BOSTON -- Index mutual fund investors are a cost-conscious bunch. Rather than seek out managers with a good shot at beating the market, they parse tiny differences in fund expenses. Index funds are cheaper because no one is being paid to pick stocks. Every cent that doesn't end up in someone else's pocket counts, the thinking goes.
If that's your mindset, you'll want to pay attention to an aspect of index fund expenses that's drawing greater scrutiny: fees that fund companies pay to license benchmark indexes.
Companies such as S&P Dow Jones Indices and MSCI have created well-known market indexes. They periodically remove and add stocks as an index's membership rules dictate, and track daily changes in its component stock prices. Mutual fund companies that establish funds tracking one of these indexes must pay a licensing fee.
Index providers have historically charged flat fees, but it's become increasingly common for their fees to adjust upward as funds gain more investors and assets.
It's out of investors' control, because fee arrangements are between the fund company and index providers. Costs are passed along to investors and reflected in a fund's expense ratio -- the ongoing charge to cover operations costs, expressed as a percentage of assets.
Index-licensing fees are drawing attention after an announcement Tuesday by Vanguard Group. The nation's largest fund company is switching the benchmarks for 22 of its funds and exchange-traded funds from indexes maintained by MSCI to indexes from two rivals.
Vanguard negotiated lower-rate, long-term deals with the University of Chicago's Center for Research in Security Prices and index provider FTSE. In coming months, 16 of Vanguard U.S. stock funds will track benchmarks from the university's CRSP indexes, with six foreign stock funds moving to FTSE indexes.
The changes are expected to lower the fees of funds holding more than half a trillion dollars, or about one-quarter of the nearly $2 trillion that Vanguard manages in U.S. funds. The biggest among the affected funds: Total Stock Market with $202 billion in assets.
Vanguard isn't saying exactly when the expense reductions will occur, or how big the cuts will be.
“It's no secret within the industry,” says Gus Sauter, Vanguard's chief investment officer, “that the cost to license benchmarks has been escalating, and represents a growing portion of expenses that shareholders pay to own an index fund.”
Exactly how big a portion isn't easy to measure because index licensing details typically aren't revealed. But based on disclosures resulting from Vanguard's move to drop MSCI, licensing fees can make up as much as one-quarter of expenses that investors pay at certain low-cost funds and ETFs.
Because Vanguard's influence is so wide, such benchmark changes deserve close scrutiny. Here are three potential consequences to watch for:
1. More fee-cutting pressure
The decline in costs to invest in index funds and ETFs has accelerated in recent months, driven in part by Vanguard. It's also come from Charles Schwab, which cut ETF fees last month to levels below those of Vanguard in some cases. The biggest ETF provider, BlackRock Inc.'s iShares unit, plans to announce details of fee cuts at some of its biggest ETFs by the end of this year.
Analyst David Togut of Evercore Partners predicted that BlackRock will seek to compete with the lower-cost benchmarks that Vanguard will use, potentially leading to price cuts in BlackRock's contracts with MSCI.
Expect more index funds and ETFs to cut expense ratios if BlackRock or other companies secure price cuts for index services, or drop existing indexing firms in favor of lower-cost providers.
“Indexing, particularly through ETFs, is going to get cheaper and cheaper,” says Daniel Wiener, editor of an independent newsletter on Vanguard's funds.
2. Greater scrutiny
The FTSE indexes that Vanguard will use for six foreign stock funds are well-established. The CRSP indexes that 16 of its U.S. stock funds will track are well-known to institutional investors who have been using CRSP benchmarks for years. But those indexes haven't been used by funds open to average investors. It will take a while for those investors to learn how the CRSP indexes differ from benchmarks such as MSCI's. The rules that CRSP uses to determine stock index membership are more complex than those for many better-known benchmarks.
3. More portfolio adjustments
The CRSP and FTSE indexes that Vanguard is moving to are similar to the MSCI benchmarks those funds currently track. But there are small differences, and Vanguard index fund managers will have to buy certain stocks and sell others in coming months so that fund holdings track the new benchmarks.
“This move is similar to an active mutual fund making a manager change,” says Todd Rosenbluth, a fund analyst with S&P Capital IQ.
For example, Vanguard Emerging Markets Index (VEIEX) will no longer own South Korean stocks, because its new index -- FTSE Emerging Markets -- classifies that country among the world's developed markets. The MSCI index the fund has been using classifies South Korea as an emerging market. In fact, Korean stocks make up nearly 16 percent of that index. As a result of Vanguard's move, Korean stocks like Samsung Electronics -- the largest single company in the MSCI index -- will be sold from the fund's portfolio.
If more funds and ETFs switch benchmarks at Vanguard and elsewhere, the resulting changes in fund holdings could come as a surprise unless an investor pays attention.
Rosenbluth says that there will be “subtle changes” that will impact returns.