(PUB) Vanguard Advisor

fairness, in the next pair of charts, the one on the left looking at the per- formance of Prime Money Market following the initial increase in the fed funds rate does look pretty darn good. The average return of 12.4% for a two- year holding period matches what we saw for Total Bond Market—without any of the volatility. In this situation, however, we need to apply a little common sense to the lessons of history. As you can see in the chart on page 4, the yield on Prime Money Market has closely tracked the fed funds rate. With a current yield of 0.01%, expecting a 12% return from cash is just setting yourself up for some serious disappointment. Yes, I expect rates to move higher, and ideally one day we’ll earn a bit more than 0.01% on our cash holdings again, but short- term rates above 12% or even 6% in the next two years? That’s a stretch. Holding cash will remove volatil- ity from your portfolio, but there isn’t much, if any, opportunity for a gain with cash yielding next to nothing. And as we’ve seen, the start of a Fed rate- hiking cycle doesn’t automatically lead to losses in stocks or bonds, so there very well may be a large opportunity cost to sitting in cash. YOU’VE HEARD THE STORY BEFORE: Vanguard is owned by the shareholders of the Vanguard mutual funds and ETFs, and provides its services at cost to those funds. This structure gives Vanguard a cost advantage over peers and has undoubtedly saved shareholders hun- dreds of millions in fees over the years. But what gets lost in the discussion of costs saved is the question of costs that aren’t. In other words, just what are those costs which are being provided at cost? And could they be even lower? Two decades ago, the asset-weighted average expense ratio paid by Vanguard shareholders was only 0.30%, or 30 basis points. At the time Vanguard was EXPENSES Counting the Costs >

CashWas Steady, But There’s an Opportunity Cost

Better Off Ignoring the First Fed Funds Increase

25%

10% 12% 14% 16% 18%

1976 1986 1999 Avg.

1983 1994 2004

Prime Money Market Avg. Prime Money Market–2004

Total Bond Avg. 500 Index Avg.

20%

15%

0% 2% 4% 6% 8%

10%

5%

0 2 4 6 8 10 12 14 16 18 20 22 24 Months Following First Rate Hike 0%

0 2 4 6 8 10 12 14 16 18 20 22 24 Months Following First Rate Hike -2%

the fed funds rate might beget another, but it doesn’t mean that the hikes will keep coming. Remember that table on page 4? Some rate hike cycles lasted for 40 months and others for just 12 months. Rates quadrupled in some, but rose less than 40% in others. The timing and magnitude of the next rate cycle is not set in stone. One thing I can guarantee, though, is that between now and then we can expect to see lots of headlines and hand- wringing over a rising fed funds rate and its “guaranteed” ability to kill the bull market. Don’t buy it. With history as our guide, we can be forearmed against such calls for looming disaster. n But should investors simply look at falling expense ratios and call it a day, or is there another lens we should view expenses through? What about the absolute dollars those expense ratios translate into? An expense ratio of 0.14% on $2.5 trillion of assets translates into revenue of about $3.5 billion. Twenty years ago in 1993, Vanguard generated roughly $360 million in revenue. Growing from $360 million to $3.5 billion is a huge jump—a 12% average annual increase. At $3.5 billion, Vanguard’s revenues are similar to the annual sales at Chipotle Mexican Grill. The second chart on page 7 shows how revenue has risen in

Pulling It All Together To simplify the story, in the final chart on the right, I’ve pulled out the average performance of Total Bond Market, 500 Index and Prime Money Market over the two years following the first hike in the fed funds rate. I also included Prime Money Market from 2004, as common sense suggests it is a better estimate of what we can expect from cash going forward—though it, too, might be overly optimistic. I don’t think there’s much point arguing about whether or not the Fed will raise the fed funds rate sometime in the next year or two. Right now it looks like an event for 2015. And one hike in just shy of $120 billion in assets under management in U.S. mutual funds and annuities. As assets at Vanguard have grown over the years to nearly $2.5 trillion at the end of 2013, the aver- age expense ratio shareholders paid on Vanguard mutual funds, ETFs and annu- ities has steadily declined all the way to 0.14% according to my calculations. The first chart on page 7 shows the change in the average expense ratio paid by share- holders of Vanguard funds against the assets invested in those products. In a world where a fee of 1% is con- sidered standard and fees rarely shrink, Vanguard should be commended for consistently cutting its expense ratios.

6 • Fund Family Shareholder Association

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