Vanguard To Buy iShares?

June 01, 2009

A deal that's been kicking around for some time in the rumor mills just got some press coverage.

ATTENTION: This is NOT an April Fool's joke. Though at first blush it may seem more implausible than the April 1 blog I posted about the "Street Shares and iDRS" (a blog that got me into so much trouble in certain circles), the word is that the Vanguard bid for iShares and/or BGI is actually for real.

Well, I'll believe it when I see it. Matt and I have been kicking this around today, and as Matt says, "You have to assume that iShares is less valuable in Vanguard's arms than someone else's. For starters, coming in, you would expect it to slash expense ratios. For instance, EEM would have to be folded into VWO, since those are essentially the same fund. But because VWO's expense ratio is about one-third of EEM's, that means you are taking a fund that made $19 million a year in revenues and turning it into one earning $7 million a year instead."

I think that pretty much sums up Matt's view that this deal is being cooked up by some nefarious spinmeister behind the scenes, and is straight out of Fantasia.

Let me give you five reasons why I don't agree with Matt (I know any of you who follow these blogs are shocked that we might disagree about something).

  1. The iShares product lineup would give Vanguard tremendous scale and distribution with the "intermediaries" (read: financial advisers) that are presently Vanguard's weak link. With that range of ETFs, Vanguard could immediately become a sort of "mega-DFA" for advisers and capture tremendous market share in the rapidly growing ETF segment of that market.
  2. From a financial perspective, it is absolutely plausible that Vanguard could raise the money necessary to complete the deal both through interested investors and by leveraging its trillion or so odd dollar asset base. The question is whether the additional scale that $300-$350 billion in iShares assets would bring Vanguard is worth the $5 billion it'd have to pay for it. In one year, that's 167 basis points off those assets, so there's your hurdle. The question, really, is what that scale would do for Vanguard investors, who are effectively the shareholders in the company.
  3. The Daily Telegraph article that mentions Vanguard indicates an interest in iShares. What DOES seem like a good potential fit for Vanguard—which neither Matt nor that article mention—is Vanguard buying the entire BGI arm, which would include a huge and extremely low-cost institutional business that I think would bring significantly more scale to the deal and might be the real appeal of a Vanguard buyout.
  4. As much as industry insiders say that Vanguard and BGI are bitter rivals and that it would be a huge culture clash, I don't really believe it. Both are full of intellectual/academic, geeky types (no offense to any of you reading this) and have a bit of an altruistic bent. I don't think it's a crazy fit. But the pay scales are different (note that the flow of employees leaving one and going to the other has mostly gone east to west) and both pricing and management teams would be huge issues that would need to be worked through. But there's a reason those people took those jobs—it's not such a wild difference in cultures.
  5. Vanguard CIO Gus Sauter has had his eye on iShares CEO Lee Kranefuss' corner office for years now. (OK, that one I AM joking about.)

I still think that the spin-off scenario is the one that's most likely to happen. Black Rock, Vanguard and all the rest in that category seem more messy—but I may well be wrong. And it is certainly fun for us to speculate a bit.

Regardless, I think, whether by spin-off or merger, there's a good chance it will be a net positive for investors and lead to better products and invigorated competition.



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