Vanguard's Embarrassment of Riches and Risk

Despite its warnings, customers keep piling into bonds

Vanguard Chairman and Chief Executive John J. Brennan couldn't resist interrupting. As he does routinely, Brennan was listening in on customer calls one day in early October. A woman in her late 30s wanted to move all of her 401(k) money from equities into bond funds. Taking over from the Vanguard rep, Brennan asked her why. Did she know she could lose money on bonds? No. In 15 minutes, Brennan persuaded her to keep her money where it was. "It's a classic example of a young person capitulating on stocks," he frets. "People are moving emotionally toward bonds."

The incident encapsulates Valley Forge (Pa.)-based Vanguard's dilemma. Almost three years into a fierce bear market for stocks, the bond rush is manna from heaven for the largest U.S. mutual-fund company. Investors poured $34 billion net of withdrawals into Vanguard Group Inc. funds in the first nine months of 2002--two-thirds of it into bond funds, according to Boston-based Financial Research Corp. If the trend holds, Vanguard will draw in more new funds than any other fund family this year--the sixth time in the past seven years.

Yet Brennan fears the flight to bond funds could easily end in tears for some investors. "It's no different than stocks in 1999," he says. "The risk is disappointment and surprise. I hate having an investor get surprised." It's not an idle concern: A recent Vanguard poll showed that 70% of respondents didn't know that if interest rates rise, bond prices fall, and vice versa. So the firm's Web site now warns of "irrational exuberance" in bonds. In a personal posting, Brennan cautions that investors who have moved entirely into bonds since March, 2000, are "investing by looking in a rearview mirror, andprobably moved to bonds too late to get the returns they were seeking."

A bond shock to investor confidence could also deal a setback to Brennan. "[It] could hurt [Vanguard's] image, its reputation, and its relationship with clients," says William Dougherty, president of investment adviser Kanon Bloch Carre. That's because Brennan wants to deepen Vanguard's ties to customers by broadening its services without losing what most appeals to its investors--its low-cost, low-hype style. Vanguard funds charge an average of 0.3% of assets, vs. 0.99% for Fidelity Investments, according to Morningstar data, because fund customers--who want low fees--own the company.

Brennan needs happy customers since his goal is to make Vanguard their main financial-services company. He has wrestled with expansion since 1996, when he took over as CEO from Vanguard founder John C. Bogle, the high priest of low-cost index investing. Brennan has built up the company's 401(k) management business and expanded Vanguard's offerings to include a series of exchange-traded funds in 2001--much to the chagrin of Bogle, who believes they encourage unnecessary trading.

It's been a slow process. In May, Brennan shelved plans for a high-fee private-equity fund for wealthy investors after failing to raise enough money. It wasn't until October that he rolled out a cash-management account that gives investors who have $250,000 or more at Vanguard free checking and a Visa gold check card, a high-end debit card. Brennan says his next big push will be to improve Vanguard's limited financial planning and advice options. "People who come to us for advice bring us a lot more assets," Brennan says.

Right now, Vanguard is sitting pretty--and not just because it's cheap. After all, other discount financial-services companies, such as online broker Ameritrade Holding Corp. (AMTD ), are struggling with low volumes. The big difference is that Vanguard still has a significant reservoir of customer goodwill because it didn't hype its business and tried to contain investors' expectations during the boom. That's why Vanguard's equity funds still had $12 billion in net inflows this year through September, down from $13 billion in the same period last year, but in marked contrast to the billions flowing out of many funds. "This type of environment is perfect for Vanguard," says Daniel P. Wiener, editor of newsletter Independent Adviser for Vanguard Investors. The question for Brennan is whether it will be too much of a good thing.

By Amy Barrett in Valley Forge, Pa.

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