Will Vanguard's Mutual Fund Tweaks Lead to a New ETF?

Includes: EFA, VEA, VEU, VGK, VPL, VT, VWO
by: IndexUniverse

By Dan Serra

Vanguard has taken out its wrench and tinkered with its Total International Stock Index Fund [VGTSX] by throwing out the fund-of-funds concept and investing in individual stocks.

Now, could an exchange-traded funds version be close behind?

Vanguard insists that's not the reason for its decision to make changes to the pioneering mutual fund's portfolio.

"We already offer two really well-diversified international ETFs, so I don't think we have any plans to offer this as an ETF," said Vanguard spokesperson Rebecca Cohen.

Vanguard's two internationally diversified ETFs are the FTSE All-World ex-US ETF (AMEX: VEU) and the EuroPacific ETF (AMEX: VEA). Both have done well attracting assets and rank among the top 10 largest international ETFs.

Vanguard also offers four others: an Emerging Markets ETF (AMEX: VWO), the European Stock ETF (AMEX: VGK), the Pacific Stock ETF (AMEX: VPL) and the Total World Stock ETF (NYSE: VT), which holds 42% in U.S. stock. Each is down more than 15% year-to-date, in line with the performance of VGTSX.

But even with its already robust lineup, that's not to say a Total International ETF couldn't happen, say observers. After all, Vanguard holds a patent protecting its use of forming a second share class for ETFs. That's not only a relatively low-cost and painless way to launch new ETFs, it also gives new portfolios instant brand recognition.

"They can easily make it an ETF," said Herb Morgan, chief executive at Efficient Market Advisors in Del Mar, Calif. "I think it would only follow that they do an ETF."

If an ETF were to come in the future, it would be an inviting player in the international ETF marketplace.

Asset Magnet

"Anything that Vanguard launches that's broad-based would attract assets," Morgan said.

From a purely investment perspective, investors could cobble together the three existing ETFs that formed the Total International's portfolio as a fund-of-funds in much the same manner. And no doubt many are doing just that, combining VWO, VGK and VPL. Or, VWO could be used in tandem with VEA. Another possibility is simply to hold VEU, which is almost identical to the portfolio of VGTSX except that the ETF fund includes Canada.

So why a Total International Stock clone in ETF form?

One reason would be ease of use. There's certainly an argument to be made for investors with VGTSX in their retirement plans looking to add more money into a taxable account or IRA. Using an ETF that's likely to be even cheaper, yet exactly replicates the existing mutual fund, would be an attractive option.

Also, existing VGTSX investors could simply switch share classes into the new ETF. That could essentially give the old mutual fund a fresh appeal and attract a whole new set of investors.

But perhaps even more appealing to Vanguard from a business perspective is that a Total International Stock ETF would present more direct competition to market leader iShares MSCI EAFE (NYSE: EFA). It's the largest broadly diversified international ETF, with $43 billion in assets.

That would be an interesting matchup considering that an ETF share class of VGTSX would present more diversification under a single umbrella than EFA since it would also include some emerging markets exposure. EFA sticks to the EAFE index, which covers the world's developed markets outside the U.S.

But at least for now, Vanguard is casting the changes to its popular mutual fund as simply tweaks to an already finely tuned portfolio.

Three Advantages For Investors

In a nutshell, the new VGTSX will buy individual stocks instead of the three index funds in a fund-of-funds structure. Vanguard emphasizes, though, that the new procedure will dip into the same pond as each individual fund. The resulting portfolio should be nearly identical to the one it had under its fund-of-funds structure.

"We're trying to reflect those underlying [stock] assets rather than fund ownership," said Vanguard's Cohen. "It's still entirely indexed."

While the fund's core investment strategy isn't changing, the switch to individual stocks does seem to hold the possibility of providing some clear advantages to certain investors.

For one, foreign tax credits will now be available where previously they were not possible in the fund-of-funds setup.

Vanguard also says it will better be able to track the indexes by investing incoming cash in securities throughout the day rather than at the day's ending net asset value. That also allows it to reflect changes in those stock holdings throughout the day to provide better tax efficiency and less tracking error.

"There are three key advantages," Cohen said. "The foreign tax credit is one of them, we can better track the index and we have more flexibility in how we manage taxes in the portfolio."

The $26 billion mutual fund, the largest international index fund, previously held shares in just its European Stock Index Fund [VEURX], Pacific Stock Index Fund [VPACX] and Emerging Markets Stock Index Fund [VEIEX]. In the latest rebalancing, those weighting stood at 55%, 24% and 21%, respectively.

With the changes, VGTSX's portfolio will consist of stocks in the same underlying indexes - the MSCI Europe Index, the MSCI Pacific Index and the MSCI Emerging Markets Index -- at roughly the same percentages.

The switch will not change the expense ratio, currently 0.27%, and is not expected to result in capital gains from the selling of the funds.

In fact, Vanguard's decision to switch now when those markets are down reduces gains.

Cohen said the transfer is being managed so that losses offset gains. It already has transferred 50% of the portfolio with the rest being done over time. It won't be until the end of the year that investors know just how successful Vanguard is in balancing those capital gains against losses.

Timing Seen As Opportune

And even though all of the changes might seem rather rudimentary, it's a much bigger undertaking than might appear on the surface, says Allan Roth.

The Colorado Springs, Colorado-based advisor points out that with international stocks tripling between 2003 and 2007, Vanguard's actually taking on a rather huge feat.

"It's an opportunity to make some transactions in a tax-free way," Cohen said as to why making the move now in a weak market makes sense.

"We want to make sure we do this in a way that has the lowest impact to shareholders. It's a combination of markets and cash flows in and out of the funds that will allow us to get to that point."

That philosophy makes sense, says advisor Morgan. "It is consistent with Vanguard's mission, and a good idea," he said. "Do it now while the markets are low."

Morgan notes that investors will also benefit by reducing what he calls "cash drag." Since each of the funds had cash floating around in the portfolio, it now means those overlaps will be reduced and more cash will be invested in the fund.

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