In my previous post, I wrote about the response Gus Sauter got from the CEO of Vanguard when he suggested Vanguard enter the ETF domain. To understand why this response is a natural response we need to understand some history of mutual funds.
Until 1976, all mutual funds were actively traded funds. These funds used investors’ money to invest in certain financial instruments (such as Stocks)with an objective to beat a benchmark index like S&P 500. They used extensive research to make their trading and investment choices. The promise of an actively managed fund was that it would beat the benchmark index.
In 1976, a small player in the mutual funds industry by the name of Vanguard introduced a new class of funds called index funds. Such funds promised that they would match a benchmark index but at as significantly lower costs. Index funds were passively managed funds in the sense that they did not actively trade securities but instead replicated the securities in the benchmark index. Since they didn’t need to buy and sell securities except when the index composition changed or to honor fund redemptions, such funds were cheaper to manage. They also charged a sixth of the management fee that an actively managed funds charged.
If you managed Fidelity’s fund business how would embracing index funds affect your business? If you converted all your funds to index funds how would it affect your revenues? Clearly, your revenues would decline significantly (perhaps by over 80%) and it would be likely that your profits would decline commensurately if not more. How would you like to embrace such an innovation? If you are like most people you would hate it. That’s exactly what Fidelity did. It didn’t enter the index funds arena for over ten years.
On the other hand, investors loved the product and as a result new money began to flow to index fund category. Since established firms didn’t embrace the innovation, Vanguard played in a largely uncontested domain for a long time. During this period, it became one of the largest mutual fund houses in the country.
Eventually, others saw the success of this innovation and followed Vanguard. Nevertheless, Vanguard continued to remain a leader in the index funds category.
In short, Vanguard rose to a leadership position due to a Rogue innovation it commercialized. You would expect such a firm should be able to recognize a rogue innovation and deal with it effectively. But from my previous post, it would be clear that this did not happen.
Just as index funds were a rogue innovation to actively managed funds, ETFs were a rogue innovation to index funds. ETFs charged even lower and were similar in structure except that most of them required even less work.
Vanguard CEO’s response was no different from how Fidelity responded to Vanguard’s innovation. In this case, Barclays benefitted from Vanguard’s slow response and became a leader in the ETF category.
Embracing a rogue innovation is a tough pull to swallow because if you manage the business, willingly reducing its size and profitability is the last thing you want to do. So the temptation is to continue to look for a way out of this situation.
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