To paraphrase Ralph Waldo Emerson, "A foolish consistency is the hobgoblin of index fund managers." Vanguard 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: ( VTSMX) Total Stock Market, ( VEXMX) Extended Market, ( NAESX) SmallCap, ( VIGRX) Growth, ( VIVAX) Value, ( VIMSX) Mid-Cap, ( VISGX) SmallCap Growth and ( VISVX) SmallCap Value.
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 ( JDSU) and Nortel ( NT) 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.