Vanguard says this frees managers to "focus on keeping costs as low as possible," passing savings to clients through lower fees for investment advice and other support services.
Vanguard's singular model is now under scrutiny. One of Vanguard's own tax lawyers has blown a whistle on its practices.
In his lawsuit filed under seal in the
Vanguard denies wrongdoing. The company, based in
Vanguard traces its client-owned structure to its founding in 1975. Government regulators have had almost 40 years to complain, if there were a problem.
Still, corporate tax lawyers and mutual fund industry observers contacted by The Inquirer say that Danon is basing his arguments on well-known provisions of federal tax law -- and that his insider analysis, if upheld by courts and adopted by the
By making funds and their investors its ultimate owners and squeezing profits out of operations, founder
But unlike mutual insurers and credit unions, which operate under well-established federal laws, no law gives Vanguard the right to operate on a tax-free basis, Danon argued in his lawsuit and in interviews with The Inquirer.
By charging its funds below-market prices for investment advisory and other services -- functions provided by
By piling up a "contingency reserve" of cash payments from Vanguard mutual funds, without paying taxes on it. The reserve has topped
Vanguard has declined to address Danon's specific allegations. "The issues presented in the complaint are far too complex to get a full and proper hearing in the news media," according to a statement Monday by Vanguard spokesman
"Vanguard has operated under its unique structure for nearly 40 years," Hoffman added. He said the company follows the laws and rules of the
The suit was unsealed after the
Is Danon right?
How do Danon's arguments hold up?
Vanguard's structure may be "unusual" for mutual funds, Willens said, but such arrangements are common, for example, with real estate investment trusts (REITs), which pay related management companies for services.
There is a temptation, Willens said, to set the fees the funds pay their management affiliates so they show only "very small amounts of taxable income." It's a tax lawyer's job to warn the company it needs to pay its affiliate about the same as it would pay an outside firm to do the same job, Willens explained.
Similarly, cash that piles up in "contingency reserves" starts to look like tax avoidance, Willens added.
What if an
"As an investor in Vanguard funds, I'm thinking, 'What? They don't charge enough fees? Right on!'" said
But he agreed Vanguard could indeed face issues similar to the real estate fund operators. "The REIT example is a very good one," Kull said. If REITs pay market-level fees, Vanguard may have to show why it deserves different treatment, he added.
"The law does let you provide mundane and run-of-the-mill services at cost or close to cost. It does not let you do that with services that require a big skill set, like we imagine investment management to be," says
"The issue is not that the funds need to pay more to the investment adviser," it's that
What's the worst that could happen to Vanguard investors?
"This assault on Vanguard's 'at cost' operating principle, if successfully challenged, has seismic implication for the mutual fund industry and could possibly put competitors on a more level playing field with Vanguard," said
Even if that happens, Vanguard, with its size and focus, will likely remain "one of the low-cost leaders in the industry," Wiener added. But ruling against the firm and its longtime structure "would be a huge hit to the firm's reputation as an investor advocate and ethical leader."
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