YOUR PRACTICE-Vanguard juggernaut can challenge advisers

CHICAGO Fri Feb 7, 2014 8:00am EST

CHICAGO Feb 7 (Reuters) - Like many financial advisers, Joseph Clemens of Denver has seen his clients wax enthusiastic about mutual funds from Vanguard, the company that put index-based investing and low-cost funds on the map.

As the Standard & Poor's 500 stock index built a 30 percent return in 2013, investors flocked to the kind of investing the Valley Forge, Pennsylvania, fund powerhouse specializes in, called passive investing. In many cases, they have called their advisers asking to be put into Vanguard funds.

"There has been a bull market in passive investing. Vanguard is king," Clemens said. One of every four U.S. dollars flowing into mutual funds last year was captured by Vanguard, according to a January report by the research firm Morningstar.

Maybe that is because the average Vanguard mutual fund share class - excluding money market funds - costs 0.13 percent a year, compared with 1.15 percent for the rest of the industry, according to Lipper, a Thomson Reuters company.

Clemens has no problem saying "yes." As a fee-based adviser whose clients' assets sit in Charles Schwab accounts, he is able to buy some Vanguard funds by paying transaction fees that typically are less than $10 per trade.

But the Vanguard juggernaut can present problems for other kinds of advisers.

It presents a particular challenge to traditional brokers, who make their money by earning commissions on the products they sell. Often their company trading platforms do not carry the full breadth of Vanguard funds, and brokers do not make money on the products they do offer when they encourage clients to buy them.

TRADITIONAL BROKER WOES

"You can't compete on price with them," says one Morgan Stanley broker who declined to be named. When his clients request Vanguard funds, he typically offers alternatives with a similar investment approach, though they will cost more.

If clients balk, he plays up the importance of the comprehensive service they receive from him on other investment choices.

"Is Vanguard going to pick up the phone and call the client? Generally speaking, the answer is 'no,'" he says. "With Vanguard, you're kind of on your own."

Some brokers offer workaround solutions to get their clients into Vanguard funds.

One Merrill Lynch adviser, who also declined to be named, says he recommends that clients he thinks should have a Vanguard municipal bond fund buy it through Merrill Edge, Bank of America Corp's online discount brokerage site.

Once the Edge account is open, the adviser then prompts the client to transfer the Vanguard funds to a regular Merrill account. He says firm officials have not questioned the procedure.

OFFERING A TISSUE, NOT A KLEENEX

David Shotwell, a fee-only adviser based in Ann Arbor, Michigan, whose firm manages $47 million, says he sometimes puts clients into Vanguard, but he often looks for comparable substitutes more readily available on the Fidelity platform he uses for his clients' accounts.

"It's like saying you want a Kleenex when you need a tissue," Shotwell says. "I approach it from the idea that they are not necessarily after Vanguard per se, but rather after a low-cost, passive-index approach. The trick is figuring out why they are asking for Vanguard and then looking at funds that provide those solutions."

EXCHANGE-TRADED FUNDS

Besides offering its array of products to investors directly and through employee benefit plans, Vanguard makes most of its funds available through brokers and investment advisers at varying costs, says Jack Brod, a principal in the company's financial adviser services division.

Independent advisers who clear trades through broker-dealer networks such as Fidelity may not have access to Vanguard mutual funds, but they can buy comparable Vanguard exchange traded funds (ETFs). Both ETFs and index mutual funds seek to track closely an index benchmark. ETFs can be even lower-cost than mutual funds though they typically require transaction costs; the market price for ETFs fluctuates throughout the day, while mutual fund shares are priced once after the close of trading.

"If you buy a Vanguard ETF, you're going to pay a commission or transaction fee," says Brod, adding that Vanguard's business with advisers has been growing due to more advisers adopting a fee-based business model that does not require them to sell commissioned mutual funds. "We do a significant ETF business."

Clemens, the Denver-based adviser, uses Vanguard ETFs for his clients, paying transaction costs of less than $10 per trade.

LESS INVESTMENT PICKING, MORE PLANNING

Of course, advisers who function strictly as planners and do not manage client money tend to be indifferent to the brands their clients request. Amy Jo Lauber, a fee-only financial planner outside of Buffalo, New York, often turns to Vanguard funds for her customers, many of whom are engineers.

"Most of them are very much do-it-yourselfers," she says. "Just tell them which funds and they'll go on the website and fill out the application themselves."

Whatever the approach to obtaining passive investment funds, it appears clients' interest in them is not waning, says Mike Rawson, the Morningstar analyst who authors the monthly fund flow reports.

He notes there is at least one worthwhile outcome that financial advisers should take note of. The increasing emphasis on passive investment choices means that advisers will spend less of their service time helping clients select funds based on the performance of active fund managers and more time on their long-term financial strategy.

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