John Spence

Vanguard To Change Benchmarks for Seven Index Funds

Vanguard announced yesterday that it will transition to new MSCI U.S. equity benchmarks for several of its index funds, a move the Valley Forge-based fund group has been positioning itself for over the past several months, and perhaps years. In 2002, Vanguard licensed the MSCI benchmarks, and shareholders in a proxy vote approved a change that allowed the trustees of eight passive equity funds to switch target benchmarks (trustees of 19 other Vanguard index funds were already empowered to make a switch on their own).

The table below shows which index funds will switch to MSCI benchmarks - each new target MSCI index tracks the same market segment as the corresponding current index.

Aside from a transition away from the Russell 2000 for the Vanguard small-cap index fund, all of the affected funds track Standard & Poor's indexes or S&P/Barra indexes. Vanguard has announced no plans to change the benchmark for its behemoth S&P 500 index fund.

Although the index changes had been brewing for some time, the formal announcement yesterday by Vanguard had to represent at least a dent in the prestige of S&P, the venerable index provider whose roots go back to Alfred Cowles. However, the loss might not be too distressing for S&P because many sources have alleged that Vanguard founder John Bogle decades ago negotiated index licensing fees that were heavily in Vanguard's favor.

In any case, relations between the two firms have been strained - S&P took Vanguard to court in 2000 and successfully blocked the launch of Vanguard exchange-traded funds based on S&P and S&P/Barra indexes. The lawsuit, which involved complex licensing fee and exclusivity issues, puzzled many industry observers because S&P and Vanguard seemed like such a natural fit. Vanguard has maintained that the transition has nothing to do with the S&P lawsuit.

Below Gus Sauter, who recently assumed an expanded role as Vanguard's chief investment officer responsible for all in-house stock and fixed income investment management functions, talks about the MSCI indexes and how Vanguard will manage the transition.

Q: What are some of the challenges of managing a transition like this? Will the funds incur capital gains and transaction costs?

A: In terms of realizing capital gains, all of the funds except for one will likely realize a loss because of the decline in the markets. The small-cap growth fund may realize very modest gains, but we have existing realized losses in all the funds including that fund. The losses will more than offset any potential for realization of capital gains. So capital gains really won't be much of an issue.

In terms of making the transition, we want to make sure we don't provide any front-running opportunities; we want to be as "stealth" as possible. For that reason, we have announced that the transaction will occur sometime between April 20th and September 30th. As soon as the transition is completed, obviously we will notify all investors that the indexes have been effectively changed. We will first of all cross any trades internally that can be crossed. A lot of the funds will be buying what the other funds are selling. Our preliminary analysis indicates that about 40% to 45% of all the trades can be crossed between the funds, so there's no cost associated with those [trades].

For the remaining trades, we will go to the marketplace. One advantage for us is that, over time, we have developed trading capabilities using all the various types of trading techniques. Because of the nature of indexing we've been very eager to adopt all of the new trading venues that have been developed. We were early adopters of all the ECNs [electronic communications networks] and the alternative trading systems. We use futures extensively, we use direct access brokers on the floors of the exchanges, and we have access to the futures trading pits. We also do basket trading. So over time we've developed a wide variety of capabilities to gain liquidity. We think that we can execute a great amount of the trading without being noticed. Also, this transition won't happen over a day or two; it will likely take a few weeks.

Q: What were the main reasons for making the transitions?

A: We had identified five characteristics of what we would consider an "ideal" index. When MSCI announced their index methodology, they incorporated four of those characteristics, so we were intrigued by their construction methodology. This year they've started to produce the results of back tests of their methodology. The back tests have revealed, as we suspected, that the indexes have a tremendous amount of style integrity. They seem to capture very well the performance of various investment styles, whether it's value or growth, or large or small. At the same time, the MSCI indexes experienced meaningfully less turnover in various segments of the market, particularly in small-caps.

So those two characteristics are what we like the most - style integrity and lower turnover.

Q: The MSCI indexes use "buffer zones" to cut down on unnecessary turnover between indexes. Can you explain, in layman's terms, how this works?

A: If the large-cap index consists of the 300 largest stocks, then there's a hurdle at stock number 301 where the mid-cap index starts. Without buffers, if stock number 300 becomes stock number 301, then it would migrate to the mid-cap index. With a buffer, you establish a band [around the cut-off point]. If the stock remains inside that band it will not migrate to the next index.

The effect is that turnover is moderated. But perhaps more importantly, this system recognizes how active managers buy and sell stocks. When a stock migrates within a relatively small range, active managers don't decide all of the sudden that a large-cap stock is a mid-cap stock. It's a gradual process, and the buffer zones reflect that reality.

04/04/2003

More information about the transition, including an explanation by Sauter, is available on the Vanguard website.