Vanguard seeks to switch six ETFs to all-cap mandates

Following U.S. lead would leave two international equity ETFs also holding Canadian stocks.

Rudy Luukko 2 June, 2015 | 5:00PM
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If investors agree, as many as six Toronto-listed Vanguard exchange-traded funds that invest in overseas equities will have even broader market exposure later this year. Vanguard Investments Canada Inc. announced today it is seeking investor approval to transform these ETFs to all-cap mandates.

The company estimates that under their proposed new names and mandates, small-cap stocks would account for about 10% of the holdings of each of the affected ETFs. This would bring their objectives in line with those of the U.S.-listed Vanguard ETFs in which the Toronto-listed ETFs invest.

The proposed changes in Canada would benefit investors because "an all-cap approach produces more complete exposure to the respective markets and increases diversification," said Atul Tiwari, managing director of Vanguard Canada, in a release.

Investors are scheduled to vote on the proposed changes in objectives and market benchmarks at a meeting to be held on Sept. 2. Vanguard intends to file prospectus amendments on or about June 12. If approved, the changes are to be implemented over several months. Vanguard said it will issue a press release when each ETF begins to track its new index.

Though the transitions will result in higher than normal portfolio turnover as the ETFs divest some of their existing large- and mid-capitalization holdings, Vanguard said it does not expect this activity to result in capital-gains distributions to unitholders.

Two of the affected ETFs -- Vanguard FTSE Developed ex North America Index (VDU) and the currency-hedged Vanguard FTSE Developed ex North America Index (CAD-hedged) (VEF) -- are each to get a roughly 8% weighting in Canadian equities. Their new benchmarks would be the FTSE Developed All Cap ex US Index and the FTSE Developed All Cap ex US Hedged CAD Index, respectively.

The proposed inclusion of Canada in these international ETFs is an oddity for Vanguard, since the company's normal practice is to offer pure plays on asset categories. A hybrid mandate, from a Canadian investor's perspective, would also complicate asset allocation by country. Unitholders would have to factor in the Vanguard ETF's Canadian exposure in deciding on how much of their portfolio to devote to the domestic market.

Adding a Canadian component would be an unwelcome surprise for investors who thought they were buying into a pure foreign-equity mandate. The proposed change in strategy is driven by the addition of Canadian stocks to the U.S.-listed ETF in which the Canadian-listed ETFs invest.

While acknowledging that the situation isn't ideal for Canadians, Vanguard Canada concluded it would be in the best interests of investors to bring the Toronto-listed international-equity ETFs in line with the changes in the U.S. If the Canadian ETFs were to go their own way, divesting their current holding in the U.S.-listed ETF and instead investing directly in the underlying foreign stocks, there would be "significant and unprecedented capital gains," a Vanguard spokesperson said.

For Vanguard investors who don't want Canadian exposure in their international equity ETFs, Vanguard has filed a preliminary prospectus for hedged and unhedged ETFs under the names Vanguard FTSE Developed All Cap ex North America Index ETF and Vanguard FTSE Developed All Cap ex North America Index ETF (CAD-hedged).

However, unlike investors in corporate-class mutual funds who can switch readily from one share class to another without having to pay sales commissions or trigger a taxable event, Vanguard ETF holders who wished to switch to one of the upcoming pure plays on ex-North American equities would need to pay brokerage commissions to sell their existing holding and to buy a purely foreign ETF. And if they did so by selling at a profit within a non-registered account, they'd realize a taxable capital gain.

In other proposed mandate changes, Vanguard FTSE Emerging Markets Index (VEE) would for the first time hold an allocation of China A-shares, which are listed on the Shanghai and Shenzhen exchanges and are available to investors outside mainland China only under a quota system. The Vanguard organization has received a quota of US$1.6 billion in A-shares, and "positive signals" that this quota can be increased over time, the Vanguard spokesperson told Morningstar.

Currently, Vanguard FTSE Emerging Markets Index has approximately 26% exposure to China, already its largest country weighting. Under its proposed new name -- Vanguard FTSE Emerging Markets All Cap Index -- the ETF would have a modest increase in its China exposure to 29%. The ETF's allocation to A-shares would be about 6%, representing holdings in more than 1,400 Chinese companies. Vanguard's Tiwari said in a release that the addition of China A-shares will provide more diversification and greater access to the growth potential of Chinese equities.

The ETF's benchmark, the FTSE Emerging Markets All Cap China A Inclusion Index, adjusts its allocation to A-shares according to the total quota approved for international investors each quarter. An increase in this quota would lead to the Vanguard ETF further increasing its A-shares weighting.

The proposed changes will also give Vanguard FTSE All-World ex Canada Index (VXC) a small exposure to China A-shares. Under its proposed new name -- Vanguard FTSE Global All Cap ex Canada Index -- this ETF would track the FTSE Global All Cap ex Canada China A Inclusion Index.

The two other foreign-equity ETFs that Vanguard is proposing to reposition as all-cap mandates are Vanguard FTSE Developed Europe Index (VE) and Vanguard FTSE Developed Asia Pacific Index (VA).

For the six ETFs that Vanguard wants to change to all-cap mandates, there will be no increase in management fees, which range from 0.20% to 0.25%. In fact, two of them -- the European and Asian ETFs -- reduced their management fees to 0.20% effective June 1, down from the previous 0.23%.

The new all-cap mandates, if approved, will join five others in the current line-up of 21 ETFs in Vanguard Canada's $5.1-billion family. The existing all-cap ETFs include Vanguard FTSE Canada All Cap Index (VCN), Vanguard U.S. Total Market Index (VUN) and Vanguard U.S. Total Market Index (CAD-hedged) (VUS).

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About Author

Rudy Luukko

Rudy Luukko  Rudy Luukko is a freelance writer who contributes to Morningstar.ca on topics involving fund industry trends and regulatory issues. He retired in May 2018 from his position as editor, investment and personal finance, at Morningstar Canada, where he had worked since 2004. He has also worked as an editor and writer for various general, specialty and institutional media, and he has co-authored courses for the Canadian Securities Institute. Follow Rudy on Twitter: @RudyLuukko.

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