Newton's "law of indexing"
08 November 2017 | Topical insights
Commentary by Jim Rowley, senior investment strategist in Vanguard Investment Strategy Group.
Sir Isaac Newton's third law of motion states that for every action there is an equal and opposite reaction. (Never in my professional career did I imagine that a physics-related concept would motivate me to undertake research aimed at explaining fund performance!)
The popularity of indexing and exchange traded funds has ignited a newfound emphasis on index fund due diligence. The most common due diligence process is one that provides a list of metrics, including – but not limited to – expenses, excess return and assets under management, and then requires advisers and investors to pick through those metrics to determine whether the fund is any good.
This approach never made sense to me for two reasons:
- One should start by measuring excess return and tracking error when gauging an index fund's ability to track its index.
- One should then view the other often-cited metrics as potential causes of excess return or tracking error.
In other words, we shouldn't necessarily look at the expense ratio and excess return independently, because the expense ratio has a direct impact on excess return. Put in Newtonian terms, the action of a fund charging an expense ratio causes the reaction of a lower excess return.
The research I worked on, published in The Journal of Portfolio Management, analyses the effects that several "action" variables have on the two "reaction" variables of excess return and tracking error; and because the sample consists of ETFs, excess return and tracking error are analysed on both a net-asset-value and a market-price basis.
Admittedly, it's not the case that every action exactly causes an equal and opposite reaction, but it is the case that the expense ratio is the dominant variable that explains excess return and that active share is one of the statistically significant variables that explains tracking error.
If Sir Isaac were alive today, and if he were an investor or adviser, I would hope that he'd find this analysis useful when trying to select index funds. I hope you do as well.
Senior investment strategist, Vanguard Investment Strategy Group
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