Wed, 3 Oct 2012
The switch from MSCI to FTSE and CRSP indexes for 22 Vanguard funds is all about three things, says Vanguard principal Joel Dickson: cost, cost, cost.
Jason Stipp: I'm Jason Stipp for Morningstar.
Vanguard this week announced changes to 22 benchmark index funds for some domestic and international stock funds; they are swapping out MSCI indexes and putting in indexes from FTSE and also from CRSP.
I'm checking in today with Joel Dickson; he's a senior ETF strategist and principal at Vanguard. He's going to give us a little more insight into that change and what they expect it means for investors.
Thanks for being here, Joel.
Joel Dickson: Well, thanks for having me, Jason.
Stipp: First question for you: the decision to change these indexes, was this primarily a decision about the fees that Vanguard is paying for the use of the indexes, or was this a decision about, we think these indexes are really superior to the MSCI indexes?
Dickson: So, to be clear, we think it's about the fees the investor was paying to access the indexes through our funds and our ETFs.
There were three main reasons for this change and its cost, cost, and cost. So, at this point what we've seen over the course of the last decade or so is a real convergence in terms of index methodology to a set of best practices that we first were talking about 10 years ago, and really the major index providers have all converged upon that set of best practices. So, it's not about a better index or better index construction; it is about having cost certainty, long-term cost savings for our shareholders.
Stipp: I think most investors are familiar with the FTSE indexes, but I think the CRSP indexes are the less well known, and I think Vanguard actually has worked with the University of Chicago, which is who basically created these indexes. Can you give a little background on those indexes and the makeup, and the history of them?
Dickson: Sure. So CRSP, as we call them, Center for Research in Security Prices, which is really in many ways a think tank, if you will, at the University of Chicago is actually a well-known and well-respected data provider on stock market data going back into the early 1960s, and in fact, as an organization, it's been around for more than 50 years at this point.
We started talking with them some time ago about potentially developing investable indexes, being able to utilize the expertise and experience they have in the individual stock data that they have done for so well and for so long. So, it's been a long, burgeoning relationship, if you will, but really brings expertise to an area that they hadn't really mined before in terms of investable indexes using the exact same processes that they have to generate their data.
Stipp: OK. Back to the fees, do you have estimates or do you have thoughts about how much investors in the Vanguard index funds and ETFs might be able to save by making this switch? What kind of cost savings will they enjoy because of these lower-cost benchmarks?
Dickson: Well, at this point the number itself would be hard to calculate, because it's over a long period of time and of course depends on market growth--other than to say it's substantial and it's in the millions of dollars.
But hopefully, investors will be able to see that in the form of lower expense ratios going forward.
Stipp: And I know with index funds, there is fee the that you pay for the index benchmark, but there is also how the index is constructed and how much turnover happens in the index and some of the other technical factors when you're following that index. So when you're looking at cost savings, would you say that the lower licensing fees or the structure of the index and having lower turnover are more important at the end of the day for the actual expense ratio on those funds?
Dickson: Well, the transaction costs that are actually incurred in dealing with index construction, reconstitution, rebalancing actually isn't in the expense ratio; that shows up as transaction costs in the net asset value of the fund or the ETF. And those costs can be significant at times, and lower turnover, more rational rebalancing can help.
But again, through a series of best practices that most of the index providers have converged to over the years, the differences between a lot of providers are relatively small along those fronts. So, a large-cap benchmark is still going to turn over less than a small-cap benchmark, all else equal, but for multiple indexes within say, the small-cap, space relatively similar transaction costs you would expect.
What has been happening is that the index licensing fees… if you think about the cost of ETFs or funds, but let's take in the ETF space, they are really two broad costs that go into the expense ratio. The operating costs of actually managing the fund, the internal cost, if you will, and then the index licensing costs.
What we have seen over the last several years is that a larger and larger percentage of the total expense ratio has been eaten by index licensing fees. So operating costs have been coming down for many ETFs, but the index licensing fees then have been becoming a bigger proportion.
In many ways, what we've done with this announcement this week has been to say, let's look at that other lever as a way of reducing cost for investors.
Stipp: As you're saying if the best practices are really widespread among these providers, they are more commoditylike in some ways, and so that actual licensing fee then becomes one of the most important things you're going to look at.
Dickson: It certainly can, and it's not to say that there are no methodological differences between index providers, just that the ultimate effect on the index for investors is really minimal, and you're getting the same risk exposures, asset class exposures that you're trying to target.
Stipp: So, on that front, when you looked at some of the differences that you might experience by shifting to these indexes, are there any areas where the exposure might be slightly different or where there might be a greater turnover as you conform to that new index? What are some of the differences that investors might see?
Dickson: Well, the largest difference that investors will see in terms of the announcements that we made would be in terms of the emerging-markets fund: VWO on the ETF side or the Emerging Markets Index fund. Our current provider has South Korea as an emerging country, and it's about 15.5% of the current fund's assets. FTSE, in their emerging index, does not classify Korea as emerging, and in fact has them as a developed market. So, you're going to see a transition in that portfolio of roughly the 15.5% of the Korea assets and then buying other countries and other stocks because of that transition of Korea out of the emerging-markets benchmark.
That by far is the largest single transition issue that we will deal with in this change. There are some slight methodology differences--like, for example, on the domestic equity side, right now our … funds are based off of indexes that define market capitalization boundaries by, let's say, number of stocks, and we're moving to the CRSP methodology, where it buckets capitalization by a percent of total market cap. So for example 70% may be the mega cap segment, whereas it might be a set number of names under other index methodologies. But again what we're talking about here are small nuance differences, not wholesale changes.
Stipp: Especially with that emerging-markets fund, do you expect that there will be some turnover or transaction costs or capital gains that might result from the fact that you're moving from one index to the other?
Dickson: There certainly will be some transaction costs, and we're trying to mitigate that in a number of ways, and one is by the use of a transition index where we're going to be slowly over the course of six months moving from the old benchmark to the new, and that's to minimize things like transaction costs in that process.
In terms of tax realizations, we don't at this point expect a net capital gain realization to result from the transition of Korea out of the emerging-markets portfolio, largely because we have a lot of realized losses built up in the fund that can handle the capital gains.
Now if Korea were to increase 50% in the next few months before the transition occurs, then my answer might be a little bit different, but then again investors have benefited from that in that case.
Stipp: My last question for you Joel: You mentioned that you had worked with CRSP in the past, and we also see a lot of other providers thinking about proprietary indexes, or bringing that in-house, and then creating products around those indexes. Any thoughts on that front at Vanguard?
Dickson: Well, as you think about the index licensing fees, which is one of the major impetuses for the changes that we've announced, one solution is potentially to self-index or custom-index in-house, and we've seen a number of ETF providers at least considering that approach.
We've looked at it over time; we've thought about it. At the end of the day, we like the idea of an independent third-party index provider, because then the investment manager and the index provider then are not sort of one and the same, which can create some conflicts, which is why there are very strict conditions that get required if somebody's going to self-index. We just think it's a little bit more straightforward to have that independent provider.
Stipp: Joel Dickson of Vanguard, thanks so much for providing some of that extra detail around that big announcement from Vanguard this week.
Dickson: Well, thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.