Price war? Not exactly

Posted by on February 25, 2011 @ 9:59 am in Investing

You may have noticed news coverage in recent weeks about reductions in expense ratios for some of Vanguard’s funds. Most recently, for example, we reported that expenses declined for several of our international index funds.

As one who long has advocated that investors focus on the costs of investing, I’m happy to see expense ratios get attention. Lower costs allow the investors who put up the capital and take the risks to keep more of the returns their assets earn.

But I have a quibble with one aspect of some reports I’ve seen: the implication that reduced expense ratios at some Vanguard funds amount to engaging in a “price war” with other firms.

In fact, Vanguard’s unique structure (clients own the Vanguard funds, which, in turn, own Vanguard) means that expense ratios of our funds reflect the costs of operating the funds and Vanguard. Over time, as fund assets have risen, or when we’ve gained economies of scale, expense ratios have fallen. It’s a function of the at-cost operating model that flows from the fact that the funds own Vanguard.

Here’s a simple illustration: Suppose a fund has $1 billion in assets, and that it incurs costs of $2.5 million (for fund management and its share of the costs of Vanguard’s administrative and distribution services, employee salaries, etc.). That works out to an annual expense ratio of 0.25%, or one-quarter of 1 percent.

Now suppose that favorable financial markets and additional assets from investors push up the fund’s assets by 20% to $1.2 billion. Further, assume that the operating costs charged to the fund rise by 5%, to $2.63 million. The fund’s expense ratio would fall to about 0.22% ($2.63 million divided by $1.2 billion).

The reverse can happen when markets or fund assets fall—operating costs spread across a smaller asset base can cause a fund’s expense ratio to rise. Indeed, that occurred for many Vanguard funds in 2009, after the sharp downturn in the financial markets from late 2007 through early 2009. The average expense ratio for Vanguard funds rose from 0.20% in 2008 to 0.23% in 2009.

The at-cost model, advances in technology, and tremendous economies of scale have helped to cut the average expense ratio of Vanguard funds by more than half, from 0.89% to 0.21%, since we began operating in 1975.

When we announce that expenses have declined—as we did recently—it’s not a marketing ploy. It’s an outcome of our structure and commitment to low costs for investors.

Notes:

• Expense ratio data provided by Lipper Inc., as of December 31, 2010.

• All investing is subject to risk.

• Vanguard provides services to the Vanguard funds and Vanguard ETFs at cost.

• Foreign investing involves additional risks, including currency fluctuations and political uncertainty.

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