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Your Index Fund Is Changing Its Target Index. Now What?

Two Vanguard funds recently changed their benchmarks. Ben Johnson lays out what such events mean for fundholders.

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Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Two of Vanguard's dividend stock funds recently announced changes to their target indices. Here to discuss what these types of changes mean for index fund investors is Ben Johnson. Ben is Morningstar's global director of ETF research.

Hi, Ben, thank you for being here today.

Ben Johnson: Thanks for having me, Susan.

Dziubinski: Now, how common is it for passive funds to change their target indices?

Johnson: Well, despite what the word "passive" might have an investor believe, what we see is that among index funds, index changes--either wholesale changes or modifications to index methodologies--are far more common than one might think. And they've affected every fund from the very oldest index mutual fund, Vanguard 500, which has gone back from kind of Istanbul to Constantinople--the S&P 500 to a homespun version of the S&P 500--during its long life span. More recently, things like thematic funds. One example at the extreme was a Latin American real estate fund that went to bed one night and woke up the next morning as a cannabis fund. So investors need to be cognizant of the fact that despite the fact that they're investing in nominally passive funds, what we see underneath the surface is a lot of activity, be it just manifesting the index methodology itself, or changes to that index methodology, or as we've seen in a number of cases recently, wholesale changes to the index.

Dziubinski: What are the implications for investors, Ben, if they do own a fund that changes its target index?

Johnson: Well, it's really going to vary, and it's going to vary by the degree of materiality of either the index change on the one hand or the change to the index itself. So in the example I mentioned before, a Latin American real estate ETF that is effectively repurposed, to use a term that is often used within the industry, to become a cannabis fund. For all intents and purposes, changes of that magnitude are effectively equivalent to a manager or a strategy change that you might see in an actively managed portfolio. Investors who wanted exposure to Latin American real estate might not care to have exposure to cannabis stocks.

On the other end of the continuum, what you see is that we've seen a growing number of more minor, less material modifications to index methodologies. So if you go back for example to late 2017 and look at the CRSP family of U.S. stock indexes, which are notable because they underpin many of Vanguard's mainline index funds and ETFs, what that index family did at that point in time was move from rebalancing the index portfolio in one day to spreading rebalancing trades over a five-day period. Now, that's a more modest tweak. In many cases, it probably didn't even register with investors--they might be finding this out for the first time here as I'm saying it. So there's really a continuum in how investors should respond, what they should understand;, it's really going to vary depending on where on that continuum either this index change or this modification to an index's methodology might reside.

Dziubinski: Let's talk a little bit specifically about the changes at these Vanguard funds. Vanguard Dividend Appreciation and Vanguard International Dividend Appreciation both changed their target indices. So walk us through what the changes were, and what in these specific cases these changes mean for the fundholders.

Johnson: This is an interesting kind of hybrid case, because what we've seen is a combination of both an index change as well as a refinement to the methodology of these funds' prior indexes. So the two funds will switch to new benchmarks effective in the third quarter of 2021. These new indexes, which are S&P Dividend Growers indexes look awfully similar to their current benchmarks, which are Nasdaq benchmarks. Now they retain many of the same key attributes, specifically very stringent criteria on dividend durability. So they're looking for stocks that have grown their dividends over a long period of time, which is what gives them their quality bent, which is one of the key points of appeal that we've long lauded for both of these funds, that remains untouched. What we see really modified at the margin is first and foremost, there's a greater degree of transparency in the methodologies for these new S&P indexes, which was a bit of a rub with the old Nasdaq indexes. So in their methodology, there was a bit of a black box sentence that said there were certain proprietary criteria that those benchmarks used to screen out certain stocks.

What we see and what is fully transparent with these new S&P benchmarks is that once they've arrived at their eligible universe of stocks, they're weeding out those that have particularly high yields, which oftentimes can be value traps. They might be stocks, who for whatever reason, have fallen on tough times, whose dividends might not be sustainable, which isn't what investors want in a strategy that's aiming for durable dividends. So we see that with full transparency now in this new methodology, which is great.

The other key modification is really, I think, a recognition of the heft of these funds, which together have tens of billions of investors' money sitting in them as we sit here today. So the new indexes are more sort of turnover-conscious, they're more cautious, they're going to tread more lightly. So they're looking at and weighting stocks by not just their market cap, but their float-adjusted market capitalization--focusing on the portion of stock shares that are actually available to be readily traded in the market. The other important modification we see is that both indexes are going from rebalancing over the course of one day, to a three-day rebalancing period, which spreads trades out over a longer duration, which mitigates the potential impact that those trades might have on the prices of the stocks that they're either going to be buying or going to be selling, which is very important now, because during any given rebalance, there could be billions of dollars of money moving in one direction or another when these portfolios look to remove existing constituents and refresh with new ones.

All told, we view these modifications very favorably. And this is a hybrid of those situations that I described earlier. It's an index change, and it's also a refinement to the methodology that investors have adhered to and benefited from today.

Dziubinski: So given changes to these funds, Ben, have we made any changes to our Analyst Ratings of them?

Johnson: We've taken a close look at the new indexes, really under sort of the umbrella of our assessment of the funds' process. So index methodology is really synonymous with process when we're looking at index-tracking funds. And in the case of both the Vanguard Dividend Appreciation index fund, and its international cousin, we've reaffirmed both our Process Pillar ratings as well as our overall ratings, which are Gold for the U.S. fund and Silver for the international fund. As I mentioned before, we really like these refinements at the margin. We laud the incremental transparency of the new S&P indexes and given the funds' size--again tens of billions of dollars now sitting in these funds--we think being cautious, taking a more measured approach to turning over the portfolio is absolutely warranted. So we've reaffirmed our Medalist ratings for both of these funds.

Dziubinski: Well, Ben, thank you for your perspective today. We appreciate it.

Johnson: Well, thank you so much for having me.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Morningstar, Inc. does not market, sell, or make any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

Ben Johnson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.