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Vanguard – the benevolent fund manager?

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Vanguard Group Inc. has drawn many headlines in recent weeks following its decision to “give back” billions of dollars in investment mandates to Australian industry funds. According to Bloomberg reports, the group has been implementing similar strategies in China and throughout the world.

The return of (or what some see as a refusal to continue with) large investment mandates is a great headline, but hides a deeper story that pervades the superannuation industry. For the uninitiated, an investment mandate refers to a contract between a fund manager, like Vanguard, to invest on behalf of a large financial institution (or financial adviser) based on an agreed, usually discounted, fee. It is this discount that is key. 

Vanguard is an A$8.6 trillion global asset manager with the A$165 billion invested in Australia; a paltry figure in comparison to its global reach. So while the decision to cease running these mandates, which reports suggest may be close to A$100 billion of the group’s Australian assets, will hurt income in the short-term, it will have limited impact on Vanguard’s overall profitability.

  • So, why do it?

    Simple: they don’t get paid enough for it.

    Recent reports have suggested that the fees paid by Australia’s largest industry super funds can be as low as 3 or 4 basis points; that is, 0.03%. For a worked example, if we assume Vanguard is paid 0.05% on an A$1 billion investment mandate, it will receive ‘just’ A$500,000 in investment management fees. There are two ways to compare this.

    On the one hand, the pension and other large funds outsourcing their investment decisions to Vanguard will typically charge an investment fee of 0.5%, or $5 million on the same investment. They will then pay out $500,000 to Vanguard and keep the remainder for other investments, administration etc. At this point, it is worth pointing out that despite the expectation that pension funds are able to provide personal financial advice within this fee, this is generally very limited.

    The second-order issue relates to Vanguard’s traditional business model, in that it offers services to three types of investors; retail or direct, wholesale, and institutional. As is commonplace, the fee charged to retail and wholesale investors is much higher than that charged to institutions, on average between 0.2% and 0.3%. So, in effect, Vanguard’s direct investors have been subsidising the fees of large institutional investors for decades.

    Again, using a worked example and the same investment amount, it would require just $250 million in ‘retail’ money to replace the lost revenue for $1 billion in institutional mandates. Vanguard is effectively backing itself in to achieve this; so all kudos to them. Another way to look at it is that Vanguard is turning a difficult situation into a marketing opportunity. It could, of course, have attempted to increase its fees to ‘normalise’ its book, and risk losing these mandates to the lower-cost players anyway. 

    A broader trend

    The decision by Vanguard highlights a broader trend occurring in the superannuation and investment sector in Australia, one driven primarily by costs, size, and internalisation. The recent Budget announcements targeting under-performing super funds are only likely to see this trend accelerate even further.

    By no means am I suggesting that large corporate and industry funds are bad. They clearly play an important role in guiding the retirement savings of millions of Australians and provided competition into a what was a bloated and uncompetitive sector for several decades. They are simply beginning to wield and use a substantial amount of market power. So much so, that their customers are now becoming competitors: Vanguard has also launched its low-cost superannuation platform, Personal Investor. 

    As we have seen in the US pension-fund system, with size comes the potential to do more and more things in-house. This internalisation, where pension funds run their own investment portfolios rather than outsourcing to fund managers, has been the driving force of consolidations in recent years. Traditionally, the strategy is to obtain a core index exposure, through someone like Vanguard, BlackRock or Amundi, as cheaply as possible, and then apply your own internal views and tilts as the Investment Committee sees fit. 

    The question which always rears its head in these situations is, how do you sack an internal investment manager if they under-perform? But that is a story for another day.




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