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.”
Still, most other fund groups paired mutual funds with for- profit management companies. During the bull markets of the 1950s and 1960s, investors began to gravitate toward flashy funds run by managers who promised market-beating performance.
In 1969 MIT and a sister fund joined the crowd by demutualizing and starting a for-profit management firm called Massachusetts Financial Services that promptly began raising fees. The mutual had gone out of the mutual-fund industry.
It came back six years later as the result of a power struggle at another venerable mutual-fund group, Philadelphia- based Wellington, home of the Wellington and Windsor funds. Wellington Management had merged in the 1960s with a fast- growing Boston fund manager. Things turned sour during the bear market of 1973 and 1974, and the Boston partners voted to oust Wellington’s president.
This fellow -- his name was, and is, Jack Bogle -- still had a lot of loyal allies on the boards of Wellington’s mutual funds, so he arranged a coup, with the funds taking charge of their own destiny as the Vanguard Group. They still paid Wellington to manage the money in the Wellington and Windsor funds (and they still do), but Bogle soon came up with an alternative, the first unmanaged index fund for individual investors.
From these opportunistic beginnings emerged a financial juggernaut built around the organizing principle of trying to reduce expense ratios instead of trying to beat the market. Bringing in more assets to manage allows Vanguard to lower its expense ratios, which helps attract even more assets. In this way Vanguard has grown to be the world’s second largest money manager. (BlackRock is No. 1, due to big acquisitions as well as organic growth.)
Vanguard is run on behalf of its customers, who also happen to be its owners. It has revolutionized the money-management business, putting pressure on competitors to lower fees. Those lower fees have in turn made it easier for millions of Americans to save for retirement and other goals. It’s a virtuous cycle that has both changed investing for the better and brought the mutual-fund industry back closer to its roots. If the IRS or the courts decide to go after Vanguard for its frugality, it would amount to throwing all this into reverse.