Successful indexing is harder than it looks

19 December 2018 | Portfolio construction


Indexing can seem like a simple and straightforward endeavour, but the process is highly sophisticated with multiple moving parts – a dichotomy that can make it difficult to evaluate index fund managers.

Realising this, Morningstar, a Chicago-based research firm unaffiliated with Vanguard, published Partnering With Passive Fund Sponsors That Have Your Back: What to Look For in Passive Parents.1

The 2017 paper underscores Vanguard's merits as an index fund manager, emphasising several criteria for evaluating an asset manager and its index funds: ownership structure, investments in portfolio management capabilities, securities lending practices, product development and low fees.

Morningstar focused on the ten largest US-based providers of passively managed mutual funds and exchange-traded funds (ETFs) that have also been assigned a Morningstar Parent rating, a proprietary measure of investment stewardship.

An ownership structure aligned with client interests

What sets Vanguard apart from the other nine firms analysed in the paper is an ownership structure that allows us to put investors first. The Vanguard Group, Inc., is owned by its US-domiciled funds and ETFs. Those funds, in turn, are owned by their investors. This unique mutual structure aligns our interests with those of our investors and drives the culture, philosophy and policies throughout the Vanguard organisation worldwide.

Morningstar pointed out that other ownership structures can have competing stakeholders. For example, publicly traded mutual fund firms have shareholders that want to see the share price increase and fund holders who want to pay the lowest fees.

The Vanguard Group, Inc.'s "mutually owned structure most closely aligns the firm's economic incentives with its fund holders'," wrote Adam McCullough, a Morningstar analyst and author of the paper.

A global team and philosophy carry stewardship

The report emphasised that passive investment sponsors can be good stewards of their clients' assets by investing in portfolio management and technology. Over time, these capabilities can help funds do a better job tracking their respective benchmark indices.

This is reflected in the work of Vanguard Equity Index Group (EIG), which manages all of our US and international equity index funds through a global trading operation located in Malvern, Pennsylvania; London, UK; and Melbourne, Australia. EIG's portfolio managers double as traders, allowing them to react quickly to new information and to execute trades around the clock, capturing value and the best price for our funds.

"We expend a lot of time and resources on execution so that our funds do a great job of tracking their benchmarks," said Joe Brennan, Vanguard's global chief risk officer and former head of EIG. "Investors know what they are getting when they own a Vanguard index fund or ETF."

The group also promotes better outcomes for investors by advocating for sensible index construction. For example, EIG has advocated for multiday index reconstitutions, so that a fund isn't forced to buy all securities on one day. A new proprietary trading system will only help strengthen the process.

As for the team itself, EIG has a longer average tenure than many of its competitors. "We don't treat indexing as a starter investment management job," Brennan said. "It's a career. We keep great people for a long time."

Lending a hand to investors

The Morningstar report also shed light on securities lending, which is a method passive funds can use to generate revenue, and emphasised that good stewards of investors' capital return a majority of that revenue to the funds.

Unlike most passive fund sponsors, Vanguard has a policy of returning 100% of its securities-lending revenues, net of programme costs, broker rebates and agent fees, to the funds.

Morningstar found that although some firms pledge to return a similar level, the total amount differed according to the fees the firms paid.

Thoughtful launches that avoid hot trends

The mutual fund industry is known for its fair share of product launches and failures. As a proxy for prudent product development, Morningstar looked at fund launches and liquidations during the trailing one, three, five and ten-year time periods as at June 2017.

The research showed that Vanguard was one of a few fund companies that showed the most "restraint" when it came to product development. Our fund launches and liquidations accounted for just a small percentage of total funds.

Vanguard takes a thoughtful, research-based approach to fund launches to ensure that our line-up is enduring and diversified. We eschew the hot trends. We want our funds to be the cornerstones of client accounts or round out a diversified portfolio.

"We don't launch funds simply to attract assets," Brennan said. "Our clients invest in our funds for decades, so they must be great solutions that are long-term and enduring."

A long heritage

Of course, Vanguard's history is rooted in low-cost investing. And low investment fees make a lot of sense. But, as the Morningstar report reveals, that is just part of the story. Vanguard's funds, services, process and people are all aligned to help clients meet their financial goals.

"Low fees are a good starting point, but to us, they are just that – a starting point," Mr Brennan said. "Our culture, our funds, our services – they are all grounded in a singular goal: to help our clients achieve the best outcome, no matter what their financial goal."

Mr Brennan added: "The Morningstar paper validated what we already knew. The 'Vanguard Way' makes a lot of sense for investors taking a long-term approach."

1 Morningstar, Partnering With Passive Fund Sponsors That Have Your Back, 18 October 2017.

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The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

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