Acquired
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.
01:37:53 · Ben Gilbert, David Rosenthal
[01:37:53] S0: Right. They they went no load. They they refused to pay eight and a half percent to people outside the firm, but now they just have a fixed cost base that they picked up of people that work inside of Vanguard that have to do the work of not only convincing people to buy these funds, but then on top of that, actually handling and facilitating the purchase. The the way that this worked is you would communicate and send in an order via mail, and then you would mail a check to invest in this fund. [01:38:26] S1: Right? Could you imagine? I mean, I remember my parents doing this. [01:38:29] S0: Yes. So, you know, eliminating distribution. Sure. But somehow, someone has to do the marketing and distribution, and now you just do it in house. [01:38:36] S1: Yep. On the back of that, the 500 index fund does finally reach the 100,000,000 capital milestone in 1982, six years after launch. Takes them six years to get to a $100,000,000, which again, that was not large at this point in time. The Wellington Fund, many years earlier, had been $2,000,000,000. Yep. And the initial IPO target had been a $150,000,000, so they're still below that six years in. [01:39:04] S0: And they've got this headwind of they just switched away from paying people to do distribution. So there's now no incentive out there in the marketplace to try to sell Vanguard funds. [01:39:14] S1: Yep. Yep. But the slow burn does start, and towards the end of the decade in the nineteen eighties, by 1988, the fund reaches $1,000,000,000 in assets, and it would obviously grow from there.
01:39:14 · David Rosenthal, Ben Gilbert
[01:39:14] S1: Yep. Yep. But the slow burn does start, and towards the end of the decade in the nineteen eighties, by 1988, the fund reaches $1,000,000,000 in assets, and it would obviously grow from there. [01:39:25] S0: So that's six years to reach a 100,000,000 [01:39:28] S1: Yep. And then another [01:39:29] S0: six six years to get to a billion. [01:39:31] S1: Yep. That's right. Now you might be wondering, that's not a lot of capital, and Vanguard's fees are super low. How is the firm staying afloat during this period? Well, it turns out that Jack's first revolution of the low cost, low fee proposition of Vanguard, it works pretty well in equities. There are other financial markets out there where the low cost strategy works even better, specifically money markets and fixed income, aka bonds, the debt market. In equities, you can have real outperformance. There is uncapped upside to investing in equities. This is the dream that active management sells. Jerry Tsai or Peter Lynch or Warren Buffett or, you know, the greatest investors of all time, we can generate annual returns in the twenties, thirties, even higher percentages like Rentec in our episode there. If you're investing in the debt markets or the money markets, there is a ceiling to your performance. It is the coupons of government bonds or muni bonds or, you know, treasuries in the case of money markets. Yep. The only thing that matters in terms of relative investment performance by products offered in those spaces is costs. [01:40:54] S0: Yep. The lowest cost provider will win in those markets.