Race to cut ETF costs may leave investors in the dark

NEW YORK Thu Oct 4, 2012 9:43am EDT

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NEW YORK (Reuters) - Exchange-traded funds are waging a price war that may save investors money on fees, but cheaper fund choices pose a greater risk because they may rely on new, more-opaque indexes.

Vanguard fired the latest volley in the cost-cutting campaign on Tuesday when it said it was switching 22 index funds away from benchmarks provided by MSCI Inc., a leading index developer.

U.S. ETFs - baskets of securities like mutual funds that trade on exchanges like individual securities - hold more than $1.2 trillion in assets and are an important revenue generator for asset managers.

ETFs appeal to cost-conscious investors because they are cheaper than mutual funds. They also allow investors to trade throughout the day, with simultaneous pricing, unlike mutual funds, which price at the end of the day. ETFs are largely passively managed, tracking indexes rather than being actively run by a portfolio manager.

Vanguard, long the low-cost leader, has been gaining market share over the last several years. But rivals such as BlackRock Inc and Charles Schwab Corp. have grown more competitive. BlackRock has announced plans to lower fees, while Schwab last month slashed its ETF fees - sometimes to pennies.

Instead of the MSCI indexes, Vanguard now will use less-pricey FTSE Group indexes for six international stock funds.

Vanguard will also use indexes designed by the University of Chicago's Center for Research in Security Prices for 15 stock and balanced funds and ETFs. The center, known as CRSP, has been working with institutions for decades but is unknown to individual investors, unlike well-known rivals such as Standard & Poor's or Russell Investments.

Unlike the MSCI, which uses a transparent rules-based methodology, CRSP's modeling is more opaque and nuanced, experts said.

"These are brand-new indexes that are not battle-tested and they have some non-transparent rules in how they get constructed," said Dave Nadig, director of research at IndexUniverse, which tracks the ETF industry.

CRSP's Chief Operating Officer David Barclay said the different methodologies should not be a drag on a fund's returns. And Joel Dickson, senior ETF strategist at Vanguard, said CRSP's approach is not a big departure from that of MSCI.

"We are talking about angels on the end of a pin and not broad-based differences," Dickson said.

Vanguard discloses fund holdings quarterly, not daily as its competitors do. That makes it harder for investors to know what securities they own, but it prevents traders from knowing Vanguard's moves in advance.

NOT YOUR FATHER'S INDEX

Other firms are launching ETFs tracking their own or customized indexes, sometimes at a lower cost. While most ETFs are based on well-known indexes like those offered by Standard & Poor's and Russell Investments, more fund providers are creating their own or using ones designed by others.

WisdomTree Investments Inc, Van Eck Funds and IndexIQ use their own indexes. Other firms, including BlackRock, have filed with the U.S. Securities and Exchange Commission to introduce their own indexes.

Do-it-yourself indexing allows firms to create products where there may not be a relevant index, said Daniel Gamba, Head of iShares Americas Institutional Business at BlackRock. In some cases, this may be at lower cost, but not always.

A proprietary index can pose conflicts of interest unless a Chinese Wall separates the fund adviser from the index provider parts of the business, said Sebastian Ceria, CEO of Axioma, a New York-based firm that works with indexers.

Another concern: investors may not understand what they are investing in if the index is unfamiliar. Investors know exactly which stocks are tracked in an S&P 500 index fund. The information is easy to find, even when components are changed.

CRSP's more-nuanced methodology is less clear for investors. For one, it has different breakpoints to define market capitalization. And companies that fall close to these breakpoints may get split between two market caps.

"That means it's not always going to be clear what is in your portfolio," Nadig said.

CRSP has "zones" around market-cap breakpoints to minimize unnecessary trading, reducing turnover and costs, said CRSP's Barclay.

CRSP has been providing indexing research to institutions since the 1960s so it is well known among institutional quantitative equity investors. But it is new to retail investors, said James Pacetti, head of business development for S*Network Global Indexes, LLC, an index provider.

"A person is going to say: 'Where do I find CRSP, is it in the paper?' " Pacetti said. "People are familiar with certain names, and CRSP is not one of them."

One Vanguard investor was unsettled by the switch.

"I had never heard of CRSP until I read the article announcing the change," said Rich Romey, president of ETF Portfolio Partners, Inc., a Leawood, Kansas-based adviser who has $8 million invested in the Total Vanguard Stock Market ETF, - one of the funds that will now be based on a CRSP index.

"We trust Vanguard's judgment so we are not going to jump ship right away," Romey said. "But we are going to watch this carefully."

(In seventh paragraph this story adds dropped words "the University of" Chicago)

(Reporting By Jessica Toonkel; Editing by Jennifer Merritt, Lauren Young and David Gregorio)

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