Court Rebuffs Vanguard's Bid to Launch ETFs Tracking S&P 500

The U.S. District Court Wednesday ruled against Vanguard in a licensing dispute over the index-fund titan's planned rollout of exchange-traded funds tracking popular Standard & Poor's indices, according to a release from McGraw-Hill, S&P's parent company. The decision effectively stalls Vanguard's push into a lucrative slice of the mutual fund world and, if it holds, will make Vanguard's ETFs either more expensive for investors or less profitable for the fund firm.

A U.S. District Court judge in Manhattan sided with S&P, issuing a permanent injunction barring Vanguard from launching its products. McGraw-Hill filed the suit against Vanguard in June 2000, one month after the nation's second-largest fund firm announced plans to launch exchange-traded shares, called Vanguard Index Participation Equity Receipts or Vipers. The suit alleged that Vanguard's use of S&P's stock indices in the planned exchange-traded funds or ETFs, including the S&P 500, isn't covered by the licensing agreement the two firms signed back in 1985.

For its part, Vanguard refuted the suit, arguing that the new ETFs were new share classes of its traditional open-end funds, like the $85.5 billion (VFINX)Vanguard 500 Index fund, already covered by the existing agreement. The Valley Forge, Pa.-based firm originally planned to roll out the new shares in last year's third quarter and if a new agreement isn't hashed out soon, the legal action will continue to hinder Vanguard's efforts to establish a beachhead in a potentially lucrative market, where low costs are key.

McGraw-Hill's statement didn't note whether the firms were currently hammering out a new agreement. Neither Vanguard nor McGraw-Hill officials returned early morning calls for comment, but a report in this morning's Wall Street Journal quoted Vanguard officials stating they planned to appeal the decision.

"This is a major blow to Vanguard," says Dan Wiener, editor of the Independent Advisor for Vanguard Investors newsletter. Instead of being able to offer a very inexpensive S&P ETF, Wiener says, "they'll be starting in the same place as everyone else. And also, since they've been so critical of expense waivers in the past, it would be hard for them to offer an ETF and waive some of the fees [until the fund gathers sizable assets] . . . . Where's the value added unless you have low cost?"

Unlike traditional mutual funds, exchange-traded funds price throughout the trading day and trade like stocks. Their popularity is a potent threat to traditional index mutual funds, where about half of the $206 billion invested in S&P 500 index funds sits in Vanguard's coffers, according to Lipper. Of the $64.3 billion invested in ETFs, nearly $57 billion is invested in funds tracking broad U.S. stock indices like the S&P 500.

McGraw-Hill has licensing agreements with other firms offering exchange-traded funds tracking S&P indices like State Street Bank & Trust and Barclays Global Investors. Skipping an additional licensing fee would've been a boon to Vanguard because index-tracking funds compete on price.

Vanguard's traditional open-end 500 Index fund carries no load and its expense ratio is just 0.18%, compared to 1.24% for its average peer, according to Morningstar. At the end of last year, Vanguard started offering cheaper "Admiral" shares of its open-end funds for long-term shareholders with sizable account balances. The Vanguard 500 fund's Admiral share classes levy 0.12% annual expenses. That matched State Street's exchange-traded Standard & Poor's Depositary Receipts(SPY), commonly called Spiders, which carry expenses that are a maximum 0.12%, dropped last year from 0.18%. Launched in 1993, there are some $25 billion invested in Spiders.

Barclays exchange-traded iShares S&P 500(IW) fund carries annual fees of just 0.09%, according to Morningstar. Though the fund was only launched last May, more than $3 billion is already invested in its shares, according to Morningstar. That's nearly four times the size of the average U.S. stock fund.

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