Sudden Shakeup at a Vanguard Index Fund

Although index funds aren't actively managed, their portfolios aren't set in stone, either. Most index investors realize this. In fact, when the most well-known index funds--the S&P 500 trackers--occasionally have to shuffle their holdings in response to additions or deletions in the underlying index, the moves typically receive a flurry of media attention. That said, though, the effects of such changes on the funds' overall composition tend to be minimal.

That's not the case, however, with  Vanguard Emerging Markets Stock Index (VEIEX). A recent change in that fund's underlying index resulted in quite a shakeup in its portfolio. Although this incident is unusual and does not foreshadow any trend, it's worth a look because it provides a graphic illustration of the fact that a passively managed fund is not static. While we're at it, we'll also evaluate what effects this change has had on the fund's profile.

Tear Down That Wall
Ever since its 1994 inception, Vanguard Emerging Markets has been an oddball in one important way. Rather than track the standard MSCI Index in its field, as do other Vanguard international indexers, this fund has instead used a custom-made version of the MSCI Emerging Markets Free Index. The "Free" index excluded or underweighted some markets that were so difficult to trade in that it wasn't practical to include them--and Vanguard's version added more countries to that list. Those exclusions set the fund apart from actively managed diversified-emerging-markets funds, which typically did buy stocks in many of those countries.

In fact, for a long time those restrictions kept the Vanguard offering out of a number of prominent emerging markets, including India and Taiwan. But over the years, as the governments in such markets liberalized their investment rules, MSCI and Vanguard adjusted both the Free Index and the custom version to let in more and more countries. Finally, in 2006, Russia stood as the only major emerging market still outside the Vanguard fund's wall.

That changed in August 2006, when Vanguard announced that because of improvements in investment regulations, it would no longer use the custom-made benchmark at all. Henceforth, it said, the fund would just track what's now simply the MSCI Emerging Markets Index.

That put Russia into the mix. The impact was visible immediately. Owing to rising energy prices (Russia's most important companies are oil and gas giants) and the vast increase in interest in its market from international investors, Russian stock prices have been on a roll since early 2001. That trend has pushed up the market capitalization of Russian companies. So, in a market-cap-weighted index like MSCI's, those firms automatically play a substantial part, regardless of whether one thinks they're actually more suitable investments right now than companies in Korea or Thailand or Turkey.

The result? The fund's stake in Russia went from 0% in its June 30, 2006, portfolio to 10.4% in its Sept. 30 portfolio. That makes it the third-most-heavily-weighted of the 23 countries represented in the fund, behind only Korea and Taiwan and just ahead of Brazil. Energy behemoth Gazprom is now the fund's top holding, with more than 5% of assets. (Samsung Electronics, with 3.9%, is the only other stock in the portfolio allotted more than 2% of assets.) Lukoil, meanwhile, is in the number-five slot.

What's the Effect?
In its new incarnation, Vanguard Emerging Markets provides investors with a portfolio that more closely reflects the way emerging-markets fund managers invest these days. In the 1990s, investing in Russia essentially was considered the wild frontier of investing, a daring and unusual play--at least if a manager ventured beyond dipping a toe into an oil giant now and then. But that image gradually changed, and, though many managers still say Russia carries more uncertainty and risk than other, more-established emerging markets, it is now much more normal for emerging-markets funds to invest in Russia than not. And managers buy more than just the energy giants; they're picking up shares in cellular telephone firms and retail as well. Thus, the fund's new makeup is preferable for an investor who wants a truly representative emerging-markets play.

In a way, this move echoes a previous occurrence here, for this isn't the first time the fund has undergone such a rapid and dramatic transformation. In response to a 2001 change in the MSCI index, the fund quickly went from completely excluding Taiwan to devoting 16% of assets to that country's stocks. These days, it would be hard to imagine this fund with no Taiwan exposure, given the prominence of that market's technology firms in other emerging-markets portfolios. In the same way, an emerging-markets index fund that today didn't own a single Russian stock would risk getting more and more out of step with reality.

But that doesn't mean this change is necessarily positive in every way. Although all emerging markets contain risks, Russia is unique in many respects. So, at the very least, adding a hefty stake in that market suddenly adds a new element of risk exposure to a fund that already had plenty. There may have been some shareholders who actually liked the fact that they could own a broad emerging-markets fund that had no exposure at all to that complicated country.

Meanwhile, as noted earlier, both Russia and energy stocks in general have been on multiyear runs, even taking into account recent reversals; such runs inevitably must end. For shareholders' sakes, let's hope it doesn't turn out to have been an unfortunate time to have added exposure to both.

A Final Word
Whether the change will actually benefit the fund's performance over the long term is impossible to know. But it's hard to criticize the move. Indexes should represent the field they cover. And in late 2006, a broad global emerging-markets index with no Russian stocks simply wouldn't fit that description. Perhaps a fundamentally weighted index wouldn't have added so much Russia; but MSCI's indexes are market-cap weighted, like all the indexes Vanguard relies on, and that's just part of the bargain when buying Vanguard index funds--which in general have performed quite well over the years.

In short, this fund remains a solid way to get inexpensive, broad emerging-markets exposure. If you're considering buying it or adding to your stake, though, be sure to keep in mind the added complexities discussed above--as well as the fact that any emerging-markets fund can be extremely volatile.

One more thing: Given the shakeup in its portfolio, it is possible that this fund will make a significant taxable distribution (unusual for an index tracker), though its current realized-gain figure implies it may not have to do so. Check with Vanguard before buying it in the coming weeks.