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By Dan Culloton | 06-29-2010 11:58 AM

McNabb: ETFs Help Expand Reach of Indexing

Vanguard chairman and CEO Bill NcNabb sees ETFs as a set of building blocks that investors can use to build diversified portfolios.

Dan Culloton: Hi. I'm Dan Culloton, Associate Director of Fund Analysis with Morningstar, and I'm here today at Morningstar's Investment Conference with Bill McNabb, Chairman and CEO of Vanguard. Bill, thank you very much for being with us today.

Bill McNabb: Great to see you, Dan. Thanks.

Culloton: Well, you guys made some big news today, announcing a major expansion of your Index and ETF Fund lineup. It wasn't that long ago that this proposal which includes ETF shares for the Vanguard 500 was in doubt that it would ever happen because you were in the midst of a court's case with S&P over whether you could even have the ability to launch these share classes. What happened since then and what allowed you to renegotiate the license for S&P in order to…

McNabb: Well, couple of things. First, the S&P and Russell, both, we did their index construction methodologies, and as you probably know, MSCI's methodology was really co-developed with Gus Sauter, our Chief Investment Officer, and we've seen a real convergence of methodologies. So we're much more comfortable with the methodologies.

But, on the practical question, both S&P and Russell seemed very anxious to expand the relationship with us, and I guess, a few years makes a lot of difference. But we're excited to have the opportunity to bring very low cost, highly diversified, simple building blocks for people to use to construct the kind of portfolios that we think make sense.

Culloton: Now the S&P 500 ETF, which will be a share class of the Vanguard 500, it's coming out of very low expense ratio, as you'd expect from Vanguard, 6 basis points, significantly lower than the other S&P 500 ETFs out there, but yet you've waited a lot of years –

McNabb: Right.

Culloton: – given a lot of years to the competition here, they have very narrow bid-ask spreads and a lot of trading volume, which is important to some ETF investors. How confident are you that you can make up that ground or get ETF investors to consider using your…

McNabb: I think, it will happen pretty quickly, but you're right there is firmly entrenched competitors, you know prices certainly matters, I think brand matters a lot. I think our brand carries some weight on that score, but we're very patient. This is a long-term strategy for us in terms of what we want to do here, and I think people doubted when we got into the ETF business overall, whether we can make any progress. And I think we're making really good progress with the existing lineup, and this is just going to further that. It's an important initiative for us, very important.

Culloton: We should note that the – your existing index funds based up on the MSCI indexes, the Vanguard Growth, Vanguard value indexes, Vanguard Small-Cap Growth, Vanguard Value, those aren't going away, and that you're still using the MSCI indexes.

McNabb: No, and we still love those indices, and in many of the categories I think as you were to – if you were to slice and dice and compare, and you guys will do a better job of that than anybody, you'll see that there is still lower cost in many categories than they are like Russell and S&P, and part of that will be scale, part of that will be licensing agreements and so forth, but no, we're very committed to those.

But, one of the things – actually I think, it was Scott Burns, one of your colleagues, wrote a very interesting piece just a couple of days ago talking about how, especially in the advisor community there is tremendous loyalty to either an S&P or a Russell or increasingly MSCI, but people have their index provider brands, if you will, that they prefer. Some of it's based on how they measure portfolios, some of it's just based on tradition, but what we've decided is in each of those broad categories we want to be a low-cost producer and the highest quality provider.

Culloton: Could you see other index providers offering besides MSCI and Russell and S&P?

McNabb: You know, if you'd told me five years ago we'd have all three, I would have said not likely, and so I guess I wouldn't say no to it. It doesn't – I can't – actually, we actually do have a fourth, we have FTSE.

Culloton: And Mergent.

McNabb: And Mergent. So I guess that the short answer is yeah, I can see it, it's not going to be an easy hurdle for somebody to get over. But FTSE does a couple things in places where other people don't really well, and it's working great for us and same with Mergent and so forth.

Culloton: You've had a lot of growth on the ETF side. This is a major expansion of your ETF lineup. You've had according to our data, you've been – over the trailing year ending in May, you've been the leader in flows with about $33 billion coming in. Do you envision a time when Vanguard is more known for its ETFs than for – than its funds, when it's a bigger – it has more under management in ETFs than in its funds?

McNabb: I don't know. It's interesting. As you know, we do ETFs as a share class, and we think each structure has its advantages and disadvantages depending on the type of investor. The way I viewed this has been – it's been phenomenal vehicle to expand the reach of indexing. If I go back and I look at the advisor marketplace broadly, it was an all active marketplace a decade ago.

Essentially, there were a handful of people who were devoted to indexing. But now you're seeing a lot broad, broad adoption of indexing as at least a core of constructing a portfolio. And you know if that continues you could see a day where the ETFs are certainly equal in size to the funds. Whether they're greater or not, that's farther out than I can project.

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