Index funds were initially labelled a ‘sure path to mediocrity’ in their quest to mirror benchmarks. But since the first index fund was launched some 45 years ago, millions of investors across the world have taken advantage of this easy-to-implement investment vehicle that offers transparency, diversification, low costs and tax efficiency.
Many investors have found the search for winning active managers an exciting but ultimately unrewarding experience. In contrast, index funds have regularly produced returns that are 1-2% above the average active managers.
(Having said this, even investors who clearly recognise the powerful case for index funds often find a place in their carefully-constructed portfolios for some favoured actively managed funds. At Vanguard, it is not a case of having index or active management to the exclusion of the other).
Let’s talk about how to go about picking an index funds. When it comes to selecting a manager, there are a lot of options out there.
Costs are not the only differentiator
Driven in part by lower direct and indirect costs, which have benefited all investors, index products continue to grow in efficiency, popularity, and volume.
As a result, index fund expense ratios have compressed meaningfully across the industry and fee differences between funds have become less of a differentiator.
While this broad-based downward shift in index fund expense ratios has undoubtedly resulted in better investment outcomes and savings for all index investors, it has also created a new dilemma.
How does an index investor select managers and funds from the pack in this new 'everyone is a low-fee provider' environment? An investor might reasonably ask, how hard can indexing be?
Just like baking, all it takes is to follow a recipe precisely. Flour, water, yeast and a few hours later, the oven yields a lovely crisp loaf of sourdough. But as many have discovered on novice baking journeys brought on by the pandemic, the process is much more than throwing together a couple of ingredients and dropping it in the oven.
Indexing is not dissimilar. Resources, index expertise, investment sophistication and other factors can provide an edge. Investors should not merely pick the lowest cost index fund because, as with baking, the quality of the ingredients and the skills of the baker matter.
Looking beyond expense ratios
Prudent investment selection cannot be achieved by focusing on cost alone.
When searching for and selecting between index investment options, investors should use a decision-making framework that takes into account a range of factors, including expenses, portfolio management capabilities, securities lending programmes, pricing strategies and scale in more equal weights than in the past.
A recent whitepaper by Vanguard provides a framework to help investors select the best index fund managers. Below are some of the main points covered.
Exploring the factors that matter
Organisational incentives – Index fund managers come in all shapes and sizes. The details here are important because an asset manager’s philosophy defines the incentives that drive the firm’s business strategy. Does the investor’s interest or the asset manager’s interest come first?
Portfolio management track record – Despite the boiler plate warnings, “past performance, while not a guarantee of future performance”, this is actually a great place to look. What historical track records do the index managers and funds have when it comes to performance after fees? Good index managers can track tightly and add incremental value to cover some or all of the management fees. Process frictions, inefficiencies and an inability to capture value add opportunities, like a thousand little papers cuts, will show up over time in long-term performance.
Buy/sell Spreads – When it comes to the total cost of ownership, buy/sell spreads must be factored in. What’s the point of going with a low expense ratio fund if it is lost on high spread costs?
With great scale comes better returns – Scale is a key differentiator and one that is increasingly difficult for new entrants to achieve. Scale enables asset managers to lower fixed trading costs like commissions and ticket charges, track or replicate benchmarks with greater precision and strengthen relationships with trading partners.
Expense ratio – I know I said it did not matter anymore, but there are a few managers and funds still charging high active-type prices for index products. This is an obvious red flag.
Managing an index is harder than it looks
Index equity managers should produce returns that are, on average, approximately equal to their benchmark index minus the fund’s expense ratio.
This concept applies broadly across markets, while the costs—and the consequent performance drag—range from minimal in developed markets to modest in emerging markets. For sophisticated index fund managers, opportunities exist to add value through the daily management of the portfolio.
Successfully taking advantage of these opportunities can effectively offset the expense ratio and increase investor returns.
Simple to understand, yes. Simple to execute, no.
Indexing is simple for investors to understand and use. It is this perception of indexing, of merely meeting a set benchmark, that has led to it being known as ‘passive‘ or ‘average’ investing. Indexing certainly is simple for investors to understand and use but it is definitely not simple to execute. Heavy investment activity and resourcing is required.
Not all indexers are the same, and this framework shows where to look in an index fund search.
Duncan Burns is Head of Equity Indexing for Asia Pacific at Vanguard Australia, a sponsor of Firstlinks. This article is for general information purposes only and does not consider the circumstances of any individual.
For more articles and papers from Vanguard Investments Australia, please click here.