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Choosing an index fund is more than just the expense ratio

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.

 

6 Comments
Dave
June 04, 2020

Another issue to watch is the growth of Units on issue.
I invested in a simple ASX 200 index fund with low fees. This has allowed it to grow quite well but when it comes time for the quarterly distributions to be made the longer-term holder gets diluted as units created after the companies in the index have paid dividends also get their share of dividends in the ETF distribution.

Graham Hand
June 04, 2020

Hi Dave. this issue is common to many pooled funds, not only the one you identify. See this explanation: https://www.firstlinks.com.au/warning-investing-unit-trusts-june

Dave
June 04, 2020

Thanks Graham,
Just read the link.
Have many funds have used Attribution Managed Investment Trust mentioned in the article since 2017. I have never heard of it before.
Dave

DE
June 04, 2020

Lending (renting) investor's securities to short sellers?

J.D.
June 03, 2020

How does Vanguard Australia "add incremental value to covers some or all of your management fees" ?

Duncan Burns
June 09, 2020

Hi J.D. Good question. The framework in the White Paper explains many of the incremental value add/saving opportunities explored. With regards to a few specific areas where Vanguard can add value to cover some of the management fee or, in some cases in excess of the management fee, here are some examples in no particular order of importance:
• For international funds (particularly those investing in US securities) there is a difference between the assumed tax in the benchmark and that which is actually paid by an Australian investor, in the instance of Vanguard International Shares index fund this has historically added between 20 and 25 basis points per year to the funds return over the benchmark
• Participation in corporate actions can add some value at times e.g. capital raisings and placements
• Intelligent trading around index changes, cash flows and other corporate events
• Securities lending is generally considered by most academic and industry studies to promote and improve market efficiency (more information can be found in this WFE research report released April of this year: https://www.world-exchanges.org/our-work/articles/wfe-research-what-does-academic-research-say-about-short-selling-bans#:~:text=The%20WFE's%20paper%20%2D%20What%20does,inefficiency%20and%20hamper%20price%20discovery.)

 

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