Vanguard's $130 Billion Year

William McNabb, Vanguard Group's chairman, president, and CEO, speaking in Chicago at the 2010 Morningstar Investment Conference Photograph by Tim Boyle/Bloomberg

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Vanguard, the 38-year-old low-cost investing pioneer, brings you the Great Deflation.

The fund company is not just having its best year ever. (It shattered that record in September.) The $130.4 billion in deposits in mutual funds and exchange-traded funds that Vanguard has taken in through November is the most ever for the industry, according to data from Strategic Insight. That beats the $129.6 billion that JPMorgan clocked, mostly for money market funds, in 2008. This year’s not over.

You’ve no doubt heard of the “Wal-Mart effect.” Now the market is watching—with equal parts gratitude and trepidation—the rapid escalation of the “Vanguard effect.” It’s asymmetric warfare, as Vanguard’s sole ownership and constituency is its fundholders, the savings it wrings from its buying power are passed on to them, not to shareholders or partners. BlackRock, Charles Schwab, Fidelity, and State Street cannot say the same.

“No one should be shocked,” says Josh Brown, the Manhattan investment adviser who blogs as the Reformed Broker. He says that Vanguard is selling the lowest-cost bond funds in an environment in which every basis point counts, as well as “the plainest-vanilla indexes” in an era whose most expensive stock-pickers, he says, have been “rendered impotent.”

The average equity mutual fund investor pays $1.24 for every $100 invested, compared with just under 36¢ for equity ETFs, according to Lipper. Vanguard ups (lowers?) that ante by offering a firm-wide average expense of 20¢ per $100 invested. Since the market bottomed in March 2009, equity mutual funds have experienced a cumulative net outflow of $242 billion, compared with a net inflow of $270 billion to equity ETFs, according to Birinyi Associates. ETFs seem to be in a chronic state of boom (PDF). “Don’t fall out of your chair if this continues for a while longer,” says Brown.

Go back to that $130.4 billion that Vanguard has taken in so far this year. Bridgewater Associates, the planet’s largest hedge fund, is $130 billion large. In 2008, the country’s largest stock mutual fund was American Funds’ $117 billion Growth Fund of America; going into August of this year, it sustained $63 billion in net withdrawals.

The world of fund management is in generational upheaval. In 2000, when the Cult of Equity was still going strong, brokers, banks, and insurers dominated global asset-management, representing six of the top 10 spots based on assets, according to Pensions & Investments. Today they hold four of those slots. The four banks and insurance houses on the list sport a total of $5.5 trillion in assets, compared with more than $11 trillion for the rest, including Vanguard and BlackRock.

And those insurgents are knifing one another over fees. In October, Vanguard took drastic action to keep cutting costs on 22 offerings. It announced that starting in January, it will ditch MSCI as its benchmark provider, shifting to a lower-cost framework under FTSE. “Licensing costs for indexes have consumed a greater portion of our costs,” says Vanguard spokesman John Woerth. “So we’ve taken a stand and used our position in the market.”

That’s been short-term costly while money managers who are jittery about the impending switch bail out. Last month, Vanguard’s $57 billion MSCI Emerging Markets ETF lost $887 million to redemptions while its nemesis, BlackRock’s $41 billion IShares MSCI Emerging Markets Index ETF, took in $2.34 billion, according to data compiled by BlackRock. This despite the Vanguard ETF having less than a third of its competitor’s expense ratio. Since the start of 2009, it has outdrawn its BlackRock counterpart in deposits by more than seven-to-one.

“We believe the vast majority of our investors have embraced the change,” says Woerth, “and understand that we’re trying to pass the savings on to them.”

While Vanguard is the world’s largest mutual fund company, it is only the No. 3 ETF player, after BlackRock and State Street. With so many fund dollars now up for grabs—and tons of it sluicing to Vanguard—that’s probably not for long.