Category: PERFORMANCE MEASUREMENT New measurement tools at The Vanguard Group offer insight into its remarkable success.


In his first real finance job, as comptroller of a Navy submarine training center in Pearl Harbor, Hawaii, Ralph K. Packard recalls that trying to compile basic financial measures was "like pulling teeth." The sailors and naval officers had no interest in controlling costs, as Packard did, though he persevered. He even ended up receiving an award from the Secretary of the Navy for his cost-reduction efforts.

Now managing director and CFO of The Vanguard Group, based in Malvern, Pennsylvania, Packard, 54, encountered similar quizzical looks as he promoted the development of a balanced scorecard for the world's second- largest mutual fund company. "Crew members," as employees are called, wondered what could be wrong as long as investors continued to put money into Vanguard's 79 funds. But again Packard persevered. He even ended up receiving the 1999 CFO Excellence Award for Performance Measurement.

The privately held Vanguard has always had a stellar reputation as the low-cost provider in the mutual fund industry, which it has maintained in the current bull market. But as new investment dollars poured in--assets under management stand at nearly $500 billion, about double the 1996 total--Packard began to worry about the challenges associated with growing so fast.

"The past few years have been good for us, but we wanted to differentiate Vanguard from other mutual fund companies that were also doing well," explains Packard, who spent 13 years in banking before joining Vanguard. "The balanced scorecard grew not out of a crisis, but out of a need to not get complacent."

And there was at least one crew member who never questioned that logic. "As you get larger, you want to make sure people feel in touch with their role and how they fit in the overall success of the organization," says Vanguard chairman and CEO John J. Brennan. "Ralph identified that three years ago, and brought a sense of vision, focus, and discipline to creating an integrated measurement system that ensures we know how we're doing on all fronts."

True Value

At Vanguard, as in the mutual fund industry overall, the measurement focus tended to be on assets under management, fund performance, and expense ratio. These common measures certainly helped paint a broad picture of how Vanguard was doing, and recently the company had developed new quality measures for client service and customer satisfaction. But the approach was incomplete.

"We had a lot of different measurements," Packard says, "but they were not in any kind of framework that covered all aspects of the business, and were not easily communicated." Moreover, Vanguard's bonuses were based on investment performance, as well as on comparative expense ratios. "Everybody can appreciate $500 billion in assets and how the funds perform," he adds. "But most of our crew members have no control over those things."

Beginning in mid-1996, Packard and the managing directors of human resources and fixed-income investments completed a thorough review of Vanguard's measurement practices, and started to put together a framework for a balanced scorecard that could be applied to Vanguard's performance. Relying solely on ideas and guidelines available in the business press, the working group determined that the scorecard should be built around four balanced "perspectives": internal processes, external service, shareholder return (fund performance and expense ratio), and innovation and growth.

Using a set of critical success factors that had come out of a recent strategic-planning exercise, Packard adapted that to the new scorecard and identified the appropriate measures for each success factor. What he found was that about 60 percent of the measures were already collected somewhere in the organization, but basic employee-related measures, such as retention and management development progress, were not even tracked. And the most glaring omission, says Packard, was the complete absence of "any good financial measures" for value creation.

For a private company whose chief product is investment returns but that never reports earnings to its investors, Packard wondered, "How do you calculate the true value you're adding to your shareholders?" That, he realized, was a key question for Vanguard, whose unique operating structure means that its 12 million fund-holders also own the entire enterprise.

Greater Insight

As Vanguard developed and communicated the concept of the balanced scorecard to its nearly 10,000 employees, Packard set about answering that question. What he came up with were two new financial measures--Vanguard Economic Value Added (VEVA) and the market- adjusted expense ratio--that proved to be insightful and invaluable. For the first time, Vanguard had measures for the true value it created for its investors and for giving employees a clearer picture of their contributions.

In coming up with VEVA, Packard considered that Vanguard added value only to the extent that it provided investors with a better return than if they had invested in a competing fund. Customizing the concept of economic value added (EVA), he looked at the increment between the total return of each Vanguard fund and a benchmark of comparable funds. On a fund-by-fund basis, he then multiplied that increment, whether it was plus or minus, by the assets in the particular funds.

On a cumulative basis, Packard found that since Vanguard's inception in 1975, it had a VEVA of $45 billion. The total for 1998--the total return differential for the year times the invested assets that year--was even more astounding: it came to approximately $15 billion in added value to shareholders. Furthermore, Packard calculated that about two- thirds of that value was created by Vanguard's investment performance, with the balance credited to its expense-ratio advantage. (This year's total VEVA is tracking at $8 billion to $13 billion.)

"This was a superior innovation," says CEO Brennan. "I've taken VEVA to our clients and told them, This is what we've done for you. They have found it a more helpful way to understand our success than being told we're at $500 billion in assets."

Dissecting Expenses

While VEVA has proven to be a compelling measure of value creation, Packard worried that it was too difficult for employees to relate to. He wanted a measurement that would help them to better appreciate their contribution to adding value. "We wanted to come up with something that was actionable," Packard says.

The expense ratio for Vanguard's funds, which is consistently lower than its peers', had fallen 10 percent between 1995 and 1998, from 0.31 percent to 0.28 percent of net assets. But while the company has easily maintained its competitive position as low-cost provider, Packard was concerned that the dramatic market appreciation, as reflected in the denominator of the calculation, was largely responsible for the recent expense-ratio decline.

"We could easily spend at high levels without adding much value to our shareholders and still have the lowest expense ratio in the industry," Packard observes. "We needed a measure that removed the benefit of market appreciation and established itself as the standard."

The result -- Vanguard's market-adjusted expense ratio -- compensates for market appreciation by including only the cash flow from investors on the asset side of the expense-ratio calculation, and is about 40 percent higher than its straight expense ratio. Moreover, Packard discovered that the market-adjusted expense ratio actually increased in 1998.

"Many crew members had the false impression that they were doing a fantastic job on efficiency," he says. "They may not have seen areas that needed improvement or opportunities to reduce costs." By calculating the market- adjusted expense ratio on a departmental level, Packard says the metric has brought more discipline to the planning and budgeting processes and to capital-allocation decisions.

It has also been a tremendous motivator. For 1999, Vanguard set a corporatewide target of reducing its market-adjusted expense ratio by one basis point. And in the first six months of the year, Packard reports, the company is on its way to meeting that goal. Moreover, the balanced scorecard is now used to determine the overall bonus pool.

A quarter-century ago, it took sheer determination to get the sailors stationed in Hawaii to care about costs. "Back then, a balanced scorecard would have been completely foreign," Packard quips. Although also once foreign to Vanguard, that concept now allows everybody to better understand where this ship is sailing.


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