It’s really not a huge surprise that Vanguard decided to switch indexes for 22 of its funds . After all, the company is no stranger to shaking things up.
It shook up indexing back in the day, it shook up the industry with low-cost 401(k)s and it's no stranger to shifting alliances. Recall that until 2010, Vanguard didn’t have an S'P 500 ETF because of a long-standing licensing dispute with Standard ' Poor’s .
But shifting away from MSCI benchmarks marks the end of an era for Vanguard, and while you can expect in-depth analysis of what this means for investors on a fund-by-fund basis, I thought I’d highlight a few arguments on whether this is a good or bad thing from our internal discussions.
Most Retail Investors Won’t Care, But They Probably Should
Vanguard has the strongest brand in the ETF space in terms of customer loyalty . That brand loyalty is well deserved—Vanguard remains one of the lowest-cost providers of any investment manager, and has a squeaky-clean reputation that lets advisors and investors sleep well at night.
From Vanguard’s perspective, this is just as it should be. In its press releases today, the company assured investors that the new indexes are good indexes, and that they’ll be cheaper, which will allow Vanguard to continue lowering fees.
But not all indexes are created equal. Each one of these index swaps has its own implications. Take VWO:Since 2003, when the current FTSE version of the emerging markets index was born, the FTSE index is up 193%. The MSCI index that VWO tracks is up "only" 180%. To suggest that investors won't notice a 13% difference in returns seems naive. Of course, there's no predictive value here. Over the next 10 years, the numbers could reverse, based solely on the inclusion of South Korea in the MSCI indexes. But the point is -- it matters.
Even in the more “boring” case of VTI, there are real differences.
While many of the CRSP indexes Vanguard has helped build for their U.S. equity exposure are too new for a long comparison, just in the last year, the MSCI Broad Market index VTI currently tracks is 0.47 percentage points ahead of the CRSP Total Market Index. Is a half-percentage point enough for investors to notice? For the type of investor drawn to Vanguard, I'd say yes.
Most Institutions Will Definitely Care, And They Definitely Should
Large institutions will struggle to understand these new indexes well enough to be comfortable with them. MSCI is getting booted, we suspect, largely due to cost. MSCI charges a premium price in the index world. But it charges that premium price because, honestly, it can.
MSCI’s indexes -- particularly the international indexes -- have numerous salutary benefits if you’re a hard-core index wonk running lots of models. Its indexes follow clean, transparent rules. They tend to dovetail into each other nicely with minimal overlap. They’ve got long tenures, and a presence on almost every major data service and analytical platform.
For these reasons, they’ve long been a favorite for large institutions that run complex models, or simply have rigorous performance analysis needs.
For institutions with an entrenched MSCI bias, Vanguard’s MSCI-based products were dreams come true. While initially a bit thinly traded, in recent years, they’ve been nearly as liquid as similar—and more expensive—products from competitor Blackrock’s iShares series.
That meant that if, for instance, you wanted to equitize a bit of cash in your billion-dollar endowment, you could comfortably trade large blocks of VWO or VEA that you knew would mimic the performance of your large, separately managed core position in those same indexes.
The new FTSE and CRSP indexes, by contrast, don’t have that institutional traction, and thus will make those kinds of decisions more difficult. Institutions will have to make an assessment of whether the short-term holding costs of the higher expense ratio at iShares is worth the cleaner match to their internal mandates or benchmarks.
It’s not a sure thing either way, but it definitely complicates the portfolio manager's job.
Choice Is Good, But So Was Competition
I’m in favor of shaking the tree once in a while, but I think this latest move by Vanguard actually makes decision-making for investors more difficult, not easier. Investors now have an additional set of choices when selecting their international as well as U.S. size ' style exposure.
Because the new indexes are quite different than the old ones, it’s no longer a matter of simply assessing the efficiency and tradability trade-offs between pairs of very similar funds. Investors will now need to think long and hard about how each fund in what were formerly apples-to-apples comparisons selects its stocks. In our ETF Analytics service, that’s what we call a “fit” decision, and it’s often the thorniest part of any investor’s analysis.
It’s also the one that, time and time again, makes the biggest difference in returns.
Slow And Steady
Perhaps the best news in today’s announcement is that Vanguard is going to phase in these changes at a glacial pace. The indexes don’t even formally change until 2013, and even then, Vanguard will be transitioning the portfolios over a period of five months.
That means Vanguard will be able to use the natural creation and redemption process to slowly, painstakingly migrate from one index to the next. That’s good for investors, because they’ll be able to mitigate the tax implications and minimize any front-running concerns.
It’s going to be a bear to keep track of what you own, however.
Stay tuned as we dig in over the coming days to put all of this into a sharper analytical framework.
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