Vanguard's Low Blow
Near the end of last month, mutual-fund giant Vanguard announced that it had lowered the expense ratios on 35 of its mutual funds. That’s after a December announcement that it had lowered expense ratios on 53 funds. All in all, Vanguard estimated, the changes resulted in an $87.4 million reduction in the fees paid by its customers.
Isn’t that outrageous!?!?! I mean, seriously, how shameless can these guys get?
That, in short, is the argument Vanguard tax lawyer turned whistle-blower David Danon and his hired expert, University of Michigan law professor Reuven S. Avi-Yonah, are making.
Yes, there's a more complicated legal angle involving transfer pricing. More on that in a bit. But the underlying reasoning is simple: Vanguard is cheating state and federal tax authorities by charging its customers much less than other fund companies do. Which is exactly as bonkers as it sounds. (This seems like it might be a good spot to disclose that while I don’t own any Vanguard funds, my wife does.)
Vanguard has $3.2 trillion in U.S. fund assets under management, and its asset-weighted average expense ratio is 0.14 percent, compared with an industry average of 0.64 percent. That means Vanguard’s fees bring in about $4.5 billion a year, and if they were raised to the industry average they would bring in about $20.5 billion. Since Vanguard is run at break-even now, that difference would presumably be profit, and thus subject to corporate income taxes. Using similar calculations, Avi-Yonah contends that Vanguard owes the Internal Revenue Service $34.6 billion in back taxes for the years 2007 through 2014. And Newsweek estimates that Danon, as the whistle-blower, could pocket as much as $10 billion of that.
Remember, these would be taxes on profits that were never earned, from fees that were never collected. Vanguard clearly wasn’t engaging in any subterfuge. The whole thing was out in the open.
My Bloomberg View colleague Matt Levine has dubbed this “the faked moon landing of financial news stories, except that it might be true." Danon collected a $117,000 whistle-blower bounty in Texas in November, meaning that Vanguard paid the state at least $2.3 million. It’s possible that Vanguard’s payment had nothing to do with the fee issue -- a company spokesman told Bloomberg’s Jesse Drucker that Danon’s arguments didn’t come up in the company’s discussions with state tax authorities. But Danon did collect a fee, and Avi-Yonah really is an expert on transfer pricing. Their claims can’t be completely dismissed.
Jeff Sommer described the legal niceties in detail in a New York Times column last weekend, which included quotes from two law professors who don’t buy Danon and Avi-Yonah’s reasoning. But the basic argument is this: Mutual-fund organizations are made up of two kinds of entities -- mutual funds that are owned by their customers and exempt from income taxes, and corporations that manage the mutual funds’ assets and charge fees for that service. Transactions between the funds and the management companies may thus be subject to transfer-pricing rules designed to keep corporations from shifting profits from high-tax jurisdictions to low-tax ones. That’s not what Vanguard is doing, of course, but Danon and Avi-Yonah argue that it is still required to charge “arm's-length” fees similar to what other management companies charge.
At almost every mutual-fund group other than Vanguard, the management company is out to make a profit, so charging too-low fees isn’t really an issue. But at Vanguard, the funds -- and by extension the investors in the funds -- own the management company, and expect it to keep fees as low as possible. Why the difference? A little history is in order, in part because it shows that Vanguard isn’t so much a weird outlier as a worthy carrier of the mutual-fund tradition.
The original mutual fund was the Massachusetts Investors Trust, founded in Boston in 1924. There were lots of investment funds being launched in those days, but MIT, as it was known, was different in that it was a customer-owned non-profit -- hence the name “mutual fund.” The fund trustees made the investment decisions, running what was effectively a Dow Jones Industrial Average index fund, and charged extremely low fees. MIT weathered the 1929 market crash and the bear market of the early 1930s better than most of its profit-seeking rivals, and came to dominate the nascent mutual-fund industry. When Congress set out to lay down ground rules for the industry with the Investment Company Act of 1940, MIT worked to ensure that the mutual structure and its customer-first aims were preserved. Even now, in its much amended modern form, the law states that when funds are managed in the interest of anyone other than the shareholders, “the national public interest and the interest of investors are adversely affected.”
Still, most other fund groups paired mutual funds with for-profit management companies. During the bull markets of the 1950s and 1960s, investors began to gravitate toward flashy funds run by managers who promised market-beating performance. In 1969 MIT and a sister fund joined the crowd by demutualizing and starting a for-profit management firm called Massachusetts Financial Services that promptly began raising fees. The mutual had gone out of the mutual-fund industry.
It came back six years later as the result of a power struggle at another venerable mutual-fund group, Philadelphia-based Wellington, home of the Wellington and Windsor funds. Wellington Management had merged in the 1960s with a fast-growing Boston fund manager. Things turned sour during the bear market of 1973 and 1974, and the Boston partners voted to oust Wellington’s president. This fellow -- his name was, and is, Jack Bogle -- still had a lot of loyal allies on the boards of Wellington’s mutual funds, so he arranged a coup, with the funds taking charge of their own destiny as the Vanguard Group. They still paid Wellington to manage the money in the Wellington and Windsor funds (and they still do), but Bogle soon came up with an alternative, the first unmanaged index fund for individual investors.
From these opportunistic beginnings emerged a financial juggernaut built around the organizing principle of trying to reduce expense ratios instead of trying to beat the market. Bringing in more assets to manage allows Vanguard to lower its expense ratios, which helps attract even more assets. In this way Vanguard has grown to be the world’s second largest money manager. (BlackRock is No. 1, due to big acquisitions as well as organic growth.)
Vanguard is run on behalf of its customers, who also happen to be its owners. It has revolutionized the money-management business, putting pressure on competitors to lower fees. Those lower fees have in turn made it easier for millions of Americans to save for retirement and other goals. It’s a virtuous cycle that has both changed investing for the better and brought the mutual-fund industry back closer to its roots. If the IRS or the courts decide to go after Vanguard for its frugality, it would amount to throwing all this into reverse.
The only possible countervailing public-policy argument that I can think of is that the owners of Vanguard funds are more affluent than Americans in general, so by forcing Vanguard to charge higher fees and then taxing the resulting profits, the IRS and the states would be doing their part to fight income inequality. But Costco’s customers are more affluent than Americans in general, too, and I don’t see anyone arguing that the IRS should force it to charge as much for its products as other stores do. That’s because it would amount to saying that competition on the basis of price shouldn’t be allowed. Which sounds awfully un-American.
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