Vanguard's Irritating Perch on the Moral High Ground
The folks at Wealthfront posted an entry on their blog a while back about why they were going to use Vanguard’s exchange-traded funds going forward rather than those offered by BlackRock. As you may know, Wealthfront is a “robo-advisor” that uses algorithms to diversify the money it manages for people across a number of ETFs. Wealthfront is not large, but it has the potential be large someday, so whose ETFs they use is a matter of some importance.
Here is the relevant section:
Vanguard is essentially a non-profit, because it is owned by the investors in its funds. Therefore any profits it earns are returned to the investors in its fund in the form of lower fees. In contrast, Blackrock is a for-profit publicly traded company. It remains highly dependent on management fees from ETFs, which were the source of roughly a third of its $11.1 billion in revenue in 2016. Cutting fees on all their ETFs to Vanguard prices (not just their new “core” share classes) would cost Blackrock over $500 million in profits, which would be an almost 20% hit to their earnings …
In essence, Wealthfront is implying that clients may be better served if the financial services industry adopts a nonprofit business model. But what in the name of all that is holy is wrong with making a profit? Last I checked, there are a lot of successful businesses with great products and satisfied customers that make obscene profits. Also, the U.S. is allegedly a capitalist country, so, you see, this is what grinds people’s gears about the whole movement in low-cost, passive-style index funds and why people go around equating them to communism.
Time to ask some questions. If being a “nonprofit” is so good in the asset management industry, then why don’t we see it elsewhere, like in the retail industry or the auto industry or the mobile-phone industry? More philosophically, why are we fighting to retain (or eliminate) profit in the health-care industry by forcing down drug prices? We could have a longer discussion here about the role of profit in society, but there are plenty of places on the internet to find that.
Vanguard isn’t a nonprofit in the strictest definition of the term. Vanguard is more or less owned by its shareholders, but it does have to pay employees. And, as you know, people in the securities industry get paid pretty well, even on the low end. Vanguard has to compete -- in a free market -- to employ these people. The remarkable thing about Vanguard is that it manages to get its few thousand employees to “buy in” to making less money than they otherwise would, but how much less? My guess is they are still doing pretty well. Nobody is going to go to Valley Forge, Pennsylvania, and live an ascetic life in the name of low operating expenses and then struggle to put their kids through college. In fact, I’d bet that the salaries of key employees (like the manager of the $250 billion flagship Vanguard 500 Index Fund) are actually quite high, relatively speaking.
So, while Vanguard does not seek to maximize profits, what about the self-interested Vanguard employee? And does that create an agency problem, or rather a conflict of interest between Vanguard and its employees? At a traditional asset manager, everyone’s interests are more or less aligned, from the CEO on down. The firm succeeds if clients succeed or grow assets under management. Vanguard is different because all it cares about is lowering fees and assumes that client success will follow.
So maybe asset management as a nonprofit works because, despite making less money, people are still pretty highly compensated compared with a lot of folks and have a pretty good quality of life. There is not a lot of stress about missing your benchmark. The market closes, you get to go home.
Except, that’s not entirely true. If you’re a Vanguard portfolio manager tracking the S&P 500 Index, then you have to execute all the changes to the index, such as additions, deletions and rebalancings, perfectly. If XYZ stock gets kicked out of the index and you forget to sell it at the market on the close, then you have tracking error 1 , which can get you fired. So an index fund manager doesn’t necessarily have to be smart, but instead must have exceptional attention to detail.
It’s a vastly different skill than picking stocks, but a valuable skill nonetheless, one that probably commands a pretty high salary. So, if Vanguard were to disclose its executive compensation it would potentially cause a firestorm in the media and result in a great deal of pressure for the firm to further reduce its pay. That would make it harder to attract and retain people, the “nonprofit” facade might break down entirely, and Vanguard would have to acknowledge that some of its managers do earn economic rents and that its business model is more Wal-Mart than United Way.
There isn’t anything really unusual about Vanguard. If you’ve ever taken a business strategy course, it’s just a low-cost producer, no different than Wal-Mart in retail or Hyundai in autos or Old Navy in apparel. Vanguard’s founder, Jack Bogle, even once wrote a book about how people should make less money, but Vanguard employees make plenty of money, otherwise they wouldn’t work there.
What’s irritating about Vanguard is not its corporate strategy, but its occupation of the moral high ground. Vanguard is successful because it offers, or is perceived to offer, a better product at a lower price. Fees of all kinds have come down over time in the financial services industry, and that is a good thing. It is the natural result of capitalism at work. It has nothing to do with anyone wanting to make less money.
Bogle could have been Sam Walton if he wanted to, and it wouldn’t have changed Vanguard’s trajectory in the slightest. He just might not have had a statue erected in his honor on the Vanguard corporate campus, though.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
You might be surprised to learn that running an index fund is not a fully automated process. There is plenty of opportunity for mistakes.
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Jared Dillian at firstname.lastname@example.org
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