By Michael Rawson, CFA
Vanguard continued to dominate the fund industry in 2013. Through the first 11 months, the firm raked in $117 billion of long-term mutual fund and ETF assets compared with $425 billion for the industry. Vanguard has finished first or second in terms of flows in all but two of the past 20 years. This has allowed the firm to increase its market share to 18% from just 8% two decades ago and places it well ahead of rivals Fidelity and American Funds, both of which have lost market share over the past five years.
Vanguard's success can be attributed to three interrelated factors, the most important of which is the increasing acceptance of passive investment strategies. Vanguard is widely credited with having popularized index investing, starting with the launch of the first public index fund in 1976. At the time, the concept of index investing, which strives to meet market averages, was labeled un-American. But over the past five years, active U.S. equity funds have seen outflows of $395 billion while their passive counterparts have attracted inflows of $349 billion, more than half of which have accrued to Vanguard. Vanguard has a dominant 44% market share of all passively managed assets, and more than twice the assets of the second-largest manager of passive fund assets, iShares.
The second factor behind Vanguard's success is its cost advantage. Vanguard's asset-weighted average expense ratio of just 0.15% is well below the 0.68% asset-weighted expense ratio of the industry overall and lower than that of Fidelity (0.67%), American Funds (0.74%), and iShares (0.33%). Part of this cost advantage stems from Vanguard's focus on broad market-cap-weighted index products, which tend to have lower expenses than actively managed or niche index funds. Vanguard's scale also helps because it can spread fixed costs over a larger asset base than its competitors and pass the savings on to investors. Its at-cost pricing strategy gives it an additional edge. Vanguard is structured as a mutually owned organization, so an owner of one of Vanguard's funds is also an owner of Vanguard itself. As a result, Vanguard has an incentive to keep costs low. This business model works well in an industry where costs and performance are inversely related.
Finally, the nature of fund distribution is changing. Disintermediation and the move from defined-benefit to defined-contribution plans means that more investors are going the direct route and managing their own portfolios. For those not inclined to manage their own money, advisors are increasingly adopting a fee-only compensation structure and are moving away from commissions. As a result, more assets are showing up in lower-cost and no-load fund share classes, such as institutional share classes, while fewer assets are being directed toward load-based share classes. Vanguard caters to the direct distribution channel and fee-only advisors. ETFs have only accelerated these changes. While Vanguard was not an early entrant into the ETF industry, it has made up for lost time, with its hybrid mutual fund-ETF fund structure that combines the tax advantage of the ETF structure with the benefits of the scale of the firm's mutual funds.
A Hybrid Approach
Nearly all Vanguard index mutual funds have both a mutual fund and an ETF share class. Both share classes draw upon the same pool of assets and belong to the same fund. Vanguard's mutual fund investors benefit from an additional avenue for tax efficiency through the ETF creation and redemption mechanism. ETF investors benefit from the scale and experience of Vanguard's mutual funds.
The only potential drawback falls to the ETF investor. If a fund has predominately mutual fund shareholders and many of those investors sell after a rising market, it could force the fund to pay out a capital gain, which would also hit the ETF investors. Although this has indeed happened, it is more likely to occur in niche funds, such as Vanguard Extended Duration Treasury Index (VEDTX), than in one of Vanguard's core products. We feel the potential threat that mutual fund shareholders are going to sell a fund after a steep runup and leave ETF shareholders left with capital gains is remote. On average, investors are lousy market-timers: They tend to buy after prices have run up and sell during market downturns, when most capital gains have long since passed.
Despite its past success and enviable market position, Vanguard made several bold changes in 2013 that should continue to put pressure on rivals. Vanguard implemented an index switch to several equity funds in order to further reduce costs. Index licensing fees are one of the largest components of the cost of running an index fund. Because most traditional equity indexes with similar style mandates have similar performance, this focus on costs was prudent. Vanguard effectively managed the index changes without forcing a capital gains distribution. A full list of Vanguard's index fund lineup, share classes, and 2013 changes can be found here.
Vanguard also introduced admiral share classes for several index funds and eliminated investment minimums on several admiral share classes for financial advisors. For most core funds, admiral share classes now cost the same as the ETF share classes. This makes the choice between picking the admiral share or the ETF share class largely one of personal preference. The admiral share class allows investors to transact at end of day net asset value. The ETF share class offers intraday liquidity and has no investment minimum. However, it may trade at slight premiums or discounts to NAV and introduces a bid-ask spread.
For retail investors, reaching Admiral pricing still requires a $100,000 minimum in some noncore, satellite funds such as sector funds. In addition, Admiral shares are not available on all of Vanguard's ETFs, so investors interested in these funds must choose either higher-cost Investor shares or higher-investment-minimum Institutional shares.
Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.