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Vanguard Takes Aim at U.K. as Fees Replace Commissions

Vanguard Founder Jack Bogle
Since the mid-1970s, Vanguard founder Jack Bogle has been telling investors that most active managers can’t beat the market consistently and that low-cost funds that mimic benchmarks instead of trying to beat them will outperform in the long run. Photographer: Scott Eells/Bloomberg

Vanguard Group Inc. rose to the top of the U.S. mutual fund industry by preaching the merits of cheap index-tracking funds. Now it wants to convert U.K. investors as that country enacts new rules that may lower fund costs that are among the highest in the developed world.

The firm is seeking to expand its less than 1 percent share of the 629 billion pound ($998 billion) market in the U.K. by more aggressively courting financial advisers, who control much of the country’s fund distribution, and striking deals to make its products more broadly available. Vanguard last month won access to the 13,000 U.K. advisers who use Cofunds, a platform with 45 billion pounds under administration.

Vanguard, which is owned by its fund investors and passes on cost savings to them, is seeking to take advantage of changes next year that will ban advisers from accepting commissions from asset managers and require them to charge clearly delineated fees. The Valley Forge, Pennsylvania-based firm, which controls 17 percent of the U.S. market for long-term funds, is lagging behind U.S.-based rivals such as BlackRock Inc., the world’s biggest money manager, in expanding abroad.

“There’s an opportunity for Vanguard, but there are other players who are better known and already are competing aggressively on price,” Jason Hollands, managing director of London-based Bestinvest Brokers Ltd., an advisory firm that oversees 4 billion pounds for clients, said in a telephone interview.

‘Different Topsoil’

Vanguard’s experience will test whether the 38-year-old firm can expand an international business that accounts for 6 percent of its $2.2 trillion in assets. The company, which overtook longtime leader Fidelity Investments two years ago at home as fund buyers flocked to passively managed products, is short on history and name recognition in Britain, where it started selling index funds in 2009.

“It is not easy for a brand to put down roots in different topsoil,” Nancy Koehn, a professor at the Harvard Business School, said in a telephone interview from Boston. “How do you build trust when you are starting anew?”

The Financial Services Authority, the U.K.’s fund regulator, is responsible for the new rules known as the Retail Distribution Review, or RDR. The rules, completed in March 2010 and set to take effect Jan. 1, are designed to give consumers access to unbiased advice and to promote competition in the fund industry. Advisers in the U.K. will be paid by customers in exchange for the guidance they offer, while brokers can accept commissions from fund managers so long as they don’t provide investment advice.

Higher Expenses

The cost of investing in British funds is higher than anywhere in the developed world aside from Scandinavia and Canada, according to academic research published by the Review of Financial Studies in 2009. The average British mutual fund charged 2.21 percent of its clients’ assets in annual expenses, compared with 1.04 percent in the U.S.

Consumer advocates including Gareth Shaw blame the higher prices on an opaque fee structure that makes it hard for investors to make fair comparisons and a commission system that rewards advisers for selling products rather serving clients.

By separating all the elements that go into fees and banning commissions, the new rules “will put the power back into the hands of customers,” said Shaw, a financial specialist at Which?, a London-based consumer organization.

Greater transparency will trigger more price competition and heightened interest in funds that seek to duplicate the returns of benchmarks such as the FTSE All-Share Index, he said. The average annual fee on U.K. active equity mutual funds -- whose managers try to outperform indexes by selecting which stocks to buy and sell -- is 1.68 percent of assets, versus 61 basis points for equity index funds, according to data from Chicago-based Morningstar Inc. A basis point equals one hundredth of a percentage point.

‘Pretty Confident’

“We are pretty confident our business model will play here,” Thomas Rampulla, head of Vanguard’s European operations, said in a telephone interview from London.

Vanguard became the largest U.S. mutual-fund company on the strength of its index funds and exchange-traded funds. Since the mid-1970s, Vanguard founder Jack Bogle, 83, has been telling investors that most active managers can’t beat the market consistently and that low-cost funds that mimic benchmarks instead of trying to beat them will outperform in the long run.

Vanguard funds in the U.S., including those that are actively run, charge an average fee of 16 basis points, compared with 79 basis points for the industry, data from Denver-based Lipper show.

U.S. Experience

Because Vanguard had so much room to grow at home as indexing took hold, the company was slow to move overseas, Chief Executive Officer F. William McNabb said in an April interview at the firm’s Valley Forge, Pennsylvania headquarters. The international business will “be an important pillar” in the coming decade, said McNabb.

At New York-based BlackRock, 40 percent of assets were outside the Americas as of Dec. 31, according to data compiled by Bloomberg. At San Mateo, California-based Franklin Resources Inc., non-U.S. assets were 34 percent as of Sept. 30, company data show.

Britain’s rule change may create an opening for Vanguard, said Rampulla, who sold products to U.S. financial advisers before moving to London four years ago.

As American advisers abandoned commissions in favor of asset-based fees over the past decade, they became more sensitive to the costs they were passing on to clients and in the process, turned into better customers for Vanguard, he said. Vanguard’s assets managed for U.S. advisers rose to $620 billion as of Sept. 30 from $260 billion at the end of 2007, company data show.

‘Good Value’

“We were a good value proposition,” Rampulla said.

In the U.K., winning over advisers is critical because the market is more adviser-driven than in the U.S., he said. “There is very little direct business.”

Mutual-fund sales by intermediaries such as financial advisers and wealth managers are about six times greater than direct sales to consumers, according to the Investment Management Association, the industry’s lobbying group.

Vanguard has already won converts. Alan Smith became a customer in 2010 when he and his colleagues soured on stock pickers after the global financial crisis.

“We couldn’t find a compelling reason to remain exposed to active funds” said Smith, CEO of Capital Asset Management, a London-based wealth-management firm that oversees 125 million pounds, 40 percent of it with Vanguard.

James Norton, whose London-based Evolve Financial Planning Ltd. manages 200 million pounds, including Vanguard funds, said passive investing in the U.K. is growing.

Lesser Known

Index funds, known as trackers in the U.K., represent about 7 percent of the British market for mutual funds, according to the Investment Management Association, about half their share in the U.S.

“When advisers aren’t getting paid commission, I think more of them will take a look at the likes of Vanguard,” Norton said in a telephone interview.

Vanguard had 3.1 billion pounds in British mutual funds as of Sept. 30, according to Morningstar data.

That compares with about 40 billion pounds for Atlanta-based Invesco Ltd., 32 billion pounds for BlackRock and 28 billion pounds for New York-based Bank of New York Mellon Corp. The largest fund provider by assets is M&G Securities Ltd., the fund management unit of London-based Prudential Plc, which is the U.K.’s biggest insurer.

“The more savvy investment advisers have heard of Vanguard, but the majority of people still don’t know the name,” Norton said.

Lacking ‘Advantage’

Vanguard’s biggest British index fund, the 556 million pound Vanguard FTSE UK Equity Index Fund, ranks 22nd in size among the country’s index funds, Morningstar data show.

Price competition has intensified because of Vanguard’s entry into the market, said Christopher Traulsen, director of Morningstar’s fund research in Europe. London-based HSBC Holdings Plc dropped the expenses on its index funds by as much 88 percent within a week after Vanguard’s arrival in the country, Traulsen said in a June 2009 article headlined “The Vanguard Effect.”

Vanguard now has a modest price edge over most peers, Traulsen said in a telephone interview. Its fund that tracks the FTSE Index charges 15 basis points, compared with 21 basis points for the larger BlackRock fund and 30 basis points for the Fidelity MoneyBuilder U.K. Index Fund, Bloomberg data show. The Royal London FTSE 350 Tracker Fund charges 12 basis points.

Distribution Deals

“Vanguard is lacking in competitive advantage,” said Ben Yearsley, head of investment research for direct investing at Charles Stanley Group Plc, a London-based firm that oversees 15 billion pounds.

Vanguard’s Rampulla isn’t discouraged. He said the firm’s unusual structure -- it is owned by the investors in its funds - - will resonate with the public.

Because the company refused to pay commissions, Vanguard products originally weren’t offered by most advisers or platforms that distribute funds, Rampulla said. That’s changing as commissions vanish.

“We are no longer going to be fishing in just a small part of the pond,” he said.

Similar deals to the Cofunds distribution agreement may be announced before year-end, Rampulla said. As the rule change nears, the company is running an educational program for advisers that lets them know how their counterparts in the U.S. and Australia have coped with the transition to a world without commissions.

No Guarantee

Vanguard wasn’t an overnight success in the U.S., said Ben Johnson, Morningstar’s director of passive research in Europe and Asia.

“It was a process that was decades in the making,” Johnson, Morningstar’s director of passive research in Europe and Asia, said in a telephone interview.

Vanguard’s limited name recognition and the lack of a prominent “evangelist” like Bogle in the U.K. advocating for index funds makes it likely the firm’s progress will be gradual, Johnson said.

“It is not a guarantee they will succeed, but over the long term, the odds are in their favor,” he said.

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