Vanguard Index Trade ‘All About Costs’

November 5th at 10:06am by John Spence

Vanguard’s recent decision to change the tracking benchmarks at its exchange traded funds is designed to lower costs for ETF investors rather than trying to find the best-performing benchmarks, industry observers say.

“Vanguard has made it very clear that their motivation for the change is simple— to cut costs,” says Daniel Wiener, editor of The Independent Adviser for Vanguard Investors.

The expense of licensing an index has risen over the years, and in a recent webinar Vanguard Chief Investment Officer Gus Sauter explained that Vanguard had identified an area to save “tens, if not hundreds of millions of dollars over time,” Wiener wrote in a newsletter.

In a recent interview with ETF Trends, Vanguard Senior Investment Strategist Joel Dickson said a larger portion of ETF fees have involved index licensing costs.

Dickson said Vanguard saw an opportunity to help return the economies of scale back to the ETF investor with new index licensing agreements. Meanwhile, major index providers “have converged over the past decade in terms of best practices and methodology,” he added. [Vanguard’s Joel Dickson on ETF Index Switch]

‘Considerable savings’

Last month, Vanguard said it plans to drop indices managed by MSCI (NYSE: MSCI) for benchmarks overseen by FTSE and the University of Chicago’s Center for Research in Security Prices (CRSP). The move is “expected to result in considerable savings for the funds’ shareholders,” the company said. [Vanguard Changing Indices for ETFs]

Wiener said the most notable difference in all the index changes involves Vanguard MSCI Emerging Markets (NYSEArca: VWO).

“MSCI classifies South Korea as an emerging market while FTSE considers it to be a developed country; hence, it will be deleted from the emerging fund’s portfolio. As South Korea is one of the largest countries in [MSCI] Emerging Markets Index at 15% or so of assets, the difference is not insignificant,” he wrote. [Emerging Market ETF Battle: Vanguard vs. iShares]

“Several concerns arise when trading such a large position,” Wiener added. “The first is taxes. Although Vanguard does not expect its trading to generate capital gains, the potential remains. The second is tracking error, or the risk that the fund’s performance fails to match that of either index.”

‘Seal of approval’

In Vanguard’s U.S. stock ETFs, it is moving to CRSP indices.

“While CRSP data is well-known among academic researchers, this is their first foray into actual index product development,” Wiener observed. “Given that this move instantly gives CRSP recognition and the Vanguard ‘seal of approval,’ I wonder just how good of a deal Vanguard was able to cut? I’ve spoken to some industry insiders who agree that Vanguard may actually have licensed the CRSP indexes for nothing.”

At the end of September, Vanguard managed 64 ETFs with total assets of $230.3 billion, according to industry data from BlackRock. Vanguard is the third-largest ETF provider but is leading 2012 with inflows of $42.4 billion through the end of the third quarter.

Longtime Vanguard watcher Wiener says investors shouldn’t be losing any sleep over the benchmark changes because the indices have performed similarly over time.

“Vanguard isn’t playing favorites in the index space and doesn’t see any one provider as delivering a premium product worth paying up for— it’s all about costs,” he said. “If this move flows through to lower expense ratios, those savings will accrue to investors’ bottom line. And that’s something all investors can appreciate.”

Full disclosure: Tom Lydon’s clients own VWO.

The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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