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To paraphrase Ralph Waldo Emerson, "A foolish consistency is the hobgoblin of index fund managers."


is taking that notion to heart. The firm has struck a deal with

Morgan Stanley

that enables the fund family -- but does not require it -- to use Morgan Stanley indices as the basis for its funds.

Now the second-largest fund family has filed documents with the

Securities and Exchange Commission

to get shareholder permission to allow some index funds to switch the indices they're based on, along with a few other investment policy changes.

Vanguard is hoping shareholders will approve a policy change that would authorize the trustees of eight equity index funds to change their target benchmarks. Clearly, any new index chosen for a fund would be required to track the same market segment as the fund's existing index.

The trustees of 19 Vanguard index funds already have the authority to change target indicies. The new proposal applies to the following Vanguard index funds:


Total Stock Market,


Extended Market,










SmallCap Growth and


SmallCap Value.

Getting on Board

There are several reasons for the switch, says Morningstar analyst Scott Cooley. For starters, Vanguard had been concerned with the high turnover of the S&P/Barra indices it had been tracking. After all, high turnover in an index can defeat the purpose of an index fund.

Additionally, the S&P/Barra indices rely primarily on a company's book value to determine whether it's listed in the growth or value index. "That's an unreliable way of determining growth vs. value," Cooley says.

For example, by using strictly price-to-book figures, richly valued technology companies such as

JDS Uniphase





ended up in the value index because of a quirk in their accounting.

Essentially, the big technology mergers of the late 1990s left many companies with large amounts of goodwill on their balance sheets. (Goodwill is the amount a company pays for another above what its tangible assets are worth.) Goodwill boosted some companies' apparent net worth. Coupled with falling stock prices, the low price-to-book ratios that many companies registered landed them in value indexes -- even though other ratios clearly marked them as growth stocks.

The Morgan Stanley indices, which still are being developed, will use as many as eight factors to determine whether a company should be considered value or growth.

Those misplaced "value" stocks dragged down the value index when value stocks were surging in 2001. So the Vanguard Value Index fund has trailed the category average since 2000, losing within 1 percentage point of what Vanguard's growth index fund lost in 2001.


Vanguard has no plans to present this proposal to shareholders of funds that use the

S&P 500

as its benchmark. Former Vanguard chief John Bogle struck a deal with Standard & Poor's some two decades ago that capped the fees Vanguard must pay, making the firm's funds more cost-effective than any other index could ever be, Cooley says.

Several Vanguard index funds have changed target benchmarks in the past. In March 1993, the trustees of Vanguard Total Bond Market Index Fund approved a change of its target benchmark from the Salomon Brothers Broad Investment-Grade Bond Index to the Lehman Brothers Aggregate Bond Index after determining that the latter was a more accurate proxy.

The Lehman index also was adopted as the target index for the bond portfolio of Vanguard Balanced Index Fund and the Total Bond Market Index Portfolio of Vanguard Variable Insurance Fund.

"Vanguard is a very savvy shopper," Cooley says, adding that this may spur S&P/Barra to rethink how it calculates its indices. "It doesn't hurt to have more than one organization vying for your business."

There's More

The proxy statement Vanguard filed with the SEC seeks shareholder approval on a variety of other matters, as well. The fund family wants to reclassify many of its index and index-oriented funds as "nondiversified" under securities laws. The change to a nondiversified status means that index funds will be able to keep replicating its target index, even if that index becomes dominated by a small number of stocks.

In other words, these measures are strictly to ensure that a fund can continue to track its index without running afoul of securities law if a discrepancy between the fund's holdings and the SEC definition of "diversified" develops.

That happened early last year with the Vanguard Growth Index fund. The fund's target benchmark index, the S&P/Barra Growth Index, had become concentrated in the stocks of several companies, and thereby slightly exceeded the fund's technical diversification requirements. In May 2001, shareholders approved a similar measure, allowing Vanguard to categorize it as "nondiversified."

The proxy statement also includes two fund-specific proposals. The firm wants to change the investment objective of its


Utilities Income fund and eliminate its concentration in utility stocks. The fund still will have the same goal of investing for income plus earnings and dividend growth, but will allow for industry diversification. If the proposal is approved, the fund will be renamed Vanguard Dividend Growth Fund.

Also, Vanguard wants to change the industry concentration policy of its Prime Money Market fund and the Money Market Portfolio of Vanguard Variable Insurance Fund so that each will invest more than 25% of its assets in the financial services sector.