Roger McIntosh, Principal & Head of Equities, explains Vanguard's investment process, in particular, what distinguishes Vanguard's indexing approach, the difference between replication and optimisation and how an optimised approach differs from enhanced indexing.
What distinguishes Vanguard's indexing approach from other index managers?
There are three approaches to managing an index fund: full replication; stratified sampling and multi-factor risk model optimisation.
Full replication is a naive approach that seeks to own all the securities in a benchmark and replicate the index change process.
Stratified sampling involves grouping benchmark securities into like classifications (eg industry and country) and choosing a subset of these assets to perform closely in line with that classification. Stratified sampling suffers the risk that the security selection process is subjective (for example select securities based on size).
In order to obtain appropriate exposure to small cap stocks without holding too many names, this approach takes larger holdings in fewer companies. This is likely to increase transaction costs and stock specific risk. The process typically seeks to replicate the index change process.
Vanguard Australia's approach is to employ multi-factor risk models and optimisation techniques as an integral part of the investment management process.
Risk models provide more explanatory power of the sources of security and hence portfolio risk compared to a stratified sampling approach. The risk model is combined with sophisticated optimisation techniques that enable us to construct portfolios that efficiently track the returns of a given benchmark with fewer securities and fewer transactions compared to the fully replicating process and with reduced tracking error compared to stratified sampling.
In some instances, such as bond index portfolios, a fully replicating process cannot be practicably implemented and the use of a risk model to correctly construct a portfolio that captures the important characteristics of the benchmark is vital.
What's the difference between replication and optimisation?
The main difference relates to managing and controlling portfolio costs.
Replication is an administrative approach that will maximise transaction costs compared to an optimisation based approach, primarily because more portfolio securities lead to more transactions. Costs arise from different sources: hard costs such as brokerage, taxes, settlement and custody costs (which are typically a fixed amount per transaction); and soft costs which are harder to measure, but can lead to portfolio wealth erosion by causing price impact from implementing naive trading strategies designed to replicate index changes.
Optimisation based processes provide an excellent framework in which to deliver the full market return for a given benchmark. Indexes are sampled constructs of an underlying market and don't reflect real world issues that the portfolio manager must judge and balance, such as how to manage additional capital flow and implement portfolio changes as a result of benchmark change without creating market impact.
Portfolios with benchmarks that have large numbers of securities, such as the ASX300 or MSCI World ex Australia don't require all the benchmark securities in order to provide benchmark like returns. Many securities individually have small weight compared to the overall market capitalisation of the benchmark and have marginal influence on the overall return of the benchmark. As you add more and more securities to the portfolio you can achieve tighter tracking to the portfolio's benchmark, but this also leads to rising portfolio costs.
Optimisation based processes seek to determine the appropriate number of securities to hold to deliver the full market return whilst taking into account the structure of the benchmark (distribution of marketcap weight; which markets; the number of benchmark securities), and the nature (the size and frequency) of portfolio capital flow activity.
How does Vanguard optimise investment portfolios?
Multi-factor risk models describe the risk (or volatility of returns) of securities as a combination of common factors (industry, country, company size, value characteristics), which are correlated and idiosyncratic (or asset specific) risk which is unique to the security and is uncorrelated with the common factors.
The optimisation problem seeks to determine the minimum risk (or minimum tracking error) portfolio that matches the common factor risk characteristics of the benchmark. That is, ensure the portfolio has the same weighting (or exposure) to the relevant industries, countries, currencies and risk factors such as size and value characteristics (such as price/earnings, price/book, price/sales). The majority of the portfolio's active risk is the asset specific component, which arises from not owning all benchmark securities, but this can be diversified by owning more securities.
We utilise Barra's multi-factor risk models and optimisation software to construct optimal portfolios while balancing other important considerations: portfolio size; nature and frequency of capital flow activity; how many securities to hold and average holding size; the number of portfolio transactions; average transaction size (fewer and larger transactions can provide some economies of scale compared to the fixed trading costs, but can also affect portfolio structure); how much turnover is required to implement index change.
How do you ensure your portfolios track the market index?
Index portfolio management revolves around efficiently managing all the events that can affect the portfolio's ability to deliver the full market return. Employing optimisation based techniques to construct portfolios is only one element in the investment management process. There are other parts that are as equally important: monitoring the risk measures (and their understanding limitations) that define the appropriate portfolio; determining and executing the best trading strategy to implement the appropriate portfolio; managing corporate actions; maintaining a sound database of benchmark securities; efficiently managing capital flow; efficiently managing changes to the benchmark; monitoring and attributing ex-post returns.
The most important key that differentiates Vanguard is the quality and experience of the investment management team and their knowledge of the whole investment management process.
Can you walk me through the process of benchmark changes and the rebalancing process?
Almost all benchmarks are a sampled representation of a broader, underlying market. Benchmark change is important to ensure that it appropriately represents this market and its evolution through time.
All index providers review their benchmark constituents on a regular basis, typically once a quarter. This allows them to keep up to date with share capital changes and the proportion of free float share capital that is included in the benchmark. They also evaluate whether any new securities ought to be added to reflect any IPO or M&A activity and also whether any other additional securities need to be added or removed to ensure the benchmark reflects its stated objective. We may participate in IPO or other corporate activity (such as placement or rights issuance) where the index provider indicates it may fast track the change into the index (typically due to its size) or we make a reasonable assessment that the change will be incorporated at the next index rebalance.
The rebalancing process is part of the broader investment management process which determines what (if any) trading is necessary to keep up to date with benchmark change and how to go about implementing the change. The evolution of benchmarks, particularly international equity benchmarks, has been to add more and more securities through time. The funds can efficiently manage this change as part of the portfolio capital flow can be directed towards benchmark additions, reducing the need for unnecessary transactions to raise cash. Also, benchmark deletions typically occur in smaller names that most commonly are not owned, also reducing the number of portfolio transactions.
Most importantly, we seek to avoid demanding market liquidity by not naively implementing benchmark changes. Many fully replicating processes will undertake this approach which can unnecessarily cause adverse price impact on the security.
How does an optimised approach differ from enhanced indexing?
Enhanced indexing is really low-risk active management. A better way to describe it is as structured quantitative processes designed to capture a factor, or characteristic, the portfolio manager believes will outperform over time. These processes still run the risk of underperforming their benchmark and shouldn't be considered as an 'index plus' strategy. Enhanced indexing processes may also have reduced after-tax returns compared to our optimised approach, simply because of increased portfolio activity. Enhanced indexing turnover averages around 20% to 50% pa compared to typical benchmark turnover of 5 to 10%. Vanguard's funds average turnover is currently around 2 to 5%. This is due to the reduced number of securities held and positive cashflow, which avoid the need for the fund to sell existing assets to acquire new benchmark assets.
We believe that our investment process, with optimisation based portfolio construction techniques as one of the key components, will provide sustained and competitive long term market performance*.
* Past performance is not an indicator of future performance. Our products are designed to closely track market returns before fees, expenses and taxes. Investments are not guaranteed and may rise or fall in value.
Vanguard Investments Australia Ltd (ABN 72 072 881 086 / AFS Licence 227263 / RSE Licence L0001335) is the product issuer. We have not taken your or your clients' circumstances into account when preparing our electronic publications so they may not be applicable to the particular situation you are considering. You should consider your and your clients' circumstances, as well as our Product Disclosure Statement (PDS), before making any investment decision or recommendation. You can access our PDS here or by calling 1300 655 101. This publication was prepared in good faith and we accept no liability for any errors or omissions. Not all articles are prepared by Vanguard so they may not represent our views.
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