MALVERN, Pa. - When the Vanguard Group brought index funds to the masses in the 1970s, competitors of the struggling young company openly dismissed the concept as a poor excuse for managing money. Today, Vanguard has $320 billion under management, and many of those detractors are downright envious.
Yet Vanguard is at a crossroads once again, as its new leader, Chief Executive John J. Brennan, officially will take the helm in January from founder John C. Bogle.
Competition from price-slashing rivals has become increasingly fierce.
And still to be seen is if a redemption stampede takes place from the bull market tumble - or investors hooked on 20%-plus returns move elsewhere once Vanguard's flagship S&P 500 index fund delivers mere single-digit results.
If Vanguard is to continue growing, the chairman-to-be must do nothing less than reshape the world's second-largest mutual fund company.
For now, Vanguard is relying increasingly on institutional and high-net worth clients. During the first half of 1997, it brought in $20 billion in new institutional money, boosting its total to $120 billion, which is about a third of the company's assets under management.
Vanguard is expected to attract even more money with the several new index funds for institutional investors it has launched during the last few months.
Some of Mr. Brennan's efforts since becoming chief executive in January 1996 have had mixed success, including attempts to attract more business from financial planners.
Other initiatives run contrary to long-held tenets installed by Mr. Bogle, who founded the firm in 1974 as a load-fund shop (naming it after Lord Nelson's HMS Vanguard in the Napoleonic wars) and began marketing index funds to retail investors in 1976.
Yet Mr. Brennan's changes seem intended to ensure that - like the very concept of stock indexing - Vanguard has its eggs in more than one basket. In fact, he notes only 26% of assets under management are in index funds.
But it's the success of indexing that has created some of Mr. Brennan's biggest headaches. Giddy investors been pouring money into the company with almost reckless abandon during the bull market.
Last year alone, Vanguard's assets under management soared 33%. Now, its Index 500 fund, which tracks the Standard & Poor's 500 Stock Index, has $45.8 billion in assets.
With the stock market drop, hordes of investors might head for the exits. Until Vanguard came along, most index-fund investors were institutional players, who are less likely to panic when the market tanks.
Seeking to cash in on the investor love affair with indexing, some of Vanguard biggest competitors - including Fidelity Investments and Charles Schwab & Co. - have reduced expenses on their index funds and rolled out low-priced ones. Some rivals are operating their index funds at a loss, said Russel Kinnel, equity fund editor for Chicago-based Morningstar Inc.
Another thorn in the side of Mr. Brennan is Vanguard's tenuous relationship with financial advisers.
While planners are a huge source of assets for Vanguard, they say the company needs to do a better job at outreach, from providing more access to fund managers to disclosing the Vanguard fund holdings of its directors and managers.
Indeed, Mr. Brennan concedes Vanguard has lagged behind some competitors for advisers, particularly Charles Schwab. "We think our service is tremendous relative to anybody else's," he said, "but it is not as broad yet as it should be."
Technology spending increases
Seeking to manage the company's eye-popping growth and position it for the future, Mr. Brennan has put some of Mr. Bogle's sacred cows out to pasture - including the notion that Vanguard did not need to invest heavily in technology or to engage in active money management. In doing so, however, he's hardly a maverick: In 1992, Mr. Bogle, sensing the changing tides, challenged his senior officers to rethink the company's long-held tenets.
Vanguard now spends a third of its budget on technology compared with 7% a decade ago. Some of that money has been used to add phone capacity to handle the flood of calls triggered by a market downturn.
"The key thing in a direct-marketing business in a market break is to be able to answer the phone, period. It quells all fears," said the detail-oriented Mr. Brennan, who has continued his mentor's practice of working the customer phone lines once a week to monitor service and stay in touch with investors.
And although Mr. Brennan said Vanguard has no plans to put more emphasis on actively managed funds, company representatives remind investors only a portion of their assets should be invested in index funds. Should they take the advice, Vanguard has plenty of actively managed funds to offer them.
Some of those funds are managed entirely in-house, a practice instituted in 1995. "What we want to have is almost parallel lines of products, active and indexed. So if you want large-cap growth and income, you buy the S&P 500 or you can buy Windsor II," said Mr. Brennan.
"We have a pretty strongly held view that we have to love all our children the same."
Mr. Bogle has a fatherly regard for Mr. Brennan, whom he recruited in 1982 after picking his name out of a stack of resumes from Harvard Business School.
After receiving his MBA from Harvard in 1980, Mr. Brennan put in a stint as a planning associate for home-goods giant S.C. Johnson & Son Inc. But his true passion was for the financial markets, and he impressed Mr. Bogle with his knack for numbers.
Both men are affable, intensely competitive and hawkish about holding down costs.
Of course, it's relatively easy for Vanguard to achieve the low costs it's so righteous about: Its independent mutual funds jointly own the Vanguard Group, which serves them at an at-cost basis.
And by farming out the management of most of its non-indexed stock funds, it can save even more money by using leverage during contract renegotiations.
While company officials dismiss as marketing gimmickry the price war begin waged by Vanguard's competitors, rivals have succeeded in catching the attention of investors, some of whom are starting to grumble that not all Vanguard index funds are dirt cheap.
Earlier this year Fidelity and Schwab cut expenses on their S&P 500 funds to 19 basis points, one notch lower than the 20 charged by Vanguard but one point higher than the 18-point fee charged by USAA Investment Management Co.
Still a low-cost leader
Vanguard, however, is still one of the industry's low-cost leaders: The average expense ratio for its funds is 0.29%, compared with the industry average of 1.24% for all open-end funds, according to New York-based Lipper Analytical Services Inc.
By rolling out new products and services, Vanguard has sought to capture more business from institutional investors, advisers and high-net-worth clients.
Last year, it unveiled a Windows-based online service that offers access to client-account and Vanguard fund information.
This year, the service will be expanded to include online trading of Vanguard funds and more than 300 other no-load offerings.
"The changes that have gone on here have been dramatic," Mr. Brennan said.
But, he adds, "we haven't lost sight of the core elements of what made Vanguard Vanguard," a focus on holding down costs, maintaining high ethical standards and putting the interest of investors first.
While Mr. Brennan paints the changes at Vanguard as proactive steps, he is, by his own admission, "paranoid about the competition."
Watch closely: He may be making hamburger out of a few more sacred cows.
Crain News Service