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Paul Justice: Hi there. I'm Paul Justice with Morningstar. A few weeks ago, Vanguard announced that it will be changing the benchmarks for 22 of its index funds. This is a major change that's going to impact a lot of assets. They are swapping out of MSCI, moving toward FTSE and CRSP for some of its international and domestic funds.

We had the opportunity to speak with Joel Dickson, an ETF Strategist over at Vanguard, a few weeks ago at our ETF Invest Conference, but to gain some more insight, today we're joined by Gus Sauter, the chief investment officer at Vanguard. Gus, thank you for joining me.

Gus Sauter: Thank you Paul. Glad to be with you.

Justice: So, this is a very broad-reaching decision that you guys have made. It's going to impact over $500 billion investor assets, certainly something that was not taken lightly. Could you explain why you decided to go about this and specifically address how you think that these changes are going to deliver cost savings to investors?

Sauter: Sure. Well, Vanguard is a unique company in our ownership structure. We're mutually owned, so the investors in our funds actually are the owners of the Vanguard Group indirectly. So, we really have no profit margin ourselves. Everything we can realize in the form of cost savings goes right through to the investors in the funds. We identified an opportunity to significantly reduce one of our most rapidly escalating costs, and that was index licensing fees, and decided to transition our existing funds to the new indexes, as you indicate.

The cost savings will be really quite substantial measured in the hundreds of millions of dollars over time and will in fact provide price certainty, as well. We have very long-term contracts with the new providers that will give a certainty of cost for many, many years and decades into the future.

Justice: Now, when you first elected to use MSCI--so you didn't always have this as your primary index provider for many funds--Vanguard really touted the quality and the construction of those indexes and how you could replicate those in an investable way. Do you feel that FTSE and CRSP, the other index providers that you’ll be using, offer similar or even enhanced benefits? Or have things changed where index providers have caught up with one another?


Sauter: Well, I think 10 years ago when we made the switch to MSCI, they clearly did step in the foreground and were the premier providers of indexes at that time. I think since then others have raised their game. Some of their competitors have adopted some of things that MSCI incorporated. And I think the level of index construction is much higher today than it was a decade ago, and MSCI I think blazed the way.

The new index providers, FTSE and CRSP, also use very high-quality techniques. They have very good index-construction methodology, and actually they have a couple of tweaks that we like in their construction. In the case of emerging markets, FTSE classifies Korea as a developed market. Today our emerging-markets fund actually has Korea in it. We do not think that is appropriate. We think FTSE’s classification is correct, that in fact, Korea is a developed market. So that's a positive in the transition to FTSE.

And then CRSP also has a little twist in their index-construction methodology, and that's the process they called packeting. Basically, it just slows down the turnover when the index is changed. All indexes are reconstituted periodically, and this packeting processes that CRSP has put into place will reduce that turnover. And that means that the turnover in our funds will be a little bit less trying to track our indexes and hence the transaction costs we incur will be a little bit less. So, there will be a double cost savings there for our investors.

Justice: Sure. Now, some of these changes that are happening are going to be in small-cap stocks. You’ve already mentioned packeting as one way that's going to help you guys replicate. Small-cap stocks can be more difficult for an index manager to go out and track the benchmark appropriately. Do you foresee any challenges in that space, transitioning to these new indexes, and over time, do you see very material benefits, say, there compared with large-cap?

Sauter: Well, our preferred portfolio management process is complete replication. So, we will pursue that in the small-cap arena as well and own all of the stocks, and we’ll track really quite tightly over time. The transition will take us a little bit of time because of the nature of small-cap stocks being less liquid, and we’ll have some turnover.

We have developed techniques over the years to minimize transaction costs, and we’ll certainly be exercising those. Ongoing, I think this packeting methodology is definitely a benefit in the small-cap arena because transaction costs are higher in the small-cap arena, so you do want to have lower turnover, and as I mentioned, we will have lower ongoing turnover. So, that is a benefit in the small-cap area.

Justice: Many of these funds are both mutual fund and exchange-traded fund listed within the same share class, so that gives you some flexibility on how you can deal with some capital gains. Obviously, you’ve already mentioned the emerging market from where you’re going to be selling out of, some of the Korea stake, about 15% of that fund. Are there any other funds were you may see where some flexibility helps you out to mitigate any capital gains distributions to shareholders? Are there areas that concern you, some funds that may not have unrealized losses that you'll be able to reap overtime?

Sauter: Yes, we've analyzed all of the funds that we're going to be transitioning and looked at all the cost structures to figure out what the impact would be on the realization of capital gains. In some of the funds we actually will have net realized capital gains; in others we’ll have net realized capital losses from the transition. We do have realized losses stockpiled in our funds that we’ve realized over the years, and those losses will actually more than offset the gains that we anticipate. And so we don't believe that we will be distributing any capital gains in any of the funds. Could that change? Well, the biggest event would be if Korea ran up significantly between now and the end of the transition period. If Korea increased perhaps 50% or 75% in value over the next six months to nine months, there might be a possibility of a realized capital gain. We don't anticipate that, so we currently believe there will not be any distribution of realized capital gains.

Justice: So time is of the essence. When do you anticipate the official benchmark changes to be finalized and will the funds be changing their holdings at that point in time or how are you going to balance the need to track perfectly with the realization of doing all these trades?

Sauter: Yes, we won’t start the transitions until next year, and they will be staggered. We don’t want to do them all at once because we want to minimize the market impact and at the same time we’re not going to preannounce when we do the transitions because we don't want Wall Street to front-run us. So they will happen. Once we start the transition of any given fund, it will happen relatively quickly, and we will have a certain date that we’ll change over and start tracking the new indexes. And the second we start tracking the new index, we will make that publicly known. So we’ll track our existing indexes up to one date and then going forward track the new indexes. We anticipate that we’ll be able to track the indexes, the spliced indexes, quite closely.

The one exception to this is the emerging markets and the other developed markets where we are moving a big amount out of emerging markets in Korea, and there we want to do it over a period of time. The interesting thing is the difficulty of the trade is not going to be selling out of Korea in the emerging-markets funds, it's going to be reinvesting the proceeds from the sale back into other emerging-markets countries. So what we’re going to do is actually transition that over 25 weeks, moving 4 percentage points out of Korea every week. There will be a transition index that FTSE is creating for us that we will track and that transition index will be totally transparent. It will be available to anybody who wants to view it on the Web. So you’ll know where we are at any point in time in the transition process, and we do think that we’ll be able to track that transition index quite closely.

Justice: So these are big changes coming for these funds. There is also a big change coming up. You’ve announced that you’re going to be retiring soon, handing the reins over to Tim Buckley as chief investment officer. Was this something that you wanted to accomplish before you left Vanguard? And congratulations on a great career.

Sauter: Well, thank you. It is something that I wanted to do before moving on. I have taken a great interest in index-construction methodology over the years, and we identified yet another opportunity to I think add significant value for our investors. So it was something that I wanted to tackle before moving on.

Justice: Well, we enjoyed talking with you. Thank you for these insights, and we look forward to speaking with you and Tim Buckley in the near future. Thank you.

Sauter: Great. Thank you, Paul.

Justice: For Morningstar, this is Paul Justice. Thanks for watching.

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