If Vanguard Group founder John Bogle knew back in 1974 that Vanguard would become the juggernaut it is, would he have done things differently?
The president of Bogle Financial Markets Research Center — located on Vanguard’s campus and often described as his personal think tank — sat down to discuss the business strategy behind the top U.S. mutual fund company. Also on the agenda: the value of trust in financial services and what he would have done differently, in hindsight. (This is part 3 of a series. Read part 1 and part 2.)
Q: Vanguard's business model gets compared to that of a nonprofit, with the firm running its index funds and ETFs at cost and any profit either reinvested into the business or returned to clients in the form of lower costs. What was the reasoning?
We pay no taxes as a mutual fund company, and we’re owned indirectly by the shareholders of the fund and directly by the funds themselves — shares of Vanguard are held by each of our funds in proportion to their share of assets. For example, if a given fund represents 10% of our asset base, that fund is going to own 10% of Vanguard. We rebalance it every year. That means each fund is going to bear more or less of the firm’s costs depending on its size.
If a fund accounts for 10% of our assets, that fund will also pick up about 10% of our expenses. When we get to the end of the year, if our expenses (Vanguard’s revenue stream) are $3.8 billion (about 0.19% of $2 trillion), the funds divide those costs up. Since the costs of our peers’ average around 1.00%, our investors save about 0.81%, or $16 billion annually. Since that return, in effect, goes to the shareholders, there are no retained earnings to be taxed.
It's a winning strategy, and it has to be a winning strategy — because, on average, all investors are even before costs, so the one who can deliver the goods at the lowest cost will win.
The nice thing about it in the investment business, which I don't think people have thought enough about, is that value is known — you can measure your value and your returns. You'll get the value of the stock market and take out cost, and whichever costs least will give you the most. In other areas — take a Mercedes Benz or a bottle of Budweiser or anything else -- you know exactly what the cost is but you have no idea what the real value is. How much do you pay for that machine when you buy a Mercedes and how much do you pay for prestige and looks?
Q: Aren't some consumers willing to pay more for trust?
You can do any survey you want, Cogent Research for example, and they’re going to say we're the most trusted company in this business.
Q: Why don't more money management companies follow Vanguard's lead?
Because they want to make money for themselves and for their owners. Forty of the 50 largest mutual fund companies are either publicly owned or owned by and large by financial conglomerates. And when they come into this business they are seeking what every capitalist firm seeks — to increase the return of their own capital.
If they pay a billion dollars to buy a mutual fund management company, they're going to take $150 million a year out in profit, no matter what. If the management of the place doesn't generate the $150 million or 15% return on that capital, they will get new managers who can! It's easy to do. They’re in business to make money on their capital.
But essentially Vanguard is only in business to make money on our fund shareholders’ capital. And therein lies a world of difference.
Q: So why does this strategy work for Vanguard?
We have the highest market share in the history of the industry — 18% of long-term assets, excluding money market funds. If you include everything we're probably at 16 — no one has ever had that high of a market share before. Ever.
When you do the math, you realize that the low-cost provider will win in this business, because most firms don’t really want to be the low-cost provider. On some level they would like to be, but Mr. Johnson up in Boston is not going to give away his family's $25 billion in the management company to be a hero for his clients. And a new entrant into the business is not going to buy a company for a billion dollars and then say, We're going to mutualize it.
Q: Could other companies do it?
The only hope for mutualization — and I’ve tried twice to get firms to mutualize and failed — is to get an existing mutual fund group to tell the manager that they've fed at the trough long enough, and now it’s time to mutualize the company. All the people in the company will stay in place. You can pay them all more because the entrepreneurs will take out nothing, so it’s going to be very difficult to do.
My thought was that if we had a really big bear market, a really big firm that suffers terrible performance — and gets into a lot of legal and regulatory trouble — would be a good candidate for the so-called independent fund directors to say “that’s it.” And that would be Putnam Investments.
But I talked to them about it and it turns out their so-called independent chairman was the former head of investments for Marsh & McLennan, the company that then owned them. As I said in my book: When the chairman stopped returning my phone calls, I figured I hadn't made the sale.
Q: You have talked about the role of your values in founding Vanguard. Are you religious?
Vaguely. I am not so hot on organized religion. My religion is slipping a lot even though my faith is increasing. I like the fundamental tenets — do unto others as you would have them do unto you, try to be a good citizen, do what’s right for the people around you.
But you have to understand that when I created Vanguard’s mutual structure back in 1974, I had no idea it would grow this large. If we weren't the low-cost provider, we certainly wouldn't be anywhere near $2 trillion. And we'd probably have more competition on the index front.
Q: If you could go back to 1974, would you do anything differently?
In terms of the structure of the company, no. In terms of the kind of funds that I was responsible for, no.
In terms of changing the nature of the bond industry in the long-, intermediate- and short-term — we started the defined maturity series that changed the industry overnight — no. I wouldn't change any of those.
In terms of using multiple advisors for our funds, I would not change that. The more advisors you have for a given fund, the more they will prove to be average. If you have seven or eight advisors, the fund will be average before costs, and with the low expenses on actively managed funds that we have at Vanguard, above average after costs — probably by 1.5% per year. That’s about a cumulative 20% over every 10 years just by being average.
So no, I would not change any of those things.
But: Would I have thought more about our management structure, would I have thought more about the people? The answer is yes. You never know what individuals will do as they get beyond their work and acquire power, and how they will handle power. So I would have done many of those things differently.
Q: Where is there opportunity now for new players in the industry?
ETFs are where all the new entrants are. That’s because it’s one of the greatest marketing ideas of the 21st century, certainly the greatest idea so far.
But the data are proving that ETFs are a long, long way from the best innovation for investors — because they jump back and forth between funds.
Q: Why are active managers convinced of their superior long-term performance, despite evidence to the contrary?
Well maybe they don't think about it. There’s a great quote from Upton Sinclair, which I’m paraphrasing: it’s amazing how difficult it is for a man to understand something when he's paid a small fortune not to understand it.