How Does Vanguard Make Money? The Surprising Truth Behind Their Low Fees

Ever wondered how Vanguard manages to offer some of the lowest fees in the investment industry while still keeping the lights on? I’ve been investing with them for years and finally decided to dig into their business model. What I found was pretty interesting!

Vanguard has built an empire worth trillions by charging what seems like pennies compared to traditional investment companies. But those pennies add up in fascinating ways. Let’s break down exactly how Vanguard makes its money and why their unique structure has revolutionized investing for everyday people like us.

The Vanguard Business Model: Not Your Average Investment Company

Vanguard isn’t structured like most financial companies While most investment firms are owned by shareholders or private entities who expect to profit from the business, Vanguard operates under a unique “mutual” ownership structure

Here’s the big difference Vanguard is actually owned by its funds, which in turn are owned by the investors in those funds This means that essentially, we (the investors) own the company! This unique setup eliminates the conflict between shareholder profits and investor returns that exists at most financial companies

Primary Revenue Sources: How Vanguard Actually Makes Money

Despite their reputation for rock-bottom fees, Vanguard still needs revenue to operate. Here are the main ways they generate income:

1. Expense Ratios: Small Percentages, Massive Scale

The primary way Vanguard makes money is through expense ratios charged on their funds. These fees might seem tiny, but they add up when applied to trillions in assets.

For example:

• Vanguard Total Stock Market Index Fund (VTSAX) charges just 0.04%
• On $1.8 trillion in assets (as of Nov 2024), that’s about $720 million annually
• Even their highest expense ratios rarely exceed 0.20% for index funds

When you compare this to the industry average where many funds charge 1% or more, you can see why investors flock to Vanguard

2. Account Service Fees

Vanguard also charges various account service fees, though many can be avoided:

• Account maintenance fees (waived for larger balances or by opting into electronic delivery)
• Transaction fees for certain types of trades
• Account closeout fees

I personally avoid most of these by maintaining a decent balance and doing everything electronically.

3. Advisory Services

For investors seeking more guidance, Vanguard offers:

• Vanguard Personal Advisor Services (0.30% advisory fee)
• Wealth management services for high-net-worth individuals
• Financial planning services

These higher-margin services help supplement the revenue from their ultra-low-cost core business.

The Secret Sauce: Index Sampling & Passive Management

Vanguard’s ability to charge such low fees stems directly from how they manage their funds. The company pioneered passive index investing when John Bogle launched the first index fund tracking the S&P 500 back in 1976.

Passive Management: Keeping Costs Down

Rather than paying teams of analysts to pick stocks (active management), Vanguard primarily uses passive management for their index funds. This approach:

• Eliminates the need for expensive research departments
• Reduces trading costs from frequent buying and selling
• Requires fewer highly-paid portfolio managers
• Results in lower overhead costs overall

As the article mentions, “Fees for active management are generally higher than for passively managed funds. Actively managed funds have higher trading costs since there is a greater turnover in fund holdings.”

Index Sampling: Smart Shortcuts

Another clever technique Vanguard uses is called index sampling. Instead of buying every single security in an index (which would be expensive and complicated), they use representative sampling to approximate the performance of the benchmark.

For example, the Vanguard Total Stock Market Index Fund holds 3,654 stocks to track its benchmark index, rather than the thousands more that might technically be included in the “total stock market.”

This sampling technique allows Vanguard to:

• Keep trading costs lower
• Manage fund inflows and outflows more efficiently
• Maintain minimal tracking error (difference between fund performance and index performance)

Economies of Scale: Bigger Is Cheaper

Being massive helps Vanguard keep costs low. With $8+ trillion in assets under management, Vanguard benefits from enormous economies of scale:

• Fixed costs are spread across a huge asset base
• Greater bargaining power with trading partners and service providers
• Technology investments can be amortized across millions of customers
• Marketing costs per customer are minimal due to strong word-of-mouth and reputation

This creates a virtuous cycle: lower costs attract more investors, which increases scale, which allows for even lower costs.

The Impact of Vanguard’s Low-Cost Approach

Vanguard’s fee structure has had a massive impact not just on their own success but on the entire investment industry:

Investor Benefits

When Vanguard charges an expense ratio of just 0.04% instead of the 1% that was once common:

• On a $50,000 investment over 20 years (assuming 6% annual return), investors save over $11,000 in fees
• These savings compound over time, significantly boosting long-term returns
• Investors keep more of what they earn

Industry Disruption

Vanguard’s model has forced the entire investment industry to lower fees:

• Competitors like Fidelity, Schwab, and BlackRock have slashed their own fees
• Many now offer zero-fee index funds (though they make money in other ways)
• Active managers have had to justify their higher fees with actual performance

Why Vanguard Doesn’t Need to Maximize Profits

Unlike most financial companies that need to maximize shareholder returns, Vanguard’s unique structure means it only needs to generate enough revenue to:

1. Cover operating expenses
2. Invest in technology and service improvements
3. Maintain reasonable cash reserves

There’s no pressure to extract maximum profits from customers because the customers ARE the owners. This aligns incentives in a way that’s rare in the financial industry.

The Growth of Index Investing: Vanguard’s Rising Tide

Vanguard has benefitted enormously from the shift toward passive investing. According to the article, “In 2010, index funds represented less than one-fifth of total equity fund market share. By 2020, this grew to more than 40%. In 2019, the total assets invested in U.S. stock index funds for the first time surpassed the assets of funds actively managed by human beings.”

This trend has been a windfall for Vanguard, as the pioneer and largest provider of index funds. Their first-mover advantage and reputation for low costs have made them the default choice for many index investors.

Challenges and Criticisms

Despite their seemingly perfect business model, Vanguard does face some challenges:

• Race to zero fees: Competitors offering zero-fee funds puts pressure on Vanguard
• Customer service concerns: Some investors complain about wait times and service quality
• Technology investments: Keeping up with fintech competitors requires significant investment
• Active management struggles: Their actively managed funds face the same challenges as other active managers

The Bottom Line: A Different Kind of Financial Company

So how does Vanguard make money? Through tiny fees applied to enormous sums, supplemented by additional services for those who want more help. Their mutual ownership structure means they only need to cover costs and invest in improvements rather than maximize profits.

I’ve personally been a Vanguard investor for years because I appreciate their straightforward approach. The fact that they can run a successful business while charging a fraction of what their competitors once did shows the power of their model.

For most investors, Vanguard’s low-cost index funds remain among the most sensible options available. As the largest issuer of mutual funds globally and the third-largest ETF provider, they’ve proven that putting investors first can also be good business.

FAQs About How Vanguard Makes Money

Q: Does Vanguard make less money than other investment companies?
A: On a per-dollar-managed basis, yes. But their massive scale means they still generate significant revenue overall.

Q: Can Vanguard funds ever be free (0% expense ratio)?
A: Unlikely under their current model. Since they don’t have other business lines to subsidize truly free products, they need to charge something to cover costs.

Q: Do Vanguard employees make less than those at other financial firms?
A: While Vanguard may not pay the astronomical bonuses seen at some Wall Street firms, they offer competitive compensation, especially considering they’re headquartered in lower-cost Malvern, PA rather than New York or Boston.

Q: Does Vanguard make money from securities lending?
A: Yes, like most fund companies, Vanguard can generate additional revenue by lending securities to short-sellers. However, most of this revenue is returned to the funds rather than kept as profit.

Remember, when it comes to investing, what seems too good to be true usually is – except maybe in Vanguard’s case, where their unique structure really does align their interests with yours. That’s probably why they’ve grown from an industry oddity in 1976 to managing over $8 trillion today!