(PUB) Vanguard Advisor

step with assets under management. By the way, you should take these numbers as an estimate as opposed to an exact figure. For a single share class of a fund, I estimate the revenue gener- ated by multiplying the year-end assets and the expense ratio of that share class as reported in the shareholder report released closest to year-end. I applied this method to each share class, and over time, summing the revenue from each share class gives an overall rev- enue figure for Vanguard that takes into account that different shareholders pay different fees for the same product. However, this method does not account for the fact that assets varied throughout the year, nor does it capture Vanguard funds based overseas. It is also slightly skewed by the fact that not every fund files its annual report at the end of December, and expense ratios can fluctuate slightly throughout the year. So it is far from a perfect measure, but it should get us in the ballpark. Is $3.5 billion to run Vanguard too much, too little, or just right? It’s hard to say. Not all of that money is going to Vanguard—some of it goes to the sub- advisers Vanguard has hired. Plus, keep in mind, Vanguard is a much larger firm today, offering more services to clients than it did two decades ago. So, let’s narrow down the analysis a bit. What Does It Cost to Index? Vanguard’s index funds are a great place to make some historical compari- sons. Additionally, by narrowing our scope, it’s possible to get a bit more accurate on the revenue (cost) side of the equation. Within each fund’s annu- al and semiannual reports, Vanguard shows the total expenses paid by the fund for management and administra- tion as a line item in the Statement of Operations. So, let’s look back. At the end of 1993, there was $11.9 billion invested in 500 Index , Institutional Index (which is the institutional version of 500 Index) and Total Stock Market combined, and the average fee paid by shareholders was 0.14%. The total expenses reported for 1993 were $16.8 million. At the end of 2013, investors had

Expense Ratios Have Come Downwith Asset Growth...

...But Absolute Revenues Have Continued to Grow

$3,000

0.35%

$3,000

$0.0 $0.5 $1.0 $1.5 $2.0 $2.5 $3.0 $3.5 $4.0

Total Assets Avg. Expense Ratio

Total Assets Fee Revenue

0.30%

$2,500

$2,500

0.25%

$2,000

$2,000

0.20%

$1,500

$1,500

0.15%

$1,000

$1,000

0.10%

Avg. Expense Ratio

$500

$500

0.05%

$0

0.00%

$0

Vanguard Assets Under Management (Billions)

Vanguard Assets Under Management (Billions)

RevenueCalculatedFromExpenseRatios (Billions)

12/93

12/95

12/97

12/99

12/01

12/03

12/05

12/07

12/09

12/11

12/13

12/93

12/95

12/97

12/99

12/01

12/03

12/05

12/07

12/09

12/11

12/13

undoubtedly working on other index funds at Vanguard. 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? As a share- holder in one of these index funds (or both), you may benefit from these other It is still hard to fathom how it costs $400 million to run just two index funds. What does running a fund “at cost” mean? services, but you may not. Who’s to say how much of these costs you, as a share- holder, should be shouldering? While considering those questions, keep in mind that though Vanguard talks as if it is a non-profit, it generates a ton of profits and compensates the top execu- tives with millions every year. (See the Partnership Plan story from last month’s issue for more.) Pulling in upwards of $400 million running two index funds alone certainly helps in that effort. Vanguard’s push to lower expense ratios has certainly benefited investors, both at Vanguard and at other fund com- panies that have lowered their fees to compete. While I hope to see expense ratios continue to trend lower, Vanguard’s size and the billions it takes in still beg the question of whether costs could be lowered even further. n

$666.4 billion in the two U.S. stock index funds (including the institutional versions) and paid an average expense ratio of 0.06%. So yes, the expense ratio dropped significantly—0.14% to 0.06%. But in 2013, Vanguard’s cost to run the two index funds was $392.3 million! What Vanguard was able to do for under $20 million in 1993 now costs it nearly $400 million? That’s an average annual increase of 17%, well ahead of the 2% average annual rate of inflation we’ve experienced. Had costs increased at the pace of inflation, it would only cost Vanguard $26 million or so to run the two index funds today—which trans- lates into an expense ratio of 0.004%. To Vanguard’s credit, the cost to run these index funds has not increased at the same pace as their assets, which have grown at a 22% annual rate over the past 20 years. Additionally, equating the costs of a running a fund to overall inflation is not a fair comparison, as the number of shareholders has increased dramatically in the two index funds. That means, among other things, lots more phone calls to answer, and statements and annual reports to mail. Yet, the other side of that coin is that there should have been huge economies of scale gained. Either way, it is still hard to fathom how it costs $400 million to run just two index funds. Yes, there are lots of annual reports to produce and ship (though lots of investors have now forgone paper documents for online downloads), but there is no cadre of research analysts required to run an index fund. Plus, the managers and traders on these index funds are

The Independent Adviser for Vanguard Investors • August 2014 • 7

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