- The Washington Times - Tuesday, March 15, 2005

With Wall Street entering an era of slower earnings growth, every penny of investment return counts, and that means management fees matter more than ever — a fact underscored by the rising popularity of low-cost exchange-traded and index mutual funds.

Instead of trying to beat the market through savvy portfolio management, ETFs and index funds merely mimic the performance of whatever benchmark they track. The baskets of stocks may broadly cover the entire market, or narrowly focus on just a portion of it, such as a sector, industry, global region or country. The main difference between ETFs and index mutual funds is that the former is traded like a stock; ETFs are priced intraday, can be used to establish long and short positions, and each transaction generates a trading cost.

Because there’s no stock selection research involved, indexed products are a cheap alternative, and a longtime favorite of bargain-minded investors. Now, with competition for indexing dollars heating up, providers are generating new products and lowering fees on existing ones. Slimmer expenses are always good news for investors, but the rapid proliferation of choices may be somewhat bewildering.

Index specialist Vanguard Group recently launched three new international ETFs, bringing to 23 the number of funds in its ETF family, known as VIPERs. With just $7 billion in ETF assets, Vanguard has a long way to go before it catches up with market leader Barclays Global Investors, which has some $123 billion under management across 98 domestic IShares funds; including international offerings, there are more than 120 IShares.

But investors would be wise to take notice of the VIPERs’ rock-bottom fees, most of which are lower, sometimes dramatically so, than expenses on similar funds offered by competitors. Known as a low-cost provider, Vanguard recently reduced expenses on a number of its VIPERs. Fees on both its total market and large-cap VIPERs now stand at just 0.07 percent, making them the cheapest ETFs on the market. Comparable funds from IShares are priced at 0.20 percent and 0.09 percent, respectively.

“A key a lot of people miss about ETFs is that they don’t realize they’re talking about an index fund,” said Gus Sauter, Vanguard’s chief investment officer. “People need to step back and understand what ETFs are. They are another door to enter the index house. And the higher the expense ratio, the lower the net return.”

Pricing competition among ETFs has led to downward pressure on expense ratios on traditional index mutual funds as well, said Dan Culloton, an analyst with Morningstar Inc. Recently, for example, Fidelity Investments sharply reduced the fees on its Spartan series of index mutual funds.

In August, Fidelity voluntarily capped expenses on its domestic equity index funds at 0.1 percent, undercutting fees on similar offerings from Vanguard. Fidelity was criticized at the time by analysts and Vanguard itself for instituting the change through a fee waiver — which meant the expenses could be restored to their previous levels at the firm’s discretion.

The cuts were made permanent earlier this month, however, when Fidelity rewrote contracts at five domestic equity index funds, including the Spartan 500 Index Fund, so fees could not be raised above 0.10 percent without shareholder approval. By comparison, Vanguard’s 500 Index, the largest mutual fund on the market with total assets of $107 billion, carries a 0.18 percent expense ratio.

Actively managed funds remains the core business at Fidelity, which has some $2.1 trillion under management, including about $47 billion spread across nine index funds. The reduction in fees demonstrates the firm’s commitment to providing investors with low-cost index options, said Jeff Carney, president of Fidelity Personal Investments. But while it has attracted a lot of positive attention for the company, there’s a good chance Fidelity is losing money on its indexing deal, Mr. Culloton said.

“I wouldn’t expect Fidelity to become a large indexer. But for new people who are coming in and want to do a core-and-explore strategy … this holds appeal,” Mr. Culloton said. “They’re looking at it as a loss-leader and a retention tool.”

For an investor who has held index funds with Vanguard for a long time, it may not make sense to jump ship for a few basis points, particularly if they would be subject to taxable capital gains, Mr. Culloton said. Another point in Vanguard’s favor is that CIO Mr. Sauter has developed a reputation as an efficient trader, goosing performance through the use of futures contracts and other techniques.

Still, by making its index mutual funds the cheapest on the market, Fidelity has issued a challenge to Vanguard, and thrown up a significant hurdle for the indexing expert. And the change may well keep some assets under the Fidelity roof — the firm has added $2 billion in new index assets since its initial reduction in fees, Mr. Carney said. However, Fidelity’s $10,000 minimum may put off some new investors.

Vanguard’s minimum is a more manageable $3,000. And more seasoned investors may qualify for discounts by buying Vanguards Admiral shares, which are available on accounts larger than $250,000, or to clients with lower asset levels who have been with the firm a number of years. Admiral shares of the Vanguard 500 charge 0.12 percent. And, of course, the large-cap VIPER ETF is the cheapest index on the market.

“We welcome the competition,” Mr. Sauter said. “It underscores what we’ve been saying all these years, and it’s interesting to see other people saying it, too.”

ASSOCIATED PRESS

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