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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.

The fund is keeping up with the times in two other ways as well: It is entering the exchange-traded realm and is getting even cheaper. Unlike many of its siblings, this fund did not have an ETF share class or low-cost Admiral shares. Soon it will. Vanguard has announced that an ETF share class will be available early next year, with an expense ratio of just 0.20% (slightly below the fund's current cost). The firm will also create Admiral shares that will--as with the Admiral shares for many other Vanguard funds--have an investment minimum of just $10,000, down from $100,000. Those are also priced initially at 0.20%.

Vanguard Emerging Markets Stock Index VEIEX
This fund's evolution was more gradual, but in the same way, kept it current. For many years, Vanguard did not want to simply use what was then called the MSCI Emerging Markets Free Index as this fund's benchmark. In a surprising amount of emerging markets, trading carried substantial difficulties--what the industry would call "liquidity issues." So Vanguard worked with MSCI to create a custom-made benchmark that excluded such markets. Some of them were major markets: At one point, China, Taiwan, and Russia were all absent from this fund.

Over the years, though, more and more countries were accepted into this custom benchmark as their markets met certain standards. The effects could be dramatic. For example, from October 2001 to October 2002, Taiwan's weighting rose from 0% of the portfolio to nearly 16%, while Mexico's share of assets fell by nearly half to 11%. Eventually, only one or two countries remained outside the lines. Finally, in 2006, the fund dumped the custom index and shifted to the most widely recognized benchmark in that field, the MSCI Emerging Markets Index.

It's open to debate whether all of the decisions to exclude specific countries, or the decisions on when to add them, were correct. But at least the strategy served a logical purpose, and it seems that reasonable efforts were made over the years to keep the portfolio up-to-date as conditions in the markets themselves changed. And, by going with the industry standard when that was deemed an acceptable option, rather than continuing to insist on a customized version, the fund now can be easily compared by investors with its benchmark and with peers.

Vanguard Pacific Stock Index VPACX
Not all Vanguard international index funds have evolved over time. This one, for instance, seems stuck in the past. When Vanguard created international index funds that focused on specific regions, it based them on subsets of the EAFE Index. With EAFE limited to markets that MSCI considered to be developed, that means the MSCI Pacific Stock Index consists solely of Japan, Australia, Singapore, Hong Kong, and New Zealand.

Moreover, in practice, the index typically has emphasized just the first two of those markets. This fund currently devotes 87% of its assets to Japan and Australia, with the bulk in Japan.

Back when only the most daring investors were venturing into emerging markets and predictions of a coming Pacific Century led by Japan were rampant, a fund that excluded Korea, China, and Taiwan but did feature New Zealand may have had some logic to it. Now it just seems odd.

Who would want this particular combination of countries in 2010? Apparently, a lot of people: The fund has $7 billion in assets. Even so, perhaps this will be the next international index fund to get a Vanguard-style makeover.

Gregg Wolper is a senior mutual fund analyst with Morningstar.

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