Why tracker funds are in the vanguard

There's more to fund manager Vanguard’s success than the trend towards trackers and passive investing, says Piper Terrett.

"More and more investors understand that the less you pay, the more you keep," as Michael Rawson of Morningstar puts it. Hence the rise of fund-management firm Vanguard, the global leader in low-cost passive investing (passive funds seek to track the market, rather than beat it).

Last year, Vanguard generated $215bn of new business in America a record in asset management. It could top that by 40% this year, says Stephen Foley in the Financial Times. The firm now accounts for 20% of the American fund industry. Globally it boasts $3.4trn in assets under management (second only to BlackRock).

Vanguard's Total Stock Market index tracker manages $400bn, more than any other fund. While the firm's success was founded on stocks, it is becoming a major player in bonds too: in April, its Total Bond Market index fund became the world's biggest bond fund, eclipsing Pimco's Total Return. That could have "seriously bad consequences for the market shares and the profit margins of rivals" such as BlackRock and Pimco.

But could there be clouds on the horizon? The huge demand for passive funds could be cyclical, notes Foley. Equity fund managers have performed exceptionally badly of late; if performance improves, the shift to passive funds may falter. And bond fund managers claim that passive investing may not be as successful in their field as it has been in equities.

First, bond indices are weighted by the number of outstanding bonds, meaning that tracker funds could end up overexposed to the most indebted companies. Second, bond managers argue they will be better placed to cope with an environment of rising interest rates than passive funds will be.

Yet Vanguard's success may not be just about the trend towards passive investing. While the firm is closely associated with this, it also runs actively-managed stock and bond funds in the US. These account for around a third of its total assets. Management of active funds is outsourced to several external managers, with Vanguard driving a hard bargain on the fees these managers can charge: Vanguard active funds had an average expense ratio of 0.27% in 2014; the industry average was 1.06%.

What's more, despite paying their managers less, Vanguard's active funds have a good record. Last year, John Rekenthaler of Morningstar compared the performance of Vanguard's active funds with its own index trackers, and its cheap active funds with active funds from other managers. Out of these four groups, Vanguard's own active funds did the best on average, followed by other cheap active funds and Vanguard's index funds. Meanwhile, "the costly funds lagged significantly, as expected".

So perhaps the real lesson from Vanguard is not that passive is better, but that costs matter greatly. On this score, the firm has an advantage over rivals: it's structured as a not-for-profit organisation owned by its funds, which means it can run at cost. For-profit asset managers may struggle to match its low fees. But if the firm keeps growing and Vanguard has big ambitions for both its passive and active funds in Europe and Asia they will be under increasing pressure to try.

Are big funds sitting on big risks?

The Basel-based Financial Stability Board, chaired by Bank of England head Mark Carney, has suggested that individual funds worth more than $100bn should be designated "systemically important financial institutions" meaning tougher regulation and higher costs.

Six of Vanguard's funds look likely to be included if this proposal is adopted, which doesn't impress the firm's boss, William McNabb. "Does designating an S&P fund really change financial risk? You haven't changed the risk profile of the markets, all you've done is layer costs and uncertainties onto little investors," he tells the Financial Times.

However, the reality is that "asset managers pose systemic risk", argues Colin McLean of SVM Asset Management, writing for the CFA Institute blog. With markets hitting new highs,assets under management are "booming". The International Monetary Fund has already pointed out the risks created by the level of concentration in the industry: the top ten fund managers have nearly a 30% market share far more than the top ten banks in the banking sector.

These dangers are made worse by the trend towards ever-larger funds. This is being driven by factors such as the rise of "star managers", the drive for economies of scale and advisers' preference for well-known funds that are "easier to explain" to clients. "A fund's scale can create an illusion of safety that may not be understood by private investors."

A particular concern is increasing exposure to illiquid assets, such as corporate bonds and emerging markets: big portfolio positions "could be left stranded if investors rush for an exit". These problems are steadily growing, yet "there seems no hurry to plug the gaps".

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