[cma]

Order-handling companies pay for "dumb" flow. Vanguard can reduce their outright trading costs to negative by being as dumb about it as possible, and then use these negative costs to artificially lower their reported fees.

Just because Vanguard claims to be smart about it, doesn't mean necessarily they actually are incentivized to be smart about it or actually are in practice. People can still judge them by how close they track the index, but that is reported separately from fees, which are all a lot of current and future retirees look at after having fees fees fees drilled into their heads. And the indexes themselves take a hit, so you need to adjust for that with a much more complicated measure.

They can effectively launder bad (or even good) tracking of the index into lower reported fees, by letting the order handlers profit on the inanity (and kickback via order-flow payments), allowing the fund managers to give themselves higher compensation without commiserate alarming fees.

To what extent, if any, do they actually do this? Do they report their income from paid order-flow in the fund prospectuses? Do they break it out by the managed funds, vs retail flow from their clients? Do they get major concessions to their retail trading costs in tacit exchange for being dumb with their etfs?

[snowmaker]

Is there any evidence that Vanguard gets kick-backs in return for their dumb order flow?

I would think that would be a HUGE scandal if it were true and ever came out.

[cma]

I haven't offered any, and it would most likely be illegal if it was explicitly going on. And there is likely a wall between the different trading desks (though often the physical embodiment portion of this is literally a cubicle wall the employees can hear each other over). But the orderflow compensation doesn't need to cross over into the retail desk if the ETF itself has enough trading volume to mask some kickback without appearing too egregious.

But price fixing is also illegal--nevertheless, two gas stations across the street at a profitable intersection can engage in it solely through price signal tit-for-tat[1]. This effectively masks intentionality.

Much more fantastical and speculative: machine learning algorithms at both firms could now, or in the future, arrive at this cooperative strategy, even with the only communication being through price signals. Without any human ever even knowingly giving the explicit go-ahead.

[1] https://en.wikipedia.org/wiki/Prisoner's_dilemma#The_iterate...

[kasey_junk]

Vanguard Brokerage Services disclosure about order flow payment can be found at:

http://vrs.vista-one-solutions.com/reports/1-6/vang/

Short answer is that Vanguard Brokerage Services did not receive compensation for equities order flow in 1QTR 2015, but did receive compensation for options order flow.

I have no idea what the laws are surrounding their index funds or how those index funds are allowed to/actually do interact with Vanguard Brokerage Services.

[murbard2]

The company managing the Vanguard fund is owned by the fund holders themselves. It's a closed system and the incentives are aligned.

[cma]

There is a principal agent problem between managers and shareholders. Managers get paid out of shareholders' pockets. If the shareholders are over-focused on fees as a metric, which they often are, managers have some potential tools (which I went into) to launder part of the fees into poor fund performance. I'm just throwing it out there, I'm not saying it is actually going on.

---

As for proxy voters choosing the management, proxy vote research usually doesn't make sense. You see strategies amongst large hedgefunds like this: keep their valuable proxy vote research private, make a vote based on the most predictable-to-them-but-not-to-you outcome based on the research (positive or negative for the company, doesn't matter unless it will be picked up by others immediately, even then they can do things like exiting their position through an obscure hedge), and then hold or sell their shares based on the overall vote outcome and its implications in the research.

Researching and making proxy votes out of naive benign interest of the company is often just doing altruistic work for a greater collective, something markets frown on and usually punish.

[murbard2]

Sure, but it still makes it harder for managers to screw the shareholders, especially when compared to funds like ishares where there is no accountability.

[iaw]

Could you elaborate or provide more reference materials on "dumb" flow?

[cma]

http://www.reuters.com/article/2010/12/17/us-markets-dumb-mo...

It is basically order flow that often blindly takes liquidity. Traders pay to get it, execute it prop at the best price (though they also can dump straight to the market without taking it prop if it isn't behaving dumb enough). Then they resell the position on the market at a more deliberate pace, providing liquidity (which lets them capture the spread, and lets them earn kickbacks from exchanges that pay for liquidity). Or they match the positions against future dumb flow coming in on the other side.

[jsprogrammer]

So, who loses money in your situation? The person who doesn't realize this is happening?

[cma]

Shareholders of the ETFs. Again, I'm not saying this specifically actually happens in the case of Vanguard, but all kinds of other conflicts of interest like this happen all the time, and reporters should be ever skeptical, and not just report he-said she-said, "oh Vanguard says they got this covered."

[jsprogrammer]

How do they lose though? In higher fund expenses or reduced NAV because the actions reduced the index?

[cma]

On Monday an index is made up of 100% MSFT, and it announces that on tuesday the index will be rebalanced to 100% APPL. The index has ETFs tracking it that are large enough to exhaust the availability of liquidity in both MSFT and APPL during a quick rebalance. Eventually over time the liquidity arrives to correct the mispricing, valuing things based again on underlying fundamentals. Both the index and the shareholders of the ETFs take a hit as the price of MSFT rises (no longer part of the index) and APPL (part of the index) lowers back down to normal, assuming no changes in fundamentals in the meantime.

The ETFs can be smart about it and try and make the trades over time instead of all at once, and Vanguard likely does. This then feeds back in and lowers the amount that the actual index takes a hit. The equilibrium in reality is that both the indexes and the shareholders in the ETFs take a bit of hit.