Two Giants Square Off
Fidelity and Vanguard are bigger than ever since the fund scandals
Last fall, as the worst scandal in the 80-year history of the mutual fund business was unfolding, industry leaders quietly began to worry: What would happen if Fidelity or Vanguard, the two giants of the business, got caught up in the mess? How would investors, who have collectively placed $1.3 trillion in stock and bond funds run by the two firms, react?
"If a blue-chip company like Fidelity were drawn into this, or especially Vanguard, which holds itself out to be a place of high regard for shareholder interests, it would have had a much greater impact on investor confidence," says Steve Savage, a managing director for Litman/ Gregory Asset Management.
Fortunately for the $7 trillion industry, the question was moot. Vanguard and Fidelity avoided the trading scandals that roiled competitors--including Putnam, Alliance, Janus, and Strong--and today they are even more dominant as a result. Now, the question within the industry is what happens if these two 800-pound gorillas become even bigger?
Record flows. For the moment, thanks in part to the fact that Fidelity and Vanguard have kept faith with their shareholders, fund investors continue to pour money into mutual funds. In the first quarter, investors added a record $135 billion to stock mutual fund holdings, according to the research firm Strategic Insight. That compares with $8 billion taken out in the same period last year. Even more impressive, in the months since the scandal broke, investors have plowed $249 billion into stock and bond funds, more money than the industry typically enjoys in an entire year. "To me, what the investor has been doing and saying lately is, we have great confidence in mutual funds as the vehicle of choice to save for the future," says John Brennan, chairman and chief executive of Vanguard, based in Valley Forge, Pa.
The dominance of the two giants is even more impressive when you consider there are scores of companies, large and small, clamoring for your investment dollar and some 16,391 individual funds in which you can invest. At the end of 2003, Fidelity and Vanguard managed 26 cents of every $1 held in stock and bond funds in the United States, according to figures compiled by Financial Research Corp., a Boston firm that tracks mutual fund investment flows.
But since the trading scandals erupted last September, Putnam, Janus, and Alliance have bled assets while Fidelity and Vanguard have attracted 38 percent of the new money that's being invested in mutual funds. Add in American Funds, the nation's third-largest fund family but one that largely relies on brokers to sell its products, and 64 cents of every new invested dollar this year is going to the biggest firms.
For the most part, Vanguard and Fidelity are considered benevolent giants, at least by most of the investing public. They are among the lowest-cost providers of asset management services in the business. While the average domestic stock fund charges annual expenses of 1.5 percent of assets, the average Fidelity domestic stock fund charges 1.3 percent. Equity funds at Vanguard, the industry's absolute cost leader, charge just 0.3 percent on average.
Partly as a result of low fees, Vanguard and Fidelity also are among the better-performing fund complexes over long periods. Over the past decade, 89 percent of Vanguard funds and 78 percent of Fidelity funds have beaten their peer groups. Vanguard's approach has been to stress consistency over time. As for Fidelity, "if you go back to the '80s it was more Janus than Janus," says mutual fund consultant Geoff Bobroff, referring to that firm's aggressive, swing-for-the-fences style. "But [Fidelity] recognized in the '90s that larger retirement investors don't want any home runs."
Today, the firms are changing but becoming somewhat more alike. Vanguard, rooted in index funds that track entire markets, is changing more as it broadens its appeal, a move that has drawn criticism from its faithful fans (story, Page 48). Fidelity, with more of a stock-picking ancestry, is trying to leverage its strength in asset management into other financial services. But some fear that as these two companies get bigger, a growing number of investors may just hand over most of their assets simply out of convenience. "It doesn't make sense to limit yourself to one family," says Litman/Gregory's Savage. "Great managers and great funds are few and far between, and they're not all at one family."
Another concern: As more money flows to Vanguard and Fidelity, the average size of portfolios at these complexes is likely to grow. And academic research indicates that funds that grow too big have a harder time outperforming their peer groups. "When funds accumulate huge amounts of money, it gets more and more difficult to differentiate themselves from the indexes," says Paul Merriman, president of Merriman Capital Management in Seattle and publisher of FundAdvice.com.
Strong gains. Fidelity and Vanguard aren't the only firms that are seeing sizable fund flows. T. Rowe Price, another company that has avoided scandal, has been performing well lately. But it's still nowhere near the size of Fidelity and Vanguard. American Funds, run by Capital Research & Management, is actually outpacing Fidelity and Vanguard in garnering new money. But unlike Fidelity and Vanguard, which for the most part sell directly to investors through no-load funds, American Funds are distributed through financial advisers and brokers, who don't stop selling just because times are tough in the stock market.
In that sense, Fidelity and Vanguard's dominance serves as vindication of sorts for no-load funds, which have lost market share to adviser-sold funds for several years. The days of Fidelity being known for just one fund--the flagship Magellan--and Vanguard being regarded simply as an index-fund firm are long gone. Starting in the mid-to-late 1990s, both firms--which have the advantage of being privately held, unlike competitors that are part of publicly traded corporations with short-term pressures--have evolved into huge financial services firms that reach into virtually every segment of their clients' lives, from college to the workplace, retirement, and beyond.
Vanguard is certainly no longer just an "index shop," as 65 of its 110 funds are actively managed, says Jeffrey Ptak, an analyst with Morningstar who follows Vanguard. While some may view this as a departure from the company's past, Vanguard CEO Brennan notes that actively managed funds like Windsor and Wellington played a big part in the firm's history. "We want a mix--a balance between stocks, bonds, and money market funds and actively managed funds and index funds," says Brennan.
The company that is synonymous with buy-and-hold investing also recently expanded on a new type of investment vehicle. These shares, known as VIPERs (Vanguard Index Participation Equity Receipts), allow investors to buy and sell shares of 16 Vanguard index funds that track a variety of markets (large-cap stocks, small-cap stocks, the basic-materials sector, technology, healthcare, and so on) and trade on the American Stock Exchange.
VIPERs should allow Vanguard to appeal to a broader audience. For instance, active investors, who have largely been shut out of Vanguard in the past, may be drawn to these products because they can buy and sell the exchange-traded shares throughout the day, instead of just once a day, which is the case with most traditional funds.
Moreover, because these shares are purchased through a brokerage account and do not require a Vanguard account, a greater number of institutional investors and financial advisers can do business with Vanguard.
On the opposite end of the spectrum, Vanguard is offering a one-stop approach to retirement investing, with a new set of so-called Target Retirement funds. These investments are balanced portfolios that invest in a mix of stock and bond funds. As the investor ages, the fund automatically rebalances and rejiggers the investments to become gradually more conservative. Fidelity runs a similar set of portfolios. "What Vanguard seems to be heading for is becoming a financial supermarket that can meet not everybody's needs, but the vast majority of investors' and savers' needs," says Daniel Wiener, editor of the Independent Adviser for Vanguard Investors newsletter.
Fidelity is already there. In addition to mutual funds, Fidelity has a highly regarded brokerage that competes with the likes of Merrill Lynch and E*Trade and has been successful at attracting IRA rollover accounts.
Perhaps Fidelity's biggest weapon in asset gathering is its lead role in the 401(k) business. At the end of last year, Fidelity oversaw $277 billion in 401(k) and similar retirement plans, spread out among more than 10,000 companies and more than 8 million plan participants. That makes Fidelity by far the biggest player in this market.
In addition to also offering traditional pension management services, Fidelity has become a big player in employee benefits services for corporate America. Earlier this month, Bank of America became the latest company to hire Fidelity to handle its human resources administration, payroll, and employee benefits for 250,000 employees and retirees. Overall, Fidelity oversees human resources programs, payroll functions, employee benefits programs, and stock plan services for 17 million U.S. workers.
The strategy is simple: Fidelity is not only in position to become the first fund firm young workers build relationships with through 401(k)'s but can build on those relationships as employees get their paychecks, earn raises, select their health insurance plans, and utilize other benefits programs.
"As baby boomers are approaching retirement, we're devoting a lot of resources to getting ready for that," says Fidelity Vice Chairman Bob Reynolds. Later this year, Fidelity is expected to announce new financial advisory programs that will appeal to boomers nearing retirement.
This strategy should ensure that Fidelity retains its dominance in the industry, analysts say, at least in the next generation. The same goes for Vanguard, thanks to the near-religious fervor with which Vanguard die-hards worship that company and its low fees. "These giants have huge momentum going forward," says Merriman.
This story appears in the May 3, 2004 print edition of U.S. News & World Report.