From the November 2008 issue of Wealth Manager Web • Subscribe!

November 1, 2008

AT THE VANGUARD

I like Vanguard funds. I know it's a no-no for active managers--and I include myself in that group--to admit this. After all, Vanguard is the "King of the Indexers," the firm that loves to bad-mouth active management.

The fact is, however, that Vanguard, as a group, does have attractive open-end mutual funds: low expenses, low minimums in most cases, respectable returns. What's not to like?

To be sure, my firm likes to invest in individual stocks in our client SMAs, so we don't use Vanguard funds on the equity side. But the fixed-income side is a different story. We don't fancy ourselves bond experts. We're stock guys. And quite honestly, most of our clients who require fixed-income exposure are probably better off in a fund. If our clients are like yours, oftentimes they don't have enough assets to properly diversify among individual bonds. And as we've seen over the last few months, the need to diversify among bonds is just as great as diversifying across equities.

Thus, my firm happily turns to Vanguard's bond funds when allocating client assets in fixed-income investments.

There is one problem with using Vanguard mutual funds, however. Actually, it is not so much a problem with Vanguard funds as it is a problem between the custodians that hold your clients' assets and Vanguard.

A few years ago, we brought on a new client who wanted a heavy exposure to fixed-income investments. The client's assets were already at Charles Schwab--one of the two firms with which we primarily custody client assets--so the transition for us to manage the portfolio was pretty clean. (It was quick and easy to move the client's Schwab retail account to our Schwab institutional account.) As I said, the account was already heavily in fixed-income investments, and the client wanted it to remain that way. We obliged and started to shift his bond investments to our favorite fixed-income areas, which happen to be Vanguard bond funds.

Immediately after we started to transition the assets to Vanguard funds, I got a call from the client. He was concerned about what he felt were high trading costs that Schwab charged to buy Vanguard funds. The high fees were imposed because Vanguard was not part of Schwab's "no-transaction-fee" platform. And Schwab's platform is not the only fund "supermarket" that charges for Vanguard funds. Indeed, because Vanguard generally refuses to fork over the basis points required by the fund supermarkets, it is not a big favorite with Schwab and several other fund platforms. Thus, if you want to buy a Vanguard fund on these platforms, you will likely have to pay up.

I explained to the client that we liked Vanguard funds and felt that they would more than make up for the higher up-front costs with their low annual expenses and expected solid returns. But he still didn't like the idea of paying so much. So after the call, I did what most of us do with a decent-sized account: I did what the client wanted. That meant eschewing Vanguard funds and buying other bond funds in the portfolio.

This turned out to be a mistake. The two Vanguard bond funds my firm especially likes to use are the Vanguard Short-Term Investment-Grade (VFSTX) and the Vanguard Total Bond Market Index (VBMFX) funds. Schwab has two funds--its Schwab Short-Term Bond Market (SWBDX) on the short side and the Schwab Total Bond Market (SWLBX), which, like the Vanguard fund, attempts to replicate the Lehman Brothers Aggregate Bond Index. So I went with those funds as my Vanguard alternatives. After all, how badly could someone mess up a short-term bond fund and an index bond fund, right?

Over the last three years (through Sept. 19), the Vanguard Short-Term Investment-Grade Fund has notched an average annual return of 3.3%. The Schwab counterpart's performance was much weaker--up 1.7%. And the gap between Vanguard's Total Bond Market Fund and Schwab's Total Bond Market Fund--remember, both of these attempt to replicate the same index, the Lehman Brothers Aggregate Bond Index--was even more surprising. For the three-year period ended Sept. 19, the Vanguard Total Bond Market Index was up 4.3% versus 1.9% for the Schwab fund. And the performance slide for the Schwab funds has been even more pronounced in 2008. So far this year, the Vanguard Short-Term Investment-Grade fund was down 1.4% versus a decline of 4.0% in the Schwab Short-Term Bond Market Fund. And the performance difference between Vanguard's Total Bond Market Index and the Schwab Total Bond Market was, in a word, ridiculous. The Vanguard Total Bond Market was up 1.4% through Sept. 19 versus a 3.8% decline in the Schwab Total Bond Market. A performance gap of roughly 520 basis points between two funds that purport to track the same index is not only surprising but embarrassing. And it just goes to show you that the conventional wisdom that "a monkey can run an index fund" is not exactly true.

The upshot is that choosing the Schwab funds over Vanguard's bond funds to save at the front end what amounts to a fairly trivial amount of money as a percentage of the client's overall portfolio was the ultimate example of being penny-wise and pound foolish.

The good news is that I and other advisors no longer face the dilemma of trading Vanguard funds for clients because of the cost. That's because Vanguard now offers advisors a second option with a friendlier up-front fee in the form of Vanguard exchange traded funds.

At the end of August, there were 710 exchange-traded funds in the U.S. with assets totaling roughly $582 billion. Those assets were spread among 24 ETF managers. Actually, that last statement is not quite accurate. Assets in the ETF world are hardly "spread" across ETF managers. They are incredibly lumpy, focused on only a few big players. While there may be 24 ETF managers, the ETF world is really a party of three: Barclays Global Investors and its iShares brand ($295 billion in assets), State Street Global Advisors and its SPDR brand ($145 billion) and Vanguard ($51 billion).

Together, Barclays, State Street and Vanguard control more than 84% of the ETF assets. Interestingly, among the top three, Vanguard is the only one that has seen a net increase in ETF assets this year--a gain of nearly $9 billion, up 21%. And Vanguard is the only one of them that has increased its market share this year.

I can't help but think that one reason for Vanguard's continuing emergence in the ETF world is that it provides a solution to a problem that has been plaguing advisors for several years: How to buy Vanguard funds cheaply. Indeed, while buying a Vanguard open-end mutual fund could cost $50 or more on some custodian platforms, a Vanguard ETF--depending on the custodian--may only cost the client less than $10 per trade.

The accompanying table lists all of Vanguard's ETFs. As you can see, the table includes not only Vanguard bond ETFs but also equity ETFs, including sector and international funds. Note that many of these funds, including all of the bond ETFs, have been around for less than 24 months, so the ability to buy Vanguard bond ETFs as surrogates for Vanguard bond mutual funds is a relatively recent development.

Expenses are quite low across virtually all of the Vanguard ETFs. The modest expenses are particularly pronounced in the international and sector areas, where fees in comparable funds are often higher.

What's particularly interesting is that, in some cases, the expenses on Vanguard ETFs are lower than the expenses on Vanguard's comparable open-end mutual funds. As previously mentioned, one of our favorite Vanguard mutual funds is the Total Bond Market Fund. Vanguard offers an ETF version that also tracks the Lehman Brothers Aggregate Bond Index. What's more, the expenses on the Total Bond Market (BND) exchange-traded fund are just 11 basis points--even lower than the 19 basis points Vanguard charges on the mutual fund.

One piece of advice I offer you is that if you decide to dump bond mutual funds to buy Vanguard bond ETFs, or bond ETFs offered by other ETF sponsors, make sure your clients are on the same page. Returning to my story, we dumped the poorly performing Schwab funds and bought the Vanguard Total Bond Market (BND) and Vanguard Short-Term Bond (BSV) ETFs. But that generated a question from a client who wanted to know why we had put so much money into a single "stock." Obviously, the client was not familiar with ETFs, and we had done a poor job of educating him. Thus, he didn't understand the trade and therefore was nervous that we were putting a lot of money into a single investment. Once I explained ETFs to him and the reasons we made the change, he felt much better.

The moral of the story is that while you may think ETFs are mainstream investments, they are still a mystery to many of your clients. If your plans include bringing more ETFs into client portfolios, especially bond ETFs, educate your clients. This goes double for income-oriented clients, who tend to be the most skittish and may get really nervous seeing a new "stock" enter their portfolios.

Given Vanguard's success with ETFs, it's a little surprising that other mutual fund families have not moved more aggressively into the market. Indeed, when you look at three of the largest mutual fund providers--American Funds, Fidelity and Vanguard--only Vanguard has a substantial presence in ETFs. Fidelity offers only one ETF--the Fidelity Nasdaq Composite Index Tracking Stock (ONEQ)--and that ETF has just $93 million in assets. And American Funds doesn't even offer an ETF. Now I know that Vanguard's focus on index funds makes it a natural for ETFs, and I suppose it would be suicide for American Funds, whose sales depend on commission-based brokers and advisors to sell its funds, to offer ETFs.

As for Fidelity, it holds itself out as an active manager, so it might send mixed signals to offer index-based ETFs. Still, there are other fund complexes, especially those that, like Vanguard, are not necessarily favorites on the supermarket platforms, which could benefit from offering ETFs.

Perhaps an indication of what the future holds for ETFs is the recent announcement that mutual fund giant PIMCO will soon be offering ETFs. My guess is that you will begin to see other fund families moving to the ETF space, if for no other reason than to improve the ability for advisors to use their products more cheaply.

Chuck Carlson, CFA, is chief executive officer of Horizon Investment Services and the author of Winning With The Dow's Losers (HarperBusiness). David Wright, CFA, provided research assistance for this article.

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