An Investment Company Owned By Its Clients

In Canada, most of the wealth management firms (advisors who work with clients) and investment product manufacturers (like mutual fund companies that provide investment products) are either owned publicly or privately.

If a company is public, it means that you can buy its stock on an exchange. It also means management is responsible to the shareholders of the company (who may or not be clients or invest in the products of said company).

If a company is private, it also means that management is not responsible so much to the investors as it is responsible to the private owners of the company.

In the case of a product manufacturer, one could argue that nothing is really wrong with this scenario since financial advisors and investors should steer money into suitable products and a manufacturer will live or die by the popularity (or suitability) of its products.

In the case of a wealth management firm (a company who provides financial advice to investors/clients), there is a structural conflict of interest. It is compounded if that same firm also manufactures products (which is not rare by any means), as you and I both know that the possibility exists that proprietary products are pushed upon the salesforce.

There is a third possibility that is not ubiquitous, but seems like a great structure: The company is owned by the clients. Sounds crazy, does it?

Well, you may be surprised to learn that Vanguard Funds in the United States is in fact owned by the clients. With management now being responsible to the clients it is easier to understand why the average expense ratio for Vanguard Funds is a miniscule 0.20% and why they manage about $1 trillion in assets: they are guided by accountability to the client and no-one else.

I heard an unconfirmed report that Vanguard will be setting up shop in Canada in 2010. I have to stress there is no confirmation of this, but if it were to happen it would be the impetus for a lot of change in the financial services in Canada – guaranteed.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 18 comments
  • Henry

    I knew the content of the post by just reading the title: the Vanguard Group.

    I think Vanguard’s best bet in Canada is to launch ETFs from my previous analysis. There is no way to provide regular mutual funds with broad distribuation in Canada with just .20% MER. There needs to be a trailer fee of at least .25% built into MER even for discount brokerages to accept them. By launching ETFs, it will be accessible to both people who use discount brokerages and fee based accounts. I think Vanguard can some nice ETFs here such as an emerging market ETF that hold VWO and charge .35% MER that includes VWO’s MER. That brings strong contrast to the competition where broad Emerging Market ETFs in Canada cost at least .65% MER. Even in the US, VWO really shines against competition even with Vanguard’s own Emerging Market Mutual Fund.

  • Patrick

    Berkshire Hathaway would also qualify, right?

  • Silicon Prairie

    It’s a good principle and Vanguard sounds like a great manager, but this is the same idea as credit unions, and the ones around here aren’t that competitive. They may have yearly member dividends that help, but I doubt the total is any better than a bank that simply pays higher interest on deposits and charges lower interest on loans in the first place. The cooperative stores around here seem to be in a similar position. Realistically the best you can usually expect is to pay a bit more at first to make sure the costs are covered and then get part of the difference back at the end of the year if things go well.

  • Preet

    @Henry – if they bring up Vanguard Advisers then they won’t need trailing commissions and can keep the MERs low. I disagree slightly with your analysis. Much of the retail assets are in funds. Bringing another set of cap-weighted ETFs won’t make much difference. Having passive and active mutual funds with MERs below 0.50 will, especially if they are distributed through what are essentially salaried planners with good credentials.

    @Patrick – I would agree.

    @Silicon Prairie – Yes, there wouldn’t be as much scale, but Vanguard is truly a special company – their presence would also change the landscape of the Canadian financial services.

  • Henry

    @Preet- However, you know that fee based advisors are a small majority in Canada. You are basically saying Vanguard should come to Canada to provide a F series of mutual funds. It isn’t easy for Vanguard to establish a network of financial advisors in Canada. A lot of fee based start at a very large minimum and a lot of fee based account starts at 1.5% or 1.25% of asset managed. You know this better than I do.

    Vanguard has been in Australia for a long time, but Vanguard Australia’s fees are not as low as you would think they are. The first 50k is .75% of assets and second 50k is .50% of assets and .35% for the rest above above 100k. If you had 150k in Vanguard Australia’s Australia Shares Fund, you pay .53% MER. That is no where as low as Vanguard in the US. However, there is also Vanguard Australian Shares Index ETF that has a MER of .27%. I am just pointing out ETFs is the way to go if Vanguard wants to come to Canada. Vanguard lists Vanguard Total Stock Market ETF and Vanguard All-World ex-US Shares Index ETF on the Australia Stock Exchange without additional fees. That is quite impressive too. I know quite a few of Vanguard ETFs are crosslisted on the Mexican Exchange and are handled JP Morgan.

    I have researched into Vanguard coming to Canada and it is not easy. My conclusion at this point is to launch ETFs in Canada for lower fees than competitor and get John Bogle over the border to do some free publicity. This is just my humble opinion.

  • Preet

    @Henry – ah yes, but you are looking at things from the investors perspective. Spend a few years in the industry and you’ll quickly become as jaded as myself… lol

    ETFs are a margin compression business second, first mover advantage first. Consider how much scale are in the US listed ETFs and compare to Canada – we have relatively attractive MERs on our ETFs already. Enough that coming in to only provide cheaper ETFs is not overly compelling. Hopefully, it would lead to other things.

    Also, more than 90% of investors need advice, this is why the fund channel will continue to do well and would need to be addressed. The margins are also better.

    Question for you: What do you think would be a good MER for a Canadian listed ETF that tracks the broad Canadian market?

  • Henry

    @Preet – Vanguard can accept low profit margins, because it is “mutual” investment company.

    While it is true, there is definitely an advantage for the first mover in the ETF. Based on this logic, Vanguard should have never launched ETFs in the US, since both Barclays and State Street were there first.

    Younger people will move to ETFs and fee based accounts. Fee based accounts are free to use ETFs. If given a choice between 1.5% fee based account or low load funds (there is nothing “low” about these funds) with the correct information, I think most people will choose the 1.5% fee based account. There is two advantages of the fee based account to an investor, which are flexibility with investment choice and fee to adviser is directly tax deductible if not in a registered account. According to my understanding, the investor is better off with a commission based account if the investor is only interested in fixed income. Full service brokerages make money from insurance as well and I have nothing against that unless the wrong insurance products are chosen for the clients.

    While it may be true that mutual funds can be more profitable than ETFs, there is a lot more cost associated with mutual funds and that is why Vanguard Australia feels relatively expensive (cheaper than most of its Australian competitors though). PH&N, Altamira, and Saxon in Canada never became as dominant as Fidelity, Vanguard, and T Rowe Price in the US. Vanguard would have major difficulty establishing dominance in the Canadian market using Bogle’s philosophy, because there is no incentive for commission based advisers to use Vanguard’s funds.

    A good MER for a Canadian listed ETF that tracks the broad Canadian market would be .10% MER with securities lending interest going back into the ETF. Again, that may seem low, but you need something to attract assets and Vanguard’s success in the US ETF market is just that.

    Crosslisting or holding US ETF inside Canadian based ETF seem to be a good option for Vanguard. ETFs that I would like to see directly available using Canadian dollars on the TSX would be based on VTI, VWO, VEA, VGK, VPL, and VT.

    Vanguard’s philosophy is that it tries to see things from the investor’s perspective, since investors are its shareholders. Vanguard has fiduciary duty to investors that use Vanguard’s product.

    Note: I am nothing against financial advisers being compensated for their advice, but the compensation has to be transparent.

  • Preet

    @Henry – fee based accounts usually charge a minimum of $1,500 per year – therefore currently not a plausible option for younger investors (or more precisely, smaller investors).

    If we assume they will need some staff: a few business development officers and a skeleton crew to man the phones and direct clients/media, you are looking at perhaps $2 million in expenses to set up shop and maintain per year? At 10bps, you need how much in assets to cover these costs? $2 billion. Will you cannibalize existing ETFs? Some. A lot of new sales will go into bank owned ETFs through branches in the near future (BMO, and presumably others will set up ETFs in house). Also, you and I know Vanguard, but what will it cost to make the name mainstream?

    My point is that from a business perspective, or mutual shareholder perspective, coming to Canada just to set up ETFs is not very compelling. There should be a more extensive business plan than that.

  • Henry

    @Preet- I think IT, HR, and some other things can be done through Vanguard headquarters in Pennsylvania. If Vanguard wants to come to Canada, Vanguard has to subsidize its Canadian operations for sure. At the end of day, the Canadian operation needs to break even if it will be kept open.

    Regarding to making Vanguard’s name mainstream in Canada, I think that will be difficult but not possible. Vanguard does advertise in the US so I think it will be able to advertise in Canada using reasonable amount of resources. My original idea is that John Bogle can come to Canada and give investment seminars to create publicity for Vanguard.

    Regarding to bank branches distributing ETFs, that is possible, but there needs to be two major changes. Regulation needs to change for bank reps who are under MFDA to allow them to sell ETFs. The banks have to create ETFs with trailer fees, which may or may not happen. Will there be incentives for bank reps to offer ETFs to their customers? Most likely no. Almost all banks except Royal Bank have a complete line of index funds that are offered through bank reps. Those index funds have a MER of 1% and a trailer fee of .25%. There is no incentive to tell the customer about the index funds, since the MERs are not that low and the trailer fee is low. As you know, the actively managed bond funds have a trailer fee of .5%, balanced funds have .75%, broad equity funds have 1.0%, and sector equity funds have 1.25%. If the present system of 1% MER bank index funds doesn’t work, why would an ETF with trailer fee system work unless both the bank and the bank reps are willing to take a cut?

    By the way, do you know why Claymore and DFA came to Canada? Do you consider either one to be successfully established in Canada? Are either one profitable in Canada? Do you think Invesco will launch ETFs in Canada?

  • Preet

    @Henry – “My original idea is that John Bogle can come to Canada and give investment seminars to create publicity for Vanguard.”

    Again, a great name for those who already know him, and unfortunately he is not young enough that we can’t consider longevity risk.

    “Regarding to bank branches distributing ETFs, that is possible, but there needs to be two major changes.”

    No – no changes needed. ING Direct is already doing it, or structuring it so that it can be done. Banks need only create mutual funds that hold ETFs to get around licensing issues – that too is already being done – look at the JOV Fiera portfolios.

    “Will there be incentives for bank reps to offer ETFs to their customers? Most likely no.”

    Many banks will offer proprietary funds with no trailers to the advisors, who are paid base salary plus bonus. Investment portfolios “in a can” can be peddled through the branch channels with high margins.

    “As you know, the actively managed bond funds have a trailer fee of .5%, balanced funds have .75%, broad equity funds have 1.0%, and sector equity funds have 1.25%. If the present system of 1% MER bank index funds doesn’t work, why would an ETF with trailer fee system work unless both the bank and the bank reps are willing to take a cut?”

    There are bond funds that pay 1%, and equity funds that pay 0.25%, trailing commissions are all over the place. An ETF with trailer fee doesn’t need to be created for branch distribution. All they have to do is bonus advisors on volume.

    “By the way, do you know why Claymore and DFA came to Canada? Do you consider either one to be successfully established in Canada? Are either one profitable in Canada? Do you think Invesco will launch ETFs in Canada?”

    Claymore and DFA came to make money. They are owned by shareholders, but not necessarily the clients. I believe they are both profitable. Invesco Trimark has portfolios (mutual fund of funds) with ETFs in them, but stand alone ETFs will probably launch once investor confidence is higher.

    Thanks for your comments Henry, always a pleasure.

  • Henry

    @Preet – This is one intense discussion.

    I think Vanguard launching ETFs in Canada is still a good idea. Regarding to launching index funds identical to the ETFs, that may or may not be a good idea. Launching a F series of index funds in Canada is compatible with Bogle’s vision. Once distribution fees or trailer commissions are incorporated, I think that contradicts Bogle’s vision. There are more costs involved and may not be extremely successful, since there is already competition from CIBC index funds with MER rebate.

    I think what Vanguard can do in Canada is to launch Life Cycle Funds and Tactical Asset Allocation Funds. There are very limited number of competitors in both areas and it is an area where Vanguard’s low MERs can truly shine. Vanguard can charge .50 to .60 bps for these funds. These funds can be managed through Vanguard Quantitative department in the US. These funds can invest in Vanguard Canadian ETFs. As a result, Vanguard can generate revenue from both the mutual funds (.50 to .60 bps) and ETFs (.10 bps), while providing competitive and excellent product.

    Am I thinking more like a business person?

  • Preet

    @Henry – yup, a good discussion!

    Vanguard’s ETFs in the states are actually a separate share class of their index funds. One of the ancillary benefits is that you can switch from the index funds to the ETFs if you desire without much in the way of penalties (or taxes, but I’m not 100% sure on that – used to know). The ETFs being a separate share class may just be an artefact of ETFs arriving later on the scene.

    The F-class platform doesn’t exist across all dealers, so in Canada it generally means you offer loaded classes if you are going to offer F-class only. OR you offer A and B class with no embedded trailers and few dealers will promote them – there’s a tradeoff.

    I think where vanguard would do well would be their actively managed funds (active management will never die), which also have their trademark low fees.

  • Henry

    @Preet- Thanks for the insight on F class.

    Keeping cost low is difficult even for Vanguard in the US. Most of their mutual funds require you to have either a 3k or 10k minimum per fund. Depending what kind of account you have with Vanguard US, you might be charged additional account fees. My discussion with other people is just easier for a lot of people to invest in ETFs instead.

    In Canada, Questrade offers 4.95 trades and that work well with investing in ETFs as little as 1k (only 10CAD for a round trip commission). In the bank owned brokerages, it is possible to get 10 CAD trades, if you qualify the asset threshold or you have a lot of business with the bank. With 10 CAD trade, 2k minimum investment per ETF works well (20 CAD for a round trip commission). ETFs work well for self directed investors.

    In terms of Canadian brokerages, I believe the paper work and administration cost is lower with stocks and ETFs than regular mutual funds. Even though the brokerage may wave the trade cost, the brokerage still make money from bid and ask spreads. So for fee based accounts, I see ETFs as the way to go, because F series have higher administration and no bid ask spread profit.

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