Why Is Vanguard Pitching Margin Loans?

The Offer

A longtime Vanguard investor received an email encouraging him to consider opening a margin account. The email included a link to a 20-page paper that explains both the workings of a margin account and the dangers entailed. I am pleased to report that the document thoroughly reflects Vanguard’s tradition of communications: detailed, sober, somewhat dull, and complete.

So far, so good. If Vanguard customers are to assume greater risk, best that they do it with open eyes. I do, however, have three questions.

Question 1: Why Margin Loans?

After defining margin investing on Page 1, the paper outlines the strategy’s purported benefits on the second page. I provide its five explanations in the order in which they are presented, along with condensed versions of Vanguard’s descriptions. (I have not changed any words but have edited for brevity’s sake.)

1) You’ll have access to ongoing credit.

Margin loans are a ready source of credit and don’t require the approval or credit checks that a bank may require. To meet short-term cash flow needs, taking a margin loan and paying interest is a convenient alternative to liquidating a portion of your portfolio, locking in capital gains, and being subject to taxes on those gains.

2) You’ll borrow at competitive rates.

Margin borrowing is generally more cost-effective than other lending options, such as credit cards or bank loans.

3) You may be able to deduct your loan interest.

Interest on margin loans may be tax-deductible. Consult your tax advisor.

4) You’ll be less likely to incur trading violations.

Trading violations commonly triggered by trading in a cash account … are much less likely to occur in a margin account.

5) You’ll have more buying power.

Margin investing allows you to increase your “buying power” (the amount of money available in your account to purchase marginable securities).

My Response

That’s a curious list! First, not only do other brokerage firms lead with what Vanguard presents as its final benefit, that being the ability to employ portfolio leverage by purchasing additional securities, but so does Vanguard itself elsewhere on its website. Thus, it’s unclear what the company believes is the feature’s greatest value: a) supplementing traditional banking services or b) permitting its customers to leverage their portfolios.

Second, the remaining three items are mighty sparse. Borrowing at competitive rates and/or receiving a tax deduction improves the deal, but those are not actually reasons to open a margin account. After all, if the purpose does not exist, the quality of the terms is immaterial. And the trading violations that margin accounts will prevent consist of either rapid-fire transactions or attempting to buy securities while lacking sufficient cash. Vanguard investors do those things?

Third, the illustration for the benefit of “buying power” depicts an investor with a 1:1 leverage ratio—one dollar borrowed for every dollar invested. That’s a very aggressive posture! If the purchased security loses 50% of its value, the investor’s stake would disappear entirely. That is far from a hypothetical situation, given that over the past five years, the shares of 28% of large U.S. companies and half of all midsize firms have declined by at least that amount.

Fourth and finally, Vanguard’s loan terms might be competitive when compared with credit card or bank rates, but they scarcely qualify as cheap. The current annual fee is 13.75% for the smaller accounts, 11.75% for loans up to $500,000, and “please call to learn about our rate offers” for amounts above that. (Hmmm. I would have expected Vanguard to be more transparent about its pricing.)

In short, I am not sold. Having read the materials, I still do not see why investors would seek such loans.

Question 2: Why Vanguard?

People frequently rap Vanguard’s knuckles by invoking what founder Jack Bogle would have done. I attempt to refrain. Times change; and so, sometimes, did Bogle’s views. Also, although the best chief executive officer in fund-industry history, Saint Jack was not infallible. Consequently, Vanguard’s current practices should not be condemned solely because of appeals to his authority.

Thus, I will not attack Vanguard, at least severely, for offering margin accounts. To be sure, as a high-cost, high-risk option, the strategy is inconsistent with Vanguard’s historic brand. However, I appreciate the firm’s desire to satisfy customer requests. If Vanguard clients seek margin loans, and the firm’s rivals already provide such features, I understand why the company might comply.

Nevertheless, Vanguard’s decision to offer margin loans—which is not new, although the marketing campaign is—represents an opportunity missed. Sometimes businesses add by subtracting. Do your customers want internet funds? Seek managed futures? Request leveraged bond funds? Fine and dandy, but there is no need to assent. In each of those cases, to the benefit of both its clients and its own reputation, Vanguard said no. It could have with margin loans, too.

Question 3: Why Solicit?

Which brings me to my third and strongest objection. Why publicize margin accounts? It’s one thing to provide the capability, quietly, for customers who expect Vanguard to match its rivals’ features. It’s quite another to approach those clients who do not. It’s easy to see how Vanguard can profit by finding more people who will permit the company to borrow low and lend high. It’s a lot harder to understand how doing so will help investors who take them up on that offer.

I have no quarrel with Vanguard’s funds. Quite the contrary. They have not lost a step since Jack Bogle was in charge. Vanguard funds remain very good at worst and excellent at best, including the company’s often-overlooked actively managed offerings. As long as that remains the case, Vanguard is well equipped to serve its shareholders. But sometimes the company’s decisions baffle me. This is one of those occasions.