Vanguard Poised to Move on VIPERs Launch

By Jim Wiandt, Site Editor

Despite a jarring legal defeat that has left the launch of its S&P 500 VIPERs in doubt, the Vanguard Group intends to move forward in launching its Total Stock Market VIPERs.

Vanguard plans to commence trading on its Total Stock Market VIPERs on May 31. The Small Cap VIPERs, based on the Russell 2000, was not immediately scheduled for launch. Presumably, Vanguard is involved in licensing negotiations with Russell ahead of the launch of the Small Cap fund.

The Vanguard VIPERs, or Vanguard Index Participation Equity Receipts, are exchange-traded funds (ETFs) that are set up as share classes of Vanguard's existing mutual funds. With the launch, the VIPERs will be the first such shares to trade. ProFunds has announced similar plans to launch ETFs that will function as a share class of existing mutual funds.

U.S. District Court Judge Alvin K. Hellerstein ruled that S&P was entitled to an order preventing Vanguard from launching the proposed VIPERs that were to be based on the S&P 500, S&P/BARRA 500 Value and S&P/BARRA 500 Growth indices. The judgment by Judge Hellerstein held that the ETFs are not covered under the terms of the existing licensing contract between Vanguard and S&P.

In the wake of the ruling, Vanguard spokesman John Woerth told IndexFunds.com, "We disagree with the decision and it is our intent to file an appeal at the earliest opportunity."

Despite the fact that its S&P-based ETFs are now in legal limbo, Vanguard has decided to move forward with ETFs that will be share classes of its existing mutual funds that track the Wilshire 5000 total market index. The move further raises the profile of the Wilshire total market index, which Vanguard has long promoted as the best vehicle for achieving broad exposure to the U.S. stock market.

The new fund will enter the ETF playing field with an extremely competitive expense ratio. At the time of the launch, the VIPERs Total Stock Market (TSM) share class will offer investors the cheapest total market access available to the average investor. The TSM VIPERs will have an expense ratio of 0.15% (15 basis points).

By way of comparison, the iShares Dow Jones Total Market and iShares Russell 3000 funds both have expense ratios of 0.20%. The Investor class of the Vanguard TSM fund has an expense ratio of 0.20%. The Admiral shares, which require an investment of $50,000-$250,000 depending on how long you've been a shareholder, are also at 0.15%. If you've got $10,000,000 laying around you can access the institutional TSM fund for 10 basis points.

Should it eventually be launched, the Small Cap VIPERs based on the Russell 2000 will have an expense ratio of 0.20%, an identical expense ratio to that of the iShares Russell 2000 and iShares S&P SmallCap 600 ETFs. The corresponding expense ratios for the Vanguard Investor, Admiral and Institutional small cap share classes are 0.27%, 0.20%, and 0.13% respectively. It will cost existing Vanguard shareholders $50 to transfer assets to the VIPERs share class.

The VIPERs based on the S&P 500, the S&P/BARRA 500 Value and S&P/BARRA 500 Growth indexes were scheduled to have expense ratios of 12, 17, and 17 basis points respectively. The question, of course, is moot for the moment, as Judge Hellerstein's ruling put the brakes on the launch of those VIPERs.

One interesting aspect of the Vanguard launch is that the VIPERs will represent the first time an ETF has been launched as a share class of an existing mutual fund. In particular, this raises intriguing questions about the tax-efficiency of the fund. Because the unique structure of ETFs, the funds are able to function in a way that is inherently more tax efficient for the fund than an equivalent traditional mutual fund.

ETF shares, which trade publicly like stocks, are created and redeemed in units of 50,000 shares. Shares of the underlying stocks are traded in-kind for ETF shares, unlike a mutual fund. Taxable events do not occur when Authorized Participants (or market makers) redeem their fund shares in exchange for the underlying stock. Taxable events do occur when the ETF is forced to sell stock when the index changes its components or rebalances. Because of the creation/redemption feature, ETFs are able to get rid of their low cost basis stock every time a redemption occurs. Mutual funds are forced to do the opposite, selling high cost basis stock first to minimize capital gains absorbed by the fund.

This particular attribute of ETFs should be a benefit for shareholders in the Vanguard traditional mutual fund, which would be able to gradually shed its low cost basis stock as redemptions occur in the ETF share class. Conversely, since shareholders in all classes of the fund will share distibutions equally, investors in the Vanguard VIPERs share class would be expected to be exposed to lower cost basis stock than those in a "pure" ETFs like the iShares. Those funds have had less time to accumulate capital gains, and they can also slough off low cost basis stock from the fund's inception date.

In short, the tax benefits for ETFs over traditional mutual funds are twofold. First, the ETF will never be forced into taxable events caused by redemptions from fund shareholders. Secondly, the ETF is able to lower the cost basis of its cumulative holdings, thereby lessening the tax consequences during an index rebalance. Pure ETFs are still subject to gains caused by rebalance (when an index adds or eliminates certain stocks), but never suffer from distibutions triggered by investors redeeming their shares.

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