Vanguard fights to stay out in front

F. William McNabb II is nervous. His firm, The Vanguard Group Inc., has been on a run lately

F. William McNabb II is nervous. His firm, The Vanguard Group Inc., has been on a run lately. This year, it unseated Fidelity Investments as the biggest U.S. mutual fund company, hitting $1.3 trillion in assets.

Vanguard’s share of the U.S. exchange-traded-fund market — which it entered in 2001, a few years after competitors Barclays Global Investors (now part of BlackRock Inc.) and State Street Global Advisors — is now 14.9%, up from just 5.3% in 2006, according to a report by The Goldman Sachs Group Inc.

But all of this success actually makes Vanguard’s chief executive anxious.

“It makes me nervous more than anything,” he said. “We have 25 million accounts and 10 million households represented. It’s an extraordinary number of people who have said, “We trust you to do the right thing for us,’ and it can keep you up at night.”

The challenge for Vanguard is to maintain momentum once the markets pick up again. Low-cost index funds are great in low-return environments, said Dan Wiener, editor of the newsletter Independent Adviser for Vanguard Investors, but what happens when active managers start doing well again?

And as other fund behemoths — such as American Funds — have learned, today’s darling among advisers can become yesterday’s news with a blink of an eye.

LOSING CACHET

On the ETF front, Vanguard has relied largely on being the lowest-cost provider, but it is losing cachet in that regard, said Scott Burns, an analyst at Morningstar Inc. Vanguard has long trumpeted the lowest-cost ETFs — with a total operating expenses averaging 0.18%. In June, however, Charles Schwab & Co. Inc. reduced expenses on its ETFs to undercut Vanguard.

“They have been a leader on cost, but the thing about low cost is that it’s becoming a commodity,” Mr. Burns said.

Mr. McNabb believes that the firm’s ability to offer both passive and actively managed mutual funds at the lowest cost possible will continue to give the firm an edge.

“There are guys who put out extraordinary numbers for long periods of time, and if you can identify those individuals, then good for you, but it’s very difficult to do,” Mr. McNabb said. “We think we give our active managers a huge tail wind in terms of the costs.”

Mr. McNabb cited a recent Morningstar study showing that low-cost funds tend to outperform high-cost ones. And with unemployment expected to hover close to 10%, investors will be looking for low-cost options for some time, he said. “If you are in a 14% annual return environment like we were in the 1990s, people will pay an extra [half a percentage point] and not care, but in a 7% annual return environment, that’s a huge part of your return,” he said. “This is a great opportunity for us because we intend to relentlessly pursue ways to reduce costs for people so that they can keep more of their returns.”

Vanguard’s growth in assets has enabled it to continue to lower costs. In October, the firm lowered account balance minimums for most retail clients to $10,000 for its broad-market stock and bond index funds, and to $50,000 for most of its actively managed stock and bond funds. The minimums had been $100,000 in each case.

Under the change, 2 million more customers now qualify to buy the firm’s Admiral Shares, which have expenses ranging from 0.07% to 0.41%, almost half the cost of the firm’s investor shares.

In November, Vanguard eliminated the investment minimums for its institutional-class Signal Shares to make those funds more accessible to financial advisers and smaller institutional clients. The minimums had been $1 million to $5 million, depending on the account type.

But while low cost may be the mantra Vanguard’s marketers and sales staff are repeating on the mutual fund side, with ETFs, they are trying to focus advisers more on the funds’ other attributes, such as their ability to track its indexes.

“Yes, our products are always at the lowest costs, but more importantly, we have a better track record,” said Martha Papariello, a Vanguard principal who heads financial adviser services. “Even if the expense ratio gap [between Vanguard and competitors] was eliminated, we are still tracking our indices better than anyone else.”

For example, for the 12-month period through Sept. 30, Vanguard’s Emerging Markets ETF (VWO), which tracks the MSCI Emerging Markets Index, had a tracking error of 5.27%, compared with 6.92% for BlackRock’s iShares MSCI Emerging Markets ETF (EEM), according to Morningstar.

For the one-, three- and five-year periods ended Oct. 31, the iShares fund’s return was 24.61%, -3.78% and 13.82%, respectively, while the Vanguard fund posted returns of 26.31%, -4.6% and 14.33%, according to Morningstar data provided by Vanguard.

That track record has caused financial advisers such as Richard Romey, president of ETF Portfolio Solutions Inc., to switch from the iShares fund to Vanguard’s.

“For us, tracking error is a key component,” he said. Five years ago, ETF Portfolio Solutions was using 11 different iShares ETFs, but now it uses five from iShares and six from Vanguard.

Next year, Vanguard plans to step up the amount of research and support it provides advisers, Ms. Papariello said.

The firm is adding to its 100-person sales staff “substantially,” she said, declining to say by how much for competitive reasons.

Additionally, Vanguard is planning to start providing advisers with some of the research and services that it offers its retirement plan and consultant clients, Ms. Papariello said.

“We have spent the past few years gaining the trust of advisers, and now that we are there, we can expand on those relationships,” she said.

A TEACHING MOMENT

Specifically, Vanguard sees a huge opportunity to help advisers gain a better understanding of the retirement plan market. “Whether it’s helping them understand more how retirement plans work or more specifically using some of the well-informed people we have here like Ann Combs [a former assistant secretary of labor who headed the Employee Benefits Security Administration] to help advisers, we can do that,” she said.

What Vanguard will not do is get into the practice management “value added” services that some competitors are offering, Ms. Papariello said.

“You won’t see us going out there with a piece on helping advisers retire,” she said. “What experience do we have on that? There are consultants that do that for a living, and I am not buying the idea that advisers really want that.”

Instead, Vanguard is looking to help advisers customize their portfolios. Vanguard does model portfolios with some clients but is looking to expand it to more advisers, Ms. Papariello said.

“Many wirehouses are looking for third parties to do these programs instead of doing them in-house,” she said.

‘STRONGER SUPPORT’

In terms of new ETFs, Vanguard doesn’t have any big plans but may add an ETF here and there, Mr. McNabb said. “Advisers should expect stronger support from the educational standpoint,” he said.

The fact that Vanguard doesn’t plan to double its ETF lineup is exactly what advisers want to hear. “I would be worried if I saw them starting to grow too fast,” Mr. Romey said. “They just need to focus on what they do best, which is to offer low-cost index-based ETFs that track their indices closely.”

E-mail Jessica Toonkel at [email protected].