Here's How Vanguard Can Be First in ETFs

NEW YORK (Fabian Capital Management) -- Investors are continuing to shift their assets from stodgy mutual funds to exchange-traded funds at a tremendous clip. Total U.S.-listed ETF assets recently reached a new all-time high of $1.762 trillion and some experts predict they will hit $3 trillion within the next several years.

Investors are choosing ETFs for a number of reasons including their low-cost, liquidity, diversification, transparency and tax efficiency. However, one element more than others appears to be driving the majority of asset flows in this mature phase of the product cycle -- that element is cost.

In the first four months of 2014, Vanguard led all ETF providers with $18.6 billion in new asset inflows and is close to surpassing State Street (STT) as the number two ETF issuer by total assets. Currently Vanguard is in third place with $360 billion in ETF assets, while State Street ranks second with $386 billion.

BlackRock (BLK) is the reigning king with $683 billion in ETF assets, which they will have to tightly defend in order to stay ahead of the Vanguard powerhouse.

The biggest strength of the Vanguard brand (both in ETFs and mutual funds) has been the passive index approach combined with rock-bottom fees. This has lured investors away from actively managed mutual funds that employ stock picking strategies to try and beat the market. Many studies have shown that the majority of these active strategies charge higher fees and post meager returns when compared to a benchmark index.

Thus, the "bread and butter" of the Vanguard ETF strategy is to provide cheap access to established indexes with excellent liquidity. Clearly the plan is working well, as five of the top seven ETFs for new asset flows in 2014 have been Vanguard ETFs.

This includes core strategies such as the Vanguard S&P 500 ETF (VOO) and the Vanguard Total Stock Market (VTI). Both of these ETFs charge just 0.05% in annual expense ratio. That's the equivalent of $50 per year for a $100,000 total investment that gives you diversified access to hundreds of underlying stocks. You can't get much cheaper than that.

When you dive into individual sectors, the differences in fees between comparable ETF offerings can be tremendous. Consider the Vanguard REIT ETF (VNQ) charges an expense ratio of 0.10%, while the iShares Real Estate ETF (IYR) is listed at 0.45%. That's nearly five times the annual fee for a similar basket of securities.

It's worth noting that other ETF providers such as Charles Schwab (SCHW) and Fidelity have also been willing to lower their expense ratios to levels that meet or even fall lower than Vanguard. In addition, they waive ETF trading fees for clients on their platform. This is clearly an attempt to replicate the success of the low-cost Vanguard model.

While Vanguard is most likely thrilled to be closing in on second place in total ETF assets, I find it hard to believe the company will be satisfied until it is a true contender with BlackRock's iShares ETFs. In order to become number one, Vanguard ETFs need to focus on broadening the scope of its business to include additional sector and core strategies.

One of Vanguard's strengths is the patented method of opening an ETF as a new share class of an established mutual fund. This allows them to use the existing track record of the mutual fund to attract new assets and replicate the same underlying holdings.

They should consider opening up an ETF share class for the very popular Vanguard Wellington Fund (VWELX) and Vanguard Wellesley Income Fund (VWINX). Combined these two balanced mutual funds have nearly $120 billion in total assets and are extremely popular for conservative investors.

Other ETF strategies that Vanguard should consider pursuing include: precious metals and mining stocks, low volatility indexes, international dividend stocks, multi-asset funds, preferred stocks, and creative bond strategies. Many of these areas have been proven to be quite successful for other ETF providers and tend to have higher than average management fees. That is a perfect opportunity for Vanguard to exploit with a lower cost and perhaps unique alternative.

I have no doubt that Vanguard's success will continue indefinitely based on its current lineup, but it will need to further its product lineup to compete with BlackRock and take over the top spot. I look forward to watching all the companies' products and the ETF industry evolve over the next several years as the competition heats up.

At the time of publication the author had a position in VNQ.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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