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Don’t stop believing in the benefits of indexing

24 June 2019 | Indexing

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There is no sure thing in investing. Markets fluctuate, sectors surge and then fade, and past performance has no bearing on future success. These uncertainties can be cold comfort for investors who are saving for retirement, putting their kids through college, or starting a business.

Indexing has provided an antidote to some of the unpredictability and expense of investing. With a straightforward mission of capturing market returns, index funds have paved the way for millions of investors to access those returns at minimal expense.

The story of indexing is still being written at Vanguard. We are proud of the role we’ve played in indexing’s rise, and we see even more opportunities for it to help investors. Some benefits of indexing are well-known, while others are less recognised. All should be celebrated for how they’ve changed the investing landscape.

Four ways indexing has become a force for good

Low costs. Indexing is synonymous with low-cost investing, and for good reason: It lets you keep more of your returns. Furthermore, the success of indexing (and Vanguard) has pushed costs down across the industry. Over the last 15 years, the weighted average expense ratio for index funds has dropped from 0.28% to 0.09%, while the weighted average expense ratio for actively managed funds has fallen from 0.83% to 0.58%. Our research shows that without the option of index funds, investors would have paid nearly $200 billion in additional costs since the early 1990s.

Diversification. Index funds offer global diversification for pennies on the dollar. Before Vanguard pioneered the index mutual fund in 1976, investors had limited ability to easily diversify their portfolios. The median number of stocks held by U.S. mutual funds in 1969, for example, was only 44. Today, investors can gain exposure to every stock in the United States for 0.04%, or a globally diversified bond and stock portfolio for just 0.07%. I never imagined that level of diversification at that price point when I joined the business 28 years ago.

Simplicity. As more investors rely on advisors or institutions to manage their wealth, indexing has unlocked another advantage: simplifying the portfolio construction process. Advisors can focus their time on more value-added work. Instead of searching for a “winning” stock, advisors can use index funds as building blocks for their clients’ portfolios, dedicating more time to the goal-setting and behavioral coaching that can make or break a client’s long-term financial outcomes.

Good governance. As indexing grows, so does our advocacy for good governance. We have a responsibility to investors to protect their interests and maximise the value of their investment over years and decades. Ensuring that the companies our funds invest in are well-governed and have an eye on the long term (instead of on the next earnings call) is core to our responsibility as index fund managers.

Indexing is just getting started

There’s been a drumbeat in recent years that indexing has grown too big. I’d say indexing is not big enough.

Indexing today represents less than 40% of U.S. mutual fund assets, leaving plenty of investors who may be paying too much for their portfolios. Relative to total U.S. equity market capitalisation, index funds represent just 15% of assets. And index funds, as the quintessential buy-and-hold investment, account for less than 5% of the trading volume on the U.S. stock exchanges. So indexing is hardly the colossus some make it out to be.

US equity investable securities and US exchange trading volume driven by index strategies

Notes: All data are as of 31 December 2018. U.S. registered fund assets are as represented by Morningstar, Inc., excluding funds of funds and money market funds. U.S. equity fund market share is represented by the Morningstar category group U.S. equity and sector equity mutual funds and ETFs. Fixed income fund market share is represented by the Morningstar category group taxable bond mutual funds and ETFs. U.S. equity market capitalisation is represented by the CRSP Total Market Index. U.S. fixed income market cap is represented by the Bloomberg Barclays U.S. Universal Index. Ownership share of outstanding securities and trading volume are best estimates based on available data.
Sources: Vanguard calculations, based on data from Morningstar, Inc.; FactSet; CRSP; Bloomberg Barclays; and ArcaVision.

At those levels, it’s not really possible for indexing to move the markets and produce inefficiencies. Market-moving activity results from active managers determining market prices.

Indexing hasn’t peaked. In fact, we think it has even more room to grow. Indexing benefits from economies of scale; growth doesn’t impede efficiency or increase costs. We see untapped opportunities to bring the benefits of low-cost investing to underserved areas of the global market, and index funds can certainly fill that need. Too many investors are paying too much for returns they could capture with an index strategy. And although indexed equity funds have gained ground, only 27% of bond mutual fund assets use an indexed approach.

One of the best parts of my job is talking with clients, and I love hearing how the power of indexing is helping investors reach their financial goals. Whether it’s building a retirement nest egg or providing a novice investor with some level of predictability when markets inevitably dip, indexing continues to prove its worth and fulfill its promise. Vanguard is proud to have been at the forefront of the indexing revolution. Thank you to all the investors who have embraced the power of indexing, turning a novel idea into a movement that makes our entire industry better.

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