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Keep an Eye Out for These New Vanguard Funds

A look at some compelling new options that could be available this year.

Dan Culloton, 02/27/2007

Below are excerpts from recent issues of our Vanguard Fund Family Report. To view a risk-free trial issue, click here. Note that Fund Family Reports for Fidelity and American Funds are also available.

Vanguard's exchange-traded fund lineup has been hampered by a couple of glaring omissions, chief among them a lack of fixed-income and core international equity options. That could change soon, though, if the Securities and Exchange Commission approves Vanguard's recent application for fixed-income ETFs and for a total international stock index fund.

In recent months, the family filed papers with regulators seeking permission to create ETF share classes for its bond index funds: Vanguard Total Bond Market Index VBMFX, Vanguard Short-Term Bond Index VBISX, Vanguard Intermediate-Term Bond Index VBIIX, and Vanguard Long-Term Bond Index VBLTX. Vanguard also has filed a registration statement with the SEC for a new total international stock market index fund (also with an ETF share class) tracking the FTSE All-World ex USA Index. The SEC has to approve these funds before Vanguard launches them, but my guess is they'll be available this year. When they are, investors should avail themselves of these new funds. Here's why.

A Chip Off the Old Bond Fund
Like all Vanguard ETFs, the proposed bond ETFs will be share classes of existing mutual funds. So, they'll look a lot like the conventional Vanguard offerings to which they'll be attached. Like their parent funds, the fixed-income ETFs will be cheap, charging expense ratios of just 0.11%. That's already cheaper than all 14 of the current iShares fixed-income ETFs, whose expense ratios range from 0.15% to 0.2%.

Vanguard's bond ETFs also will own more securities and be more diversified than most of their iShares rivals. The Vanguard short-, intermediate-, and long-term bond funds track indexes that include government, corporate, and agency bonds in their duration ranges, so they offer exposure to more bond sectors than most of the iShares, whose indexes usually focus exclusively on Treasuries or corporate bonds of specific maturities (iShares, however, has two ETFs that track Lehman Brothers Government/Corporate Bond indexes, as well as the iShares Lehman Aggregate Bond AGG, which is diversified across bond sectors).

A Representative Sample?
Vanguard's bond funds also own bigger samples of their indexes, which could help them hug their indexes closer. Like most index funds that track the sprawling Lehman Aggregate, Barclays owns a sample of the bogy because of the difficulty of compiling such an expansive portfolio and because many of the index's constituents are too illiquid and expensive to trade. The iShares ETF invests in a smaller slice of the index than other funds that use sampling, though. Instead of owning nearly 3,000 securities from the benchmark, like the conventional version of Vanguard Total Bond Market Index does, the iShares ETF owns about 120 (there are nearly 7,000 bonds in the actual index). It's possible to match the characteristics of the underlying index with such a small sample, but it's less precise and requires more turnover. Granted, Vanguard Total Bond Market Index had its own problems with tracking error in 2002 when it lagged its benchmark by 200 basis points. Since then, however, Vanguard's fixed-income team has tightened risk controls, and the fund has shadowed the benchmark closely.

Vanguard's ETF lineup will still have some holes on the fixed-income side. Don't expect exchange-traded shares for Vanguard Inflation-Protected Securities VIPSX, for example, because that's an actively managed fund. The family also still lacks an international-bond option for U.S. investors. Still, the proposed bond ETFs would be fine additions to the family's arsenal and worthy rivals to the iShares entrants, which have owned the fixed-income corner of the ETF market.PAGEBREAK

Globe Trotting Made Easy
I'm also looking forward to the launch of Vanguard FTSE All-World ex USA Index Fund. It's not a name that rolls off the tongue, but it could be like music to the ears of some Vanguard investors. What will this fund offer that Vanguard Total International Stock Index VGTSX doesn't already? Mainly Canada and an ETF share class.

Vanguard Total International Stock Index is one of my favorite Vanguard offerings. It has low expenses, broad diversification, and, unlike a lot of core foreign stock holdings, a dedicated helping of emerging-market stocks. Truth be told, though, the Total International Stock Market offers something less than the entire foreign stock market. Mainly, it omits Canadian stocks because its developed-markets sleeve is constructed to mimic the MSCI EAFE Index, which omits Canada (EAFE stands for Europe, Australasia, and the Far East). No offense to our neighbors to the North, but most Total International Stock Index investors probably didn't miss Canada until energy stocks such as EnCana ECA and Suncor Energy SU started booming in recent years. Nevertheless, it's hard to honestly offer complete exposure to foreign developed markets when you exclude one of the world's wealthiest nations.

Another drawback of the Total International Stock Index is that it is a fund of funds; instead of owning a portfolio of stocks, it owns three other Vanguard index funds: Vanguard European Stock Index VEURX, Vanguard Pacific Stock Index VPACX, and Vanguard Emerging Markets Stock Index VEIEX. While that still gives investors exposure to nearly 2,000 international stocks, the fund-of-funds format prevents Vanguard from issuing an ETF share class. The FTSE All-World ex USA Index makes up for these shortcomings by including stocks from Canada as well as 47 other developing and emerging countries in one package that can be served up as a conventional or exchange-traded fund.

The new fund will have some drawbacks of its own. The 0.4% expense ratio of the conventional share class will be higher than Total International Stock Index's 0.31% levy (but it's likely to decline as assets grow, as Vanguard has shown its propensity to pass on economies of scale to shareholders). FTSE All-World ex-USA also will charge a 0.25% purchase fee and a 2% redemption fee on the conventional shares. Some may find this irksome, but the fees are there to deter frequent trading and are paid into the fund, not to Vanguard's coffers. You could avoid fees (but not trading commissions) by selecting the new fund's ETF share class, which will charge an even lower 0.25%.

Index investors have a lot of choices in this area. Fidelity Spartan International Index FSIIX charges just 0.1% for exposure to the MSCI EAFE, and in January, State Street launched SPDR MSCI All Country World Index Ex-US ETF CWI (another mouthful). But Vanguard's new all-foreign stock index fund still will be a contender for core foreign equity exposure, especially if expenses tick down. The new fund and ETF will be compelling and cheap one-stop options.

Disclosure: Morningstar licenses its indexes to certain ETF providers, including Barclays Global Investors (BGI) and First Trust, for use in exchange-traded funds. These ETFs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs that are based on Morningstar indexes.

Dan Culloton is a senior analyst with Morningstar.

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