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Wednesday, September 24, 2014

Vanguard's Unique Corporate Structure

One thing I've come to realize over and over again, is that very few people understand what makes Vanguard such a unique company. Some might even be confused by my referring to both Vanguard and TIAA-CREF as non-profits, which is both strange and unfamiliar given that most people think of non-profits as charitable institutions, while Vanguard is clearly not one.

What makes Vanguard unique is the ownership structure. A traditional financial institution such as Fidelity or Charles Schwab or any of the traditional Wall Street banks and investment banks is a privately owned company that manages mutual funds or other financial services for its customers. This leads to a conflict of interest: the owners of Fidelity, for instance, make more money if it charges its customers more. That means that Fidelity becomes more profitable, the higher the expenses it can charge its customers. As you can imagine, Fidelity's expense ratios (other than a few funds where it competes directly with Vanguard) are quite high as a result.

Vanguard the operating company, however, is owned by the mutual funds it operates. In other words, the mutual funds own and direct the operating company. With this ownership structure, there's no conflict of interest between the customer of a Vanguard fund and Vanguard itself: the lower the expenses Vanguard manage to operate at, the more profitable the mutual funds are, and better off the Vanguard customer is.

Now, this is by no means a panacea. For instance, you can imagine a corrupt situation where Vanguard's operating firm's officers serve as the officers of its mutual funds, and so they vote their own compensation packages sky high while hurting Vanguard's customers. There's no guarantee that this can't happen, but given that large financial institutions with no relationship to Vanguard's officers get to vet and do due diligence of Vanguard's funds before they invest, there's good reason to believe that the market will serve as an adequate watchdog and prevent this from happening.

The result of this ownership structure difference is substantial: Vanguard's dramatically dropped its expenses for the vast majority of its customers over its life, and it continues to do so today. And if you ask me why I'm an unabashed Vanguard fan (over Fidelity, Schwab, or even Wealthfront), I'd point to this structure as being unique and unreplicated in the financial industry.

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