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That's Why They Call It Vanguard

Finance: Mutual Funds

That's Why They Call It Vanguard

It pioneered index funds--and now it's outpacing its rivals

Four years ago, the no-frills Vanguard 500 Index Fund nearly doubled its assets, to $17.3 billion, swelled by a 37% annual return and $4.7 billion in new cash. At the time, then Vanguard Group Chairman John C. Bogle expressed some concern. The fund, which had operated in obscurity for 20 years, had become the darling of the day. "I'm a little worried that the index fund is hot," he said. "Hot is not our style."

Well, if the index fund--which tracks Standard & Poor's 500-stock index--was hot then, it's absolutely sizzling now. And building on the success of the S&P and other spin-off index funds, Vanguard--the nation's largest mutual-fund company after No. 1 Fidelity Investments--has become the hottest mutual-fund firm.HOT BOND FUNDS. In the fund business, cash follows performance, and last year boatloads of money put in at Vanguard's Valley Forge (Pa.) dock. Vanguard's equity funds took in an estimated $27.2 billion--about 17% of the industry's cash inflow--in the first 11 months of 1998, according to Robert L. Adler, whose AMG Data Services tracks flows to mutual funds. It's also 22.5% greater than Vanguard's equity cash inflow for all of 1997. It's also remarkable, considering that cash flows to equity funds fell 26% industrywide from January, 1998, to November, according to the Investment Company Institute.

As investors scan 1998 results in coming weeks, Vanguard is going to look even more appealing, and the cash heading toward the now $74.2 billion Vanguard 500 Index fund should surge. But it's not just index funds that will attract new money. Adler says only about a third of 1998's cash went to indexed portfolios. Nonindex Vanguard funds, such as Windsor II, Health Care, Growth & Income, and Primecap took in significant new dollars in 1998. Vanguard's actively managed funds are certainly top-tier performers when compared with other large mutual-fund companies (table).

The Vanguard bond funds, where the company's obsessive attention to keeping expenses low really pays off, are on a roll as well. They garnered about $16.8 billion in new cash in the first 11 months of 1998--about twice the sum for all of 1997. It's also nearly one in four dollars that went into bond funds industrywide. Vanguard's best-selling bond fund of the year? You guessed it. One of its bond-market index funds.PENNY-PINCHING. So Vanguard is the hot fund manager? That's a bit ironic, since the index funds are by definition not managed, at least not by highly compensated portfolio managers. Most of the work is automated and performed by computers. Extremely low costs--Vanguard 500 Index levies no sales charges and has expenses that are about one-eighth that of the average mutual fund--are one reason why the penny-pinching Bogle early on pushed into indexing. The rest of the industry ignored it, believing that investors would never settle for just "average" (page 108).

Those averages have turned out to be downright spectacular--and few competitors have been able to beat them. During 1998, even with a backdrop of global economic instability, the S&P 500 earned a 28.58% total return. Only 17% of actively managed, U.S. diversified equity funds were able to clear that hurdle, according to Morningstar Inc. Now, nearly all the major fund companies offer S&P 500 index funds as well. "You only have to look at the index funds that have started elsewhere to know that Vanguard is having an impact on the industry," says Vanguard watcher Daniel P. Wiener, editor of the Independent Adviser for Vanguard Investors. But only a few do it with equally low expenses, and most would prefer that investors opt for the higher-margin, actively managed funds.

To be sure, Vanguard is not about to catch archrival Fidelity, but it is closing the gap. As of Nov. 30, Vanguard commands $428.4 billion, or 8.83% of all mutual-fund assets, vs. Fidelity's $613.4 billion, or 12.65%, according to Financial Research Corp. In 1994, Vanguard was also the second-largest fund company, but then it had only 6.47% of industry assets, compared with Fidelity's 12.55% (chart, page 86).

Sometime this year, Vanguard is expected to take Fidelity's long-held crown as manager of the largest equity fund: The Vanguard 500 Index fund could overtake the $83.6 billion Fidelity Magellan Fund. Magellan will not cede the title lightly. In 1998, the giant gained an index-busting 33.2%.

But Fidelity won't be able to rely on Magellan's winning ways to lure in new bucks. As part of a management overhaul, the Boston-based giant closed the fund to new investors. And despite strong returns by many of its funds in 1998, Fidelity's actively managed equity funds took in only an estimated $2 billion, says Fidelity watcher David J. O'Leary of Alpha Equity Research. That's a pittance compared with Fidelity's glory years, and it is way less than the $5.1 billion that O'Leary says flowed into Fidelity's index funds. Still, Fidelity is bound to be a tougher competitor this year, as the good news about improved returns gets around and bad news about weak returns, management turmoil, and fund managers' personal trading fades away.NEW NET SERVICES. Vanguard's success comes not so much because of any recent initiatives that the company has taken, but because market forces came around to what the company has been doing for years. Still, under the leadership of Chairman and Chief Executive John J. Brennan, Bogle's longtime right-hand man who succeeded him as CEO three years ago, Vanguard has started to adapt to the changing investment environment.

Most notably, in recent months Vanguard has given a higher profile to its discount brokerage arm, Vanguard Brokerage Services, extending its trading services to the Internet in a service called Access VBS. As part of that expansion, Vanguard has boosted to 2,000, from 400, the number of mutual funds that it makes available through the service--all of them from Vanguard's competitors.

That puts Vanguard in a better position to compete with the mutual-fund supermarkets that are operated by Charles Schwab & Co. and Fidelity Brokerage Services. And it's a new leaf under Brennan; Bogle was a critic of the supermarkets, complaining that they encouraged bad investment habits, such as short-term trading. "Brennan has decided the relationship Vanguard enjoys with its clients is vital, even if it has to be in the position of offering non-Vanguard products," says Burton J. Greenwald, a consultant to the mutual-fund industry. "Vanguard doesn't want its customers to look to Schwab, Fidelity, or Merrill Lynch as their primary supplier of financial services."UNIQUE CORPORATE STRUCTURE. One area where Vanguard will always have an edge is on costs. Besides cultivating a cost-cutting culture, parent Vanguard Group has a corporate structure that's unique in the mutual-fund industry. It's organized like a mutual insurance company, with the shares in the parent owned by the funds themselves. Thus, the parent doesn't look to make a profit but to service the funds at cost. All the other major mutual-fund companies, both public and private, have shareholders who are looking to earn a profit on running funds. Perhaps that's why, despite the success of Vanguard, it has not had any noticeable impact on expenses industrywide, which have been climbing in recent years (table, page 83). True, Fidelity's expense ratios have dropped, but that's mainly because some of its mutual funds have performance-based fees, and with their returns lagging, they have paid management fees at a reduced rate.

Vanguard itself would be the first to tell you the S&P 500 index fund is no magic bullet. It only looks that way because of a long cycle in which large-cap stocks trounced small- and mid-caps, and thus S&P 500 index funds beat the portfolio managers. Should the market's preferences change, the S&P 500 index funds might pale. But lean and mean Vanguard has plenty of other funds, both index and actively managed, to take up the slack.By Amy Barrett in Philadelphia and Jeffrey M. Laderman in New YorkReturn to top

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