Vanguard and BlackRock (iShares)

About ETF’s

ETF’s (Exchange Traded Funds) are an alternative to traditional active or passive mutual funds that trade on exchanges.  There are many advantages to ETF’s over mutual fees including:

1) tax efficiency – mutual funds deliver you capital gains (and losses) even when you don’t make any trades due to internal fund activity.  These gains and losses are avoided (in the vast majority of cases) for ETF’s, UNTIL YOU SELL

2) liquidity and stock-like features – ETF’s are often more liquid and you can buy and sell them on the exchange immediately, and you can see their prices transparently.  Trading like stocks also allows you to do things like use leverage, etc… which you can’t do with mutual funds

3) lower prices – historically ETF’s have had lower prices than mutual funds, and did not have origination fees or “loads” like many funds did

The primary disadvantage that used to be levied against ETF’s was that you had to pay brokerage fees each time you made a trade, and if you invested regularly (i.e. payroll deductions) these costs added up over time.  This argument has been diminished by lower trading costs across the board and changes in investor behavior.

Vanguard and ETF’s

Vanguard was originally slow to adopt ETF’s, despite their advantages, because Vanguard thought that ETF’s enabled rapid trading which was against their business model of supporting long term investors.  However, over time, Vanguard has gotten into the ETF business and as brought their low-fee ethos to the ETF arena.  Vanguard ETF’s are now among the most popular offerings and have been gaining in market share.

Note that Vanguard has a unique ownership structure.  Vanguard is owned by its mutual funds and charges at cost to the mutual funds, and does not make a “corporate” profit.  This is in contrast to competitors that not only charge the cost of doing business but also must make a profit to pay to the corporate parent.  Many of these companies have grown large and very profitable over the years (as funds under management increase) while Vanguard has been able to  turn its increasing scale into cost reductions for its products (i.e. if there are more customers and more fees, the fee that they need to charge per unit of dollar under management goes down assuming their costs are not completely variable).

BlackRock

BlackRock bought iShares, who were one of the pioneers in the ETF space.  While iShare ETF fees were not high by industry standards (in general), the arrival of Vanguard has put pressure on iShare products and they began losing market share.  As a result, iShare products reduced fees and are now in a sort of “price war” with Vanguard.

A Wall Street Journal article titled “BlackRock Wages Reluctant Fee Fight” describes a recent earnings call where the CEO (Fink) of BlackRock talked with analysts:

Mr. Find railed against competitors that sell investment products to certain clients “at cost”, or without profit.

You can call that fee pressure, Mr. Fink said.  But he had another term for it: “stupidity”… Although Mr. Fink didn’t single out any rivals in his comments, observers took the barbs to be aimed at Vanguard.

What is interesting about Mr. Fink is that he did not offer a reason for WHY his company was better for investors than Vanguard.  This is analogous to the famous line of “Where are the Customer’s Yachts?” about how Wall Street always seems to makes money while their customers (investors) don’t always fare as well.

Fink had an opportunity to explain why the profits that iShare pays to BlackRock (beyond the fees necessary to run the ETF’s) result in superior products for customers and investors, and he didn’t take that bait.  The reason, of course, is that there isn’t any reason why his products should cost more than Vanguards’ to the end customer, because they are essentially interchangeable (where they have equivalent products) which means that they have no extra value.

Fink seemed to be saying that it was “stupid” for Vanguard to be in business where they weren’t making any corporate profit, and just using their economies of scale to reduce prices (rather than paying that money to shareholders).  It is certainly true that Bogle, the founder of Vanguard, could have been a billionaire if he had monetized his inventions (the index fund), but instead he started the one company on Wall Street that definitely does NOT provide yachts for its’ employees.  Whether or not the average investor wins or loses on Vanguard products is up to the product mix, market activity, and customer activity, but it isn’t due to Vanguard taking off an inordinate share of fees to pay a corporate parent in the form of profits.

Mr. Fink didn’t offer a defense because there isn’t one.

Cross posted at Chicago Boyz

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