Vanguard’s Path to Becoming the Low-Cost Leader in Investment Management Vanguard is now one of the world’s largest investment management companies. It became an industry giant by leading the way in low-cost passive index investing. In active trading, an investment manager is compensated for making an educated decision on which stocks to sell and which to buy. This incurs both transactional and management fees. In contrast, passive index portfolios aim to mirror the movements of a major market index like the S&P 500, Dow Jones Industrial Average, or NASDAQ. Passive portfolios incur fewer fees and can be managed with lower operating costs. A measure used to compare operating costs in this industry is known as the expense ratio, which is the percentage of an Investment that goes toward expenses. In 2019, Vanguard’s expense ratio was less than 14 percent of the industry’s average expense ratio. Vanguard was the first to capitalize on what was at the time an underappreciated fact: over long horizons, well-managed index funds, with their lower costs and fees, typically outperform their actively trading competitors.
Vanguard provides low-cost investment options for its clients in several ways. By creating funds that track index(es) over a long horizon, the client does not incur transaction and management fees normally charged in actively managed funds. Possibly more important, Vanguard was created with a unique client-owner structure. When you invest with Vanguard you become an owner of Vanguard. This structure effectively cut out traditional shareholders who seek to share in profits. Under client ownership, any returns in excess of operating costs are returned to the clients/investors.
Vanguard keeps its costs low in several other ways. One notable one is its focus on its employees and organizational structure. The company prides itself on low turnover rates (8 percent) and a very flat organizational structure. In several instances, Vanguard has been able to capitalize on being a fast follower. They launched several product lines after their competitors introduced those products. Being a fast follower allowed them to develop superior products and reach scale more quickly-both further lowering their cost structure.
The low-cost structure has not come at the expense of performance. Vanguard now has 410 funds, and over 30 million investors, has surpassed $5.5 trillion in AUM (assets under management), and is growing faster than all its competitors combined. When Money published its January 2020 list of recommended investment funds, 44 percent of the funds listed were Vanguard funds.
Vanguard’s low-cost strategy has been so successful that industry experts now refer to The Vanguard Effect. This refers to the pressure that this investment management giant has put on competitors to lower their fees in order to compete with Vanguard’s low-cost value proposition.
Illustration Capsule 6.1 describes how Etsy has thrived by seeking uncharted blue waters. Did Etsy pursue their Blue Ocean strategy in an industry with well-defined boundaries and competitive rules or did they pioneer a new industry? What was the fundamental nature of Etsy’s competitive advantage?