Get Divvy With It … Again

August 24, 2006

Vanguard files for a second dividend index fund; plus, emerging market emerge, setting up a huge battle with BGI.

Vanguard has filed papers with the Securities and Exchange Commission (SEC) for the right to launch a new index-based dividend fund. The fund will be Vanguard's second index-based dividend fund, and its fourth dividend fund overall.

The new Vanguard High Dividend Yield Index Fund will track a custom-made index called the FTSE High Dividend Yield Index.  According to the relatively vague prospectus, the fund will seek out … surprise, surprise … high-yielding stocks.

So how does that differ from the other Vanguard dividend funds?

This gets a bit confusing, but here's the idea:

Vanguard's other dividend index fund is the Vanguard Dividend Appreciation Fund (AMEX: VIG, and VDAIX), which launched in April. VIG tracks a Mergent index designed to select companies that both: a) pay relatively high dividends now; and b) have strong underlying growth, which will support even higher dividends later.

The new Vanguard fund does away with the second requirement - strong growth - and focuses solely on high yield.  The result should be a significantly higher payout for the fund, with (perhaps) less potential for capital appreciation.

Vanguard offers a similar pair of funds on the active side.  The names of the funds are completely backwards, however: The Vanguard Equity Income Fund (VEIPX) focuses on stocks with high yield and good growth potential, while the Vanguard Dividend Growth Fund (VDGIX) focuses primarily on yield. (Emphasis mine).

Index Is Pricey!

In a quirk, Vanguard's new index-based dividend funds are actually more expensive than its active offerings. The traditional mutual fund share class of both the High Dividend Yield and Dividend Appreciation fund charge 40 basis points, compared to 32 basis points for the Equity Income Fund and 37 basis points for the Dividend Growth Fund. Both of the active funds have substantial assets, however, and are able to benefit from economies of scale. It's possible that as the index funds accumulate assets, they will lower their expense ratios as well.

Regardless, the expense ratios for the ETF shares for the index funds are the cheapest overall. The Dividend Appreciation ETF (AMEX: VIG) charges just 28 basis points. Vanguard is planning on having an ETF share class for its new High Yield fund, but there is no word yet on expenses or tickers.

Emerging Markets Emerge

In other Vanguard news, the company has decided that the stock markets in Russia and Malaysia have matured enough to be included in their $9.6 billion Emerging Markets Stock Index Fund. 

Since inception in 1994, the Vanguard fund has tracked a custom-made MSCI benchmark called the Select Emerging Markets Index, which excluded certain countries due to concerns about liquidity, repatriation of capital and various barriers to entry.  One by one, however, those "excluded" markets have been upgrading and coming to meet Vanguard's standards. In 2003, Chile, Peru and India were admitted to the club. Now, Malaysia and Russia have made the grade.

With those additions, Vanguard says the Select Emerging Markets Index is now "effectively the same" as the standard MSCI Emerging Markets Index.  As a result, Vanguard is changing the fund's benchmark to the standard index.

This move will significantly raise the stakes in the huge market for ETF-based Emerging Markets exposure. For years, Barclays Global Investors has justified the higher fees on its Emerging Markets ETF - the iShares MSCI Emerging Markets Fund (NYSE: EEM) - by noting that its fund was more complete than Vanguard's.  In particular, it often called out the differences in exposure to Russia and Malaysia. 

Now, however, the two funds will be substantially identical. Vanguard charges just 30 basis points in expenses for its Emerging Markets ETF (AMEX: VWO), while iShares charges a whopping 0.75 percent.  Currently, the iShares fund has ten times the assets of the Vanguard fund - $12 billion vs. 1.2 billion - but the new fee levels could put pressure on that ratio, or at the very least, put pressure on BGI to lower its fees.

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