The Vanguard Advantage
Vanguard Chairman and CEO John J. Brennan says he gets no pleasure watching investors withdraw billions of dollars from scandal-tainted mutual-fund families such as Janus Capital Group Inc. (JNS ) and Putnam Investments Inc. (PEYAX ) "I don't want to dance on the graves of my competitors," he says.
But there has to be some revelry behind the scenes at Vanguard Group Inc., the nation's second-largest fund family, with $690 billion in assets under management. Since the mutual-fund probe became public in September, inflows into Vanguard funds have soared by $13.5 billion, according to estimates from AMG Data Services in Arcata, Calif. That makes no-load Vanguard the second-most-popular fund family for new money behind broker-sold American Funds, which attracted an estimated $16 billion in the same period. In total assets, Vanguard is second only to Fidelity Investments, which has $954 billion.
Still, Brennan concedes that it's a challenging time to be in the fund business. There's more scrutiny of fund complexes. Legislators are looking into areas where regulators traditionally rule the roost. A focus on transparency and disclosure will force many firms to change their ways, including Vanguard, considered one of the most open and shareholder-friendly of the big firms.
UNIQUE BUSINESS MODEL. Like all the major mutual-fund companies, Vanguard has had to supply data about market-timing, late trading, and other practices to the Securities & Exchange Commission. But there hasn't been a hint of any wrongdoing at the firm.
Of course, the SEC probe isn't over, but Vanguard has long had policies in place that regulators are now forcing on others. Case in point: Fair-value pricing has been standard at Vanguard for 20 years. That's a procedure in which securities are repriced after the stock exchange closes to reflect significant market events. The failure to do so at many other fund companies led to market-timing practices that are now under regulatory scrutiny. And market-timers? Vanguard discourages it by booting frequent traders from the funds.
On the contentious issue of expenses, Vanguard is on the side of the angels. Its funds are sold directly to investors without sales charges. Investors can also buy them at mutual-fund supermarkets like Charles Schwab, but they -- not Vanguard -- pay for the privilege. As for ongoing expenses, shareholders in Vanguard equity funds pay, on average, just $30 per $10,000, vs. a $159 industry average. With bond funds, the bite is just $17 per $10,000. Lower costs do not mean cut-rate performance, either. Fund returns are competitive.
Vanguard can undercut rivals because its business model, crafted by founder John C. Bogle back in 1975, is radically different. Vanguard Group, the fund-management company, is owned by the 118 funds it runs. That means portfolio management and other services are provided at cost to the funds.
Vanguard watchers are betting that its clean image will help the company snag institutional clients now bolting from tarnished firms such as Alliance Capital Management LP and Putnam. "Vanguard is clearly going to be the biggest winner in this," says Douglas Klein, president of 401k Education Inc., a consulting firm in Verona, N.J. "Any institution or pension fund doing a search would be crazy not to include Vanguard on its short list."
Brennan wants to be sure new customers find more than just Vanguard's best-known products, the index mutual funds. Last year, Vanguard introduced new all-in-one retirement funds, targeted to an investor's retirement date, which look a lot like the best-selling funds offered by Fidelity and pitched to 401(k) customers. This month, Vanguard is expected to roll out up to 20 exchange-traded funds to cater to active traders. It also plans to launch 10 index sector funds to track such industries as telecommunications and utilities. While the sector funds will have minimum investments of $250,000, critics say such offerings cater to traders. That's heresy to Vanguard purists who cling to Bogle's vision that the firm should promote low-cost funds for buy-and-hold investing and eschew gimmicky or trendy funds.
BAD BLOOD. That conflict -- the traditional Vanguard way, vs. Brennan's move to branch out in new directions -- is being played out among Vanguard's 10,000 employees and on Internet message boards. It has also helped widen the rift between Bogle, 74, and Brennan, 49, his hand-picked successor. Although they have offices in the same building (Bogle runs an investment think tank funded by Vanguard), the two have been at odds for several years and no longer speak. Bogle refuses to comment on Brennan: "I have nothing to say." Brennan also declined to speak about his predecessor and ex-mentor.
Part of their differences are philosophical, but part is personal. Brennan, who can be short-tempered, took over the CEO's job in 1996 and the chairman's title in 1999. Bogle sought to remain chairman of the funds' board past the retirement age of 70, and the board initially balked. The directors later offered to let him stay on, but he then declined.
While it's not readily apparent in fund flows or performance, observers say the rift is hurting morale. That's because many of the firm's employees remain loyal to Bogle and espouse his core beliefs. There's even a bronze statue of the founder in the campus courtyard of the Valley Forge (Pa.) headquarters.
The outspoken Bogle, long an advocate for fund shareholders, is Vanguard's best asset. His high profile -- popping up in media interviews and even on Capitol Hill -- goes a long way toward explaining how Vanguard became so large without spending much on advertising. "Bogle has been on the front lines trying to fight the good fight," says Don Phillips, managing director of fund-research firm Morningstar Inc.
Burton G. Malkiel, the Princeton University economics professor who has served on Vanguard's board of directors since 1977, knows both men well. He says Brennan is the right leader for now. "As organizations grow, they often need different kinds of leaders at different times," Malkiel says. "I don't think Brennan could have done the visionary stuff Bogle did, and I don't think Bogle could have run this complex organization in such a way as Jack Brennan has done."
For all the pro-investor rhetoric at Vanguard, the firm is opaque in some areas. For instance, even though the management company is owned by the 118 funds, Vanguard does not disclose Brennan's annual compensation (said to be $5 million). It's not in any fund documents. "Jack Brennan's salary has no bearing on how portfolios are run," says a spokeswoman. Is it a lot? Former Putnam CEO Lawrence Lasser got an annual paycheck of as much as $34 million in recent years.
Brennan fought -- and failed to stop -- a Securities & Exchange Commission rule requiring fund companies to disclose how they vote the proxies for the stocks in their portfolios. His objection: The information costs money to disclose, and "it does not make people better investors." The firm denies it, but it looks as if forced disclosure has changed Vanguard's voting habits. The company used to rubber-stamp 90% of the slates of directors put up for election by the companies in which it held stakes. But in 2003, it ratified only 29% of those slates, withholding votes from at least one nominee in 71% of the cases.
For the most part, Vanguard does look out for its shareholders. It keeps investment costs low by outsourcing much of its portfolio management to other firms and negotiating institutional rates for the service. And there are no company cars or expense-account lunches.
Brennan, who joined Vanguard in 1982, gets to work before 6:30 a.m. and tries to squeeze in a midday run. In celebration of his 50th birthday in July, he plans to enter the Philadelphia Marathon in the fall. While at Dartmouth College, Brennan played hockey and, in his spare time, has coached soccer, baseball, basketball, hockey, and lacrosse for his three children.
Although tough to watch, the scandals will ultimately improve the industry, Brennan says. "Out of this painful period of time, we'll see constructive change," he adds. "That, frankly, makes our product better. That's the silver lining." For Vanguard, that silver lining is looking like a golden opportunity.
By Lauren Young in Valley Forge, Pa.