Vanguard research reveals why it is important to consider a range of factors in addition to cost as part of the due diligence process.
High cost is one of the biggest enemies of successful investing. In fact, a significant body of research suggests that low costs are actually the best predictor of future investment performance1.
Index investing can be a successful way for investors to harness the power of the markets at low cost and as investors have become more cost conscious, indexing has grown rapidly. As a result, index fund expense ratios have come down across the industry. Some asset managers have recently unveiled products with ultra-low expense ratios, effectively promoting the notion that index funds are a commodity solely differentiated by price.
But being a good index fund manager means offering investors much more than just low fees. The main objective of an index fund is to provide investors with exposure that closely mirrors the risks and returns of a benchmark index, but managers can vary considerably in their ability to deliver this.
As index fund fees drift towards zero, more complex (and less visible) elements of index fund management become more important to performance, not to mention due diligence.
Portfolio management capabilities
To some, the concept of index fund management might seem straightforward. But in reality, indexing is highly complex and requires considerable experience and sophistication.
For example, achieving tight tracking versus a fund's target benchmark—a primary concern for index fund investors—is not a simple process. It relies on portfolio management decisions such as sampling techniques, use of derivatives, trading at times other than market close, management of index reconstitutions and many other factors.
Tracking error—a measure of the consistency of an index fund's return relative to its benchmark return—potentially indicates the risk inherent in a manager's process. But investors should not evaluate tracking error in isolation. Rather, they should seek index fund managers that have demonstrated an ability to combine minimal tracking error with reasonable excess return, or tracking difference.
Chart 1: Investors should expect the combination of reasonable excess return and low tracking error (Portfolio A)
Illustration of tracking error and average excess return relative to a common benchmark for two index funds
Investors should also assess whether an index fund manager is a good steward of their capital. Here it is helpful to have a grasp of securities lending. This is an investment strategy through which funds can generate additional revenue by making short-term loans of securities they hold, secured by collateral, and charging the borrower a fee to borrow the security.
Firstly, it is important to consider whether investors are adequately compensated for the risk they take. Asset managers can differ significantly in terms of how much of their securities-lending revenues they return to investors and how much they retain as profit.
Investors must also decide which approach to securities lending they are most comfortable with. The value-oriented approach, whereby funds can only lend a small proportion of the fund's shares—which may boost returns for investors without undertaking undue risk—is on the conservative end of the spectrum.
The alternative approach is volume-based securities lending. Volume-based lenders attempt to maximise revenues by loaning out a larger part of their portfolios, but this also carries greater risk for investors.
Economies of scale matter
Scale is a key differentiator in asset management and it is becoming increasingly difficult for new entrants to achieve. Scale confers a number of advantages, including in securities lending, where large managers are more consistently able to participate using the wide variety of securities they hold.
Other benefits of scale in asset management include lower trading costs, global trading platform access and a greater say in influencing regulatory policy. Investors in index funds should factor in scale as part of their due diligence.
Investors should carefully consider whether their interests are aligned with those of the asset manager. For example, does the manager have a proven track record of disciplined expense management, or do costs fluctuate over time? The incentives driving an index fund manager's business strategy are in part defined by the firm's ownership structure and philosophy. Investors, in turn, have their own objectives.
Investors can improve this alignment by avoiding any conflicts of interest where possible. The owners of publicly traded or privately owned firms may have competing interests with those of their fund investors. Mutually owned, or similarly structured, asset managers, on the other hand, can offer better alignment with investors' objectives.
Looking beyond costs
Keeping costs low will continue to be crucial to obtaining successful investment outcomes. But with industry-wide index fund expense ratios approaching ultra-low levels, prudent investment selection cannot be achieved by focusing on cost alone.
As a result, investors will increasingly need to turn the spotlight on a broader set of more complex factors to assess index fund managers.Vanguard's framework for selecting index funds considers more than just costs.
- *See for example Financial Research Corporation (2002), Morningstar (Kinnel, 2010), James J. Rowley Jr., CFA; David J. Walker, CFA; Carol Zhu, 2019. The case for low-cost index-fund investing. Valley Forge, Pa.: The Vanguard Group.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results
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