(PUB) Investing 2016

VANGUARD 10 Things Vanguard Won’t Tell You (Part 1)

VANGUARD HAS GROWN into the largest mutual fund company by put- ting shareholder interests ahead of their own. They tend to do this better than any other mutual fund company. And Vanguard’s focus on lower- ing cost has saved investors millions and millions of dollars over the years. But Vanguard is not perfect—far from it. In many areas, Vanguard could stand to improve their services and be more transparent. In some instances, Vanguard could step up and take more of a leadership position within the industry beyond simply charging less. By shining a light on these places, I don’t intend to dissuade you from buying and holding Vanguard funds—Dan and I both own Vanguard funds personally. We are not about to abandon offering our independent take on the good, the bad and the ugly at Vanguard. While we will both continue to applaud Vanguard when they are doing something right, Vanguard has plenty of cheerleaders in the media, and I’d be doing all of us a disservice if I didn’t call out Vanguard when they could be doing better. Vanguard isn’t being devious or nefarious by not telling you these 10 “secrets.” In fact, these aren’t truly secrets—you just have to know where to look and be willing to turn a skepti- cal eye on Vanguard’s pronouncements. Let’s start with four this month, and cover the remaining six next month. 1. Investors are paying Vanguard half a billion dollars to run its largest stock index funds—and those costs have been rising in dollar terms even as expense ratios have fallen in percent- age terms. How did this happen? Well, at the end of 1993, with $11.9 billion invested in 500 Index, Institutional Index (which is the institutional version of 500 Index) and Total Stock Market combined, the aver- age expense ratio paid by shareholders was 0.14%. That generated $16.8 million in fees to run the two index funds.

Fee Revenue Hasn’t Kept Pace With Asset Growth

Expense Ratios Have Come Down, But Fee Revenue Is Up

$600

$0 $100,000 $200,000 $300,000 $400,000 $500,000 $600,000 $700,000 $800,000 $900,000

$600

0.00% 0.02% 0.04% 0.06% 0.08% 0.10% 0.12% 0.14% 0.16% 0.18%

Fee Revenue (LHS) Combined AUM (RHS)

$500

$500

$400

$400

$300

$300

$200

$200

Fee Revuene ($ millions) $100

Fee Revuene ($ millions) $100

Fee Revenue Expense Ratio

Combined Assests ($ millions)

Asset-Weighted Expense Ratio

$0

$0

12/94

12/97

12/00

10/03

12/06

12/09

12/12

12/15

12/94

12/97

12/00

12/03

12/06

12/09

12/12

12/15

revenue has not grown as quickly as the two funds’ skyrocketing asset lev- els. Still, at the very least, it begs the questions: What does Vanguard really mean when it says it runs funds at cost? How is that cost determined? Are some of those fees being used to subsidize expenses elsewhere within Vanguard? While I applaud the trend of lower expense ratios, Vanguard’s size and the billions it takes in every year raises the question of whether costs could be lowered even further. 2. Vanguard is a non-profit with a profit-sharing plan. And being a Vanguard partner has been much more lucrative than being a Vanguard fund shareholder. The Partnership Plan , created in 1984 by founder Jack Bogle, is

Fast forward to the end of 2015, and investors held $853.9 billion across the different share classes and clones of 500 Index and Total Stock Market Index, and paid an average expense ratio of 0.06%. So yes, the expense ratio dropped significantly—0.14% to 0.06%. But the dollar cost to run 500 Index and Total Stock Market Index has soared to over $500 million. So does that mean what Vanguard was able to do for under $20 million in 1993 now costs it half a billion dol- lars? That’s an average annual increase of 17%, well ahead of the 2% annual rate of inflation we’ve experienced. Had costs increased at the pace of inflation, it would only cost Vanguard $27 million or so to run the two index funds today—which translates into an expense ratio of 0.003%. It is hard to fathom how it costs $500 million to run just two index funds. Though the new Institutional Plus shares of 500 Index and Total Stock Market charge just 1 basis point (which sounds like Vanguard is giv- ing their services away for free), on a minimum investment of $5 billion, that translates into $500,000. I realize that Vanguard has many, many more annual reports and account statements to print and mail because these index funds have many, many more shareholders to service. To Vanguard’s credit, in recent years, fee

Partnership Distributions Have Outpaced 500 Index

$100 $120 $140 $160 $180

Partnership Dividend 500 Index Fund

$0 $20 $40 $60 $80

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14 • Fund Family Shareholder Association

www.adviseronline.com