In a world where index products are seen as commodities, it may be tempting to simply pick the one with the lowest management fee.
But the reality is that not all index funds are created equal.
Fees are an important consideration but, given how compressed fees are in the index fund space, other factors are arguably more important when it comes to choosing the best index fund manager to safeguard and grow your clients’ wealth.
So, what questions do you need to ask when assessing an index fund manager? These eight questions are an excellent place to start.
1. Are they incentivised to act in your client’s best interests?
Index fund managers come in all shapes and sizes, all with different business models and philosophies.
These details are important because a fund manager’s ownership structure and philosophy define the incentives that drive the business strategy and the behaviour of the professionals who manage your clients’ money.
A fund manager’s ownership structure may seem immaterial from the outside, but in practice it can determine how incentivised the manager is to deliver value for investors. For example, if a fund manager is publicly listed or owned by outside interests, there may be other considerations driving its behaviour.
2. Do they have a history of disciplined cost management?
Fees and costs are deducted from the fund’s net asset value by the fund manager, and this can have a substantial impact on your clients’ long-term returns. Despite a trend towards fee compression across the industry, fees and costs, along with a fund manager’s history of disciplined expense management, should remain an important factor in recommending a preferred product to your client.
3. Does their portfolio management expertise provide opportunities to add value?
The objective of an index fund is to match the return of its benchmark index year after year.
In theory this sounds simple. But in practice, matching an index’s performance involves transaction costs and other frictions that exist in the real world, meaning you would expect an index manager to fall short of the benchmark return.
Expert portfolio managers can minimise these frictions to produce tighter index tracking on a risk-controlled basis.
Experienced index managers seek to minimise trading costs and market impact, while continuing to track the benchmark closely.
Managers can also add incremental value through sophisticated portfolio management, efficient trading, managing corporate actions, participating in secondary placements and prudent securities lending, all of which have the potential to offset some, or even all, of the fund’s expense ratio.
4. Do they keep tracking error appropriately low?
Tracking error can be thought of as a measure of the consistency of an index fund’s return relative to its benchmark’s return.
Portfolio management decisions including sampling techniques, use of derivatives, trading at times other than market close, management of index reconstitutions, withholding tax and many other factors combine to drive tracking error.
However, tracking error cannot be evaluated in isolation. Advisers should understand that what represents a reasonable tracking error (tolerance level) varies by mandate based on the characteristics of the underlying market.
For instance, investors should expect tighter tracking error in an ASX 300 fund, where it’s relatively easier to hold securities at index weight, compared with a global small companies fund that includes a large number of names.
5. Do they employ prudent securities lending? (And are all the profits from securities lending directed to benefit investors?)
Globally, securities lending is a widely used value-adding investment strategy involving the loan of portfolio securities to financial institutions that have a need to borrow them.
This basic framework exists across the globe, but the approach or lending philosophy adopted by fund managers can vary significantly.
An investor should understand the program’s fundamental approach to securities lending. On the conservative end of the spectrum is value lending, where a fund manager concentrates on lending relatively small amounts of hard-to-borrow securities (e.g., small cap or emerging markets stocks). On the more aggressive end is volume lending, which concentrates on lending significantly larger amounts of securities.
6. Do they enjoy deep liquidity and tight spreads?
The cost of investing in an index fund is more than just the management fee. The total cost includes all fees associated with buying, selling, and owning the investment.
Fund buy/sell spreads are costs buyers and sellers of a fund need to pay when buying into and selling out of a fund. ETF bid/ask spreads (the difference between the price that buyers are willing to pay versus sell an ETF on the exchange) should be factored into your total cost of ownership.
Bid/ask spreads are determined by the market. ETFs which keep transaction costs low, have deep liquidity and sufficient market maker support will generally have tighter bid/ask spreads. Your fund manager should work closely with market makers and constantly monitor the trading and liquidity of their ETFs.
7. Do they have sufficient scale?
Economies of scale in index fund management exist at both the fund and firm levels, often manifesting in the form of increasing effectiveness of other value-add capabilities.
For example, scale enables managers to replicate quality indexes more closely with a higher number of securities. Smaller scale managers may need to opt for less diversified benchmarks with fewer securities or manage the portfolios through representative sampling that may not match the risk characteristics of the benchmark.
Scale at the firm level allows for lower trading costs by increasing the opportunities for cross trading within a family of funds, as well as negotiate lower trading and other direct costs with various service providers.
8. Do they execute their own trades or rely on external parties?
For funds that own international securities, a key capability required for combating market impact is a strong global trading operation. Fund managers with trading desks in regions around the world are able to carefully execute their funds’ trades in ways that best align with the strategies of the portfolios.
In contrast, those with only a domestic trading desk must often rely on regional brokers for markets outside their location, who are usually paid commissions based on trade volume, to execute trades on their behalf. As a result of their incentives, such partners may not value the idea of managing market impact, instead trading in a way that is indifferent to maximising value for clients.
Furthermore, the local market expertise afforded by a global platform empowers a fund manager to perform more effective due diligence when considering how to approach trading strategies in various capital markets around the world.
Towards a contemporary index fund selection framework
Expenses were once the most visible differentiator of investment outcomes, leading many financial advisers to evaluate products primarily based on cost. Over time, as fees have compressed, the real savings achieved by switching to the lowest-cost index product are minimal.
Instead of a single-minded focus on fees, advisers should use a contemporary decision-making framework that considers things like organisational incentives, portfolio management capabilities, securities lending programs and scale in more equal weights than in the past.
Learn more about Vanguard’s approach to indexing.
Vanguard Investments Australia Ltd (ABN 72 072 881 086 / AFS Licence 227263) is the product issuer and the Operator of Vanguard Personal Investor. We have not taken yours or your clients’ objectives, financial situation or needs into account when this article so it may not be applicable to the particular situation you are considering. You should consider yours and your clients’ objectives, financial situation or needs, and the Product Disclosure Statement (“PDS”) and the IDPS Guide (“the Guide”) for Vanguard products, before making any investment decision or recommendation. A copy of the Target Market Determinations (TMD) for Vanguard’s financial products can be obtained at vanguard.com.au free of charge and include a description of who the financial product is appropriate for. You should refer to the TMD of the relevant Vanguard product before making any investment decisions. You can access our disclosure documents at vanguard.com.au or by calling 1300 655 205. Past performance information is given for illustrative purposes only and should not be relied upon as, and is not, an indication of future performance. This article was prepared in good faith and we accept no liability for any errors or omissions.
