VALUE ISSUE

Despite a drop in assets of 7% since Dec. 31, 2001, Vanguard Group Inc. made news in 2002 by becoming the world's largest manager of equity and fixed-income mutual fund assets, surpassing Fidelity, and for having the Vanguard 500 Fund become the world's largest mutual fund, albeit briefly. While the mutual fund business continues to grab much of the attention, Vanguard is looking to jump-start its defined benefit plan business, now just a fraction of its overall institutional business. William McNabb, managing director and head of the institutional business, talked with reporter Dave Kovaleski about how Vanguard is laying the groundwork to build its defined benefit business.

A There are three broad themes.

One, we have a diversified asset base. While we're well known for indexing, we've got a very big active equity business, and we've got an incredible fixed-income business. Being a strong competitor in each of those broad categories differentiates us from a lot of other firms.

The second thing is the diversity of our client base. With our retail business and our full-service defined contribution and investment-only business, we're not wholly reliant on one particular segment of the market.

The third thing is really cultural. It's about the way we believe in dealing with clients. The concept we talk about a lot internally is loyalty. When I talk to my group, we always use the phrase ‘It's all about the client' and we have a very loyal client base.

But in order to have great client loyalty, you got to have great people from a service standpoint, and you've got to have some loyalty to those people as well. That concept is something that's been part of this culture since the founding of the company. When you're that focused on the client, you have to focus on your own people if you're going to make it happen

Nobody likes to see their assets go down but I think relative to the competition, we've done well, so we've been able to hold onto our people. We've not done any restructuring or had any layoffs. We are slightly smaller than we were at our largest (but) we just let attrition takes it toll.

A The biggest initiative is we are launching a series of commingled trusts to more actively pursue the higher end of the DB marketplace. We've had a lot of success with our investment-only business, but there are certain product gaps for large mandates in the DB world so we're coming out with a series of commingled trusts.

We have several thousand corporate clients that we have deep relationships with on the DC side and less deep on the DB side. These products will enhance our ability to attract DB assets. Our quant group record has a great track record, and I don't think anyone manages index money better than (Managing Director) Gus Sauter in the world. I'm very optimistic. His group runs structured equity too.

I don't think it's a change in direction. I think it's a natural evolution for us. This is an important initiative for us and probably the single biggest thing going on now on the institutional side.

A We're humble in our ambitions here initially in that we recognize how difficult it's going to be. But I'd argue that our quantitative group has built up such an incredible track record over the last 15 years that I think it's a pretty compelling story.

My philosophy is that the client is pretty smart, and smart clients over time find their way to the best products. Our products are among the best, our prices are fair and our service will back it up. If we meet those criteria, then I'm confident growth will take care of itself.

A I don't think it's a pure price issue, it's more broadly defined as a value issue. You have to couple the investment results, service, and the price. At the end of the day, it's about what goes back to the client from a return standpoint and what they receive from a service standpoint. Sure our prices will be competitive, but to me it's that value proposition that's more important than pure price.

A We don't set specific growth goals, but obviously we know what we need to do in order to make it a going concern. I would say it would be very successful in five years if it were a third of our institutional business in assets. That would be immensely successful.

A We've ramped up those areas over the last few years so we feel pretty good about that. Our sales group already has a well-established relationship with our corporate clientele and in a sense they'll be able to potentially solve more problems for the client (with these new products). As a sales person, that's all you can ask for.

A We're through our third year in a row now of down markets and right now we're in a midst of a fourth. But it's relatively encouraging in that participants are hanging in there pretty well. I think education efforts have paid off. The next big evolution is advice.

Participants who are maintaining a sense of diversification have done very well. In the late '90s we saw more risk taking where equity exposure was too great. The principle of broad diversification seemed lost. I think that diversification is an important message. The importance of balance has never been more apparent.

A We believe very strongly that active management and indexing can co-exist. People forget that the Wellington fund, an actively managed fund, was our first fund.

Our philosophy is this: Active funds, as a rule, struggle to beat indexes. They struggle not because of market efficiencies, that's the biggest misconception out there, but because of cost. As you get into larger markets, they certainly get more efficient, but there are pockets of inefficiency in any size stock. It's all on the cost side. So if you want your active funds to have the best chance of outperforming indexes, what do you have to do? You have to keep your costs down.

That's how we run our active funds. One of the reason we've succeeded on the active side as well as we have, is most of it is subcontracted out. The strategy there is, one, we get diversification of thought. Two, when you're looking at the disciplines, we go find the best that are out there. Look at our funds, it's kind of a who's who. There's an accessibility we're providing here. You look at our success over the last 20 years and as big a part of the reason for our success as anything is we're pretty darn competitive in most active equity categories.