Julie Ann Marra: Hello, and welcome to Vanguard’s Investment Commentary Podcast
Series. I’m Julie Ann Marra. In this month’s episode, which we’re taping on October 2,
2015, we’ll be taking a closer look at indexing. Joining me is Walter Lenhard, a Senior
Investment Strategist at Vanguard Equity Investment Group. Walter, thanks for being here.
Walter Lenhard: Thanks for having me, Julie.
Julie Ann Marra: The prevalence of indexing has risen dramatically in recent years. Can you talk about indexing’s place in the industry and its exceptional rise in popularity?
Walter Lenhard: Sure, indexing really has boomed over the last 20 years. You think back to the early ‘90s, most investors were focused on actively managed mutual funds, and everyone wanted to beat the stock market. But what they realized is the market’s extremely efficient, and it’s very challenging to outperform the stock market. So more and more investors have recognized the benefits of indexing—the low cost, the risk control, the diversification—and more and more assets have moved from actively-managed funds toward indexing. Now, indexing represents about a third of all U.S. mutual fund assets under management.
Julie Ann Marra: Wow. Okay, let’s step back for a second and just broadly define what indexing is.
Walter Lenhard: Well, first of all, there are a number of companies out there that construct indexes. So companies like the Dow Jones, Standard & Poor’s, CRSP, and Russell all create indexes. And what an index fund is, is it just follows the performance of those indexes.
So let’s take the most widely tracked index out there, which is the S&P 500; and that really represents the top 500 U.S. companies. So, in that index, Apple represents about 3% of the index. The second is Microsoft at about a percent and a half. The third is Exxon, about one and a half percent as well. So what an index portfolio manager does is he’ll buy those stocks in the same weight that the index holds them. So what we’re trying to do is not outperform the stock market, really, but provide exposure to the stock market to investors at an extremely low cost.
Julie Ann Marra: And yet, active funds still make up a majority of the market and are certainly appropriate for many investors. As you said, when choosing a traditional index fund, investors get low-cost market exposure. But the flip-side of that is they’re also giving up any attempt to achieve outperformance. So, can we talk a little bit more about some of the tradeoffs of that, or some of the deeper benefits of indexing?
Walter Lenhard: People often describe the three main benefits of indexing as being low cost, broad diversification, and risk control. But there’s a second layer of benefits that’s also very important; and those are low turnover, low transaction cost, and low capital
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gains realizations for taxable investors. A typical active manager struggles because he’s got a headwind of higher costs, higher turnover, higher transaction costs. It’s very difficult to beat an index because of those costs.
Julie Ann Marra: So an index fund is seeking to match its benchmark as closely as possible.
What factors are coming into play as a fund manager is trying to make this happen?
Walter Lenhard: Well, as you said, the number one goal is to track the index as tightly as possible. And the first thing that we have to do is be perfectly invested, a hundred percent invested every single day. We don’t want to have any extra cash, or we don’t want to be over invested. So what we’ll do is we’ll try to figure out the exact amount of cash that’s coming in on a daily basis, and we’ll invest that cash on the 4:00 close to try to get the tightest possible tracking error versus the benchmark.
So, these days, our cash flow’s been so strong. We’re investing almost a billion dollars a day in cash. And it’s really a wonderful time to be an indexer because we can invest that cash very efficiently at low commission costs. There’s a lot of liquidity in the stock market, so we’re able to turn that cash into securities.
The second most important thing we’re looking at is the actual constituents of an index. So we’re looking at the actual holdings every single day; and we’re trying to figure out what stocks get added to the index and what stocks get removed from the index, and we’re going to adjust the portfolio so it looks just like the index.
And then the third main factor is costs. So these indexes operate in a cost-free environment.
They don’t charge brokerage costs; they don’t charge custody fees. So in order for us to track these indexes as closely as possible, we need to keep our expenses at a bare minimum in order to ensure that tight tracking.
Julie Ann Marra: Let’s talk about some of the ways that the industry has changed in regard to indexing. What trends have you seen in recent years?
Walter Lenhard: In the early years of indexing, the most popular indexes were the S&P
500 for U.S. stocks and MSCI EAFE for international stocks. And both of those indexes represented large- and mid-cap stocks for the various regions.
These days the trend is more toward a total solution. So our largest U.S. mutual fund is the
Total U.S. Stock Market. Our largest international index fund is the Total International Index.
So rather than focusing on just large- and mid-cap stocks, investors are more concerned about total exposure. So combining large-caps, mid-caps, and small-caps together to get that exposure. So that’s one trend.
The second trend is there’s an increasing number of indexes and index funds out there, so it’s more of a challenge for investors to try to figure out which funds to buy. And that can be a challenge because there can be gaps and overlaps in your holdings. Some investors own the
S&P 500 and the Total U.S. Stock Market, but that would cause an overlap of about 70% to
80% of your holdings. You’ve got to be careful about that. Other investors might own the S&P
500 and a small-cap index, and they might have a gap there. They might be missing some mid-cap names. So it’s extremely important to understand your total portfolio construction and whether there are any gaps or overlaps, and it’s also a good opportunity to talk to a financial advisor about whether there is appropriate coverage for your total portfolio.
Julie Ann Marra: So I wanted to ask you, I’ve noticed, at times, some international funds seem to deviate pretty dramatically from their benchmarks. Can you explain what’s going on there?
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Walter Lenhard: Sure. As you mentioned, the number one goal of the portfolio manager is to track the index as closely as possible. But sometimes our international index funds might mistrack by a percent or two if you look at the performance on our website. And what’s happening there is something called fair-value pricing, so let me explain what that is.
This is a phenomena that just hits our international index funds because international stocks close at different times around the globe, so the international indexes all use those local closing prices.
So the London exchange closes at a different time than the U.S. stock market, which closes at a different time than Tokyo. So the international index is calculated based on local prices.
What we do for our U.S. mutual funds is value everything at 4:00 East Coast Time. So what we do is we then take the local closing prices and we adjust them by a fair-valuation metric which either increases or decreases the value of some of those international holdings.
So what that does on a positive side is it gives our investors a more accurate valuation for their holdings. The downside is it can show up as some temporary mistracking versus the international indexes. The good news, however, is as soon as the global stock markets open up again, these prices will converge; and that tracking error that shows up day one will vanish the next day. So if you want to see the amount of the mistracking that’s attributable to fairvalue pricing, you can look on our website; and it’s broken out there.
Julie Ann Marra: Great. Well, this has been great. Walter, do you have any final thoughts before we wrap up?
Walter Lenhard: My final thought would be about the daily volatility we’re seeing in the marketplace. It seems like every day the stock market could be up or down a percent. And I just want investors to recognize the fact that index funds are fully invested. So we’re going to ride up or down with the stock market, but that’s a natural phenomenon. The stock market’s always going to go up. It’s always going to go down. And in order to benefit from the longterm returns of the stock market, you really have to be invested through the full market cycle.
So don’t worry about a drop in the stock market. Don’t redeem out. Just stick with us through the ups and the downs of the stock market cycle.
Julie Ann Marra: Great. Thank you, Walter.
Walter Lenhard: Thank you.
Julie Ann Marra: And thank you for joining us for this Vanguard Investment Commentary
Podcast. Be sure to check back with us each month for more insights on the markets and investing. Thanks for listening.
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