17

THE WINDS OF CHANGE: THE VANGUARD EXPERIMENT IN INTERNALIZED MANAGEMENT

FBA-CCH Conference
on Mutual Funds and Investment Management
San Diego, California
March 12, 1975

I AM MOST PLEASED to have this opportunity to appear before this meeting of the Federal Bar Association, and to talk about something that is truly unique in the mutual fund industry: the restructuring of one of the pioneer mutual fund groups in a manner designed to give the Funds corporate independence and self-sufficiency, and the ability to obtain investment advisory and distribution services under terms which are negotiated at arm's length. From a business standpoint, we have done something useful, novel, and exciting; from an independent standpoint, we have something that is clearly designed to serve our shareholder; and from a legal standpoint, we have, in a real sense, converted the theoretical letter of the Investment Company Act of 1940 into the real spirit of this statute.

Wellington Fund, the original member of our Fund Group, was founded in 1928—just short of a half century ago. With the other ten Funds that were added during the ensuing years, our Group's assets presently aggregate $1.7 billion. For a large and established complex, we have taken a giant step. And you might ask “why?”

I will try to answer that key question definitively today, for there are, we believe, many good solid business and philosophical reasons behind our actions. But at the outset, I must frankly acknowledge that our new structure was born of corporate conflict. In January, 1974, our Fund directors were faced with this situation: The Funds’ Management Company had replaced its chief executive, who also served as the Funds’ chief executive. This situation compelled the directors to examine all of the courses of action that were open to them. I propose to say no more about this corporate background, except to emphasize that it provided only the precipitating issue. The underlying issue—involving the fundamental relationship between the Funds and those who serve them—is much more important, and it is this issue that I will deal with in depth today. Specifically, I want to cover six areas involved in our restructuring:

1. The mandate from the Fund Directors;
2. The concept of internal management;
3. The timetable for implementation;
4. The challenges we faced;
5. The opportunities our new structure holds;
6. The implications for the industry.

1. The Mandate

Faced with the fait accompli I have noted, the Fund independent directors (8 of the 11 Board members, and essentially the same for each Fund) made some prompt decisions. They made them solely with a view to serving the interests of the Fund shareholders, and I think it is fair to say that they were assiduous in their efforts, incredibly diligent, and, as a result, are probably among the best-informed and most knowledgeable group of directors in the entire mutual fund industry today. The independent directors decided, first, to constitute themselves as a working group, assuming primary responsibility for resolving the issues facing the Funds; second, to hire independent legal counsel to advise them; third, to continue their own chief executive in office, at least for an interim period; and fourth, to give him a mandate.

The mandate I received, as the Funds’ chief executive, was to undertake a definitive study of how our Fund Group could best be organized to obtain the highest quality administrative, investment advisory, and distribution services at the lowest reasonable cost. This was a substantial project: a review of the past, an analysis of the present, and an appraisal of the future. It required an exhaustive study—ultimately encompassing five volumes (perhaps 300 pages in all)—of financial data, performance and distribution results, organizational and personnel specifications, legal and regulatory aspects, and plans and projections. (The Management Company, of course, also prepared a substantial amount of material of its own for the Fund directors.) If it would be premature at best to characterize our study as an industry landmark, it in fact proved to be just that for our organization. Our “Future Structure Study,” as it came to be called, may be seen as the outgrowth of one of the basic issues facing the mutual fund industry: What structure would provide the optimum means for a major fund group to meet the challenges of today and capitalize on the opportunities of tomorrow?

The Directors requested that our Future Structure Study cover all the options available to them. It occurred to us, of course, that was a lot of options, and the number was quickly reduced to seven. They ranged from Option 1—the status quo (meaning the standard structure in the fund industry, with a management company totally responsible for all fund activities)—all the way over to Option 7, starting anew by terminating the existing advisory and distribution contracts, and having the Funds form their own organization exclusively to serve all of their needs.

However, the most serious consideration was given to what we defined as Options 2, 3, and 4:

Option 2, of course, was the option ultimately adopted. In July, the Fund Directors formally decided to internalize Fund corporate management and administrative activities, and to retain Wellington Management Company as investment adviser and distributor for the Funds. Their decision to take this unprecedented step was not an easy one. If some see it as a conservative step, in view of the other options available, I can only say that the decision reflected an honest judgment that the Fund shareholders would be best served not only by the intrinsic merit of the arrangement itself, but by the relative simplicity of the step, the likelihood of quick regulatory approval, and the maintenance of the existing Fund officers and staff, and the existing organization of the adviser and distributor. Further, it is often good judgment to take small steps, when the issues are novel and complex.

2. The Concept

The adoption of Option 2—the Funds assuming control of all their administrative activities—was based on one crystal clear concept: Independence. The Fund Directors wanted to be independent of those who provided them with the services they required—not just independence for its own sake, but for the sake of the shareholders they serve. This concept rests on the conviction that the quality and efficiency of these services can best be maintained if the Funds are clients, rather than creatures or captives, of the adviser and distributor. Here is how we defined “independence,” quoting excerpts from our application to the SEC that I will later discuss:

If independence was relatively easy to define, defining administration was more of a challenge. That is to say, exactly what functions would the Funds assume for themselves? The Directors ultimately decided the Funds would have their own executive officers, who would assume full responsibility for these functions:

1. Financial, including accounting, budget, and control
2. Legal and compliance
3. Operational, including shareholder account maintenance and custodianship
4. Shareholder reporting and communications
5. Monitoring and planning, including the evaluation of all services externally provided to the Funds
6. Any additional services the Funds may request

These responsibilities will be assumed by a Fund staff of approximately 60 persons—now fully in place—who will be compensated exclusively by the Funds, who will have no economic interest in the adviser, and who, in the last analysis, will have their professional careers tied to the Funds.

Perhaps a reasonable way of viewing the scope of the Fund staff's responsibilities is to look at the financial dimensions, based on 1975 pro forma estimates:

This total compares with about $6,500,000 of investment advisory fees estimated to be paid by the Funds in 1975 under the revised advisory contracts that were agreed to. The basis of the agreement was that the Funds’ achievement of the real—but highly intangible—benefits of independence should be accompanied by tangible savings to shareholders. The net result was to reduce Fund management fees by about $1,045,000 (based on net assets on July 31, 1974), representing $621,000 of costs to be assumed from the management company (the Funds were, of course, already bearing most of the costs outlined above), plus $424,000 of savings to Fund shareholders. These savings were an implicit recognition that, as the management company's responsibilities to the Funds were reduced, it was both fair and appropriate to provide for a commensurate reduction in its profits.

Having determined the conceptual, operational, and financial steps required to bring the Funds to an independent and self-sufficient posture, we then had to decide on the optimum structure for our complex. To optimize operational efficiency and economy in dealing with the 11 separate Funds that comprise our Group, we decided to create a new corporation—we call it a service company—to carry out the Funds’ affairs. It will be owned entirely by the Funds. It will have essentially the same officers and directors as the Funds themselves, will directly employ all members of the staff, and will provide to the Funds the services earlier outlined. A service contract defines the Funds’ relationship with the service company; provides for its initial capitalization of $300,000 and subsequent changes; spells out the services to be provided to the Funds and the basis for cost allocation; and specifies the basis on which Funds may join the Group. Most importantly, the service company provides its services to the Funds at cost, on a non-profit basis. The service company is, in sum, simply the vehicle through which the Funds carry out their individual and collective activities.

The concept of a service company also enabled us to deal with another difficult business and conceptual issue: how to collectively identify our Fund Group. Our problem here was rather unique, since our Funds do not have a common name (e.g., Dreyfus, Fidelity, Eaton & Howard, etc.), a situation that developed from a court decision (Taussig v. Wellington) that, in essence, gave Wellington Fund exclusive rights to the name “Wellington” in the investment company, as distinct from investment advisory, field. Even putting aside this question, it seemed somehow inappropriate under our newly achieved independence to continue referring to “The Wellington Group of Investment Companies,” when it was hardly clear whether “Wellington” referred to Wellington Fund or Wellington Management Company. So we decided to develop a new name for the service company, and also to use that name as the means of collectively identifying the Funds. The name we chose was Vanguard—The Vanguard Group for the service company, The Vanguard Group of Investment Companies as the identifier for the funds collectively. Perhaps it goes without saying that the principal reason for our name selection is that we believe our new structure indeed places us “in the forefront” of this changing industry.

A final word on our concept of internal management. It contemplates that the Funds (through Vanguard) are (1) directly responsible for the performance, at cost, of all administrative services required by the Funds in carrying out their corporate business and financial affairs, and (2) ultimately responsible, through a continuous process of monitoring and evaluation, for the performance of all investment advisory, distribution, and other services provided to the Funds by external organizations, and for assuring that these services are provided at reasonable cost. As I have noted, the Funds decided to retain Wellington Management Company as adviser and distributor, under contracts with revised terms and conditions. Interestingly, the revisions required were small in number, with the major one (other than the fee reduction) being the simple deletion of the adviser's responsibility under the previous management contract “to administer the affairs of the Fund,” limiting the new responsibility solely “to managing the investment of the assets of the Fund.”

3. The Timetable

Let us now turn briefly to the timetable involved in this restructuring. Following the decision by the Board in late July to adopt an internal management structure, it took most of August and September to turn our concept into a tangible plan (functions, staff, structure, fees, name, etc.). In particular, the renegotiations of the financial terms of the Fund advisory agreements was no small task, for two reasons: (1) to assure the independence of each individual Fund, we decided to abandon the “complex-wide” element of our existing fee structure (under which approximately one-half of each Fund's fee was based on the aggregate assets of all of the Funds in our Group) and have each Fund's fee stand on its own; (2) to assure that our restructuring provided financial benefits (in the form of demonstrable cost savings) to each Fund, we had to examine literally dozens of fee schedules, expense allocation formulas, and asset projections. We ultimately agreed upon a sliding scale of advisory fees beginning at .445% on the first $250 million of assets and declining to .10% on assets in excess of $700 million.

On October 4, we filed our application with the SEC, essentially to obtain several required exemptions from Section 17(b) of the Investment Company Act of 1940. These exemptions were required to allow the Funds to engage in a “joint transaction”—the formation, capitalization, and ownership of the service company—and to permit the Funds to purchase the certain furniture and fixtures from the Management Company, for approximately $60,000. The creation of the service company enabled us to face the joint transaction issue squarely. However, it is interesting to speculate as to whether an SEC application would have been necessary if no assets were purchased from the Management Company, and if, rather than determining to carry out the Funds’ activities through a service company, we had simply determined to have each Fund staffed by its own employees, who would also serve all of the other Funds.

Proceeding the way we did, however, enabled us to make a definitive articulation of our position as being “consistent with the provisions, policies and purposes of the Act”—particularly with respect to fostering the operation and management of investment companies in the interests of their shareholders rather than other (Section 1(b)(2)), the duty to evaluate investment advisory and principal underwriting contracts (Section 15), and the fiduciary duty sections (36(a) and (b)).

On January 17, 1975, the SEC acted on our application, releasing without comment our documents for public notice. They asked no change or amendment whatever, a remarkable tribute to our lawyers, who had no boilerplate to copy from in this unprecedented arrangement. During the ensuing notice period, there was no request for a public hearing, and the SEC determined not to order one. Hence, on February 18, our application was approved, with the SEC finding “on the basis of the information stated,” that our proposed transaction is “reasonable and fair and does not involve overreaching on the part of any person concerned, and consistent with the policies of the Funds and the general purposes of the Act.”

Our Fund proxies, providing for the formation and operation of Vanguard, and submitting revised advisory agreements to shareholders, were cleared by the SEC last week. Proxy solicitation will ensue immediately, with our annual meetings scheduled during the last three weeks of April. If all works according to plan, and we have every reason to assume it will, the new contracts will be approved, the new corporation will get under way, and Vanguard group will be handling the Funds’ affairs on May 1, 1975.

4. The Challenges

If I have oversimplified the development of the Vanguard concept, or if I have understated the complexity of its implementation and the length of time it took, one thing is clear: internalizing a fund group's management is a substantial undertaking with a set of risks, costs, and challenges that should not be underestimated. Lest you consider taking this step unaware of the consequences, let me summarize them briefly:

• Perhaps the events which precipitated our restructuring made us particularly susceptible to the challenge of public relations. The press loves controversy and will inevitably personalize conflict to the extent possible. Our restructuring was, to a degree, therefore conducted in a “goldfish bowl.” With the financial press covering rather fully the executive changes, the deliberations of the directors, the restructuring announcement, the SEC filing and approval, the Vanguard name, and so on. It would have been better to deal with these matters with a lower profile, but one's span of control only goes so far.
• As a result of this publicity, we attempted to track the impact of the restructuring on our Fund sales and liquidations. It is my conviction that the impact on liquidations was no more than normal (e.g., our liquidations remained at approximately industrywide levels), and the impact on new share sales was moderately negative (e.g., a decline in market share slightly greater than what might have been anticipated, based on other known factors).
• Organizational change is another important factor. Internal management means that, in general, the Fund staff members assume new full-time responsibilities and with them new attitudes. Some of their relationships with previous associates may take on an adversary (hopefully not an antagonistic) character; and the executives and staff of the adviser will inevitably reflect some uncertainty about the change. Positive and open communications can allay these transitional problems. But I would not underestimate the advantages to the Funds in having experienced people in place to do the job; intimate knowledge of how all of the Fund management, advisory, and distribution affairs are conducted is most valuable.
• This experience and knowledge play a key role not only in establishing the new structure and in forming the new organization, but in the real arm's length negotiation that is involved both in defining operational responsibilities and in establishing new financial terms. I can only say that until one gets into such a negotiation—with respect to fee rates, allocation of expenses, etc.—one cannot be fully aware of the multiplicity of issues that exist.
• Another challenge is preparing the compilation of data for Fund directors to review and evaluate the proposed new advisory and distribution agreements. In our Directors’ Annual Review—1975, we had to make not only definitive and complex studies of investment and distribution performance, and of comparative management fees and expense ratios, but also of comparative investment advisory fees, recognizing that the new contracts are of the advisory, not the management, variety. Suffice it to say that such studies must be scrupulously fair and objective.
• Finally, a word about State expense ratio guarantees. An external advisory firm, newly independent, will doubtless raise the question as to why it, any more than, for example, the Fund's transfer agent or custodian, should guarantee the Fund's expense ratio. If that question is far less complex than its answer, it must nevertheless be answered. This is one loose end we have not yet dealt with definitively.

In sum, the challenges—and I have only had time to highlight them here—are numerous, complex, and worthy of your consideration.

5. The Opportunities

If I had to identify the single key opportunity in our new structure, it would be that the Vanguard Group concept should be good for shareholders. Our Fund Group will now have its own staff, with an eye solely to the interests of the shareholders, without conflict of interest, divided loyalties, or the lure of other business activities. Our duty is to make sure that the Funds’ interests come first and that they are well served. Now I recognize that is a generality, and a pretty glittering one at that. But it can be translated into some rather clear specific advantages:

1. The Incentive for Performance. The Fund shareholders can be confident that, if the adviser fails to provide satisfactory performance, he faces the same risk faced by any adviser to any large institutional client. In this sense, all of the advisory fees paid by the Funds are, in the finest sense, incentive fees. And we hope this incentive in itself will help to enhance the investment results realized by our shareholders.
2. Sophisticated Quantitative Evaluation of Performance. The Fund staff will apply the same rigorous, sophisticated—and sometimes technical—standards of performance evaluation, fairly and objectively, that any major institution uses in evaluating its advisers. The ability to monitor results soundly is, as you know, beyond the capability of all but the most sophisticated investors.
3. Quality of Advisory Service. The shareholder can also be sure the Fund staff is carefully monitoring and evaluating the adequacy, competence, and quality of the people who comprise the staff of the adviser and distributor, to ensure that the Funds are receiving the services for which they have contracted.
4. Fund Policies Consistent with Fund Objectives. The Fund staff will also be in a position to see that each Fund's investment program is consistent with the Fund's policies and objectives, as spelled out in the prospectus.
5. Fair and Competitive Expense Ratios. Our Fund contracts have been negotiated at arm's length; not only as to the amount of advisory fee, but also as to the allocation of expenses as between Fund and adviser—clearly, a very important area. This negotiation, as I mentioned, has already laid the groundwork for a significant reduction in Fund expenses.
6. Shareholder Reports: Objectivity and Perspective. The shareholder will receive Fund reports that will “tell it as it is,” with candor and fairness. If results are good, we will say so; and if they are not, we will be equally candid. In short, our reports will be written from the perspective of the shareholder.
7. Encouragement of Distribution Activities. The Fund Group will be in a position to encourage distribution activities. A good cash inflow should be in the interest of Fund shareholders, for our Fund Group expenses are relatively fixed, and thus become lower in ratio as assets increase; our investment advisory fees do the same, by reason of the scaling down under our new fee schedule.
8. New Funds and the Negotiation Process. The formation of new funds—their objectives, markets, cost structure—has a particular advantage under the Vanguard concept. These funds must be valid in purpose, sound in their objectives, and with reasonable expenses. An analysis of the prospectus of our new money market fund, for example, shows particularly attractive advisory fee and expense provisions.

In total, then, our structure is designed to provide clear and specific advantages to the Funds and to their shareholders, present and future. At the same time, most of the advantages are presently only theoretical. They must be turned into practical advantages if we are to successfully capitalize on the opportunities our new structure provides.

6. Implications for the Industry

It is difficult to be certain what implications, if any, the new Vanguard concept has for the mutual fund industry. If the background for our change was unique, it is nonetheless easy to identify a number of perfectly valid reasons why other Fund complexes might want to consider some form of internal management:

• Organizational pressures, arising from legitimate but major differences of opinion between a fund group and its management company about executive leadership, business issues, or performance evaluation
• Financial pressures, ranging from a management company's lack of earnings viability to capital inadequacy for the company or its parent
• Legal pressures, including private litigation, conformance with federal law and SEC regulation, etc.
• Or, most hopefully of all, an enlightened sense of self-interest about the optimal structure for the conduct of the Fund Group's activities

In an industry as traditionally imaginative as this one, perhaps the Vanguard concept will spark other—and perhaps even better—structural innovations to deal with the issues I have discussed today. After all, our concept is similar to that of Union Service Corporation, which is owned by the Broad Street Fund Group, and has carried out all of those Funds’ activities throughout its history. If we elected not to go as far as Union Service, we have gone a good bit beyond the steps earlier taken by the Investors Mutual Group (which has its own President, independent of, although paid by, its management company) and by the Putnam Group (which recently named a Vice Chairman with a small staff to assume responsibility for representing the Funds’ interests).

The principal impact of our Group's declaration of independence is, as I have noted, to make the Funds clients of the adviser rather than its creatures, a clear parallel to the investment counsel field. This would seem to be the direction in which the Putnam and Investors Groups are also heading. On the other hand—like many a large pension plan (U.S. Steel, for example), university endowment fund (Harvard), and private foundation (Ford)—the Broad Street Group has placed its emphasis on in-house investment advice. It is difficult to find fault with their investment results, and almost impossible to argue with their low expense ratios. In any event, there are numerous precedents and parallels in the field of institutional money management for what we at Vanguard have done, and for what others may do.

The direction in which our industry will move, further, may depend importantly on the outcome of a number of concerns that we intend to come to grips with sooner rather than later. Three of these, in particular, may have industry implications, and I will conclude by reviewing them.

One is the objective of giving the Fund Group a clear identity in the shareholders’ minds. In our case, we want to make it clear that Vanguard is a cooperative undertaking of a family of funds with common management; that its function is to provide investors with a broad range of financial management services at the minimum reasonable cost; that its staff is concerned solely with the interests of the shareholders. This “identity” problem is a real one for any group which restructures. In our case, it is exacerbated to a degree by our need to create a new name.

The second item is the question of financing fund distribution activities. It is no secret that, at present, mutual fund distribution activities rarely produce self-sustaining sales revenues. If sales activities are to be maintained, then, the only resource remaining to support them is management fees. In our case, the issue becomes especially clear, for there are no administrative fees or functions encompassed in our purely investment advisory contracts. I believe that it is better in the long run to face this issue squarely than to avoid it, and we will soon be working toward separate pricing of investment advisory and distribution services. To clarify this issue, we need look only to the Broad Street Funds, which already have an asset charge for distribution services, and to some of the joint bank–mutual fund products, in which an investment adviser may receive one-fourth of the total management fee, with an administrator/distributor receiving the remaining three-fourths to pay administrative and sales costs. These practices, of course, seem to conflict with SEC policy as expressed in the 1972 Statement of the Future Structure of the Securities Markets and reaffirmed in a 1974 letter to the Axe-Houghton Funds:

Nonetheless, I believe separate pricing will prove to be both good law and good economics, and will ultimately enable our Fund directors to judge the investment adviser's and distributor's services separately, rather than jointly.

The third concern that has industrywide implications is the development of a structure that provides the best possible investment advisory services to shareholders. The internally managed fund group, calling on the services of an established professional investment counsel organization, is a new approach to this question. We believe it will enhance the probabilities of attaining performance excellence for each of our funds, measured against other institutional accounts with similar investment objectives. We intend to give our adviser the maximum of cooperation and support in our attempt to meet this goal. But there are a variety of other organizational forms in existence also seeking the same goal, so we will be continuously evaluating the accuracy of our basic judgment, as well as continuously monitoring how other institutional accounts are providing for the delivery of investment advisory services, and the results that they obtain.

The Winds of Change

Let me close by emphasizing this: The winds of change are blowing in the mutual fund industry. The business, economic, legal, structural, philosophical, and ethical challenges are great. Perhaps, in the last analysis, the principal implication of the Vanguard concept is not that it is the only, or even the best, way to deal with these challenges, but that it is an early signal that major structural change is in the air. Bob Dylan tells us, “You don't need a weatherman to know which way the wind blows.” That is true. But while they will be strong and gusty, we believe that the winds of change are blowing in our direction.