By the turn of the twenty-first century, Vanguard Group had become the largest mutual fund family in the world, besting Fidelity Investments. While Fidelity was increasing its fund assets about 20 percent a year, Vanguard was growing at 33 percent. Fidelity advertised heavily, while Vanguard did practically no advertising, spending a mere $8 million for a few ads to get people to ask for prospectuses. The Kaufmann Fund, one-hundredth Vanguard's size, spent the same amount for advertising, and General Mills spent twice as much just to introduce a new cereal, Sunrise.[169]
What was Vanguard's secret? How wise is it with such a consumer product to spurn advertising? The answer lies in the vision and steadfastness of John C. Bogle, the founder and now retired chairman.
In 1950, as a junior at Princeton, Bogle was groping for a topic for his senior thesis. He wanted a topic that no one had written about in any serious academic paper. In December 1949 he had read an article in Fortune on mutual funds. At that time, all mutual funds were sold with sales commissions often 8 percent of the amount invested, and this was taken off the top as a front-end load. (This meant that if you invested $1,000, only $920 would be earning you money. Today we find no funds with a front-end load of more than 6.5 percent, so there has been some improvement.) In addition, these funds had high yearly overheads or expense ratios. As Bogle thought about this, he wondered why funds couldn't be bought without salespeople or brokers and their steep commissions, and whether growth could not be maximized by keeping overhead down.
Right after graduation he joined a tiny mutual fund, Wellington Management Company, and moved up rapidly. In 1965, at age 35, he became the chief executive.
Unwisely, he decided to merge with another firm, but the new partners turned out to be active managers, buying and selling with a vengeance, and generating high overhead costs. The relationship was incompatible with Bogle's beliefs, and in 1974 he was fired as chief executive.
He decided to go his own way and change the "very structure under which mutual funds operated" into a fund-distribution company mutually owned by shareholders. The idea came from his Princeton thesis, and included such heresies as "reduction of sales loads and management fees," and "giving investors a fair shake" as the rock on which the new enterprise would be built. He chose the name "Vanguard" for his new company after the great victory of Lord Nelson over Napoleon's fleet with his flagship, HMS Vanguard. Bogle launched the Vanguard Group of Investment Companies on September 26, 1974, and he hoped "that just as Nelson's fleet had come to dominate the seas during the Napoleonic wars, our new flagship would come to dominate the mutual fund sea."[170]
But success was long in coming. Bogle brought out the first index fund the next year, a fund based on the Standard & Poor's 500 Stock Price Index, and named it Vanguard 500 Index Fund. It was designed to mirror the market averages, and thus required minimal management decisions and costs. It flopped initially. Analysts publicly derided the idea, arguing that astute management could beat the averages every time, though they ignored the costs of high-priced money managers and frequent trading.
Twenty-five years later, this Vanguard flagship fund, which tracks the 500 stocks on the Standard & Poor's Index, had more than $92 billion in assets and had beat 86 percent of all actively managed stock funds in 1998, and an even higher percentage over the past decade. By early 2000 it overtook Fidelity's famed Magellan Fund as the largest mutual fund of all. The relative growth between Magellan and Vanguard's 500 Index for the five salient years of 1994 to 1999 is shown in Table 11.1.
Table 11.1. Relative Growth Comparisons of the Two Largest Mutual Funds, 1994–1999
Assets (millions $) | 5-Year Gain (Percent) | ||
|---|---|---|---|
6/30/94 | 6/30/99 | ||
Source: Company reports. | |||
Commentary: Especially notable is the tremendous growth of Vanguard's 500 Index Fund in these five years, growing from $8 billion in assets to over $92 billion. | |||
$33,179 | $97,594 | 194.2% | |
Vanguard 500 Index | 8,443 | 92,644 | 997.3 |
The Vanguard family of funds had become the world's largest no-load mutual fund group, with 12 million shareholders and $442 billion in assets as of the beginning of 1999. Fidelity, partly load and partly no-load, had nearly $700 billion, but the gap was closing fast.
A feature article in the February 8, 1999 issue of Forbes had this headline:
The Gospel According to Vanguard—How do you account for the explosive success of that strange business called Vanguard? Maybe it isn't really a business at all. It's a religion.[171]
Bogle's religion was low-cost investing and service to customers. He believed in funds being bought and not sold; thus, no loads or commissions to salespeople or brokers. Customers had to seek out and deal directly with Vanguard. The engine was frugality, with the investor-owner's best interests paramount. This was not advertised, not pasted on billboards, but the gospel was preached in thousands of letters to shareholders, editors, Securities & Exchange Commission members, and members of Congress. Bogle made many speeches, comments to the news media, appearances on such TV channels as CNBC, and wrote two best-selling books. With his gaunt face and raspy voice, he became the zealot for low-cost investing, and the major critic of money managers who trade frenetically, in the process running up costs and tax burdens for their investors. As the legions of loyal and enthusiastic clients grew, word-of-mouth from past experiences, and favorable mentions in business and consumer periodicals such as Forbes, Wall Street Journal, Money, and numerous daily newspapers, as well as TV stations, brought a ground swell of new and repeat business to Vanguard.
Bogle turned 70 in May 1999, and was forced to retire from Vanguard's board. The new chairman, John J. Brennan, 44, seemed imbued with the Bogle philosophy and vision. He said, "We're a small company, and we haven't begun to explore our opportunities, yet." He noted that there's Europe and Asia, to say nothing of the trillions of dollars held in non-Vanguard funds. "It's humbling."[172]
Each year Forbes presents "Mutual Funds Ratings" and "Best Buys." The Ratings lists the hundreds of mutual funds that are open-end, that is, can be bought and sold at current net asset prices. (Note: A far smaller number of mutuals are closed-end funds that have a fixed number of shares and are traded like stocks. These generally have higher annual expenses, yet sell at a discount from net asset value. We will disregard these in this case.)
The Best Buys are the select few funds that Forbes analysts judge to "invest wisely, spend frugally, and you get what you pay for," and that have performed best in shareholder returns over both up and down markets. Vanguard equity and bond funds dominate Forbes' Best Buys:
Of 43 U.S. equity funds listed in the various categories, 12 were Vanguard funds. Of 70 bond funds, 27 were Vanguard.[173]
Forbes explains that "the preponderance of Vanguard funds in our Best Buy Tables is a testament to the firm's cost controls. Higher expenses, for most other fund families, are like lead weights. Why carry them?"[174] Table 11.2 shows representative examples of the substantially lower expenses of Vanguard funds relative to others on the Best Buy list.[175]
Looking at total averages, the typical mutual fund has an expense ratio of 1.24 percent of assets annually. The ratio for Vanguard's 101 funds was 0.28 percent, almost a full percentage point lower.[176]
How does Vanguard achieve such a low expense ratio? We noted before its reluctance to advertise; nor does it have a mass sales force. Its commitment has been to pare costs to the absolute minimum. But there have been other economies.
Fidelity and Charles Schwab have opened numerous walk-in sales outposts. Certainly these bring more sales exposure to prospective customers. But are such sales-promotion efforts worth the cost? Vanguard decided not. It had one sales outpost in Philadelphia, but closed it to save money.
Vanguard discouraged day traders and other market timers from in-and-out trading of its funds. It even prohibited telephone switching on the Vanguard 500 Index; redemption orders had to come by mail. Why such market timing discouragement? Frequent redemptions run up transaction costs, and a flurry of sell orders might impose trading costs that would have to be borne by other shareholders if some holdings had to be sold.
Not the least of the economies is what Bogle calls passive investing, tracking the market rather than trying to actively manage the funds by trying to beat the market. The funds with the highest expense ratios are hedge funds, and these usually are the most active traders, with heavy buying and selling. They seldom beat the market, but squander a lot of money in the effort and burden shareholders with sizable capital gains taxes because of the flurry of transactions. Still, the common notion prevails that more is better, that the more expensive car or service must be better than its less expensive alternative. See the following Information Box for discussion of the price-quality perception.
Table 11.2. Comparative Expense Ratios of Representative Mutual Funds
Annual Expenses per $100 | |
|---|---|
Source: Company records as reported in Forbes Mutual Fund Guide, August 23, 1999. | |
Commentary: Vanguard's great cost advantage shows up very specifically here. It is not a slightly lower expense ratio, but is usually three or four times lower than similar funds. Take, for example, the category of Index Equity Funds, where the goal is to simply track the Index averages, which suggests passive management rather than free-wheeling buying and selling. Vanguard's costs are far below the other funds; in one case, the Gateway fund is five times higher. | |
Balanced Equity Funds: | |
Vanguard Wellington Fund | 0.31 |
Columbia Balanced Fund | 0.67 |
Janus Balanced Fund | 0.93 |
Ranier Balanced Portfolio | 1.19 |
Index Equity Funds: | |
Vanguard 500 Index | .18 |
T. Rowe Price Equity Index 500 | .40 |
Dreyfus S&P 500 Index | .50 |
1.02 | |
Municipal Long-Term Bonds: | |
Vanguard High Yield Tax Exempt | .20 |
Dreyfus Basic Muni Bond | .45 |
Strong High Yield Muni Bond | .66 |
High-Yield Corporate Bonds: | |
Vanguard High Yield Corp. | .29 |
Fidelity High Income | .75 |
Value Line Aggressive Income | .81 |
Ivesco High Yield | .86 |
Another factor also contributes to the great cost advantage of Vanguard. It is a mutual firm, organized as a nonprofit owned by its customers. Almost all other financial institutions, except TIAA-CREF (and we will discuss this shortly), have stock ownership with its heavy allegiance to profit maximization.
Many firms espouse a commitment to customer service. It is the popular thing to do, rather like motherhood, apple pie, and the flag. Unfortunately, pious platitudes do not always match reality. Vanguard's commitment to service seems to be more tangible.
Service to customers is often composed of the simple things. Such as just answering the phone promptly and courteously, or responding to mail quickly and completely, or giving complete and unbiased information. Vanguard's 2,000 phone representatives are ready to answer the phone by the fourth ring. During a market panic or on April 15, when the tax deadline stimulates many inquiries, CEO John Brennan brings a brigade of executives with him to help man the phones. Vanguard works to make its monthly statements to investors as complete and easy to understand as possible, and it leads the industry in this.
The philosophy of a customer-service commitment was espoused by Bogle. "Our primary goal: to serve, to the best of our ability, the human beings who are our clients. To serve them with candor, with integrity, and with fair dealing. To be the stewards of the assets they have entrusted to us. To treat them as we would like the stewards of our own assets to treat us."
In a talk he gave at Harvard Business School in December 1997, Bogle described to the students how "our focus on human beings had enabled Vanguard to become what at Harvard is called a 'service breakthrough company.' I challenged the students to find the term human beings in any book they had read on corporate strategy. As far as I know, none could meet the challenge. But 'human beingness' has been one of the keys to our development."[177]
Not the least of the consumer best interests has been a commitment to holding down taxable transactions for shareholders. Vanguard has led the industry with tax-managed funds aimed at minimizing the capital gains that confront most mutual fund investors to their dismay at the end of the year.
Why is Vanguard's low-expense approach not matched by competitors? All the other fund giants that sell primarily to the general public are for-profit companies. Are they willing to sacrifice profits to win back Vanguard converts? Hardly likely. Are they willing to reduce their hefty marketing and advertising expenditures? Again, hardly likely. Why? Because advertising, not word-of-mouth, is vital to their visibility and to seeking out customers.
One potential competitor looms, another low-cost fund contender. TIAA-CREF, which manages retirement money for teachers and researchers, in 1997 launched six no-load mutual funds that are now open to all investors. The funds' annual expenses range from 0.29 percent to 0.49 percent, comparable to Vanguard's. A significant potential attraction over Vanguard is that each fund's investment minimum is just $250, compared with Vanguard's usual minimum of $3,000. As of late August 1999, the combined assets of the six TIAA-CREF funds was $1.5 billion, far less, of course, than the near $500 billion of Vanguard at the time.
TIAA-CREF is also run solely for the benefit of its shareholders, being another mutual with the long-term aim of providing fund-management services at cost. Still, there is some doubt that expense ratios can be kept low should the new funds fail to attract enough investors.
Is this a gnat against the giant Vanguard? Perhaps; however, the low investment requirement of only $250 should certainly attract cost-conscious investors who cannot come up with the $3,000 that Vanguard requires on most of its funds. Still, six fund choices versus the more than 100 of Vanguard is not very attractive yet. Efforts to be as tax-efficient as Vanguard are also unknown.
The success of Vanguard with its disavowal of most traditional business strategies flies in the face of all that we have come to believe. It suggests that heavy advertising expenditures may at least be questioned as not always desirable—and what a heresy this is. It suggests that relying on word-of-mouth and whatever free publicity can be garnered may sometimes be preferable to advertising. All you need is a superior product or service. It supports the statement that textbooks like to shoot down: "If you build a better mousetrap, people will come." Conventional wisdom maintains that without advertising to get the message out, the better mousetrap will fade away from lack of buyer knowledge and interest. But the planning of Bogle and Vanguard to tread a different path and not be dissuaded, despite the critics, illustrates a remarkable and enduring commitment first formulated more than three decades ago.
How do we reconcile Vanguard with the commonly accepted notion that communication is essential to get products and services to customers (except perhaps when selling solely to the government or to a single customer)?
Maybe we should not try to fit Vanguard into these traditional beliefs. Maybe it is the exception, the anomaly, in its seeming repudiation of them. Still, let us not be too hasty in this judgment.
I do not believe that Vanguard contradicts traditional principles of business strategy. Rather, it has revealed another approach to the communication component: the effective use of word-of-mouth publicity. If we have a distinctive product that can be tangibly demonstrated as superior in relative cost advantages to competitors, then demand may be stimulated without mass advertising. Word-of-mouth, enhanced or developed through formal publicity—from media, public appearances, and publications—can replace massive advertising expenditures of competitors. But is there a downside to all this? Let us examine the role of word-of-mouth in more detail in the following Information Box.
Vanguard illustrates a commendable application of one important business strategy principle: the desirability of uniqueness or product differentiation. It differentiated itself from competitors in two respects: (1) its resolve and ability to bring out a low-priced product and at the same time one of good quality, and (2) its achievement of good customer service despite the low price.
Even today, after several decades of competitors seeing this highly effective strategy, Vanguard still is virtually unmatched in its uniqueness, except for one newcomer that is hardly a contender, but could be a factor should Vanguard let down its guard and be tempted to seek more profits.
Is it likely that Vanguard can continue its success pattern without increasing advertising and other costs and becoming more like its competitors? Why should it change? It has become a giant with its low-cost strategy. The last decade saw a growing momentum created by favorable word-of-mouth and publicity that made the need for heavy advertising and selling efforts far less than in the early years. It took bravery, or audacity, in those early years not to succumb to the Lorelei beguilement that advertising and commission selling was the only viable strategy. Something would be lost if Vanguard were to change its strategy and uniqueness and become a higher-cost imitation of its competitors.
If Vanguard is so good, why are so many investors still doing business with the higher-cost competitors? We can identify four groups of consumers who are not customers of Vanguard:
Those who have not studied the statistics and editorials of publications like Forbes, Money, and Wall Street Journal, and are not aware of the Vanguard advantage.
Those who are naive in investing and content to let someone else—a broker or a banker—advise them and reap the commissions.
Those who are swayed by the massive advertisements of firms like Fidelity, Dreyfus, Rowe Price, and others.
Those who put their faith in the price-quality perception: the higher the price, the higher the quality, with quality guaranteeing higher investor returns.
In addition to continued investments by its ardent customers, Vanguard should find potential in the gradual eroding of the commitment of these four consumer groups. Of course, the overseas markets also offer a huge and virtually untapped potential for Vanguard.
Invitation for Your own Analysis and Conclusions
You do not have to agree with Bogle's planning strategy. Playing the devil's advocate, persuasively present another perspective. (You may want to do some research on American Funds.
In the new millennium, several shifts in the relative positions of the major players in the mutual fund industry were taking place. By 2005, the assets of the three largest fund houses and their percent change from 2000 were:
Assets ($ billion): | 2000 | 2005 | Percent Change |
|---|---|---|---|
Vanguard | $448.3 | $747.1 | 67% |
American | 333.2 | 714.4 | 114 |
Fidelity | 569.3 | 629.7 | 11 |
As you can see, Vanguard had forged to the top, easily surpassing Fidelity. But American Funds was charging fast, more than doubling its assets, and seeming likely to soon overtake Vanguard as the largest mutual fund family. What is there about American that makes it so appealing to investors?
American Funds is a complete opposite of Vanguard is almost all respects. Its funds try to beat the market by being actively managed with, of course, the higher expenses coming from this. Adding to the costs, it is distributed through brokers who love to sell the American family of funds because of a nice 5.75 percent sales commission. It does no advertising (similar to Vanguard in this), and its stock pickers shun the limelight and appear on no TV chat shows. CEO Paul Haaga scorns the self-proclaimed virtues of arch-rival Vanguard. He refers to Bogle as "a saint with his own statue." Unlike most funds that have a chief stock-picking manager, with American it is difficult to know who is selecting specific stocks because each fund has as many as eight managers, all seemingly equal. So, who is an investor to blame for a poor performance? Still, American's biggest funds have mostly done better than the S&P 500, and this performance along with eager broker recommendations have lured investors. However, skeptics point to academic studies of the difficulty of beating the market over long periods, especially as funds get larger. Vanguard doesn't have to worry about this, because many of its assets are in index funds that aim only to match the market.
A harbinger that beating the market for American may be becoming more difficult were recent asset figures for the largest equity funds. As of July 31, 2006, the equity assets (i.e., stock only) of Vanguard were $532.7 billion. Fidelity was next with $444.7 billion, while American with only 29 funds was third at $386.3. Matching Forbes Best Buys recommendations, described earlier for 1999 with those of 2006, Vanguard stock funds had 25% of the recommendations in 2006—slightly below 1999—but its bond funds recommendations were 49% for 2006, well above 1999 figures.[178]
In July 2009, the Vanguard Wellington Fund celebrated its 80th birthday. It was the seventh fund ever launched and the first balanced fund holding both stocks and bonds. It still shows no signs of age, surpassing all its older competitors with $40 billion assets. The fund was named Wellington after the English duke who defeated Napoleon at the battle of Waterloo.[179]
"The success of Vanguard is due to media exploitation of what would other-wise be a very ordinary firm." Discuss.
Why do you think people continue to buy front-end load mutual funds with 5–6 percent commission fees when there are numerous no-load funds tobe had?
Do you think Bogle's shunning advertising was really a success, or was it a mistake?
Was Vanguard's failure to open walk-in sales outposts a mistake and an example of misplaced frugality? Why or why not?
What are the differences in passive and active fund management? How significant are they?
"Vanguard seems too good. There must be a downside." Discuss.
What is a service breakthrough company?
Can publicity ever take the place of massive advertising expenditures?
You are an executive assistant to John Brennan, the new CEO of Vanguard now that Bogle has retired. Brennan is thinking of judiciously adding some marketing and advertising expenditures to the paucity that Bogle had insisted on. He has directed you to draw up a position paper on the merits of adding some advertising and even some walk-in sales outposts such as other big competitors have already done. (You may be instructed to make a cost/benefit analysis, which is described in a box in Chapter 16.)
You are John Brennan, CEO. It is 2009, and TIAA-CREF is turning out to be a formidable competitor, and is gaining fast on your first-place position in the industry. What actions would you take, and why? Discuss all ramifications of these actions that you can think of?
You are a member of the board of directors of Vanguard. John Bogle is approaching the retirement age as set forth in the company policies. However, he wants to continue as chairman of the board, even though he is willing to let Brennan assume active management. Debate the issue of whether to force Bogle to step down or bow to his wishes.
Debate Bogle's no-advertising policy.
Is Vanguard still No. 1 in the mutual fund industry? Has it increased its advertising expenditures? Has Brennan made any substantial changes? What ever happened to Fidelity's Magellan Fund in the 1990s and before? How is TIAA-CREF doing? How is American Funds doing?
[169] Thomas Easton, "The Gospel According to Vanguard," Forbes, February 8, 1999, p. 115.
[170] John C. Bogle, Common Sense on Mutual Funds, New York: Wiley, 1999, pp. 402–403.
[171] Easton, p. 115.
[172] Easton, p. 117.
[173] Forbes, August 23, 1999, pp. 128, 136–137.
[174] Ibid., p. 136.
[175] Ibid., pp. 128, 137.
[176] Easton, p. 116.
[177] Bogle, pp. 423, 424.
[178] "Fund Survey: Family Counseling," Forbes, September 18, 2006, p. 186, and 188–189. Also used in this update: Michael Maiello, "The Un-Vanguard," Forbes, September 19, 2005, pp. 182–185; and "How the Largest Funds Fared," Wall Street Journal, December 4, 2006, p. R6.
[179] Sam Mamudi, "At 80, Willington Still Going Strong," Wall Street Journal, July 9, 2009, p. C3.