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.