How do brokerages make $s on cheap index funds?

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Re: How do brokerages make $s on cheap index funds?

Post by MrPotatoHead » Sun May 06, 2018 7:39 pm

Silk McCue wrote:
Sun May 06, 2018 4:09 pm
MrPotatoHead wrote:
Sun May 06, 2018 3:35 pm
Silk McCue wrote:
Sat May 05, 2018 9:15 am
Vanguard isn't in business to make a profit, but rather to serve the interests of its owners (those of us that hold Vanguard funds) and thus they are the lost cost leader. Even in the actively managed funds Vanguard does this at lower expense than the competitors because they do not have a direct profit motive.

LOL...gosh you are killing me. That adults actually believe this fairy tale. So by this logic I should really be loving on my USAA insurance... But, whatever it takes you to get through the day...

And this is not mean to be snarky, just more like I am stunned every time I see it. But I get it, we all have to believe in something. I am partial to the flying spaghetti monster myself.

Others have posted some of the reason way I say this...but I'll just mention, you can find many books explaining how you can rich starting your own no-profit.
Thanks for the mocking and misconstrued reply. Doing so certainly added to the conversation immensely and was certainly a benefit to the OP. You are to be commended.

I am actually sorry you took it that way; it just gets old after a while. My personal opinion is Jack Bogle was/is close to a Saint. He made himself a lot of money but he could have made a lot more structuring Vanguard different way, but to me he is/was a saint. I believe he designed it to be the way you perceive it, but perception is not reality. Bogle's influence is muted now and has been for some time and every day it will grow more so; reality is a painful mistress.

The central problem that is faced is the simple fact you have to pay market based compensation for employees who have skills that are in high demand or require special knowledge. 3 of my 4 children are either a CPAs or actuaries, all are in the insurance industry. I can assure you their level of compensation will not change because they work for a mutual insurance company verses a for profit publicly traded firm.

So essentially the costs are the same for every company. The only savings to be had is via returning what would be profit to the owners of the company. But the problem with non-profits is there is no incentive to do so. So the returned profit tends to simply dissipate in inefficiency as there is no catalyst to return value to the owners.

In my consulting firm, I have a standard rule. You get paid your salary for x-amount of billable hours per year. Then you get paid a bonus for x-amount to x- amount. And for every hour you bill over x amount per year you get 25 extra dollars per hour billed. You would be amazed at how many contractors who use to bill 1600 hours a year suddenly started billing 1800-2400 hours a year. And how all of a sudden a few found the energy for 2500 of more hours in a year. That is the profit motive at work.

Mr Bogle it seems was driven by a basic inner decency and willing to take from himself so others would prosper. You cannot realistically expect those values to transfer to those who follow despite the appearance and rhetoric of loudly espoused corporate cultural values.

As I said, I was not trying to belittle you. It just gets old and I am getting up in age. I have been in business for a long time as an employee, a consultant, a multiple business owner, on the board of directors of for profits and on the board of directors of non-profits. This is the vantage from which I make my comments as they reflect my own experience.

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Re: How do brokerages make $s on cheap index funds?

Post by willthrill81 » Sun May 06, 2018 8:08 pm

I absolutely believe that being a non-profit doesn't necessarily make one more efficient or even more valuable for its potential clients. But when a non-profit has to compete against for-profits for those clients, there is much more motivation for it to become efficient and innovative. Competition is nearly always in the customers' best interest.

So far, I don't think that there's much fault of Vanguard's that can be laid squarely on their being a non-profit. But that could change, so we have to be watchful.

"The price of freedom is eternal vigilance."
-Desmond Tutu
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: How do brokerages make $s on cheap index funds?

Post by fennewaldaj » Mon May 07, 2018 12:35 am

I wonder if there will come a time when fidelity, american funds, ect and others decide that they would make more money with lower ERs on there active funds. Some of these active funds are so giant they would have to be very profitable even at half or even a third the current expense ratio. It would also be easier to beat there benchmarks and retain assets that way.

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Re: How do brokerages make $s on cheap index funds?

Post by afan » Mon May 07, 2018 1:56 pm

I think fidelity and American have been lowering their fees on active funds.

As the cost of index funds have become very low, essentially free after you account for securities lending, investment companies have a choice. They can follow the low cost trend and compete for those low cost investors. Or they can figure that business is not worth having. The high priced brokers want no part of this business and would rather focus on people who will buy commissioned products or pay high AUM fees. Fidelity and Schwab decided to go for the mass market.

It was either compete on price or see a huge share of assets go away. They would rather have relationships, at low profits, than lose out altogether. I assume it does not cost Schwab or Fidelity any less to run a fund than it does Vanguard. Given economies of scale and the relative size of the giant broad index funds, I suspect Vanguard's costs should be a bit lower. Schwab and Fidelity seek to maximize profit overall but could take losses somewhere if the overall strategy worked.

I was fascinated to see the comment about how long the Fidelity nindex funds have been profitable. I did not think Fidelity broke those out. Does anyone have a link to where Fidelity reported this?
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama

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Re: How do brokerages make $s on cheap index funds?

Post by alex_686 » Mon May 07, 2018 2:05 pm

Nate79 wrote:
Sun May 06, 2018 5:34 pm
SlowMovingInvestor wrote:
Sun May 06, 2018 3:39 pm
I suspect that they are subsidizing some of their cheapest funds internally, and really -- internal accounting and cost sharing can be easily modified to subsidize these funds.
Maybe Vanguard's MM funds are loss leaders just like what you are claiming is being done by other firms? Why is it that other firms are wolves in sheep clothing and Vanguard only rides in on a white horse?
It depends on what you mean by subsidizing. SEC rules are pretty explicated about this, each fund must bear shared costs on a pro rata bias. A fund family can't steal return from one fund - with its own unique set of owners - to subsidize another fund with a different set of owners. So nothing with internal operational costs.

What they can do is waive their management fee and this must be explicit in the prosecutes. See the difference in net and gross expense ratios.

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Re: How do brokerages make $s on cheap index funds?

Post by Nate79 » Mon May 07, 2018 2:51 pm

It's interesting that lending revenue is often mentioned as reducing the ER but when I look at the annual report for Vanguard and Schwab's S&P500 mutual funds the income is quite small compared to overall expenses, on the order of 10% of expenses. It wouldn't move the ER. On the other hand for VTSAX the lending revenue is on the order of 1/3 of total expenses, a meaningful number. I was a little surprised to see such a big difference in lending revenue between the two Vanguard funds.

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Re: How do brokerages make $s on cheap index funds?

Post by afan » Mon May 07, 2018 4:56 pm

The sending revenue does not reduce the expense ratio. To do that, it would have to be paid to the fund company.

Instead, for Vanguard at least, the revenue is paid to the fund as income. Thus, it increases the return.

Vanguard has said that it will always have an expense ratios, since reflects the cost of running the fund. The lending revenue could be large enough that the net effect was zero cost, but there would still be an expense ratio.

The amount one can generate from lending depends on the demand for the securities. Apparently there is more to be made from small stocks than large.
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama

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Re: How do brokerages make $s on cheap index funds?

Post by TD2626 » Mon May 07, 2018 5:23 pm

deltaneutral83 wrote:
Sat May 05, 2018 10:51 am
It's also a point of vanity to say "We at brokerage ABC hold "X" amount in assets" insinuating that the more they hold the better they must be. They are happy to let a BH have a high 6 or 7 figure account with index funds because it boosts their tagline.
Fidelity's S&P 500 fund has more in assets under management than their (largest active fund) Contrafund. I'd guess Fidelity does see Boglehead types as:

A) Not losing the company too much money, since although it is likely a loss leader, they do charge only slightly under Vanguard's at cost options.

B) Growing the company's assets under management inexpensively

C)Customers that coild eventually become more profitable for the company by buying more expensive products. (Not that that's a good idea).

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