Vanguard fund-of-funds and investor shares

The Vanguard total market funds’ investor shares make it possible for Vanguard to offer its fund-of-funds for a direct cost of zero (0.00% ER). This, by the way, is why Vanguard can not offer “admiral shares” of the fund-of-funds because the directly attributable fund cost is zero. (See Oblivious Investor’s interview with Emily Farrell, Head of U.S. Business PR at Vanguard for details.)

The Vanguard fund-of-funds, which include the firm’s target date retirement, lifeStrategy, and managed-payout fund offerings, are by far the majority shareholders of investor shares in the funds used for portfolio allocations. As of July 31, 2018, the breakdown of investor share ownership is as follows:

  • The total net asset value of Vanguard Total Stock Market investor shares is $131,200,000,000.00; the fund-of -funds hold $119,126,213,100.00, or 90.80%, of these total TSM investor shares.
  • The total net asset value of Vanguard Total International Stock Market investor shares is $131,600,000,000.00; the fund-of-funds hold $79,069,196,900.00, or 60.08%, of these Total International Stock Market investor shares.
  • The total net asset value of Vanguard Total International Bond Market investor shares is $27,700,000,000.00; the funds-of funds hold $26,993,987,000.00, or 97.45%, of these Total International Stock Market investor shares.
  • The  total net asset value of the Vanguard Total Bond Market II investor shares is $ 95,800,000,000.00; the fund is held exclusively by Vanguard fund-of-funds.
  • The total net asset value of the Vanguard Short-Term Inflation-Protected Securities investor shares is $6,500,000,000.00; the fund-of-funds hold $6,411,000,000.00, or 98.63% of these Short-Term Inflation-Protected Securities investor shares. (See Google sheet for calculations.

Vanguard explains its zero direct cost for the funds-of-funds in it’s discussion of the fund advisory agreement in the Statement of Additional information:

The Agreement provides that the Funds will not contribute to Vanguard’s capitalization or pay for corporate management, administrative, and distribution services provided by Vanguard. However, each Fund will bear its own direct expenses, such as legal, auditing, and custodial fees. In addition, the Agreement further provides that the Funds’ direct expenses will be offset, in whole or in part, by a reimbursement from Vanguard for (1) the Funds’ contributions to the cost of operating the underlying Vanguard funds in which the Funds invest and (2) certain savings in administrative and marketing costs that Vanguard expects to derive from the Funds’ operations. The Funds expect that the reimbursements should be sufficient to offset most or all of the direct expenses incurred by each Fund. Therefore, the Funds are expected to operate at a very low—or zero—direct expense ratio. Of course, there is no guarantee that this will always be the case

At this point it is instructive to examine the expense attribution of three similar indexed target retirement funds offered by Vanguard, Fidelity, and Schwab. Information regarding expense ratios is taken from the prospectus of each firm’s 2035 target date fund. Vanguard as previously discussed utilizes higher cost investors shares to offer the fund at no direct cost. Fidelity and Schwab utilize lower cost index funds in the portfolios and then access direct costs to the funds (offsetting these costs with reimbursements or waivers).

2035 Target Date Fund Vanguard Fidelity Schwab
Management fee: None None 0.08%
12b-1 distribution fee: None None None
Other expenses: None 0.15% None
Acquired fund fees: 0.14% 0.04% 0.04%
Reimbursement: None -0.05% -0.04%
Total net expenses: 0.14% 0.14% 0.08%

How Vanguard could offer admiral shares

Note that Vanguard could theoretically restructure the fund-of-funds so that they could offer investor share and admiral share versions of the funds. The funds could execute tax free conversions of the investor share funds for either admiral shares or exchange-traded fund shares of the underlying funds. This would, for example, reduce the acquired fund fee for the 2035 target fund from 0.14% to 0.07%. Thus the investor share version of the fund would theoretically have the following expense structure:

2035 Target Date Fund Vanguard investor shares
Management fee: None
12b-1 distribution fee: None
Other expenses: 0.07%
Acquired fund fees: 0.07 %
Reimbursement: None
Total net expenses: 0.14%

Since we now have 0.07% direct fund expenses it is now possible for Vanguard to offer admiral shares for large asset accounts. (Current policy for admiral shares suggests admiral shares could be offered for account balances ranging from $10,000 to $50,000).

2035 Target Date Fund Vanguard admiral shares
Management fee: None
12b-1 distribution fee: None
Other expenses: 0.03%
Acquired fund fees: 0.07%
Reimbursement: None
Total net expenses: 0.10%

It must be further noted that Vanguard has executed a lower cost target retirement fund program for institutions by offering funds that lower the acquired fund fee by utilizing a mixture of institutional, admiral, and investor share class funds.

The 2035 Vanguard Institutional Target date fund achieves its 0.09% acquired fund fee expense ratio by holding the following funds:

  • Total Stock Market Index Fund Institutional Shares
  • Total International Stock Index Fund Investor Shares
  • Total Bond Market II Index Fund Investor Shares
  • Total International Bond Index Fund Admiral Shares

Reference notes

 

About

Barry Barnitz, administrator of both the Bogleheads® wiki and of Financial Page, a Bogleheads® blog

Posted in Mutual funds, Target date funds
August 2018
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