Only a few years ago, the top three fund families in the U.S. were nearly identical in size. Not any more. With about $2.3 trillion in assets, Vanguard is now nearly as large as its next two competitors combined: Fidelity Investments and American Funds. Over the past three years, Vanguard has grown steadily while both Fidelity Investments and American Funds have experienced net outflows.
Advisors must now consider two key questions: Will Vanguard further dominate the mutual fund and ETF industries? And, if so, is that good for investors?
First, a little backstory. The Vanguard Group was founded by John Bogle in 1974, after he was fired as chairman of Wellington Management. He created a distinctive corporate structure for the new firm: a not-for-profit mutual fund company owned by its funds, which in turn are owned by their shareholders. By removing the demand for profits, this structure has given Vanguard a sustainable competitive advantage.
Over the next few years, Vanguard debuted a few other innovations that would ultimately be key to its success: creating the first index mutual fund in 1976, switching from a broker distribution system to a no-load system in 1977, and developing a defined-maturity bond fund strategy, also that year.
Success did not come easily; in the first five years, investors pulled out 36% of the firm's initial total assets. But Bogle's crusade for low costs and indexing eventually caught on; by the turn of the 21st century, Vanguard was the No. 2 player, behind Fidelity.
At this point, Vanguard made another move that would prove fortuitous. With ETF growth surging, Vanguard chose to enter the ETF space, competing with iShares (owned by Barclays Bank then and BlackRock now) and State Street. Both Fidelity and American Funds chose to stay out of ETFs, although Fidelity has recently offered them.
Vanguard then gained a key strategic advantage by making its ETFs a different share class of its mutual funds - and then patenting its method, preventing competitors from gaining the same economies of scale. The cost advantages from both scale and the ability to sell at cost yielded an average ETF annual expense ratio of 0.13% versus 0.61% for the industry as of the end of 2013, according to Lipper.
RECORD MARKET SHARE
Investors have taken notice. By the end of 2013, Vanguard controlled nearly 18% of the long-term fund market, which excludes money market funds - the highest share any fund company has achieved in the mutual fund industry's history. Note that this measure is for fund assets only and does not include other brokerage assets at Fidelity or other firms.
The shift, says Morningstar fund analyst Michael Rawson, is largely due to investor frustration with active management and high costs. Over the past decade, money has flowed out of actively managed equity funds and into index funds (which account for 64% of Vanguard's total assets, the company says. Morningstar's work has shown conclusively that costs are predictive of returns, Rawson says: "The less you pay, the more you keep."
Although Rawson declines to give any specific estimates, he predicts that Vanguard's share will continue to grow. And Vanguard's lower costs and the large economies of scale in the index business provide the company with sustainable competitive advantages, he says.
Other prominent advisors, including financial theorist William Bernstein and Rick Ferri of Portfolio Solutions, say they envision Vanguard with a 30% to 40% market share by 2030.
Bogle himself - who no longer has an active role in Vanguard management, but is president of the Vanguard-funded Bogle Financial Markets Research Center - says he thinks gaining a percentage point a year of market share will be difficult to sustain; he offers a "best guess" of a 25% share in 2030.
Vanguard executives shy away from making forecasts, but the company is investing heavily in infrastructure, says Michael Miller, managing director of the company's planning and development group. "We want to have the capability to support an asset base of $5 trillion to $10 trillion" - two to four times the current level - "in the future," Miller says. "Not doing so would be irresponsible, given our history," he adds.
GOOD FOR INVESTORS?
Competition is generally good for consumers, so if Vanguard becomes so dominant that it weakens the competitive landscape, should investors (and advisors) begin to worry?
Morningstar's Rawson sees Vanguard's continued growth as being generally good for investors, as larger scale tends to lead to lower costs. He does note, however, that any firm that becomes too large and unwieldy poses a systemic risk.
Bernstein worries that Vanguard's size is a concern. He points to a phenomenon known as "normal accidents," which occur when systems become so complex and tightly linked that catastrophes are inevitable. (Think about the fears leading up to the Fed rescue of AIG, for instance.) Normal accidents are especially prone to occur when a system becomes dominated by a single or a few large organizations.
And both Rawson and Bernstein caution that there is always a danger that Vanguard will make some decisions on behalf of stakeholders other than its investors. Rawson cites the Vanguard Russell 2000 ETF (VTWO) as an example: It was launched to meet advisor demand, he argues, but didn't have a clear benefit for the investor. The fund has languished, and now has roughly $354 million in assets - relatively small by Vanguard's standards.
Even Bogle has noted other examples of funds that didn't appear to meet investor needs, like the Vanguard Market Neutral Fund (VMNFX).
And some observers suggest that the same patented share class distinction that has given Vanguard an edge can ultimately hurt its investors: They argue that because the shares can't be sold in kind by market makers, as is the case with pure ETFs, the funds have a greater risk of passing on capital gains to investors.
Miller argues that growth is good for Vanguard investors. Yet in an internal Vanguard blog post last year, which was shared with Financial Planning, Vanguard CEO Bill McNabb cited several potential "dangers" - including the possibility that a larger Vanguard could become bureaucratic and self-serving. "Throughout Vanguard's history, so much has gone right," McNabb writes. "Yet so much could still go wrong. I talk to the crew every day, who take pride in what we do for our clients. Rightfully so. But a little fear and paranoia are good, too, and we must remain hypervigilant to the risks that can take us off course."
Meanwhile, Vanguard's competitors haven't exactly thrown in the towel. Schwab and iShares have developed broad ETFs with Vanguard-like costs, and Fidelity has long offered index mutual funds with competitive prices.
Many of the index ETFs offered by for-profit rivals may in fact be loss leaders aimed at luring away Vanguard investors, Rawson says - although he adds that iShares appears to be making sure it won't cannibalize some of its large, profitable products with the new offerings.
As an example, Rawson points to the new iShares Core MSCI Emerging Markets ETF (IEMG), which has a 0.18% annual expense ratio. Because the new, lower-cost fund includes small-cap stocks, he notes, it is actually broader than the older iShares MSCI Emerging Markets ETF (EEM), which the company kept intact with a 0.67% expense ratio - but investors in the older, more expensive fund might have to pay capital gains taxes to make the switch. (iShares did not respond to requests for comment on the matter.)
And while active management is on the decline, there's another growing source of competition: alternative offerings such as low-cost factor investing, which involves weighting indexes or low-cost portfolios toward small cap, value or other factors.
In particular, so-called smart beta funds, based on indexes from Research Affiliates Fundamental Index, are gaining favor. Indeed, Invesco's PowerShares - which offers several ETFs based on Research Associates' indexes - had net asset inflows of $13.8 billion last year, according to Morningstar, representing growth of 23.7%. While the much-larger Vanguard took in $129.7 billion in the same period, it represented a lower 7.2% growth rate.
Amid high inflows to weighted index fund providers - a group that also includes Dimensional Fund Advisors - Morningstar's Rawson sees factor weighting as the future of indexing. And there is substantial evidence that such factor investing, which economists Eugene Fama and Ken French see as compensation for taking on additional risk, has outperformed market-cap weighting. (Nonetheless, Bernstein argues that, as investors flock to fundamental indexing, excess return will be partially arbitraged away.)
Yet Miller says Vanguard has no plans for non-cap-weighted indexes; he still sees Vanguard's largest competitors as Fidelity, American Funds and iShares - as well as Schwab, which is a large force in the brokerage business.
And Vanguard does not take growth for granted; indeed, Miller says that the company's guiding principle is not about growth. "We don't hesitate to close funds when it's in the best interest of investors," he says.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.