The Vanguard Group

Mutual Fund Industry Practices and their Effect on Individual Investors

Full Statement of John C. Bogle
Founder and Former Chief Executive of The Vanguard Group and
President of the Bogle Financial Markets Research Center
Before the U.S. House of Representatives
Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises of the Committee on Financial Services
Washington, DC
March 12, 2003

Summary

  1. Higher costs lead to lower investment returns—immediately in the case of money market funds, promptly in the case of bond funds, and over time in equity funds, irrespective of style and risk. Over the past twenty years, costs have deprived the average equity fund investor of nearly one-half of the stock market's return. Costs matter.
  2. Over the years, the mutual fund industry has changed in many ways that have ill-served fund investors. With substantially rising expense ratios and portfolio turnover, the gap between equity fund returns and stock market returns has doubled.
  3. Despite the industry's 114-fold increase in assets—from $56 billion in 1978 to $6.4 trillion in 2002—the huge economies of scale involved, and the addition of much lower cost bond and money market funds, the expense ratio of the average mutual fund during this period has risen from 0.91% to 1.36%, an increase of 49%. There is, however, at least one exception to this trend of rising costs. The expense ratio of the average Vanguard fund during the same period has declined 58%, from 0.62% to 0.26%.
  4. Mutual fund costs include not only expense ratios, but sales charges, portfolio transaction costs and other expenses. In fact, expense ratios represent less than one-half of the all-in costs incurred by fund investors.
  5. Powerful evidence shows that, despite the staggering growth in mutual fund assets and huge economies of scale in fund operations, fund expense ratios have risen sharply over the years, meaning that the aggregate dollar amount of fees have risen even more rapidly than fund assets.
  6. Given the impact of fund costs, their rise over the years, and the apparent near-obliviousness of investors to these factors, far better cost disclosure is required. Including information about the dollar amount of an investor's specific costs in shareholder statements is an important first step, and can be accomplished efficiently and economically.
  7. Fund annual reports should prominently feature data showing fund returns, expense ratios, portfolio turnover, the costs of such turnover, and total expenses paid by the fund.
  8. We have far too little solid information about the nature and extent, and sources and uses, of the expenses fund investors incur. It's high time for an economic study of the mutual fund industry.
  9. Particularly in areas where relative cost is virtually the sole difference between success and failure (i.e. money market funds), disclosure of the costs that managers incur for each of the services they provide is essential.
  10. Given the obvious success that true arms-length negotiation of advisory fees has enjoyed in the few instances where it is practiced, methods of providing such negotiations between funds and their advisers should be fostered. Increasing the participation of independent directors, providing them with their own staff, and requiring that the chairman of the fund's board be an independent director would all be constructive steps.

The better the investing public is informed about mutual fund costs, the more likely it is that these costs will at last be forced to return to reasonable levels and redress the inbalance between the interests of fund investors and the interests of fund managers. Giving fund boards true independence from the fund's adviser would be a major step forward.

Statement

I have been both a student of, and an active participant in, the mutual fund industry for more than half a century. My interest began with an article in the December 1949 issue of Fortune magazine that inspired me to write my Princeton University senior thesis ("The Economic Role of the Investment Company") on this subject. Upon graduation in 1951, I joined Wellington Management Company, one of the industry pioneers, and served as its chief executive from 1967 through January 1974. In September 1974, I founded the Vanguard Group of Investment Companies, heading the organization until February 1996, and remaining as senior chairman and director until January 2000. Since then I have served as president of Vanguard's Bogle Financial Markets Research Center.

Vanguard was created as a mutual organization, with its member mutual funds as the sole owners of the management company, Vanguard Group, Inc. The company operates the funds on an "at-cost" basis. Essentially, we treat our clients—the fund shareholders—as our owners, simply because they are our owners. We are the industry's only mutual mutual fund enterprise

Recognizing the simple mathematics of the financial markets is our stock in trade. If a market's annual return, for example, is 10% and the total cost of financial intermediation is 2½%, then the net annual return to investors in that market is 7½%—75% of the market's return. These mathematics are eternal, immutable, and unarguable. So the firm that I created is dedicated above all to minimizing the operating expenses, the management fees, and the portfolio transaction costs that our shareowners incur. The objective is to deliver to our investors a return that is as close as humanly possible to 100% of the return of any market in which they chose to invest.

I believe it is fair to say that we have succeeded in minimizing the costs of fund ownership. Since Vanguard's creation, the Vanguard fund expense ratios have steadily declined, from 0.73% in 1974 to 0.60% in 1985, to 0.30% in 1994, to 0.27% in 1999, when they leveled off. (Exhibit I). Last year, the operating expenses and management fees paid by our funds came to 0.26% of their net assets, the lowest "expense ratio" of any firm in this industry. During 2002 the average expense ratio reported by Lipper Inc. for all stock, bond, and money market mutual funds was 1.36%. That 1.10% cost saving, applied to our present fund net assets of $550 billion, results in annual savings for our owners of $6 billion.

Exhibit I



Recognizing the critical nature of the link between mutual fund costs and mutual fund returns has been central to Vanguard's rise to industry leadership in asset growth, cash flows, and market share. (Our share of industry assets has risen for twenty consecutive years, from 1.9% in 1982 to 8.7% in 2002.) That growth has come largely in areas where the link between cost and return is virtually causal: Stock index funds (in 1975, we created the first index mutual fund); index and index-like bond funds (we also created the first such funds); and money market funds, which are sufficiently commodity-like to assure that their net yields hold a direct, virtual one to one, relationship to costs: The lower the cost, the higher the yield to investors. The net assets of the Vanguard funds in these three categories total $425 billion, or 77% of our asset base.

Costs Matter

This linkage between cost and return is not just academic theory. It appears most clearly in money market funds, whose gross returns inevitably cluster around the interest rate for short-term commercial and bank paper. But when the net yields of money market funds are considered, the variations are enormous. With a correlation of 0.96 (1.00 is perfect), the rankings of money fund yields during the five years 1997-2002 closely paralleled the rankings of money fund costs during the same period. Simply put, the lowest-cost decile of funds earned a gross return of 4.80% and deducted an expense ratio of 0.37%, for a net yield of 4.43%. The highest-cost decile earned 4.67%, deducted 1.74%, and produced a net yield of 2.93%. (Exhibit II) Money fund investors could have improved their annual yield by 51% simply by choosing the lowest-cost funds.

While the correlation between the costs and returns of actively-managed equity funds is less visible, it is nonetheless powerful and profound. A study of stock fund returns during the decade ended June 30, 2001, for example, showed that the low-cost quartile of funds earned an average net return of 14.5% per year, while the average high-cost fund earned an average of 12.3%, a 2.2% gap that was even larger than the 1.2% expense ratio gap between the two groups (0.64% vs. 1.85%). Exhibit III Appendix

An additional statistical test showed that this clear linkage between cost and return prevailed even more strongly when fund returns were adjusted for risk. The higher-cost funds were clearly assuming higher risks, and the return gap in favor of the low-cost quartile rose to 3.0% per year.

The cost-return relationship also prevailed when funds were grouped by their investment styles (large-cap growth, small-cap value, etc.), using the nine "Morningstar boxes." Significantly, the low-cost advantage prevailed in all nine of the style boxes, with eight of the comparisons yielding a risk-adjusted return advantage for the low-cost funds in the narrow range of 1.9% to 4.3%. (In the small-cap value group, there were only six funds in each quartile. Here, the low-cost funds produced 5.3% per year in extra return.)

Exhibit III

Risk-Adjusted Returns
Ten-Years Ended June 30, 2001
  Low-Cost Quartile High-Cost Quartile Low-Cost Advantage
Large-Cap Value 15.3% 13.4% 1.9%
Large-Cap Blend 14.6 11.0 3.6
Large-Cap Growth 13.3 10.2 3.1
 
Mid-Cap Value 15.8 11.5 4.3
Mid-Cap Blend 14.3 12.4 1.9
Mid-Cap Growth 13.7 11.6 2.1
 
Small-Cap Value 15.9 10.6 5.3
Small-Cap Blend 15.1 11.8 3.3
Small-Cap Growth 16.6 13.7 2.9
 
All Funds 13.8% 10.8% 3.0%

In both theory and practice, therefore, costs matter. It therefore follows that fund investors should have full disclosure of all investment costs.

A Changing Industry

The mutual fund industry that I read about in Fortune magazine in 1949 is almost unrecognizable today. Over and over again, the article spoke of "trustee," "trusteeship," "the investment trust industry," words that we rarely see today. Over the half-century-plus that followed, in my considered judgment, the fund industry has moved from what was largely a business of stewardship to a business of salesmanship, a shifting of our primary focus from the management of the assets investors have entrusted to our care to the marketing of our wares so as to build the asset base we manage.

While there may be room to argue about the exact nature of the change in industry intangibles, there can be no question about the change in industry tangibles. These changes can be easily measured. Exhibit IV

In summary:

  1. Today's mutual fund industry is far larger ($6.5 trillion of assets vs. $2 billion), and offers more asset allocation choices (then 90% stock funds, now 50% bond and money market funds).
  2. Equity funds are more risk-oriented, with only one of eight among 3,650 equity funds generally reflecting the broad stock market today, compared with nine out of ten of all 75(!) equity funds doing so in 1949.
  3. Then, funds were managed by investment committees. Now, the individual portfolio manager is the modus operandi.
  4. Measured by annual portfolio turnover—then 16%, now 110%—our equity fund investment philosophy has moved from long-term investing to short-term speculation.
  5. With that change, we have moved away from our earlier active role in corporate governance to a role that is largely passive.
  6. Our shareholders, on average, now hold their fund shares for much shorter periods—just over two years, compared to 16 years in the 1950s and 1960s.
  7. As the creation of new funds (often speculative funds, formed to capitalize on the market fads of the day) has soared, the fund failure rate has risen to an all-time high. (At present rates, fully one-half of all of today's funds won't be around a decade hence.)
  8. The costs of fund ownership have also soared, with expense ratios of the largest funds rising 134%—from 0.64% in 1951 to 1.50% in 2002.
  9. Once a profession practiced almost entirely by privately-held enterprises, the management of mutual funds has largely become the business of giant financial conglomerates, which own 36 of the 50 largest fund managers.

The question is: Have these changes in the fund industry been a service to fund shareholders? Or have they been counterproductive to their interests?

Mutual Fund Expenses

The final section of Exhibit IV endeavors to answer that question: These changes have adversely affected the returns earned by equity fund investors. Largely because of far higher costs, the returns earned by the average mutual fund in the "new" industry has lagged the returns of the stock market itself (measured here by the Standard & Poor's 500 Stock Index) by a substantially larger amount than the lag during the era of the "old" industry.1 Specifically, the performance lag has nearly doubled, from 1.6 percentage points per year to 3.1 percentage points per year. Here are the figures:

  Annual Rate of Return
Old Industry New Industry
1950-1970 1982-2002
Stock Market 12.1% 13.1%
Average Equity Fund 10.5% 10.0%
Lag 1.6% 3.1%
% of Return Captured
by Average Fund
87% 76%

When the impact of these returns and these lags are compounded over time, the shortfall in the returns earned by fund investors is dramatic. This example shows the returns on a $10,000 initial investment at the start of each period:

  Proift on $10,000 Initial Investment
1950-1970 1982-2002
Stock Market $88,820 $105,250
Average Equity Fund 63,670 56,765
Total Shorfall $25,150 $48,485
% of Cumulative Market Profit Captured by Average Fund 72% 54%

It is the investor who puts up 100% of the capital and takes 100% of the risk. Yet in this example, the investor in the average mutual fund received only a bit over one-half of the market's profit in the recent bull market. It would seem obvious that we ought to know why.

Fund Costs Make the Difference

As it turns out, the major reason that the return of the average equity fund lagged the stock market by 3.1% is the costs that investors' funds incur—the management fees, the operating expenses, the-out-of-pocket fees, the portfolio transaction costs, the sales charges, and the "opportunity cost" represented by the significant cash positions typically held by funds. I estimate the average annual impact of these costs over the past 20 years as follows:

Cost Category Amount
Management Fees 0.9%
Other Operating Expenses 0.4%

Expense Ratio

1.3%
Portfolio Transaction Costs (estimated) 0.8
Sales Commissions (annualized) 0.5
Opportunity Cost 2 0.5

Total

3.1%

It may be coincidental that the fund costs exactly match the fund lag, but it is not coincidental that the two numbers are similar. For intuition tells us, and the record confirms, that equity mutual funds as a group produce before-cost returns that are similar to the returns earned by the stock market itself. After all, when funds buy and sell stocks, it is often among one another and with other financial institutions. It would strain credulity to imagine that an entire giant equity fund industry—now owning nearly one-fourth of all of the stocks in the market—could provide a higher return (or, for that matter, a lower return), before costs, than the return of the very equity market in which it invests.

Trends in Fund Expenses

It seems obvious not only that it is costs that make the difference between success and failure in investing, but that fund costs have been in an upward trend over the long-term and are today at the highest levels in history. Certainly we know that the expense ratio of the average equity fund has risen from 0.98% in 1978 to 1.61% in 2002, a 64% increase.

Exhibit V

Such sweeping industry averages, heavily weighted by the thousands of new funds that entered the industry, present one perspective on the rise in fund costs. Another perspective shows an even larger increase. An examination of the changes in the expense ratios of the 25 funds that dominated the "old" industry back in 1951 shows that, despite the fact that the average assets of these funds had risen nearly 60-fold, their average expense ratio had risen 66%—from just 0.64% to 1.06%. Of the 20 funds that survived this half-century era, only three (Vanguard Wellington, Fidelity Fund, and American Fundamental) reduced their expense ratios. The average expense ratio of the other 17 funds rose from 0.60% in 1951 to 1.16% in 2002, an increase of nearly 100%. Exhibit VI.

This substantial increase in expense ratios, combined with the staggering growth of fund assets, means that the revenues generated to fund managers rose almost exponentially. Specifically, these 25 original funds were operated at an average cost of just $520 thousand in 1951; in 2002, the average cost of the 20 remaining funds came to $44 million, a 85-fold increase, dwarfing the 57-fold increase in assets.

Of course, like the Consumer Price Index, fund operating costs have risen during this long era, and of course funds are providing more investor services than heretofore (though modern information technology has created substantial efficiencies). But the fact is that there are staggering economies of scale involved in the investment management process. (When a fund grows from $500 million to $5 billion, the manager hardly requires ten times as many security analysts.) There is no evidence whatsoever that fund managers have shared these economies of scale with fund owners. Indeed, the evidence presented in Exhibit VI clearly shows that the preponderance of managers have not only arrogated these savings to themselves, but have increased fees as well, adding to their already substantial profit margins.

Following the Money

I estimate that the direct expenses incurred by all mutual funds of all types in 2001 amounted to about $73 billion dollars (1.1% of average fund assets of $6.7 trillion), of which about $15 billion represented direct operating costs and $58 billion represented fees paid to fund managers. Based on the pre-tax profit-margin of 45%, typical of publicly-held fund managers, we can estimate that the profits of fund managers total about $26 billion. Thus the managers' costs of operating the funds came to about $32 billion. Some $27 billion was probably represented by marketing costs and other operating costs, with no more than $5 billion—about 7% of total fund costs—expended on portfolio management and research services, the principal service that fund investors seek.

The foregoing figures are, I believe, reasonable estimates. But the fact of the matter is that we simply don't know nearly as much as we should about where the money goes in the mutual fund industry. We ought to know. It is high time that either the SEC or General Accounting Office conduct an economic study of this industry, showing the specific sources and uses of shareholder dollars. Given the obvious and crucial role of fund costs in shaping fund returns, it is high time to "follow the money," wherever the trail may lead.

Other Studies of Costs

The Investment Company Institute has produced numerous studies of mutual fund costs over the years. They purport to show that what they refer to as "the cost of fund ownership" is not only far below the cost figures presented earlier in this statement, but reflects a long-term secular downtrend. But because of a flawed statistical approach and an remarkably narrow definition of "cost," the ICI conclusions are not supportable. Exhibit VII. In brief:

  1. By weighting the data, not by the average fund or by fund assets, but by sales, the ICI captures, not a long-term reduction in the costs charged by the industry, but investors' ever-increasing selection of lower cost funds. Price competition, however, is properly defined, not by the action of consumers, but by the action of producers.
  2. The ICI's original 1998 study noted that the cost reduction had come largely in funds with extremely high costs, and that the lowest-cost decile actually increased costs by an estimated 27%. (This analysis was subsequently dropped.)
  3. The study acknowledged that much of the cost reduction was attributable to index funds and funds sold to large institutions; costs for regular equity fund investors were 10% higher than the reported figure.
  4. The ICI data also exclude many of the costs of fund ownership, including the substantial costs of portfolio turnover. I estimate that these other costs would increase their (flawed) 2001 annual cost figure of 1.28% for equity fund ownership to 2.70%, an increase of more than 100% (i.e. the ICI understates fund costs by fully 50%). If unweighted, the cost would rise to another 0.61% to 3.31%, 160% above the ICI figure.

Cost Disclosure

Investors are largely unaware of the high level of mutual fund costs, and even less aware of the powerful effect of these costs on the compounding of their returns over the long-term. Since managers have an obvious vested interest sustaining this ignorance, I believe that we urgently need new SEC rules that require greater cost disclosure. Some recommendations:

  1. Annual mutual fund shareholder statements should inform each fund owner as to the dollar amount of expenses he or she is incurring through the fund's expense ratio. This figure should not be backward-looking, for the calculation complexities are truly awesome. It should be forward-looking, showing the expected annual expense based on the value of the shareholder's investment at year-end. At the same location where the statement presents the year-end dollar value of the account, it should also present the dollar amount of expenses expected during the coming year. That figure would simply be the product of multiplying the account balance by the fund's most recent annual expense ratio, or, if materially different, a reasonable estimate of the projected expense ratio during the coming year. A footnote would present both the calculation methodology and the expense ratio used to make the calculation. For example, if a shareholder's year-end value were $11,212 and the expense ratio were 1.58%, an annual expense of $177 would be projected on the shareholder's statement.
  1. The present prospectus cost-impact statement combining expense ratio and sales charges and providing costs on a $10,000 investment over three-, five-, and ten-year periods should be modified by adding transaction costs so the "all-in" cost of fund ownership is fully disclosed. This disclosure should be included in both the annual report and prospectus. I emphasize that these transaction costs go well beyond mere commission costs, to market spreads, market impact, etc., even as I recognize that these costs are difficult to measure with precision. But even a rough estimate (although I believe most managers have much better information than that) would be better than no estimate at all. Once we have had some experience with the reporting of these transaction cost data, we should consider adding transaction costs to the direct expenses presented in the shareholder statement. For example, using the above example, if estimated transaction costs were equal to 1.00% of net assets, all-in costs would be 2.58%, or $289 in annual costs for the shareholder.
  1. Cost disclosure in fund annual reports must be enhanced, so that shareholders can relate fund cost to fund returns. Funds should be required to present a table, either on the inside cover of the report or the immediately facing page, the following information: 

    1. The fund's total return for the year, compared to a) whatever market sector benchmark (if any) it deems appropriate, and b) the annual return of the broad market in which it invests (i.e. the total stock market, total taxable bond market, total exempt bond market), etc.
    2. Rate of portfolio turnover during the year, and the estimated impact of transaction costs on returns (i.e., the ratio of transaction costs to net assets).
    3. Total costs for the year as a percentage of net assets, including a) the expense ratio, and b) the transaction cost ratio.
    4. The total dollar amount of costs incurred by the fund during the year, including the amount of the management fee, the amount of the 12b-1 fee, and other operating expenses.

Like the disclosure of each investor's costs in the annual shareholder statement, this added disclosure in the annual report and would enhance the investors' understanding of the amount of costs they are incurring and the impact of costs on the returns they receive.

A Money Market Fund Example

Cost disclosure is important because cost plays such a crucial role in shaping the returns earned by fund owners. While the importance of cost applies to all types of mutual funds, it is most obvious in money market funds. There, the tension between operating a fund in the interest of shareholders and operating it in the interests of management companies can be measured directly. The impact is virtually dollar-for-dollar. There is simply no way to seriously allege that a money fund's portfolio manager can outguess in a meaningful way the vast, efficient and professional market for short-term funds. (In fact, the record is clear that in the few cases where managers have attempted to do so, they have lowered quality standards, resulting in substantial losses for the fund, typically made whole by its management company.)

As shown earlier in Exhibit I, money fund performance comes down almost entirely to relative costs. While there are few examples about the nature of the costs that money funds incur, those that we have are instructive. The Vanguard money market funds, for example, are operated at cost by their own employees, and report the exact amount of costs that they incur on each of the principal activities involved: 1) investment management; 2) distribution of shares; and 3) shareholder services and operations. The Smith Barney money market funds, on the other hand, are among a handful of money funds that pay separate fees to their external service providers for each of these three services. Thus, we can make a fair comparison of where the money goes. During 2000, the money fund assets of the two groups were virtually identical, so the comparison is striking.

Exhibit VIII

Money Market Comparison

  Smith Barney Funds   Vanguard Funds
Fiscal Year 2000   Fiscal Year 2000
Fees Total
Expenses
Expense
Ratio
  Total
Expenses*
Expense
Ratio
Investment Management $257,036,799 0.40%   $15,394,000 0.02%
Distribution $65,374,726 0.10%   $11,798,000 0.02%
Shareholder Services $48,500,618 0.07%   $169,412,000 0.25%
Other $8,791,460 0.01%   $4,527,000 0.01%

Total Expenses

$379,703,603 0.59%   $201,131,000 0.30%
Total Assets $64,865,192,337     $67,460,548,000  
  *Vanguard's actual investment management expenses totaled $7,697,000; this figure was doubled to account for other general management expenses, with the "Service" expenses commensurately reduced.

The aggregate assets of the Smith Barney money funds in 2000 were $64.8 million compared to $67.4 million for the Vanguard money funds. Yet the expenses of the two organizations were radically different. Smith Barney's costs totaled almost $380 million, nearly 90% higher than Vanguard's costs of just over $200 million. The former's expense ratio was 0.59%, nearly double the latter's. Specifically, under their investment management contracts, the funds paid Smith Barney $257 million to "select the fund's investments and oversee (their) operations." The actual cost of Vanguard's analysts and portfolio managers was $8 million. Adding in another $8 million for management overhead brought the total to almost $16 million. What could possibly account for this gap of $241 million? It couldn't be distribution or shareholder services for, they are accounted for separately. A money market fund requires only so much management, and it can't cost but a small fraction of a quarter of a billion dollars. To the extent that $241 million gap between Vanguard's costs and Smith Barney's fees represent a profit to Citicorp, those profits come at the direct cost of the return earned by the funds' shareholders.

It is for this obvious reason that shareowners deserve complete information, not only about the costs incurred by their funds in the form of management fees, but the costs incurred by their managers in return for providing those services. Simply providing this information to investors should help bring the fees that mutual funds pay to their service providers into a more reasonable relationship to the actual costs those providers incur, especially in commodity type funds where the ability of managers to add sustained value is not a possibility. (Or, if it is argued that there is a small possibility, it is dwarfed by the size of the fees themselves.)

Fee Negotiations

The cost example used above is, in a sense, unfair. Of course a mutual at-cost organization such as Vanguard should deliver lower costs than one operated by a profit-making firm such as Smith Barney. But the gap seems, well, disproportionate. What is more, while Vanguard operates its money funds, most bond funds, and all index funds at cost, it also has entered into numerous contracts with external investment advisers—profit-making entities—all who provide their services to Vanguard's actively managed funds, engaging in arms-length negotiations to establish appropriate fees.

The fee scales we have negotiated over the years go back to Vanguard's founding in 1974, when our investment management fees were reduced in an amount more-than-commensurate with the direct costs that the funds would incur when the firm assumed the responsibility for Vanguard's operations. They were reduced again in 1977, and again by an amount more-than-commensurate with the extra costs incurred, when Vanguard assumed the responsibility for distribution. At that point, controlling its own operations and distribution, Vanguard was in a position to negotiate with its former management company, Wellington, solely on the basis of its investment advisory services, just as do the trustees of large corporate pension funds.

As circumstances changed and fund assets grew over the years, Vanguard negotiated frequent fee reductions with the external independent investment managers responsible for its actively-managed funds. Taking into account not only these fee reductions but the economies of scale involved in Vanguard's shareholder services and other operations, the average expense ratio for the equity funds (including index funds) in the Vanguard Group declined from 0.74% in 1978 to 0.66% in 1984, to 0.38% in 1994, and to 0.33% in 2002. During the same period, the expense ratio of the industry's average equity fund actually increased from 0.98% in 1978 to 1.61% in 2002.

Exhibit IX

Credit for much of this 55% drop in Vanguard's unit costs in face of a 64% increase in the unit costs of other equity funds came from unremitting arms-length negotiations with our external advisers, the most recent of which took place in 1995. Our goal was to adopt steeply-sliding fee scales that would not require negotiations as assets grew, in effect to demand that our investors receive their fair share of the advisers' economies of scale, and in part to anticipate future growth that would not require the give-and-take tension of frequent fee renegotiations. For example, the Vanguard Wellington Fund effective fee rate, paid to adviser Wellington Management Company, was reduced as follows:

1978   -30%
1983   -6%
1986   -15%
1991   -26%
1995   -17%

At the fund's 2002 asset total of $22 billion, with a base fee of $8.5 million, and each additional billion-dollar increase in assets resulting in an additional fee of just $300,000 (three basis points), the advisory fee average rate is 0.04%. In 2002, the fund's expense ratio (the fund's share of Vanguard's costs of 0.30%, plus the advisory fee of 0.04%) was 0.34%, 70% below the 1.18% expense ratio of its balanced fund peer group. If Wellington were today paid under the 1975 fee scale, its fee would have been $92 million, or $83.5 million larger than the $8.5 million actually paid to its external advisor.

The Vanguard GNMA fund presents a similar, if starker, illustration. Following its founding in 1980, the fund grew substantially, and both its advisory fee and its expense ratio dropped steadily, from 0.65% at the outset to 0.34% in 1990, to 0.24% in 2002. The fund's advisory fee scale was reduced as follows:

1983   -56%
1986   -12%
1991   -14%
1995   -48%

For 2002, the advisory fee amounted to 0.009% of the fund's assets (i.e., less than one basis point). (The average management fee on other GNMA funds appears to be about 0.45%.) At the fund's present size of $27 billion, it generates fully $2,600,000 in advisory fees to Wellington's fixed-income group, doubtless well in excess of their costs. While each additional $1 billion of assets produces an added fee of only $90,000, the extra assets—invested as they are in securities whose principal value is guaranteed and interest payments are guaranteed by the U.S. Government—creates no extra costs for credit research. This miniscule fee rate, added to the fund's share of Vanguard's operating expenses of 0.23%, brings its total expense ratio to 0.24%, fully 77% below the expense ratio of the average GNMA fund, a major advantage to investors. If the Vanguard GNMA fund had adhered to its original fee schedule, its fee last year would have been $21 million, more than $18 million larger than the $2.6 million fee actually paid to its external advisor. Exhibit X presents the actual fee schedules for Vanguard's Wellington Fund and GNMA Fund over the years.

Lower fees have been heavily responsible for the fact that both our Wellington and GNMA funds have provided superior returns to their shareholders over the years. In 1987 - 2002, for example, Wellington outperformed 90% of all balanced funds, and GNMA outperformed 99% of all GNMA funds. Yet our fee rate reductions are normally very small, and only nominally erode huge increases in the dollar amount of fees received by our external advisers. But the examples in Exhibit X clearly illustrate both the tremendous cumulative impact a number of reductions can have over time, and the huge value fee negotiations can have for fund investors. Such arms-length negotiation, however, is conspicuous only by its absence in the mutual fund industry. Establishing some way for funds to negotiate with advisers is a change long overdue.

 

©2003 Bogle Financial Center. All rights reserved.