By Duncan Burns, Head of Equity Indexing for Asia Pacific, Vanguard Australia
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. By contrast, index funds have regularly produced returns that are 1-2% above the average active managers.
Now that I have got you interested in index funds, let’s talk about how to go about picking one.
When it comes to selecting a manager, there are a lot of options out there.
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 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, your oven yields you a lovely crisp loaf of sourdough.
But as many of us have discovered on our 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 your ingredients and the skills of the baker matter. If you know what to look for in a low cost index provider, you can increase your chances of achieving superior after-fee performance.
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 in this new and improved world of close price competition. Below are some of the main points covered.
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 sort of historical track records do the index managers and funds have when it comes to performance after fees. Great index managers can track tightly and add incremental value to covers some or all of your 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 you give it up by paying 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 we are keeping this one on the list for now. Believe it or not there are a few managers and funds out there still charging high active type prices for index products. This is an obvious red flag.
In today’s capital markets, index equity managers should increasingly be expected to produce returns that are, on average, approximately equal to their benchmark index minus their 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.
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.
So now you know, not all indexers are the same, I hope this framework shows you where to look and helps you with your index fund search.
An iteration of this article was first published in Firstlinks on 3 June 2020.
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