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No Signs of Complacency at Vanguard

Nor has it sold its soul to reach the top.

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Each year we review Vanguard from an overall parent standpoint. Our due diligence included meeting with company executives at the firm's Malvern, Pennsylvania, headquarters earlier this year. What follows is an initial assessment of where Vanguard stands today, both its opportunities and challenges. It is not comprehensive, but it's a snapshot of the issues we're thinking about. It also builds on the excellent piece Ben Johnson wrote in May.

Even as it has grown into a $3.5 trillion behemoth in 41 years, Vanguard's core values and mission remain intact. Vanguard continues to focus on helping individual investors succeed, although what form this takes continues to expand and evolve. At the center is its unique structure: Vanguard remains the only firm owned by its fundholders, freeing it from the conflicts of interest inherent in other ownership structures. For Vanguard, that has manifested in a sensible lineup of typically core-oriented strategies and a history of sharing economies of scale with clients in a much more meaningful way than many of its competitors.

Its at-cost structure has led to a firmwide average expense ratio of just 0.18% (18 basis points), 0.13% on an asset-weighted basis. The "Vanguard effect" is leading to fee compression across the industry. Its mutual structure is the foundation for Vanguard's low-cost advantage, but it also creates a mindset that imbues the firm's culture. To be clear, though, this structure also allows Vanguard to make investments in its business that will ultimately benefit shareholders in the form of lower fees or better services.

After growing steadily for years, Vanguard's popularity has exploded more recently. With nearly 22% of the combined open-end mutual fund and exchange-traded fund asset base, the firm is more than twice the size of its next-largest U.S. rival. As investors have embraced low-cost investing, Vanguard's inflows have gone parabolic. The firm collected an estimated $230 billion in U.S. inflows in 2015 and is slightly ahead of that pace so far in 2016. Outside of Vanguard, the rest of the industry has collectively experienced net outflows.

Given its size and dominance in recent years, it would be easy for Vanguard to go astray. Confidence is understandably running high. (As one executive said to us, "Simplicity has won, and it has won big.") If not for its obligation to fundholders and its at-cost model, the firm might be tempted to start making acquisitions or indulge in needless empire-building. But 20 years removed from founder John Bogle's tenure as CEO, the firm has largely avoided such pitfalls.

Vanguard has stayed true to its principles even as it has evolved well beyond Bogle's blueprint. 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, which so far, and by an SEC exemptive order, are share classes of its existing index funds, helped Vanguard carve a new distribution channel for itself to investment advisors, especially those in broker/dealers.

The firm is also far more global than in the past, both in its operations and its mindset. In the 1990s, Bogle said there was no need for U.S.-based investors to diversify abroad, arguing that owning U.S. companies with overseas operations was sufficient. Today, Vanguard pushes U.S.-based investors, which are 90% or so of its client base by assets, to avoid home-country bias and give equal attention to foreign markets. Vanguard led the way in February 2015 by increasing the foreign-equity weightings in its target-date funds and its LifeStrategy offerings.

Although Vanguard manages only about $300 billion abroad and doesn't have the brand recognition it does in the United States, Vanguard's operations are globally integrated. The two biggest areas of impact are talent acquisition and trading. With 12 international offices, Vanguard has access to a far larger talent pool than if it operated only in the U.S. Plus, it has used international assignments as a way to retain and season promising executives. With trading desks in Asia and Europe, Vanguard also has a 24-hour trading operation, leading to better execution and lower costs for all of its portfolios.

Getting From Here to There
Now that Vanguard has climbed to the top of the industry, the firm's executives acknowledge that what got the firm there 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. While Vanguard continues to periodically cut the expense ratios of individual funds, as of April 2016, 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%).

Furthermore, 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. In a win for investors, these firms have been undercutting each other's fees throughout their target-date, ETF, and index fund lineups. Schwab recently launched a target-date series composed entirely of passive ETFs and that charges just 8 basis points, which is 2 basis points cheaper than the levy on Vanguard's Institutional Target Retirement series. So, although Vanguard's offerings are almost always among the lowest-cost options in any category, they are not always the cheapest.

Plus, there are limits as to how low Vanguard funds' expense ratios can go. By SEC exemptive order, Vanguard's funds are offered at cost. But its for-profit rivals can theoretically price individual products below cost, making up the lost revenue in other parts of their businesses.

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.

Launched in May 2015, PAS offers a hybrid model more personalized than what  robo-advisors (which provide low-cost, technology-driven, automated guidance) offer, but at much lower cost than most traditional advisors. Vanguard charges just 0.30% beginning with a $50,000 account minimum. Fees decline at specific breakpoints. Once their portfolios reach $500,000, clients are assigned one specific advisor versus a pool of advisors. Vanguard makes a point of emphasizing that they aren't competing with robo-advisors on price. (Robo-advisors Wealthfront and Betterment charge 0.25% to manage a $50,000 portfolio.) Largely sticking to existing Vanguard clients, PAS had $36 billion in assets as of March 2016. 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.

This points at a tension that exists for Vanguard even though it is mutually owned. Specifically, 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. Although its international divisions now break even, for years U.S.-based fundholders subsidized those operations. In that case, 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. This will presumably be less of an issue as PAS' assets grow.

There are other potential agency issues for Vanguard and its fundholders. More broadly, there is a balance between focusing efforts on further cost cuts or reinvesting in the firm's infrastructure and service offerings. CEO Bill McNabb points out that technology is the primary source of scale but that it requires constant reinvestment. Such long-term investments in infrastructure may not pay off immediately, but they can lead to lower costs over time, as well as a better client experience. Moreover, 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 with $2.1 trillion in managed assets--far less than Vanguard--and $5.4 trillion in total customer assets.

The Outlook
Vanguard's operational issues are clearly at the margin. Vanguard has the wind at its back in almost every meaningful respect: There's an increasing investor focus on fees, flows into passive vehicles remain strong, and the number of investors using fee-based or robo-advisors, which themselves favor Vanguard vehicles, continues to grow by the day.

Even two thirds of Vanguard's 60-plus actively managed funds are combating the passive trend and are attracting inflows. For the year to date through July 2016, its actively managed funds had together collected an estimated $23.9 billion. That's more than twice the inflows of its next-closest U.S. competitor, DoubleLine. (With the success of its passive lineup, it's easy to forget that 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, not active or passive.)

Such flows could increase a bit more once Vanguard introduces its first actively managed ETFs. Vanguard hasn't announced any immediate plans, but it recently requested permission from the SEC to introduce such share classes in the U.S. It already offers actively managed ETFs in Europe and Canada. It seems likely that Vanguard would offer something similar to what it distributes in those markets, likely alternative strategies involving minimum volatility, momentum, or liquidity, all of which are run by Vanguard's own Quantitative Equity Group, which is its fourth-largest subadvisor by assets.

In April 2016, the Department of Labor instituted the fiduciary rule, which also cuts Vanguard's way as it places a higher standard on retirement advice, making it harder to justify investment vehicles with high expenses or commissions. This stands to benefit Vanguard's target-date series, which is already the industry's largest, and its low cost may make it even more attractive to accounts subject to ERISA.

While it's difficult to name specific threats to Vanguard's current dominance, 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. For instance, size can make it more difficult to deliver a high level of customer service. And with size comes greater visibility and scrutiny.

Vanguard's low-cost investing model--indexing in particular, 40 years after the launch of  Vanguard 500 Index (VFINX)--has been so successful that Vanguard is now a substantial and nearly ubiquitous shareholder. Rob Main, the head of Vanguard's corporate governance group, said that Vanguard owns 5% or more of most companies in which they invest. To its credit, Vanguard takes its corporate governance role very seriously and has a team of 12 researching corporate proxies. Main believes that its governance efforts can add value through proxy votes and dialogues with corporate management. But as essentially a permanent 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. Although nothing came of it, Vanguard got a taste of this in recent years when the Financial Stability Oversight Council explored whether large asset management firms like Vanguard should be designated as systematically important financial institutions. That push seems to have died down, but it could be revived should there be a major market dislocation, especially if it involved large investor losses.

Overall, though, Vanguard continues to be a model of fiduciary prudence. It has earned the trust of millions of investors through its low fees and reputation for acting on their behalf. The only way it could squander that trust would be to violate the principles it has followed for four decades.

Kevin McDevitt does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.