Vanguard Group, the largest U.S. mutual fund manager, said on Tuesday it was switching 22 of its biggest index funds away from benchmarks provided by MSCI Inc in order to cut costs.
News that one of its biggest index licensing customers had defected caused shares of MSCI to plunge over 30 percent before recovering slightly. The shares finished down 27 percent at $26.21, their lowest in over three years.
Vanguard's move comes as other managers of index funds are also moving to cut costs. Charles Schwab said last month that it was trimming fees on its line of exchange-traded funds to as little as 0.04 percentage points a year while BlackRock, the top ETF manager, has said it plans to announce price cuts soon.
Vanguard said it would shift six international stock funds with $170 billion of assets to track indexes from the FTSE Group, including its giant Vanguard Emerging Markets Index ETF . And 16 U.S. stock and balanced funds with $367 billion of assets, including the Vanguard Total Stock Market ETF , will switch to indexes developed by the University of Chicago's Center for Research in Security Prices.
The change affects both mutual funds and exchange-traded funds, Vanguard, based in Valley Forge, Pennsylvania, said in a statement.
"We negotiated licensing agreements for these benchmarks that we expect will enable us to deliver significant value to our index fund and ETF shareholders and lower expense ratios over time," Gus Sauter, chief investment officer at Vanguard, said in a statement.
MSCI said the switch is expected to be phased-in over a number of months starting in January 2013 and covers Vanguard funds that generated annual revenue and operating income of about $24 million from licensing fees. The New York-based firm reported operating revenue of $901 million and operating income of $322 million in 2011.
NOT AS 'STICKY'
But MSCI chief executive Henry Fernandez could do little to calm investors over fears that other customers might follow Vanguard's move. MSCI shares, already down over 20 percent in morning trading, dropped another 5 to 8 percentage points during a 45-minute conference call Fernandez held with analysts.
ETF managers' choice of index provider "may not be as sticky as we all thought," Fernandez said on the call. Later, he explained that despite long-term licensing contracts, ETF managers could still switch indexes in "relatively short periods of time."
Analysts expect BlackRock, responsible for 8 percent of MSCI's revenue last year, will likely press for price reductions. "At the very least, BlackRock will seek to be competitive with the lower cost target benchmarks that Vanguard will use, potentially leading to price cuts on its contracts with MSCI," David Togut, an analyst at Evercore Partners, wrote in a report on Tuesday.
Still, BlackRock, which has been losing ETF market share to Vanguard for several years, said it was sticking with MSCI indexes on its iShares family of funds.
"MSCI is the gold standard of global and international equity indexes - the near-universal choice of professional investors," Mark Wiedman, global head of iShares, said in a statement. "We plan to deepen our partnership with MSCI to help deliver the highest quality products and portfolio construction to our clients."
Shares of BlackRock declined 1.5 percent to $177.17. The firm has already said it plans to cut prices on some ETFs that compete most directly with large Vanguard funds. Now BlackRock faces the prospect of Vanguard reducing its fees even more.
Vanguard's decision follows a similar move it made in 2003 to dump higher-cost indexes provided by McGraw-Hill Co's Standard & Poor's unit in favor of the MSCI benchmarks.
The new indexes may be somewhat inferior at tracking market results but will lower Vanguard's costs and the savings will be passed on to investors, said Daniel Wiener, editor of "The Independent Adviser for Vanguard Investors" newsletter.
"Indexing, particularly through ETFs, is going to get cheaper and cheaper," Wiener said. "Vanguard is not going to let someone else, be it Schwab, iShares or any of its other competitors take the mantle of 'lowest cost' from its shoulders."
Vanguard officials defended the switch, saying investors would see little difference. "There's been a real convergence in index construction methodology over the past decade to a set of best practices," Joel Dickson, senior ETF strategist at Vanguard said.
The impact of the change could be felt around the globe, as the new FTSE index on Vanguard's $67 billion emerging market fund does not include South Korea, which accounts for over 15 percent of the fund's current MSCI index.
Since FTSE bumped South Korea from its emerging markets index in September 2009, the MSCI index has posted a slightly better return, Wiener noted. The FTSE index gained 17.9 percent versus a gain of 19 percent for the MSCI benchmark.