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By Murray Coleman

After years of investor complaints that its low-cost lineup of index-based funds has been missing a key component, the Vanguard Group has finally responded.

On Thursday morning, the Valley Forge, Pa.-based mutual funds and exchange-traded funds provider said it had filed to launch the Vanguard FTSE All-World ex-US Small-Cap Index Fund. It will come in three versions—institutional, investor and ETF share classes.

"This has been a significant hole for them. But we've been convinced that Vanguard realized the need for a low-cost small-cap international index fund. It just took time for them to do it right," said Chance Carson, president of Alpine Strategies.

The Colorado Springs, Colo.-based advisor says he has asked the indexing pioneer on several occasions why it hadn't brought to market a passively managed foreign small-cap fund.

In each case, Vanguard executives told Carson that they were focusing on picking the right index and making sure it provided access to the most investable areas of what can be a highly illiquid overseas marketplace.

A spokeswoman for the company declined to discuss the filing beyond details announced on Thursday, pointing to Securities and Exchange Commission regulations prior to receiving an official green light to move forward.

Competition

"At the very least, this shows that Vanguard intends to remain extremely competitive, particularly with Barclays [Global Investors]," said Carson, who also runs the AboutETFs.com Web site.

Several international small-cap ETFs are already well established in the market.

WisdomTree was the first company to launch a small-cap international ETF, in 2006, with its International SmallCap Dividend Fund (NYSEArca: DLS). The following year, BGI launched two: the FTSE Developed Ex-US Small Cap ETF (NasdaqGM: IFSM) and the iShares MSCI EAFE Small-Cap Index Fund (NYSEArca: SCZ).

State Street Global Advisors also joined the ETF market last year with the SPDR S&P International Small Cap Fund (NYSEArca: GWX).

The lowest expense ratio of the group came through SCZ, which charged 0.40% per year. On the high-end among pure small-cap international ETFs has been GWX at 0.60%. (For an in-depth breakdown, see this story.)

But the international small-cap index funds market has seen some change lately. Last month, Vanguard opened its long-closed International Explorer Fund (VINEX) to new investors. With an expense ratio of 0.35%, the actively managed fund easily became the cheapest mutual fund in the category.

In a rare event in the funds world, however, a mutual fund—and an actively managed one at that—became the least expensive option for retail investors when matched against corresponding ETFs. (See story here.)

Marketplace Anomaly

Despite any eventual introduction of a new Vanguard international small-cap fund, such an anomaly in the marketplace will still exist.

Vanguard FTSE All-World ex-US Small-Cap Index Fund's investor shares will require at least $3,000 to initiate positions. They will come with an expected annual expense ratio of 0.60%. Meanwhile, institutional shares will require a minimum of $5 million up front and charge 0.35% per year in expenses.

The FTSE All-World ex-U.S. Small-Cap ETF will come with an expense ratio of 0.38%. (The index mutual fund share classes will come with 0.75% fees on purchases and redemptions.)

So that leaves the ETF version in a virtual dead heat with BGI in terms of pricing. And the investors share class of the mutual fund will still be more expensive than the actively managed VINEX.

But with its FTSE index, another key question is how it will compare to the IFSM, the original pure international small-cap ETF to hit the market, but at 0.12% more costly.

"It's amazing that an actively managed fund in small-cap international stocks beats everyone else," said David Fernandez, president of Wealth Engineering in Scottsdale, Ariz.

But he's pleased to hear that Vanguard is coming out with an index mutual fund in the category. "Although costs are important, I still prefer a passive approach," said Fernandez. "For clients who prefer mutual funds, there just haven't been many good options available besides what DFA [Dimensional Fund Advisors] offer."

The lowest-cost international small-cap fund he has been using in portfolios is the DFA International Small Cap Fund (DFISX). It has an expense ratio of 0.55% per year.

"The new Vanguard index fund should provide a real alternative for traditional index mutual funds investors," said Fernandez. "It's something we'll take a hard look at in relation to DFA funds."

Source: Vanguard Files for International Small-Cap ETF