The Vanguard Myth

Anyone who spends any time following the FIRE community online will inevitably encounter certain ideas popping up time and time again. One of these prevalent concepts is index investing, and along with it, everyone’s favourite index investment fund, Vanguard.

Index investing & Vanguard

Index investing means investing in entire stock markets, rather than picking individual stocks. It’s a great thing, because diversification virtually eliminates single stock risk. If you invest in one company, and then that company hits hard times and goes bust, you lose your dough. But if you buy shares in EVERY company, and one company goes bankrupt, you’ll hardly even notice. Since the overall trend of the entire market is upwards on average, buying the whole index is a sensible way to invest. (At this point it’s worth noting that managed funds and Listed Investment Companies also enjoy this benefit of diversification, and I’m a big fan of LICs, but the LIC vs Index debate is a whole topic for another day.)

VanguardThere are many different indices which you can invest in, each covering different markets or sectors, and also different ways to invest in an index. By far, the most popular method of index investing at the moment is through the investment company Vanguard. Vanguard is a multinational company, originating in the US, founded in 1975 by the father of index investing himself, Jack Bogle. Vanguard currently has more than 5.7 TRILLION dollars of assets under management! Vanguard offers Australians three ways to buy into a wide variety of indices: you can buy units in their wholesale funds if you have half a million bucks to spend; you can buy units in their retail funds with a modest minimum investment of five grand by paying higher ongoing fees; or you can buy shares in their Exchange Traded Funds (ETF) on the Australian stock exchange. The ETF method is the cheapest option available to most investors, and it’s what I’m using. The fees are extremely low, but you pay a small brokerage fee whenever you buy or sell. That’s fine for me, because I buy moderately large parcels infrequently, and don’t plan to ever sell.John Bogle

I currently have shares in two of their ETFs.  Vanguard’s International Shares Index ETF (ASX:VGS) is the main bulk of my international holdings, and I have their Asia excluding-Japan Index ETF (ASX:VAE) for the added diversification of emerging economies.  I will also soon be adding their Australian Shares Index ETF (ASX:VAS) to the Aussie stocks I already have through a variety of LICs.

The low fees are the key to Vanguard’s success. There are a number of competitors vying for investors’ money, such as BetaShares, Blackrock, and VanEck. For the most part, Vanguard consistently offers lower management fees than the competition.  BetaShares deserves a loud shoutout here for their brand new ETF tracking an index of the 200 biggest companies on the Australian stock exchange, A200, which gives Vanguard’s Aussie shares ETF a run for its money.  BetaShares logoFor years Vanguard’s VAS was the clear market winner, with a management fee of only 0.14%, but A200 fully halves that with ultra-low fees of 0.07%.  These annual management fees go towards the running costs, and in most cases profits, of the various investment companies.

When you’re talking about decades-long compounding of large amounts of money, a few hundredths of a percent difference in annual fees can make a huge impact on how much your savings will be worth when you retire. Vanguard’s competitive edge is why many Australian investors have trusted the company with 100% of their investment savings, something which shocked me when I first read it. In an area where diversification is sacred, many investors don’t feel it’s necessary to diversify the companies which hold their ETFs. That’s a powerful testament to how well regarded Vanguard is.

Investors = Owners

The reason why Vanguard has this edge over its competitors is because of its unique ownership structure. Investors flock to Vanguard because the company is owned by the funds which it manages, and those funds are owned by investors like you and me. This is a profound difference. It means that the owners and the investors have their goals perfectly aligned, because they are one and the same. With other investment companies, the owners have a strong incentive to raise the fees, to get more profits from the investors. When they do offer lower fees, it’s probably a strategy aimed at gaining market share, rather than a trait ingrained in their very DNA. But Vanguard is run at-cost, without generating any profits. If you want to learn more about this, JL Collins has written a great article explaining Vanguard’s owner-investor alignment, Aussie Firebug talked about it in his recent podcast, and you can read more on Investopedia.

At Vanguard, the owners ARE the investors, so the incentive is always towards more efficiency and less fees. It’s a thing of beauty!

But there’s just one problem with this love story… It’s not quite true.

Say it ain’t so!

Munch ScreamVanguard’s ownership structure entered the annals of investment fable in the US, where Vanguard was founded. And in the States, it’s undoubtedly true. Vanguard Group’s main, American business is owned by its funds. But the other international branches are owned by Vanguard’s American head office. Vanguard Australia is owned by Vanguard USA. This means that Australian investors like you and me don’t own part of the company. It also means that the whole point about the owners and investors having their interests aligned towards low fees goes out the window here.

The owners of Vanguard Australia have a strong incentive to raise fees. Higher fees paid by Australian investors would subsidise the American investors, allowing them to lower the fees on the US products.

Vanguard Australia’s website has some fine examples of spin.  It spells out the fact that the ownership structure only applies to the US domiciled funds, but it tries hard to market that as a positive for Australian investors too, without actually saying anything substantive to explain why that would be good for us:

Vanguard Spin

Go global

World GlobeIf you’re really attached to the idea of being an owner-investor, there are still ways to do that Down Under.  You can buy shares in Vanguard’s US-domiciled ETFs which are cross-listed on the Australian stock exchange, as long as you’re willing to deal with a little bit of extra tax paperwork.  Vanguard’s US Total Market Shares Index (ASX:VTS) and World excluding-USA Shares Index (ASX:VEU) are both great products, and owning them puts you in the same position as American investors in the same funds.  They’re superior to the Australian-domiciled equivalents in significant ways.  They provide much deeper diversification; the Australian-domiciled VGS gives you exposure to 1,591 different companies in 29 different countries, while a combination of VTS and VEU would give you 6,348 companies across 52 different countries.

The most important advantage of investing in the US-domiciled ETFs is in the fees.  VGS charges 0.18% management fees, while VEU costs 0.11% and VTS is an astoundingly cheap 0.04%.  Some of that difference can certainly be attributed to economies of scale; there are way more American investors to spread out the fees between, while the administration costs wouldn’t scale up as steeply.  Australia will always lose out on that front, because our market is comparatively tiny.  Exactly how much can be attributed to scale is anyone’s guess.  The more devout Vanguard investors will, of course, believe that it’s the whole story.  But the fact remains that there’s a financial incentive for the US investors to levy higher fees upon the Australian investors.

Conclusion

It’s not all doom and gloom. Vanguard as a global business leans heavily on its reputation, and gouging in one market would cost them goodwill internationally. Vanguard are well known for providing low fee investment solutions, and customer loyalty relies on it. This is especially true in the index industry where competing products are effectively identical, tracking the same or very similar markets, with fees often being the only differentiating factors beyond branding. So there’s still a solid incentive to provide their customers everywhere with good value to preserve the power of the Vanguard brand. But that’s exactly the same as any other for-profit business, including all of Vanguard’s competitors.

I’m not trying to be a nay-sayer here.  I’m planning to continue investing in Vanguard’s Australian domiciled ETFs.  But I’ll be watching the growing competition with interest!  I’m hoping that Vanguard responds to the challenge presented by BetaShares’ A200 offering.  Even though VAS and A200 track slightly different indices (VAS tracks the 300 largest Australian companies),  the additional 100 stocks in VAS only increases the size of the index by around 2.5% compared with the top 200.  Is the 2.5% increase worth a 100% increase in fees, compared with A200?  For me personally, the answer is still yes.  I plan to put a significant chunk of money into VAS very soon, because I expect that Vanguard will eventually bring its fees down to remain competitive.  But that expectation is based on Vanguard having good competitive business sense, a large share of the market, and enormous amounts of funds under management.  That’s enough for me.  It doesn’t require any mystical owner-investor incentive alignment.

So what do you make of all this?  Does Vanguard’s ownership structure make you more or less likely to invest in their products?  Is there a structural incentive that I’ve missed, that would explain why Vanguard being owned by American investors would be good for Australians?  Leave a comment below!

Disclaimer:
I’m not affiliated with Vanguard, but I am invested in some of their products. You should consider your personal financial situation before investing, and seek professional advice if necessary. I’m not a qualified adviser, lawyer, or business analyst, and this post is intended for entertainment purposes only. I do hope you found it interesting though!

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Post Script 9/7/2018

This post sparked a bit of discussion on Reddit, and user Quantifical got in touch with Vanguard Australia directly to ask about it.  This was their reply: “Vanguard Australia is a wholly owned subsidiary of the Vanguard Group.  Vanguard’s ownership structure means that profits are able to be reinvested by way of lowering our fees for investors.  Vanguard’s philosophy ensures that these lower fees are passed on to all our investors and not just those in the US.  As previously mentioned, Vanguard Australia has recently lowered its fees and has a history of doing so wherever possible.  As Vanguard Australia continues to grow, we will continue to evaluate our fees and pass on these reductions wherever possible.”

So, it boils down to exactly what I said above.  The ownership structure does what they say it does, but only in the US.  Outside of the US, the only thing keeping the fees low is their commitment to their low-fee philosophy.  Which is great, but it’s exactly the same as every other competitor to Vanguard!

9 comments

  1. I think where vanguard will struggle on the fee reduction is the fact that S&P charges 10 bps when ETF providers use them. This has been confirmed recently by Vanguard’s own distribution/sales team. Betashares use a German company Solactive AG utilsing the Solactive Australia 200 Index. Solactive charge much less than 10bps so unless Vanguard can negotiate with S&P to lower the use of their index, the lowest I can see VAS MER going down is 0.10%.

    Liked by 1 person

    1. I didn’t know that, thanks for pointing it out! That puts Vanguard in a tight spot for the Australian shares ETF market. It will be interesting to see if the competition among indexing companies pushes S&P to lower their fees.

      Like

  2. I agree with your description of the legal structures of Vanguard Australia vs Vanguard US, and as you say there is nothing stopping them from upping costs. There is no shortage of competitive pressure though so even if they did decide to raise costs they might well end up losing more than they gain if they see fund outflows. I seem to recall STW which was the original Aussie ETF is seeing large outflows vs VAS seeing large inflows.

    Also, although Vanguard say the minimum on their wholesale managed funds are $500,000 if you call them up they will actually accept anything over $100,000. Admittedly that doesn’t help anyone who is just starting out on their FIRE journey from scratch but for people who have just come into an inheritance or have sold an investment property etc the $100,000 minimum is a lot easier to get to.

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