Small-cap stocks could hit a rough patch when Vanguard readjusts its $4 billion Small Cap Index Fund in the coming months. Instead of the Russell 2000, mutual fund giant Vanguard will match its small-cap fund to Morgan Stanley's brand new MSCI U.S. Small-Cap 1750 Index (see MFMN 4/4/03).

"There's likely to be some price movement on the stocks. There's also likely to be some speculative activity around those names," said Amy Schioldager, managing director and head of U.S. equity portfolio management at Barclays Global Investor.

That move, to begin taking place this week and be completed by Sept. 30, will result in turnover of 20% to 70% of the holdings in the small cap index fund, said Gus Sauter, Vanguard's chief investment officer, in an interview.

The Small Cap Index Fund is just one of seven domestic equity funds that will be realigned to match new MSCI indices. But because small-cap stocks are less liquid and more volatile, and because Vanguard's Small Cap Index Fund is relatively large (among the funds to be switched only the $7.4 billion Vanguard Growth Index fund is larger), its readjustment is likely to have more impact on individual stocks. Vanguard said it's making the change because it likes Morgan Stanley's methodology better, and because MSCI indices have a lower turnover on an annualized basis, which will slightly reduce transaction costs.

Pros Make Educated Guess

A list of the holdings in the new MSCI indices has not yet been released, but Morgan Stanley has released its methodology, and that's enough for experienced professional investors to make an educated guess, Schioldager said.

"Anybody can take a rough approximation of what Vanguard will rebalance, and bet on it speculatively - anyone who is familiar with the methodology, and that includes a lot of money managers, hedge funds and investment managers," she said.

Schioldager declined to comment on her own best guess for the look of the new index. But T.Rowe Price equities analyst Sudhir Nanda estimated that to realign the Small Cap Index Fund, Vanguard would need to sell the 500 smallest stocks in the Russell 2000 and buy the 250 largest stocks in the MSCI index. That's because the MSCI Index contains fewer stocks, and because each firm uses different cut-off points to measure small-cap versus mid-cap stocks. The stocks that are smallest in market capitalization are the ones most often dropped, Nanda explained.

Keeping it Low Key

Like with the annual rebalancings of the Russell 2000 or the S&P 500, it is hard to know whether changes in individual stock prices will be short-term blips or longer-term depressions. That will depend on how fast and how much of each stock Vanguard sells. Vanguard wants to have as little price impact on the individual stocks as possible.

"The goal is to make the changes as economically as possible, with as little impact on the funds as possible," said Brian Mattes, company spokesman. Without specific names or dates, it will be very hard to front-run the changes, he added.

Still, with opportunities for speculation scarce, more professional investors may jump on this one. "For people who look for index-like events, there are fewer opportunities to speculate, so when there are opportunities, it's possible to see larger price moves," Schioldager said.

Copyright 2003 Thomson Media Inc. All Rights Reserved.,

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