The conversation in our industry has again turned to the “commoditization” of index investing as a handful of prominent asset managers have decided to hop on the low-cost indexing bandwagon. Whenever this comes up, it makes me think of Charlie Brown.
If you don’t remember Peanuts, Charlie Brown’s friend/antagonist Lucy would hold a football for him to kick. When he ran up and tried, she would pull the ball away and Charlie Brown would go flying and land flat on his back. But Lucy would always set the ball up again and convince Charlie Brown that she wouldn’t pull it away this time. Another pratfall ensued.
Commoditization keeps coming back like Lucy with her football. This recent shift in strategy by some of Vanguard’s competitors has been accompanied by a bold sales and marketing effort that attempts to narrow the differences across firms and competing products to the exclusive dimension of cost.
Not surprisingly, we believe there is some additional perspective that can benefit the conversation.
Yes, fees are very important, but they are not everything. If costs were all that mattered and indexing were a true commodity, any blockhead could pick the right index provider. Just find the lowest price.
In that case, Econ 101 would tell us that Vanguard should probably have 100% market share in the index space by now. Low-cost investing—whether it be indexing or the more than $1 trillion of active strategies we manage—has been the ethos of Vanguard for more than 40 years.* We’ve been a low-cost leader in indexing for decades.
But while we’ve enjoyed tremendous success and manage a significant share of indexed assets, we are by no means 100% of the market. Instead, we compete in a robust market where institutions and individuals select providers based on how firms distinguish themselves across multiple factors such as: the ability to prudently track an index over the long term, providing clients with robust choices across benchmarks, the level of client service, a firm’s overall investment philosophy, and the organizational commitment to indexing. Vanguard is highly differentiated from other providers across all of these dimensions and more, and we find that most investors apply this holistic lens when selecting the right index provider with which to partner.
The robots have not taken over—indexing is still a high-touch human endeavor. The delivery of many services has been automated and commoditized in recent years. When was the last time you walked into a record store, talked to a bank teller, or relied on a human being to print your boarding pass?
While it may be tempting to think that the same application of technology can displace the human element of running an index fund, we have not seen that disruption and probably never will. Indeed, people remain one of the most critical difference across providers. The portfolio managers charged with running Vanguard’s index funds have honed their craft over decades and apply their judgment, perspective, and experience to ensuring that our products are successfully implemented in a constantly changing and evolving market environment. Index fund management is an absolutely critical competency that we maintain in-house at Vanguard—it is not a discipline we farm out to third parties, as others in our industry do.
Low-cost indexing by for-profit asset managers should not be confused with charity—there’s always a catch. Vanguard has been able to offer low-cost index funds for decades because of a truly unique corporate structure. Our firm is owned by our funds’ investors. We operate at-cost across all of our products. Our success accrues to our fund investors in the form of lower expense ratios on our funds.
As a result, each of our funds stands on its own two feet. We don’t offer index funds to clients at below the cost we incur to manage them with the hope that we can somehow cross-sell a higher-margin investment strategy or monetize the relationship in some other way. There are no loss leaders at Vanguard.
Vanguard’s main competitors in the index fund market are for-profit enterprises seeking to generate returns for their external investors—an appropriate and noble aspiration for the dominant form of corporate ownership in our society. The average operating margin for the three largest publicly traded asset managers in 2015 was on the order of 40%. Offering index funds with similar fees to Vanguard’s at-cost structure—often with a fraction of Vanguard’s operating scale—works against this goal. It can only be offset by capturing much higher-margin business elsewhere in the client relationship. If that does not occur at these firms, something has to give—and it may very well be the decision to compete as a low-cost index provider.
So I can’t help but feel as if I’m watching Lucy set up the football. However, unlike Charlie Brown, I’m confident that she will pull it away. I am also confident that the index fund industry will continue to be a competitive and differentiated market place for years to come.
* U.S. domiciled assets as of May 31, 2016.
All investing is subject to risk, including the possible loss of the money you invest.
Vanguard provides its services to the Vanguard funds and ETFs at cost.