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Vanguard Enters ETF Fray, Bogle Not Sure He Would Have Done It

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The Vanguard Group announced its plan to launch Exchange Traded Funds (ETFs). The funds, called Vipers, would be linked to Vanguard index funds. In a Wall Street Journal interview, Vanguard founder John Bogle said, "Anything that gets investors involved with heavy trading will hurt them."

Entering a crowded field of new ETFs, Vanguard said it had filed with the SEC to launch ETFs for nine of its U.S. index funds. Bogle, who now heads up the Bogle Financial Markets Research Center said that if he were still running Vanguard, he may not have launched the Vipers. While he has no problem with the instruments themselves, which may actually cost investors less money, he is opposed to anything that encourages trading, "Investors cut their own throat when they trade."

Initially, only five ETFs will be available. Funds will be offered for the Total Stock Market Fund (VTSMX), the Vanguard 500 Index (VFINX), the Small-Cap Index (NAESX), the Growth Index (VIGRX), and the Value Index (VIVAX). The shares will be available on the American Stock Exchange.

The ETF offering marks a major departure for Vanguard, which has consistently advocated long-term index investing. Clearly the launch was meant to attract the capital of short-term investors, as long-term investors are likely to gain higher returns by investing in Vanguard's traditional open-end mutual funds.

ETFs can be traded like stocks, and shorted or bought on margin. The funds manage to avoid paying capital gains by not selling stocks to the open market when redemptions are made. Stockholders who redeem their shares are given a share distribution from the underlying equity shares, which they then sell themselves. Thus, individual investors must pay taxes on their gain, but the fund itself doesn't.

While Vanguard has not yet revealed its fee structure for the ETFs, the expense ratios are likely to be less than those of Barclays Global. Barclays charges 10 basis points annually (a basis point is one-hundredth of a percent) on its ETFs. The ETFs are able to charge lower fees than open-ended mutual funds because of the very limited interaction ETF managers have with their investors. Open-end investors send emails and make telephone calls to investment advisors, raising fees.

Still, while the Vanguard 500 Index Fund charges 18 basis points on its open-ended mutual fund, most investors - especially those who make regular purchases - are likely to pay lower fees in the traditional mutual fund. This is because investors must pay brokerage commissions each time they buy or sell ETF shares.

Nonetheless, the low expense ratios and tax efficiency of the new exchange-traded funds can make them attractive to index investors. Unlike most index investors, however, most of the buyers of the new ETF shares will likely hold their shares for weeks or months, rather than years.