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Vanguard to Advisors: Let's Snuggle

VANGUARD HAS LONG BEEN A RIVAL to advisors and brokers with its no-load, low-cost, direct-to-investors business strategy. Three decades ago, the firm's straight-talking founder, John Bogle reckoned not only that professional money managers couldn't beat the market, but that financial intermediaries, such as stockbrokers, weren't of much use either. A retail investor would be better off making market

VANGUARD HAS LONG BEEN A RIVAL to advisors and brokers with its no-load, low-cost, direct-to-investors business strategy. Three decades ago, the firm's straight-talking founder, John Bogle reckoned not only that professional money managers couldn't beat the market, but that financial intermediaries, such as stockbrokers, weren't of much use either. A retail investor would be better off making market returns, paying little in expenses and nothing in loads. The rest, of course, is history.

“Only because I believed that millions of investors could make their own decisions without the advice — and cost — of an intermediary securities broker did we convert to a no-load (no sales commission) distribution system in 1977,” says Bogle in the preface to his popular book, Bogle on Mutual Funds (Dell, 1993).

Bogle's philosophy has worked well for Vanguard, whose assets shot from $133 billion in 1995 to $530 billion at the height of the stock market bubble in 2000, according to AMG Data Services, making it the second largest fund family in the U.S., behind Fidelity and ahead of American Funds. Since then, Vanguard's assets have continued to grow steadily, hitting $840 billion in July of this year, behind Fidelity's $912 billion.

But now Vanguard wants to remind advisors that Bogle is retired and, well, current management sees the beauty of professional financial advice. The Malvern, Pa., fund giant is tinkering with its business model — and its image — to appeal to registered investment advisors, particularly for its VIPER exchange-traded funds (ETFs). In the past six months, the firm has struck up a number of selling agreements with brokerages, such as Smith Barney and Morgan Stanley, and, like countless other fund families, is offering education and marketing support to help get advisors to use Vanguard ETFs. It also meets periodically with the broker/dealer research departments, and provides them with statistical data in order to help them determine whether its VIPERs would make a good fit for any of their recommended lists, sometimes called model portfolios. In addition, Vanguard has doubled its wholesaling force to 40 since last July, and expects to add another 10 by year-end. And it started a Web site portal for advisors in June that offers research analysis and client worksheets. In mid-September, to get the word out to advisors, the firm will be launching a marketing campaign in financial trade publications.

A Change of Heart

Vanguard declined to say how much it is investing in these efforts, but the company is at something of a disadvantage to rivals when it comes to big spending because of its unusual corporate structure. The group is owned by over three million individuals and institutions that invest in Vanguard funds, which makes it difficult to get costly expansion projects approved. Still, Vanguard's head of marketing, Bert Dalby, says management is stepping up investments in sales, marketing and communications “in a big way.”

There are plenty of good reasons for Vanguard's change of heart. For one thing, the ranks of do-it-yourselfers have thinned over the years while advisor-recommended assets have hit a growth spurt. In 1999, 22 percent of mutual fund sales were direct to investor. That number has fallen to 15 percent in 2005, according to data from Boston-based consulting group Financial Research Corp. (FRC). Meanwhile, 50 percent of mutual fund sales were advisor assisted in 1999, versus 57 percent today. FRC estimates that by 2009, direct sales will fall to 10 percent and advisor assisted sales will jump to 61 percent. Seeing the handwriting on the wall, many of Vanguard's no-load rivals began reaching out to advisors with commission-based pricing five years ago, including American Funds, Strong Capital Management, Dreyfus, Scudder, Janus and Invesco. In some cases, these funds introduced load funds.

But not Vanguard: It may be courting financial advisors, but it is not going to begin charging loads on its open-end funds. It is counting on the migration towards fee-based advice, and away from commissions, among brokers. Fee-based advisors are more inclined to use no-load funds because they are getting paid for their ongoing advice. Some 43 percent of advisors were fee-based in 2004 (over 50 percent of their business in fee-based products), up from 34 percent in 2002, according to Boston-based Cerulli Associates. By comparison, commission-based advisors accounted for 21 percent of the total in 2004, and advisors who do a mix of fee and commission business (10 percent to 50 percent fee-based) accounted for 36 percent.

“I think they see a need, particularly among their boomer clients, to provide advice as they approach retirement,” says Sonya Morris, editor of the Vanguard Fund Family Report at Morningstar. “Vanguard and fee-based advisors is a pretty logical combo, and ETFs are becoming a more popular tool for financial planning and for building portfolios, so to grow their ETF business they're going to have to court advisors.”

The king of index funds, Vanguard got into the ETF game in 2001, but it still lags well behind Barclay's, the leader in this business. Whereas Barclays' iShares hold $138 billion in assets, Vanguard has $8.1 billion in ETF assets. And ETFs are still in a high growth mode. In 2004, ETFs saw $56 billion net in flows, versus just $327 million for mutual funds, according to data from FRC.

Friend or Foe?

Vanguard does have an image problem because some advisors still regard Vanguard as a rival. “I think that's the biggest hurdle,” says Geoff Bobroff, a fund industry consultant in East Greenwich, R.I. “If I'm a broker and I'm charging you commissions and fees for services, I'm not sure that I want to introduce you to Vanguard, either directly or indirectly.” On the other hand, some advisors say the very fact that Vanguard's reputation for low-cost, integrity and catering to the small investor works to its advantage, especially in the wake of the mutual fund scandals.

Vanguard says it is so far working with a “handful” of firms to offer marketing and educational support, and has a few more significant deals in the pipeline for this year. Not many actually include Vanguard products in their recommended lineups — at least not yet. Dalby emphasizes that the partnerships the firm are developing are nothing like the revenue-sharing arrangements mutual funds often have with b/ds. “There is no payment for distribution whatsoever, which is typical of the ETF marketplace, because the margins are so slim,” he explains.

Company executives declined to put a number on their goal for advised assets, which stand at $150 billion today, up from $120 billion a year ago. That represents about a sixth of Vanguard's total $850 billion in assets, some $245 billion of which is in 401(k) plans.

Some advisors are getting Vanguard's message. John Stoeser, a partner with Bellevue, Wash.-based Northwest Capital Group inside Smith Barney, just began using VIPERs six months ago, and is planning a joint seminar with a Vanguard wholesaler for this fall. “They're not only rolling out Web-based tools and working with us in terms of marketing and educating our clients. They're a very trusted name that goes way back. So rather than seeing them as a competitor, I see them as a partner in serving clients,” says Stoeser, who only invests in index funds and ETFs. Still he acknowledges that other advisors remain leery of Vanguard.

One thing Stoeser and other fee-based advisors like about Vanguard is its famously low expense ratios, which the firm cut further at the beginning of the year. The average expense ratio for Vanguard's index funds is 18 basis points, versus an industry average for index funds of 95 basis points, according to Lipper, a Reuter's company, data. And whereas fees on VIPERs range from 12 to 30 basis points, fees on Barclay's iShares are between 35 and 75 basis points. John Stoeser says he uses Vanguard's ETFs in broad-based areas of the market, while using Barclay's iShares more selective niche areas.

Vanguard's attempt to work with advisors isn't entirely new. But it's never been a significant part of its business. In 1998, under the direction of a new chief executive John Brennan, the fund firm began hiring brokers and planners to offer clients advice online and over the phone. This service still exists, but it's very small — with just 200 “advice professionals,” the company says. And in 1990, Vanguard began offering custody services, but it discontinued these in 2003. “From Vanguard's perspective that's an untapped market for them,” says Sonya Morris. “So it's a logical area for them to pursue growth.”

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