The evolution of indexing:
An active / passive discussion
March 9, 2011
Walter H. Lenhard, CFA — Senior Investment Strategist
Vanguard Quantitative Equity Group
Indexing philosophy
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Indexing philosophy
• The success of index investing does not depend on market efficiency
• Beating the market is extremely difficult
• Costs matter
• By consistently earning the return of the broad market,
you have the potential to outperform most investors
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The zero sum game means that after cost, a majority
of dollars will underperform the costless market benchmark
•
The holdings of all investors aggregate to form a market
•
Outperformance by one, necessarily means underperformance by another
•
The key to increasing the likelihood of remaining on the winning side is by lowering costs
(but maintaining skill)
Distribution of fund returns
Tax
impact
Source: Vanguard.
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Expense
ratio
impact
After all costs, fewer
dollars exceed the
benchmark
Most equity funds lagged the broad market
over 15 years
General equity funds versus the Dow Jones Wilshire 5000 Composite Index over 15 years
55% Worse (596 funds)
45% Better (483 funds)
236
Wilshire 5000
183
165
135
111
71
48
43
10
38
26
4 to 5
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3
10
<-6
-5 to -6
-4 to -5
-3 to -4
-2 to -3
-1 to -2
0 to -1
0 to 1
1 to 2
Sources: Lipper Analytical Services, Wilshire Associates, and Vanguard.
Past performance is not a guarantee of future returns. The performance of an index is not an exact representation of any particular
investment, as you cannot invest directly in an index.
As of December 31, 2010.
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2 to 3
3 to 4
Most large-cap funds lagged the S&P 500
over 15 years
Large-cap funds versus S&P 500 over 15 years
67% Worse (280 funds)
33% Better (140 funds)
110
S&P 500
104
79
47
41
3
1
2
<-6
-5 to -6
-4 to -5
13
-3 to -4
Sources: Lipper Analytical Services, S&P, and Vanguard.
As of December 31, 2010.
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-2 to -3
-1 to -2
0 to -1
0 to 1
1 to 2
15
5
2 to 3
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Large-cap funds vs. the S&P 500 Index
Percentage of large-cap funds outperformed by the S&P 500 Index
88%
85%
78%
73%
71%
65%
67%
65%
73%
61%
50%
43%
57% 57% 58%
48%
46%
Sources: Lipper Analytical Services, S&P, and Vanguard.
Number of funds for each time period: 1–year, 2,391; 5–year, 1,767; 10–year, 1,044; 20–year, 173.
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70%
54%
51%
As of ended December 31, 2010.
71%
66% 67%
63%
61%
76%
42%
41%
42%
Index fund history
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Index fund history: Net flow to index funds
Net flow to index funds in billions of dollars from 1995 to 2009
70
62
61
60
56
50
47
40
40
35
35
30
25
26
27
2000
2001
34
33
28
25
20
12
10
0
1995
1996
1997
Source: Investment Company Institute.
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1998
1999
2002
2003
2004
2005
2006
2007
2008
2009
Equity index funds’ share continued to rise
Percentage of equity mutual fund total net assets from 1995 to 2009
16.0
13.7
14.0
13.0
12.0
10.5
10.9
11.3
11.1
11.2
2004
2005
2006
11.5
9.7
10.0
8.9
9.0
1999
2000
8.2
8.0
6.5
6.0
5.1
4.0
4.0
2.0
0.0
1995
1996
1997
Source: Investment Company Institute.
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1998
2001
2002
2003
2007
2008
2009
Index fund management
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Investment process: Which indexing technique
Replication versus Optimization
Key factors to consider:
• Portfolio size
• Index characteristics— number of securities, length of “tail”
• Transaction costs and other market-specific issues
• Nature and size of cash flow profile
• Index-effect in relevant market
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Investment process: Equity indexing process
Pre-trade
compliance
engine
Reconciliation
Cash flow projection
Index updates
Optimizer
generates
trade lists
Execute
trades
Monitor
performance
Performance attribution
Overnight compliance
reporting
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Three levels of risk control:
Goal is to minimize risk to avoid unintended bets
Individual stock level
Replication: Maximum overweight/underweight
Optimization: Maximum overweight/underweight
< 0.5 bp
< 1.0 bp
25%
Sector Weights
20%
15%
10%
Factor level
S&P 500 Index
s
tili
tie
at
io
un
ic
C
Large-Cap Equity
Te
l
ec
om
m
U
n
s
ia
l
at
er
M
og
y
s
us
t ri
al
Te
ch
no
l
e
th
ea
l
H
In
d
ca
r
ia
ls
Fi
n
an
c
er
g
ta
pl
e
er
s
on
su
m
C
er
di
s
cr
et
io
na
r
s
y
y
0%
um
Sector weights
Market capitalization
Volatility
Style
on
s
•
•
•
•
5%
En
1
2
Index Fund
Portfolio Characteristics
3
Portfolio level
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Weighted Median Market Cap
Dividend Yield
Price/Earnings Ratio (1-year forward)
Price/Book Ratio
Estimated 3–5 Years EPS Growth Rate
Return on Equity
Long-Term Debt/Capital
Number of Securities
S&P 500 Index Fund
$59.2B
1.8%
17.0x
2.9x
12.4%
19.9%
33.9%
500
$59.2B
1.8%
17.0x
2.9x
12.4%
19.9%
33.9%
500
Index methodology
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Clearly defined market segmentation
Sources: MSCI, Russell, and S&P.
MSCI, Russell, and S&P market-capitalization ranges calculated by FactSet as of December 301,2 009.
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Index construction philosophy
Higher Frequency
Rebalancing
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Lower Frequency
Rebalancing
+ More Style Purity
- Less Style Purity
- High Turnover
+ Lower Turnover
- Higher Cost
+ Lower Cost
- Less Tax Efficient
+ More Tax Efficient
Timely and efficient construction
Buffer zones for managing turnover
Buffer zones
Source: MSCI.
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Sector weight
GICS Sector
Consumer discretionary
MSCI US Broad
Russell
S&P Composite
Market Index
3000 Index
1500 Index
11.0%
11.1%
9.9
9.7
10.5
Energy
10.4
10.2
10.2
Financials
16.4
17.1
16.9
Health care
11.6
11.6
11.4
Industrials
11.4
11.5
11.2
Information technology
18.8
18.4
18.5
Materials
3.9
4.0
3.8
Telecommunication services
2.8
2.8
2.8
Utilities
3.8
3.7
3.9
100.0
100.0
Consumer staples
Total
Source: FactSet as of June 30, 2010.
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100.0
10.7%
Performance Convergence
5-year average annual returns through January 31, 2011
Large-Cap Indexes
Growth Indexes
S&P 500
2.24%
S&P 500
Growth
3.44%
S&P 500
Value
0.92%
Russell 1000
2.51%
Russell 1000
Growth
3.91%
Russell 1000
Value
0.96%
2.49%
MSCI US
Large Cap
300 Growth
3.81%
MSCI US
Large Cap
300 Value
1.05%
MSCI US
Large Cap
300
Past performance is no guarantee of future results. The performance of an index is not an exact
representation of any particular investment, as you cannot invest directly in an index.
Source: Vanguard
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Value Indexes
Fair-value pricing
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Fair-value pricing protects shareholders
• Vanguard funds employ fair-value pricing to reflect events after the close of a stock’s primary
market or exchange
• But it can cause a temporary pricing discrepancy that’s normally corrected by the following day
• Fair-value pricing ensures NAV reflects true value, discourages market timing, and protects
shareholders
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Nestle
Nestle
$55
$53
11:30 a.m. ET
4:00 p.m. ET
European markets close
U.S. markets close
Fair-value pricing example
Much can happen in a few hours…
15-hour gap
Tokyo market closes 1 a.m., EST
4.5-hour gap
London market closes 11:30 a.m., EST
New York market closes 4 p.m., EST
Lehman
declares
bankruptcy
Share price for British bank:
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$50
$55
$45
FVP
$40
FVP
Indexing in a client portfolio
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Indexed strategies can benefit clients and advisors
• The difficulty of active management
• The role of indexing in a client portfolio
• Combining active and passive strategies
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Excess Return Persistence
Institutional investment manager hire/fire decisions from 1996 to 2003
Amount of excess return
Years before manager change
3
2
1
Years after manager change
1
2
3
Fired firm
2.27
(2.06)
(0.74)
0.98
1.47
3.30
Hired firm
10.39
7.04
3.42
0.42
1.12
1.88
Difference
8.12
9.10
4.16
(0.56)
(0.35)
(1.42)
Data: 8,775 hiring decisions by 3,417 plan sponsors delegating $627 billion in assets. 869 firing decisions by 482 plan sponsors withdrawing $105 billion in assets.
Analysis covers the period 1996 through 2003.
Source: The Selection and Termination of Investment Management Firms by Plan Sponsors Amit Goyal, Sunil Wahal (Journal of Finance
Volume 63, Issue 4, printed August 2008)
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Combining active portfolios with indexed portfolios
combines risk control with the opportunity to outperform
The returns of active/passive combinations fell between those of all active and all indexed
portfolios
Best
Rankings of semiannual returns, 1982–2009
Worst
Analysis of five possible portfolios in 56 semiannual periods during 1982–2009. A spliced index—the Dow Jones Wilshire 5000 Index through April 22, 2005, and the MSCI US Broad
Market Index thereafter— was used as a proxy for a broad-market index portfolio. (Index performance does not reflect real-world operating costs, which could alter the results.) The active
portfolios were combinations of Lipper fund category averages roughly approximating the market capitalization of the broad market. Past performance is no guarantee of future results.
These hypothetical examples are not representative of any particular investment, as you cannot invest directly in an index or a fund-group average.
Sources: Vanguard and Lipper Inc.
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How will clients react when a strategy is out of favor?
•
No strategy works consistently year over year
•
It’s during those periods where a strategy is out of favor where clients may not
appreciate the long-term track record
•
This is where indexing can help
Client asks questions
Client pulls some assets
Client pulls most assets
Update resume
But the advisor faces a
risk of losing clients
US Stock
Market
Return
Portfolio’s periodic returns
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On average this portfolio
has added alpha for a client
Adding a broad market index fund dilutes alpha, but can
temper the drawdown
Combining index and active strategies, maintains positive alpha, but truncates the
extreme downside risk of active management
Client asks questions
Client pulls some assets
Client pulls most assets
But the advisor faces a
lesser risk of losing
clients
Update resume
•
On average this portfolio
has still added alpha
US Stock
Market
Return
Portfolio’s periodic returns
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Indexing offers additional benefits in portfolio construction
• Greater control of asset class risks
• Diversification
• Style consistency
• Tax advantages
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Conclusion
• On average active management has not met investor expectations
• Index funds derive their long-term performance advantage from lower costs, style purity and
the relative efficiency of the capital markets
• Despite the averages, opportunities do exist for active management to add value
• Combining index and active strategies can truncate downside risk and lead to improved client
retention
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Disclosures
• All investing is subject to risk. Diversification does not ensure a profit or protect against a loss
in a declining market. Prices of mid- and small-cap stocks often fluctuate more than those of
large-company stocks. Funds that concentrate on a relatively narrow market sector face the risk
of higher share-price volatility.
• © 2011 The Vanguard Group, Inc. All rights reserved.
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