Acquired
01:31:27 · Ben Gilbert, David Rosenthal
[01:31:27] S0: Okay. So they've got this completely broken IPO. They didn't raise enough capital. The pitch is bad. [01:31:33] S1: Yes. Oh, Ned Johnson at Fidelity. Remember Fidelity we talked about? Yeah. And Ned, he would famously comment to the press about the launch of this fund. Quote, I can't believe that the great mass of investors are going to be satisfied with just receiving average returns. The name of the game is to be the best. Deeply ironic because a giant amount of Fidelity's asset base today is composed of index funds, many of which are Vanguard index funds held within Fidelity. [01:32:00] S0: The funny thing about Fidelity is that I think they're primarily a brokerage. They they do have their own in house funds, but I think a lot of people own Vanguard funds using Fidelity's website. [01:32:11] S1: Yes. They do. Yes. They do. We will get to that.
01:32:11 · David Rosenthal, Ben Gilbert
[01:32:11] S1: Yes. They do. Yes. They do. We will get to that. [01:32:13] S0: Okay. So the pitch is quite bad, but the machinery they've constructed as it plays out in scales is actually pretty genius. So if you think about it, if the customers own the management company, the business itself, there's really no incentive to generate any more margin than you actually need to run the business. There's no, like, point in profits for shareholders you'd wanna dividend it out to. So you could just dividend those excess profits out to customers who are the investors in the fund, or you could just say, oh, we're we're doing that in the form of lower fees. It's a much more tax efficient way to do it than generating profit, recognizing taxes on that profit, dividending it out, and then those people having to pay taxes on it, they're they'll say, hey. Look. We'll just lower the fees in the future because we're now confident we don't need higher fees. [01:33:02] S1: Every time Vanguard lowers fees, you should view it as, like, hey. We have reported higher earnings, essentially.
01:33:02 · David Rosenthal, Ben Gilbert
[01:33:02] S1: Every time Vanguard lowers fees, you should view it as, like, hey. We have reported higher earnings, essentially. [01:33:09] S0: Exactly. Exactly. And then as you get economies of scale and you grow, you can further cut prices. And, David, as you mentioned earlier, the business of asset management really lends itself well to the economies of scale game. There are just not that many variable costs in managing money. Almost everything is fixed, except things like customer service, which we'll come back to later and is kinda where Vanguard's vulnerabilities are. Yeah. It's in these variable costs. So once you're managing very large amounts of money for lots of customers, fees can be super low on a percentage basis. This is the exact same thing from our Costco episode. David, do you remember the phrase? [01:33:46] S1: Oh, yeah. Scale economies shared. I think didn't we make acquired T shirts and sweatshirts with that phrase? [01:33:52] S0: We did. We did. Yeah. Linked from the the email on our website. You can share the benefit of your scale economies. Costco does this back with customers, and Vanguard does this too. [01:34:05] S1: Yeah. I I mean, at the risk, Ben, of stealing what I suspect might be your quintessence of this episode, Vanguard is Costco for finance. Exactly. But even further,
01:34:05 · David Rosenthal, Ben Gilbert
[01:34:05] S1: Yeah. I I mean, at the risk, Ben, of stealing what I suspect might be your quintessence of this episode, Vanguard is Costco for finance. Exactly. But even further, [01:34:15] S0: it's it's like Costco on steroids. Even Costco who lowers prices as much as they can to reward customers and encourage customer loyalty and make everything about customer experience better. Even Costco has outside shareholders who want the business to generate profits. That there there is a reason you are investing in Costco as a business, and that's because you expect it to Yep. Generate cash flows today and in the far future. [01:34:39] S1: Costco itself, several $100,000,000,000 market cap company today. [01:34:42] S0: Right. Vanguard doesn't have that at all. You are investing in the beautiful machine of capitalism as a communist.
01:34:42 · Ben Gilbert, David Rosenthal
[01:34:42] S0: Right. Vanguard doesn't have that at all. You are investing in the beautiful machine of capitalism as a communist. [01:34:52] S1: Yes. Yes. Even Saul Price and Jim Senegal were not this fanatical. Yes. Yes. So it takes a few years for this machinery to kick in for the scale economies to get to a point where it really can and for the investing public to wake up to this idea. In the meantime, they start with $11,000,000 of fund capital, and then they still experience customer withdraws and cash outflows. Like, the stock market starts to rise, so that sorta keeps the fund alive, but they're not getting new cash in. And they they can't because they can't do their own distribution. It gets so bad that the next year in late nineteen seventy seven, they have to take the extreme drastic measure of merging another small legacy Wellington fund called the Exeter Fund into the index fund just to keep it alive and get enough capital into the fund to keep operating it. [01:35:59] S0: Which is crazy to me that they figured out how to sort of acquire this other fund and then just merge its assets into their index fund, and all the investors were like, cool. Sounds good. I guess we're index fund holders now.
01:36:09 · David Rosenthal
[01:36:09] S1: Yeah. I I I didn't see anything in Jack's memoirs about the, governance issues associated with that. Somehow, they get it done, though. And that fund, when they do this merger, had $58,000,000 of assets, you know, again, compared to the $11,000,000 and bleeding out rapidly in the index fund. I mean, that's, like, six times the size of the index fund. So, yeah, really, the seed capital that you should think about in the Vanguard five hundred index fund and, again, also its sister fund, the total stock market index, you know, biggest collectively fund in the world today, comes not from the IPO of clients into the index fund itself initially, but the majority of the initial capital base comes from this other Exeter. Former Wellington actively managed fund that just gets folded in. Yep. Totally, totally wild. So after this emergency transplant to save the index fund here, finally, in 1981 into 1982, Jack and Vanguard do win the right to take over distribution of the index funds. And the way they do it is through, you know, another loophole. This one kinda even more tenuous. Jack argues, oh, we're not taking over distribution. We're just eliminating distribution. We're gonna no longer go to stockbrokers and have them charge sales loads to go into our index funds. We're not gonna allow that at all, and thus we are eliminating distribution. Again, conveniently ignoring the fact that now they gotta employ a lot of people within Vanguard that are gonna market and sell and advertise the funds.