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When considering an index fund, cost is just one factor

May 29, 2013

When evaluating index funds, many investors believe cost is the most important issue. But there are other factors to consider.

Cost is important. The lower a fund's cost—whether it's an index or actively managed fund—the higher the total return realized by the shareholder. In the case of an index fund, a low expense ratio means that the portfolio manager has less of a gap to close between the performance of the benchmark index and the fund itself. Factors minimizing our costs include Vanguard's large size, wealth of experience, and corporate structure.

The importance of people and reputation

To Vanguard, however, people are also critical to index fund success. Vanguard Quantitative Equity Group (QEG) manages index and structured equity portfolios covering U.S. and international markets. Managers in Vanguard Fixed Income Group (FIG), supported by deep credit research and risk analysis teams, manage our index fixed income assets. The portfolio managers on these teams average 13 years of experience.

Our people have helped us become a "thought leader" in the industry. We introduced the first index fund for individual investors in 1976, the first bond index fund for individual investors in 1986, the first international stock index funds in 1990, and the first ETF as a share class in 2001. Such accomplishments have contributed much to our considerable reputation. That's an important factor, because investment providers rely on reputation when dealing with counterparties. In our case, trading desks across the country—and around the world—are familiar with Vanguard. It's a large determinant of who wants to do business with us and, sometimes, the prices that we get.

Size, scale, and process

Another consideration: We're able to further negotiate favorable terms and minimize costs because of our large size. Our size can also be a disadvantage. Large trades can create an unfavorable market impact, widening bid-ask spreads. But our portfolio managers and traders tactically trade the funds' daily cash flows in an attempt to minimize the cost to the funds. One cost is taxes—but most index funds are tax-efficient by nature. Vanguard funds are managed with tax efficiency built into our day-to-day processes.

The core aim of our indexing processes, however, is full index replication. Full replication helps with fund tracking accuracy and gives investors the broadest possible diversification within the index. When it's not cost-effective or simply not possible to own all of the securities in an index, we create an optimized sample basket of stocks or bonds in the index that seeks to mimic the risk and return characteristics of the full index. We've developed proprietary quantitative models that help us do this.

Credit research

Robust credit research is also important in the fixed income area. This may seem a surprising component of index fund management, but it's essential to our bond indexing operation. Most of our bond index funds use the sampling methodology because their underlying benchmarks are too vast (for example, the benchmark for Vanguard Total Bond Market Index Fund has more than 8,000 bonds in it). Our portfolio managers rely on the work of our credit research teams to help them match the duration, maturity, and credit characteristics of the benchmark without taking on excess risk.

Managers of our international funds must also have the answers to a wide range of questions about foreign stocks: Is this stock liquid enough to hold in the fund? What is the local tax surcharge on currency transactions? How stable is this market during times of geopolitical turmoil? Does it make sense to hold this stock in its local market—or pay a premium to hold the stock's American Depositary Receipt (ADR) traded in the United States? This is an area where the depth of our experience is so important. For perspective, Vanguard Total International Stock Index Fund holds more than 6,000 stocks in roughly 50 countries.

Securities lending and risk management

The practice of lending out a fund's securities for other investors to short has been the subject of controversy for some investment firms. But Vanguard's approach is absolutely client-focused. We lend stocks to other institutions prudently and in special situations that can generate revenue for the funds and our shareholders without putting client assets at undue risk. All earnings from securities lending flow back to the investors in the funds.

Finally, we believe an index fund should have a good risk management process. Our risk management teams provide a continuous feedback loop to portfolio managers, helping to set the appropriate guardrails for the funds. They can offer perspective on how a decision today can play out over weeks and months to come.

Given such issues—risk management, securities lending, credit research index replication, size and scale, tax efficiency, and more—it's clear that when evaluating index funds, there's much more to consider than cost.

Notes:

  • All investing is subject to risk, including possible loss of the money you invest.
  • Foreign investing involves additional risks including currency fluctuations and political uncertainty.
  • Investments in bond funds are subject to interest rate, credit, and inflation risk.
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