Indexing at Vanguard - quality not commodity
28 June 2021 | Portfolio construction
Index mutual funds and ETFs are now so popular within the investment landscape that one might be tempted to think that they have been around for ever. In reality, they’ve existed as an official strategy for less than 50 years: in pioneering the concept of indexing, John C Bogle, founder of Vanguard, developed the first index fund for individual investors on New Year’s Eve 1975.
Since then, total assets under management globally have grown to $14.5tn1 at the end of 2020 (ETFs stood at $7.6tn, narrowly eclipsing index mutual funds, which had $6.9tn in assets). While low cost has been a critical success factor in the growth of indexing – and the average expense ratio across Vanguard's index mutual funds and ETFs in Europe is 53% less than the industry average2 – evaluating index products solely by reference to cost can mean neglecting crucial facets that contribute significantly to successful investor outcomes.
Vanguard is committed to adding value to indexing through considered benchmark selection, best-execution trading practices, robust and consistent risk management and a commitment to stewardship – at a price that allows investors to keep more of their returns.
Named the First Index Investment Trust – and later renamed Vanguard 500 Index Fund – the first index fund for individual investors mirrored the S&P 500, an index widely seen at the time as a reliable proxy for the US stock market as a whole. Priced more competitively than a great many conventional mutual funds, it enabled the ordinary investor – even those of limited means – to take an equity stake in the nation's largest and most admired corporations … efficiently, conveniently and cost-effectively.
From those beginnings, low-cost index funds are increasingly seen as a solid foundation for the vast majority of investment portfolios and an ideal way to achieve broad diversification. Nevertheless, it took some time for the approach to gain any meaningful traction; more recently, however, the rise of index investing has been relentless. At the end of 2008, less than $1.7tn was invested globally in index funds (both mutual funds and ETFs)1 but, since the global financial crisis, they have risen rapidly in popularity across equity, bond and commodities markets, and fundamentally reshaped the asset management industry.
Total global assets under management (USD trillion)
Source: Strategic Insight Simfund, data as at 21 April 2021.
Index funds have succeeded in gaining the most ground in equity markets – particularly in the US – the past 10-year period having posed a unique set of challenges for the managers of active funds. And enthusiasm for indexing is gathering momentum in the fixed income arena too, a market that is generally more opaque and challenging to replicate and less liquid than equities, and therefore traditionally more aligned with active investment. Index mutual funds and ETFs passed a critical structural test during the market turmoil of March 2020 by continuing to offer liquid access to markets, further boosting their appeal.
In truth, the past decade has been marked by the ascendancy of indexing, but with ubiquity comes homogeneity. Amidst the growing and widespread popularity of index mutual funds and ETFs, it has become tempting to regard them as mere commodities, with fund selection based purely on securing the lowest-cost exposure to markets. Indeed, in recent years, some asset managers have announced ultra-low expense ratio products in order to advance the notion that index funds are differentiated solely by price. However, while expense ratio differences of 50, 20 or even 10 basis points have a significant impact on a fund’s relative performance, they become increasingly irrelevant as that disparity declines. At lower levels, one must look beyond expense ratios to a broader set of more complex factors in order to seek out managers adept at providing investors with exposure that closely mirrors the risks and returns of a benchmark index—the primary objective of any index fund.
How Vanguard's commitment to quality adds value to indexing
Despite a widespread belief that index fund management is straightforward and simple, in reality it's a complex undertaking that is heavily reliant on lengthy experience, deep expertise and technological sophistication. In what follows, we set out what we regard as constituting the 'Vanguard difference' and, by implication, our view of the drivers that should form the core of any decision-making framework.
- A focused range of core indexing solutions
Our indexing range comprises 34 equity index products, from large cap to small cap, across developed and emerging markets, plus 27 bond ETFs and funds covering the main benchmarks of the fixed income market as well as 20 multi-asset index products. Our aim, however, is not to be all things to all investors, but rather to provide strategic, diversified and competitively priced core building blocks designed to meet the long-term needs of the majority of investors for whom we feel we can offer enduring, high-value solutions.
- Considered benchmark selection
We look to offer exposure to reliable and highly diversified benchmarks through major, recognisable and transparent core indices which accurately reflect markets and available liquidity, and with transparent and objective index rules. Our scale enables us to efficiently replicate the broadest possible benchmarks – our fixed income index funds, for example, reflect the true investable universe by tracking float-adjusted indices which more accurately represent investors’ opportunity set.
We adopt a considered approach to appropriate benchmark selection based on the exposure in question, working in partnership with only the largest, globally recognised index brands: FTSE, MSCI and S&P Dow Jones for equities and Bloomberg Barclays and J.P. Morgan for fixed income. Coverage includes emerging and developed markets, UK, Europe, Japan, Asia-Pacific and the US, as well as ESG (environmental, social and governance) and socially responsible investing (SRI).
- Superior tracking methodology
We have 45+ years' expertise in tracking benchmarks accurately, efficiently and cost-effectively across many market cycles. As a result, we offer some of the tightest tracking in the field of indexing, and are relied upon by millions of investors for the delivery of consistent, reliable performance.
We use full replication for our equity portfolios wherever practical, possible and cost-effective, on the basis that holding physical assets in the benchmark index in their exact weight represents a 'purer' form of indexing, and results in lower tracking error. Physical as opposed to synthetic replication offers investors the benefit of transparency through the direct ownership of securities, thereby ensuring that any issues related to counter-party risk are eliminated.
Where we cannot replicate – such as in the case of benchmarks which hold an unmanageable number of securities or contain illiquid stocks – we optimise by holding a representative sample of securities, as is the case with our fixed income index funds, deploying the expertise of our portfolio managers and credit research teams in matching the fundamental risk characteristics of the sample to the benchmark itself. Sampling additionally allows for lower turnover and therefore reduced transaction costs.
- Combined transactional model
Our combined portfolio manager/trader model fosters deep expertise, and allows us to manage index changes, rebalances, corporate actions and cash flows better than typical index fund team structures, resulting in optimal outcomes for clients. Our fixed income portfolio managers/traders, for example, are all sector specialists rather than generalists, and can therefore demonstrate an unparalleled level of immersion and expertise.
Our scale, coupled with our extensive and long-standing trading relationships, our robust global trading platform, and our intelligent management of market impact, can result in lower trading costs, greater choice of favourable securities lending opportunities, improved global access to trades, and tighter replication.
- Robust and consistent risk management
All Vanguard’s index funds worldwide use the same daily, disciplined and tightly risk-controlled approach in order to ensure investor peace of mind. Our equity index funds adopt a prudent and conservative securities lending approach with low structural risk, and we are fully transparent about the portion of lending revenue we return to end investors.
- Commitment to stewardship
As long-term stewards of our clients’ capital, we take investment stewardship seriously. Our global Investment Stewardship team represents Vanguard fundholders’ interests through industry advocacy, company engagement and proxy voting.
Vanguard believes that material environmental, social and governance (ESG) risks can impact long-term value creation in portfolio companies. The ESG landscape continues to develop rapidly. As such, Vanguard continually evaluates ESG opportunities and our approach to product development remains deliberate and consistent.
Value not cost
At Vanguard, we've built a sustainable, scaled and successful index franchise by recognising that quality isn't about cost, it's about value – which is why we believe in doing the basics brilliantly and at a price that allows investors to retain substantially more of their investment returns. Our indexing expertise and unerring commitment to quality mean that, when you select a Vanguard index fund or ETF, you know exactly what you are going to get: low-cost, high-value, transparent access to a broad market exposure.
Together with our unmatched expertise and our commitment to working with advisors, it reinforces why Vanguard remains the choice for sophisticated, high-quality indexing… and why clients trust Vanguard to give them the best chance of investment success.
1 Source: Strategic Insight Simfund, data as at 21 April 2021.2 Vanguard average expense ratio: 0.14%. Industry average expense ratio: 0.30%. All averages are for index mutual funds and ETFs and are asset-weighted. Industry average excludes Vanguard. Sources: Vanguard and Morningstar, Inc., as at 30 April 2021.
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