that level, if not higher.

Dziubinski: And then on the flip side, what could use some improving?

Lucas: I think that they could be more careful in some of the promo-ing of private equity that they've done. The basic comparison they've made is the ability of private equity over a long period of time to beat global equities by 350 basis points, or 3.5 percentage points, a year. But they're comparing private equity to something like the MSCI ACWI benchmark--that's mid- and large-cap global stocks. The reality is that, historically at least, private equity has been dominated in biotech- and technology-related companies, especially in North America. And so, if you compare those results to, say, for example, Primecap, which is the manager that Vanguard knows well, they've historically invested pretty significantly in biotech and tech, doing so through public equities. The results are less impressive. I think they could be more careful in the comparisons they're giving, because there are challenges to investing in private equity, even as responsible as Vanguard is doing it.

Dziubinski: And then lastly, Alec: How likely do you think that these initiatives are going to help Vanguard fortify and maintain its position in the industry?

Lucas: I would say highly likely. I mean, it's hard to envision a future in which Vanguard isn't a major player in the asset-management industry and hard to envision a future in which they're not a leader. I think, if you think about Vanguard--the biggest threat to Vanguard is Vanguard itself. They face the challenge of maintaining their investor-first culture, and if they can do that, they can continue to serve investors well for a very long time.

Dziubinski: Well, Alec, thank you so much for your perspective on this very well-liked and respectable fund firm. We appreciate your time.

Lucas: Thank you.

Dziubinski: I'm Susan Dziubinski for Morningstar. Thank you for tuning in.