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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.

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  1. It certainly seems like the “risks” of just using Vanguard are absurdly negligible when comparing to the relative long-term cost reductions you get when going with Vanguard exclusively.

    As crazy as Vanguard fraud or failure sounds, it is nice to know the answers to those questions. Thanks.


  2. I am not in the least worried about Vanguard. But a valid question, to my mind, would be how investors can protect themselves from falling into a Ponzi scheme like Bernard Madoff’s.

  3. Way to go Mike! Thanks for putting this article together, I was thrilled to hear that you were working on it as I was one of the many readers wondering about this 🙂

  4. Larry,

    To the best of my knowledge, the most important thing somebody can do to avoid falling victim to a Ponzi scheme is to make sure that their advisor/manager is not the same as their custodian.

    In the case of Madoff, his firm was both the money manager and the custodian. His clients/victims received statements from his firm, reporting nonexistent holdings.

    In the case of reputable money managers, a separate custodian is used. For example, clients of Rick Ferri’s firm have their assets held by Schwab, and they receive periodic statements directly from Schwab, so they know the investments are really there.

  5. This weekend my mother asked me the same question, as I’m finally getting around to helping her get her finances in order, suggesting that she move everything to a few index funds at Vanguard. Thanks Mike!

  6. LIttleJohn says

    Thanks for doing the work on this and many other fine articles!
    Even though the institutional/custodial risk is minimal, one still should’nt have all their eggs in one basket.
    Tangentially, lack of FDIC/SIPC coverage isnt the only reason for not keeping cash in a MM fund at VG or elsewhere.

  7. Thank you, Mike. Chances are the Madoff case was one in a million that may never recur in its exact form again, but still a lot of intelligent people invested with Madoff and may have felt they were exercising due diligence before doing so. Perhaps the fact that his funds never seemed to lose money should have been another tipoff that this was a fraudulent situation.

  8. Sam I Am says

    That was an awesome effort on your part, Mike! As a regular reader of the Boglehead forum, I know how frequently these type questions are raised. Though I consider myself an experienced investor, there were a couple of new things that I learned as well.

    For a new investor, this is a great resource, one that answers virtually every question a newbie might have on the subject of using single investment company for all investments.

    Heck, I feel better about using Vanguard after reading, myself!

  9. Sam I Am,

    I’m happy to hear you enjoyed the article. To be clear though, the awesome effort was surely Linda’s (for finding the answers to the questions), rather than mine.

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