MALVERN,
Pa. — The Vanguard trading floor is the epicenter of one of the great
financial revolutions of modern times, yet it is a surprisingly relaxed
place.
A
few men and women gaze at Bloomberg terminals. There is a muted
television or two and a view of verdant suburban Philadelphia. No one is
barking orders to buy or sell stock. For a $4.2 trillion mutual fund giant that is still growing rapidly, it occupies a small fraction of the space of a typical Wall Street trading hub.
You
can barely hear the quiet hum of money being invested — money in
scarcely imaginable quantities, pouring into low-cost index mutual funds
and exchange-traded funds (E.T.F.s) that track financial markets.
In
the last three calendar years, investors sank $823 billion into
Vanguard funds, the company says. The scale of that inflow becomes clear
when it is compared with the rest of the mutual fund industry — more
than 4,000 firms in total. All of them combined took in just a net $97
billion during that period, Morningstar data shows. Vanguard, in other
words, scooped up about 8.5 times as much money as all of its
competitors.
“Flows
of this magnitude into one company are unprecedented,” said Alina Lamy,
an expert on fund flows at Morningstar. “Since the crisis, investors
have been saying, ‘I may not be able to control the market, but I can
control how much I pay in mutual fund expenses.’ And when they look for
quality funds with low fees, the first answer is Vanguard.”
The
triumph of index fund investing means Vanguard’s traders funnel as much
as $2 billion a day into stocks like Apple, Microsoft and Amazon, as
well as thousands of smaller companies that the firm’s fleet of funds
track. That is 20 times the amount that Vanguard was investing on a
daily basis in 2009. It is manageable, in large part, because no
stock-picking is involved: The money simply flows into index funds and
E.T.F.s, and through February of this year, nine out of every 10 dollars
invested in a United States mutual fund or E.T.F. was absorbed by
Vanguard.
By
any measure, these are staggering figures. Vanguard’s assets under
management have skyrocketed to $4.2 trillion from $1 trillion seven
years ago, according to the company. About $3 trillion of this is
invested in passive index-based strategies, with the rest in funds that
rely on an active approach to picking stocks and bonds.
More
broadly, this deluge of money abandoning higher-price actively managed
funds for Vanguard’s plain vanilla cut-rate vehicles has come as an
existential shock to a mutual industry that has long been resistant to
change.
What is being called the Vanguard effect was felt last month when the indexing giant’s rival, BlackRock, announced
that it would revamp its stock-picking operations, promoting instead a
process that relies more on computer-driven methodologies.
The
effect within Vanguard has been no less profound. For decades, the firm
has made the case that cheaper index funds will, over time, outperform
more-expensive mutual funds that rely on brainy portfolio managers to
pick stocks.
The main advocate of this doctrine was the founder, John C. Bogle,
who retired in 1999 but runs a research operation on the Vanguard
campus. For years, the firm has relied more on his simple message and the passion of his devotees than on fancy advertising campaigns to spread the word.
Photo
“Mr. Bogle used to say, ‘This is not our money,’ and I agree,” said F. William McNabb III, Vanguard’s chief executive.Credit
Mark Makela for The New York Times
Unlike
its peers, Vanguard is owned by its funds — and ultimately its
investors — so as money rushes in, expenses are persistently reduced,
resulting in perpetual savings for the legions of Vanguard clients. They
number well over 20 million and include New York Times employees:
Vanguard runs the company’s 401(k) retirement plans.
The
model has been a powerful one: Since 1976, fees on Vanguard funds have
fallen to about 0.12 percent from about 0.70 percent. By comparison,
Lipper calculates that the average fee for all mutual funds is currently
1 percent, although it has been coming down rapidly.
“Mr.
Bogle used to say, ‘This is not our money,’ and I agree,” said F.
William McNabb III, Vanguard’s chief executive, referring to the
extraordinary inflows. “For many years, there has been a real move to
our way of investing. And it’s more than active versus passive — it’s
high cost versus low cost.”
This
no-frills approach has come under some strain as cash flowing into
Vanguard funds reaches new highs year after year, some people who follow
Vanguard closely say. There have been reports of operational snarls,
including website outages, longer-than-usual wait times on the phone and
misdirected fund transfers.
“All this growth has come at the same time that the company has been cutting costs,” said Daniel P. Wiener, the editor of the Independent Adviser,
a newsletter for Vanguard investors, who says he has received many
complaints about the current state of customer service at Vanguard.
“Most companies when they are growing spend more. Vanguard is trying to
spend less. At some point, cutting costs will bite you.”
There
is no doubt about Vanguard’s commitment to pinching pennies. In touring
the 287-acre campus of pathways, low-slung buildings and a commanding
statue of Mr. Bogle, the sensibility is decidedly puritan.
Photo
Vanguard employees on the equity trading floor, a relatively relaxed place.Credit
Mark Makela for The New York Times
There
are few flashy cars to be found in the parking lots. The walls are
largely devoid of eye-catching art — with the exception of some musty
paintings of the HMS Vanguard, a Napoleonic-era British warship that
inspired the company’s name.
In
sum, the look is slightly drab, certainly by Wall Street standards:
rows of uniform cubicles, colorless carpets and an executive boardroom
that seems more appropriate for a community college than one of the
largest financial institutions in the land.
Vanguard
executives say they are disciplined in terms of plowing money back into
people and technology, but not overly so. “Our true investment spending
has doubled in the past five years,” Mr. McNabb said.
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This
tension between breakneck growth and spending restraint is most acutely
felt in the firm’s retail division — or the front lines, as they are
referred to here — where 6,000 customer service representatives attend
to the wishes, demands and whims of the close to eight million clients
who purchase their mutual funds directly from Vanguard. In 2015 and
2016, this division added 350,000 new accounts each year, numbers never
before seen at the firm.
“The
spotlight is on us, given the growth, and there have been operational
challenges,” said Karin A. Risi, who oversees Vanguard’s retail investor
group and is in the midst of an aggressive hiring push. “But it is not
fair to say we are not investing. Bringing in 2,000 crew on a base of
6,000 is not insignificant.”
As
with many executives at Vanguard, Ms. Risi gets a glint in her eye when
she talks of the virtues of investing in low-cost index funds. Like the
majority of her peers, she has spent the bulk of her career at the firm
and, as a certified culture carrier, it is clear that she is taking the
current growing pains to heart.
Photo
“My parents were Vanguard
investors, and I was investing in Vanguard funds in high school,” said
Karin A. Risi, who oversees Vanguard’s retail investor group.Credit
Mark Makela for The New York Times
“My
parents were Vanguard investors, and I was investing in Vanguard funds
in high school,” she said. “So I feel the burden of this responsibility.
We are serving a mission here.”
Beyond
their devotion to indexing, Vanguard employees talk as if they are
working on a frigate, a nod to the nautical images and themes embraced
by Mr. Bogle at the company’s founding.
Employees
are called crew, one eats at the galley (not the cafeteria) and works
out in the “ship shape” room, and new workers come onboard as opposed to
being hired.
“You
absorb the culture and you join the cause,” said Joseph Brennan, who,
as head of global equity indexing, has had a front-row seat as the firm
has expanded. His division embodies Vanguard’s credo of do more with
less: The 45 people he oversees globally look after $2 trillion in
assets.
“Our assets per head are incredible,” he said. At $44 billion per person, that certainly qualifies as an understatement.
Up
and down Wall Street, where the sum of a firm’s assets under management
has become a badge of power and sway, Vanguard’s ability to attract and
run so much money with so few people has been a cause for envy and
disbelief. Some have even warned that index funds will distort the broader market, especially if active stock pickers are pushed farther to the sidelines.
Already,
six out of the 10 largest mutual funds by asset size belong to
Vanguard, with the largest, Vanguard Total Stock Market Index, now
weighing in at $465 billion, according to Morningstar. Only two —
American Funds’ Growth Fund of America and its EuroPacific Growth Fund,
both belonging to the Capital Group — are actively managed, promising
higher returns for a steeper fee.
“There is this existential crisis in the soul of every professional asset manager,” said Josh Brown, a financial adviser and blogger
at Ritholtz Wealth Management. “Vanguard has become synonymous with the
idea that people should pay less — not more — for stock market
exposure.”
Correction: April 23, 2017
An article in the Mutual Fund Quarterly last Sunday about the
growth in inflows to the index fund giant Vanguard misspelled the given
name of the executive who oversees its retail investor group. She is
Karin A. Risi, not Karen. (The error was repeated in a picture caption.)
http://www.businessinsider.com/index-fund-assets-under-management-2016-1?utm_source=markets&utm_medium=ingestStop me if you've heard this before: investing in broad, low-cost index funds is the best way to save for retirement.
In the wake of the tech bubble — which saw a lot of
average-people-turned-stock-traders lose everything — and the housing
bubble — which saw average-people-turned-real-estate-professionals lose
everything — a vocal part of the financial services community has
espoused the virtues of index funds like those offered by Vanguard as
the best, most responsible way to save for retirement.
Vanguard's S&P 500 fund, for example, charges investors just 0.05% per year
— or $50 for $10,000 invested — to track the returns of the benchmark
US stock index. And if you're, say, a 30-year-old professional looking
to save for retirement and you want to buy some stocks, buying the
S&P 500 for what amounts of a minimal management fee is your best
bet.
Of course, you have to actually stick it out through tough times (like 2015, though many readers will be quick to remember far
more challenging years — like 2008 — that saw the S&P 500 fall in
excess of 30%) and continue to add to your holdings over time. And as we've written before, it is about time in the market not timing the market that builds long-term wealth.
So in the wake of this new push towards low-cost financial products,
the amount of money that has piled into index funds is truly incredible,
rising from around $11 million 1975 to $4 trillion today. CFA Institute
This
is, on the one hand, an incredible innovation benefiting investors of
all stripes. Investing cheaply in a broad index of stocks is a huge
benefit to disciplined long-term investors.
On the other hand, and in the eyes of Vanguard founder Jack Bogle,
these funds have led to the rise of merely the latest speculative hot
potato being passed around Wall Street.
Vanguard, you'll recall, is the world's largest mutual fund company
and Bogle saw the S&P 500 fund in the same spirit as most all of the
company's products: something that would be held "forever" and used by
prudent investors saving for retirement.
This was all good and well for a while. And then it wasn't.
In the CFA Institute's Financial Analysts Journal this month, Bogle writes:
"The fundamental principles established
by that first index fund are simple: Buy virtually the entire US stock
market and hold it intact 'forever,' eliminate advisory fees, and
minimize both operating costs and portfolio turnover. These simple
principles have won the day. But in 1993, almost two decades after the
creation of the original index fund, a new form of index fund—originally
designed for stock traders and speculators—came into existence. That
change and that challenge, little noted in financial history, will be
long remembered."
This new form of fund, called an exchange-traded fund (or ETF), is
treated like a stock on daily exchanges but these instruments have
morphed from being simple index-trackers to more complex or arcane
bets.
The "HYG" ETF, for example, tracks a basket of high-yield bonds. The "EWJ" ETF tracks Japanese stocks. Simple enough.
The "JNUG" ETF, meanwhile, tracks the performance of small gold mining companies ... except it is also levered 3-times. This means that "JNUG" seeks to give investors triple the performance of small mining companies on a given day.
Bogle's view — which he's made public before
— is that these ETFs are merely vehicles that allow speculators to take
more and more risk. And as Bogle notes, the triple-levered ETFs allow
investors to make bets which of course are extra-great when you're right
and extra-bad when you're wrong.
The turnover in these funds, as Bogle writes, is truly extraordinary, writing (emphasis ours):
Through September 2015, shares of the 100
largest ETFs, valued at $1.5 trillion, were turning over at an
annualized volume of $14 trillion, a turnover rate of 864%.
By way of comparison, the annualized
turnover volume of the 100 largest stocks, valued at $12 trillion, is
running at $15 trillion for the same period, a turnover rate of
117%. Trading in the 100 largest ETFs thus represents about 89% of such
stock trading, up from a mere 7% 15 years ago. Given these
powerful data, it is hardly unfair to describe today’s ETFs—as a
group—as the modern way to speculate in the stock market.
But like the idea that high-frequency traders increase markets
liquidity, proponents of ETFs will argue that the propagation of these
funds ultimately drives down overall costs for most investors.
In short, this school would tell you the 0.05% fee on the Vanguard
S&P 500 fund wouldn't be 0.05% without those speculators Bogle so
dislikes because the sheer volume of trades being done in these funds
allows the management fees to be so low since fees are earned in other
ways.
Bogle's article, however, ultimately concedes that indexing is
winning in a big way, is likely to continue to do so, and yes of course
things aren't perfect.
For while only a handful of those invested in ETFs might be using
what Bogle might see as the preferred application of the funds — i.e.
saving for retirement cheaply over the long-term — ultimately these are
the funds that give investors the thing they really want: beta.
Active managers are taking it on the chin lately, but they may have no one to blame but themselves.
While the underperformance of active managers against index funds and passive investing has been well documented over the past few years, the full extent of their failure to live up to benchmarks is devastating.
S&P Dow Jones Indices released their latest SPIVA report card
on Thursday, which the authors called the "de facto scorekeeper of the
active versus passive debate" as it measures all types of actively
managed funds against their respective benchmarks.
The report showed that active managers have been falling short of
their passive counterparts not just during the post-financial crisis
period, but for well over a decade and during various phases of multiple
economic cycles.
"Given that active managers’ performance can vary based on market
cycles, the newly available 15-year data tells a more stable narrative,"
said the report. "Over the 15-year period ending Dec. 2016, 92.15% of
large-cap, 95.4% of mid-cap, and 93.21% of small-cap managers trailed
their respective benchmarks."
Aye Soe and Ryan Porier, the authors of the SPIVA report, noted that
this is particularly egregious given that active funds are measured
against the benchmark that best fits their fund type. For example, small
cap funds are measured against the S&P small cap index. So, the
data show a true "apples-to-apples" comparison.
If you shorten the timeframe, the numbers do look a bit better for active managers, but still pretty bad.
"During the five-year period ending Dec. 31, 2016, 88.3% of large-cap
managers, 89.95% of midcap managers, and 96.57% of small-cap managers
underperformed their respective benchmarks," the report said. S&P Dow Jones Indicies The underperformance of active managers is particularly
devastating because these funds are not only being compared to their
benchmarks on an absolute basis, but are also competing on a
fee-weighted basis with passive managers tracking those benchmarks. Active managers cost more in fees than their passive
counterparts because they promise to generate far higher returns than
one could get by just dumping one's money into an index-tracking ETF.
These fees are the lifeblood of an active manager, and if these funds
can't justify their fees with outperformance, they could be in serious
trouble. And that's exactly what is happening. Just under $1 trillion has flowed out of actively managed funds since the financial crisis, while indexed ETFs have seem a $1.7 trillion inflow and the trend is only accelerating. The report includes all funds over the 15 year period, not just
the ones that survived. Since funds that closed down in that period
were an option for investors, this keeps the scorecard fair and
eliminates survivorship bias.
Given the underperformance, it is perhaps not too surprising that
only a minority of funds made it through the entire period tracked
by the SPIVA report.
"Funds disappear at a significant rate," Soe and Porier wrote. "Over
the 15-year period, more than 58% of domestic equity funds were either
merged or liquidated. Similarly, almost 52% of global/international
equity funds and 49% of fixed income funds were merged or liquidated."
While the report does not definitively prove that one should invest
solely in passive or index funds — diversification can be good and
certain funds can outperform over shorter periods — it does make the
monumental shift out of active funds easier to understand.
The tide is going out on active managers. Passive funds, which simply track an index, have hoovered up assets over the past decade. The combined assets of the nation’s exchange-traded funds were $2.4 trillion in August, according to ICI. The seemingly inexorable rise of these types of funds has everyone on Wall Street talking, with some even describing it as "investor socialism." And these funds, which are low cost, tax efficient and offer daily liquidity, pose an existential threat to the actively-managed funds industry.
These funds have suffered from poor performance of late, helping
speed the shift from actively managed funds to the low cost, tax
efficient passive alternatives.
And according to a 240-page study Deutsche Bank released this past
week, there really isn't much active funds can do to stem the flow of
assets. All they can do is slow the shift.
The note said:
"Since indexing was adopted in the 1970s,
the debate on the merits of passive vs. active investing has never been
so intense. With secular structural product trends favoring ETFs over
mutual funds combined with less visible alpha by active managers across
many categories, we think passive investing will gain further share
until a better equilibrium is reached."
The equilibrium Deutsche Bank is referring to is the breakdown of
assets between active funds and passive funds. Right now, more money is
managed in active funds. That could soon change.
Here is a roundup of Deutsche Bank's major points.
Let's assume for the next five years that equity mutual funds
improve their performance. In that scenario, equity index funds will
grow from managing 38% of assets today to about half of the assets in
five years, the report said. So that's in the best case scenario.
But if mutual fund performance worsens, passive will take up as much
as 65% of the share of the assets during the time frame, the report
said.
Actively-managed equity mutual fund assets could shrink by 20% if performance worsens.
Hybrid and fixed income strategies face a similar hurdle. Even if
active investment performance improves, passive's share will rise from
30% today to about 40% in five years – or 50% if it doesn't, the report
said. Deutsche Bank
Still, Deutsche
Bank isn't worried about an impending death of active management.
Nearly 40% of the industry's assets are in active strategies in which
managers are providing superior long-term returns compared to their
passive cousins, the report said.
Some of the active firms set for higher growth include Fidelity Investments, T. Rowe Price and JPMorgan, according to Deustche.
What's more likely in the long term is that investors will
increasingly adopt a mix of active and passive strategies, the report
said.
FeelPic/iStock/Thinkstock
CFA Institute
S&P Dow Jones Indicies
Deutsche Bank
The tide is going out on active managers.
Deutsche Bank
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