Advisers eagerly await arrival of cheaper Vanguard bond ETFs

Jan 22, 2007 @ 8:07 am

By David Hoffman

PHILADELPHIA — Financial advisers eagerly are awaiting the arrival of fixed-income exchange traded funds announced last week by The Vanguard Group Inc. that would undercut the fees of those from Barclays Global Investors.

Barclays of San Francisco offers the only fixed-income ETFs. It launched eight such ETFs this month — the first new fixed-income ETFs since 2005 — for a total of 14 funds.

All the Barclays ETFs have expense ratios between 0.20% and 0.15%.

That compares with an expense ratio of just 0.11% for the proposed Vanguard ETFs. Their debut is contingent on the Securities and Exchange Commission’s approval — which they are expected to receive — of a pending exemptive application.

Sweetening the deal

The ETFs actually are shares of existing Vanguard index funds, which industry experts said gives the company the ability to charge such low fees. That is a big deal to financial advisers.

Lower expense ratios are better for investors, but that is even more the case when bonds are involved, said Richard Romey, president of ETF Portfolio Solutions Inc. in Overland Park, Kan.

Although generally less risky, bonds historically produce lower returns than equities, he said.

That means expenses generally account for a bigger percentage of a fixed-income product’s total return than is the case with an equity product, Mr. Romey said.

It magnifies the importance of cost, giving Malvern, Pa.-based Vanguard’s proposed ETFs a clear edge over those from Barclays, he said.

If Barclays were offering actively managed fixed-income ETFs, that might be a reason to pay the higher fee, but that isn’t the case, said Scott Kays, president of Kays Financial Advisory Corp. in Atlanta.

“The fact is, on an ETF, there’s not a whole lot of ways to add value, especially a fixed-income ETF,” he said. “The only way to add value is lower expenses.”

Vanguard’s proposed ETFs are good news, said James V. Kelly, president of Kelly Capital Management LLC in Philadelphia. He launched one of the earliest ETF-only separate accounts in 1999.

“Generally, there is plenty of room in the fixed-income space to add fixed-income-oriented ETFs, so I’m glad to see both Barclays and Vanguard bringing forth some offerings,” Mr. Kelly said.

But “I also believe in capitalism and competition, and whenever we have had Vanguard in play … they tend to have a favorable impact on the marketplace in terms of expenses,” he said.

Barclays won’t lower its expenses in response to Vanguard’s planned ETFs, said Christine Hudacko, a spokeswoman for the company.

“When we look at the products that are offered along with the services of, we feel that pricing is very competitive,” she said.

Through its iShares website, Barclays offers investors several tools to help them use ETFs.

But Vanguard claims that the advantages offered by its proposed fixed-income ETFs go beyond cost.

The company’s ETFs will offer greater diversification than “competing products,” said Kenneth E. Volpert, a principal and senior portfolio manager for the Vanguard Fixed Income Group.

For example, the Vanguard Total Market Bond Index Fund — with which a proposed ETF would be coupled — held 2,801 securities at the end of last year in its attempt to replicate the Lehman Brothers Aggregate Bond Index.

Barclays’ iShare Lehman Aggregate Bond Fund ETF, however, held 125 securities at the end of the year in its attempt to replicate that same index.

That is important, because the proposed Vanguard ETF would more closely resemble the underlying index than the Barclays offering, said Dan Culloton, an analyst with Morningstar Inc. of Chicago.

Another advantage is that having more securities protects it from potential defaults, Mr. Volpert said.

“Any one default is not going to have a meaningful impact on the fund,” he said.

The early bird

Regardless, several industry experts predicted that Vanguard’s proposed ETFs will have a hard time competing with Barclays’ fixed-income ETFs simply because the latter company got to market first.

“The first-mover advantage is still pretty significant in the ETF space,” Mr. Culloton said.

“If there’s a fund in a necessary core category, it gets the volume, and that sticks,” he said. “It’s hard to break volume away from the first fund on the scene.”

Several industry observers have speculated that that was one of the key reasons Fixed-Income Trust Receipts, or FITRs, from the now-defunct ETF Advisors LP of New York, failed.

The four ETFs were launched in November 2002, shortly after Barclays unveiled its first fixed-income ETFs in July of that year, and as a result, they never were able to gain traction, according to those familiar with the products.

The FITRs were liquidated six months after their launch, despite the contention by some industry observers that they were superior to iShares.

“I was saddened to see the FITRs go away,” Mr. Kelly said.

No one, however, expects Vanguard’s proposed fixed-income ETFs to disappear. Those familiar with the FITRs said that another reason they failed was that ETF Advisors was undercapitalized — something that clearly is not an issue for Vanguard.


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