To Counter Barclays, Vanguard Will Offer Exchange-Traded Funds

The best-known index mutual fund manager is feeling the heat from new competition.

Vanguard Group, which oversees $540 billion, said Friday that it will introduce its first exchange-traded funds, tapping the rising popularity of hybrid securities that combine aspects of mutual funds and stocks.

The new products from the second-biggest U.S. fund company mark an appeal to the active traders Vanguard has long shunned--underscoring its effort to fend off Barclays Global Investors.

The San Francisco-based unit of Britain’s Barclays is expanding its exchange-traded funds that seek to mimic benchmark indexes.

“What Vanguard wants to do is protect its franchise as the leading provider of index-tracking securities,” said Daniel Wiener, editor of the Independent Adviser for Vanguard Investors. “Barclays has come into their territory in a big way, and Vanguard sees the competitive threat.”

Vanguard said it’s adding exchange-traded shares to five of its funds, including its biggest, the $105-billion Vanguard 500 Index Fund. They’ll also be linked to the $15.8-billion Growth Index Fund, $19.3-billion Total Stock Market Index Fund, $3.4-billion Value Index Fund and $4-billion Small-Cap Index Fund.

The new securities allow investors to own a basket of stocks like a mutual fund but enable them to trade it continuously as an individual stock. Barclays and Merrill Lynch & Co. are among the firms that have attracted assets through such funds.

Barclays Global, with $783 billion in assets--mainly from institutions rather than individuals--is the world’s largest index fund manager and is increasing its effort to lure retail investors.

It has 47 exchange-traded index funds in registration and plans to roll them out in waves. The first will debut May 19, with another wave set for May 26. The rest are planned for June and July.

To Barclays, Vanguard’s motive is clear.

“What this represents is a reaction to what [Barclays] is doing with exchange-traded funds, and a final validation that the exchange-traded fund concept is important for investors,” Barclays spokesman Tom Taggart said.

Vanguard spokesman John Demming said Vanguard is adding the shares to help protect long-term investors from the effects of short-term traders, whose movement in and out of funds drives up transaction costs.

Valley Forge, Pa.-based Vanguard filed an amendment with the Securities and Exchange Commission seeking to add the new share class, VIPER shares, short for Vanguard Index Participation Equity Receipts. The shares will be listed on the American Stock Exchange.

“The addition of VIPERs on our existing index funds will be beneficial for the funds’ long-term buy-and-hold shareholders because short-term investors are likely to be attracted to the VIPER shares and away from the traditional shares,” Demming said. “So the harmful effects of short-term traders on long-term investors in our index funds will be reduced.”

Demming said Vanguard began studying exchange-traded funds more than a decade ago and has been working with SEC staff on the VIPER shares offering since May 1999.

Vanguard would rather earn half a fee with an investor in a VIPER than no fee if the investor takes money out of an index fund and goes to Barclays, Wiener said.

Barclays’ iShares S&P; 500 Fund will have an annual expense ratio of between 0.08% and 0.10%--about half the cost of Vanguard’s regular S&P; fund.

Vanguard hasn’t set fees for the exchange-traded funds.