by Barry Ritholtz
(Bloomberg View) --Unless we are constantly vigilant, too many things in print pass without comment and are accepted as true. And so it is with a weary heart that I am compelled to offer a counterpoint to a recent argument that takes issue with Vanguard Group Inc.'s business model.
Before we get into the details, a few disclosures: I am a fan of low-cost investing. The Vanguard Effect has been called by my Bloomberg Intelligence colleague Eric Balchunas “a private-sector wealth-transfer machine [that] has saved average investors $1 trillion.” I personally own a variety of Vanguard funds, as do my clients. I like Vanguard a lot.
The company, with about $4 trillion under management, certainly doesn’t really need me to defend it; its success speaks volume. However, the article, “Vanguard’s Irritating Perch on the High Moral Guard,” does raise issues that deserve a response, starting with:
If being a “nonprofit” is so good in the asset management industry, then why don’t we see it elsewhere?
Let’s note that Vanguard isn’t a nonprofit -- it is mutually owned by its investors. In a mutual, instead of dividends that come out of profits, money is returned to investors in the form of reduced costs for services. It is an extremely tax-efficient arrangement.
You see the mutual structure in lots of places -- primarily insurers, which have used it for centuries, but also in savings and loan associations, in banking trusts, and in community banks as well as credit unions.
Let’s consider another statement:
The U.S. is allegedly a capitalist country, so, you see, this is what grinds people’s gears about the whole movement in low-cost, passive-style index funds and why people go around equating them to communism. Clients may be better served if the financial services industry adopts a nonprofit business model.
This is perplexing. Vanguard has offered price-based incentives that financial-services consumers have responded to. What could be more capitalistic than that?
The technology and consumer industries have seen continuous price pressure. As those sectors and products have matured, and as economies of scale have come into play, prices have fallen. Flat-panel televisions, smartphones, computers, automobiles and washing machines all deliver far more capability today at lower costs than just a few years ago.
Why shouldn’t financial services be subject to the exact same market pressures?
What could be more capitalistic than products competing in the marketplace for customers on quality and price? Quasi-capitalists seem to dislike competition; to me, complaining about price competition sounds more like communism.
Other assertions are simply based on a lack of information:
I’d bet that the salaries of key employees (like the manager of the $250 billion flagship Vanguard 500 Index Fund) are actually quite high, relatively speaking.
You might lose that wager. Vanguard is notoriously cheap -- its executives fly coach. Employees are typically paid less than at other financial firms, on or off Wall Street. True, its executives are paid well by most measures of compensation in America, but they are paid much less than their peers at other similar financial-services firms that often grant stock options that can be worth hundreds of millions of dollars in a few years. Incentivizing executives to focus on short-term stock price is not how Vanguard rolls. According to Bloomberg News, a “key aspect of Vanguard’s executive pay is a deferred compensation program.” Set up by founder John Bogle in 1983 to keep management focused on the long-term, it is hard to argue it hasn’t worked.
The article also mischaracterizes the demands that Vanguard places on its managers, downplaying the obvious talents they bring to the job:
An index fund manager doesn’t necessarily have to be smart, but instead must have exceptional attention to detail. It’s a vastly different skill than picking stocks, but a valuable skill nonetheless, one that probably commands a pretty high salary.
Aside from the insult it delivers, the statement is just wrong: Raw intelligence isn’t the primary characteristic determining how well a fund manager performs. A growing body of evidence suggests investment success is related to a variety of factors, intelligence being merely one of them. (And there are numerous types of intelligence and we don’t really understand the correlation between them and investment success). Plus, doesn’t anyone who is managing billions of dollars on behalf of thousands of clients need to have “exceptional attention to detail”? That’s just a weird complaint to make. A lot of the process of tracking the index is assisted by software; any competent asset-management business shouldn't have much of an issue with tracking error.
Then, the article makes light of just what Vanguard has managed to accomplish:
There isn’t anything really unusual about Vanguard. If you’ve ever taken a business strategy course, it’s just a low-cost producer, no different than Wal-Mart in retail or Hyundai in autos or Old Navy in apparel.
This may be the most profound error of all. To minimize the revolution that Wal-Mart Stores Inc. has wrought in retailing is just breathtaking. Who would argue that millions of American consumers would be better off paying high prices for a limited selection of goods at the mom-and-pop shops that dominated so much of the industry before Wal-Mart? And if it were so easy to do, where is the competition that out-Vanguards Vanguard and takes a big chunk of its market share? After all, it’s just a low-cost provider, right? The same could be said of Wal-Mart.
And yet, none of that has happened. If you are wondering why, it is because there are a lot more moving parts to Vanguard -- and Wal-Mart -- than meets the eye of the casual observer. Providing the lowest cost is more than structure; it is also about execution, logistics and corporate culture. To make the above statement requires one to ignore the intensity of the competition, and just how smart and hardworking the people there are. If anyone could just drop prices and capture market share, it should have happened already.
And last is this odd statement:
What’s irritating about Vanguard is not its corporate strategy, but its occupation of the moral high ground. Vanguard is successful because it offers, or is perceived to offer, a better product at a lower price.
Let’s respond by turning this one around. What is the moral quotient of companies that sell complex, overpriced financial products that mostly underperform their benchmarks? Not all financial companies do this, but enough of them do that Vanguard doesn’t have to make much of an effort to claim the moral high ground. Its customers have mostly put it there of their own free will. As for Vanguard’s competitors, they have no one to blame but themselves.
Failing to see that is a fundamental misunderstanding of what makes Vanguard so successful.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Barry Ritholtz is a Bloomberg View columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm.
He blogs at the Big Picture and is the author of “Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy.”
To contact the author of this story: Barry Ritholtz at [email protected] To contact the editor responsible for this story: James Greiff at [email protected]
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