Stocks — Part X: What if Vanguard gets Nuked?

You don’t have to read very far into this blog to know I am a strong proponent of investing in Vanguard index funds.  Indeed, you’ll find this in the Manifesto:

Vanguard.  End of story.

Understandably, this raises some questions.  Today let’s look at the four most common:

1.  What makes Vanguard so special?

When Jack Bogle founded Vanguard in 1975 he did so with a structure that remains unique in the investment world:  Vanguard is client-owned and it is operated at-cost.

Sounds good, but what does it actually mean?

As an investor in Vanguard Funds, your interest and that of Vanguard are precisely the same.  The reason is simple.  The Vanguard Funds, and by extension the investors in those funds, are the owners of Vanguard.

By way of contrast, every other investment company has two masters to serve:  The company owners and the investors in their funds.  The needs of each are not always, or even commonly, aligned.

To understand the difference, let’s look at how other investment companies (most companies in fact) are structured.  Basically, there are two options:

1.  They can be owned privately, as in a family business.  Fidelity Investments is an example.

2.  They can be publicly traded and owned by shareholders.  T. Rowe Price is an example.

In both cases the owners understandably expect a return on their investment.  This return comes from the profits each company generates in operating its individual mutual funds.   The profits are what’s left over after the costs of operating the funds are accounted for — things like salaries, rent, supplies and the like.

Serving the shareholders in their funds is simply a means to generate this revenue to pay the bills and create the profit that pays the owners.  This revenue comes from the operating fees charged to shareholders in each of their individual funds.

When you own a mutual fund thru Fidelity or Price or any investment company other than Vanguard, you are paying for both the operational costs of your fund and for a profit that goes to the owners of your fund company.

If I am an owner of Fidelity or Price I want the fees, and resulting profits, to be as large as possible.  If I am a shareholder in one of their funds, I want those fees to be as modest as possible.  Guess what?  The fees are set as high as possible.

Now to be clear, there is nothing inherently wrong with this model.  In fact it is the way most companies operate.

When you buy an iPhone built into the price are all the costs of designing, manufacturing, shipping and retailing that phone to you.  Along with a profit for the shareholders of Apple.  Apple sets the iPhone price as high as possible, consistent with costs, profit expectations and the goal of selling as many as they can make.  So, too, with an investment company.

In this example I chose Fidelity and Price not to pick on them.  Both are excellent operations with some fine mutual funds on offer.  But because they must generate profit for their owners, both are at a distinct cost disadvantage to Vanguard.  As are all other investment companies.

Bogle’s brilliance, for us investors, was to shift ownership of his new company to the mutual funds it operates.  Since we investors own those funds, thru our ownership of shares in them, we in effect own Vanguard.

Any profits generated by the fees we pay would find their way back into our pockets.  Since this would be a somewhat silly and roundabout process and, more importantly, since it would potentially be a taxable event, Vanguard was structured to operate “at cost.”  That is, with the goal charging only the minimum fees needed to cover the costs of operating the funds.

What does this translate into in the real world?

Such fees are reported as “expense ratios.”  The average expense ratio at Vanguard is .20%.  The industry average is 1.12%.  Now this might not sound like much, but over time the difference is immense and it is one of the key reasons Vanguard enjoys a performance as well as a cost advantage.

With Vanguard, I own my mutual funds and thru them Vanguard itself.  My interests and those of Vanguard are precisely the same.  This is a rare and beautiful thing, unique in the world of investing.

Click on the quote below for more:

“No one, other than the funds and their shareholders, owns a piece of Vanguard. Nobody. Our CEO, Bill McNabb, and even our founder, Jack Bogle, are client-owners in exactly the way you are.”

2.  Why are you comfortable having all your assets with one company?  Isn’t this what tanked investors with Bernie Madoff?

Because my assets are not invested in Vanguard.  They are invested in the Vanguard Mutual Funds and, thru those, invested in the individual stocks, bonds and REITS those funds hold.  Even if Vanguard were to implode (a vanishingly small possibility), the underling investments would remain unaffected.  They are separate from the Vanguard company.  As with all investments, these carry risk, but none of that risk is directly tied to Vanguard.

Now this can start to get very complex and for the very few of you who care, there’s lots of further info you can easily Google.  For our purposes here, what’s important to know is:

1.  You are not investing in Vanguard, you are investing in one or more of the mutual funds it manages.

2.  The Vanguard mutual funds are held as separate entities.  Their assets are separate from Vanguard, they each carry their own fraud insurance bonds, each has its own board of directors charged with keeping an eye on things.  In a very real sense, each is a separate company operated independently but under the umbrella of Vanguard.

3.  No one at Vanguard has access to your money and therefore no one at Vanguard can make off with it.

4.  Vanguard is regulated by the SEC.

All of this, by the way, is also true of other mutual fund investment companies, like Fidelity and Price.  Those offered in your 401k are, in all likelihood, just fine too.  (If you have an employer sponsored retirement plan, like a 401k, that doesn’t offer Vanguard funds by all means invest in it anyway.  Especially if any company match contributions are offered.  Those are free money and an instant return on your investment.)

It is NOT true however for what are called Private Investment Funds.  Those are where you turn your money over directly to an individual or group of individuals to manage and invest.  That’s what Madoff was running.

3.  What if Vanguard gets nuked?

Ok, let’s be clear.  If the world ends on December 21, 2012 as evidently the Mayan Calendar suggests it might, everything you have invested in Vanguard (or elsewhere) will go up in smoke.  But that’s not gonna happen. (Come December 22nd, I’m putting “told you so” right here.) (Told you so.)

If a giant meteor slams into Earth setting the world on fire followed by a nuclear winter, your investments are toast.

If space aliens arrive and enslave us all, unless you bought human feedlot futures, it’s gonna mess up your portfolio.

If super volcanos or global warming or viruses or an ice age or the reversal of the magnetic poles or AI robots or nanobots or maybe Zombies take us out, investing with Vanguard will be of no help at all.

Relax.  It ain’t none of it gonna happen.

At least not on our watch.

But lesser disasters can and do happen.  Vanguard is based in Malvern, Pennsylvania.  What if, God forbid, Malvern is nuked in a terrorist attack?  What about a cyber attack?  Hurricane?  Pandemic? Power outage?

Every major company and institution is aware of these dangers and each has created a Disaster Recovery Plan.  Vanguard has one of the most comprehensive going.  The company is spread across multiple locations.  Its data is held in multiple and redundant systems.  You can check out their plan here:  Business Recovery Plan

But, if you are expecting a planet or even just a civilization ending event, Vanguard’s not for you.  But then, no investments really are.  You’re already stocking your underground shelter with canned goods.  Short of that, you can sleep just fine with your assets at Vanguard.  I do.

4.  Am I on the take?

This blog is such strong a proponent of Vanguard it is reasonable to ask….

“Am I on the take?”

Nope.  Vanguard doesn’t know I’m writing this and they are not an advertiser.  Nor do they pay me in any fashion whatsoever.

(However, this blog does participate in Google Adsense. It is possible that when they choose the ads that appear, Vanguard’s might be one of them.)

For my International readers — an Addendum:  With its client centered focus, Vanguard is growing rapidly and now is available in many countries outside the USA.  You can check the list out here:  Vanguard Global

 

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50 Comments

  1. Trisha Ray
    Posted September 7, 2012 at 10:32 am | Permalink

    As always – nice and clear. Questions we hesitate to ask for fear of sounding stupid. Thanks!

    • Posted September 7, 2012 at 11:04 am | Permalink

      Good to hear it! I’m always concerned about the clarity of what I write.

      Actually, most of these questions came from some guy named Eric. No hesitation there. :)

  2. Kevin
    Posted September 7, 2012 at 10:40 am | Permalink

    I was just trying to explain to my wife the benefits of Vanguard last night but I could not articulate it very well! Perfect timing with this article, thanks!

  3. Posted September 7, 2012 at 11:23 am | Permalink

    Beautifly written as always, and very informative. I love Vanguard, but I am also one of those who does not invest ALL my money with them. I understand the risks (and much better now, thank you), but I while I am sure that majority of the money invested with them would be returned eventually, if they were to implode, I still worry about how much time and effort would that take.

    And yes, to illustrate how “management fees” impact the mutual funds and investments in general, I did a spreadsheet last year (because financial firms do not give you that information easily), and I found out the in the 10 years my company and I were contributing into Great West Life (Canadian Company) employer sponsored retirement fund, fund managers made more money on my money than me. They made about 2% return over 10 years, I made only 1.6% average return. I would love to dump them, but when company copays $1 for each $1 that I contribute (up to a certain level), and I get to defer taxes until retirement (RRSP), I am getting at least 100% return on my money instantly :)

    • Posted September 7, 2012 at 2:00 pm | Permalink

      Thank you sir! Always nice to see you here. You make a couple of very important points.

      I should have pointed out (and in fact will edit the post to add) that the odds of Vanguard imploding are vanishingly small. Certainly small enough not to be a factor in my choice of investments. Further, since only long-term money should be invested waiting a few months if the unthinkable should happen is not a problem. I keep cash on hand for immediate needs.

      Great illustration of the impact of fees on returns, but even more important is your excellent point about employer sponsored retirement funds; what we call 401k here in the USA.

      Unfortunately, few of these plans offer Vanguard funds as an option. When I was working mine didn’t. But, as much as I love Vanguard, if your company offers such a program with a contribution match, GO FOR IT!

      This is the reason in #2 in my post I have the line: “All of this, by the way, is also true of other mutual fund investment companies, like Fidelity and Price. Those offered in your 401k are, in all likelihood, just fine too.”

      I should have been clearer. Mmmm. Think I’ll edit and add this point too.

  4. Julie
    Posted September 7, 2012 at 12:33 pm | Permalink

    You write about the Vanguard Mutual Funds. Does the same apply to their ETF’s or are their further risks with these.

    • Posted September 7, 2012 at 1:49 pm | Permalink

      Great question, Julie. The short answer is: Yes, my comments about the mutual funds also apply to the ETFs. That said, given the choice, I prefer the funds.

      First, ETF stands for Exchange Traded Fund. Basically these are mutual funds that you can buy and sell just like individual stocks. Here’s why the people who like them like them:

      1. If you live outside the USA, the ETF versions may be the only way you can buy Vanguard funds. If this is the case, by all means go ETF.

      If you go to Vanguard’s site and look up a fund, say VTSAX, directly under the name of the fund you’ll see a line with links indicating it is available as an ETF.

      2. When you buy or sell a mutual fund your trade is executed at the end of the business day. With ETFs, like stocks, it is executed immediately. If you are a short term trader, this is important.

      Here’s why I don’t use them:

      1. If you are a long term investor #2 above is of no consequence. Since short term trading is an always dangerous and most often losing game, I avoid it.

      2. Buying or selling an ETF most often involves paying a brokerage commission. I don’t like extra expenses.

      3. Living in the USA I don’t need ETFs. I can easily buy the mutual fund versions.

  5. Posted September 7, 2012 at 12:44 pm | Permalink

    Really enjoyed the article! I’m thinking of investing one of our ROTH IRAs with them. Still trying to figure it out.

    • Posted September 7, 2012 at 1:33 pm | Permalink

      Thanks SFL….

      Good luck with your Roth decision, and just deciding to have a Roth is a great decision. :)

      • Posted September 7, 2012 at 3:16 pm | Permalink

        Thanks :) The pf atmosphere is how I got introduced to the ROTH IRA. Surprisingly, no one including my in laws who are well educated talk about choosing retirement funds.

        • Posted September 7, 2012 at 3:46 pm | Permalink

          Sadly, I’m not surprised.

          Investing was never a part of my formal education either. My daughter had one class in high school and nothing, so far, in college.

          the world is filled with highly educated folks lost in the financial wilderness….

          • Posted September 7, 2012 at 4:29 pm | Permalink

            Personal finance is not a priority in formal education. Hah, even WSJ and Bloomberg have a crappy personal finance section. The best advice comes from reading lots of pf bloggers.
            I took lots of classes in finance, and only a couple professors mentioned stocks, but never really talked about how to get started, the advantages, etc.

  6. Eric
    Posted September 7, 2012 at 2:23 pm | Permalink

    Sir,

    In fact, Vanguard is based in Malvern, Pennsylvania
    https://en.wikipedia.org/wiki/The_Vanguard_Group

    • Posted September 7, 2012 at 2:39 pm | Permalink

      Doh!

      I stand corrected. You are absolutely right. Man, I need a fact checker.

      Although, in my defense, they do have an operation in Baltimore.

      T. Rowe Price is the one in Baltimore. And Fidelity is in Boston.

  7. Posted September 7, 2012 at 2:38 pm | Permalink

    Awesome thoughts, Jim! John Bogle is on a noble mission to save the world from insanity. I encourage your readers to read this article about this great man and his priceless advice.

    http://www.nytimes.com/2012/08/12/business/john-bogle-vanguards-founder-is-too-worried-to-rest.html?_r=1&pagewanted=1&hpw

    • Posted September 7, 2012 at 3:03 pm | Permalink

      Thank you, my friend.

      Mr. Bogle has done more for the individual investor than anyone else in history. He is my personal hero and I only wish I’d found Vanguard and Indexing sooner.

  8. Steve
    Posted September 7, 2012 at 6:59 pm | Permalink

    Nice to see you back off your holidays JLC, I like your clear explanation of all things financial and quit often link them on my facebook page but unfortunately most people don’t have my interest in finance and shares.
    But getting to your article and Vanguard (of which I am a fan) and the company structure seems to be very similar to a mutual society or Cooperative here in the UK.
    Now I had the pleasure of working for an old Cooperative http://www.co-operative.coop/corporate/aboutus/ourhistory/
    and actually its a very different atmosphere to any other company that I have worked for and it’s true that ethics and honesty was more important there than any other company.

    But I must worn that in a old mutual or cooperative where the original company creator has gone, sometimes they can get over bloated and inefficient (Vanguard is in it’s infancy compared to The Coop) and the guys at the top can sometimes become overpaid, old and less interested in the company and more interested in retiring.
    Now the Coop is making a comeback and is more efficient and has got some of it’s spark back but this has taken more than 10 years to do.
    When they made me redundant they informed us and said the depot was to be closed quickly and it took 3 years (and that is fast for the Coop).
    I am not saying this will ever happen to Vanguard but you have to keep your eyes open.

    • Posted September 8, 2012 at 12:40 am | Permalink

      Thanks Steve, and thanks for linking some of this stuff on your facebook page. I always appreciate readers passing the blog along to their pals.

      wow. that’s some history in the link you provided.

      your concern about mission and value drift in organizations once a founder leaves is well worth consideration.

      When Jack Bogle stepped down as Vanguard’s CEO in 1996 it gave me pause and focused my attention. Since then there have been two more CEOs and the course and values remain rock solid. To a great extent the organizational structure locks them in and the core beliefs are deeply engrained. I’m not much worried.

      That said, were I to notice any drift I’d shift into high alert. For now and the foreseeable future, while I’ll always keep an eye open, I sleep well at night.

  9. Jan
    Posted September 8, 2012 at 1:39 am | Permalink

    Excellent! This is your best ever, Jim. Thank you. I will sleep a little bit better tonight.

  10. RW
    Posted September 8, 2012 at 11:25 am | Permalink

    While I do have Vanguard in some of my 401k holdings. When I tried to roll over a Roth IRA into a Vanguard fund, I found that some of the funds are closed to new investors. In fact, some of your favorites you mention in earlier posts.
    Jack Bogle is certainly a pioneer in the investing world, I found the Bogleheads guide to investing to be a good read for the Jr. investor like myself. Wish I would have done this much early in life…
    Vanguard certainly has lower fees, more of your money working for you vs fees taking a cut of your cash. How do you feel about Reits? Also would like to hear your take on dividend investing? Seems to be an easy way to reap cash quarterly based on what I have read so far…
    From prior posts seems you are not a big fan.

    • Posted September 8, 2012 at 12:53 pm | Permalink

      Hi RW….

      There are four funds that meet all our investing needs and I describe them here: http://jlcollinsnh.wordpress.com/2011/06/14/what-we-own-and-why-we-own-it/

      Just did a quick check and all are still open to new investors. Which have you found closed?

      I do use, and link to, the Admiral version of these funds which have a lower expense ratio but a 10k investment minimum. However each also has an “Investor Shares” version and Vanguard provides links to those at the top of the page.

      One of the four funds I use is a REIT. Combined with the equity in my house it comprises 25% of my portfolio. Real Estate held this way in my inflation hedge.

      My concern with dividend investing is:

      1. It requires selecting individual stocks, a complex endeavor that almost always underperforms the Index.

      2. It focuses on only one of the ways companies produce value and return to shareholders.

      3. Dividends paid, outside a tax advantaged account, are taxable.

      That said a well executed dividend investment program will get you to FI. It’s just more work and less powerful than VTSAX. Here’s more: http://jlcollinsnh.wordpress.com/2011/12/27/dividend-growth-investing/

      • RW
        Posted September 8, 2012 at 2:33 pm | Permalink

        Thanks, I have not made the move to dividend investing. I am more of a set it and forget it kind of person. So the Index funds do meet my style. I will look again at the Admiral versions offered. Thanks again!

  11. PFgal
    Posted September 9, 2012 at 9:41 am | Permalink

    You and others have convinced me to switch to Vanguard. Now I just have to figure out the logistics, since I already have everything at Schwab. I think a phone call to Vanguard is in order….

    • Posted September 9, 2012 at 2:08 pm | Permalink

      Hi PFgal….

      you’ll find the folks there very helpful when you call. Of course you are also going to have to get Schwab to release your funds.

      I have no experience with them, but I do have a friend who recently switch from Merrill Lynch. Seems the folks at ML did everything they could to drag their feet and block the process.

      Any doubts she had about leaving them were dispelled by their behavior.

      hope your experience with Schwab is smooth and professional. please let us know.

  12. Posted September 9, 2012 at 10:21 am | Permalink

    Good writeup on Vanguard, Jim. Index investing is the safest way for most, although I feel people should also know how to do some basic valuation and understand the principles behind income statements and balance sheets.

    • Posted September 9, 2012 at 2:18 pm | Permalink

      Thanks 101….

      and you bring up an interesting point.

      Investing knowledge is something that interests you and me. I certainly agree that anyone planing to actively invest by picking individual stocks had better be able to do some basic valuation and understand the principles behind income statements and balance sheets.

      But even then, with vanishingly rare exception, they will underperform an index fund like VTSAX. Their effort and knowledge will actually end up costing them money.

      The second thing I’ve come to understand is the vast majority of people have zero interest in investing and certainly none in income statements and balance sheets. Yet these folks also want/need to be financially secure.

      The good news is that very successful investing can be had with very simple tools.

      This is the message and purpose of this blog.

  13. ChetBodet
    Posted September 9, 2012 at 10:23 pm | Permalink

    So question for you,

    I am a young guy, 24, looking to start saving more towards financial independence. What is the best option to buy Vanguard funds if I want to have access to them before the minimum withdrawal age set on IRAs? I already have a Roth IRA and am currently at a company that does not offer a 401K plan. Any advice would be incredibly appreciated.

    • Posted September 9, 2012 at 11:44 pm | Permalink

      Hi Chet….

      If I understand your question correctly, it’s pretty simple:

      Just open a regular (non IRA) account. You can buy any fund outside an IRA and have penalty free access anytime.

      Of course, assuming you are here in the USA, you will owe taxes on any capital gains and/or dividend the fund pays and, if you sell shares at a profit, you will owe a tax on capital gain.

      Funding your Roth first is a good move.

      congrats on getting an early start!

      • ChetBodet
        Posted September 10, 2012 at 8:48 am | Permalink

        As far as tax implications go would it be better just to open the regular account or would it be worth it to consider opening an IRA and risk the early withdrawl penalties?

        • Posted September 10, 2012 at 9:26 am | Permalink

          That depends on two things:

          1. How likely are you to withdraw this money early and incur the penalties. If you are planning, say, to buy a house and this is your downpayment money you want to avoid IRAs. If you are just thinking, OMG what if I get in trouble and need this cash, that’s something else.

          2. Are you in a high enough tax bracket to make the deduction worthwhile? Most 24-year-olds are not. Remember, IRAs (except ROTH) don’t eliminate your tax payments they only delay them until you pull the money out. I, for example, am now in a higher tax bracket retired than I was in my 20s.

  14. Malaika
    Posted September 13, 2012 at 2:38 pm | Permalink

    Jim, Great writing and an interesting article. Thank you for taking the time to share this information especially for “dummies like me”. Very much appreciated and a very easy read .

  15. jpartin56
    Posted March 9, 2013 at 7:54 pm | Permalink

    I opened a Vanguard account yesterday and qualified for concierge service for my retirement rollover to a Vanguard IRA. I must say that the fellow that I talked to would be a mirror of what you have said repeatedly in your blog. He could’ve steered me to any number of funds for a retirement portfolio and patiently answered my ‘what if’ questions pertaining to different mixes of funds. The choice that I ended up with was the Target 2020 fund, I may add a REIT fund as a small percentage if I feel that I can tolerate the added risk. I can’t say enough good things about my experience with Vanguard. I have some real peace of mind now thanks in large part to you and your blog. Thanks!

    • jlcollinsnh
      Posted March 9, 2013 at 8:01 pm | Permalink

      Welcome Jim!

      Glad, but not surprised, you had such a good Vanguard experience.

  16. Posted March 11, 2013 at 1:45 pm | Permalink

    Don’t forget to put “told you so” about the Dec 21st Mayan Apocalypse comment!

    • jlcollinsnh
      Posted March 12, 2013 at 12:40 am | Permalink

      Ha!

      You’re right. The world didn’t end.

      But you just said it for me!

  17. TwoThing
    Posted May 30, 2013 at 1:55 pm | Permalink

    Hi Jim,

    First off, I love your blog. Quite addicted to reading your posts. :D

    Just a question though, that may or may not be related to this. I live outside the US and I currently invest in Vanguard ETFs through Standard Chartered brokerage. They have a bit of commission and currency spread but those are expenses I cannot avoid and I am willing to shoulder. Vanguard individual investor services are not available where I am from and SC is one of the few that allow us to trade in the US stock market.

    My question now is, if it’s Standard Chartered that gets nuked, will my investments disappear with it even if I bought Vanguard ETFs shares (Standard Chartered acts as the custodian)?

    I’m not sure if you would know the answer to this but just like to hear your thoughts if ever.

    Thanks a lot!

    • jlcollinsnh
      Posted May 30, 2013 at 3:05 pm | Permalink

      Welcome, TT…

      Glad to have you here!

      Unfortunately, I am not at all familiar with Standard Chartered. But, if it is like most brokerages and mutual fund companies, your ETFs should be fine. They are separate things from SC and so you are not invested in SC, but rather just thru them as your broker.

      But because there is much at stake here, I would continue your research beyond my opinion.

      If you haven’t already, you might read: http://jlcollinsnh.com/2013/05/02/stocks-part-xvii-what-if-you-cant-buy-vtsax-or-even-vanguard/

      and especially the comments. You might even ask your question there. My international readers have begun sharing info there beyond what I can offer.

      Good luck and, as you learn more, please tell us in a comment over on that post.

      Thanks!

  18. T-bone
    Posted May 31, 2013 at 11:49 pm | Permalink

    I am a small businessman who offers a 401K to his employees. Our current 401K administrator doesn’t offer much advice or value, and my staff is unhappy with him/them. Is there a way I can set up a 401K through Vanguard?

  19. Jam Dough
    Posted December 30, 2013 at 10:17 pm | Permalink

    Great article, thanks !

    One point though I would like to raise. Because Vanguard appoints fund managers to allocate the investing parties capital accordingly (via computer analysis), what assurance do we have that such managers are allocating said funds as described within the stated fund structure?

    cheers,

    Jam Dough

    • jlcollinsnh
      Posted January 3, 2014 at 8:25 am | Permalink

      Hi Jam…

      Interesting question.

      To check you could simply go on line and look to see the holdings match the fund’s stated objectives. Or look at the Prospectus for the same, if a bit more dated, info.

      Perhaps more to the point, any fund manager who strayed from the fund’s goals would be quickly terminated. Plus, they’d really have no motivation to do so.

      Hope this helps!

  20. AML
    Posted August 5, 2014 at 7:54 pm | Permalink

    Great Series!!! I am on board with the Vanguard philosophy but unfortunately have a large amount in funds at Merrill Lynch from my younger days blindly listening to family advice (parent has a friend who is my financial adviser at ML). I just realized one of the funds has a 3.68% expense ratio with a 1.0 load!!! I’m wondering if you have any advice on the best way to sell and transfer funds while minimizing taxes and penalties on a non-retirement/taxable account. I am in a high tax bracket and would prefer not to get hit on all angles by this mistake.

    Thanks in advance for the advice and for the great articles!!!

    • jlcollinsnh
      Posted August 6, 2014 at 1:09 am | Permalink

      Thanks AML…

      Glad you like it!

      Over these past few years writing this blog, I’ve begun to learn that many are faced with this same situation: High fee funds bought years before that the robust market has given large capital gains now waiting to be taxed.

      Obviously, in tax-advantaged accounts these can be moved instantly with no tax consequence. But it taxable accounts there is no easy answer.

      A lot depends on how big a gain we are talking about.

      Second, there are no government penalties in selling out of these funds, just the tax due. But some of the fund companies levy their own exit fees, a despicable practice.

      Third, capital gains taxes are fairly modest.

      For 2014:
      
Under the 25% tax bracket the tax is zero

      For the 25%, 28%, 33% and 35% brackets it is 15%

      Once in the top bracket of 39.6% it is 20%

      With those points in mind, here are a few approaches to consider:

      1. If you can see a year coming when you’ll drop below the 25% bracket, sell and move your funds then and you escape tax free. Or if you are in the top bracket and see a time coming when you’ll drop to 35% or less and can take the cap gain hit at 15% instead of 20%.

      2. Sell and transfer the funds over a period of several years, starting with the ugliest, highest fee ones first.

      3. If while pursuing the strategy in #2 the market takes one of its periodic major dives, use that opportunity to then move all your funds while prices are depressed and the cap gain hit will be less.

      4. Rip the bandaid off all at once — sell/pay the tax and be done with it — lick your wounds and move on.

      5. Of course if any of your taxable investment have losses in them, you can sell those to offset some of your gains.

      Sorry I don’t have any magic bullets to offer here. But as problems go, this one isn’t the worst:

      You do have capital gains and that’s always something to celebrate.
      Once you sell and start anew at Vanguard your cost basis will be reset.

      As taxes go, capital gains get favorable treatment.

      Good luck and let us know what you decide!

  21. Serena P.
    Posted August 12, 2014 at 8:40 am | Permalink

    Hi Jim!

    Thank you for your super informative blog. My husband and I have really learned a lot. I have a mutual fund issue that I’m hoping you can help me out with. My 401k only offers Fidelity funds. I checked out the expense ratios and management fees of the 2 funds that I’m currently investing in and they were indeed higher than I liked. I transferred everything to the only index fund that they offered which mirrors the S&P 500, which is called “BlackRock Equity Index Fund M”. The thing that caught my eye was that they said, “This investment is not a mutual fund.” This got me worried. Are they one of those Private Investment Funds that you warned us about? This is what they say on their page:

    “The Fund is a collective investment trust maintained and managed by BlackRock Institutional Trust Company, N.A. (“BTC”). The Fund shall be invested and reinvested in a portfolio of equity securities with the objective of approximating as closely as practicable the capitalization weighted total rate of return of that segment of the United States market for publicly traded equity securities represented by the larger capitalized companies. The criterion for selection of investments shall be the S&P 500 ® Index.
    The Fund may invest through one or a series of collective investment trusts managed and trusteed by BTC.

    When deemed appropriate by BTC and unless otherwise provided in the Fund’s investment strategies, BTC may invest all or any portion of the Fund in one or more futures contracts, forward contracts or other similar assets for the purpose of acting as a temporary substitute for investment in securities.

    In the event of a conflict between this summary description of the Fund’s investment objective and principal investment strategies and the Trust Document under which the Fund was established, the Trust Document will govern. For more information related to the Fund, please see the Fund’s Trust Document, Profile and most recent audited financial statements.”

    I’d appreciate your input. I just transferred my entire life’s 401k over to them and I want to know if I need to frantically undo it.

    Thanks!
    Serena

    • AB
      Posted August 19, 2014 at 1:30 pm | Permalink

      Serena,

      You have nothing to worry about with this fund (as far as structure goes). It is not a private investment fund of the Madoff or hedge fund kind. A collective investment trust leverages the economies of scale available to fund sponsors and qualified plans, such as 401k plans. This translates to lower expense ratios in many cases. The trust is an entity legally separate from BTC. It essentially operates similarly to a mutual fund, but it’s not publicly traded due to the nature of how it is established. Since the fund is within your 401(k), it is subject to the provisions of ERISA.

      Vanguard offers such funds to its clients, my employer being one of them. We have the Trust version of their Target Retirement Funds in our plan lineup, as the trusts carry lower ERs than the mutual funds. Also, the stable value option in our plan is technically a collective trust.

      I’m happy to provide more information if you need it, but hopefully this puts your fear to rest.

    • jlcollinsnh
      Posted August 19, 2014 at 6:09 pm | Permalink

      Hi Serena…

      I’m afraid this is out of my area of expertise. That said, what AB offers makes sense to me.

      Thanks AB!

  22. Posted September 10, 2012 at 11:59 am | Permalink

    Hey Mad F….

    Thanks for linking to this post. That got me poking around your site a bit.

    I especially enjoyed your interview with Mr. MM. So that’s what he sounds like! :)

    http://www.madfientist.com/mr-money-mustache-interview/

  23. Posted September 11, 2012 at 11:14 am | Permalink

    Hi Jim,

    Thanks for writing such a great post to link to!

    I’m glad you enjoyed the interview with Mr. Money Mustache. It was a lot of fun talking to him; he’s a great guy so speaking to him was just as enjoyable as reading his articles.

    Speaking of the podcast…I was actually planning on getting in touch soon to see if you’d be interested in being interviewed for a future episode of the Financial Independence Podcast? I’m a big fan of your writing so I’d love hear more about your journey to FI. If you’re interested, please email me and we can talk more about it!

    Thanks again for the great post and hopefully I’ll hear from you again soon!

    - Mad Fientist

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