What if Vanguard gets nuked?

As low cost index trackers become more and more popular, one question I often get during financial coaching is:

What would happen to my money if Vanguard went bust?

I worked in corporate finance and saw enough companies go bust to know that it’s a good question. And it’s worth sharing the answer with readers. But The Escape Artist doesn’t believe in re-inventing the wheel.  Particularly if someone smart has already written about this in a way that is clear, useful and accurate.

And they have!  Jim Collins is the wise elder statesman of financial independence bloggers in the USA.  And, as part of his excellent stock series, Jim wrote a post titled “What if Vanguard gets nuked?”. So I reached out to Jim for his permission to republish it here…which he very kindly granted to me.

Although it’s written from a US perspective, if you substitute “the FCA” for “the SEC”, the same regulatory and commercial principles apply in the UK.

Enjoy!

The Escape Artist

What if Vanguard gets nuked?  by Jim Collins

You don’t have to read very far into my blog to know I am a strong proponent of investing in Vanguard index funds.

Understandably, this raises some questions.  Today let’s look at the four most common:

1.  What makes Vanguard so special?

When Jack Bogle founded Vanguard in 1975 he did so with a structure that remains unique in the investment world:  Vanguard is client-owned and it is operated at-cost.

Sounds good, but what does it actually mean?

As an investor in Vanguard Funds, your interest and that of Vanguard are precisely the same.  The reason is simple.  The Vanguard Funds, and by extension the investors in those funds, are the owners of Vanguard.

By way of contrast, every other investment company has two masters to serve:  The company owners and the investors in their funds.  The needs of each are not always, or even commonly, aligned.

To understand the difference, let’s look at how other investment companies (most companies in fact) are structured.  Basically, there are two options:

i.  They can be owned privately, as in a family business.  Fidelity Investments is an example.

ii.  They can be publicly traded and owned by shareholders.  T. Rowe Price is an example.

In both cases the owners understandably expect a return on their investment.  This return comes from the profits each company generates in operating its individual mutual funds.   The profits are what’s left over after the costs of operating the funds are accounted for — things like salaries, rent, supplies and the like.

Serving the shareholders in their funds is simply a means to generate this revenue to pay the bills and create the profit that pays the owners.  This revenue comes from the operating fees charged to shareholders in each of their individual funds.

When you own a mutual fund thru Fidelity or Price or any investment company other than Vanguard, you are paying for both the operational costs of your fund and for a profit that goes to the owners of your fund company.

If I am an owner of Fidelity or Price I want the fees, and resulting profits, to be as large as possible.  If I am a shareholder in one of their funds, I want those fees to be as modest as possible.  Guess what?  The fees are set as high as possible.

Now to be clear, there is nothing inherently wrong with this model.  In fact it is the way most companies operate.

When you buy an iPhone built into the price are all the costs of designing, manufacturing, shipping and retailing that phone to you.  Along with a profit for the shareholders of Apple.  Apple sets the iPhone price as high as possible, consistent with costs, profit expectations and the goal of selling as many as they can make.  So, too, with an investment company.

In this example I chose Fidelity and Price not to pick on them.  Both are excellent operations with some fine mutual funds on offer.  But because they must generate profit for their owners, both are at a distinct cost disadvantage to Vanguard.  As are all other investment companies.

Bogle’s brilliance, for us investors, was to shift ownership of his new company to the mutual funds it operates.  Since we investors own those funds, thru our ownership of shares in them, we in effect own Vanguard.

Any profits generated by the fees we pay would find their way back into our pockets.  Since this would be a somewhat silly and roundabout process and, more importantly, since it would potentially be a taxable event, Vanguard was structured to operate “at cost.”  That is, with the goal charging only the minimum fees needed to cover the costs of operating the funds.

What does this translate into in the real world?

Such fees are reported as “expense ratios.”  The average expense ratio at Vanguard is 0.20%.  The industry average is 1.12%.  Now this might not sound like much, but over time the difference is immense and it is one of the key reasons Vanguard enjoys a performance as well as a cost advantage.

With Vanguard, I own my mutual funds and thru them Vanguard itself.  My interests and those of Vanguard are precisely the same.  This is a rare and beautiful thing, unique in the world of investing.

Click on the quote below for more:

“No one, other than the funds and their shareholders, owns a piece of Vanguard. Nobody. Our CEO, Bill McNabb, and even our founder, Jack Bogle, are client-owners in exactly the way you are.”

2.  Why are you comfortable having all your assets with one company?  Isn’t this what tanked investors with Bernie Madoff?

Because my assets are not invested in Vanguard.  They are invested in the Vanguard Mutual Funds and, thru those, invested in the individual stocks, bonds and REITS those funds hold.  Even if Vanguard were to implode (a vanishingly small possibility), the underling investments would remain unaffected.

They are separate from the Vanguard company.  As with all investments, these carry risk, but none of that risk is directly tied to Vanguard.

Now this can start to get very complex and for the very few of you who care, there’s lots of further info you can easily Google.  For our purposes here, what’s important to know is:

i.  You are not investing in Vanguard, you are investing in one or more of the mutual funds it manages.

ii.  The Vanguard mutual funds are held as separate entities.  Their assets are separate from Vanguard, they each carry their own fraud insurance bonds, each has its own board of directors charged with keeping an eye on things.  In a very real sense, each is a separate company operated independently but under the umbrella of Vanguard.

iii.  No one at Vanguard has access to your money and therefore no one at Vanguard can make off with it.

iv.  Vanguard is regulated by the SEC.

All of this, by the way, is also true of other mutual fund investment companies, like Fidelity and Price.  Those offered in your 401k are, in all likelihood, just fine too.  (If you have an employer sponsored retirement plan, like a 401k, that doesn’t offer Vanguard funds by all means invest in it anyway.  Especially if any company match contributions are offered.  Those are free money and an instant return on your investment.)

It is NOT true however for what are called Private Investment Funds.  Those are where you turn your money over directly to an individual or group of individuals to manage and invest.  That’s what Madoff was running.

3.  What if Vanguard gets nuked?

Ok, let’s be clear.  If the world ends on December 21, 2012 as evidently the Mayan Calendar suggests it might, everything you have invested in Vanguard (or elsewhere) will go up in smoke.  But that’s not gonna happen. (Come December 22nd, I’m putting “told you so” right here.) (Told you so.)

If a giant meteor slams into Earth setting the world on fire followed by a nuclear winter, your investments are toast.

If space aliens arrive and enslave us all, unless you bought human feedlot futures, it’s gonna mess up your portfolio.

TWDIf super volcanos or global warming or viruses or an ice age or the reversal of the magnetic poles or AI robots or nanobots or maybe Zombies take us out, investing with Vanguard will be of no help at all.

Relax.  It ain’t none of it gonna happen.

At least not on our watch.

But lesser disasters can and do happen.  Vanguard is based in Malvern, Pennsylvania.  What if, God forbid, Malvern is nuked in a terrorist attack?  What about a cyber attack?  Hurricane?  Pandemic? Power outage?

Every major company and institution is aware of these dangers and each has created a Disaster Recovery Plan.  Vanguard has one of the most comprehensive going.  The company is spread across multiple locations.  Its data is held in multiple and redundant systems.  You can check out their plan here:  Business Recovery Plan

But, if you are expecting a planet or even just a civilization ending event, Vanguard’s not for you.  But then, no investments really are.  You’re already stocking your underground shelter with canned goods.  Short of that, you can sleep just fine with your assets at Vanguard.  I do.

4.  Am I paid by Vanguard?

This blog is such strong a proponent of Vanguard it is reasonable to ask….

“Am I on the take?”

Nope.  Vanguard doesn’t know I’m writing this and they are not an advertiser.  Nor do they pay me in any fashion whatsoever.

 

You can follow The Escape Artist on Twitter here

14 comments

  1. Hey EA…

    I’m honored you’d ask and I hope your readers enjoy the post.

    Thanks!

    1. Jim

      Thank you so much. Your interview with MadFientist was one of the podcasts that really helped me when I was figuring out whether I could really quit my job and be free.

      All the best

      TEA

  2. TheLuckyOne · · Reply

    Clearly you must have a spy camera in my brain as once again you have answered a question that I didn’t know to ask yet even though all the components of that question are swimming around in there along with SIPP/ BTL 3%/Brexit/TFLS/CGT etc. Sometimes all these things can look like problems but no, they are just opportunities and choices that I’m delighted to have. More importantly since I escaped from the camp I can spend as much time as I like understanding all these opportunities and then making informed (good?) choices. Thanks Mr T.

    1. Thanks for the comment. I don’t have a spy camera in your brain 🙂 (although no doubt Google are working on one) but I do know what people often worry about…partly because they tell me and partly because I’ve been through all same thought processes myself!

      All the best

      TEA

  3. The escrow system protects your money from the company money both for fund companies’ and brokers’ creditors, but not from miss-management or fraud. So its still worth spreading it around across a few of each, though I don’t spread it thinly enough for the government’s £50k FSCS equity limit

  4. sirsteve · · Reply

    Thanks for the post – which is highly relevant to my own situation. I’m in the fortunate position of having accumulated fairly substantial investment funds through a combination of saving, investment returns and a pension lump sum. Following a discussion on worst case scenarios on the Monevator website, I decided to spread these funds across 3 (low cost) platforms. But the investments themselves are all in a mix of Vanguard LifeStrategy funds. I’ve never been entirely happy with putting all of my eggs in the Vanguard basket but I couldn’t find any other providers who offered similar low cost, auto-rebalanced funds. Anyway Jim’s article provides considerable reassurance on the risks of having all my investments with Vanguard. Having said that, I’m not so sure that Vanguard’s mutual status is necessarily such a comfort – I write as someone who had a substantial chunk taken off the value of their AVC pension fund when Equitable Life hit the rocks!

    1. sirsteve – yes, I agree that mutual status is not a guarantee of competence…but there are very few guarantees in investing or in life.

      I think mutual status does reduce the risk of fraud. The pressure to meet aggressive targets is one cause of corporate frauds.

      Mutual status also removes the incentives for sneaky hidden charges that exists in financial services (e.g. the FX commission spread charged by most broker platforms).

      It’s a bit strange that no one has yet started a mutually owned competitor to Vanguard. I would have thought this would be a perfect venture for either The Co-operative Bank or John Lewis Financial Services. Vanguard obviously has a big headstart and economies of scale but I would have thought there’d be room in the market for another mutually owned index fund provider…

      1. Haleshine · ·

        That would be awesome. Put some competition in the mutual index trackers industry and drive the cost even further down!

  5. London Rob · · Reply

    Really useful to read, and thanks to both of you for this. I’ve got a few Vanguard funds in my ISA (tax free area for JLC!) – but I am also wondering what I can outside of that tax wrapper in the UK. I have some Income Accumulator funds, does Vanguard do something similar? I know there is the Lifestyle Strategy, but do they actually have these that automatically reinvest the dividends so they dont count as your income?
    Thanks in advance 🙂

    1. London Rob – You can see on the Vanguard website that their funds come in a choice of accumulation or income units

      1. London Rob · ·

        great stuff thanks – note to self, engage brain before posting daft questions 🙂 Thanks for the link – I will take a gander, although Acc. units less necessary when they ramp up the ISA allowance in 2017…!

    2. Although accumulation units invest the income for you, you will still have to account for the income as income. Then when you sell you will have to adjust the capital gains calculation for the income. Personally I would always avoid accumulation units unless in a tax shelter.

  6. Great article, thanks! Does the same apply to Vanguard ETFs held in a brokerage account? I’m just wondering if the brokerage (TD Ameritrade) went under, would I lose all my investments?

    1. Yes, the same principles apply…your investments should be held separately from the broker’s assets. So your investments should be unaffected by your broker going bust. But I still think its important for investors to choose their broker carefully and consider its financial stability in addition to the fees it charges…

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