When the Vanguard Group of Malvern, Pa. began offering its Admiral shares in November, it did so claiming it wanted to reward its largest, most loyal investors. But the product is more likely designed to prevent shareholders from straying to exchange-traded funds, according to industry observers.

The new shares, which offer lower expense ratios for investors with accounts of significant size and tenure, have proven to be very popular, said D. Christopher Brown, vice president of research with Financial Research Corporation of Boston. Admiral shares attracted $9.6 billion in November and an additional $2.7 billion in December, he said.

"I would say they certainly have attracted a sizable chunk of Vanguard's client base," he said. " ... I would think the fact that [investors] get special treatment would help to keep them from straying to other products, including exchange-traded funds."

That is important because it allows Vanguard to compete with other exchange-traded funds with VIPERs, its exchange-traded share class, while also offering a traditional index product that is as competitive as most exchange-traded funds, said Daniel P. Wiener, editor of the Independent Adviser for Vanguard Investors.

"If anything, the relationship between [Admiral shares] and the VIPERs is that it's a way to provide low operating expenses to compete with the exchange-traded funds," he said.

Admiral shares will help to minimize the number of Vanguard investors who convert their assets to VIPER shares, said Mercer Bullard, president and founder of Fund Democracy LLC of Chevy Chase, Md. The consequences of having its larger accounts switch to VIPER shares would be considerable, he said.

"When you have an exchange-traded fund, which is the main threat to [Vanguard's] index business, you essentially give up the relationship with the investor," he said. "That's very important to Vanguard because they want to own that relationship. They don't want to have their large accounts be large brokerages through whom shares of Vanguard's [exchange-traded funds] are going to be held."

The conundrum Vanguard faces now is whether it should drop its VIPER shares' expense ratios to a little under 10 basis points to compete with Barclays' iShares, among the cheapest exchange-traded funds available, or whether it should keep expense ratios only as low as those of the Admiral shares, Bullard said. If its VIPER shares offer significantly lower expense ratios than Admiral shares, the product could be cannibalized, he said.

However, the Admiral shares, which range in price from 13 to 24 basis points, are priced competitively with other exchange-traded funds, according to Edgar Cha, an analyst with Strategic Insight of New York. For instance, S&P Depository Receipts and Nasdaq QQQ's have expense ratios of about 18 basis points, he said.

The fact that Vanguard introduced its Admiral shares roughly two months after it announced it would offer an exchange-traded share class on some of its funds is not coincidence, said Bullard.

"I think that when they were looking at exchange-traded funds, because the Vanguard response has been so negative [to exchange-traded funds], they wanted to be able to offer something that would be more consistent with their traditional products," he said.

The new share class is available only to those investors with:

* An account balance of $250,000 or more

* An account three years old or older with a balance of $150,000 or more

* An account 10 years or older with a balance of $50,000 or more.

All investors with accounts under $250,000 must convert their shares online.

But Admiral shares will offer the discounts at the expense of Vanguard's other shareholders, who will pay increased expense ratios.

"This is definitely a program aimed at the richest Vanguard investors," said Weiner. "But Vanguard has always favored richer people." The firm has traditionally waived certain fees for larger investors, he said. Its Admiral funds were a forerunner to the Admiral shares and offered many of the same cost advantages, he said.

Even though other shareholders will be subject to fee increases, that is not likely to prompt a flood of redemptions because Vanguard's fees will still be among the lowest, Weiner said.

The fee increases are also justified because small accounts are usually subsidized by large accounts, Bullard said.

"Imagine the very active $3,000 account holder and the very inactive, retired $100,000 account holder," he said. "You have a massive redistribution of wealth from one to the other... If you take a $3,000 account that makes a lot of calls, does a lot of trades, you have someone who is costing so many multiples of what they are getting it is something that Marx would have been proud of."

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