Vanguard Outdraws BlackRock and State Street

Vanguard's emphasis on low expenses and index investing have helped make it the largest mutual fund manager by assets in the U.S. Now it is using low costs to grab market share from BlackRock (BLK) and State Street (STT), the world's largest sellers of exchange-traded funds.

Vanguard ETFs sold in the U.S. pulled in a net $25.6 billion in the first nine months of this year, 26 percent more than BlackRock and State Street combined, according to Chicago-based research firm Morningstar. State Street and BlackRock dropped to a 70 percent combined share from 85 percent in 2005. Vanguard last month offered 20 new ETFs, taking on the bigger companies for the first time with funds that track broad market benchmarks including the Standard & Poor's 500-stock index and the Russell 1000.

ETFs, which trade through the day like stocks and usually track indexes, have been one of Wall Street's most popular products. Assets rose almost fourteenfold in the past decade, to $897 billion, Morningstar data show. ETFs may gather more deposits than index-based mutual funds this year. Through September, ETFs attracted $64.9 billion, compared with $55.7 billion for index funds, according to Morningstar.

Fees charged by BlackRock and Boston-based State Street, which oversees $216 billion in ETFs, are on average about double those of Vanguard and Charles Schwab (SCHW). The BlackRock iShares ETF that tracks an MSCI emerging markets index manages $48.2 billion and has an expense ratio of 0.72 percent. That means an investor who puts in $10,000 would pay $72 annually in fund fees. The fund, opened in 2003, gathered $2.7 billion this year through Sept. 30, according to data compiled by Bloomberg.

The Vanguard ETF that follows the same benchmark has an expense ratio of 0.27 percent. Opened in 2005, the fund drew $13.3 billion this year and assets have climbed to $39.9 billion. "Cost isn't everything, but it does matter," says David Nadig, director of research for Index Publications in Decatur, Ga., which produces a website covering the ETF industry. "For the more competitive segment of the market, investors are voting with their feet."

Both iShares and State Street say they aren't considering cutting expense ratios, except according to preset formulas that drop fees when the assets in a fund reach certain thresholds. "We are absolutely sticking to our strategy," iShares managing director Noel Archard says. "Our customers aren't asking for lower expense ratios. They're asking for more services." Those services include education on how to use ETFs, multi-ETF asset-allocation models, and portfolio analysis, he says.

A frequent advantage for State Street and BlackRock's iShares, with their bigger funds, is liquidity. The iShares $36.6 billion MSCI EAFE Index Fund, which tracks developed non-U.S. markets, charges 0.35 percent and had an average bid-ask spread of 2 basis points, or 0.02 percentage points, during normal trading hours in the week ending Oct. 8, Bloomberg data show. Schwab's similar $357 million International Equity ETF (SCHF) has an expense ratio of 0.13 percent, while its average bid-ask spread is 13 basis points, or 0.13 percentage points. "If the bid-ask spread is too large, perhaps because the fund is too small and liquidity is tight, you might end up paying more than you should, even if the underlying expense ratio is low," says George Padula, a wealth management adviser at Back Bay Financial Group in Boston, which oversees about $350 million, including $65 million in ETFs.

For active traders, the wider spread, which affects each transaction, is more of a burden than the expense ratio, which is an annual charge. The most active traders are large institutional investors, Index Publications' Nadig says. BlackRock and State Street are the world's largest money managers for institutions. Vanguard and Schwab, by contrast, cater mostly to retail investors, which may help them capture future ETF deposits.

The bottom line: Using the same low-cost strategy that helped it succeed in mutual funds, Vanguard is expanding its range of ETF offerings.

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