Vanguard Clamps Down On International Arbitrage

April 25, 2003 ( - Vanguard is adding a 2% redemption fee to nine international equity funds held less than two months to discourage investors from exploiting time and price differences between US and international markets.

The redemption fee will apply to all shares purchased on or after June 27, 2003, and will be assessed on redemptions and exchanges of shares out of the nine funds, according to a news release.

This is second measure taken in recent years by the mutual fund house to curb arbitrage trading.   In January 2002 Vanguard placed a limit of two telephone or online exchanges out of a fund within a rolling 12-month period, and permitted telephone and online exchanges of fund shares only until 2:30 PM Eastern time.   Although these policies, which remain in place, did help to curtail some arbitrage trading, Vanguard believes that a more stringent policy should be implemented.

“We believe that a short-term redemption fee will serve as an effective means of ending this adverse trading activity. Our primary concern is to protect the interests of our long-term shareholders, by ensuring that fund returns are not eroded by the exploitive actions of a few shareholders,” said Gus Sauter, Managing Director-Vanguard Quantitative Equity Group. “This is a redemption fee, however, we hope to never collect.”

The nine affected funds are:

  • Vanguard International Growth
  • Vanguard International Value
  • Vanguard International Explorer
  • Vanguard Total International Stock Index Fund
  • Vanguard European Stock Index Fund
  • Vanguard Pacific Stock Index Fund
  • Vanguard Developed Markets Index Fund
  • Vanguard Institutional Developed Markets Index Fund
  • Vanguard Emerging Markets Stock Index Fund

Born of Necessity

Mutual funds that invest predominately in foreign stocks are susceptible to arbitrage trading due to the manner with which these funds’ net asset values (NAVs) are determined.   These United States-based funds generally determine NAVs at the close of the New York Stock Exchange. When calculating a fund’s NAV, foreign securities owned by the fund typically are valued at the last quoted sales price on the foreign exchange on which the securities are listed.

However, because of time zone differences between the US and Europe and Asia, foreign exchanges close many hours before the New York Stock Exchange, so the last quoted sales price on a foreign exchange does not reflect events that occur after the close of the foreign exchange but before the fund prices its holdings. Arbitrageurs attempt to take advantage of these pricing differences by engaging in short-term trading of fund shares.

This frequent in-and-out trading by arbitrageurs forces a fund’s investment managers to buy and sell securities far more often than they otherwise would. The result is higher transaction costs, which diminish returns for all shareholders. Higher transaction activity also can result in the realization of capital gains, which could boost taxes for some fund shareholders.