Vanguard (and every other US-regulated mutual fund company) does not hold funds directly. Funds are held by 3rd party custodians.
Investors who remain uncomfortable holding all of their assets in Vanguard may hold their funds with alternative custodians.
What if Vanguard went broke?
"This is a very serious and timely issue, so I'll address it to hopefully set everyone at ease.
First, The Vanguard Group Inc. (VGI) is actually a subsidiary of the various mutual funds, each of which is a separate legal entity. The best way to describe Vanguard's unique structure would be to think of General Motors turned upside down, with Chevrolet, Cadillac, Oldsmobile, Pontiac, etc. as the corporate parents, and General Motors as a subsidiary. If you think of Chevrolet, Cadillac, Oldsmobile, Pontiac, and the other GM divisions as mutual funds, and General Motors (the subsidiary, in this situation) as Vanguard Group Inc., you'll get the picture.
Since VGI is actually owned and funded by the various mutual funds, for all practical purposes, it won't go bankrupt unless all of the various mutual funds that support it went bankrupt. The only way that could happen would be for the value of all of the stocks and/or bonds held by each and every individual Vanguard mutual fund to go to zero. So, forget about Vanguard going bankrupt -- it just isn't going to happen.
It's also important to point out that even if VGI were to somehow go broke, VGI has no recourse to the assets of the funds. Rather, each fund's custodian holds that fund's assets. Even the fund managers do not have custody of their fund's holdings. They simply decide which stocks/bonds to sell, and the custodian actually delivers (in the case of a sale) or takes delivery (in the case of a purchase) of the actual asset.
Another huge and very important difference between Vanguard's mutual funds and the Enrons and WorldComs of the world is that Vanguard is required to "mark to market" (value each fund share based on the value of all of the fund's holdings) each day the market is open. That keeps the fund's books current. This "marking to market" pricing is subject to both routine and spot audits by both the SEC and the Pennsylvania Department of Banking.
One major reason for the lack of problems with mutual funds comes from the fact that they're regulated by the Investment Company Act of 1940, which spells out the legal responsibilities of the mutual funds to their investors. In addition to the provisions of the Investment Company Act of 1940, the SEC also directly regulates mutual funds. While the SEC can investigate fraud allegations against investors at public companies like Enron and WorldCom, where the accounting is much more complex than at mutual funds, it has no authority to set corporate governance rules for these public companies. These are huge differences.
Keep in mind, too, that, despite all of this, if something were to happen to the Vanguard Group (the entity that provides the fund with the administrative services they need to exist), the funds would continue to operate and would simply replace VGI with another entity to provide these same services.
Some have expressed concerns about putting "all their eggs in one basket" by consolidating their investments at Vanguard. There's simply no need to worry about that. Each fund is a separate investment company (and part owner of the Vanguard Group, rather than the other way around). Thus, having all of your investments in several Vanguard funds is tantamount to having your investments spread among a variety of baskets, each independent of the other. So, put your fears to rest; your investments are safe at Vanguard."
One of the warning signs of the Ponzi schemes conducted by Bernie Madoff and Stanford Financial was that both institutions self-custodied their assets. That is, the same institution was responsible both for managing the assets and for holding them.
By contrast, Vanguard (and every other US-regulated mutual fund company) must custody their assets with a third party. All of the funds managed by Vanguard have their assets held with JPMorgan Chase. JPMorgan is audited by PriceWaterhouseCoopers, which provides additional, independent verification that Vanguard's funds hold what they're supposed to.
While there are many safeguards in place, as described above, some investors remain uncomfortable with the idea of investing entirely through a single custodian or are forced to diversify due to employer contribution plans. For many fund types, it is difficult to find similar availabilities at close to or equally low cost. However, there are some exceptions for those who seek (or are forced) to diversify custodians.