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Vanguard Cannibalizes Its Referral Business

Background.

The Company The Vanguard Group, the second-largest mutual fund company in the U.S., plans to start providing personal financial advice to investors "despite the risk of alienating thousands of financial advisers who bring it business." [Vanguard Is Heating Up Advice War (WSJ, 3/20/96, p. C1)]

 On financial advisers/planners. Financial planners typically don’t collect any commission on the recommended funds, but get paid a percentage of their clients’ assets. Mutual funds, on the other hand, charge a management fee-a fixed percent (.45-2.5) of the clients’ assets. Although they are not as common a practice as they once were, in addition to management fees, some funds charge a "load"--a commission for the purchase (up-front load) and/or for the sale of the mutual fund (back load) ranging from 1%-8%.

 About 25% of the assets in Vanguard’s funds came through financial advisers, notes the Journal.

Q&A

Q. So if they are expected to cannibalize their "referral" business, why is Vanguard doing it?

A The NPV criterion can be used here. Vanguard must believe that this project has a NPV>0.

Q. Where is the additional value coming from?

A Additional value is created only if the net effect on cash flows is positive. Vanguard hopes to generate advising fees greater than the management fees that they would lose from the "referral" business. Moreover, there is indication that the financial planning business itself is growing and is "attractive."

Q. What is meant by "attractive"?

A Note that "attractive" is not the same as profitable. For a business to be attractive it must be creating returns higher than the opportunity cost of doing business, i.e., the business must be a NPV>0. Thus, being attractive implies being profitable, but not the other way around. Put differently, when valuing decisions, you need to consider the risk of the profit, not just its magnitude.

 

By Alex Tajirian