ETF INVESTING: Vanguard Patents Unique ETF Structure-September 19, 2005
September 19, 2005--BOSTON--Dow Jones- The Vanguard Group has created a unique structure for its exchange-traded funds, and any competitor considering a copycat product will have to get the mutual-fund giant's permission first.

Unlike other ETFs, the Vipers, or Vanguard Index Participation Equity Receipts, are separate share-classes of Vanguard's index funds. In contrast, rival firms' ETFs are "stand-alone" funds.

The pioneering construction is evidently important enough to Vanguard that the Valley Forge, Pa.-based company has quietly but significantly moved to prevent other firms from imitating its design.

"We have a patent on our Vipers ETF structure that we invented," said Gus Sauter, Vanguard's chief investment officer.

The patent protection means that rivals will have to negotiate with Vanguard in order to introduce similar funds - an arrangement that Sauter said would be seriously considered.

"We would be willing to talk to other fund companies that would want to use the innovation," Sauter said.

Vanguard claims the unique Vipers structure benefits investors in both ETF and index-fund share classes, but some observers aren't completely sold.

Additionally, Vanguard has taken shots from critics over the amount of money invested in the Vipers from Vanguard's own mutual funds.

The rapid rise of ETFs, baskets of securities that trade on an exchange like a stock, has menaced the index-fund business, which is dominated by Vanguard on the retail side.

Barclays Global Investors and State Street Global Advisors, large asset managers traditionally focused on large institutional investors, began rolling out ETFs in earnest several years ago to attract individual investors and financial advisers.

After initial resistance, Vanguard finally threw in the towel to meet the threat and launched its own ETFs, but with a twist -- the Vipers are hitched to the firm's lineup of broad-based and sector index funds, such as the Vanguard Total Stock Market Vipers(VTI) and the Vanguard Energy Vipers(VDE).

The move was controversial, as Vanguard founder Jack Bogle, champion of buy- and-hold investing with low-cost index funds, had voiced concerns that ETFs were harmful to investors because they can facilitate rapid trading.

However, Vanguard could not ignore the competitive threat posed by the now $ 250 billion ETF business and its potential to poach assets from index funds. Hopping on the ETF bandwagon also allowed the firm to sell its products through brokers, a group Vanguard has traditionally eschewed in favor of direct- distribution strategies.

Not surprisingly, Vanguard says its separate-share class ETF structure is superior to competitors' offerings. In the patent application, which lists Sauter as a co-inventor, Vanguard points to several benefits of the design.

Perhaps most importantly, the Viper share class provides a home for traders away from long-term investors in the index-fund share class. Rapid trading raises a fund's administrative and trading costs and can increase taxes for shareholders. It also can distract managers from day-to-day portfolio duties.

In addition, Vanguard claims a symbiotic relationship exists between the Vipers ETFs and the index funds.

The way in which all ETFs create and redeem shares provides tax benefits. Brokers and specialists, known as authorized participants, make markets in ETFs much like individual securities. Authorized participants create and redeem large blocks of ETF shares called creation units -- typically 50,000 shares -- based on demand. Once created, the individual shares are traded among investors on exchanges.

ETF shares are created and redeemed "in-kind," meaning only stock changes hands with no cash involved. As Morningstar Inc. analyst Christopher Traulsen pointed out in a commentary on the investment research firm's Web site, this process heightens ETF tax efficiency in two ways.

First, ETFs are not forced to sell stock and raise cash to meet investor redemptions, which can result in distributing capital gains to remaining shareholders. Plus, the in-kind redemption process enables the manager to offload stocks that have risen in price, allowing the ETF "to flush out unrealized capital gains from the portfolio on an ongoing basis, assuming there are sufficient redemptions to do so," Traulsen noted.

As a result, the Viper ETF share class enables the manager of the corresponding index-fund class to "wash out" potential capital gains in the mutual fund.

However, some have pointed out that Vanguard's ETFs might not be as tax efficient as competitors' stand-alone versions. They argue that if a Vanguard index fund with unrealized capital gains sees big redemptions, it would be forced to pay out a distribution to all remaining shareholders, including the ETF investors, since both share classes must be treated equally in terms of taxes.

Vanguard counters that its index funds have traditionally not seen big outflows during major market corrections, and that many of its funds actually have amassed unrealized losses to offset gains.

It's unclear if Vanguard's Vipers will be more or less tax efficient than rivals' ETFs over time. It's also uncertain whether the patent will discourage other fund shops from introducing ETFs structured as separate share classes of existing funds.

Two years ago when Fidelity Investments introduced its first and only ETF -- Fidelity Nasdaq Composite Index Tracking Stock (ONEQ) -- it was launched in conjunction with an unattached index fund tracking the same benchmark.

Fidelity opted to launch the ETF and the mutual fund in separate wrappers, and some observers have wondered whether Vanguard's patent could have influenced that choice.

Fidelity spokesman Adam Banker said the firm opted to separate the ETF and the index fund on the Nasdaq Composite in order to offer distinct investment options. But the idea of the Boston-based fund company paying fees to archrival Vanguard to use the separate share-class ETF design seems highly unlikely.

Still, Vanguard's structure could appeal to fund managers considering a plunge into ETFs. Since ETFs trade throughout the day, managers can use in-house ETFs to put money to work immediately.

Vanguard employs it own ETFs for just that purpose, but has faced criticism from newsletter editor Daniel Wiener for not being more forthcoming about how the firm's own mutual funds are driving growth and fee cuts in the Vipers.

Sauter, Vanguard's indexing guru, said the mutual funds own less than 20% of the Vipers, and he expects that figure to decline over time.

Source:Dow Jones