For two points of illustration, one can examine the S&P 500 funds and the Russell 2000 funds. Ironically, the Vanguard 500 suffered no capital gains last year despite having been in existence since 1976, because while there were redemptions and rebalances, the fund was holding enough short-term losses to offset the gains. Vanguard, in fact, claims that its 500 fund could suffer from a 40% net redemption before having to pay out a gain. Conversely, because of fund management issues, the new iShares 500 fund actually did pay out distibutions last year.

The effect of low cost basis stock on mutual fund shareholders is better illustrated by the case of a high-turnover fund like the Vanguard Small Cap (Russell 2000). Because so many stocks move in and out of the Russell 2000, and because the Vanguard Small Cap index fund has been around for so long, the fund suffered an astonishing 13%+ capital gains distribution last year. Because of the redemption process, an ETF would be unlikely to ever suffer from that sort of distribution (the iShares Russell 2000 passed out a gain of 0.19% in 2000).

In fairness to Vanguard, the iShares fund had less than a year to accumulate gains, and the level of an ETF's advantage over a traditional mutual fund is entirely dependent on the level of fund redemptions. By and large, ETFs simply have not been around long enough to make grounded conclusions about the tax efficiency issue. Frankly, the investor who is concerned about tax efficiency will likely do best in a fund that is specifically designed to be tax-efficient.

Publicly, Vanguard has stated that the primary reason it wants to introduce the VIPERs shares is to move its more active traders into the ETFs, thereby making its funds more efficient. In addition, the VIPERs give Vanguard the opportunity to shed low cost basis stock from its funds, and also allow Vanguard to attract a whole new group of investors who use brokers. Brokers will now be able to offer investors direct access to the Vanguard Total Stock Market fund.

As ETF assets have grown exponentially, some have wondered if ETFs pose a direct threat to traditional index funds. Vanguard's entry into the arena may either stop any loss of market share, or it could open a new market of indexed product users to the company.

While Judge Hellerstein's ruling was a sharp blow to Vanguard for some of these reasons, the Russell 2000 and Wilshire 5000 products may actually be the most interesting from an investor standpoint. There are, afterall, already two S&P 500 ETFs - the SPDR (SPY) and the iShares 500 fund - as well as iShares S&P 500/ BARRA Growth and Value ETFs. The iShares 500 fund is also a less expensive 9.45 basis points (compared to 0.12% for SPDRs and the proposed Vanguard VIPERs 500).

While the Vanguard 500 growth and value funds would have nosed out the equivalent iShares products by about 18 basis points (compared to the iShares' 17 basis points), the Total Stock Market product is a 5 basis point improvement over what's currently available on the market. In addition, there is currently no product based on the Wilshire 5000. The Vanguard fund is an optimized version, holding only about 3,400 of the most liquid Wilshire 5000 stocks, while tracking the index very closely. The Russell 2000 fund, should it launch, will be interesting to watch from a tax efficiency standpoint (i.e., to what extent wthe ETF share class be able to help the fund's cost basis).

Apparently, the coast is clear on the licensing agreements with Wilshire, with existing agreements or renegotiations covering the new ETF share class. Terms of the contract Vanguard has with Standard & Poor's (S&P) are extremely favorable to Vanguard. Essentially, licensing fees collected by S&P from Vanguard on the S&P 500 index are limited to $50,000 per year. Most ETFs and open-ended index funds are paying index providers somewhere in the range of 1.5 to 16 basis points (0.015%-0.16%) in licensing fees. The Vanguard 500 fund alone has over $100 billion in assets.

Probably more important were limitations that S&P had owing to its contract with Barclays Global Investors (through the iShares). It was apparent that S&P was caught completely by surprise when Vanguard announced its planned foray into ETFs in mid-2000.

All of the turbulence and delay aside, the VIPERs are finally upon us.

05/17/2001

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