Vanguard started out in 1975 with a novel idea of managing mutual funds. This idea has really caught on over the years and has propelled Vanguard to the top of the heap.
The world of mutual funds has historically been a battle between those who can build the best portfolios and outperform the broader market the best. Doing so requires both a lot of skill and effort, and the real challenge here isn’t to pick good stocks that go up, it’s to move huge amounts of money in and out of them and still make that profit.
This is more difficult than it sounds, and is nothing like the ease that individual investors can initiate and close positions based upon how a stock is performing. When you drive a fund-sized vehicle, you have to plan your moves in advance, as well as using riskier tactics such as looking to buy pullbacks more.
An individual may see a stock they like and just buy some shares, and when we don’t see what we expected or things change enough, we can just sell it. We can also reduce our exposure to the market or even be out of it, and even can place bets that something will go down if we choose, an individual stock, a basket of them, or even an index.
Funds have to be fully invested according to the fund’s stated plan, and also need to enter and exit positions more gradually. This involves taking on more risk where they have to time their trades not just in accordance with how a market is moving, but often try to swim against the tide, buying when something is going down and selling when it is going up.
In a case where both an investor and a fund buy a stock, the investor is going to get their shares priced at the current market, let’s say $50 a share. Funds can’t just swoop in and buy gigantic lots of it though, as this would drive the price way up due to this increased demand. After the buying spree is done, we will generally see the price drop most if not all the way back to where it was, due to the price finding equilibrium with the supply and demand aside from this buy.
Because of the size of their orders, funds can’t really trade shorter term, and have to use horizons of a fairly good length, for no other reason than to cover the slippage between our intended price, $50, and the average price of what they pay.
There is therefore a lag involved here, and if the pick is a good one and goes up like we hope it will, the fund will pay more, and if it does not perform well, they will get a lower price but will be entering during a period where risk of losses is higher.
Since managing active funds takes a lot of skill, funds will have to go out and spend a lot of money on this talent, and the good ones do command some pretty big compensation packages. This and the other costs associated with running the fund come right off the top by reducing investor returns by the exact amount of these costs.
Vanguard Changes the Investing Landscape Dramatically
Back in 1975, well before mutual funds became as phenomenally popular as they are today, a fund company called Vanguard rolled out the first popular index fund, looking to significantly cut management costs by reducing the exercise to just buying all the components of an index in proportional amounts and looking to duplicate the returns of the index.
Index funds don’t quite replicate this, as there are costs and slippage involved, slippage meaning the difference between the price you want to pay and the actual amount paid, but they come pretty close, and this is because their sole objective is to come as close as they can.
Over four decades later, Vanguard remains at the top of the index fund hill, both in terms of funds under management and fund growth. Of the two, fund growth is the more indicative of how a fund is doing, because those who are in these funds tend to stay regardless. If there are any complaints, they are directed at the market, and while investors often blame the market regardless, in this case it’s actually appropriate.
Index funds don’t beat all active funds, but they do beat about 80% of them, once we deduct the costs of each and calculate real returns to their investors. We may think that in perfect market conditions, index funds should at least comprise the majority of funds under management, but there is a big lag in play here and people who are invested long-term in lesser performing funds will not always be eager to switch horses,
There’s also the matter of a lot of investors not being fully aware of the differences between these funds, or perhaps may not even be that aware of how their fund stacks up to index funds, or even what an index fund is.
This is the main reason why we want to look at fund growth to see how much more money is flowing into a company like Vanguard’s index funds as well as what is happening with this with index funds in general. Index funds have really grown over the past few years and are projected to surpass actively managed funds in a few years, and Vanguard is very well poised to benefit from this.
The Investing Public is Preferring Simplicity More and More
Vanguard is consistently beating the competition, not just other index funds but all funds period. Vanguard has had the largest net inflow of funds each year over the last 12 years among all mutual funds, and has added over $2 trillion in funds managed over this period.
Perhaps even more impressively, of the world’s top 20 mutual funds, 13 of them are Vanguard’s. It seems that the ideas that company founder and index fund pioneer John Bogle had in mind all those decades ago is not just a hit, but a very enduring one.
It’s not that index funds don’t have their critics, even though we might think it to be difficult to criticize something that simply works so well and in a way that is clearly superior to most other funds.
Some feel that index funds promote less efficient pricing of stocks, although the people who believe this simply do not understand how these markets really work. If we assume that efficiency means pricing as close to fundamentals as possible, then this might be a valid point, but what really drives these prices is market supply and demand.
Fundamental data does influence supply and demand, but it does not define it, as the actual supply and demand from all factors does. Index funds increase the demand, in a way that is clearly not based upon anyone making any decisions based upon any factors.
While looking at fundamental data can be helpful at times, it’s just one influencer, and while what amounts to blind buying of stocks may dilute this impact, we do not want to put the cart before the horse here and it’s this this desire to invest that is the horse, not where analysts think prices should be.
If our hope is to see stock markets rise over time, index funds are a great prescription, and this is the hope of just about all investors actually. Index funds may even be seen as changing the landscape of stock markets toward an even more bullish bias than active funds do, because index funds are all about buying and holding not just a few stocks but all of them in an index. Its impact is broader and not so driven by business performance, which can serve to be a limiting factor if stocks are bought and sold based upon this and not just one’s wish to invest.
Vanguard is well positioned to maintain its leadership in index funds as well as in the mutual fund industry as a whole. While they are under pressure from fellow fund giant BlackRock as far as net inflows go, and from the fast-growing ETF industry, John Bogle’s great idea not only continues to be valid, it is now set to become the biggest one out there as well.