Long The S&P 500? Implications Of The Upcoming Vanguard ETF Reverse Split

Sep.24.13 | About: Vanguard S&P (VOO)

Vanguard is the world's largest mutual fund company and one of the world's largest investment management companies, managing more than $2.5 trillion in global assets. The firm offers more than 160 funds to U.S. investors and more than 80 additional funds in non-U.S. markets. IN an effort to make one of its investment vehicles more attractive, Vanguard announced September 11, 2013 that it is going to conduct a reverse share split on its popular Vanguard S&P 500 ETF (NYSEARCA:VOO). What is interesting about the VOO being reverse split is that it has not been slowly decaying toward zero. Generally, in order to save products that have lost much of their share price and bring the price back to more attractive levels, reverse splits are often conducted. For example, as the S&P 500 continues to broach new highs with little volatility, volatility products such as the ProShares Ultra VIX Short Term Futures ETF (NYSEARCA:UVXY) and the Velocity Shares Daily 2X VIX Short-Term ETN (NASDAQ:TVIX), which are popular products used to gain exposure to volatility, have been decimated. As such, the UVXY recently underwent a 1 for 10 reverse split and the TVIX underwent its own split. Now, Vanguard's most popular S&P 500 is ETF is being reverse split in order to make it more attractive, even though it has increased in price by 50% in since inception in 2010.

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So What Will Happen With The Product? Any Impact On Other Products?

No other S&P 500 products, such as the popular SPDR S&P500 ETF (NYSEARCA:SPY) will be affected by this split in any way. The VOO reverse split will be conducted at a ratio of one new share for every two held. The reverse split will apply to shareholders of record as of the close of the markets on October 23, 2013. The fund will trade at its post split price on the markets beginning October 24, 2013. The ticker symbol for the fund will not change. The fund will be issued a new CUSIP number.

An Example Of The Split

The reverse split will increase the price per share of the fund with a proportionate decrease in the number of shares outstanding. In a 1 for 2 reverse split, every two pre-split shares held by a shareholder will result in the receipt of one post-split share, which will be priced twice as high as the value of the pre-split share. For example:

If you hold 100 shares of VOO priced at $75.00 each, then after the reverse split you will hold 50 shares valued at $150.00 each. The value of the investment remains unchanged at $7,500.

Thus, the reverse split does not change the value of a shareholder's investment. Further, the ticker symbol for the fund will remain the same. The fund will be issued a new CUSIP number, which identifies the product on exchanges.

There are two more considerations to think about during this split. What happens with fractional shares, and what happens to owners of options contracts.

Fractional Shares From Reverse Splits

For those shareholders who hold quantities of shares that are not a whole number with an exact multiple of the reverse split ratio, the reverse split will result in the creation of a fractional share. This will affect any shareholder who does not hold a number of shares that is a multiple of two. After the reverse split occurs fractional shares will be redeemed for cash and sent to your broker of record. The major issue associated with such a move is that it forces shareholders to realize either very tiny gains or losses, which could result in an annoying, yet taxable event for those shareholders, in addition to a having a potential loss on investment if prices are below where they were purchased. Given that volatility is near a five-year low, as the markets are soaring ever higher, a gain is quite possible with VOO. One way to mitigate this is to purchase more shares to round out your VOO holdings to a multiple of two, or to sell an appropriate number of shares (preferably on an up day) to round out the holdings.

What About Those Holding Options Contracts?

For those traders who may be holding options on VOO, this split will affect your contract, albeit minimally. Once Vanguard conducts the reverse split, the contract undergoes an adjustment that is commonly known as "being made whole", which means the option contact is modified accordingly so that options holders are neither negatively nor positively affected by the split. While we know the reverse split will adjust the price of the underlying shares of the VOO option, the option will be adjusted so that the changes in price due to the split do not affect the value of the option.

Calculating New Option Values

So if there is no positive or negative effect on the option value, just how much will the option be worth post-split? You actually don't need to worry about such things, because the options clearing corporation automatically adjusts the price to maintain the option market. However, for those who want an estimate of what the VOO option will be worth, the calculation is simple. Each VOO option contract is (usually) in control of 100 shares of VOO at some predetermined strike price. To find new the share coverage of the option after the split, all you do is simply take the split ratio and multiply by the old share coverage (normally 100 shares). To find the new strike price, take the old strike price and divide by the split ratio. Let's look at an example.

Let's say you hold a call option contract for 100 shares of VOO at a strike of $50.00. Since the split is 1 for 2 we divide $50.00 by 1/2, generating a new strike price of $100.00. The option will now cover 50 shares because we multiply 100 by 1/2. Thus, your new call option contract (which will expire on the same day as originally scheduled) will be good for a purchase of 50 shares of VOO for $100.00 each.

My Recommendation With VOO Options

Although the value of an option will not change, there's a problem. You must understand that once a reverse split like this occurs, volume on these older contracts often dries up, especially when new contracts are written at the newer strike level. Thus, wide bid/ask prices can result. The resulting wide bid/ask price and the lack of volume makes it tough to enjoy a profitable trade. You really need to the stock to move significantly in the direction of your option (for calls that's up, and for puts that's down) in order to hope to sell the option for a decent profit. Rather than deal with this issue, it is best to sell your options holdings ahead of the split, if you can afford to, to ensure there is still as reasonable bid/ask price. You can always repurchase a newer option once they are written a few weeks after the reverse split.

My Recommendation With VOO Common Shares

There have been instances where I have recommended selling ahead of reverse splits as I thought that certain instruments that reverse split only did so because they were on a path to zero. Thus, the reverse split was a symptom of a larger problem in the stock. One prime example was the UVXY split above. Three months after the split, the ETF was down 50%. There have also been times where I have recommended buying ahead of a reverse split, specifically because I thought the post-investment price would attract new investor dollars in the short run. I recommended this with a triple leveraged gold miner ETF, and the call proved to be correct . Just one week after the call, the stock soared 38%. So what to do with VOO? Well, I don't think selling is warranted as the Federal Reserve's recent "no taper" announcement was a green light to buy stocks, in my opinion. So I wouldn't sell this ETF until tapering is announced (unless you are taking profits). I wouldn't necessarily buy this ETF either, as I don't think having the price go from the current $77.75 to over $155 will attract any new investment dollars. Thus, my recommendation for VOO is to hold. The only exception would be to either buy or sell enough shares to round out holdings to prevent having fractional shares.

Bottom Line

This VOO reverse split will truly only 'hurt' investors who own common shares at a total that is not a multiple of 2, as they will be forced to sell fractional shares at a loss, or a potential gain, that could results in a taxable event. Owners of options contracts will not be affected besides being faced with owning a new contract at a different strike price for a different number of shares. The total value of the contract will, however, remain the same. I think you should essentially hold your investment through the split, with the exception of buying or selling enough shares to round out holdings to prevent creation of fractional shares.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.