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Vanguard Jumps on ETF Bandwagon


Vanguard Group plans to beef up its fund lineup by adding 11 new index funds and 20 ETF versions of its mutual funds.

The Valley Forge, Pa.-based asset manager has filed a registration statement with the Securities and Exchange Commission for the new product offerings, which it expects to roll out some time this fall.

The move signals Vanguard's headfirst plunge into the ETF marketplace, as it expands its existing two Vanguard Index Participation Equity Receipts, or Vipers, to 22. Vanguard already offered Viper share classes on its Total Stock Market and Extended Stock Market funds. The company will also launch 10 sector funds based on Morgan Stanley indexes designed to mirror certain segments of the economy.

"The introduction of these new funds and share classes fulfills our desire to offer a full suite of index offerings tracking the best-available benchmarks," said Gus Sauter, chief investment officer at Vanguard, in a prepared statement. He also noted that Vanguard would be the first company to offer traditional and exchange-traded shares across a wide range of benchmarks.

It is hard to argue with the timing of Vanguard's decision to infiltrate the ETF arena given its recent growth spurt. Indeed, ETFs saw their assets climb $3.14 billion to $121.57 billion in June, according to Washington-based Investment Company Institute. They have also grown 20% in each of the last two years.

Wrestling for Viper Victory

But don't expect Viper issues to make an instant splash, though, as they will face fierce competition from Barclay's Global Investors' iShares and State Street's Sector SPDRs, two well-established ETF brands that dominate the market. The new sector funds will require a hefty minimum investment of $250,000, one that serves to protect investors from market-timers.

And Vanguard's Vipers have a fundamental difference from their peers that could prevent them from garnering sizeable assets. In order for a Vanguard investor to redeem his or her shares, they must exit the same way they entered the fund. "It's too bad that they did not set them up so that everybody is going in and out through the ETF share class, because that's the way to get a tax-efficient ETF," said Gary Gastineau, managing director at Summit, NJ-based ETF Consultants LLC. Essentially, they can't take advantage of one of the product's most attractive features.

Two advantages ETFs have over traditional mutual funds are tax efficiency and low costs, which ultimately deliver more to an investor's bottom line. Since the turnover rate in these portfolios is much lower than actively managed mutual funds, the potential for capital gains is reduced. And the average expense ratio for SPDRs is 28 basis points, nearly five times the average 1.45% for an actively managed mutual fund.

Since many competing ETFs are based on the same benchmark, their major difference is the cost. While all fall into the no-load category, expense ratios can vary from fund to fund. It will be difficult for Vanguard to undercut SPDRs because firms can't go much lower than 28 basis points and still turn a profit.

The move also comes as somewhat of a surprise because Vanguard has long been reluctant to penetrate the ETF space, having adopted a more conservative, cautionary long-term investing strategy. Ironically, its venerable founder, Jack Bogle, has repeatedly said that sector investing is a recipe for disaster, calling it the "ultimate loser strategy." Some industry observers have speculated that it marks a dramatic shift in the company's overall investment model. Sauter responded to that criticism by saying that the firm remains committed to long-term investing.

New Take on Sectors

Still, Vanguard's restructuring of its fund offerings certainly suggests that ETFs, specifically sector funds, are perhaps more useful to mainstream investors than once thought.

"The way people view sector products has evolved," said Dan Dolan, director of wealth management strategies for the Select Sector SPDR Trust. "It's not just about picking a sector, but, rather, how to use them in conjunction with other sectors and formulate a serious investment strategy." Dolan said that three or four years ago, sector investing consisted of simply buying a hot technology fund, but now that mentality has changed. SPDRs enable investors to hold up to nine sectors with exposure to the S&P 500 Index, the weightings of which they can customize. Collectively, the nine funds comprise all of the companies listed in the S&P 500.

Dolan believes that Vanguard's emergence as a player in the ETF space has the potential to threaten his own assets, but that the overall impact will be positive for the business.

Further evidence of a sea change can be seen in Fidelity Investments' announcement in June that it, too, will bring an exchange-traded product to market in the second half of this year. Its offering is designed to track the Nasdaq Composite Index. When the two biggest mutual fund firms seek entrance into relatively uncharted waters, folks are going to pay attention.

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