You don’t often see the terms “Wall Street” and “forgoing profit” in the same sentence.
But a decision made by the Vanguard mutual fund house decades ago to forgo profits is a key reason that index funds are now a multi-trillion-dollar factor on Wall Street and continue to gobble up market share.
The idea that forgoing profit can be good business is an important lesson that we should all take from the recent celebration of the 40th anniversary of the Aug. 31, 1976, launch of what is now known as the Vanguard 500 Index Fund.
That fund, pushed by Vanguard founder Jack Bogle, was designed to mimic the S&P 500, not to outperform it. A fund that replicates an index is much cheaper to run than an active fund, which needs to hire analysts and managers and engage in extensive research to try to outperform the index.
Now, to the forgoing profit part.
Unlike a mutual fund house owned by profit-seeking shareholders, Vanguard is owned by the investors in its mutual funds. These holders (who include my family and me) don’t have any meaningful ownership privileges — we don’t get cash dividends, for example, and have no say in choosing Vanguard’s leadership.
But the owned-by-the-customers structure, another Jack Bogle innovation, means that Vanguard isn’t focused on increasing profits and paying cash dividends. Instead, Vanguard plows its profits back into the business by reducing the fees it charges shareholders.
“It’s a question of allocating those profits to Main Street rather to Wall Street,” Bogle told me in a telephone interview. “The profits go to the fund’s investors, not to the managers.”
Consider these amazing cost-reduction numbers.
In the first year after its launch, Vanguard says, its newly established S&P fund charged investors 0.43 of one percent of their average balance as a management fee, plus a $6 annual charge.
This means that if you had $10,000 in the fund, Vanguard charged you $49 a year — a $43 management fee plus the six-buck annual charge.
The current fee for a $10,000 investor: $5, with no annual charge. That’s right, the fee today is almost 90 percent below what Vanguard charged 40 years ago for the same-size investment.
If you have less than $10,000 in your account, your fee is 0.16 percent. For someone with a $3,000 balance — the minimum required to open an account — the fee is $4.80 a year, and no annual charge. That’s more than 60 percent less than the $12.90 it would have cost in 1976.
Because an index fund charges investors less than active funds do, it will outperform the average actively managed fund. The more that Vanguard cut index fund fees, the higher the funds climbed in shareholder-return rankings, and the more money poured in. It’s what’s known as a virtuous cycle.
Pressure from Vanguard has forced other firms to offer low fees to compete. For example, Fidelity, owned by its employees and its founding Johnson family, told me that its index funds charge less than the equivalent Vanguard funds. Fidelity says it charges 0.09 percent (as opposed to Vanguard’s 0.16) for holders with less than $10,000 in its S&P 500 fund, and 0.045 percent (as opposed to Vanguard’s 0.5) for accounts with more than $10,000.
What this means, of course, is that the forgoing-profit model has saved billions of dollars not only for Vanguard’s index investors, but also for index investors in other fund companies.
One final note: Even though index funds are my biggest individual stock holdings, there’s a lot to be said for well-managed relatively low-cost active funds. Both Dan Wiener, editor of the Independent Adviser for Vanguard Investors newsletter, and Fidelity spokesman Vince LoPorchio told me about active funds that have outperformed their benchmarks for extended periods.
But for people without the time, inclination or skill to pick individual stocks or funds, index funds offer a cheap, simple, efficient alternative. So millions of people have profited from Vanguard forgoing profits. Isn’t life interesting?