The first time I interviewed John Bogle, founder of the

Vanguard Group

, 15 years ago, he fretted about how the low-cost fund he'd introduced to mimic the

S&P 500

index had failed to catch on.

Today, that fund,

(VFINX) - Get Report

Vanguard 500 Index, has $105 billion in assets, and Vanguard reigns as the king of indexing. Although other fund companies have tried to jump on the indexing bandwagon over the years, their products cost too much and lack finesse.

That has changed over the past year as the 36 exchange-traded index funds on the

American Stock Exchange

have attracted a good deal of investor attention and dollars -- so much so that I gave Bogle a call a couple of months ago to ask if he worried that these newcomers might eclipse the Vanguard mutual funds.

"Absolutely not," he thundered. (Bogle often thunders.) The exchange-traded funds are for speculators, not investors, he told me.

Vanguard Unleashes Vipers

So I noted with interest last week that Vanguard filed with the

Securities and Exchange Commission

to offer five of its nine index funds as exchange-traded funds (or ETFs). It will call them "Vipers," for Vanguard Index Participation Equity Receipts.

Vanguard actually asked the SEC for permission to offer nine of its indexes, although to start with, it plans to offer only five -- the 500 Index,

(VIGRX) - Get Report

Growth Index,

(VIVAX) - Get Report

Value Index,

(VTSMX) - Get Report

Total Stock Market Index and

(NAESX) - Get Report

Small-Cap Index, according to John Woerth, a Vanguard spokesman. The company hopes to introduce the Vipers in the third quarter of this year. (Those ticker symbols are for the standard share classes of the index funds; because the Vipers are still in registration, they don't have ticker symbols as yet.)

The ETFs will be offered as a different share class of the existing funds. Many fund companies offer different share classes, with varying pricing structures, to different groups of investors.

Vanguard plans to allow investors in the five index funds to move to the exchange-traded fund shares at no charge, Woerth says. But if you buy them on the exchange, you must pay a commission.

Vanguard sees the ETFs as aimed at short-term investors or speculators, Woerth said. Buy-and-hold investors will stick with the traditional funds, the company believes. In the end, the ETFs might actually benefit the traditional shareholders because the excessive traders will move from mutual funds to ETFs, Woerth says.

Investing in iShares

I don't see it that way, though. The Vanguard announcement came just a few days before the first four of the exchange-traded indices offered by Barclays Global Investors (BGI) began trading on the Amex last Friday, May 19.

Called iShares, they mirror common indexes: the

Trust S&P 500 Index

(IVV) - Get Report

, the

Trust Russell 1000 Index

(IWB) - Get Report

, the

Dow Jones U.S. Internet Index

(IYV)

and the

Dow Jones U.S. Technology Index

(IYW) - Get Report

. Barclays has set up a special Web site with information about its new funds at

www.ishares.com . Another 11 are scheduled to begin trading this Friday, May 26.

I think Vanguard's announcement marks a watershed in the mutual fund industry. I've been arguing for nearly a year now that traditional open-end mutual funds are flawed, so much so that they're going the way of the dinosaur.

Vanguard's Vipers and the excitement over the introduction of the BGI iShares back me up, I think. Investors in our Start Investing community have been clamoring for information about these shares for weeks. "We're not saying we're going to put traditional mutual funds out of business," Tom Taggart, a BGI spokesman, told me -- meaning, of course, that that's just what they're saying.

Costs Are Lower

Consider the costs. The average U.S. diversified stock fund costs about 1% to 1.5%, or 150 basis points, annually in expenses. The new BGI S&P 500 iShares cost less than 9.5 basis points, compared with 20 basis points for its conventional S&P 500 fund! And even its sector indices will carry expense ratios of just 60 basis points. Exchange-traded funds are cheaper, in part, because the sponsor doesn't have to foot the bill for communicating with shareholders.

BGI's pricing must sting Vanguard, which has a hard-won reputation for being a low-cost provider of funds. Its conventional 500 index fund's expenses total 18 basis points. Vanguard hasn't revealed the expenses for its ETFs yet, but they're sure to be low. Lower than its mutual funds, I'll bet. Vanguard doesn't like to be beat.

ETFs have many advantages beyond costs. Unlike mutual funds, which must keep some cash on hand for redemptions, ETFs stay fully invested in the index. They are priced constantly, rather than once a day like a mutual fund. They can be bought on margin, which means they can be bought with borrowed money and they can be sold short (borrowing a security, selling it and betting the price will go down so you can buy back the shares at a lower price, repay the loan and pocket the difference).

The ETFs are more tax efficient, too, because there is very little trading in the portfolio. "This is the natural evolution of investing, the marriage of stocks and funds," says Lee Kranefuss, chief executive of the individual investors business at BGI. "It puts together the best benefits of both." I think so, too.

Impact on Mutual Funds

Bogle, who retired as chairman of Vanguard last year, told

The Wall Street Journal

that he probably wouldn't have introduced the Vipers if he were still running the company because they encourage heavy trading, which he says is bad for investors.

I'm not sure that's the case. I bought the

Nasdaq 100 Index

(QQQ) - Get Report

more than a year ago. I sold off half when it more than doubled in price a year later. But I don't see myself as a trader. I want to own the Nasdaq 100 index for the long term. It is also one of the most popular investments at

Sharebuilder.com

, where long-term investors can tuck away a little money each month for their kids' college or retirement.

Let's face it, Tim. (That's Tim Middleton, my colleague who writes our mutual fund column). Funds are on their way out. You need to get yourself a new column. The Vanguard move marks a turning point.

What I'm waiting for is a fund company to introduce an actively managed fund on the exchange. Then the floodgates will open. Funds will have to move to the exchange or contemplate extinction.

Next week, I plan to write about another new Web investment option, one that actually allows you to build your own mutual fund online.

Follow Mary's Start Investing Portfolio at MoneyCentral.

Mary Rowland is the Start Investing columnist for MSN MoneyCentral. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. She welcomes your feedback at

mctsc@microsoft.com.

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