The most successful businesses do what others find impossible. They produce something special which can’t be copied or sell at price points no one else can match.

For years, Amazon has steadily gained market share by doing the latter. How? Sacrificing margin.

The firm has been able to operate like a non-profit entity because of a unique investor base willing to overlook current earnings and value the company on sales growth. In the last twenty years, the stock has delivered a compounded annual return exceeding 30% with an income statement that looks like this:

 

"Your margin is my opportunity." - Jeff Bezos

This defies how it’s supposed to go. Investors usually myopically focus on short-term results. If other retail heavyweights failed to produce profit growth, investors would vote their stock down, and management out.

But not Amazon. Not Bezos.  Like Willy Wonka, he’s managed to build an empire operating on a completely different plane.

As you’re probably already aware, Amazon has hit a tipping point that is making life very difficult for retail competitors. Amazon Prime is up to 80 million subscribers, and Amazon’s North America division generated almost $80 billion in revenue last year.

That’s serious scale. But the unit’s operating margins remain surprisingly thin at just 3.0%. Rival retailer Target has a 7.2% operating margin followed by Wal-Mart and Best Buy at 4.7%.

Could Amazon raise prices and bump their margin? Sure.

However, Bezos would rather bump more competitors out of business first.

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In the world of asset management, there is an emerging giant undercutting everyone on price and winning. Their name is Vanguard.

Last year, Vanguard set a record with $305 billion of inflows. The pace is even stronger this year—$206 billion through June. The firm’s asset-weighted fee average is a mere 0.12%.

When the firm started in 1974, it had similar fees to other mutual funds. But over the years, they have continually cut fees, earning a reputation as the low-cost provider. Their almost free investing model has sapped billions of dollars of revenue from financial industry competitors. They are the Amazon of asset management.

Unlike Amazon, though, Vanguard’s cost advantage does not emanate from a unique relationship with Wall Street. It’s not a public company.

What Vanguard’s founder, Jack Bogle, and company do have going for them is a unique ownership structure. Fund investors double as the shareholders. This allows Vanguard to essentially operate at cost, spending incremental profit on lower fees.

Low-cost providers are nearly impossible to beat in industries with sparse product differentiation. When products are fungible, scale wins. Period.

Amazon distributes similar goods as other retailers. They just do it cheaper and more conveniently, so they win.   

However, investment management is not a fungible commodity. There are many different strategies and products, built to appeal to an array of variant objectives. Differentiation counts, because managers perform differently.

Vanguard has benefitted from a killer combination in recent years—low cost and quality performance. This is because although the firm distributes ETFs and actively managed funds, they specialize in passive, index-based investing—a style which has surged in popularity amid widespread underperformance across the active manager community.

Consider these sobering statistics: according to SPIVA, during the five-year period ending Dec. 31, 2016, 88% of large-cap managers, 90% of midcap managers, and 97% of small-cap managers underperformed their respective benchmarks.

Investing is a game of probability. Why would anyone want to pay 6x more for a product with a 90% likelihood of being inferior?  The average actively managed mutual fund fee is 0.72%—6x higher than Vanguard’s 0.12% annual fee. And roughly 90% of those funds are underperforming Vanguard’s ultra-cheap option.

Unsurprisingly, many investors are flocking toward passive. Flows out of active mutual funds and into passive funds likely approached $500 billion in 1H, almost double any other start to a year. Active funds lost an estimated $72 billion. As shown in the chart below, this is a multi-year trend.

Which leads to this question: Why shouldn’t everyone join the stampede and hire Vanguard?

For starters, I do not believe we’re ever going to live in a world with just one retailer or asset manager.

Businesses are collections of people trying to solve each other’s problems. No single organization can possibly scratch every customer itch. People are complex, the world is complex, and that makes business too complex for any one individual or organization to figure everything out.

Moreover, conditions are always changing. That creates constant opportunity to better appeal to people’s evolving preferences and needs.

With investing, cycle dynamics play a key role in what people want. Keeping that in mind, consider the environment under which Vanguard has recently ascended to the top of the asset management food chain. Here is a look at how this cycle compares to previous ones from a return and volatility perspective.

S&P 500 Cycles

Years	Returns	Volatility
1930 - 1945	3.4%	28.9%
1946 - 1968	12.9%	16.9%
1969 - 1977	2.6%	20.3%
1978 - 1999	17.2%	12.5%
2000 - 2008	-3.6%	20.1%
2009 - 2016	14.3%	10.6%

 

When somebody buys an index, they are guaranteed:

• 100% of the index’s upside, and
• 100% of its downside

Passive investing has existed for a long time but really caught on in recent years. Conditions were ripe.  100/100 is a dandy ratio in an environment with lots of upside and little downside.

Here’s the rub, though: Investment cycles mean revert.

Just look at the table…

1969-1977:  low returns, high volatility

1978-1999:  high returns, low volatility  

2000-2008:  low returns, high volatility          

2009-2016:  high returns, low volatility

Notice a pattern?

What would you guess probably comes next?

That’s right, eventually we’re going to see a flip back to low returns and high volatility.

Will passive’s 100/100 ratio still feel like the right strategy then?

It is well-documented that investors suffer from a behavioral bias called loss aversion. We abhor losses about 2x as much as we enjoy gains. What that means is our experience of riding a passive investment will not always feel like 100 by 100. We’ll feel the losses more. Our perception will be more akin to a 100/200 ratio. 

We are presently enjoying the lowest volatility era since 1930. So, loss aversion doesn’t influence our behavior a whole lot. It’s easy to be passive and stay invested. But what about when volatility spikes? Passive is a fine strategy for many investors, but only if they have the discipline to stick with it.

Even though Vanguard has been selling at price points others cannot match, it operates in an environment with abundant product differentiation. Will a 0.12% fee seem like a bargain when the S&P 500 declines more than 20%?

You get what you pay for in this world. Cheap is good, but not always best.

 

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Sources: Bloomberg, Hedgeye Research, HiddenLevers

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