* Vanguard index creators unknown to individual investors
* Ditching MSCI cuts costs but raises questions
* Different methodology requires more due diligence
By Jessica Toonkel
NEW YORK, Oct 4 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,
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
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
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
"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
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
"We trust Vanguard's judgment so we are not going to jump
ship right away," Romey said. "But we are going to watch this