John Spence

Vanguard Shareholders Approve Index Fund Policy Changes

Retail index fund giant Vanguard yesterday announced that shareholders have approved several investment policy changes for various funds. Two of the changes apply specifically to Vanguard's stable of index funds.

Moving targets

Shareholders approved a change that allows the trustees of eight passive equity funds to switch target benchmarks if they deem it is in the shareholders' best interests. Previously, these funds could only change benchmarks through a shareholder vote.

The trustees of 19 other Vanguard index funds were already empowered to make a switch on their own. For example, in 1993 the trustees changed the index for Vanguard's Total Bond Market Index fund and also for the bond portion of its Balanced Index fund.

"Now if we want to change indexes for these eight funds we don't have to go through the process of a separate proxy at some point in the future, which saves money," said Vanguard index fund manager Gus Sauter in an interview. "The trustees now also have the ability to make changes in a timely fashion, since the whole proxy process would take probably up to a year to coordinate and go through."

Sauter stressed that changing indexes would not alter the investment style of a fund. "Obviously, the trustees are constrained to making sure that any substitute index would track the same segment of the market as outlined in the investment objective of the fund," he noted.

At the moment, Vanguard says it has not targeted specific index funds as likely candidates for a benchmark change (see previous article for more).

"We'll conduct a review of all the various indexes that measure the segments of the market these eight funds track," said Sauter. "If we determine that there is a more appropriate index out there we would make a proposal to the trustees."

However, Vanguard is interested in new indexes developed by Morgan Stanley Capital International (MSCI).

"When MSCI announced this past summer that they were coming out with a U.S. index series, we examined their proposed rules and we liked many characteristics of the construction methodology," said Sauter. "So we entered into an agreement with MSCI that if our board of trustees at some point in the future would like to track their indexes, they would have the ability to do so. There have been a number of indexes lately that have been locked up by some of our competitors under exclusive contract arrangements, and we did not want to be excluded from having the ability to make a change if the trustees wanted to."

Non-diversified index funds

Vanguard shareholders also approved the reclassification of several index funds as "non-diversified" under securities laws. Mutual funds are classified as non-diversified when all stocks each representing over 5% of assets, when combined, comprise over a quarter of the fund's assets. Vanguard's Growth Index fund ran afoul of the rule when frothy large-cap growth stocks dominated in the bull market.

"In the Growth Index fund about two years ago there were four stocks that were each representing over 5% of the fund's assets," said Sauter. "In aggregate they amounted to over 25% of the fund's assets. At that point in time, we had to send out a separate proxy to the fund investors to gain their approval to classify the fund as non-diversified, in order to continue to track the index."

In essence, Vanguard is saying that its index funds shouldn't deviate from a market capitalization-weighted index just because it grows top-heavy.

"In our opinion, investors anticipate that an index fund will track the benchmark we stated we'd be tracking," said Sauter. "At this point in time there are no funds that are even close to being classified as non-diversified, but we didn't want to have to at some point in the future jump through hoops again. The situation with the Growth Index fund was rather unprecedented at the time, and it was driven by the extreme valuations of large-cap growth stocks back in the late 1990s."