Near the end of last month, mutual-fund giant Vanguard announced that it had lowered the expense ratios on 35 of its mutual funds. That’s after a December announcement that it had lowered expense ratios on 53 funds. All in all, Vanguard estimated, the changes resulted in an $87.4 million reduction in the fees paid by its customers.
Isn’t that outrageous!?!?! I mean, seriously, how shameless can these guys get?
That, in short, is the argument Vanguard tax lawyer turned whistle-blower David Danon and his hired expert, University of Michigan law professor Reuven S. Avi-Yonah, are making.
Yes, there's a more complicated legal angle involving transfer pricing. More on that in a bit. But the underlying reasoning is simple: Vanguard is cheating state and federal tax authorities by charging its customers much less than other fund companies do. Which is exactly as bonkers as it sounds. (This seems like it might be a good spot to disclose that while I don’t own any Vanguard funds, my wife does.)
Vanguard has $3.2 trillion in U.S. fund assets under management, and its asset-weighted average expense ratio is 0.14 percent, compared with an industry average of 0.64 percent. That means Vanguard’s fees bring in about $4.5 billion a year, and if they were raised to the industry average they would bring in about $20.5 billion. Since Vanguard is run at break-even now, that difference would presumably be profit, and thus subject to corporate income taxes. Using similar calculations, Avi-Yonah contends that Vanguard owes the Internal Revenue Service $34.6 billion in back taxes for the years 2007 through 2014. And Newsweek estimates that Danon, as the whistle-blower, could pocket as much as $10 billion of that.
Remember, these would be taxes on profits that were never earned, from fees that were never collected. Vanguard clearly wasn’t engaging in any subterfuge. The whole thing was out in the open.
My Bloomberg View colleague Matt Levine has dubbed this “the faked moon landing of financial news stories, except that it might be true." Danon collected a $117,000 whistle-blower bounty in Texas in November, meaning that Vanguard paid the state at least $2.3 million. It’s possible that Vanguard’s payment had nothing to do with the fee issue -- a company spokesman told Bloomberg’s Jesse Drucker that Danon’s arguments didn’t come up in the company’s discussions with state tax authorities. But Danon did collect a fee, and Avi-Yonah really is an expert on transfer pricing. Their claims can’t be completely dismissed.
Jeff Sommer described the legal niceties in detail in a New York Times column last weekend, which included quotes from two law professors who don’t buy Danon and Avi-Yonah’s reasoning. But the basic argument is this: Mutual-fund organizations are made up of two kinds of entities -- mutual funds that are owned by their customers and exempt from income taxes, and corporations that manage the mutual funds’ assets and charge fees for that service. Transactions between the funds and the management companies may thus be subject to transfer-pricing rules designed to keep corporations from shifting profits from high-tax jurisdictions to low-tax ones. That’s not what Vanguard is doing, of course, but Danon and Avi-Yonah argue that it is still required to charge “arm's-length” fees similar to what other management companies charge.
At almost every mutual-fund group other than Vanguard, the management company is out to make a profit, so charging too-low fees isn’t really an issue. But at Vanguard, the funds -- and by extension the investors in the funds -- own the management company, and expect it to keep fees as low as possible. Why the difference? A little history is in order, in part because it shows that Vanguard isn’t so much a weird outlier as a worthy carrier of the mutual-fund tradition.
The original mutual fund was the Massachusetts Investors Trust, founded in Boston in 1924. There were lots of investment funds being launched in those days, but MIT, as it was known, was different in that it was a customer-owned non-profit -- hence the name “mutual fund.” The fund trustees made the investment decisions, running what was effectively a Dow Jones Industrial Average index fund, and charged extremely low fees. MIT weathered the 1929 market crash and the bear market of the early 1930s better than most of its profit-seeking rivals, and came to dominate the nascent mutual-fund industry. When Congress set out to lay down ground rules for the industry with the Investment Company Act of 1940, MIT worked to ensure that the mutual structure and its customer-first aims were preserved. Even now, in its much amended modern form, the law states that when funds are managed in the interest of anyone other than the shareholders, “the national public interest and the interest of investors are adversely affected.”