During a February speech, Vanguard CEO Tim Buckley said 58% of most advisers' work could eventually be done by computers. This would force a significant change in pricing for most in the industry. Shortly thereafter, Vanguard announced it would create factor-based index ETFs. These two events are directly linked and help explain why one of the bastions of low-cost, passive index investing is now launching ETFs that are more expensive and active than the products that made them so successful.
Why the change?
Just two years ago, Vanguard Group launched its Personal Advisor Services, which offered clients a personal planner at an incredibly low cost. It was one way to increase revenues from clients. The service rapidly ballooned into one of the largest wealth management offerings in the nation. Now that it has successfully climbed vertically in the service stack, it makes sense for Vanguard to broaden its product offerings. Such a move provides the company with very tangible benefits.
1. Averting the race to zero. What Vanguard pioneered in low-cost index investing has radically altered the investment landscape, and we are in the midst of a race to zero. Competition keeps driving down the internal cost of index products and, by extension, all investments. At the current cost of 9 basis points, the average Vanguard ETF cost disclosed on its website, every additional drop of 1 basis point is a 12% reduction in revenue. Vanguard started the price war, and it needed a differentiated product to generate offsetting revenues. Factor-based index ETFs are its answer. The internal costs are about the same, but Vanguard can charge fees that are significantly higher (and far more profitable).
2. Broadening market share. While many investors appreciate the value of passive index investing, a broad swath of people want something more unique. Factor-based index solutions appeal to many folks, especially those who work with advisers. Funds and ETFs from firms like Dimensional Fund Advisors (the pioneer of factor-based investing) and BlackRock Inc. have grown successfully by positioning themselves as enhanced index alternatives. Vanguard has taken notice and wants access to those clients, either directly or through advisers.
3. Climbing up the value stack. It's no secret that Vanguard's foray into planning has been a massive success, reaching $100 billion in AUM in a couple of years. Providing an adviser and planning to clients for 30 basis points is an industry changer, but not very profitable. By adding a broader array of investment alternatives, Vanguard can offer services and strategies to clients in a way that competes directly with investment advisers. In addition, it makes higher margins from its investment solutions to subsidize its PAS cost structure.
Another assault on the independent adviser
This is a winning strategy for Vanguard, but it is also an addition to the long list of threats to the independent adviser. Many advisers believe they can beat Vanguard's offering because it is limited to passive indexes. Obviously, that's no longer true. Independent advisers who want to maintain their pricing will need to take on a three-pronged strategy:
1. Understand your clients better than anyone else. The one thing Vanguard will struggle to do is forge meaningful bonds with any of its clients. One of the biggest competitive advantages any adviser has is the ability to be deeply connected to his or her clients and be more responsive and specific to each client's needs. People's lives evolve and their needs change. It's very hard for a firm of Vanguard's size to match the kind of intimate knowledge and service an independent firm can provide.
2. Offer low-cost investment solutions augmented by highly specialized complementary strategies. Even though Vanguard is broadening its portfolio choices, the company is still constrained by its narrow suite of solutions. If clients want a laddered bond portfolio or a tax-managed index of individual stocks, they won't find it at Vanguard. People appreciate options tailored to their specific financial life goals. Independent advisers can craft bespoke investment solutions for their clients.
3. Provide specialized guidance and planning services. In order to provide scale and deliver low cost planning, Vanguard relies on unsophisticated planners and a simple, predictable set of circumstances. That will change as it brings on more financial planners. But in the meantime, the ability to deal with more complex situations that might transpire in a family's lifetime is still a potential competitive advantage for independent advisers.
Living in a world of co-opetition
Vanguard is looking both to augment its client solutions with more profitable products and appeal to independent advisers to use its funds. Whether you view Vanguard as a friend or a foe, don't make the mistake of ignoring its strategic shifts. Evolving your firm to provide a distinct and unique client experience is the best way to thrive regardless of where the industry goes.