What If Vanguard or Fidelity Went Bankrupt?

Continuing on the line of thinking started by my post on What if my bank fails?, the next question might be what if my mutual fund company went bankrupt? I mean, I have a lot of money in Vanguard and Fidelity right now. What happens if one of them “pulls an Enron” or simply runs out of money?

One source of information is this 2004 Money magazine article written shortly after previous mutual fund scandals:

What happens if my fund company fails?
Your money is safe. Under the Investment Company Act of 1940, which governs the industry, each fund is set up as an individual corporate entity, with its own board of directors. Essentially, your fund hires the fund company to manage its assets. If the company were to file for bankruptcy, its creditors would not be able to touch the funds’s assets. And the fund’s directors could immediately hire a new manager, pending shareholder approval.

The way I read this, mutual fund managers are interchangeable. If the fund company goes bankrupt, the assets would remains the same, one would just have to hire a new company to manage it. In addition, one of the features specific to Vanguard is that it is set up as client-owned. How this works is that each of us might own a share of a mutual fund like VFINX. In turn, that mutual fund is a separate entity that contributes money to fund Vanguard’s operations, instead of the other way around. Here is an excerpt from Mel Lindauer of the Diehards forum, which explains this setup well:

First, The Vanguard Group Inc. (VGI) is actually a subsidiary of the various mutual funds, each of which is a separate legal entity. The best way to describe Vanguard’s unique structure would be to think of General Motors turned upside down, with Chevrolet, Cadillac, Oldsmobile, Pontiac, etc. as the corporate parents, and General Motors as a subsidiary. If you think of Chevrolet, Cadillac, Oldsmobile, Pontiac, and the other GM divisions as mutual funds, and General Motors (the subsidiary, in this situation) as Vanguard Group Inc., you’ll get the picture.

Since VGI is actually owned and funded by the various mutual funds, it technically couldn’t go bankrupt unless all of the various mutual funds that support it went bankrupt. The only way that could happen would be for the value of all of the stocks and/or bonds held by each and every individual Vanguard mutual fund to go to zero. So, forget about Vanguard going bankrupt — it just isn’t going to happen.

Some have expressed concerns about putting “all their eggs in one basket” by consolidating their investments at Vanguard. There’s simply no need to worry about that. Each fund is a separate investment company (and part owner of the Vanguard Group, rather than the other way around). Thus, having all of your investments in several Vanguard funds is tantamount to having your investments spread among a variety of baskets, each independent of the other. So, put your fears to rest; your investments are safe at Vanguard.

The Real Question – Ethics and Management
In the end, the real fear that one should have is that their mutual fund management will simply make poor or reckless investment decisions and lose your money perfectly legally. Also, in previous ethics scandals, managers also performed illegal trading or other activities specifically forbidden in their prospectuses. This is why ethics and consistency of management should be a component of why you choose to invest in a mutual fund, and why I feel very comfortable with the majority of my assets in Vanguard index funds.

I have never heard of a mutual fund company going out of business. But I’ve read about a lot of bad mutual funds with horrible performance. And this drop usually happens after a period of great performance and the heavy advertising and money inflows that ensues. Something to think about.

Comments

  1. What a great post! I never knew that was how mututal funds were set up. It’s good to know the funds are set up in a way to ensure the money is safe from outsiders. Poor performance on the other hand…

    I think that is why I also like Vanguard and their super cheap index funds! :)

  2. Independent George says:

    If the value of VTSMX has dropped to zero, then the value of the underlying assets must also have dropped to zero.

    If the underlying assets in a total market index has dropped to zero, then the US economy has collapsed overnight.

    If the US economy has collapsed overnight, then the global economy will also have collapsed overnight.

    If the worldwide economy has collapsed overnight, then my chief concern won’t be the value of my retirement portfolio, but finding fresh water, ammunition, and batteries so that I mght survive another day against hordes of brain-eating zombies which have taken over the world.

  3. Talking about bad management, how about fraud. I mean what if the reported daily NAV is not an actual reflection of the underlying fund assests. The fund manager (fraudently) inflates the NAV. Are there checks in place for that.

  4. If the sky is falling you hold a little money in gold…

  5. Thanks for the post. After reading your bank post, this is exactly what I was wondering since I have much more money in Fidelity mutual funds than I have in my bank.

    About performance, this is one classic reason why chasing performance is bad. As funds do well, they get more popular and bloated which makes it very hard for the manager to manage all those assets and they start doing more poorly. Fidelity Magellen is, of course, a classic example of this. I think some fund companies have caught on to this problem and started closing funds to new investors early enough to try to prevent this. In 2006, Fidelity closed quite a few funds.

  6. Hi!
    I?m from Argentina, and this post is excellent, but not necesarely true, at least, here. In 2001 we have a economic-political-social breakdown and all the banks in Argentina (I?m talking of citybank, HSBC, BBVA, Santander, Scotia, ABM amro, etc) closed all the customers accounts and kept the money. DO you understand what I am saying?? Because of the economic inestability (due to IMF receipts), they take all the money away, far away, to their?s central houses, although at the beginning all this banks were the same bank here, in new york or in Bangladesh!! Ok, long story short, there were a lot of Germans, Italians and others retired peolpe from all around the globe that have the mutual funds here, in Argentina, and they lost every penny. And of course, us, the people from Argentina, also lost every money we have in funds, banks, etc.
    But this is just the way it is here. This is difficult to understand for the eyes of a stock holder first world enthusiast. But never subestimate what can be done by a group of people with power that doesn?t care about anything else that money. If not, think about international laws, UN, Bush, Halliburton and all the problems the states developed in Middle East to get more oil (and money)!.
    See you!

  7. Interesting. I have Vanguard funds. I bought them a few months ago and they’re steadily climbing. My Google shares, on the other hand, are all over the place, like me after too much coffee.

  8. Steve Austin says:

    I target 3-5% net worth in gold. Call it Independent George’s Zombie Self-Insurance Policy.

  9. “Talking about bad management, how about fraud. I mean what if the reported daily NAV is not an actual reflection of the underlying fund assests. The fund manager (fraudently) inflates the NAV. Are there checks in place for that.”

    The answer appears to be yes. From the Mel link above:

    Another huge and very important difference between Vanguard’s mutual funds and the Enrons and WorldComs of the world is that Vanguard is required to “mark to market” (value each fund share based on the value of all of the fund’s holdings) each day the market is open. That keeps the fund’s books current. This “marking to market” pricing is subject to both routine and spot audits by both the SEC and the Pennsylvania Department of Banking.

  10. Bill Wu says:

    Mutual funds go ‘out of business’ all the time. When this happens one of several things can happens (all of which require shareholder approval)

    * They liquidate their holds and give cash back to shareholders.
    * They are merged into another fund and an exchange shares occurs.

    The second is usually the fate for most diversified funds that go out of business. The first is usually the fate of highly specialized funds, who’s assets would have to be liquidated in a merger anyway.

  11. Anne Marie says:

    My retirement accounts are all over the map, two rolled over 401K IRA’s in Fidelity, one Roth IRA at etrade, some at STIRS, and now I have some money I need to find a way to invest other than the online savings accounts. Can I buy Vanguard Index funds, which from what I read here sound like a good way to go for now, through Fidelity or ETrade. Are they traded like stocks, and if I do that am I paying double fees somehow? Have a feeling it’s not going to be easy to get these acccounts moved from Fidelity, plus my CA 529 just got moved to Fidelity, although still haven’t done all I need to do to access it online. I like etrade cause it’s user friendly. By the way they have a high yield savings now, and a checking account that refunds all ATM fees for any ATM, nice for me as WAMU, isn’t in my town. Any tips on the best way to consolidate and park this money in a stable MM would be appreciated.

  12. good info to know. thanks.

  13. Heather says:

    It’s funny I did try and look up what went on in Argentina after reading this good post. But you make me feel safer in my Vanguard funds (I’m keeping almost no assets in banks), I almost forgot that I was… hungry… for… brrrraaaains!

  14. Speaking of ethics…

    Do you have any advice on the best socially responsible mutual funds? I have my IRA with Vanguard and I’m considering switching from the Star and the Target Retirement 2040 to the FTSE Social Index-any thoughts on this fund or others with Fidelity or TIAA-Cref that you’d recommend for a 2040 projected retirement? To what extent do you try to avoid certain sectors such as tobacco?

    Thanks for any advice, great blog!

  15. Ted Valentine says:

    A word to the wise for you above looking for specific investment advice on funds and such: do some reading on your own and educate yourself.

    I just finished Burton Malkiel’s ‘Random Walk Guide to Investing’. This is a really good step by step guide for self investors. It is under 200 pages and I read it in less than a week. The book tells you in easy to understand rules how to invest your retirement portfolio using index funds and why this makes the most sense.

    http://www.amazon.com/Random-Walk-Guide-Investing-Financial/dp/0393058549

    Malkiel clearly explains how if you chase returns from the “hot” investment tips you will just lose money and/or have poor returns. The reason, he believes, is the market is so efficient that it already knows whatever you may hear about. You’re behind the curve. So he says, invest in the the curve instead. I have had the unfortunate experience of learning this the hard way with my own money.

    Here are some more highly recommended books from another site: http://thefinancebuff.com/2006/10/recommended-reading-list.html

    Another tip: You don’t have to buy these books. They are available free at your library. I’ve found some are in audio format, which makes good use of the daily commute!

  16. Nathan Whitehead says:

    I’ll second what Matias from Argentina says. One should look at many different countries and situations to get a sense of what could go wrong. Just looking at individual bank failures in the US is really not enough. You have to worry about a national/global recession that makes ALL the banks get close to failing at once. The chance of that situation isn’t very high, but because the consequences can be so severe it can still matter for your personal finance decisions.

  17. was there action taken against mutual funds that “invested” in online gambling sites that are still illegal in the USA. would us based mangers be liable for failing in their fiduciary duties/aiding and abetting a criminal enterprise since such entities are ILLEGAL in the states?

  18. Mutual funds are not FDIC insured. Totally at risk. SPIC which insures brokerage accounts is a PRIVATE company. That means they are at risk as well.

  19. What a great post! I never knew that was how mututal funds were set up. It’s good to know the funds are set up in a way to ensure the money is safe from outsiders. Poor performance on the other hand…

    I think that is why I also like Vanguard and their super cheap index funds!

  20. The Most important challenge GM faces is to win back the trust of the tax payers. Giving away billions of tax payer money is not going to go under good sights of the consumers

  21. Credit Unions. Join one. Invest in funds with Vanguard. Buy single stock through a deep discounter, and hold… i.e. sharebuilder. You don’t get scared and sell. And, please don’t feed the zombies.

  22. I am wondering what happens, if all my money is in one “target-fund”. A Target fund is highly diversified so at little risk to loose all its value. But what if the manager screws up big time? Wouldn’t it be better to split my money into 3 target funds?

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  1. [...] As for Vanguard, the Investment Company Act of 1949 protects you. When you buy a mutual fund share from Vanguard, you own an asset, out of which they’re only allowed to take out the amount expressed as your expense ratio. They can’t touch the rest – they can only manage it. It’s explained well in this post over at My Money Blog. [...]

  2. [...] possible to lose money in a money market fund, but it is rare. Jonathan of My Money Blog recently did the research on this subject, and he learned that the Investment Company Act of 1940 protects the money you [...]

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