Can Vanguard Become Too Big?

Only a few years ago, the top three fund families in the U.S. were nearly identical in size. Not any more. With about $2.3 trillion in assets, Vanguard is now nearly as large as its next two competitors combined: Fidelity Investments and American Funds. Over the past three years, Vanguard has grown steadily while both Fidelity Investments and American Funds have experienced net outflows.

Advisors must now consider two key questions: Will Vanguard further dominate the mutual fund and ETF industries? And, if so, is that good for investors?


First, a little backstory. The Vanguard Group was founded by John Bogle in 1974, after he was fired as chairman of Wellington Management. He created a distinctive corporate structure for the new firm: a not-for-profit mutual fund company owned by its funds, which in turn are owned by their shareholders. By removing the demand for profits, this structure has given Vanguard a sustainable competitive advantage.

Over the next few years, Vanguard debuted a few other innovations that would ultimately be key to its success: creating the first index mutual fund in 1976, switching from a broker distribution system to a no-load system in 1977, and developing a defined-maturity bond fund strategy, also that year.

Success did not come easily; in the first five years, investors pulled out 36% of the firm's initial total assets. But Bogle's crusade for low costs and indexing eventually caught on; by the turn of the 21st century, Vanguard was the No. 2 player, behind Fidelity.

At this point, Vanguard made another move that would prove fortuitous. With ETF growth surging, Vanguard chose to enter the ETF space, competing with iShares (owned by Barclays Bank then and BlackRock now) and State Street. Both Fidelity and American Funds chose to stay out of ETFs, although Fidelity has recently offered them.

Vanguard then gained a key strategic advantage by making its ETFs a different share class of its mutual funds - and then patenting its method, preventing competitors from gaining the same economies of scale. The cost advantages from both scale and the ability to sell at cost yielded an average ETF annual expense ratio of 0.13% versus 0.61% for the industry as of the end of 2013, according to Lipper.


Investors have taken notice. By the end of 2013, Vanguard controlled nearly 18% of the long-term fund market, which excludes money market funds - the highest share any fund company has achieved in the mutual fund industry's history. Note that this measure is for fund assets only and does not include other brokerage assets at Fidelity or other firms.

The shift, says Morningstar fund analyst Michael Rawson, is largely due to investor frustration with active management and high costs. Over the past decade, money has flowed out of actively managed equity funds and into index funds (which account for 64% of Vanguard's total assets, the company says. Morningstar's work has shown conclusively that costs are predictive of returns, Rawson says: "The less you pay, the more you keep."

Although Rawson declines to give any specific estimates, he predicts that Vanguard's share will continue to grow. And Vanguard's lower costs and the large economies of scale in the index business provide the company with sustainable competitive advantages, he says.

Other prominent advisors, including financial theorist William Bernstein and Rick Ferri of Portfolio Solutions, say they envision Vanguard with a 30% to 40% market share by 2030.

Bogle himself - who no longer has an active role in Vanguard management, but is president of the Vanguard-funded Bogle Financial Markets Research Center - says he thinks gaining a percentage point a year of market share will be difficult to sustain; he offers a "best guess" of a 25% share in 2030.

Vanguard executives shy away from making forecasts, but the company is investing heavily in infrastructure, says Michael Miller, managing director of the company's planning and development group. "We want to have the capability to support an asset base of $5 trillion to $10 trillion" - two to four times the current level - "in the future," Miller says. "Not doing so would be irresponsible, given our history," he adds.


Competition is generally good for consumers, so if Vanguard becomes so dominant that it weakens the competitive landscape, should investors (and advisors) begin to worry?

Morningstar's Rawson sees Vanguard's continued growth as being generally good for investors, as larger scale tends to lead to lower costs. He does note, however, that any firm that becomes too large and unwieldy poses a systemic risk.

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