VANGUARD A FUND FAMILY FOR THE 1990s In an era of diminished expectations, Vanguard's low-cost mutual funds aim to improve returns. Investors are signing on. Competitors are growing nervous.
By Andrew Evan Serwer REPORTER ASSOCIATE Karen Nickel

(FORTUNE Magazine) – DEEP IN the Delaware Valley, about a mile from where George Washington's troops spent the icy winter of 1777-78, another kind of revolution is taking shape. After years of hefty fees, onerous sales charges, and mounting redemption penalties, a movement is afoot to bring the cost of mutual fund investing down, way down. That's good news for the customers. At a time when every fraction of a percentage point counts (see preceding article), it means investors will keep more gains for themselves rather than forking them over to mutual fund managers. The change is being driven largely by one man and one company. John C. Bogle, 61, iconoclastic CEO of the Vanguard Group, a Valley Forge, Pennsylvania, mutual fund organization, is rattling the status quo among the mutual fund titans, offering his product to investors at a fraction of the normal charge. Bogle's low-cost approach has shaken the competition and made his mutual funds some of the best investment bargains around. ''The marketing strategy of my company,'' says Bogle, ''just happens to be giving shareholders the best deal possible, and it works wonderfully.'' Concedes an insider at Fidelity Investments, the industry leader: ''We watch Vanguard more than anyone else now.'' The mutual fund business attracts a hodgepodge of players, all pitching for the investor's dollar. Brokerages and insurers such as Merrill Lynch, Shearson Lehman Brothers, and Kemper Financial Services create funds and hawk them through their own brokers and agents. Independent sponsors like the Franklin Group or Federated Investors sell their funds through brokers and banks, sometimes under their own names, sometimes under the seller's name. All these funds come with a sales charge called a load, usually 4% to 5% but occasionally as high as 8.5%, which the investor must pay either when he buys the fund or when he sells it. Vanguard competes among a third group, the direct marketers, who sell funds to the public through advertisements and the mail. The giants of this crowd are Fidelity of Boston, Dreyfus of New York City, Vanguard, and T. Rowe Price of Baltimore. Together, these four command roughly $300 billion of assets, nearly one-fourth of the U.S. mutual fund market. As a group, direct marketers are the low-cost providers of mutual funds -- three of the four biggest impose no sales charge, and the fourth, Fidelity, has loads ranging from zero to 3%. Between 1982 and 1990, annual sales by direct marketers grew 30-fold, from $1.5 billion to $45.7 billion, four times as fast as the other two groups. As people have become more sophisticated and cost-conscious about investments, Vanguard has expanded even faster. Its rock-bottom fees for stock, bond, and money market funds, averaging 0.38%, vs. 1.27% for the industry, have fueled a steady growth in market share -- from 2% in 1980 to 5% in 1990 -- and forced competitors to respond by offering promotional discounts. WHY ARE SO MANY investors focusing on the fees the funds charge? Because while they may look small, they matter, big time. Although a few stock fund managers consistently outperform the broad market averages, most don't. The typical equity fund paid shareholders an annual return of 9.8% over the past 20 years, while the stock market's broad index, the Standard & Poor's 500, returned 11.1%. For someone who invested $10,000 at the beginning of that period, the difference between the performance of the average fund and the market as a whole would come to more than $17,000. The reason stock funds lag is that, on average, they assess their holders 1.55% of assets annually for expenses (often called an expense ratio). Bogle is out to narrow the gap. Rather than levy the industry's average expense charge for equity funds, Vanguard lops off only 0.43%. That means Vanguard shareholders start each year more than a full percentage point ahead of the competition. The discounts get even better on Vanguard's broad line of stock index mutual funds, which are unmanaged portfolios designed to mirror the market's performance. The fees on these range from 0.19% to 0.33%. The case for indexing has long been known to institutional investors, but it is just catching on with individuals. Since only 18% of mutual funds outperformed the S&P 500 over the past ten years, according to Lipper Analytical Services, a mutual fund tracking service, picking the next crop of winners is a dice roll. So why not buy a fund that matches the market and spare yourself the headache? With $5.3 billion in seven index funds, Vanguard has about 80% of this market and plenty of room to grow (just 1% of equity mutual fund assets are now indexed). In 1990 both Dreyfus and Fidelity introduced index funds, but neither has attracted anywhere near the kind of money Vanguard is pulling in. $ To broaden the appeal of indexing, Vanguard has added several flavors beyond the S&P 500 covering small stocks, international stocks, and bonds. Nowhere does Vanguard's advantage shine brighter than in the realm of fixed- income funds, where investors have stashed the bulk of their mutual fund assets. Because bond yields move in a narrow range, the annual performance difference among comparable funds is typically no more than a few percentage points or so. As a result, the fund with the lowest fees is destined to finish at or near the head of the class. Over the past three years, according to Morningstar, another fund-ranking service, Vanguard has earned boasting rights to the best-performing mortgage-backed securities fund out of 57 measured and the second-best Treasury bond fund out of 27 measured. It would rank No. 1 in Treasury funds but for the fact that Dreyfus temporarily waived its fees. Vanguard has the edge in municipal bond funds, even though its entries rank third and fourth among 315 such funds for three-year performance. Don Phillips, Morningstar's president, notes that the rival funds took higher risks to achieve higher returns, betting on lower-rated bonds. ''On a risk- adjusted basis, Vanguard's municipal funds are much better,'' says Phillips. ''Vanguard's managers know they have an advantage with low costs, so they take fewer risks.'' In money market funds, Vanguard's Money Market Reserves: Prime Portfolio ranks 14th out of 239 over the past 12 months, as measured by Lipper Analytical. Why not better? Nine of the 13 funds ahead of Vanguard have been waiving their normal fees. Says A. Michael Lipper, president of Lipper Analytical: ''You can pretty much assume that any money fund with a better yield than Vanguard's Prime Portfolio is waiving fees.'' Competitors can't afford to play that game forever. During the past year, two of the leaders, Fidelity's Spartan fund and Dreyfus's Worldwide Dollar fund, have begun to phase in fees. TALL (just over 6 feet), gangly, and cantankerous, Jack Bogle thinks he has a leg up on the competition and wants the world to know it. Like a fundamentalist preacher, he takes every opportunity to rail against the industry's perceived sins: excessive fees, inadequate reports to shareholders, deceptive advertising. ''In one recent publication I counted 15 ads for funds that claimed to be the No. 1 this or that,'' Bogle says. ''That kind of stuff is really misleading. Some of these fund companies act like they were selling soap.'' Bogle's sermons make the competition mad. Says Ned Johnson III, CEO of Fidelity: ''We offer many services that Vanguard doesn't. I think Jack Bogle forgets that there is more than one way to run an investment company.'' Bogle has been offering bargains since he came into the world as part of a two-for-the-price-of-one package with his twin brother, David. His grandfather, William Yates Bogle, was one of three founders of American Can (now Primerica), but the family lost its wealth in the 1929 stock market crash, so Bogle grew up thrifty. ''I remember working as a kid behind a soda fountain counter so I could save money to buy a bike,'' he says. His father, a middle manager at American Can, had chronic health problems and died of cancer at 55. Bogle's mother was the dominant and guiding force in his life. Says he: ''She was very ambitious for me.'' Bogle's confrontational style was already taking root by the time he was a teen. No baseball heroes for young Jack. He idolized Billy Mitchell, the U.S. Army general who foresaw the importance of military air power and was later court-martialed for outspoken criticism of his superiors. Bogle thought so highly of Mitchell that he named his Boy Scout patrol after him. Bogle attended Princeton University on scholarship. There he read a December 1949 FORTUNE article on the burgeoning mutual fund industry, which inspired him to write his senior thesis on the subject. He pitched his paper to Walter Morgan, CEO of the Wellington Group, a Philadelphia money management firm, and in 1951 wound up as Morgan's clerk. Sixteen years later, Bogle moved into Morgan's seat as Wellington's boss. But his reign was stormy. Like his boyhood hero, Bogle found himself in constant battle with his superiors. ''Wellington's board and I were in a real power struggle,'' he says. ''I wanted to control everything, and so did they.'' The ultimate insult came when Bogle dismissed one of the directors, a tenured money manager, for poor performance. The board voted Bogle out in 1974. The board's boot wasn't enough to bounce Bogle out of the business. Mutual funds, by law, are independent corporate entities, with their own boards of directors. Bogle's relationship with the boards of the individual funds was unaffected by the dictates of Wellington's board. He worked a new deal with them that gave him administrative responsibilities for the funds, such as regulatory compliance and sending out dividend checks. The investment advisory operation and distribution through brokers remained with Wellington.

To handle the administrative duties, Bogle created a new company called Vanguard and made the funds its owners. He then began to strip Wellington of its remaining hold over the funds. In 1977, during an industry slump, he persuaded the funds' directors to abandon Wellington's broker distribution network, with its 8.5% sales load, and sell directly to the public at no charge. Over the next several years, Bogle wrestled away some of the investment advisory business from Wellington as well. Wellington remains a large money management firm and the investment adviser to some of Vanguard's funds. HARDLY was Vanguard up and running than Bogle began shaping it into the Wal- Mart Stores of fund companies. He streamlined operations and trimmed expenses across the board. He clipped the size of the funds' newsletter by an eighth of an inch to save $65,000 in postage per issue. Out on the road, first-class travel was forbidden. Bogle set the standard, always traveling coach. Frugality is as comfortable as an old shoe to Bogle, who wears wool ties instead of silk because, he says, the itchy ones last longer. Vanguard's corporate structure, radically different from that of competitors, gives it a cost advantage. Instead of the management company's owning a group of mutual funds, Vanguard flips the corporate chart upside down -- investors in the funds own the company. So Vanguard doesn't have to generate profits and dividends for stockholders as other mutual fund companies do. Fidelity, for example, earned $32 million last year -- money its mutual fund investors had to shell out. The real kicker on costs is how Bogle manages and markets the funds. The company spends next to nothing -- $5 million per year -- on advertising. Fidelity, which is twice as big, spends an estimated $40 million. Instead of maintaining an army of security analysts for its equity funds, Vanguard contracts out the funds to professional money managers who are able to spread the expense of equity research over many clients. To further trim expenses, Vanguard pegs the managers' pay to performance. As Vanguard has grown, the efficiencies have grown with it: Its average expense ratio has dropped from 0.68% in the Seventies to 0.38% today, while the rest of the fund industry has remained locked at over 1%. Competitors find plenty to carp about in Vanguard's ways. Johnson of Fidelity is especially critical of its reliance on outside money managers. ''We bring our people along from the day they start here as junior analysts,'' he says. ''We don't rely on contracted money managers we have no control over.'' Johnson's home-grown stock pickers do have an edge on Vanguard's hired hands -- several of Fidelity's funds have achieved spectacular returns. But Vanguard's funds have the advantage of low costs. Net of loads, expenses, and federal taxes, Vanguard's growth fund is the sixth- best performer of 288 in that category over the past three years; Vanguard's growth and income fund finishes fifth in its group of 156 funds; the equity income fund lands in 11th place out of 39 contenders (for a ranking of the best-performing funds, see the following article). Vanguard's flagship fund, Windsor, has beaten the market over the past decade, but it took some lumps during the past two years as its largest holdings, auto and bank stocks, failed to pay off. Windsor manager John Neff is a true value investor who makes big bets on unpopular stocks paying hefty dividend yields. In 1990 he loaded up on the shares of banks, thrifts, and insurance companies, all goats until late in 1991, when bank stocks took off. For the year Windsor is up 26.6%, four percentage points ahead of the S&P 500. Despite an enviable record, Vanguard's equity funds can't come up with returns that will match Fidelity's mighty Magellan fund. But they may not have to. Many investors have opted to park their money in Vanguard's money market, bond, and low-risk stock funds, where the fees are modest and the returns are good, and shift a portion to one of Fidelity's highflying equity funds. Vanguard reports that 28% of its investors also own Fidelity funds. More fire from the competition is aimed at Vanguard's paltry capitalization of $15 million, enough to run the business but nowhere near the capital of public companies like T. Rowe Price or Dreyfus. Howard Stein, head of Dreyfus, is quick to point out that shareholders of Vanguard's money funds are vulnerable to unpleasant surprises. Says Stein: ''What if Vanguard had a problem with one of its money market funds? Where would the capital come from to shore it up?'' Last year T. Rowe Price bailed out its money market fund and bond funds to the tune of $64 million to buy back commercial paper and notes it held from Mortgage & Realty Trust, a Pennsylvania REIT that filed for Chapter 11 (it has since emerged). Investors lost nothing, although owners of T. Rowe Price common stock were hit with a 27-cent per share charge to earnings. Stein points out that Dreyfus could take similar actions to support its funds in an emergency with its $726 million of equity capital. Vanguard could not afford such largess, and Bogle doesn't deny the risk of a money fund debacle. But he points out that it is not just Vanguard's problem: ''That's something we say over and over again could happen, not just here but with anybody's money market fund.'' T. Rowe Price may have felt the need to bail out its money fund to save its image, he says, but it was under no obligation to do so. Nor has Dreyfus or any other money fund manager made such a promise. Adds Bogle, a bit defensively: ''If Howard Stein wants to guarantee his funds, let him put it in the prospectus.'' The biggest challenge facing Vanguard is its fans, not its critics. Bogle and his heir apparent, President John ''Jack'' J. Brennan, 37, spend most of their time trying to cope with hypergrowth. The company now takes in $1.1 billion a month, nearly as much as its entire asset base in the mid-Seventies. And Vanguard still has throngs of potential converts. In a recent study of 3,447 mutual fund investors by Renaissance Applied Research in Carmel, Indiana, 39% could not answer whether their fund had a sales load or not. Floor space at Vanguard is in such short supply that some staffers have been lodged in the basement. ''We're at the point where we're about to move people out to the parking lot with car phones,'' says an executive. He's not quite serious: The company is building a new campus headquarters on 213 acres near its prosaic corporate park in Valley Forge. The sheer logistics of handling a deluge of new money keeps all of Vanguard's employees running full tilt. Says Vincent McCormack, head of operations: ''We now have 2.6 million shareholders, and we send out 35 million to 40 million pieces of mail a year. Our account activity is now 50% higher than we projected last year.'' The company has 290 phone reps who field up to 25,000 calls a day. In the service center, a digital screen flashes the number of seconds a customer is on hold. If it moves toward 20 seconds a battle cry is sounded and ''the Swiss Army'' -- an emergency force of lower, middle, and senior executives -- is mobilized to man the phones. President Brennan, a Harvard B-school grad, pitches in too. He arrives every morning at 6, long before the first phone rings. ''I make the coffee,'' he says. ) The pressures of high growth are not made easier by Bogle's brash style, which he turns on employees as freely as on competitors. ''He's a tough guy to deal with at times,'' says McCormack. He can drive staff members crazy by demanding reams of seemingly irrelevant numbers. When it comes to making complex calculations, he delights in beating out calculator-wielding execs with his slide rule or his head. BOGLE HAS NOT announced when he will retire, though he openly talks about his weakened heart and history of pacemakers (he's been through three of them, though he doesn't wear one now). The prospect of stepping aside doesn't thrill him, nor is he eager to pass the power to his younger sidekick. Says he: ''Jack Brennan could still use a bit more seasoning.'' Others disagree. ''There will never be another Jack Bogle,'' says Gerald Perritt, editor of the Mutual Fund Letter, a monthly advisory, ''but Brennan is more polished, more of a diplomat, and that's what Vanguard will need in the years ahead, more of a caretaker.'' It is hard to imagine what will be left for Brennan to do when he gets his chance at the helm. But Brennan maintains that if he just follows what Bogle has preached, the best is yet to come: ''We are in a brutally competitive environment, but I believe the no-load, low-cost segment of this business will thrive. We are the right company at the right time.'' Many an investor is shouting amen.

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