Vanguard Will Sell New Funds. That Doesn't Mean It Loves Them.

October 8, 2000


THE Vanguard Group, the nation's second-largest mutual fund manager, is getting into the business of selling exchange-traded funds. But that doesn't mean that Vanguard executives have much nice to say about E.T.F.'s, the fledgling products that act like index mutual funds but can be traded like stocks.

Vanguard's competitors see exchange- traded funds as cheap, tax-efficient and flexible alternatives to conventional mutual funds. Vanguard is pitching its new E.T.F.'s - called Vipers, short for Vanguard Index Participation Equity Receipts - as a way to help its traditional mutual fund investors by luring away short-term investors whose frequent trading raises fund expenses.

But even as the company prepares its first five Viper issues for release - pending their approval by the Securities and Exchange Commission - it has provided a five-page fact sheet that aims to dispel the "alarming number of myths" that it says are being perpetuated about exchange-traded funds.

Some of those myths, Vanguard says, are that exchange funds have lower expense ratios than index funds, that they are extremely tax efficient and that they will replace traditional index funds.

In Vanguard's view, most exchange-traded funds have higher fees than Vanguard's, they are less tax efficient than Vanguard's competitors say, and they will not make conventional mutual funds obsolete.

Certainly, it is a different approach to marketing a new product.

"They just can't figure out how they really feel about it," said Daniel Wiener, editor of The Independent Adviser for Vanguard Investors, a newsletter.

Mr. Wiener compared Vanguard's reluctant move into E.T.F.'s with the decision by the largest fund family, Fidelity Investments, to start index funds several years ago. Fidelity, whose public face is the legendary stock picker Peter Lynch, will never be known for its index funds, but many of its customers want those choices.

"Fidelity offers index funds because they would rather offer those funds and keep the assets than have people run to Vanguard," Mr. Wiener said. It is the same with Vanguard and exchange funds. "Vanguard sees the writing on the wall," he said. "They've got to offer these things. They want to retain their assets as much as they can."

Thomas Taggart, a spokesman for Barclays Global Investors, the world's largest manager of index funds for institutional clients like pension funds and one of the leading sellers of exchange-traded funds, is more than willing to mock his rival. "The world is waiting to find out whether Vanguard is for or against E.T.F.'s," he said.

Exchange-traded funds have been around since 1993, when the American Stock Exchange created the Standard & Poor's Depositary Receipt, known as a Spider, which tracks the S.& P. 500-stock index. Clearly, McGraw-Hill, the parent of Standard & Poor's, enjoys the additional stream of revenue. Shortly after Vanguard revealed its plan for Vipers, McGraw-Hill sued Vanguard, saying the company had violated the terms of its licensing contract to use S.& P. stock indexes. The suit is pending.

This year, exchange-traded funds have proliferated. Assets stood at $52.6 billion at the end of June, according to Strategic Insight, a consulting firm in New York. While that was a far cry from the $7 trillion invested in mutual funds, E.T.F. assets had grown nearly 50 percent in six months. One reason was that Barclays started an extensive advertising campaign, renamed its exchange-traded funds "iShares" and created dozens of new E.T.F. categories.

Vanguard is the largest manager of index funds for individual investors. Because all exchange funds are index funds, they threaten Vanguard most. But Vanguard says it is not looking to Vipers to gain it a big piece of the E.T.F. pie. George U. Sauter, the Vanguard executive in charge of the firm's indexing division, said in an interview that Vipers were aimed at a challenge the firm has long fa But since Vanguard's original filing in May with the S.E.C., the company has changed its strategy. Originally, it planned to allow existing Vanguard fund shareholders to switch to the corresponding exchange-traded funds at no cost. Now it will charge brokers a $50 fee per transfer, which will presumably be passed on to customers.

"That process is very manually intensive and fairly high cost," Mr. Sauter said.

What Vanguard says are myths about exchange funds are, in the Barclays view, often valid positions. In Vanguard's document, it compares fees in 13 of its mutual funds with those of 13 similar iShares. Seven Vanguard funds have lower expense ratios - the annual management fees deducted by funds in daily nibbles - than their iShare rivals. Two have the same fee and four iShares are less expensive.

When told of the comparisons, Lee T. Kranefuss, who runs the Barclays retail investing business, said, "They're comparing apples and oranges." He noted that Vanguard was comparing products that, while similar in focus, did not follow the same indexes. Barclays has several offerings that Vanguard does not duplicate, he said.

Vanguard compares the 0.84 percent expense ratio of iShares that separately track indexes for Australia, Hong Kong and Japan to the 0.37 percent expense ratio for the Vanguard Pacific Stock Index fund, which invests in several countries.

A more convincing argument made by Vanguard presented a comparison of a hypothetical $10,000 investment in the Vanguard 500 Index fund with a $10,000 investment in the iShare 500, both of which are intended to approximate the performance of the S.& P. 500. A direct purchase through Vanguard would cost $18, according to the document. By Vanguard's reckoning, the iShare purchase, made in a new Fidelity brokerage account, would cost $102.97.

Vanguard's calculation includes many exchange-fund costs that it thinks are overlooked, including brokerage commissions, bid-ask spreads and minimum charges for brokerage accounts with assets below a threshold of $20,000 or $30,000. These are convincing points for the majority of Vanguard's investors, who do business directly through the company, though less compelling for investors who buy funds through "supermarkets" that carry a variety of funds or through brokerage firms, where there can be similar fees.

Vanguard also questions the tax efficiency of exchange-traded funds, citing several that have had sizable capital gains distributions, which are taxable. Three of Vanguard's tax-managed funds have not made a distribution since they were created in 1994.

IN response, Mr. Kranefuss of Barclays cited a recent study that compared the taxable capital gains distributions of Vanguard 500 Index with the comparable Spider. The Spider's taxable gains were significantly lower, according to the Financial Research Corporation, a consulting firm that compiled the study.

From 1993 to 1999, the Vanguard fund had an average annual capital gains distribution of 0.41 percent of its net asset value. By comparison, the Spider had no distributions except in 1996, when its distribution was 0.16 percent of its assets, according to the study.

"The idea that these are not as tax efficient as Vanguard funds is not correct," Mr. Kranefuss said.

The crux of Vanguard's position is that exchange-traded funds are more expensive products that might be worth the money for short-term traders.

"For investors who want short-term flexibility, who want to get out of the market at 5 after 2, E.T.F.'s give you that flexibility," Mr. Sauter said. "We don't believe they're for everybody. They're appropriate for investors with short-term time horizons."

Mr. Kranefuss bristled at such a notion. "The benefits of E.T.F.'s - lower costs and tax efficiency - are benefits for long-term investors," he said. "Our customers are long-term investors."


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