Index funds have become increasingly popular with investors over the past ten years. But some might say indexing has become too popular and index funds too big. We recently sat down with two tenured Vanguard investment leaders in the United States: Joe Brennan, Head of Equity Indexing, and Greg Davis, Head of Vanguard’s Fixed Income Group, to discuss the growth of indexing and other topical issues in the stock and bond markets.
Joe, your team runs some large equity index funds in the United States. What’s behind the growth of these funds?
Joe Brennan: We’ve seen a broader interest in index funds, largely driven by the tremendous growth in exchange-traded funds (ETFs). Vanguard low-cost ETFs have really taken off with investors of all types. In particular, advisors are making shifts in their business models, becoming asset allocators, behavioral coaches, and tax managers as opposed to stock and fund pickers, and they are using low-cost ETFs as building blocks to construct portfolios for their clients.
One of Vanguard’s US-domiciled bond index funds is now the largest bond fund in the world. Greg, why do you think that’s the case?
Greg Davis: We’ve seen investors – individuals, institutions and financial advisors – gravitate toward the fund you’re talking about because it represents the taxable US fixed income market across sectors, making it the closest proxy for investors looking for broad-based, high-credit-quality exposure to the US fixed income market. The fund is highly diversified, making it an appropriate fixed income complement for investors constructing portfolios with broad equity exposure. And it is very low cost.
The fund it supplanted as the industry’s largest has suffered steady and large redemptions. As the saying goes, "Uneasy lies the head that wears a crown." Does Vanguard face a similar risk?
Greg Davis: We are talking about two vastly different types of funds. Ours is an index fund, where we look to provide performance in line with a transparent benchmark. We have been able to do that very effectively since the fund’s inception. And, broadly speaking, Vanguard funds are managed using a team-based approach. We encourage investors to be attracted not necessarily by performance, but by low cost, diversification, and relative predictability. A vastly different value proposition than an actively managed fund with a single "star" manager.
Vanguard as a whole discourages short-term investors from coming in – we do this by screening large purchases and by closing funds – as our goal is to protect the long-term interests of shareholders. When short-term investors do come in, they are generally in our ETF products, ultimately paying their own transaction costs. We have the ability to tweak the liquidity process, too. When there are outflows from one of our competitors, we make sure that we’re not picking up transitory investors who are just looking for a short-term parking spot.
We’ve seen media reports about index funds and ETFs moving the market and exacerbating volatility. Can indexing get too big and pose broader issues to the market?
Joe Brennan: We do not believe so, for several reasons. Index funds trade and buy at the margin, across a large list of securities, and have low turnover. So, the corpus of the index fund is actually quite stable, and trading is very manageable. In the US, indexed management makes up approximately 15.5% of total equity market capitalization (source: Bank of America Merrill Lynch, as of March 31, 2015); thus, the lion’s share of the market comprises active managers. Moreover, trading across Vanguard index funds represents only about one-quarter of 1% of the typical overall daily trading volume on the worldwide exchanges (source: Vanguard).
This is not to say that there may be some price volatility at the individual stock level when an issue is added or deleted from one of the well-followed benchmarks. But such volatility is limited to a single stock and short-lived.
The biggest drivers of volatility in the equity markets are factors such as leverage, corporate valuations, and systemic or geopolitical shocks – not a style of management like indexing. I believe that linking indexing to heightened market volatility is just misguided.
Greg Davis: Index mutual funds and ETFs represent a relatively small component of the broad-based fixed income market – about 10% or so (source: International Monetary Fund, Global Financial Stability Report, October 2014). I would say that high-quality investment-grade fixed income funds (generally, those rated Aa3/AA- or better by credit rating agencies) are not moving the needle because those markets are very deep and very liquid, with a considerable number of diverse participants.
Can Vanguard itself be too big?
Joe Brennan: Vanguard’s clients are a different, more careful, long-term breed. They tend to invest with a strategic asset allocation and take the long-term view. While we have experienced extraordinary growth, both indexing as a strategy and Vanguard as an asset manager are drops in the bucket compared with the overall capital markets. Those concerned about size tend to look at absolute numbers, not relative numbers. There is an important distinction.
Another thing that gets lost in the size debate is that passively managed funds act in an agency capacity. Fund transactions are controlled by the investor, not the fund manager, and funds are owned by millions of investors, each with their own time horizons, risk preferences, and investment goals. Even under the most stressful market conditions, fund investors as a whole stay the course. For example, Vanguard examined retirement-plan participant behavior in the US from September 2007 to December 2009 in Vanguard-administered retirement plans. During that time, about three-quarters of participants made no changes to their accounts, and only 3% eliminated all exposure to stocks.
Greg Davis: Vanguard is mainly invested in the investment-grade markets, and the majority of our assets are concentrated in US Treasuries, mortgages, and the corporate bond market, in which we also represent a relatively tiny share.
And, as mentioned, we are careful about growth on the fixed income and the equity side. We screen large purchases to ensure that the prospective investor is a long-term investor. We don’t promote "hot" funds. And we close funds when we believe that asset size impedes sound and prudent management.
Does size pose a problem in terms of managing Vanguard’s funds?
Joe Brennan: Size doesn’t pose a problem for equity index investing, but it is a consideration when managing a fund. Creating trading strategies around index changes and rebalances is something we do regardless of size. Worldwide, ETFs now account for a large portion of cash flow into Vanguard’s index funds, but that comes through in-kind baskets,* meaning we’re trading less than the numbers suggest.
Greg Davis: No. As an example, our largest US bond index fund has about 40% of its assets in US Treasury issues and 20% in private home mortgages, with the remainder mostly in investment-grade credit and a small amount in asset-backed securities and commercial mortgages. The majority of those sectors are extremely liquid. We don’t see any capacity constraints now or in the future. In fact, size can be an advantage when you can leverage it for economies of scale.
Let’s turn to the markets. There is a lot of chatter about rising interest rates in the United States. Do you think the US Federal Reserve will act this year? And what impact does the uncertainty of "when" have on the markets?
Greg Davis: At the start of the year, most people expected the Federal Reserve to hike interest rates in June or September. But first-quarter growth was weaker than expected – a weakness that was largely attributed to the weather. The strengthening of the dollar and continued low levels of inflation have also given the market and the Federal Reserve reason to pause. The market is now pricing in a 50/50 chance that rates will rise in September. If the economic data come out weaker than expected, the hike could be pushed to December or later.
However, rising rates are not necessarily a bad thing. If you have a long-term time horizon, and you’re invested in a short- or intermediate-term bond fund, rising rates ultimately mean higher income.
There has been concern that we are going to see a repeat of the "taper tantrum" we saw in 2013. Investors have to keep in mind that compared to developed markets’ interest rates around the globe, the United States has some of the highest rates. For example, with German 10-year bonds trading at about 70 basis points, the US market looks very attractive to international investors. Lower rates everywhere else could cap how quickly US rates rise.
We’ve enjoyed a good run in many global equity markets since the great financial crisis. The US market, for example, is up nearly 250% from the trough in March 2009 through the end of March 2015. Do you have concerns on where we go from here?
Joe Brennan: Clearly, equity markets have enjoyed robust returns. Coming off the bottom of a cycle in a period of fear and volatility always tends to create opportunities in equity markets. Investors have shown continued interest in equities for a number of reasons, including attractive valuations, growth prospects, and global economic healing.
True to the cycles, valuations are more full compared with five years ago, and future returns appear less attractive. This does not necessarily indicate that there will be a big sell-off in equities or that those valuations can’t continue to be stretched further. The forward-looking picture is just more modest, so investors should temper their expectations.
Liquidity in the bond markets is making headlines. Greg, can you shed some light on the topic?
Greg Davis: There is a tremendous amount of concern about liquidity in the bond markets, specifically the corporate bond market. Investors forget that there’s not a huge amount of turnover with bonds. Bonds are, for the most part, buy-and-hold types of instruments. In the government bond market, there’s daily turnover from market-making and cash flow. But many corporate bonds are sold in a new issue market, put into an account, and held to maturity.
We are not concerned about liquidity in the event of outflows, because the portfolios Vanguard holds are high-quality and heavily weighted in extremely liquid segments of the market. Funds are highly regulated entities and the US Securities and Exchange Commission requires US-domiciled funds to hold at least 85% of assets in liquid securities. On the other hand, liquidity could be an issue in some of the more narrowly defined sectors of the market, such as high-yield corporates.
Some of our more credit-sensitive index portfolios, which tend to be primarily ETFs, have an in-kind creation-redemption process to handle most transactions. And, on the active fund side, the benchmarks have a liquidity buffer built in. We manage those funds to ensure liquidity.
What does the future hold for indexing?
Joe Brennan: The market has certainly stretched the definition of indexing beyond market-cap-weighted strategies. You hear terms like smart beta, fundamental indexing, or alternative indexing. But we tend to think that this dilutes the definition of market-cap-weighted indexing. These strategies are better defined as a passive implementation of active management. I caution investors to understand what they are buying.
Financial advisors have come to realize that asset allocation is critical and costs matter. Indexing plays a key role here, because it provides investors that very highly diversified, low-cost exposure. Active managers will have to continue to revisit fees and consider how competitive what they are delivering is relative to an index offering.
Greg Davis: We’re still at the very early stages of adoption of indexing on the fixed income side, and the future is very positive. We believe the uptake of ETFs and target-date funds will continue to serve investors well.
Joe Brennan: Ultimately, I think the drivers of indexing’s popularity will remain in place. The market now understands that costs are important, and indexing remains the purest form of low-cost investing.
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Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia. As a renowned market commentator and editor Robin has spent more than two decades writing about all things investment. |
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