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How Two Vanguard Index Funds Kept Up With the Times

Meanwhile, one of their siblings is still living in the past.

Gregg Wolper, 10/27/2010

With index funds, you know what you own. They have their portfolios, which mirror their benchmarks, and they stick with them. No need for shareholders to worry about an active manager taking bold bets that backfire.

At least that's the popular impression. In reality, index funds do change. At the most basic level, they must adjust their portfolios when indexes make their regularly scheduled alterations, called "reconstitutions," or institute even larger revisions. For some indexes, those alterations can have a surprising impact. As just one example, in late 2004, Dow Jones made sweeping changes in its Select Dividend Index, doubling the number of stocks and altering some of the rules for inclusion. Then there are unscheduled events: mergers or bankruptcies that force indexes to change a component or two.

Even more substantial, though, are the changes that the fund companies themselves initiate. Typically these involve swapping one benchmark for another, or with funds of funds, tinkering with allocations. The histories of three Vanguard international index-trackers show how timely adjustments can be useful or even necessary in some cases, and how an index fund that's too passive can end up out of step.

Vanguard Total International Stock Index VGTSX
With nearly $28 billion in assets, Vanguard Total International Stock Index is one of the biggest internationally focused mutual funds of any kind. However, the fund has not rested on its laurels.

At one point, this was a fund of funds, owning three Vanguard index-trackers. But a couple of years ago, it dispensed with that structure and started owning stocks directly. Separately, the nature of its emerging-markets component changed gradually over time as well. (More details on that are provided below.)

The latest and most important change is occurring right now. Last month, the fund changed its benchmark. It now aims to track the MSCI All Country World ex USA Investable Market Index, rather than its former benchmark, the MSCI EAFE + Emerging Markets Index. The most noteworthy consequence of the change is that this fund will own Canadian stocks for the first time. Why didn't it before? Because the makeup of the EAFE Index is, in some ways, a relic of the past. Not only did it exclude all markets deemed emerging by MSCI, but it was set up geographically, so Canada was simply lumped in with the United States under the "North America" label. Because EAFE was intended as a foreign (non-U.S.) benchmark, it excluded North America..

Years ago, that may not have mattered much. But with the rise of resource stocks and the "commodity currencies," a major foreign benchmark without Canada (but including every other major market, and some far from major) is hard to justify. After the portfolio adjustment is complete, the difference will be noticeable. A look at the weightings in iShares MSCI ACWI ex US Index ACWX, an exchange-traded fund, shows Canada in third place with 7.8% of assets, ahead of every country save Japan and the United Kingdom.PAGEBREAK

Conversely, Vanguard Total International's emerging-markets weighting will decline. That might seem unwise, given how the rapid growth rates and relative financial health of many emerging markets seem to put to shame the debt-laden, growth-challenged economies in nearly all developed markets. However, the stunning rallies in emerging markets had pushed their weighting in this fund all the way to 25%, up from just 11% five years ago. So reducing that stake by a few percentage points might not be a bad thing. Finally, the fund will have more than 3 times the number of stocks, and a larger portion of its portfolio in small caps, than it had under its previous benchmark.

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