7 Vanguard Funds Switch Indexes, Dumping S&P; for Morgan Stanley

Some of Vanguard Group’s popular index funds will be getting a makeover.

Valley Forge, Pa.-based Vanguard announced last week that it will adopt new benchmarks for seven stock index funds, in a move to cut costs over time.

By the end of September, Vanguard will be using Morgan Stanley Capital International Inc. indexes for the funds, replacing indexes compiled by Standard & Poor’s and money manager Frank Russell Co.

However, the $66-billion Vanguard 500 Index fund, which tracks the S&P; 500, will keep that index as its benchmark.

Vanguard, which sells 40 index funds with a total of $200 billion in assets, is making the change for the seven portfolios because MSCI benchmarks better represent the market segments the funds follow, spokeswoman Rebecca Cohen said.

The MSCI indexes also have more flexible rules that will require fewer trades to track the benchmarks over time, lowering costs, she said. Low management costs have long been one of Vanguard’s main marketing pitches to investors.

Funds affected are Vanguard Mid-Cap Index ($3.3 billion in assets); Vanguard Value Index ($3 billion), Vanguard Growth Index ($7.4 billion); Vanguard Small-Cap Index ($4 billion); Vanguard Small-Cap Value Index ($1.3 billion); Vanguard Small-Cap Growth Index ($487 million); and the Vanguard Variable Insurance Mid-Cap Index Portfolio ($253 million).

Indexes currently used by the funds include the S&P; MidCap 400, the Russell 2000, the S&P; 500 Barra Value and the S&P; Barra Growth.

The S&P; growth and value indexes “didn’t do a very good job of tracking the areas they were supposed to track,” said Russ Kinnel, director of fund analysis at Morningstar Inc. in Chicago.

Under S&P;’s method, stocks are judged to be either growth or value issues based on their price-to-book-value ratios -- the stock price divided by the estimated net worth per share of the company.

The MSCI indexes, by contrast, use a number of factors to determine whether a stock should be categorized as a growth issue or a value issue.

Vanguard’s Small-Cap Index fund also may benefit from a switch from the Russell 2000 index because the replacement MSCI index is “rebalanced” twice a year instead of just once a year -- meaning the underlying portfolio is reconfigured to make sure it’s tracking true small-capitalization stocks. That would catch market shifts on a more timely basis, analysts said.

Vanguard shareholders voted in December to allow the seven funds’ boards of trustees to switch to the MSCI benchmarks. Vanguard already uses MSCI indexes for six other funds.

The index switches may result in portfolio turnover of 20% to 70% for the funds involved, temporarily raising trading costs, Vanguard said. But the change shouldn’t result in significant capital gains tax liabilities for shareholders, the company said.

In 2001, S&P; won a court ruling blocking Vanguard’s plan to launch exchange-traded funds, or ETFs, based on S&P; indexes without S&P;’s permission.

Vanguard has denied that any move to change its fund benchmarks was related to a desire to come out with additional ETFs.