Christine Benz: Hi, I'm Christine Benz for Morningstar.com.
Vanguard recently announced that it plans to switch the benchmarks for 22 of its index funds. Joining me to share his insights into the switch is Dan Culloton. He is associate director of fund analysis for Morningstar.
Dan, thank you so much for being here.
Dan Culloton: Thanks for having me.
Benz: So, Dan, 22 funds here; let's discuss the biggest funds that are going to be affected by the switch.
Culloton: The biggest funds that are getting new indexes are the Vanguard Total Stock Market Index and the Vanguard Emerging Markets Index. The Vanguard Emerging Markets Index will be getting a FTSE Emerging Markets Index going forward, and Vanguard Total Stock Market will go from the MSCI Broad Market Index to the CRSP version of the Total Market Index.
Benz: Vanguard is already using FTSE for a number of its index funds already. CRSP is a new name to Vanguard investors. Let's talk about what CRSP is and also how its methodologies might differ from Vanguard's existing index providers?
Culloton: CRSP may be a new name to retail investors and maybe some advisors and institutions out there, but in academic finance, it's not a new name at all. It's been around since 1960, doing research into security prices, and it's housed at the University of Chicago Booth School of Business. So, people who have been doing research into indexes and into the markets are very familiar with the name. They got into the indexing business in 2009 actually with the help of Vanguard with some financial backing from them.
Benz: How about CRSP's methodology, Dan? How does that differ some of Vanguard's existing providers?Read Full Transcript
Culloton: Well, there's no real enormous differences between MSCI's methodology and CRSP methodology, but they do some things that could make incremental differences to the exposures over time.
One is, they use a different method of moving stocks across market cap and style boundaries in their indexes--where it's more gradual and allows for stocks to be held in more than one index at a time, which could reduce turnover over time.
The other thing is that, all of these index providers have various data points that they use to score stocks on growth or value--put them in growth or value buckets--and CRSP is a little different. They add some, I guess you would call them, earnings quality metrics, such as looking at current assets and return on assets in their growth factors, which could also have a difference in exposures over time.
And then they breakup market cap a little bit differently, too. While MSCI uses a specific number, say in its large cap index, it takes the 750 largest stocks in the market. CRSP breaks up its market-cap boundaries by a percent of market cap. So its large-cap index, instead of being the 750 largest stocks, would be the top 85% of the market.
Benz: Over what time period does Vanguard expect that these transitions will occur to the new indexes?
Culloton: They expect to do it slowly over the next several months. I expect they will probably be deep into 2013 before the transition is complete. They do this just to reduce the market impact cost and the transaction cost of the overall change.
Benz: And the overall change is driven by a desire to cut costs by reducing the amount that they are having to pay these index providers. Do you have any sense, Dan, at this point of what the magnitude of those costs savings might be?
Culloton: It is hard to get a handle on what the precise costs are going to be. We have Vanguard's assertions that it will be tens, perhaps hundreds of millions of dollars overall in aggregate for investors. I've no reason to gainsay at this point, but what we can do is look at investment vehicles that do reveal what they pay to index providers, and one of them that does is the SPDR ETF, SPDR S&P 500 ETF. And based on their disclosure, it seems like about 30%, or about a third, of a fund's expense ratio could go to indexing licensing fees.
Benz: As these switches are enacted, do you have any sense of what the transactional cost might be? Has Vanguard given any indication? And also whether there will be any tax implications of making these changes?
Culloton: They have assured investors and us that they can complete this change without any tax impact and with minimal transaction costs, primarily, as I said before, by stretching the transition period out over a period of several months. And also by utilizing tax-loss carryforwards that they've built up in the funds over the years to offset maybe capital gains they may generate by moving from one index to another.
Benz: As you are looking at these Vanguard funds that are affected by these changes in the months ahead, what are the key metrics that you'll be looking at to gauge the success and any potential transactional costs associated with enacting these changes?
Culloton: Well, I think there are three important things for us and for investors to look at. And that's one, the portfolios. Once the full portfolio has become available both on our systems and other systems, it's important to look at how the exposures of these indexes will change in terms of holdings, in terms of sectors, in terms of regions, in terms of market cap.
Benz: Vanguard has said with the Emerging Markets fund that there will be a significant change in terms of its exposure. So, let's discuss that one because that's the biggie?
Culloton: Yes. FTSE doesn't classify Korea as an emerging market anymore. So, Korea will be coming out of the emerging-markets index that that fund tracks.
Benz: So MSCI did classify Korea as an emerging market; FTSE, the new provider, does not.
Culloton: Right. And the thinking there is that eventually most index providers, including MSCI, will move Korea from the developing to the Developed Markets Index, and that if you are going to change, you might as well change now when everybody else isn't changing.
Benz: So portfolio obviously something you’ll be keeping an eye on. What are the other two metrics that you'll be looking for as these changes unfold?
Culloton: Turnover. One of the reasons for moving to these indexes is that it would reduce the cost of turnover. So if turnover were to spike, that might be a sign of trouble, or that the indexes aren't providing the efficiencies that were advertised.
And then tracking error, that might also be an indication that perhaps the indexes are harder to track, or that something is going wrong in the process.
Benz: So a shorthand explanation of tracking error is, index return is this, fund return is this, and you are looking for the difference there?
Culloton: Right. … if all things are going well, an index fund should trail its index by no more than it's expense ratio, and if there is a big variation there, it could raise a red flag.
Benz: Last question for you, Dan, is, how does this affect the attractiveness of these Vanguard Index products? Vanguard has had a real facility in running index funds, keeping costs down. Does this affect your willingness to recommend the funds? Or are you still comfortable with recommending them at this juncture?
Culloton: We're still very comfortable with Vanguard because of its expertise in running index funds. They really set the industry standard in a lot of ways. So we view these changes as neutral to positive, if it really does decrease cost.
That said, we do have a lot of due diligence yet to do as more data becomes available on the CRSP Indexes and how they compare with the MSCI Indexes and the FTSE Indexes, and we'll be watching for that data when it comes out.
Benz: Thank you, Dan, for sharing your insights. A lot of investor dollars here and a lot of interest in how things unfold. Thank you for being here.
Culloton: Thank you.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.