From the June 2006 issue of Research Magazine • Subscribe!

Vanguard VIPERs Find Role in Expanding ETF Market

During the frigid winter of 1777, Valley Forge, Penn., was home to America's army. It was there a rigorous training regime under the command of General George Washington transformed a ragtag troop into a disciplined brigade. Though no battles were fought there, a struggle against the odds and low morale was won.

Today, Valley Forge is the proud headquarters of the Vanguard Group, which finds itself in the midst of a battle of sorts. The indexing giant has successfully fought for its place in the mutual fund industry and it's trying to do the same in the burgeoning ETF business.

Through the end of March, assets in Vanguard's ETFs, also known as VIPERs (Vanguard Index Participation Receipts), surpassed the $15 billion mark -- representing an impressive 92 percent increase in asset growth over the past year.

The VIPERs are a mix of 11 sector, 10 domestic, and three international exchange-traded funds. Included in this group is a new addition, the Dividend Appreciation VIPERs (VIG). Launched in late April, the fund tracks an index of large-cap stocks that consistently report year-over-year dividend growth.

In the past, Vanguard has been criticized for jumping into the ETF business too late. Its first two ETFs launched in 2001, but it wasn't until three years later that the company rounded out its VIPERs lineup by offering sector and targeted-cap funds. To Vanguard's credit, its "late start" has still beaten many of its largest and peer competitors. Fidelity, for example, has only one ETF. AMVESCAP, through its planned acquisition of PowerShares, is just getting into the ETF business. Other mutual fund companies have been blindsided by not having an ETF strategy, or they've turned their head the other way to focus on higher-margin businesses, like hedge funds.

While the VIPERs have gained a following, they still have their detractors. Unlike competitors that offer "stand-alone" ETFs, some argue the tax efficiency of VIPERs isn't any greater than that of Vanguard's conventional index shares. Noel Archard, head of institutional sales for VIPERs, disagrees: "From a minimizing capital gains perspective,

Vanguard index fund managers take advantage of any modest cash flows from the traditional share classes to harvest losses. These losses can then be used to offset future gains."

Another important topic is dividends. "For investors in higher brackets," Archard warns, "the level of qualified dividend income (QDI) should be among the considerations when evaluating index products." The law, which passed under The Jobs and Growth Tax Relief Reconciliation Act of 2003, sets a maximum tax rate of 5 percent on QDI for taxpayers in the 10 percent and 15 percent brackets and 15 percent for those in higher

income-tax brackets, so long as required holding periods are met. Archard adds, "Vanguard's index funds have tended to distribute higher levels of Qualified Dividend Income than their ETF counterparts."

Solving the Dollar-Cost-Averaging Dilemma

Despite their rapidly growing ranks, the VIPERs share class still represents a fraction of the assets compared to the traditional mutual fund shares. As of March 31, the assets of the Total Stock Market VIPERs make up only $6.1 billion of Vanguard Total Stock Market Fund's $71 billion in total net assets. The same trend is also seen with VIPERs in other asset classes. The REIT VIPERs have only $1.1 billion of the fund's $9.1 billion and the Emerging Markets VIPERs make up $1 billion of the fund's $9.3 billion. The relative youth of the VIPERs share class is a likely reason for this phenomenon. The clear advantage for assets in the mutual fund shares has been the steady flow of contributions coming from 401(k) retirement plans.

No matter how low brokerage commissions fall, it's still tough to rationalize the cost of dollar-cost averaging into exchange-traded funds. In most cases, the numbers don't favor the investor. Yet, many investors still want to own ETFs. What can they do? For new or smaller clients, particularly those interested in dollar-cost averaging, establishing a mutual fund account directly with Vanguard might be the answer. As long as the index funds have a VIPERs share class, those mutual fund shares can be converted by the investor for a one-time $50 fee at any time. For small clients, this might be the best way to become ETF shareholders. Advisors that recommend this approach needn't worry about losing a client. Instead, they can encourage their clients to check back with them before converting their mutual fund shares to VIPERs, in order to determine the logic and timing of any such change.

Overcoming Trading Restrictions and Redemption Fees

One area of frustration has been the wave of trading restrictions and redemption charges on short-term investments in mutual fund shares. This is a particularly onerous obstacle for many advisors who were used to jumping in and out of various sector mutual funds. The trading scandals of a few years ago are the main culprit, and today most fund families have imposed steep redemption charges or trading restrictions, making it difficult for active investors to fluidly enter and exit the market.

Vanguard's sector index mutual funds have a redemption charge of 2 percent if they're held less than one year. The lone exception is the REIT index fund, which is capped at 1 percent. In contrast, the sector VIPERs have no holding period requirements because redemption charges aren't part of the equation for them or any ETFs. Trading flexibility has been one of the key benefits of the VIPERs and it's one of the reasons many advisors have opted in favor of them over old-school sector mutual funds.

For advisors interested in more sophisticated strategies, most of the VIPERs have underlying call and put options. Long ETF positions can be hedged with put options. Some advisors are selling covered calls in order to generate additional income for their clients. VIPERs can also be leveraged with margin or shorted. While some brokerage firms allow their clients to margin mutual fund positions, mutual funds themselves are prohibited from trading on margin. Simply put, traditional mutual funds don't offer the same level of sophistication or flexibility.

Cost and Diversification

Compared to peer mutual funds and ETFs, the VIPERs have consistently lower expense ratios. Eric Schulman and Adindu Nwachuku, financial advisors and partners with Smith Barney in West Hartford, Conn., use VIPERs because "we realize cost is a factor and the low internal expenses are appealing. It matches our philosophy of making sure we keep our clients' expenses as low as possible."

Vanguard's Archard cites the Emerging Markets VIPERs as an example of the cost differences between VIPERs and their peers: "VWO has a 0.30 percent expense ratio, which is less than half that of the competitors' emerging market ETF." Most ETFs in the emerging market asset class are single country funds from iShares, which have expenses that range from 0.59 percent to 0.75 percent.

The BLDRs has an emerging markets ADR of 50 stocks, which charges 0.30 percent. The expense ratio category average for emerging market ETFs was 0.61 percent in the first quarter, according to

ETFguide.com's database.

Diversification is another consideration. In the large-, mid-, and small-cap segments, the MSCI indexes have more holdings compared to S&P indexes. The Vanguard SmallCap VIPERs (VB) has 1,750 holdings, making it less concentrated than the S&P 600 small-cap index. More holdings haven't put a damper on the performance of VB either. Through March 31, it delivered a one-year gain of 25.77 percent versus 23.86 percent for the iShares S&P SmallCap Index (IJR) over the same time span.

While low expenses are a key motivator for some investors, outstanding performance is usually the bottom line. Many investors begin by looking at the three- and five-year track record of funds. Therefore, the remainder of this year will be instrumental for Vanguard

because many of the VIPERs lock in their three- and five-year performance histories. If the VIPERs can couple solid longer-term returns with rock-bottom expenses, advisors will be compelled to notice.

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