6
•
Fund Family Shareholder Association
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.
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
CashWas Steady, But
There’s an Opportunity Cost
0 2 4 6 8 10 12 14 16 18 20 22 24
Months Following First Rate Hike
0%
5%
10%
15%
20%
25%
1976
1986
1999
Avg.
1983
1994
2004
Better Off Ignoring the First
Fed Funds Increase
0 2 4 6 8 10 12 14 16 18 20 22 24
Months Following First Rate Hike
-2%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
Prime Money Market Avg.
Prime Money Market–2004
Total Bond Avg.
500 Index Avg.
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
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
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.
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
EXPENSES
Counting the Costs
>
