Why Vanguard Avoids Collaborating with Rivals to Increase Index Fund Fees

Is there a reason why Vanguard doesn't collaborate with its rivals like Fidelity and State Street to have their index funds fees increase every year? This question boils down to both legal restrictions and corporate strategy.

The Legal Perspective: The Sherman Antitrust Act

The simple answer lies in the perfectly legal environment provided by the Sherman Antitrust Act. Competitors cannot collude on pricing; it's explicitly forbidden by law. The Sherman Antitrust Act ensures that businesses operate ethically and independently.

The Strategic Perspective: Why Vanguard Chooses to Lower Fees

Vanguard's strategy is significantly different from its competitors. The company is not driven by profit but by a philosophy of cost minimization. Vanguard is owned by the very funds it manages, adhering to a unique structure where profits are distributed back to the funds themselves.

Vanguard’s Cost-Plus Model

Vanguard operates at near-cost. Its operational costs are covered by the funds themselves, ensuring that any surplus goes back to the investors. The larger these funds grow, the lower the expense ratio becomes due to economies of scale. This residual income is passed on to fund investors, resulting in much lower fees. However, there is a current tax issue regarding this model, and it remains to be seen whether Vanguard will have to adopt a transfer pricing model.

Fidelity’s Differentiator

In contrast, Fidelity is a profit-driven company. It extracts profits from the funds it manages, which is why it is able to maintain lower fees only so long as it competes with Vanguard. The losses in profit on the lower fees make it a difficult and ultimately unsustainable strategy for Fidelity in the long run.

The Market Dynamics: No Collusion Needed

Market competition naturally keeps fees low. Index fund fees are typically low because the management requires minimal involvement, with little to no active fund management or research. The primary goal is to closely mimic the movements of an existing index, often achieved with the help of computers.

Competition Without Collusion

Firstly, the difficulty of collusion is high. Pricing agreements would be easily detected due to the lack of a reasonable explanation for synchronized fee hikes. Second, the index fund market has low barriers to entry. Any firm can set up an index fund relatively easily. The larger funds currently dominate due to their lower fees, which attract more investment. Any attempt to raise fees would be met by competition from smaller funds that offer lower cost alternatives.

Conclusion

Vanguard’s commitment to reducing fees and its unique ownership structure provide a strong rationale against any form of collusion with other fund managers. Meanwhile, the competitive nature of the market ensures that fees remain low, without the need to illegally collude. The key to understanding this situation lies in understanding both the legal framework and the strategic choices of individual providers.