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Vanguard Switches to Full Replication Indexing on Small-Cap Fund

Index fund kingpin Vanguard Group of Valley Forge, Pa., has tinkered with the index tracking methodology it uses for its Vanguard Small Cap Index Fund. The move was driven by the fund's growth of assets under management; the fund has grown almost three-fold, from $1.7 billion at year- end 1996 to $4.9 billion today, according to Vanguard.

In a July 18 prospectus amendment filed with the Securities and Exchange Commission, Vanguard disclosed that as of July 1, it had begun following the "replication" method of tracking the Russell 2000 index for the fund. Under this method, Vanguard must hold each and every security that makes up the small cap index in proportion to its weighting within the index itself.

Sampling by Computer

Vanguard had previously employed a "representative sampling" method, a common method of tracking the same index for the fund that is employed by many index fund managers. Under this method, Vanguard had invested the fund's assets in many, but not all, of the component stocks of the Russell 2000 small cap index. As of March 2002, the fund was invested in 1,896 of the index's then 1,905 component stocks. A proprietary computer system at Vanguard determined which stocks to include or exclude, based upon fundamental analysis that included sector diversification, market cap, earnings and price/earnings ratios.

The change in methodology came hot on the heels of an article in The Wall Street Journal, which printed just a few days before Vanguard's SEC filing. The article explored the differences in performance returns among small-cap index funds, although it did not go into whether full replication boosts performance over sampling.

According to Brian Mattes, a principal with Vanguard, the change had absolutely nothing to do with returns or the newspaper article. In fact, the fund has been steadily increasing the number of Russell 2000 component companies it invests in simply because the funds' assets have been steadily increasing, Mattes said.

"It got large enough to do the replication. In this case, size does matter," Mattes said. In fact, Vanguard's Small Cap Index Fund is the 10th largest index fund overall, and the fund complex manages six of the 10 largest index funds, according to Morningstar of Chicago.

Like the recent tracking change Vanguard has made to its small cap index fund, the giant Vanguard 500 Index fund, which tracks the S&P 500 and has $77 billion in assets under management, started out employing the sampling technique when the fund was smaller. Sufficient assets allowed it to convert to the replication method about 15 years ago, Mattes said.

Not all index funds employ the full replication method. In fact, many index fund managers prefer to utilize the sampling method because of a fund's small size, or because tracking a large index would mean significantly more work for fund managers and accountants, as well as burden investors with increased custody and transactions costs.

In the case of a diminutive fund which tracks a broad equity index like the Wilshire 4500, it wouldn't make sense to replicate all of the equity holdings, said Fred Bair, quantitative analyst and member of the index team at T. Rowe Price in Baltimore. T. Rowe manages four equity index funds, three of which utilize the sampling method. That includes the $73 million T. Rowe Price Extended Equity Market Index, which tracks the Wilshire 4500 index.

"With so many securities to invest in, many of which represent only a small portion of the index, a small fund would end up buying fractional shares of a few companies, which would likely have very little impact on the fund's performance, anyway," Bair said. Even if the fund was much larger, and replication of a large index was possible, the sampling method would still be preferable, he said. Instead, a manager could take all of those small, thinly traded and sometimes very low priced securities and match that basket of undesirables with a comparable basket of securities chosen for similar size, volatility and characteristics, Bair said.

Replication Preferred

Mattes acknowledged that it's impractical to employ full replication for the broadest index funds. But in the case of a sizeable small-cap index fund, replication is the preferred methodology because it "eliminates the random sampling tracking error that will occur," Mattes said.

Vanguard is a believer in precisely replicating an underlying equity index whenever possible. It employs the replication method on some of its other index funds, including its mid-cap, value, small-cap value and small-cap growth index funds.

All told, of Vanguard's 25 equity and balanced index funds, 17 now fully replicate their indexes. But Vanguard resorts to the sampling method on the Vanguard Total Stock Market Index Fund, which tracks the broadest index, the Wilshire 5000, and the Vanguard Extended Market Index Fund, which tracks the Wilshire 4500. In both cases, the fund manager invests in only 3,000-plus stocks of the indexes.