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Tae Kim

Tae Kim

Vanguard | What You Should Know

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One of the most common investing questions I get is why do you prefer Vanguard over other investment firms?

  • Don’t you see how better other investment firms are?
  • Didn’t you see Fidelity’s 0% expense ratio index funds?
  • Or, have you seen Charles Schwab’s ETF trading platform? It’s completely customizable.

It’s easy to get swayed by the new and sexy products out there.

But once you understand a few things about Vanguard that not many people are aware of, I guarantee it will change how you view the company and its products.

Mr. Jack Bogle

In order to understand Vanguard, we need to start with its founder – Mr. Jack Bogle.

Mr. Jack Bogle – Founder of The Vanguard Group

Mr. Bogle founded Vanguard in 1975 when the financial industry was set up exclusively to enrich those selling financial products at the expense of their customers.

Now that I think of it, in some way, the industry hasn’t changed that much since.

With the start of Vanguard he created the first S&P 500 index fund. The Vanguard 500 Index Fund

A passively managed fund with low cost that would only track the market, instead of trying to beat it.

He gave the individual investors like you and I the ability to tap into the amazing growth of the stock market without needing to overpay fund managers who could hardly beat the market themselves.

However, that isn’t the primary reason why Vanguard is so special in comparison to other investment firms out there.

Unique Company Structure – Client Owned & Operated At Cost

It has to do with the company structure that Mr. Jack Bogle setup at its founding.

It was so unique and revolutionary that it continues to remain unique in the investment world till today.

Vanguard is by design client-owned and it operated at-cost.

What does this mean? It means that when you choose to purchase a fund from Vanguard, you not only are its customer, you are also its owner.

Most other investment companies are set up differently. They are structured to serve two separate masters – the company owners and the investors in their funds, their customers.

Fidelity for example is a private company owned by the founding Johnson family, employees and ex-employees.

Fidelity exists to provide quality service to its investors, however, it must also provide healthy profit for its owners; the Johnson family, Fidelity employees and it’s ex-employees.

If there is tension between the two groups because the market isn’t doing well and profits are low, who do you think will pay the cost to raise profits?

Charles Schwab is a publicly traded company so it’s owned by individuals who own its stock.

Similarly, individuals who own the stock expect good returns on their investment.

Charles Schwab needs to provide quality service to its customers / investors to keep them happy, but at the end of the day, if pressure is on to raise profit, who do you think will pay the cost? A publicly traded company is pressured to generate profit. And it most often will do that at the expense of its customers / investors.

It’s the same story with BlackRock, the world’s largest asset manager, with US$10 trillion in assets under management. A major public company with shareholders as its owners.

And the same with State Street, the world’s fourth largest asset manager, with nearly $3.59 trillion in assets under management.

Apple As An Example

When times are going well and the company is churning out good profit while still serving it’s investors well, these private company and public company models are not a problem.

And there is nothing inherently wrong with this model. Most companies operate this way and it works great a lot of times.

Think about Apple. They make fantastic and reliable devices. And they charge as much as possible to generate as much profit for its shareholders.

Who would have thought smartphones would be sold for $1,000 each.

However, because of the value it provides, customers still buy them. In Apple’s case, a lot of them.

Customers get a high quality phone they want and investors of Apple get high returns for their investments.

Customers are excited because they have the latest Apple device in their hands, but the real winners are the investors. Apple is generating ridiculous profits by charging its customers $1,000 for its phones.

It’s estimated that it costs the company around $500 to make an iPhone. This means Apple is making approximately 50% net profit from each of its iPhone.

And to be honest, if you are an investor of Apple, you would want them to charge more and make more money for you right?

Other Investment Firms

It’s the same story with investment firms. Owners of Fidelity, Charles Schwab or Black Rock – both private and public owners want profits to be high as possible.

Profits are what’s left over after costs of operating the funds are accounted for; staff salaries, product development, system maintenance, etc.

You can increase profits by cutting costs, but if there is a limit to how much operating costs you can cut back, where do you think they’ll find room to increase profit?

In the case of investment firms, because the products they are selling are investment products and money is made on fees charged to customers & investors, this comes out to higher fees to its customers.

Vanguard is Unique

This is where Vanguard is very unique in the investment world. Mr. Jack Bogle shifted the ownership of Vanguard to the mutual funds it operates. And since the investors own those funds through the ownership of shares within them, the investors – you and I in effect own Vanguard when we invest with them.

And because the company is client-owned, it would only make sense that Vanguard operates its funds “at-cost,” the minimum fees needed to cover the costs of operations of the funds – nothing more.

Vanguard is inherently structured to provide the lowest possible fee to its customers as possible, because they are also its owners.

Your interest as the investor and the interests of Vanguard are exactly the same.

Vanguard – My Kind Of An Investment Company

The bottom line is this. Since Vanguard investors are also the owners of the company itself, it is to everyone’s aligned interest to keep the fees as low as possible. Today and for the foreseeable future.

Other investment firms do not have this structure. Private and public companies alike need to serve two different masters – it’s owners and it’s customers.

There are alot of hypes about index funds from other companies like Fidelity that have lower expense ratios than Vanguard – but it’s a guess to see if this will hold up in the long run. I really do hope so, but it feels like a short-term marketing ploy for customer acquisition

There’s a business term for this. They call them “loss leaders” and you see them often in retail.

Printers and printer ink are good examples. While printers are often sold at or below cost, the price of ink is set extremely high. Loss leader pricing is used to get customers to purchase the printer, at a loss, but make money from selling them printer ink, which is more expensive.

Who knows if this is the direction Fidelity will go in the future but I’m sure they will eventually figure out a way to make money from these funds. And the concern is how they will do this. At the expense of their operational cost or cost to the investors.

I know I’m picking on Fidelity here but I do want to say Fidelity is still a great company with some fine funds in their offering. I just want to highlight that because they need to generate profits for their owners, they are at a structural disadvantage compared to Vanguard. Of course this goes with all other investment firms I mentioned here.

I have a good chunk of my 401(k) and my donor advised fund with Fidelity so I’m not saying you should never invest with them. Just understand the big picture incentives when you do so.

Today, Vanguard operates approximately 200 funds with an average expense ratio of 0.09%.

The industry average ranges between 0.5% and 1.0%.

If choosing the right investment firm has kept you from investing your money, don’t wait. Go with Vanguard. And if you want to learn more about the best funds to invest your money into, check out my post on the “5 Best Vanguard Funds to Buy & Hold Forever” here.

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