S&P Launches Frontal Attack on Vanguard Vipers


Taking its lawsuit against Vanguard to another level, Standard & Poor's requested that the Securities and Exchange Commission (SEC) hold a public hearing on Vanguard's application to launch its exchange-traded funds (ETFs).

Standard and Poor's is currently suing the Vanguard Group to prevent it from launching an ETF based on the S&P 500 index. The SEC plays a critical role in the launch of any ETF, because it must exempt the funds from certain regulations on a case-by-case basis. An excellent article written by Mercer Bullard, a former assistant chief counsel at the SEC and head of Fund Democracy, a shareholder advocacy group, helps to explain the tangled web of possible motivations and outcomes in the suit.

Vanguard claims that its Vipers are covered under its existing licensing agreement with S&P. Standard & Poor's, however, says that Vanguard must negotiate another agreement, because ETFs are a different financial instrument, not a different share class. The dispute reflects the race to the bottom that has hit not only expense ratios, but correspondingly licensing fees as well.

The Vanguard group has claimed throughout that its Vipers merely represent another share class of its open-ended funds. Internally, the Vipers will be treated like a share class, with investors being able to transfer funds from one account to another without taking a capital gains hit. This will be the case whether or not Vanguard prevails in its suit, though Vanguard now plans to charge investors $50 to move from its open-ended fund to its Vipers. Vanguard decided to implement the charge after it got wind of rumblings that some short-term investors would buy into the open-ended fund to circumvent commissions on the Vipers.

A Vanguard representative reached for comment noted that on nine different occasions since the Vanguard 500 opened in 1985, new share classes were added, and none of these additions prompted any protest from S&P. He said he feels that this situation is no different than any of the other occasions when, for example, new institutional share classes were added. An official in the Index Services department of Standard & Poor's/ McGraw-Hill declined to comment on the lawsuit.

Interestingly, the dispute likely involves more issues than just licensing fees. Bullard speculates that S&P may have negotiated some sort of limited exclusivity deal that would preclude them from licensing further ETFs based on the S&P 500. Thus, if Vanguard were to win its lawsuit, there might be pressure from both State Street Global Advisors (SSgA) - which manages SPY, the select Spider based on the S&P 500 and Barclays Global Investors (BGI) to renegotiate terms of their deals.

SSgA has borne the brunt of being an ETF trailblazer. Entering the field before expense ratios and licensing fees imploded to tiny quark-sized figures, State Street pays 0.04% of SPY's assets annually to S&P. It also pays S&P 0.03% of assets (or $450,000, whichever is larger) on its select sector Spiders, of which there are nine. Bullard projects that based on the miniscule 0.0945% expense ratio that BGI charges on its iShares S&P 500 fund, Kranefuss and Company were able to negotiate a better deal. He guesses that they're paying only 0.01% for the license. This, of course, assumes that Barclays is not trotting out the fund as a loss-leader flagship of the iShares funds.

It seems likely that BGI may in fact be paying an expense ratio that is higher than 1 basis point for its iShares 500, and that this is at the heart of the lawsuit. While Bullard hints at the fact that Vanguard's entrance into the field may be all about renegotiating fees down to less profitable levels for S&P, he also guesses that Barclays is paying a low single basis point on its iShares 500. It may in fact be more likely that BGI is also paying more like 2 or even 3 basis points to license the S&P 500 index.

It appears in any case that SSgA is stuck paying 4 basis points on its S&P 500 ETF. Because iShares had a clearer idea of the playing field when it negotiated, however, it seems quite likely the BGI representatives negotiated some sort of conditional exclusivity deal with S&P whereby the iShares expense ratios would be lowered to the level of any new ETF entrant. Therein lies the rub. It seems unlikely that S&P would take on its best client to scrape out a basis point or two on a fund that will have a tiny amount of assets compared to the flagship Vanguard 500 for some time to come. However, with the possibility of the Vipers forcing renegotiation of terms with iShares 500 (which currently has over $600,000,000 in assets), and even State Street's SPY (with over $20 billion in assets) the stakes of this battle become clearer.

Vanguard pays something less than 0.01% to S&P off the top of its Vanguard 500 fund, the world's largest mutual fund, with assets of over $104 billion, more than twice the total net assets of all 93 ETFs currently in existence. With that kind of money, the Vanguard folks feel that it's definitely a case of the old feeding-hand being bitten. Clearly, Vanguard played a significant role in bringing the S&P 500 the kind of unrivaled benchmark status that it now enjoys.

And with the group of very savvy (and very loyal) long-term investors, it is not out of the range of possibilities that Vanguard could dump S&P altogether and restructure its S&P fund into a very similar (and no-cost) beast - say, the Sauter 503 or Bogle's Basket. This would relieve S&P of approximately $10,000,000 per annum. All this aside, clearly Standard and Poor's was caught off-guard by the Vipers launch. And there are who would question the notion of an exchange-traded fund being just another chip off the old open-ended block. The implications of the suit are significant. We'll be watching closely.