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Our focus on costs: We're monsters of efficiency

February 20, 2014

A few years ago, while ordering headsets for Vanguard telephone associates, a manager noticed that there were hundreds of broken devices lying on empty desks or tucked away in drawers. Why not recycle the used ones?

The manager contacted the manufacturer, which offered to replace or refurbish the broken sets under the terms of a warranty—a single phone call yielding $20,000 in savings. The point? Just as Vanguard extols the virtues of low-cost investing to our clients, we try to manage the cost of our business operations with green-eyeshade efficiency.

These efficiencies eventually make their way to clients in the form of lower costs. At the end of 2012, for example, the average expense ratio for Vanguard mutual funds stood at 0.19%, less than one-fifth of the industry average of 1.11%, according to Lipper, a Thomson Reuters Company.

Fund asset chart

The exceptional growth we have seen in assets under management over the years (they stood at about $2.4 trillion at the end of 2013) has provided us with additional opportunities to lower the cost of investing. How do we harness these economies of scale to lower costs and enhance services? Here are some notable examples.

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Making the web our clients' go-to transaction tool

In the late 1990s, with client transaction volumes beginning to increase sharply, Vanguard realized that the web gave us an opportunity to reach more clients at a lower cost. It would mean a heavy up-front technology investment, but the long-term benefits could be huge: Online transactions were projected to cost a small fraction of those carried out through telephone representatives. Even so, the strategy came with some risk—namely, that just because you offer a service doesn't mean clients will want to use it.

As it turned out, our clients, who had been early adopters of the option to manage their investments by phone, also proved to be early adopters of web-based investing. The bar chart below shows that in 2012 Vanguard retail clients made almost five times as many transactions on the web as they did by phone. As a result of this shift, transaction and processing costs have tumbled, and those savings have directly benefited our clients in the form of reduced investment expenses.

Web chart

Putting the squeeze on our funds' transaction costs

Buying and selling securities is an unavoidable part of running a mutual fund. Even buy-and-hold index funds, such as Vanguard 500 Index Fund, need to do this when cash comes into or leaves the fund, or when stocks enter or leave its benchmark index. The 500 Index Fund, which had assets averaging more than $100 billion in 2012, traded securities worth more than $9 billion that year even without counting in-kind purchases and redemptions, which incur no transaction costs. And as you can imagine, our actively managed funds generally buy and sell securities even more frequently than their index counterparts.

Here's where the economy of scale comes in. For a transaction to take place, brokers establish a "bid" price for the seller of a given security, and they set a higher "ask" price for a prospective buyer. The difference (or "spread") between the two tends to be greater for both smaller trade sizes and less frequently traded securities.

A 2012 Vanguard research paper, A topic of current interest: Bonds or bond funds?, for example, showed that on a municipal bond trade of more than $1 million, the bid-ask spread for large players could be less than one fifth of what an individual might pay.

Gregory NassourAnd Vanguard, thanks to our broad selection of funds with different investment objectives, can sometimes carry out "interfund" transactions, which are even more cost-efficient. This might occur when a Vanguard index fund has to sell a security that's exiting the index being tracked, and an actively managed Vanguard fund is looking to buy that same security.

"The transaction is executed at a price midway between the bid and the ask price," explains Gregory Nassour, a principal in Vanguard Fixed Income Group. "That way, the fund holding the security is able to sell it for more than the bid price, while the fund wanting the security pays less than the ask price. Both funds—and, ultimately, our shareholders—benefit."

Walking the talk

Keeping the cost of investing low is a central, recurring theme that runs through the counsel Vanguard offers its clients. It's also a principle that has guided us in the way we have run our company since it was founded nearly 40 years ago. And a key part of our strategy for the future.

Note: All investing is subject to risk, including the possible loss of the money you invest.

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