Thursday, February 11, 2016

How Much Profit Should Vanguard Make on Managing Your Assets?

Justin Fox reports on a weird transfer pricing issue that I have been following:
Near the end of last month, mutual-fund giant Vanguard announced that it had lowered the expense ratios on 35 of its mutual funds. That’s after a December announcement that it had lowered expense ratios on 53 funds. All in all, Vanguard estimated, the changes resulted in an $87.4 million reduction in the fees paid by its customers. Isn’t that outrageous!?!?! I mean, seriously, how shameless can these guys get? That, in short, is the argument Vanguard tax lawyer turned whistle-blower David Danon and his hired expert, University of Michigan law professor Reuven S. Avi-Yonah, are making. Yes, there's a more complicated legal angle involving transfer pricing. More on that in a bit. But the underlying reasoning is simple: Vanguard is cheating state and federal tax authorities by charging its customers much less than other fund companies do.
We’ll return to the transfer pricing later as well. I’m not a tax lawyer so forgive me if I get this one wrong. Vanguard’s customers are also its shareholders. If they did raise the fee so as to make C corporate profits taxable at 35% - would not their rich customer/owners get a deduction off their taxable income which may now be at a rate of 39.6% (under Bernie make that 52%)? OK – let me turn to something I do get – transfer pricing:
Danon and Avi-Yonah argue that it is still required to charge “arm’s length” fees similar to what other management companies charge. At almost every mutual-fund group other than Vanguard, the management company is out to make a profit
I have a lot of respect for Avi-Yonah as a tax professor but when I read his report, I realized any competent economist for Vanguard could push back. And the reason is in that Morningstar report:
The asset-weighted expense ratio for passive funds was just 0.20% in 2014, compared with 0.79% for active funds.
Avi-Yonah’s analysis would take the overall average of 0.64% for the intercompany fee for Vanguard which is four times its costs. A profit to cost ratio of 300% sounds incredibly high. But Vanguard is a passive fund not an active fund. So wouldn’t the appropriate comparable fund analysis suggest a fee closer to 0.2% of assets under management so the profit to expense ratio would be around 25%? Justin Fox does a nice job of presenting whether or not the IRS could or even should pursue this. But if they did – one would hope their transfer pricing analysis would be a bit better developed.


davidcay said...

The issue is that the Internal Revenue Code does not take into consideration Vanguard's structure, in which mutual fund investors own (but do not control) the investment manager, Vanguard Group Inc.

I explained this in plain English back in December in Newsweek (so long before competitor Time):

Reuven Avi-Yonah's analysis is compelling. He is also the most widely read tax scholar in America and the fee he charged for writing an opinion, $850 per hour, is modest considering what others with similar skills charge.

My Newsweek piece also explains how this matter can be resolved.

JDM said...

Gotta say, to me this sounds utterly stupid. And utterly wrong. (Not incorrect, that is, but wrong.) And thanks, davidcay, for the link to your piece.