June 23, 1999

The Vanguard Group
100 Vanguard Blvd.
Malvern, PA 19355
Phone: 610-648-6000

by Matt Richey (TMFVerve)

Ownership: Owned by Member Funds
Competition: Fidelity, Alliance Capital, T. Rowe Price
A Future IPO? Not a chance
Here at The Motley Fool, we think there's only one type of mutual fund worth considering -- the index fund. While most fund companies offer at least one index fund, only one company's entire philosophy revolves around the virtues of low-cost index investing -- The Vanguard Group.

Offering more than 90 pure no-load mutual funds with an average expense ratio of only 0.28% versus 1.24% for the average mutual fund, Vanguard is the efficiency king of the mutual fund industry. Vanguard's most efficient and famous fund, the $87.5 billion in assets Index 500 Fund, replicates the performance of the S&P 500 with an expense ratio of only 0.18%. That means an investor can put $10,000 into 500 of America's biggest and best companies for an annual fee of only $18.

Index fund owners not only benefit from low fees, but also from low portfolio turnover, which means lower capital gains taxes. The efficiencies of low fees and low portfolio turnover give equity index funds an annual performance advantage of 2.0%-2.5% over the average actively managed equity mutual fund. Over time, that difference in returns adds up in a big way. As the largest and best-known provider of index funds, Vanguard has a fundamental advantage over the competition.

Offering the highest standards of quality at the lowest reasonable cost is the essence of Vanguard's mission. Senior Chairman John Bogle and CEO John Brennan eat, drink, and breath low costs. While competitors such as Fidelity, Alliance Capital (NYSE: AC), and T. Rowe Price (Nasdaq: TROW) spend lavishly on television and print ads, Vanguard gets by on an annual advertising budget of only $8 million. That means the average Vanguard fund owner with $10,000 in assets pays only $0.18 per year in advertising costs. Stripping out every ounce of fat from its fund operations has made Vanguard a brand name among investors, despite the relative lack of advertising.

Vanguard derives much of its low-cost advantage from a unique corporate structure. Most mutual fund companies are owned and operated by a for-profit management company. Such is the case with chief rival Fidelity Investments, whose parent management company FMR Corp. is privately held. In contrast, The Vanguard Group is owned by its member funds, which operate on an "at cost" basis. This non-profit structure is more common in the insurance industry, where a number of mutual life insurance companies have a similar form of "mutual" ownership. As a non-profit organization, all efficiencies and cost savings are funneled back to the fund shareowners. This non-profit setup gives Vanguard funds a 40 basis-point (or 0.4%) advantage over its for-profit fund competitors. And as the only mutual mutual fund company, Vanguard can sustain its low-cost competitive advantage.

With $442 billion in assets under management and an average expense ratio of 0.28%, multiplying those two figures gives us estimated 1998 annual revenue of $1,237.6 million. One of the best aspects of the asset management business is that the long-term growth in prices of stocks, bonds, and other financial securities basically ensures an ever-growing base of assets -- and management fees. And when customers add new money, assets and revenues grow even faster. In 1998, Vanguard grew assets by 33%, half of which came from new money, which is now pouring in at a rate of more than $200 million per day, according to a recent Forbes story.

The growth shows no signs of slowing, either. According to figures from Financial Research Corp. in a recent Business Week article, since 1994 Vanguard has expanded its market share from 6.47% to 8.83% of all mutual fund assets. Fidelity still holds the market share lead with 12.65% of assets, but that figure is only slightly improved from its 12.55% share in 1994. As investors continue to discover the indisputable cost advantages of index investing, Vanguard will likely continue to gain share. In addition, the company is moving into Schwab's territory by offering online brokerage services with $20 online trades and the availability of more than 2,000 no-load funds (including a number of non-Vanguard funds).

Unfortunately, there's not a snowball's chance in... an oven of Vanguard going public. The mutual ownership structure is what gives the company much of its cost advantages over competitors. Luckily, the benefits of ownership are available by owning any of Vanguard's many excellent low-cost index funds.

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