X
<

The Truth Behind Three Common Indexing Questions

PART:
1
The Truth Behind Three Common Indexing Questions PART 1 OF 1

The Truth Behind Three Common Indexing Questions

Partner Voice: What's this? Partner Voice allows financial brands to connect directly with the Market Realist audience by enabling them to provide educational information on investment choices. Each report is produced by the financial brand, and approved for publication if our editorial team deems it educational and suitable for the Market Realist audience.

Indexing has become an undeniable force in the investment world. Consider: $1.4 trillion in net new cash flow and reinvested dividends went into domestic equity index funds and ETFs in the decade through year-end 2016, which is astonishing when compared with the $1.1 trillion in net outflows from domestic equity active funds in the same period.1

Indexing’s rise didn’t happen by accident. For example, in my previous roles as global head of Vanguard Fixed Income Group and head of bond indexing, my teams and I were part of the effort to improve index fund management through a range of methods designed to help improve investor outcomes. That included everything from refining index sampling techniques to better approximating the fundamental characteristics of benchmarks to working closely with benchmark providers to strengthen index methodologies.

But the push to improve indexing does not stop there. In my new role as Vanguard’s chief investment officer, my global team and I are dedicated to staying abreast of new themes and issues in the investment world—especially those that directly affect indexing. We revel in exploring the details of what makes indexing tick and finding innovative ways to deliver more value to our clients. So we scour investment journals, attend conferences, and continue to refine our process. Our mission: to optimize the investment outcomes for our clients and investors overall and to do so at a low cost.

It’s clear, then, that I am a firm believer in the value indexing delivers to both the investor and the market as a whole. Over the last few months, I’ve noticed indexing has received some criticism from a few commentators alleging indexing hurts price discovery, stifles competition via common ownership, and leads to higher volatility. I believe those claims are inherently false. Let’s walk through these claims one by one and set the record straight.

Hurting price discovery?

The concern about indexing hurting price discovery is a naive view. Price discovery is driven by active managers, Vanguard included. I know from my years as a bond guy the vital role that active managers play in keeping security prices aligned with their value. So the thought that indexing could somehow get in the way of that is troubling for me. But the truth is that even though indexing has grown in popularity in recent years, it’s still a small part of overall trading volumes (i.e., portfolio managers’ trading of index funds’ underlying securities). Since indexing represents about 5% or less of equity daily volumes, as shown in the chart below, there is still considerable price discovery and liquidity provided by active managers.

Breakdown of overall individual stocks’ trading volume

The Truth Behind Three Common Indexing Questions

Sources: Vanguard and Bloomberg, 2017.

Lack of competition?

Critics claim that managers of corporations whose stocks are in some of the leading indexes become complacent participants, rather than competitors, because they feel their stock prices are being propped up by the steady drumbeat of index investments. The truth is that there is no evidence to support the idea that these anticompetitive practices are actually happening or that there’s a cause-effect relationship between common ownership and product price competition. All the corporate executives that I know are diehard competitors and are doing everything in their power to expand market share, increase revenues, and boost profits.

In addition, as owners of just about every company in every industry, index funds have no incentive to favor one industry over another: Higher product prices in any one industry would cut against our fund investors’ interests in other sectors.

At Vanguard, we always advocate for what is in the best interests of our fund investors. We believe fierce industry competition produces greater shareholder return and a healthier industry as a whole, since competition forces companies to constantly innovate and find new ways to deliver value to both consumers and shareholders. We firmly believe the best performers should be rewarded, which is why we advocate for executive compensation plans to be tied to relative performance, not stock price, and have explicitly promoted competition among firms in their respective peer groups.

Driving volatility?

As for the last issue—the concern that equity index funds contribute to market volatility—I don’t see any substance to that claim. Regardless of size, indexing is not a monolithic investment strategy. Index investments are spread through many market caps and investment styles, and the majority of index assets are held by long-term investors in broad-based, market-cap-weighted funds. There is no convincing evidence that the growth of index funds has had an impact on market volatility or the dispersion of stock returns. Even as index funds’ share of mutual fund assets has consistently grown, market standard deviation has risen and fallen in a seemingly random pattern and dispersion among the stock market’s securities has remained somewhat constant, except for the tech bubble and the global financial crisis.

The real truth: Indexing has earned its accolades

Indexing has transformed the investment experience for millions of investors, and Vanguard has been a driving force behind that. We take pride in the fact that we have helped investors enjoy the many benefits of indexing, including:

  •  Low cost.
  • Broad diversification.
  • Relative predictability.
  • The potential for long-term outperformance compared with the performance of many high-cost active fund managers.

In short, indexing can offer a firm foundation for investors seeking to achieve their investment goals. And as Vanguard’s CIO, it’s my job to make sure that indexing and active management continue their symbiotic relationship in the investment landscape.

1. Investment Company Institute, 2017. 2017 investment company fact book: A review of trends and activities in the investment company industry. Washington, D.C.: Investment Company Institute. p. 46. (57th edition; also issued in electronic format.)

Find more great content on our indexing topic page.

Greg Davis

Gregory Davis, CFA, is Vanguard’s chief investment officer, responsible for the oversight of approximately $4 trillion managed by Vanguard Fixed Income, Equity Index, and Quantitative Equity Groups. The funds managed by these groups include active and index stock and bond funds, money market funds, and stable value funds. Previously, Mr. Davis was principal and global head of Vanguard Fixed Income Group, responsible for its portfolio management, strategy, credit research, trading, and planning functions. He has also served as the company’s Asia-Pacific chief investment officer and a director of Vanguard Investments Australia. Mr. Davis is a member of the Treasury Borrowing Advisory Committee of the U.S. Department of the Treasury.

Mr. Davis has more than 19 years of investment management experience. Before joining Vanguard in 1999, he worked at Merrill Lynch as an associate in global debt markets.

Mr. Davis earned a B.S. in insurance from The Pennsylvania State University and an M.B.A. in finance from The Wharton School of the University of Pennsylvania. He is a CFA® charterholder and a member of the CFA Society of Philadelphia.

CFA® is a trademark owned by CFA Institute.

View more posts by Greg Davis

For more information about Vanguard funds or Vanguard ETFs, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bonds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.

All investing is subject to risk, including possible loss of principal. Vanguard Marketing Corporation, Distributor of the Vanguard Funds.

X

Please select a profession that best describes you: