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Is It Safer to Use Multiple Fund Companies?

One question I’ve been asked several times is whether it makes sense to diversify across multiple brokerage firms or fund companies. My wife and I do not diversify in this way — we keep all of our retirement savings at Vanguard. But I thought it would be helpful to turn directly to a mutual fund company to get a more behind-the-scenes look at the systems in place to protect fund investors so you can make your own evaluation.

Linda Wolohan from Vanguard’s public relations team was quite helpful, tracking down answers to every one of my questions. What follows are my questions (in bold), followed by her replies.

If Vanguard went out of business, what would happen to an investor who owned Vanguard mutual funds?

It is extremely unlikely that Vanguard would ever fail. Vanguard is owned by Vanguard mutual funds, and Vanguard mutual funds are owned by the funds’ shareholders. Because of this structure, we’re able to make every decision with only client needs in mind. [For example,] Vanguard is not engaged in the investment banking or underwriting businesses that have been in the news for suffering financial losses.

[In addition,] Vanguard is a distinct and separate legal entity from the funds in which you are invested. It is the service company that provides transfer agency services (recordkeeping, etc.) and administrative services (statements, client service, fund accounting, etc.). Because the funds and Vanguard are separate legal entities, if Vanguard were to enter bankruptcy, Vanguard’s creditors could not claim the funds’ assets to pay Vanguard’s obligations. Each fund’s assets would remain in the protective custody of the fund’s custodian bank. As a result, they would remain available to meet share redemptions and regular operating expenses.

Mike’s note: A mutual fund’s custodian is disclosed in its Statement of Additional Information. For Vanguard funds, you can find this report by clicking “view prospectus and reports” on a fund’s page on Vanguard’s site. 

If the custodian bank for a Vanguard fund went out of business or became insolvent, what would happen to investors in the fund?

Vanguard has relationships with several independent custodian banks, which facilitates the efficient transfer of fund assets to a new custodian bank should a fund’s existing custodian bank experience financial stress.

Federal banking law generally provides that fund securities held in segregated custodian bank accounts are not assets of an insolvent custodian bank and are not subject to claims by the custodian bank’s general creditors. As a result, a fund’s securities and similar investments would not be subject to the liens or claims of creditors of the custodian bank or of the FDIC as receiver or conservator of the custodian bank.

Cash in a fund’s custodian bank account generally would be treated as a deposit obligation and become part of the custodian bank’s bankruptcy estate, accessible by its general creditors. For FDIC-insured custodian banks, FDIC insurance may provide limited protection to a fund’s cash deposits in the event of the bankruptcy of such bank. Generally, Vanguard funds hold only small amounts of cash in custodian bank accounts for liquidity purposes.

In a hypothetical failure of an FDIC-insured custodian bank, the FDIC would intervene, a receiver would be appointed, and custodied securities would be transferred to a stable FDIC-insured custodian bank. For example, upon the insolvency of Washington Mutual (which was not a custodian bank for any of the Vanguard funds), a transfer of assets to a stable bank took place within a 48-hour period with minimal disruption to clients.

If one of Vanguard’s custodian banks (including FDIC-insured custodian banks) were to show signs of financial instability, Vanguard would likely move assets to another of our solvent custodian banks well in advance of any imminent failure.

Does the SIPC provide any degree of protection here?

No. SIPC protects investors from the bankruptcy or insolvency of a brokerage firm. Neither Vanguard nor its custody banks are broker-dealers, so their clients do not receive SIPC protection.

Does it increase (or decrease) safety in any way to own ETFs rather than index mutual funds?

Assuming that the ETF is a 1940 Act vehicle and is therefore required to have an independent custodian, there is no meaningful difference between the two in terms of safety. As previously noted, the failure of a mutual fund’s service company or its custodian is extremely unlikely to result in a loss to the fund’s shareholders. For the same reasons, the failure of an ETF’s service company or custodian is extremely unlikely to result in a loss to the ETF’s shareholders.

Of course, because ETFs must be held in a brokerage account, owning an ETF introduces a third entity that could fail—i.e., the broker. However, this does not make ETFs less safe than mutual funds. If a brokerage firm holding an ETF in a customer account were to fail, the ETF’s shareholders would be protected by SIPC. In most cases, SIPC’s role is to ensure that customer cash and securities are still in the brokerage account and to organize an orderly transition of those assets from the failed brokerage firm to a solvent one. In the unusual case where some or all of a customer’s cash and securities are missing, SIPC insurance covers losses up to $500,000 (maximum of $250,000 for cash losses).

Does it increase (or decrease) safety in any way to own Vanguard funds at a separate brokerage firm (e.g., owning Vanguard ETFs in an account at Schwab)?

No. Investors’ assets are separate from the brokerage firm and are solely theirs. Consequently, a brokerage firm’s failure should not result in loss of customer assets. If in an extremely unlikely circumstance a client’s assets are lost (i.e., the Vanguard fund shares owned by the client have been removed from the client’s account), investors would be protected by SIPC up to the limits discussed above.

What prevents the fund custodian from committing fraud (e.g. siphoning off fund assets, but continuing to report that they’re all there)?

Many processes and controls are in place that would make it difficult for a custodian to commit fraud or for any fraud to go undetected.

  • Vanguard performs a rigorous due diligence review on each prospective custodian in order to understand its internal policies and procedures, including those intended to prevent fraud.
  • Vanguard and our custodians work closely on an ongoing basis to identify and address opportunities to improve the custody services that are provided, including fraud prevention.
  • A custodian may only act upon authorized instructions from an approved Vanguard officer or representative. Because Vanguard reconciles its internal accounting system for each fund with those of the custodian every day, any unauthorized trades or differences in securities positions or cash balances would be readily apparent to Vanguard and trigger immediate follow-up.
  • It would be difficult for a custodian to report that assets are in the fund if they are not. For example, the counterparty on the other end of a Vanguard buy or sell instruction for 100 shares of a stock would report a failed trade if the cash or shares did not settle as expected under the typical market practice of “delivery versus payment.” As a result, Vanguard would be aware that something was amiss at the custodian almost immediately.

If somebody at the custodian somehow committed fraud and the auditor didn’t notice it, would investors have any recourse?

Each Vanguard fund’s contract with its custodian provides that the custodian will be liable to the fund for any losses attributable to fraud. The fund — on behalf of its investors — would pursue a recovery against the custodian for these losses.

Would investors be meaningfully safer in any way if, rather than holding their entire portfolio at Vanguard in Vanguard funds, they held half at Vanguard and half at another brokerage firm with low-cost index funds (at Fidelity in their Spartan funds, for example)?

From a fund custody perspective, there is no meaningful advantage to an investor holding assets in that manner. Non-Vanguard funds are subject to the same custody requirements as Vanguard funds. It is reasonable to assume that other large, well-respected asset managers have similar controls and processes as Vanguard to prevent potential fraud by their fund custodians. Further, they are likely to want to appoint the most sophisticated and stable custodians for their funds, so there is the potential that certain fund assets will be custodied at the same bank.

Given the protections from creditors for mutual fund assets at custodian banks under applicable banking and contract laws, and assuming the funds in question have an industry standard custody contract in place, it is unlikely that splitting assets in this manner to diversify “custodial risk” would be particularly effective.

What prevents Vanguard from committing fraud in some way (e.g., taking a buy order and taking an investor’s money, but never sending the money or information of the order to the custodian)?

Vanguard has many controls in place to ensure that the funds it receives are handled properly and that it complies with all aspects of the law. One of those numerous controls includes spreading responsibilities across multiple roles in separate areas of Vanguard to, in part, protect against a single person being able to commit fraud.

If somebody at Vanguard somehow did commit such a fraud and the auditor didn’t notice it, would investors have any recourse?

Clients should certainly contact us directly, but they also can contact the funds’ boards of trustees or the funds’ primary regulator, the SEC.

Growth Stocks or Value Stocks for Young Investors?

A young investor asks,

“I have read that a growth tilt is a good idea for a young investor with a long time until retirement. I’m 24 and consider myself risk tolerant. What do you think about using Vanguard’s Growth Index Fund instead of their Total Stock Market Index Fund?”

First, we need to back up a step. When categorizing investments, “growth” can mean either of two different things.

“Growth” as opposed to “Income”

The first possible meaning is a part of a classification system (used, for example, by Edward Jones, Dave Ramsey) in which investments are labeled as either growth, income, or growth-and-income. Using this terminology, most stocks and stock mutual funds would typically be categorized as “growth.” (High-dividend stocks would usually be categorized as growth-and-income.)

I suspect this is what your source meant with his/her suggestion that young investors should allocate a large part of their portfolios to growth investments. But, as it turns out, this growth-as-opposed-to-income characteristic is not exactly what the “growth” in Vanguard’s index fund and ETF names refers to.

“Growth” as opposed to “Value”

Fund companies can name their funds almost anything they want, but with regard to Vanguard’s index funds (and with regard to Morningstar’s classification system), when something says “growth,” that’s as opposed to “value.” And it refers to the fact that the fund owns primarily growth stocks instead of value stocks.

Growth stocks are those of companies whose profits are expected to grow more quickly than average. And value stocks are those of companies whose profits are expected to grow more slowly than average.

But the fact that growth companies are expected to grow more quickly than value companies does not mean that growth stocks are expected to earn higher returns than value stocks. This is because the higher-than-average expected growth in profits is already built into the price of growth stocks. A growth stock will generally only have above-average returns if the company’s profits grow more quickly than expected.

In other words, while growth companies are expected to grow more quickly than value companies, funds that own primarily growth stocks are not expected to grow any faster than their counterparts. (In fact, if anything, it’s the value funds that have higher expected returns.)

For example, Vanguard Small-Cap Growth Index Fund does not have higher expected returns than Vanguard Small-Cap Index Fund or Vanguard Small-Cap Value Index Fund. And Vanguard Growth Index Fund’s expected returns are no higher than those of Vanguard’s Total Stock Market Index Fund.

So, for a young investor, it’s possible that personal circumstances would make a tilt toward growth stocks advantageous. (For example, if you had reason to think that your job safety had an unusually strong correlation to value stock returns, you might want to tilt your portfolio away from them and toward growth stocks so as to reduce the likelihood of your portfolio crashing at the same time that you get laid off.) But such cases are not common. And a desire to increase the risk and expected return of your portfolio is not really a good reason to tilt toward growth stocks.

Accepting Your Risk Tolerance

Jenna writes in, asking:

“I recently started working with a financial advisor who was recommended by a friend. As part of the initial meeting, the advisor gave me a book by Nick Murray. The gist of the book appears to be that 1) because I’m a long-term investor, the best allocation is 100% stocks and 2) my advisor’s primary purpose is talking me into sticking with that allocation when the market takes a dive. Am I right that this should be setting off all sorts of mental alarms?”

Back when I worked for Edward Jones, Nick Murray was a favorite author among advisors in my region. I agree that one of the most valuable services provided by an advisor is to help people refrain from panic selling after market declines. But I would argue that the first and most important step to achieving that goal is to help the investor find an allocation that’s a good fit for his/her risk tolerance so that there’s no panic in the first place.

Can Risk Tolerance Change?

There are two groups of factors that determine your risk tolerance:

  1. Your life circumstances (e.g., job security, flexibility with regard to goals, a pension that satisfies your basic spending needs), and
  2. The the stuff inside your head (e.g., how comfortable you are with unpredictability, how much you worry about scary world news or economic news, how much stress it causes you if your portfolio drops by X%).

When I first started writing this blog, I thought investors should actively work to increase their risk tolerance by changing the second item above. In essence, learn to care less about volatility so that you can have the higher expected returns that come with higher-risk allocations.

For example, if I met a 20-something investor who expressed fear about investing his retirement savings in stocks, my approach would have been to explain to him that he doesn’t need to worry about market fluctuations because he’s so many years away from spending the money. Then I would have suggested that he use a stock-heavy asset allocation because of his young age.

In the few years since, my view of the matter has changed dramatically. I now believe it’s a much better idea to understand and accept who you are. Forcing yourself into a high-risk portfolio is a dangerous proposition if you’re not truly comfortable with it to begin with.

In other words, if I met a particularly risk-averse 20-something investor today, I would still explain that he doesn’t need to worry about market fluctuations from year to year. But I’d then suggest he use a fairly conservative allocation anyway, because the truth is, this investor probably will worry about market fluctuations, regardless of the fact that other people tell him not to.

Using REITs to Save for a Down Payment

A reader writes in, asking:

“What do you think about using Vanguard’s REIT ETF rather than CDs or a savings account as a way to save up money for a down payment on my first home? My line of thinking is that a REIT fund would likely outperform such low-risk investments, and if the fund has a loss, it might not even be a problem because it’s likely that real estate prices will be falling as well.”

There’s certainly a degree of common sense appeal to such a strategy.

  • Like any stock fund, it’s true that a REIT fund will earn higher returns than CDs or savings accounts over most periods.
  • And it’s true that a REIT index fund or ETF would usually be more closely correlated to home prices than other stock investments would.

But it’s still a risky way to save because you can’t count on a high correlation between the price of the home you want to purchase and the performance of a REIT index fund or ETF.

Commercial Real Estate vs. Residential Real Estate

Most REIT index funds have the majority of their assets invested in commercial REITs rather than residential REITs. (See, for example, the holdings of Vanguard’s REIT index fund.) As a result, there’s a real possibility that home prices could be rising (making your desired home purchase more expensive) at the same time that the price of your REIT fund is falling due to a poorly-performing commercial real estate market.

Real Estate is Local

It’s also important to remember that home prices don’t move in lock-step across the country. Home prices could be falling overall, while home prices in your area are holding steady or even climbing. If your REIT fund’s price falls along with most home prices, saving for a home in your area will be a challenge in such a scenario.

To pick two examples off the top of my head: Asheville, North Carolina and Hot Springs, Arkansas — two places we had considered moving to last year — both saw home prices increase through 2007 and 2008. Trying to save for a down payment in one of those cities would have been rather difficult if you were using an investment that, like Vangaurd’s REIT index fund, lost almost half of its value (47%) over those two years.

It’s Not Crazy. But It’s Not Safe Either.

Using a REIT fund to save for a home down payment probably would make more sense than using something like a total stock market index fund, because the REIT fund probably would have higher correlation to home prices in your area. But again, that correlation isn’t going to be very reliable.

And a REIT fund will likely earn you greater returns than a savings account would. But when I say “likely” here, all I mean is “greater than 50% probability.” It’s not at all something you can count on. And it makes the worst-case scenario significantly worse (home prices increasing while the value of your savings is decreasing — something that can’t happen with a savings account).

In short, unless you’re very flexible with regard to when you purchase the home (such that you wouldn’t mind waiting several years for your REIT fund to bounce back after a decline), I’d suggest sticking with the normal advice: Use something safe for short-term savings.

Risk Tolerance in Action

Credit where credit is due: The inspiration for this article comes from a recent post on the Bogleheads forum: “A Time to Evaluate Your Jitters.” I strongly encourage you to read the post, as the author made his points more eloquently than I’ll be able to.

In the last week we’ve mentioned two productive things to do during a market downturn:

  1. Rebalance your portfolio, and
  2. Check for tax-loss harvesting opportunities.

Today let’s add a third: Get a first-hand evaluation of your risk tolerance.

Is Investing Supposed to Be This Difficult?

If my email inbox is any indication, many investors have found it difficult to stick to their investment plans this week. Their plans call for rebalancing (which in this case means selling bonds and buying more stocks), but they’re nervous about doing so.

Rebalancing isn’t supposed to be easy. Selling your better-performing assets to buy more of your worse-performing ones is difficult for most investors.

But it’s not supposed to give you an ulcer or heart attack either. If you’re experiencing that degree of hesitance to stick to your original plan, what you’re getting here is first-hand, concrete evidence that your risk tolerance is not as high as you thought it was.

If the only way you’re going to be able to sleep at night is to use a lower stock allocation than your original plan called for, then so be it. It’s a costly lesson, but it’s a valuable one too.

So don’t waste it.

Whatever stock/bond allocation you end up settling on, do not move to a more aggressive allocation in the future. Otherwise you’re likely to repeat the same mistake when the market takes its next downturn.

A lower-risk, lower-expected return allocation that you can stick with is much better than a higher-risk, higher-expected return allocation that has you panic-selling in every bear market.

But This is Unprecedented!

Several readers have told me that this week has been an exception. They’re normally risk-tolerant, but this decline has been particularly difficult to deal with because the events causing it are so unprecedented.

But that’s the point. It’s always unprecedented.

Think back to the end of 2008. The housing market was crashing. The biggest, most famous financial institutions were failing one by one, and experts were predicting that our entire financial system would literally collapse if the Federal government didn’t step in to hold the pieces together. It was unprecedented.

Or think back to 2001. The technology sector upon which we’d pinned our hopes of wealth and prosperity had started to come to pieces. Then, after about a year of the market declining, terrorists attacked us on our own soil, killing thousands of people. To say that that was unprecedented is an understatement.

Risk tolerance isn’t just about your ability to deal with abstract market declines. It’s about your ability to stay calm while your portfolio is tanking and you’re being inundated with news of frightening, sometimes genuinely catastrophic, I-never-thought-this-could-happen type events.

Risk Means Different Things to Different People

In a recent guest post, the author (Neal) argued that an investment in real estate becomes less risky the longer it’s held. In the comments, two readers (Dylan and The Finance Buff) disagreed. One even argued that such an investment becomes more risky the longer it’s held.

So who was right?

As far as I can tell, they all were. They were just using different definitions of risk.

Traditional Risk Measurement

In traditional finance literature, variability (specifically, standard deviation) of annualized returns has often been used as a measurement of risk.

Perhaps the most famous example of someone using this definition is Jeremy Siegel in his mega-selling Stocks for the Long Run in which he argued that stocks become less risky the longer you hold them because (historically in the U.S.), the standard deviation of inflation-adjusted annualized stock returns has been smaller over longer periods than over shorter periods.

Variation in Total Ending Value

Others argue that risk is better measured as variability of total ending values. This definition turns the “stocks become less risky with time” idea on its head. When measured in terms of ending value, stocks (and other investments with highly variable returns) become more risky the longer you hold them because, when compounded over a few decades, even a slight difference in annual returns leads to a dramatic difference in total ending value.

Probability & Magnitude of Shortfall

Still others argue that the best definition of risk involves probability and magnitude of a shortfall–that is, the risk of not having the amount of money you need when you need it.

Using this definition, the riskiness of an investment depends on your expectations for it and on how you plan to use it. For example, even if an investment steadily delivers 4% inflation-adjusted returns every single year, it’s going to be a problem if your financial plan was relying on 7% returns.

Probability & Magnitude of Loss

Finally, it can be helpful to consider risk as probability and magnitude of loss. But, as with the previous definition, this one varies from person to person. For example:

  • Are you going to experience significant stress any time you sign into your brokerage account and see that the portfolio value is lower than last time you checked?
  • Or, for instance, would you be OK as long as the value is higher than it was, say, three years ago?
  • Or would you be OK as long as the decline is smaller than a given percentage?
  • Or would you be OK as long as the decline is smaller than a given dollar value?

Why Is This Important?

I think there are two useful takeaways here.

First, when you hear writers, financial advisors, or anyone else use the term “risk,” be aware that they could mean any of several different things. If the meaning isn’t clear, ask.

And more importantly: When assessing your risk tolerance, put some thought into what type(s) of risk you care most about. This information will play an important role in selecting an appropriate asset allocation.

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