The Case For Indexing
The Case for Indexing
Vanguard presentation for PAPERS Annual Forum
Presented by :
Walter H. Lenhard, CFA – Senior Investment Strategist
For Institutional Investor Use Only. Not For Public Distribution.
Recommendations and portfolio analysis provided by Vanguard Advisers, Inc., a registered investment advisor.
Vanguard Marketing Corporation, Distributor to Vanguard Advisers, Inc. and Vanguard Marketing Corporation, Distributors.
Agenda
• Indexing
• Advantages of indexing
• Empirical results
• Myths & misconceptions
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The evolution of indexing
What is indexing?
• Attempting to track the return of the entire market (or a subset of the market) by
replicating or sampling the holdings of a market index
Principles
• Performance is a zero-sum game
• Beating the market is extremely difficult
• Costs matter
• Consistently earning the broad market’s return provides the potential to outperform
most investors
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Zero-sum game
The Loser’s Game
Relative investment performance before costs is a zero-sum game
Underperformance
Outperformance
Market performance
>4
Costs reduce aggregate performance
The Loser’s Game
However, costs reduce active performance to less than market performance
Costs
Underperformance
Outperformance
Market performance
Cost impact
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The advantages of indexing
• Can provide consistent performance relative to benchmark
– Broad diversification within a market segment
– Negligible manager risk
• Could provide long-term outperformance
– Low advisory and administrative costs
– Low turnover (minimal transaction costs)
– Fully invested
• Can be tax-efficient
– Low turnover/low realization of capital gains
>6
Most equity funds lagged the broad market
General equity funds versus the Dow Jones Wilshire 5000 Composite Index over 15 years
65% Worse (494 Funds)
35% Better (266 Funds)
Wilshire 5000: 10.5%
176
132
118
76
71
54
44
36
8
20
12
< 6%
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-6% to -5% -5% to -4% -4% to -3% -3% to -2% -2% to -1%
11
-1% to 0%
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, 2008.
2% to 3%
3% to 4%
4% to 5%
2
5% >
Winners do exist
While “The Loser’s Game” argument is a mathematical
tautology and proves most actively managed funds must
underperform their benchmark, it allows that some
funds can provide long-term outperformance.
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Most large-cap funds lagged the S&P 500
Large-cap funds verses S&P 500 over 15 years
76% Worse (231 funds)
24% Better (72 funds)
73
S&P 500: 10.49%
58
49
44
28
20
17
2
< -6%
4
6
-6% to -5% -5% to -4% -4% to -3% -3% to -2% -2% to -1% -1% to 0%
Sources: Lipper Analytical Services, S&P, and Vanguard.
As of December 31, 2008.
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0% to 1%
1% to 2%
2% to 3%
2
> 3%
Most funds lagged style benchmarks
Percentage of managers outperformed by Russell benchmark over 15 years
Value
Blend
Growth
Large*
84%
69%
59%
Medium**
79%
66%
62%
Small***
67%
55%
47%
* Versus Russell 1000 Value, Russell 1000, and Russell 1000 Growth.
** Versus Russell Midcap Value, Russell Midcap®, and Russell Midcap Growth.
*** Versus Russell 2500 Value, Russell 2500, and Russell 2500® Growth.
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.
Sources: Lipper, Frank Russell Company, and Vanguard.
As of December 31, 2008.
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Large-cap funds verses 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%
71%
68%
66% 67%
63%
61%
76%
61% 62%
54%
51%
53%
50%
43%
48%
46%
42%
41%
85 9 86 9 87 9 88 9 89 9 90 9 91 9 92 9 93 9 94 9 95 9 96 9 97 9 98 9 99 0 00 0 01 0 02 0 03 0 04 0 05 0 06 0 07 0 08 Yrs Yrs Yrs
2
2
2
2
2
2
2
2
2
1
1
1
1
1
1
1
1
1
1
1
1
1
1
19
5
20
10
Sources: Lipper Analytical Services, S&P, and Vanguard.
Number of funds for each time period: 1–year, 2,245; 5–year, 1,597; 10–year, 801; 20–year, 155.
As of ended December 31, 2008.
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Myths & misconceptions about indexing
Myths not backed by real-world evidence:
• Indexing only works in efficient markets, not with small-caps or international stocks
• Active managers outperform index funds in bear markets
• Redemptions during a bear market will cause index funds to realize capital gains
• There are better ways to index than the traditional market-cap weighted method
• Managers who beat the index in the past will do so in the future
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Mixed track record for active managers in
bear markets (and dismal in bull markets)
Myth: Active managers beat index funds in bear markets
Percentage of active U.S. equity funds that outperformed the broad U.S. market in
bear and bull cycles
90%
80%
78%
70%
60%
60%
57%
50%
40%
51%
45%
49%
48%
44%
43%
39%
38%
30%
29%
25%
20%
10%
0%
1/1971-12/1972
1/1973-9/1974
Bull market
10/1974-11/1980
12/1980-7/1982
8/1982-8/1987
9/1987-11/1987
12/1987-5/1990
6/1990-10/1990
11/1990-6/1998
7/1998-8/1998
9/1998-8/2000
9/2000-3/2003
Bear market
The Dow Jones Wilshire 5000 Index was used as proxy for the broad market. Past performance is no guarantee of future results. The performance of an index is
not representative of any particular investment, as you cannot invest directly in an index.
Source: Vanguard IC&R paper, The Active-Passive Debate: Bear Market Performance. Derived from data provided by Morningstar and Wilshire Associates.
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4/2003-12/2006
Active management in the guise of indexing
Myth: There are better ways to index than the traditional market-cap weighted
method
• An index represents the market or a subset of the market
• By definition, an index must be cap-weighted
• Any deviation form cap-weighting is a bet against the market
• New ‘index’ constructs are embedded with active bets and factor biases
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No one stays in the winner’s circle
Myth: Managers who beat the index in the past will do so in the future
Rank of top-20 domestic equity funds and their rank in subsequent decade
Rank 1988–1998
Rank 1998–2008
Rank 1988–1998
Rank 1998–2008
1
1,485
11
767
2
1,977
12
1,787
3
1,991
13
1,683
4
620
14
1,977
5
1,699
15
1,606
6
2,066
16
2,287
7
1,460
17
2,308
8
2,154
18
2,162
9
2,274
19
2,263
10
2,123
20
208
378 funds included in study from December 31, 1988 through December 31, 1998 with 10-year history. 2,322 funds included in study from December 31, 1998 through
December 31, 2008 with 10-year history.
Average rank of top performers in subsequent decade: 1,745.
Source: Lipper Analytical Services.
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Conclusion
• Most investors would be better off indexing 100% of their equity assets.
• Survivorship bias understates indexing superiority.
• Indexing and active management can complement each other effectively,
particularly for experienced investors.
• Research validates practice of largest U.S. pension plans allocating 30%–40% of
equity assets to indexing.
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