Ric Edelman Accuses Vanguard of Hiding Fees

Last Updated Mar 2, 2011 7:56 PM EST

On his radio show, The Truth about Money, prominent independent financial planner Ric Edelman accused Vanguard of hiding fees as much as 1.40 percent annually. This did not go unnoticed by the Bogleheads Forum, a group of nearly 20,000 investors who discuss financial news and theory. Is Edelman right? Let's look at the claim, the facts, and responses from both Vanguard and Edelman.

The Truth About Money
About 21 minutes into his February fifth radio show, Robert from Newport, California, called in and asked whether Vanguard's claim of total expenses of .06% annually is true? Edelman called Vanguard's claim "a little disingenuous," and went on to say that funds have other costs for trading stocks that average 1.4 percent annually. He concluded by telling the caller, "So in addition to the .06 percent, add another 1.4." He has since removed this part form the pod recast.
Edelman is referring to costs all funds have in addition to the stated expense ratio. As he stated, mutual funds incur brokerage costs from trading stocks. In addition, mutual funds pay soft costs for product placement, and can pay market impact costs when their volumes are large by paying a higher price when buying and selling for a lower price. The 1.4 percent annual hidden fees that Edelman quoted are close to other estimates I've seen of the industry average. But is it true for Vanguard?

The facts please?
The only Vanguard fund requiring less than a million dollar investment charging a .06 percent annual expense ratio is the Vanguard S&P 500 index fund ETF (VOO). If Edelman's claim is true, it would stand to reason that this fund should underperform the total return of the S&P 500 index by 1.46 percent annually (.06% expense ratio plus 1.40% hidden costs).

While this ETF was only launched last September, the mutual share class of this same fund has been around for decades. So if we compare the return of the Vanguard S&P 500 Index Fund Admiral share class (VFIAX), having a 0.07 percent expense ratio, with the total return of the S&P 500 index over the past ten years, the results are as follows:

Instead of underperforming by 1.47 percent annually to support Edelman's statement, the fund came within 0.016 percent of the benchmark. This means Vanguard shareholders not only avoided the 1.4 percent fees Edelman claimed, but also seemed to only pay 0.016 percent of the 0.07 percent expense ratio currently charged by Vanguard.

Vanguard's response
I asked Gus Sauter, Vanguard's Chief Investment Officer, to listen to the Edelman claim and respond. Sauter responded "that's painting things with an extremely broad brush." He noted that the case for indexing recognizes that indexing is largely a buy and hold strategy, so an index portfolio incurs a fraction of the transaction costs of an actively managed fund. He stated, "At the end of the day, you just have to compare the performance of the fund versus the index."

Sauter further went on to say "we also look for opportunities to reduce transaction costs, and even turn them in our favor by arbitraging futures when they are cheap relative to the index, or by trading prudently to avoid significant market impact. And, in some cases, we even have transaction costs work in our favor by placing limit orders."

Edelman's response
Ric Edelman called me back and stated that he didn't mean to imply that this Vanguard fund had hidden expenses of 1.4 percent annually. He noted, however, that mutual fund families pay for shelf space such as Schwab's OneSource platform, though he wasn't sure whether Vanguard used such practices. Rebecca Katz, Vanguard Public Relations Principal, addressed the matter with certainty by saying "We do not pay for distribution on third party platforms. Period."

I showed Edelman the Vanguard S&P 500 performance versus the benchmark and he responded with the following statement:
Assuming the quote from the show is accurate (no doubt, as you're a thorough guy!), then I clearly didn't say what I meant to say.
He noted he would make the correction on this week's show and remove the clip from the podcast.

My take on the matter
Ric Edelman brings up an important point on hidden costs of mutual funds but does so in a misleading manner. Broad index funds have lower turnover and thus the case for indexing is even stronger. While I applaud Edelman for saying he would correct the matter, there is still much that we don't see eye-to-eye on, particularly regarding fees.

Fees do matter and I've written on one portfolio where Edelman charged 1.79% annually. I believe high cost indexing is an oxymoron. Further, in the same February 5 radio show, Edelman touts the benefits of having a mortgage which I couldn't disagree with more strongly. I've questioned the fact that Edelman's fees are reduced when funds are withdrawn from his management to pay off the mortgage.

On another note, this issue did bring up the fact that Gus Sauter has managed to close the gap between the total return of an index and the fund's return to far below the expense ratio. Now that's what I call genuinely good for the shareholder. Edelman isn't convinced, responding "I think it's luck, due to the tracking error. It could just as easily have been wrong in the other direction - and at times, I'd bet it would be."

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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