Request for review of a proposed Wiki article on SIPC protection of mutual funds

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nisiprius
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Request for review of a proposed Wiki article on SIPC protection of mutual funds

Postby nisiprius » Thu May 18, 2017 8:21 pm

Here's a draft. I'd like comments, particularly if you notice any important inaccuracies. Note that the purpose of the article is not to be a complete explanation of the SIPC and Investment Company Act of 1940 protection, but just an explanation of why holding a mutual fund in a brokerage account isn't any safer than holding it directly.

SIPC protection for mutual funds

Particularly now, as Vanguard moves to upgrade older accounts to brokerage accounts, customers are seeing notices such as these:

Vanguard funds not held in a brokerage account are held by The Vanguard Group, Inc., and are not protected by SIPC.

Is it safer or better to hold a mutual fund in a brokerage account? The answer is "no." This is a brief explanation of why not. It may not be fully accurate, cover all legal or regulatory details, and is not intended as legal or investing advice.

The situation is not specific to Vanguard. The only reason why Vanguard customers are apt to notice it is that Vanguard is in transition from a system in which mutual fund accounts and brokerage accounts were separate, and many customers did not have brokerage accounts, to one in which most customers will have brokerage accounts and hold their Vanguard funds within the brokerage account.

  • Mutual funds and stocks are both examples of financial assets.
  • You can hold a mutual fund directly with a mutual fund company, with no brokerage involved. You can hold stocks directly, with no brokerage involved, although this is very rare nowadays. (This sometimes happens, for example, when employee purchase company stock in an ESOP plan, or when people own policies at a mutual insurance company that demutualizes and receive stock in the insurance company).
  • You can hold a mutual fund in a brokerage account. You can hold stocks in a brokerage account.
  • No government agency insures the value of stocks. If you own GE stock and it goes down, you lose money. If you own Enron stock, and it becomes worthless due to fraud, you lose money. It doesn't matter where the stock is held. You are no better off holding it in a brokerage. No government agency insures you against loss, even loss due to fraud.
  • No government agency insures mutual funds themselves. Mutual fund investors are protected in many ways by the regulations of the Investment Company Act of 1940. For example, the mutual fund company itself does not hold the assets in the fund; they are held independently by a custodian bank. Nevertheless, there is no kind of government backing or insurance behind a mutual fund. In particular, the SIPC does not provide any protection.
  • When assets are held in a brokerage, the fact that the brokerage is holding them for you, rather than your holding it yourself, adds a layer of risk. The risk is that the brokerage might mismanage or lose the assets it says it is holding for you, or might even commit fraud. In the Bernard Madoff case, among other things, his supplied customers with printed statements saying that the customer's account included holdings in the Fidelity money market fund that did not even exist at that time.
  • The purpose of SIPC insurance is basically to guarantee the accuracy and integrity of your brokerage statements. If your statement says that you own 100 shares of GE stock, then if it turns out that you do not because of any kind of problem at the brokerage, the SIPC is supposed to make good on your losses.
  • If you hold stocks directly, not within a brokerage account, your holding is not protected by the SIPC. If you hold mutual fund shares directly, not within a brokerage account. then your holding is not protected by the SIPC.
  • If you hold assets within a brokerage account, then your holding is protected by the SIPC, but you are no safer, because the SIPC merely protects you against the extra risk you incur by trusting a brokerage firm to hold them for you.
  • Just as with stock, the SIPC is guaranteeing that the brokerage has really bought shares for you and earmarked them as belonging to you. However, if there were any problem within the mutual fund itself, the SIPC would not be involved in it.
  • Your risk is the same whether mutual fund shares are held within or outside of a mutual fund account.
Last edited by nisiprius on Thu May 18, 2017 9:38 pm, edited 1 time in total.
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student
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Re: Request for review of a proposed Wiki article on SIPC protection of mutual funds

Postby student » Thu May 18, 2017 8:55 pm

I think this is very clear. Thanks for writing this. Here is a link to a similar article. http://www.kiplinger.com/article/invest ... ected.html

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Re: Request for review of a proposed Wiki article on SIPC protection of mutual funds

Postby whaleknives » Thu May 18, 2017 9:40 pm

nisiprius wrote: . . .
Vanguard wrote:Vanguard funds not held in a brokerage account are held by The Vanguard Group, Inc., and are not protected by SIPC.

Is it safer or better to hold a mutual fund in a brokerage account? The answer is "no." . . .

Does anyone know why Vanguard is making the inference that a brokerage account is desirable because of the SIPC protection? Could it provide risk protection or distribute risk for Vanguard? Or is it just a marketing tool to simplify Vanguard's life with brokerages for everyone?
"I'm an indexer. I own the market. And I'm happy." (John Bogle, "BusinessWeek", 8/17/07) ☕ Maritime signal flag W - Whiskey: "I require medical assistance."

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Re: Request for review of a proposed Wiki article on SIPC protection of mutual funds

Postby nisiprius » Fri May 19, 2017 6:59 am

whaleknives wrote:
nisiprius wrote: . . .
Vanguard wrote:Vanguard funds not held in a brokerage account are held by The Vanguard Group, Inc., and are not protected by SIPC.

Is it safer or better to hold a mutual fund in a brokerage account? The answer is "no." . . .

Does anyone know why Vanguard is making the inference that a brokerage account is desirable because of the SIPC protection? Could it provide risk protection or distribute risk for Vanguard? Or is it just a marketing tool to simplify Vanguard's life with brokerages for everyone?
Unfortunately, for some reason my account is apparently not eligible for conversion--or maybe fortunately as I have no wish to convert it. So I haven't actually seen the full notice. My bad.

Could someone provide the full text of what Vanguard is saying to customers?

My assumption is that Vanguard is not trying to make people think a brokerage account is safer, they are just complying with whatever disclosure they need to comply with, or that they think is prudent. If you are going to mention SIPC protection at all, then it is probably important to tell people that just because they have a "Vanguard" account, it doesn't mean they have SIPC protection. It's complicated. I mean, you're not supposed to have more than three bullet points and it took me eleven.

I once had a separate VBS account, eventually I got rid of it (zeroed the balances, told them to "close" the account, not showing anywhere... but I suspect that it still has a zombie existence of some kind). I don't remember where I first read that mutual fund accounts have no SIPC protection. I grabbed my paper statement and was shocked to see that it didn't mention the SIPC on it at all. Took me a while to figure it out.
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Re: Request for review of a proposed Wiki article on SIPC protection of mutual funds

Postby plannerman » Fri May 19, 2017 7:09 am

Can you provide any (recent) examples where SIPC actually provided protection for investors?

plannerman

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Re: Request for review of a proposed Wiki article on SIPC protection of mutual funds

Postby dodecahedron » Fri May 19, 2017 7:18 am

plannerman wrote:Can you provide any (recent) examples where SIPC actually provided protection for investors?

plannerman


Some Madoff investors got some limited recovery of some of their losses:

http://www.madofftrustee.com/claims-03.html

In more typical cases, it sounds like SIPC may act more quietly, e.g., merging insolvent brokers into solvent ones that agree to take over the accounts.

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Re: Request for review of a proposed Wiki article on SIPC protection of mutual funds

Postby nisiprius » Fri May 19, 2017 7:34 am

plannerman wrote:Can you provide any (recent) examples where SIPC actually provided protection for investors?

plannerman
Right, Laurence Kotlikoff's fulminations. I don't think I want to go there. I've actually just added something to the Wiki article--I guess everyone can see it:

https://www.bogleheads.org/wiki/SIPC_pr ... tual_funds

--about the SIPC not helping investors in the Reserve Primary Money Market Fund's "breaking the buck" or Third Avenue Focused Credit's collapse.

A problem as an outsider exploring the dark side is that a lot of this stuff is quite hard to find out. For example, I don't think there's ever been a case of actual fraud on the part of a mutual fund company (involving collusion with their custodian bank and all that), but I don't know.

The SIPC was created to cover an absolutely real, exigent problem in the 1970s when brokerages did not have much security, times were tough and brokerages were folding left and right, and there was a widely reported "back office crisis" because they weren't doing a good job on automating. Further more, there where whispers that organized crime was trying to get into the business. The New York Times never reported directly that organized crime was involved, but it did report the existences of rumors that it was involved. There were literally cases of brokerages being unable to locate stock certificates they were holding for customers and those certificates being found mysteriously where they shouldn't have been (in one case, literal physical stock certificates in a literal physical safe in a union's pension office).

The industry "story" would surely be that the SIPC hasn't had to do anything because brokerages are great and haven't had any problems recently, and that might be true. Like a lot of people, I was fairly shocked to find out that the SIPC had been basically pencil-whipping and collecting truly tiny token amounts of premiums to provide its insurance--I believe it was $150/year for Fidelity, the whole shebang. And didn't keep a giant pool of dough.

However, as nearly as I can tell, Kotlikoff did not point to a single instance of anything bad except for SIPC's treatment of Madoff's clients which frankly is a special case. What Kotlikoff did was to draw hypothetical parallels between the way SIPC was treating Madoff clients and how Kotlikoff said it could treat ordinary retail investors. On that basis, he implied that the SIPC was worthless, even "a Ponzi scheme."

So, in answer to your question: I don't know. It's a two-part question. One is whether the SIPC has helped anyone lately. The other is whether, in this day of electronic data processing and high security, any brokerages have lost track of any customers' assets lately.

I think I'll add a disclaimer to the Wiki article saying that it's not about the value of SIPC protection in itself.
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Re: Request for review of a proposed Wiki article on SIPC protection of mutual funds

Postby whaleknives » Fri May 19, 2017 9:11 am

nisiprius wrote:. . . Could someone provide the full text of what Vanguard is saying to customers? . . .

My Vanguard brokerage upgrade link seems to have disappeared, and I had to Google for these links:

I couldn't find them on the Vanguard site, or using Vanguard search.

The web page says
    ". . .
    Protection
    You'll have SIPC protection with a Vanguard Brokerage Account (up to $500,000). This is something your current account doesn't offer.
    . . .
    Why else should I make the switch?
    One of the reasons we began offering the Vanguard Brokerage Account was to help streamline our operating systems. The result? Better service for you and all of our investors as more and more make the transition. . .
The disclosure pdf says
    ". . .
    Protection for Vanguard fund holdings
    All holdings, including Vanguard mutual funds, are covered up to SIPC limits.

    *Vanguard funds not held in a brokerage account are held by The Vanguard Group, Inc., and are not protected by SIPC. Brokerage assets are held by Vanguard Brokerage Services, a division of Vanguard Marketing Corporation, member FINRA and SIPC. . ."
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Re: Request for review of a proposed Wiki article on SIPC protection of mutual funds

Postby House Blend » Fri May 19, 2017 9:35 am

The wiki page already has a link to the SIPC website. Might want to add this more specific link:
http://www.sipc.org/news-and-media/brochures

I thought that the "How SIPC Protects You" brochure was quite helpful, even though it has nothing specific to say about unbrokeraged mutual fund holdings. FWIW, I found it after I entered "SIPC" into a search box at Vanguard, and got this page:
https://investor.vanguard.com/investing ... protection

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Re: Request for review of a proposed Wiki article on SIPC protection of mutual funds

Postby rkhusky » Fri May 19, 2017 2:38 pm

So, for example, Vanguard "loses" my 1000 shares of Total Stock Market and they will not admit that I have them, even though I have my 2016 year-end statement that shows the shares, but they have no record of them being transferred anywhere. Suppose further that the custodian bank does not have a record of the shares. Is it better for me if I own TSM as a stand-alone mutual fund or in a brokerage account?

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Re: Request for review of a proposed Wiki article on SIPC protection of mutual funds

Postby alex_686 » Fri May 19, 2017 2:47 pm

dodecahedron wrote:
plannerman wrote:Can you provide any (recent) examples where SIPC actually provided protection for investors?

plannerman


Some Madoff investors got some limited recovery of some of their losses:

http://www.madofftrustee.com/claims-03.html

In more typical cases, it sounds like SIPC may act more quietly, e.g., merging insolvent brokers into solvent ones that agree to take over the accounts.


Stockwalk.com, back from 2002 was the last big one that I can think off.

And no, the SIPC does not try to quietly merge insolvent brokers together like the FDIC does with banks. Most failed banks have positive equity but have liquidity issues. Most failed brokers have negative equity. Why would I want to buy a brokerage firm with negative equity?

No, the real credit goes to the SEC. The audit the broker's audit processes. They insist, when possible, segregated accounts. Before this it was co-mingled accounts that go most brokers into problems.


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