Vanguard: Too Cheap for Its Own Good?

All other things being equal, investors who minimize their investing costs will have the best returns. But when all other things aren't equal, it doesn't always make sense to go for the cheapest investment if it means sacrificing quality.

That's the controversial situation that ETF provider Vanguard is dealing with right now. After creating a huge success with its Vanguard MSCI Emerging Markets (NYSEMKT: VWO  ) ETF, the company decided to make a money-saving move that has some of its biggest customers crying foul -- and putting their money where their mouths are.

Shifting indexes
Last month, Vanguard announced that it planned to change the index that its emerging markets stock ETF tracks. Rather than using MSCI's (NYSE: MSCI  ) Emerging Markets Index, Vanguard chose to shift to a rival benchmark, the FTSE Emerging Index. In its letter to shareholders, Vanguard argued that the FTSE index offers similar coverage of emerging market stocks, but because of its agreement with FTSE Group, moving away from the MSCI index will produce what it called "significant savings to shareholders over time" due to lower costs.

The move isn't the first in a series of cost-cutting measures that major ETF providers have made. Both Schwab (NYSE: SCHW  ) and BlackRock (NYSE: BLK  ) have made moves to reduce the annual expenses they charge ETF shareholders.

But Vanguard's move is significant because it leads to some substantial changes to the actual stocks that the ETF owns. Most notably, the FTSE index doesn't include South Korea as an emerging market, and so the fund will have to sell shares worth roughly 15% of its total assets. Tech giant Samsung and automotive company Hyundai are among those stocks that will get the boot. To minimize disruption, the fund plans to cut its exposure to Korean stocks over a 25-week period in 4% increments.

Up in arms
But major investors question whether Vanguard's move is a smart one. After bringing in well over $10 billion during the first nine months of the year, inflows fell to just $1 million in October. That's even as rival iShares MSCI Emerging Markets (NYSEMKT: EEM  ) pulled in $1.3 billion last month. An article in the Financial Times listed several institutional investors with multibillion-dollar portfolios who questioned whether savings of 0.01% or 0.02% in index licensing fees justifies the decision, especially given that many institutions that hold Vanguard ETF shares may now have to rewrite their investment policies in order to reflect the change in benchmark. Moreover, Vanguard itself admitted that the transition would create temporary additional costs that would offset the longer-term savings, and even raised the possibility that the fund would realize capital gains as a result of the adjustments.

Given that Vanguard prides itself on how its funds are shareholder-owned, it's a little surprising that the company chose not to put the shift up for a shareholder vote. The letter from Vanguard says that the fund's board of trustees approved the change of target index for the ETF, suggesting that it saw the decision as being relatively minor and made it in the ordinary course of its business.

Keep your eyes open
Vanguard is doing what it can to protect its shareholders by not disclosing exactly when the changes will start taking place. But the more important question facing the fund is whether the move will cause a massive shareholder defection. After having worked so hard to dethrone the iShares emerging market ETF, Vanguard certainly doesn't want to give back the title.

In the long run, shareholders both large and small will vote with their money. If fund flows continue going away from Vanguard, then the company will eventually realize that there are some things that aren't worth doing just to wring an extra bit of cost savings out of an ETF.

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