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.