Vanguard to Offer Tradeable Versions of Its Popular Index Funds

Vanguard, which dominates traditional index funds, is moving into the exchange-traded fund business, and soon will offer versions of the firm's most popular indexes that can be easily traded by active investors.

The move comes as another indexing powerhouse, Barclays Global Investors, is preparing to launch a slew of the exchange-traded funds in the coming weeks. Competition between the world's two biggest indexers could drive down costs for all index-fund investors.

Vanguard's exchange-traded shares -- called VIPERs for Vanguard Index Participation Equity Receipts -- will be launched as new share classes of nine existing index funds, only five of which will be offered initially: (VFINX)500 Index fund, (VTSMX)Total Stock Market Index, (VIGRX)Growth Index, (VIVAX)Value Index and (NAESX)Small-Cap Index. The funds will trade on the American Stock Exchange.

Unlike traditional mutual funds, exchange-traded funds are priced throughout the trading day and can be bought and sold like stocks. Their popularity has posed a threat to traditional index funds, the core of Vanguard's business. Exchange-traded index funds now command about $38 billion in assets. Vanguard currently has $240 billion in index assets under management.

Annual expenses for Vanguard's exchange-traded funds "have not yet been determined," says Vanguard spokesman John Demming. But Vanguard, a long-time low-cost proponent, can be expected to challenge the current price leaders. Spiders (SPY), exchange-traded products that track the S&P 500, charge annual fees of 0.12%, well below the 0.18% levied by Vanguard's 500 Index fund. The annual fee on the upcoming Barclays S&P 500 index product will be 0.09%. However sales commissions on shares of exchange-traded funds could cut into any potential cost savings. Vanguard offers its traditional mutual funds without any sales commissions

The Securities and Exchange Commission still must approve Vanguard's application to sell the exchange-traded funds. "We're hoping for approval sometime during the third quarter," says Demming.

Vanguard says it's launching the exchange-traded funds to drive short-term traders out of its traditional index funds. Investors who frequently buy and sell regular mutual funds can drive up transaction costs, reducing the returns for all investors. They can also force a fund to realize capital gains, which can result in a tax hit for the remaining shareholders.

However, Vanguard surely didn't make its decision in a vacuum. Investors have shown an increasing interest in these products. And Barclays, the largest index manager in the world, will begin selling the first four from an expected lineup of more than two dozen exchange-traded index funds next Friday.

The first four Barclays funds, to be known as iShares, will track the S&P 500 (IVV:Amex), Russell 1000 (IWB:Amex), Dow Jones U.S. Technology (IYW:Amex) and Dow Jones U.S. Internet (IYV:Amex) indexes. A second batch, tracking 10 additional indices, should come out one week later. Fees on the first four will range from 0.09% for the S&P 500 fund to 0.60% for the technology funds.

Vanguard's "announcement is clearly a reaction to [us] and validation of the importance of the exchange-traded fund concept," says Barclays spokesman Tom Taggart.

For now, Vanguard's entry into exchange-traded funds should have little impact on the rest of the mutual fund industry. Only 9% of the industry's $5 trillion in assets are in index funds, says fund-industry consultant Geoff Bobroff. And non-index, actively managed exchange-traded funds don't exist at this point, though people in the business say they are coming. Until that day arrives, the other fund giants are likely to be very quiet.

Bobroff does think that exchange-traded funds could command half of the money in index funds within the next five years.

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