Vanguard Signals Advisors

July 31, 2007

Are Vanguard's new Signal shares a good deal for advisors, or a bait-and-switch?

Vanguard is known for making dramatic cost-cutting moves that ultimately benefit its customers. However, some market participants are still trying to interpret how one of the company's latest moves will affect them.

Effective June 1, Vanguard introduced a new share class for 16 of its index funds, including its Vanguard 500 Index Fund, called Signal shares. The Signal shares are available only to financial advisors, who are now not allowed to purchase the low-priced Admiral shares.

Admiral shares, which require a minimum $100,000 investment, were introduced several years ago. Their expense ratios can be 50% of those of the regular "Investor" shares, which have no minimum investment. For example, while the Investor shares of the Vanguard 500 fund have a 0.18% expense ratio, the Signal shares of the same fund-and the Admiral shares as well-have an expense ratio of just 0.09%. But although the new Signal shares carry the same expense ratio as the Admiral shares, they work a bit differently. To be eligible to purchase a fund's Signal shares and take advantage of their lower fees, a financial advisor must have a minimum of $5 million invested in that fund. The threshold is lowered to $1 million for defined contribution plans and at the underlying account level for noninfluenced or directed assets.

So what does this mean for financial advisors? There doesn't seem to be a consensus.

 Vanguard Principal Martha Papariello, who runs the Financial Advisor Services business unit, says that financial advisors had been asking for a way to have all their clients get the benefits of lower Admiral shares fees even if not all of those clients had the minimum $100,000 invested in the fund. She says financial advisors had been telling Vanguard that they found it "burdensome" to have to pass the retail shareholder rules through to their clients and that they were accustomed to having their investments treated at an aggregate level.

"Our clients were not all that satisfied with the Admiral shares, so this is our response to them," she explains. The Signal shares are a way for Vanguard to acknowledge aggregated assets, Papariello adds.

The shares also provide a certain amount of administrative ease as financial advisors will no longer have to keep track of clients in two share classes of the same fund. "They wanted to be able to select a product and then apply it across their investor base," Papariello says.

She also points out that Vanguard's existing clients will have a three-year grace period during which they can accumulate assets to meet the minimum threshold while enjoying the benefits of the Signal shares. It is only new clients who will have to move immediately into the Signal shares starting October 5. "We are trying to be cognizant and give our investors time," she says.

 "For the most part, it has been viewed positively," says Papariello of the introduction of the Signal shares.

However, Rick Miller, PhD, chief executive of Cambridge, Mass.-based Sensible Financial Planning and Management LLC, begs to differ. "I've not heard anything that causes me to believe that it's positive," Miller says, adding that his firm has holdings in many Vanguard funds, with a good portion of that in the fund group's ETF shares. The introduction of the Signal shares has simply made it harder for financial advisors to access the savings of the Admiral shares for their clients, in his opinion.

"The number of advisors that are going to have $5 million in one fund is going to be small," he says, pointing out that if a financial advisor is in charge of $100 million in assets, $5 million represents 5% of the total portfolio.  Moreover, for firms using multiple platforms, as his does, it means that although they could have $5 million invested in a single fund, if it is spread out over more than one trading platform, they cannot access the Signal shares since there is no way of keeping track of assets across multiple platforms.

Of the $145 million in assets managed by Miller's firm, he could find only one that had more than $5 million invested in one fund-and that amount was spread across two platforms. While the amount on one platform qualifies for Signal shares status, the amount on the second platform does not. Miller said he would consider a comparable ETF offered by iShares for those assets, since Vanguard did not have an ETF class of shares for that particular fund.

Papariello concedes that the new structure might cause some smaller financial advisors some difficulties but pointed out that Vanguard's Investor share classes are still priced competitively and that ETFs were also available for many of the affected funds. "Investor shares are still a very good value," she says.

Miller is not entirely sure why Vanguard introduced the Signal shares, but he dismisses the idea that it was in response to demand from financial advisors as "hooey." They could have simply allowed financial advisors to create an omnibus holding to take advantage of the pricing for Admiral shares, he says, noting that share classes are expensive to maintain.

While Miller sees the Signal shares as a sign that Vanguard is pulling away from financial advisors, Burton Greenwald, who heads B.J. Greenwald Associates, a Philadelphia consulting firm, sees a far different trend. He believes the addition of the Signal shares could represent a shift in strategy for Vanguard, one in which it pays more attention to those who act on behalf of investors.

"I think it's emblematic of Vanguard seeking a more aggressive approach toward financial intermediaries," he says, adding that the fund group typically did not reach out to intermediaries but that the company's attitude has changed with the introduction of ETFs. Greenwald notes that 80% to 90% of mutual fund transactions involve some sort of financial intermediary. "Vanguard has been late in the game to attract them," he adds.

Greenwald believes Vanguard may be on the right track with the Signal shares. "The minimum may be high, but I think the concept is good," he says, adding that "I think the question is not that financial advisors would have that much. I think the question is: Do they have that much that they want to put into one fund?"

He speculates that ever cost-conscious Vanguard may have seen the smaller accounts as costly to maintain.

Both Greenwald and Miller, however, are hopeful that Vanguard might modify its new policy by lowering the minimum investment. "They could change it in ways that would be more encouraging to advisors," Miller says.

Joe Baker, president of ALCUS Financial Group LLC in Mount Pleasant, South Carolina, and a certified financial planner, is a fan of the new share class, viewing it from a different angle.

"The Signal shares will allow a lot of financial advisors to get into defined contribution plans and compete with larger firms on that level," he says. Baker explains that many registered investment advisors use Vanguard and that Signal shares will allow them to compete better with large fund companies like Fidelity and T. Rowe Price. Plans that deal directly with those firms might have a hard time justifying adding a financial advisor-and the accompanying fees-but the low cost of the Signal shares means that investors get a comparable price.

Charles "Chip" Roeme is the managing principal of Tiburon, California-based Tiburon Strategic Advisors LLC. He describes the introduction of the Signal Shares as a "wise and savvy business move."

"I think what they're doing is in their own business interest as well as in their clients' interest by staggering their share classes," he says. The biggest investors get the best prices, while the smallest investors get the most expensive prices-but ones that are still relatively cheap, Roeme adds.

 "I'm sure there's some advisors who won't be happy about it, but I think it's the right decision."

Roeme believes it would be accurate to view the Signal shares as a way of rewarding Vanguard's best customers. "Think of it as a frequent flyer or buyer club," he says.

But clubs are about exclusion as much as they are about inclusion, and the truth about the Signal shares is that some financial advisors will find themselves left out of the club because they don't enough assets. Only time will tell how the new share class will affect financial advisors and their clients-and Vanguard.

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