Once Upon A Time, Vanguard Loved MSCI

On Tuesday, Vanguard rocked the exchange-traded products world by announcing it would drop MSCI MSCI indexes on 22 of its funds. Pennsylvania-based Vanguard, the firm that pioneered index funds and today is the third-largest U.S. ETF sponsor, said the moves "should save millions of dollars in licensing expenses for the funds—savings that will ultimately benefit shareholders," according to a statement issued by the firm. Of the 22 Vanguard funds that will start tracking new indexes, six are international funds, including the now soon-to-be former Vanguard MSCI Emerging Markets ETF VWO. With $67 billion in assets under management, VWO is the third-largest U.S.-listed ETF and the largest emerging markets ETF. VWO will start tracking the FTSE Emerging Markets Index, which is sponsored by U.K.-based FTSE Group. Other marquee Vanguard ETFs ditching MSCI in favor of FTSE indexes, include the Vanguard MSCI Europe ETF VGK and the Vanguard MSCI Pacific ETF VPL. There is perhaps no other way of describing this news than as bad for MSCI, which was spun off from Morgan Stanley MS in 2007. The investment bank would sell the remainder of its stake in 2009. On Tuesday, shares of MSCI plunged almost 27 percent on volume that was nearly 26 times the daily average. It was the largest single day decline for the stock on record, according to Bloomberg. Not Always This Way Without confirmation to this effect, there is no reason to believe there was a rift between Vanguard and MSCI leading up to the announcement. In fact, Vanguard was once an ardent supporter of MSCI. On a page that was still up on the Vanguard web site as of early Wednesday, the fund issuer said the following: "In recent years, most of Vanguard's index funds and Vanguard ETFs have switched to new benchmarks from Morgan Stanley Capital International, because MSCI incorporated many of the criteria that Vanguard believes to be the cutting edge in constructing better indexes." On that page, Vanguard goes on to outline six advantages of MSCI indexes, including float adjustment, market coverage, market cap levels and rebalancing schedule. Vanguard even said "there can be better ways to slice the pie" while going on to note "For index funds, the MSCI benchmarks potentially provide several incremental advantages on a net basis. As the table above illustrates, these benefits include lower portfolio transaction costs and potentially lower taxes, allowing your clients to capture more of the return of the target market. "More important, MSCI indexes are a better reflection of their target markets. By tracking these indexes, Vanguard's index funds and Vanguard ETFs are better tools for implementing your asset allocation strategies." What Happened? Vanguard's reason for shifting away from MSCI indexes, cost-cutting, is plausible. The Vanguard brand, in large part, is built around the fact that investors view the company as the purveyor of some of the lowest-cost ETFs and mutual funds on the market. All that is to say unless Vanguard publicly discloses another reason for parting ways with MSCI, the cost issue will have suffice as the explanation. What is clear is that the change is not just big news, it is big. Period. It is the largest ever international index switch, according to FTSE. "Today's agreement with Vanguard underlines FTSE's continuing growth as a global brand," said Mark Makepeace, Chief Executive of the FTSE Group, in a statement. "With the switch, FTSE will become the third-largest equity exchange traded product index benchmark provider globally, with more than $124 billion in ETF assets benchmarked to FTSE indices." BlackRock BLK, parent company of iShares, the world's largest ETF sponsor, is not looking to fan the flames of its rivalry with Vanguard, but the firm is standing behind MSCI. "MSCI is the gold standard of global and international equity indexes – the near-universal choice of professional investors. We plan to deepen our partnership with MSCI to help deliver the highest quality products and portfolio construction to our clients," said Mark Wiedman, global head of iShares, in an email to members of the media sent on Tuesday. South Korea The role South Korea's status as an emerging market played in Vanguard's decision to move to the FTSE Emerging Markets Index is a point of speculation. South Korea's emerging markets status has been hotly contested. The country is an OECD member and FTSE, the International Monetary Fund and the World Bank all view the country as developed. The iShares Emerging Markets Dividend Index Fund DVYE, which tracks a Dow Jones index, devotes a scant percentage of its weight, 3.99 percent, to South Korea. That puts the country behind Malaysia, Czech Republic and Indonesia, to name a few, in that ETF. Still, MSCI continues to classify South Korea as emerging. That is not a knock on MSCI. It is just statement of fact. FTSE classifies the following nations as advanced developing economies: Brazil, Czech Republic, Hungary, Malaysia, Mexico, Poland, South Africa, Taiwan and Turkey. The following are classified as secondary emerging nations: Chile, China, Colombia, Egypt, India, Indonesia, Morocco, Pakistan, Peru, the Philippines, Russia, Thailand and the United Arab Emirates The bottom line is this: Twenty-two Vanguard funds will no longer use MSCI indexes and the announcement runs counter to the kind words the fund sponsor once had for the index provider. For more on ETF indexes, click here.