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Vanguard rewards loyalty
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July 26, 2000: 2:58 p.m. ET
But some say new, low-expense share class is also response to ETFs, lawsuit
By Staff Writer Jeanne Sahadi
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NEW YORK (CNNfn) - Vanguard, the king of low-cost investing, plans to offer a price break on expenses to reward its most loyal investors and those with the biggest accounts.
But some think -- although Vanguard denies it -- that the move is also a response to the cost pressures created by exchange-traded funds and possibly a lawsuit in connection with the company's proposed exchange-traded shares known as VIPERs.
The fund firm said Wednesday it will offer a new "Admiral" share class that will undercut the expense ratio of Vanguard's traditional investor class shares by as much as 25 percent.
So for long-term Vanguard 500 investors or those with deep pockets, their Admiral shares will incur an expense ratio of 0.12 percent rather than the 0.18 percent charged for investor-class shares.
 Three types of investors will be eligible: those who have been in a Vanguard fund for 10 years and accumulated a $50,000 balance; those who have invested $150,000 or more in a fund account that is at least three years old; and investors who have $250,000 or more in a fund.
"Our new Admiral share class reflects the simple reality that large accounts and loyal shareholders create tremendous cost savings for all fund shareholders," Vanguard Chairman and CEO John J. Brennan said.
Expenses tend to be lower in funds where account balances are large, and funds with long-term investors may produce fewer capital gains since asset size remains stable. Normally, if investors move their money in and out of a fund frequently, especially large amounts, the fund incurs higher transaction costs and the portfolio manager may need to sell holdings to account for the loss of assets. In doing so, he may create high capital gains for the remaining investors, who must pay taxes on those gains.
The new Admiral shares will be launched in the fourth quarter of 2000 and initially will be available for only seven of Vanguard's domestic index funds: the Vanguard 500; Total Market; Extended Market; Growth; Value; SmallCap; and Balanced.
Vanguard will phase in the Admiral program for most of its other funds throughout 2001.
ETF pressures may be an issue
While lowering costs for shareholders is always a welcome move, Vanguard's announcement may be as much for the benefit of Vanguard as for its shareholders, said Dan Wiener, editor of the Independent Adviser for Vanguard Investors.
"This is a big PR story," Wiener said.
He noted, for instance, that only three of the seven index funds initially eligible for the Admiral program -- the SmallCap, Extended Market and the 500 funds -- have been opened 10 years or more. That means that some $50,000 investors will not be eligible for the expense break for at least a couple of years. (Vanguard spokesman John Demming said the staggered introduction of the program was connected to the timing of each fund's annual reports and when each fund's fiscal year ends.)
What's more, Wiener said, the company already has four Admiral funds in its fixed income arena, which, like the new share class, offer lower expenses and have minimum investment requirements of $50,000 or more.
That's also why Wiener thinks part of Vanguard's incentive for creating Admiral shares may be to counter an argument Standard & Poor's makes in a lawsuit it launched against the company in June, alleging that Vanguard's proposed exchange-traded shares, known as VIPERs, will use the S&P indexes and trademarks without Vanguard having expanded its licensing agreement with S&P.
The 1988 licensing agreement "does not include exchange-traded funds." S&P spokeswoman Christina Pretto told CNNfn.com in June.
But Vanguard has presented its VIPERs as a new class of shares that "represent interests in the same funds already covered by S&P licenses."
But Vanguard's Demming, who said he could not comment on the specifics of the lawsuit, said there is no connection whatsoever between the Admiral program and the suit, or for that matter the VIPERs themselves.
What's more, he said, Vanguard has created separate class shares at least nine other times in the past.
And, he added, "There's no relation between the Admiral shares and the VIPERs." VIPERs, he explained, are meant to draw short-term investors out of Vanguard funds, while the Admiral shares are intended to reward investor loyalty and investors with high account balances.
Will Admiral shares compete with ETFs?
Although the VIPERs, which still are being reviewed by the Securities and Exchange Commission, have yet to set their expense ratios, it is likely that they will be priced to compete with other exchange-traded funds, whose expense ratios can be as little as half those of the lowest cost index funds. At present the only ETFs available are index-based.
Vanguard's new program is another way to address the cost pressures introduced by ETFs, Wiener said. "The low, low operating expense ratio is a way of dealing with the lower costs of ETFs."
Not so, said Brian Mattes, a Vanguard principal. "We have existing fund offerings that have the same or lower expenses. If we were concerned, then we would restrict the Admiral shares to our index funds. It's a complete fallacy."
One thing is certain, even if the Admiral shares were to compete with ETFs, they could not do so in terms of minimum investment - there are none for ETFs -- or in terms of trading capability. ETFs, unlike funds, trade like stocks, pricing continuously throughout the day.
The cost of ETFs can be high for short-term traders, since commissions are charged for every sale and purchase. But for the buy-and-hold investor with a high account balance, ETFs may prove more cost-effective than a traditional fund with a higher expense ratio, Morningstar analyst Scott Cooley said.
That may be true for other fund companies, but not for Vanguard funds, Mattes said. "We don't have to compete. We are cheaper."
Mattes noted that while some ETFs may have lower expenses than some of Vanguard's funds in terms of flat basis points, that difference may be erased quickly should an investor choose to add money to his account periodically, which is a common practice, he said.
That's because the investor must pay a commission to do so, and that cost will be added to the overall cost of owning the fund. In a traditional mutual fund, there is no commission charged for contributing more to your account. 
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