Gus Sauter, Vanguard Group's chief investment officer, vividly recalls the first time he proposed exchange-traded funds to his boss.
"That's the dumbest idea you've ever had," then-CEO Jack Brennan told him after a five-minute discussion back in 1998.
Mr. Sauter persisted. Eventually he convinced Mr. Brennan that these newfangled ETFs - index-tracking funds that trade in real time at ever-changing prices on a stock exchange - were a natural fit for Vanguard, the largest manager of traditional mutual funds that mirror various indices.
Today, Mr. Sauter's "dumb" idea has grown to about $135-billion (U.S.) of Vanguard's $1.5-trillion of assets under management. And after years of trailing in the race to attract new money from ETF investors, the fund giant is poised to take the top spot this year. In the first 10 months of 2010, Vanguard grabbed $31-billion versus $18-billion for iShares, now owned by New York money manager BlackRock Inc. and the market leader for much of the past decade.
iShares is still the firm to beat in total U.S. ETF assets under management, with roughly $413-billion - more than three times Vanguard's total. But iShares has seen new money invested in ETFs slip for three years running, while Vanguard's has doubled over that same period. According to data from Lipper, a unit of Thomson Reuters, iShares could end the year at half its 2007 inflow level.
"Today, we don't care if you're in an ETF or a traditional mutual fund," current Vanguard CEO, Bill McNabb, explained in an interview at the firm's Valley Forge, Pennsylvania headquarters. "ETFs will become almost by default a bigger and bigger part of what we do."
The success of Vanguard's ETFs starts with the basic appeal of the products generally, Mr. McNabb noted. Expense ratios are among the lowest available. And because big investors sometimes redeem shares in return for the underlying stocks, painful year-end capital gains payouts are rare.
NEW KING OF THE HILL
The de-throning of iShares would have seemed all but impossible just a few years ago. Until recently, the firm had dominated sales charts, issuing hit funds like clockwork. In 2005, it garnered $42.3-billion of the entire ETF industry's $52-billion of net inflow. Two years later, riding a wave of freshly introduced fixed income funds, iShares peaked with a record $52.3-billion of new money from ETF investors.
The changing of the guard is likely to bring at least one major benefit to investors: lower prices. "You can think of Vanguard as the Walmart of retail investing," said Charles Sizemore, who runs Dallas money manager Sizemore Capital Management. "The company's relentless obsession with keeping fees cut to the bone will force competitors to do the same."
And Vanguard is not the only one pushing lower cost ETFs. State Street Corp., which runs the oldest and largest single ETF, the $81-billion S&P 500 SPDR , has undercut fees with some new products. Several giants of the mutual fund world have also awakened to the ETF market, adding to the pricing pressures. Charles Schwab and Pacific Investment Management, home of bond manager legend Bill Gross, undercut iShares fees on some recent offerings.
As the ETF market matures and the largest providers duplicate more of one another's most popular funds, fees are likely to drop more, according to Scott Burns, Morningstar's director of ETF research. "There's a price war on and it's going to be just like other commodities, like airlines or steel or corn," Mr. Burns said.
None of this is especially good news for BlackRock, one of the world's biggest asset managers, which paid $13.5-billion for iShares parent, Barclays Global Investors, in a deal that closed last December.
BlackRock's shares have flagged this year, declining 31 per cent so far, in part due to concerns about the future of its ETF business. Goldman Sachs downgraded the stock to "neutral" from "conviction buy" in October, citing the heightened price competition in ETFs.
Laurence Fink, BlackRock's CEO, sounded a bit defensive on the firm's third quarter call with analysts a few weeks later. "It's much more complex than the simplicity of just fees," Mr. Fink said. "I'm not terribly worried about it. I think the next two years it's going to be all about innovation," he added later in the call.