Why I Still Prefer Vanguard Index Funds Even Though They’re No Longer The Cheapest

For decades, the name Vanguard has been synonymous with “index funds.”  Ever since the establishment of the first index fund open to individual investors, the venerable Vanguard 500 (VFINX), Vanguard index funds have stood out as the low-cost gold standard of the mutual fund industry and have attracted a fiercely-loyal following of passive investors.  The reason is simple:  when it comes to long-term investment returns, low costs are the single most important predictor of relative performance.  All else being equal, a low-cost fund will practically always outperform a higher-cost fund by the difference in expenses.  I’ve made no secret that Vanguard is my mutual fund company of choice for the same reasons everybody else seems to love them:  low costs, investor-friendly culture, and an emphasis on passive investing.

Interestingly enough, most Vanguard fans (i.e. those investors most sensitive to cost) continue investing with Vanguard even though their index offerings are no longer the least expensive on the market.  At the time of Vanguard 500′s launch, Fidelity Investments chairman Edward Johnson was quoted as saying he “…couldn’t believe that the great mass of investors are going to be satisfied with receiving just average returns.”  Several years ago, Fidelity did a 180 on that philosophy and dramatically dropped the expense ratios on their line of Spartan Index funds (which includes a large-cap fund, small-cap fund, EAFE developed markets fund, and total bond market fund) several hundredths of a percent below their rival Vanguard offerings.

Fidelity has remained ever-so-slightly less expensive ever since this change;  however, Vanguard doesn’t seem to have lost a lot of business over it, mainly because Fidelity’s cost advantage is too small to overcome the hassle and expense of switching for most investors.  Schwab recently cast its hat in the index ring, lowering its expense ratios on funds in direct competition with Vanguard to barely more than half what Vanguard charges.  Additionally, small boutique firms such as Dimensional Fund Advisors compete with Vanguard not so much on price as offering index funds in asset classes Vanguard currently ignores.

The quickest and easiest way to get expense and performance data on practically any mutual fund in existence is by visiting Morningstar.

Why Stick With Vanguard Funds?

Despite the proliferation of lower-cost alternatives elsewhere, I’ll be sticking with Vanguard funds.  At first glance, this may sound illogical.  If costs are such a good predictor of future success, doesn’t it make sense to always go with the cheapest option?  Well yes, but there are other considerations.

  • Vanguard is a not-for-profit company – Vanguard has a long history of lowering costs across the board as economies of scale grow.  Since investors are Vanguard’s shareholders, they reap all the rewards of corporate cost savings.  Therefore, Vanguard will always be consistently lowering expenses for investors, which increases investor returns in the long run.  Fidelity and Schwab, in contrast, are both for-profit companies.  Their cost-cutting tactics are nothing more than a gambit to steal business away from Vanguard and cross-sell more expensive actively-managed funds to unsophisticated investors.  I wouldn’t be surprised if Fidelity and Schwab actually lose money on their index offerings, hoping to make up for it in other products.  If this is the case, who’s to say they won’t jack the price back up  if things don’t work out they way they planned?  Vanguard never will.
  • Vanguard’s Admiral funds are just as cheap – While Vanguard’s investor share classes may be a bit pricier than the competition, their Admiral shares are actually cheaper.  Admiral shares were introduced by Vanguard to reward long-term fund investors who had accumulated significant assets.  To qualify for admiral, you must invest either $100,000 minimum upfront or have been a shareholder of a particular fund for at least 10 years and have a balance of at least $50,000.  Fidelity has recently introduced a new share class, or Advantage shares, that mirrors Vanguard’s Admiral shares and have slightly lower expenses still.
  • Vanguard has a far greater variety of index funds -  Fidelity has only 4 funds in its Spartan series, covering large-cap, small-cap, developed markets, and bonds while Schwab offers only 3 separate asset classes.  Vanguard, on the other hand, offers well over a dozen index funds in many different asset classes in addition to those mentioned above, including real estate, small-cap international stocks, small-cap value stocks, and even a Global Index Fund.
  • The cost differences are very, very small – The reality of the situation is that while costs do matters, the cost savings at this level amount to just a few hundredths of a percent, representing only about $200-300 or so per year for an investor with a $1,000,000 portfolio.  For most such investors, it simply isn’t worth the trouble to switch.
  • There are tax consequences to switching – If you invest entirely within your a tax-advantaged account such as a 401k or IRA you don’t have to worry about it, but the rest of us have to deal with the tax consequences of buying and selling investments.  If you have investment gains, switching could entail a significant tax bill next April.

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