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Vanguard Lays Groundwork for Potential Switch to New Indexes

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Retail index fund giant Vanguard today filed a preliminary proxy statement with the SEC seeking shareholder approval on several investment policy changes for many of its index funds.

In a move that may presage a shift to new benchmarks for many of its index funds, Vanguard is seeking approval of a policy change that would authorize fund trustees to change target benchmarks if they deemed shareholders would benefit. The trustees of 19 Vanguard index funds are already empowered to change target indexes at any time.

Winds of change blowing?

Vanguard index fund manager Gus Sauter raised eyebrows in the industry when he wrote an article for last quarter's edition of The Journal of Indexes that was critical of current index methodologies. In the article, Sauter even outlined techniques index providers could use to reflect market segments in a way that would be friendlier to passive managers like himself. Specifically, Sauter called for index objectivity and transparency, adjustment for cross-holdings, and new methods for determining growth and value.

"That article was a compilation of my thoughts on index best practices after 16 years of experience," said Sauter in an interview.

In a statement released today, Sauter hinted that Vanguard's ideas on index construction could move from theory to practice.

"We regularly evaluate the target benchmarks of our index funds to ensure that they are constructed appropriately to reflect the performance of a given market. In addition, we examine other indexes in the marketplace for potential use as benchmarks for our funds or the development of new funds," said Sauter. "Over time, we've developed our own views with respect to best practices in index construction and rebalancing methodology. Index providers have been exploring many of these same ideas and we are beginning to see opportunities open up that we believe may be worth pursuing."

In the statement, Vanguard announced that it has secured the right to use new U.S. stock indexes under development by Morgan Stanley Capital International (MSCI). Vanguard said it likes the methodology the new MSCI indexes are expected to employ. However, Sauter noted that Vanguard is not obligated to adopt the new MSCI indexes.

"Nothing is set in stone yet," he said.

Today's proposal applies to the following Vanguard index funds: Total Stock Market (Wilshire 5000), Extended Market (Wilshire 4500), SmallCap (Russell 2000), Growth (S&P/Barra 500 Growth), Value (S&P/Barra 500 Value), Mid-Cap (S&P 400), SmallCap Growth (S&P/Barra 600 Growth), and SmallCap Value (S&P/Barra 600 Value).

Vanguard said it has no plans to change the benchmark for its S&P 500 index fund, which is the largest mutual fund in the U.S. with about $63.9 billion in assets, according to Morningstar.

Morningstar senior fund analyst Scott Cooley said the performance of Vanguard's large-cap style index funds, as well as the turnover in its small-cap funds, may have triggered today's announcement.

"The returns of Vanguard's large-cap style index funds were similar last year, although by all accounts 2001 was a stellar year for value," said Cooley.

Vanguard index fund
2001 returns
Large-cap growth
-12.93%
Large-cap value
-11.88%
Source: Morningstar

Cooley notes that the S&P/Barra indexes tracked by these funds only use one variable to separate growth and value - price-to book ratio (p/b) - while other index providers use more metrics. Vanguard has also been concerned about high turnover in its small-cap index funds, said Cooley.

Moving to non-diversified status

Additionally, Vanguard is seeking shareholder approval to reclassify many of its index funds as "non-diversified" under securities laws.

A "diversified" index fund runs into a problem when its benchmark becomes dominated by a few big stocks. For example, in May 2001 shareholders in Vanguard's Growth index fund approved a similar proposal when four stocks - Microsoft GE, Cisco, and Intel - became so large the fund violated diversification rules.

Diversification rules have also been a problem for Barclays Global Investors' iShares Sweden ETF, which was forced to rebalance when a few names in the index grew too large.

Vanguard's Sauter said non-diversified status is appropriate for Vanguard's index funds because they should reflect a market index regardless of how big individual stocks grow. However, Morningstar's Cooley noted that the last few years have shown the benefits of the diversification rule because investors have not been overly exposed to "bubble" companies on the way down.

Additional reading

  • Gus Sauter's article on index construction can be found in the archives of The Journal of Indexes.
  • A style sheet for the new MSCI U.S. equity indexes can be found here.