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Vanguard could have the edge in active ETF battle

Index champ has $652 billion in actively managed mutual funds

Oct 10, 2013 @ 3:23 pm

By Jason Kephart

Most fund companies that missed out on the indexing craze are lining up to offer actively managed exchange-traded funds, but the biggest winner, if such funds take off, will be the indexing giant The Vanguard Group Inc.

Vanguard, the largest mutual fund company and third-largest ETF firm, is one of the many companies in midst of applying for approval from the Securities and Exchange Commission to launch actively managed ETFs. BlackRock Inc., Eaton Vance Corp., Fidelity Investments and T. Rowe Price Group Inc. are among the dozen or so other companies angling to offer the products.

Actively managed Vanguard ETFs may seem like a stretch, considering that the company's rapid rise to the top of the asset management company food chain has come on the back of its index mutual funds and ETFs.

But Vanguard has $652 billion in actively managed mutual funds, which is more than Pacific Investment Management Co. LLC, the third-largest mutual fund company, with $536 billion in assets, has across all its funds. Obviously, Vanguard knows its way around active management.

The reason that Vanguard would be the big winner in actively managed ETFs, however, has nothing to do with the active-versus-passive debate. Instead, it is more about the way that ETFs have completely disrupted the classical distribution channels that asset management companies use to reach advisers.

This isn't all that different from the way that Netflix, which lets consumers pick and choose TV shows at will, has disrupted the old cable network model, which gives consumers far fewer choices.

“ETFs are a way to bring Vanguard to the market at a level playing field,” said Martha King, managing director of Vanguard's financial adviser services division.

Vanguard's mutual funds are sold only directly from the company.

If an adviser wants to buy one of Vanguard's actively managed mutual funds —say, the $15.6 billion Vanguard Windsor Fund (VWNDX) — through one of the mutual fund supermarkets such as Schwab OneSource, there is an extra transaction fee tacked on.

One adviser who uses Schwab as his custodian played guinea pig for us and found that it would be a $30 transaction charge to buy a Vanguard fund. That isn't a huge amount, but it could add up when making regular contributions.

On the flip side, that same adviser can buy any of Vanguard's ETFs for an $8 commission fee.

As Vanguard says, costs matter, so it is clear which vehicle is more adviser-friendly.

That is where actively managed ETFs come in. If Vanguard gets approval — and there is little reason to think that it won't — it will have an easier road to delivering its low-cost alpha-seeking funds to advisers.

Of course, that doesn't mean that we should expect to see something like the $36 billion Vanguard Primecap Fund (VPMCX) in ETF form right out of the gates. Stock pickers are probably still going to feel uneasy about the daily holding disclosures, though BlackRock, Eaton Vance and T. Rowe Price are working with the SEC to get around that requirement, so stay tuned.

Instead, something like the recently announced actively managed Vanguard Global Minimum Volatility Fund, which will be launched before year's end, would make a lot more sense. It will be run by Vanguard's quantitative-equity group, so instead of making big bets on a particular stock or sector, it will likely more or less follow the index.

One reason that Vanguard chose to go the active-management route rather than track a minimum-volatility index is that it doesn't consider any index that isn't market-capitalization-weighted to be suitable for an index fund, spokeswoman Katie Henderson said.

Minimum volatility has already proved to be a popular strategy in ETF form. The PowerShares S&P 500 ETF (SPLV) and the iShares MSCI USA Minimum Volatility ETF (USMV) were launched in 2011, and have $3.9 billion and $2 billion in assets, respectively.

If Vanguard has figured out how to make actively managed ETFs work, it should be sending shivers up the backs of the rest of the asset management industry because the last thing any of its competitors probably want to see is another avenue for the company to grow.

Vanguard's mutual funds and ETFs have had more than $90 billion in inflows through last month, according to Morningstar Inc.

That is 26% of all the dollars that have been invested into mutual funds and ETFs, and almost three times as many new dollars as BlackRock, second in inflows, has seen go into its mutual funds and iShares ETFs.

“Trends and factors continue to shift in Vanguard's favor,” Ms. King said.

Actively managed ETFs could just be the latest trend in Vanguard's favor.

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