Revenge is sweet, but even Jack Bogle couldn’t have scripted a sequel this perfect. As few sentient adults have been able to avoid learning, Fidelity lost its Midas touch in 1996. Vanguard’s fortunes exploded. While Magellan, Fidelity’s largest fund, was embarrassing the firm with D+ returns, Vanguard’s Index 500 index fund was trouncing most of the country’s fund managers. Shareholders bailed out of Magellan. Investors piled into Vanguard. Vinik, Posner and 16 other highly paid stockpickers beat a path out of Fidelity, while at Vanguard Jack Bogle smoothly passed on his CEO title to longtime protEgE Jack Brennan. Perhaps the most exquisite detail is this: Fidelity, whose superiority complex is founded on beating market gauges like the Standard & Poor’s 500, is planning to introduce–gasp–three index funds. Bogle, with uncharacteristic restraint, isn’t gloating over this capitulation. But as he looks forward to Friday, when he’ll celebrate the first anniversary of a successful heart transplant, he says, ““I’m on cloud nine. I could be happier–but damned if I know how.''
Word around Wall Street is that Vanguard’s triumph is a simple story. The market has shined on large-com- pany stocks, competitors say. Vanguard, whose stable of funds focuses on such stocks, was merely standing in the right spot. But that’s an oversimplification. The truth is Bogle has been vindicated because his firm’s principles are better for investors. (Vanguard manages the 401(k) plan for The Washington Post Company, which owns NEWSWEEK.) Does that make Fidelity the bad guy? Not really. Fidelity has fattened too many retirement accounts to earn that label. And its managers are too smart not to learn from its recent failures. But so should you. Vanguard’s moment in the sun may not last forever, but the investing truths drawn from this latest clash between mutual-fund titans are durable. Here they are:
Index funds are a sure thing. Vanguard hauled $8 billion into its Index 500 fund last year because investors supposedly understand the advantages of pegging your money to the market. But my bet is that most of them have been electrified by this simple fact: the index has gained 69.1 percent over the last two years, beating 1,420 of the 1,646 diversified U.S. funds with stockpicking managers. That’s great, but it’s the wrong reason to go into an index fund. The right reason: the best index funds have a huge cost advantage. The math is simple. Vanguard charges just .20 of a percentage point to manage an index fund. The average for actively managed funds: 1.5 percent, seven times as much. A fund manager has to outperform the index by 1.3 percentage points just to stay even with Vanguard’s S&P 500 fund. That’s not hard for a year or two, but ““it’s incredibly difficult to do consistently over long time periods,’’ says Don Phillips, president of Morningstar, an investment information company in Chicago. Vanguard can do it because costs are controllable. Fidelity couldn’t keep it up because performance isn’t.
A superstar culture is risky. It was fun. It was exciting. And now it’s over. Fidelity’s star system worked undeniably well for a long time. But the risks for a fundholder multiply in a place that rewards individual performance at the expense of teamwork. First, hypercompetition drives fund managers to goose returns without much regard for risk. You get short-term results that blow your socks off, but also nasty surprises. Why did so many ostensibly sensible Fidelity funds like Blue Chip Growth swoon when technology stocks dived last summer? Because so many Fidelity fund managers were willing to disregard their charter in search of sharp gains. A star system holds you hostage to a star’s own self-interest in another key way, too. When they decide the gig is up, they leave, as a steady stream of Fidelity managers has in the last year. You’re reduced to following them–or trying to unearth the next star.
Predictability is important. How often have you put predictability at the top of your mutual-fund shopping? It’s not glamorous, but knowing that your funds will do as promised is essential to a top-performing portfolio. Your goal shouldn’t be for every fund in your portfolio to swing for the bleachers. Instead you want every fund to execute its assigned task so that your risks are diversified. Surprisingly few do. Funds have gotten so sloppy about this that last year Morningstar began ignoring their stated objectives when categorizing their investment style. Fidelity had to drastically rein in its fund managers after corporate customers, who hired Fidelity to manage their retirement programs, complained about funds’ unpredictability. Vanguard’s stock and bond funds stick like glue to their defined goals, a key reason that it captured more than twice as much retirement business as Fidelity last year.
Greed hurts. Bogle is hardly as pure of heart as he pretends. But there’s no question that his company is leagues ahead of its competitors in sharing its booty with shareholders. Here’s how it works at most fund complexes. Let’s say that in your stable of mutual funds is a billion-dollar fund. For the job of running that fund you collect a 1.5 percent management fee, or $15 million. The fund has a rip-roaring year or two and attracts an additional billion from investors. Now the same 1.5 percent nets you $30 million, though your costs have hardly risen at all. Could you increase your customers’ returns by cutting those fees? Sure. But most fund companies prefer the extra profits and have maintained or actually increased fees over the years. Vanguard has steadily cut its levy as dollars have flooded in.
Greed also pushes fund companies to have huge funds. But being part of a large fund accomplishes nothing for you–and often hurts. Such behemoths rarely perform as well as when they had smaller waistlines. ““Fidelity’s genius-stockpicker style works exceptionally well with smaller pools of money,’’ says Phillips. ““But as the funds got bigger, performance petered out.''
It will undoubtedly be a different story three years from now. Never slow to adapt, Fidelity is looking more Vanguardian every day. In addition to launching index funds, it’s planning to lower management fees on some bond funds. And because Magellan returns have faltered, its fees have dropped a hair. But it’ll take more than a few more imitations to out-Bogle Bogle. Your mantra as a low-cost investor: Show me the money.
