NEW YORK -- Vanguard Group has decided to revamp seven of its popular index funds, aligning them with indexes operated by Morgan Stanley Capital International in a move designed to cut costs and improve returns.
The funds will be switched by the end of September, six of them abandoning indexes compiled by Standard & Poor's and one moving from an index run by Frank Russell Co.
Vanguard is making the changes because the MSCI indexes better represent certain investment styles, said Gus Sauter, managing director of Vanguard's Quantitative Equity Group.
Sauter said the move will also lower funds' operating costs, in keeping with Vanguard's low-cost reputation. The MSCI indexes have more flexible rules about what stocks are included in the various indexes, resulting in less frequent trades and therefore lower trading costs, he said.
The seven funds are Vanguard Mid-Cap Index, Vanguard Value Index, Vanguard Growth Index, Vanguard Small-Cap Index, Vanguard Small-Cap Value, Vanguard Small-Cap Growth Index Fund and Vanguard Variable Insurance Mid-Cap Index Portfolio with $253 million in assets.
The Vanguard 500 Index fund, a $67 billion household name, will continue to track the S&P 500, Sauter said.
"Investors frequently say they want an S&P 500 fund. It happens to have a great deal of brand recognition. With the other funds, investors don't say, 'I want a certain small-cap value fund,"' Sauter said.
Vanguard operates 40 index funds, called such because their holdings mirror those of particular equity indexes, with $200 billion in total assets. Vanguard's index funds track 22 benchmarks from seven index providers.
The indexes currently used by the funds that will be switched to MSCI indexes include the S&P SmallCap 600, S&P MidCap 400, the S&P 500 Barra Value, the S&P Barra Growth and the Russell 2000.
S&P refutes Vanguard's claim that the way it manages its indexes doesn't best represent various investment styles or asset classifications.
"The mid-cap and small-cap indices are world class. They have had tremendous support," said Lynn Cohn, a spokeswoman for S&P.
Inflows into the S&P SmallCap 600 increased by 43.5 percent in 2002 and inflows into the MidCap 400 rose by 22.2 percent, Cohn said, adding, "I think that shows a lot of market support for these indexes."
S&P isn't planning to make any changes to its indexes in response to Vanguard's move, she said, but "S&P is always talking to the indexing community about how to make our indices more useful."
Others agree with Vanguard.
In the S&P indexes, stocks are more narrowly categorized as a growth issue or a value issue, because only one measure is used to determine that, whereas MSCI uses several gauges, said Russ Kinnel, director of fund analysis at Morningstar Inc. And, the lines between the large-, mid- and small-cap categories are more rigid at S&P.
The S&P indexes "weren't working very well. They were defining growth and value purely by the price-to-book ratio. Price-to-book works well for some industries and not for others. But mainly, it is just one measure," Kinnel said.
The price-to-book ratio, calculated by dividing stock prices by the estimated net worth per share of a company, is a good measure for value-oriented issues such as financials, but not for growth-oriented issues such as technology, Kinnel said.
By using just that one measure, Kinnel maintained that the performance of some of S&P's growth and value indexes varied greatly from the average for their particular category.
"They really didn't behave as you would expect," he said. "The value funds did much worse than you'd expect and the growth would do much better. And, from an index fund what you want is predictability and results that aren't too far from the category average."
Vanguard's Small-Cap Index fund also stands to benefit from a new benchmark, Kinnel said. The MSCI index rebalances its holdings twice a year, whereas the Russell does so once annually. Kinnel said the twice yearly rebalancing means the fund will have a more true tracking of smaller companies stocks.
Vanguard doesn't have any plans to make more changes to index funds' benchmarks or to make such proposals to shareholders, spokesman John Demming said.