New Vanguard Vipers Put A New Twist On ETFs With Separate Share Classes

October 01, 2003

In a move that had the ETF marketplace abuzz, The Vanguard Group said at the end of July that it plans to launch several class shares of 11 new index funds (one large-cap and 10 sectors) and expand its VIPER shares across nine existing equity index funds. All 11 new funds track MSCI domestic indexes. The registration statements for the new funds and prospectus amendments to add the VIPER shares were filed July 31 with the SEC.

Gus Sauter, Vanguard's chief investment officer, said Vanguard would be the first fund family to offer both traditional funds and ETFs tracking the same indexes. The new large-cap fund will track MSCI's US Prime Market 750 index, which invests in the largest 88% of large-cap U.S. stocks. The Vanguard Large-Cap Index Fund will be available in four share classes: investor (minimum investment $3,000), admiral (minimum investment $250,000), institutional (minimum investment $10 million), and VIPER.

The 10 sector funds, which track discrete sectors of MSCI's US Investable Market 2500 index, are: energy, materials, industrials, consumer discretionary, consumer staples, health care, financials, information technology, telecommunications and utilities. Vanguard's nine traditional index funds receiving VIPER shares are: value, growth, midcap, small-cap, small-cap value, smallcap growth, European, Pacific and emerging markets.

In offering the new products, Vanguard adds another layer of complexity to ETFs by launching its VIPERs as a separate share class of its existing lineup of index funds. Sauter says there are significant differences between separate share class ETFs and stand-alone ETFs such as iShares, Spiders and Cubes.

"With our structure, we're adding another ETF share class to an existing fund that has a track record and has critical mass," said Sauter. "There are already sufficient assets so that the ETF, upon inception, is guaranteed to have enough assets to track the index."

Sauter pointed out numerous ways in which the Vanguard 'conventional' and VIPERs shares provide potential benefits for each other.

"It helps having true cash flow coming into the fund," said Sauter. "In a conventional ETF, everything is done in-kind, whether it's a creation or a redemption. It's all done with stock. In our structure, the ETF piece is done with stock, but the fund is also receiving substantial cash flow through the conventional class of shares. That's beneficial because you're able to redirect that cash flow to incorporate index changes into the portfolio. Indexes are changing constantly."

Although ETFs have tax efficiency advantages, they obviously can't get around selling all of a stock when it is deleted from an index.

"In a traditional ETF, you may have to sell off all of your other stocks in order to purchase a stock that has been added to an index. If you have cash flow coming, you can use that to buy new stocks," said Sauter.

Sauter believes the tax advantages of ETFs may not be well understood by investors and advisors. He also noted that all registered investment companies, including mutual funds, have the ability to make in-kind redemptions to reduce capital gains.

"There seems to be a misconception out there that ETFs don't distribute capital gains-in fact, 70% of ETFs paid out a capital gain in 1999. For example, the iShares S&P 500 distributed a capital gain in its first year. When a stock is deleted from an index, ETFs must sell all of the stock. The advantage we have with the VIPERs is that with the conventional class we can realize losses and stockpile those to offset gains that may be forced upon us. From the ETF class, we have the opportunity to clear out the low cost lots," said Sauter.

Patrick O'Connor, a portfolio manager for the U.S. iShares, says none of BGI's domestic iShares have distributed a gain since the first-year gain Sauter references. "In our first year, all the money was coming in, and the market was going up in the early days," said O'Connor.

In Vanguard's VIPERs structure, investors in both share classes are treated equally from a tax standpoint, which allows many of the benefits discussed below. However, it may lead to one potential disadvantage, said Lee Kranefuss, head of ETF business at BGI.

"The downside is that you cannot treat shareholders in the two share classes differently," said Kranefuss. "For example, the index fund can generate taxable gains when investors are buying and selling shares-when cash is flowing in and out of the fund. In an ETF, most or all of that activity takes place on the secondary market, so capital gains would not be generated. However, since the ETF is a separate share class of the fund (in Vanguard's setup), the gains are passed out to ALL shareholders. Therefore, the ETF share class might not be as tax efficient as a stand-alone ETF."

Sauter said that Vanguard's index funds have booked significant losses that can be used down the road.

"If you have redemptions out of the conventional class, you're going to sell off the highest cost lots in the portfolio," said Sauter. "So you're going to realize capital losses. Right now, virtually every fund out there has significant cost lots that have big losses. When we had redemptions out of the conventional class of shares the past few years, we sold off the highest cost lots, and we've realized very significant capital losses. For example, our S&P 500 portfolio has more than $4 billion in losses which can be applied against any future realized capital gains."

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