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Rekenthaler Report

Has Vanguard Lost Its Way?

Today's company isn't entirely what Jack Bogle built.

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A Difficult Path

Founding Vanguard was an ambitious decision. First, the company renounced a huge chunk of management fees by hiring sub-advisors for its equity funds, rather than running those funds directly. Then it undercut that revenue by devising the industry’s first index fund. The firm’s strategy demanded both patience and the faith that, eventually, high volume would make up for its low profit margins.

Staying on track was also demanding. Running a discount business in a luxury-priced industry required ongoing financial discipline. The company negotiated aggressively to keep its costs low. It also ran a tight ship, internally. Years back, when I asked a friend who had joined Vanguard what she thought of her new employer, she replied, “This place is very efficient. But I wouldn’t call it fun.”

However, once Vanguard’s blueprint had been established and its corporate culture developed, the company’s executives faced few tough decisions. Their challenges were operational, not strategic. While other fund companies floated high-concept funds, marketed intensively, and/or paid outside distributors big dollars to sell their wares, Vanguard said no. It thrived not through innovation, but instead by doing more of the same. (The exception being exchange-traded funds, which Vanguard offered at the relatively early date of 2004.)

Sincere Flattery

At long last, that formula has run its course. The trouble is, Vanguard has attracted too many imitators. No longer does Vanguard walk alone. These days, BlackRock (BLK), State Street (STT), Fidelity, and Schwab (SCHW), among others, offer comparably priced index-fund lineups. To be sure, Vanguard remains the industry’s leader, attracting about 40% of this year’s net index-fund sales, but it faces fierce competition--leading to pressure on its funds’ expense ratios. As with the rest of the industry, Vanguard has been forced to cut its index funds’ costs, repeatedly.

That’s a headache for Vanguard, which lacks its competitors’ deep pockets. Vanguard’s rivals possess higher-margin businesses that they can use to subsidize their index funds, as well as to cover their increasingly steep technology costs. For example, Fidelity spends an annual $2.5 billion on technology. To raise that much money, the ETF version of Vanguard’s largest fund, Total Stock Market (VTI), would need to control $8 trillion in assets--as much as the company currently owns.

The prognosis isn’t that dire. Fidelity’s technology bill is particularly high, being well above that of both BlackRock and Schwab. In addition, most of Vanguard’s assets are in higher-expense funds than VTI. Vanguard therefore collects more fees than that illustration suggests, while also facing lower costs. Nevertheless, the numbers are instructive. Despite the firm’s sales success, Vanguard’s business has been squeezed.

Evidence of Change

This strain has manifested itself in two ways. One has been a decline in customer service. Whereas Vanguard executives once boasted that the company answered calls within three rings, complaints now abound about the difficulty of reaching company representatives. (Stated another friend, “I get prompt responses from Fidelity and Schwab, but with Vanguard I have waited on hold as long as 45 minutes.”) Customer-service surveys support the anecdotal evidence.

To be sure, outsiders cannot know if Vanguard’s customer-service woes have occurred because the company lacked the assets to pay for the necessary upgrades, or through mismanagement, or because of a calculated business decision. Some organizations have opted against answering their telephones for routine calls, figuring that the cost savings outweigh the reputational harm. (Try to reach somebody at Uber (UBER). I dare you.) Perhaps Vanguard is among that group.

Nevertheless, the second development at Vanguard bolsters the suspicion that the main reason is money: the aggressive promotion of the company’s advice platform, Personal Advisor Services. Launched in 2015, PAS delivers financial advice via technology and telephone. The fee is 0.30% per year of client assets, scaling down after the first $5 million.

The service has been an unquestioned success. At roughly $250 billion, it has thrived in the marketplace, becoming easily the largest digital-advice platform. Reviews have been uniformly positive. Admittedly, the reviewers generally evaluated only the features of the program, rather than invested assets to experience the service, but I haven’t received any gripes from PAS clients. And the platform’s revenue has surely been to Vanguard’s liking, checking in at close to $750 million per year.

Unexpected Arrivals

To date, the investments used by PAS have been exactly what one would have expected from Vanguard: low-cost index funds, primarily ETFs. However, two recent Vanguard announcements have startled observers. This spring, Vanguard promised to bring private-equity funds to qualified PAS clients. Then, last month, the company introduced three actively run “Advice Select” funds, available exclusively for the program’s customers.

Now that’s different! Private-equity funds directly contradict Vanguard’s existing brand, being costly, complex, and illiquid, rather than cheap, simple, and easily traded. Even more surprising, at least to me, were the Advice Select funds. Never did I think that Vanguard would remind me of Wall Street wirehouses, circa 1990. But marketing special, in-house funds that could only be held by their advice clients was, in fact, how those firms operated. The old is once again new.  

Of course, as some of my coworkers have caustically reminded me, Vanguard has certainly not emulated wirehouse prices. Its advisory fee is 0.30%, as opposed to the wirehouses’ 1%-plus agreements. What’s more, the funds used by PAS remain unusually cheap, with the Advice Select funds costing a relatively modest 0.40% to 0.45% per year, and the remaining investments much less than that. By almost any standards, PAS is a low-cost program.

Wrapping Up

The strategy that carried Vanguard through its first 40 years appears to have reached its breaking point. In response, Vanguard executives have broadened the company’s revenue stream, thereby altering its mission. A Vanguard that offers private-equity investments and an advisory service that features exclusive funds isn’t Jack Bogle’s Vanguard. Whether that means that Vanguard has lost its way, or has sensibly adjusted to changing times, I cannot tell. Early days yet.

Fortunately, the process works in both directions. Just as Vanguard is slowly becoming more like other fund companies, other fund companies are slowly becoming more like Vanguard. For investors, that is good news indeed.  

 

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler has a position in the following securities mentioned above: VTI. Find out about Morningstar’s editorial policies.