The future of indexing

23 January 2018 | Webinars


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The future of indexing

In recent years investors have flocked to index funds, attracted by their simplicity and low costs. But can there be too much of a good thing? If passive investing continues to grow at its current pace, will it start to distort the market?

Vanguard's head of active/passive portfolio research, James Rowley, speaks to Leo Schulz, senior investment writer, about the future of indexing.


Leo Schulz: Since they were introduced to the consumer market by the founder of Vanguard, Jack Bogle in 1976, index funds have provided investors with a low-cost, straightforward means to achieve their life goals. What does the future hold for what is sometimes hailed as one of the greatest financial innovations?

My name is Leo Schulz and we have with us on the telephone today from the United States, James Rowley, Vanguard's head of active/passive portfolio research. The format for today will be a little different to the usual. Jim will talk us through a formal presentation and then we will take questions at the end.

For our live listeners, you should now see a box coming on to the screen in which you can type questions; we have a large audience today so if we don't get to your personal question we will definitely follow up. The webinar earns participants an hour's CPD points; you will need to request your certificates by contacting your usual representative, writing to, or phoning 0800 917 5508; all of those details are of course on our website, Jim – thanks for joining us today

James Rowley: Thank you very much, Leo, happy to be here.

Leo Schulz: And if I can just hand over to you, we're all very interested to follow the presentation.

James Rowley: That would be great, thank you very much. Thank you very much everybody for tuning in. It's a pleasure to have you here, and I want to spend maybe the next 25 minutes talking you through our presentation, Setting the record straight: truths about indexing.

When we work our way through the presentation, there are going to be three sub-sections to talk about; the first section is going to be advocating for indexing. I want to talk a little bit about the benefits of the strategy itself and its effect on wealth creation.

The second part I'd like to talk about is defining indexing. There are actually a lot of misconceptions about market size, its characteristics, and what it actually means to be “passive”.

The third part I want to spend some time talking about is defending indexing. There are a lot of assertions that we all seem to come across in the marketplace through industry and media, making claims about how indexing may be distorting capital markets or have an adverse impact, and I want to tackle some of those assertions head on.

You'll probably note that in this presentation, a lot of it is built using US-based data, and there's a reason for that. Typically speaking, data that we have access to in the US just tends to be a longer time series, in many cases it is deeper than datasets outside the United States.

So that is our backdrop - we use that because for the most part we feel very confident that the conclusions that we come to would be applicable all around the world and you'll probably hear that if the opportunity comes, where we have looked at some non-US data, I'll provide some commentary on findings that, even though not visually represented, are things that we have come across in our research.

When we think about the benefits of indexing, I find it's always important to step back and think about why indexing works. Probably one of the first places you'll hear the conversation start is about how indexing is about deficient markets. We would actually like to point out that that's not the place to start with respect to indexing.

Indexing works because of the principles of zero-sum gain. One of my personal favourite pieces to read, which hopefully when our time here is over everybody can google, is The Arithmetic of Active Management by Bill Sharp. It quite simply talks about how all the dollars or pounds or euro or yen in the given marketplace make up the return of that market collectively.

And when you think about the law of averages, only half the dollars can do better than average because half do worse, or half the pounds can do better, and half must do worse, meaning every dollar or pound of outperformance must be countered by a dollar or pound of underperformance, and indexing happily just takes the average of that.

And what the chart here shows you, and this chart happens to be the US version, but we have versions using other data theories, is that if we look at the excess returns of an array of active funds, and we plot where their excess return falls, as you can see and what we would expect with that theory is that the returns are centred on actually slightly less than zero. This is to account for the costs of those given funds. But it does look like a bell curve, and it's roughly centred on a number of little bit less than zero - you find plenty of funds that outperform, but you also find plenty of funds that underperform.

To wrap that up – remember, that when we talk about indexing, it's predicated on the principles of the zero-sum gain, and not market efficiency.

And the other aspect that's important when we talk about indexing is the effective cost on performance. And I think even in my time, in my experience in this industry, we hear costs and we automatically equate it to something that's altruistic, meaning invest in low cost because it's the nice thing to do, or it's the right thing to do.

There's no shortage of academic and empirical research and evidence that will show that it's not for altruistic reasons that we believe in low cost, it's because of investment performance reasons. And again this chart comes from the forthcoming paper, The case for low-cost index fund investing, and we can find this chart replicated in other types of investment asset classes, in other versions of this paper around the world, and this relationship holds true.

We think about how higher expense ratios are associated with lower excess returns. This is a relationship that is applicable to both active and index funds. And when we think about trends, yes, are there data points there off the trend line? Absolutely, but taken holistically, when you look at this dataset and you think about the trend, every basis point higher in cost translates into a basis point less in return.

And that's the important concept when we talk about indexing, but really investing in general: higher expense ratios are associated with lower excess returns, meaning this cost discussion, while it's nice, we all want to save more of our money and it is a good thing, but maybe more importantly if we build portfolios, it's because lower costs translate into better investment performance.

Keeping the theme of the benefits of indexing, if the former was taking a look at why indexing works, I want to spend a little bit of time here focusing on the applicability to investors. Why is it important when we build portfolios?

The phrase that we like to use here is that index funds provide relative performance predictability, meaning when you think about how we build portfolios, we maybe model our asset classes, we have an expected risk return profile for that asset class, but then we have to implement it.

The benefit of doing it with index funds is when we implement that asset class or that sub asset class in our broader asset allocation, when we implement that with index funds, we expect with a high degree of predictability that that index fund is going to capture the performance characteristics of that asset class. Doing so with active funds is less certain, and by no means does that make active a bad choice or the wrong choice; it's just a matter of relative performance predictability.

The chart here is showing the 75th percentile to the 25th percentile of excess returns for active funds and index funds, where active funds are the grey bars, and index funds are the blue bars.

Now again when you talk about relative performance predictability, there's a reason why index funds - those blue bars - seemingly form a straight horizontal line all the way across through time. That's because relative to that index, we would expect index funds to deliver essentially the return of that index, whereas active funds are less certain over time.

Again, we think about what the benefits of indexing here happen to be is that it's a high degree of relative performance predictability. When we as investors build portfolios and implement that asset allocation, with index funds with a high degree of relative performance predictability, we will capture their risk return characteristics of that asset class. Whereas when we use active funds - again, it doesn't make it bad, it doesn't make it wrong - it's just less predictable, it's less certain.

Keeping on the theme of benefits, and when we maybe think about costs again, there's a very important context in this debate when we say active versus passive. We have previous Vanguard research that would show what if we looked at, or if we started our conversation with hey where are investors putting their assets? Let's look at cash flow that goes into active or passive funds - we've probably all seen the headlines that talk about cash flows going into passive funds or very much taking away cash flows from active funds.

We've a little bit of a different take here, which is to say what if we switch the labels? Instead of saying active and passive, what if we switched into high-cost and low-cost? What the chart here is showing is the cash flows that are going into funds according to their cost quartile, meaning let's make the label lowest cost quartile, second lowest cost quartile, etcetera.

And what we find out here is well maybe investors aren't necessarily just putting their money into passive funds, maybe they're putting their money into the lowest cost funds, because here in this chart, the lowest cost quartile is inclusive of active and passive funds. And there's a really important concept in this whole, if you can see me in the studio I've got my fingers up, air quotes, “active/passive debate” - that maybe we need to consider it's a high-cost, low-cost debate.

That was a quick review of what we think some of the benefits of indexing happen to be. We think that those benefits are going to endure into the future. I'd like to turn a little bit now and define indexing a little bit.

We love to hear the statistics about how x percent of the market is indexed, and if I were fully honest, when we were developing this research and developing the presentation I had a lot of my colleagues in marketing say hey Jim, let's figure out a way to measure the markets and how much is in passive, and I would tell them, I don't know if I really like the chart a lot, because we can define this measurement in many, many, many different ways.

How do you measure assets? We can take assets to mean fund assets, US fund assets, equity assets, do we mean only registered funds where here in the US we'd be talking about Investment Company Act funds, in Europe we'd be talking about UCITS Funds. Are we talking about registered funds and privately managed funds such as separate accounts or pension plans?

And what are we measuring it as a percentage of? Just registered funds themselves or are we measuring it as a percentage of total market capitalisation? And I throw all of those different questions out there in those terms and hopefully everybody's take away is the next time we see a headline that says passive is x percent of the market, maybe hopefully we just stop for a moment and ask what is that metric actually measuring? Let's put it into context.

The context is important because we look at this chart and we say, hey globally 30% of total registered fund assets are in index strategies. And we might be able to grab more headlines by saying well, 40% of equity funds that are registered fund assets are in index strategies. That might be a much more headline-grabbing number versus what we have - the 10% - which would be the value of all global investable securities that are owned by registered index funds, and put another way, registered index fund assets as a percentage of total global market capitalisation, now the number's only 10%.

And I share those contrasts - a really big number like 40% and a really small number like 10% - just to provide the range of ways this number can be measured. Hopefully the next time we hear it, we can stop, pause, process, and think about what that number's actually measuring.

The reason why the number becomes even more challenging now is even if we measure what percent of assets are passive, what's the definition of passive? Let's think about the different ways that we can own a passive fund. They could be large capitalisation equities, they could be small capitalisation equities, they could be emerging markets equities, they could be developed market equities.

And if we think about strategic beta, or non-market cap weighted, we would have a very debate over they might be technically legally passive funds, but we know that the indexes on which strategic beta funds are built that they try to track, those indexes themselves are not market-cap weighted and we would argue they happen to be active; again that doesn't make them bad, it just means they weight themselves other than in a way than market cap.

Now if I think about my slide beforehand, which is where we have different ways where our funds can be in passive, right, they can be in developed markets, emerging markets, small caps, large caps; they could be government bonds, they could be corporate bonds, meaning the trend is not that investors are putting their money into one single, giant index fund, they're putting it into a disparate array of different types of index funds with different strategies.

And even the mere label of what constitutes an index fund, whether it be market-cap-weighted or non-market-cap-weighted, i.e. strategic beta, when we put those all together and when we think about well what does that giant aggregate-weighted or asset-weighted investor portfolio look like, we get performance like we see on the screen right now.

And to highlight this, and we have built this for data in Australia, in the UK, and in Canada, this happens to be the United States, if we said let's take all the index funds in the US that have a mandate to track a US equities benchmark, what does that asset-weighted portfolio look like relative to the US total stock market?

The dark blue line is that asset-weighted portfolio of index fund investors in the US. Once we put them together, we now start to see the effect of investors who aren't buying the market portfolio, they're maybe over-weighting small cap value relative to large-cap growth; they may be owning certain strategic beta funds, which are not market-cap-weighted, and you end up getting this cyclical style performance.

And I would even argue that if we took the labels off of this chart and I said these are just fund investors against the market, I don't think that we'd know that these are index-fund investors; they could be any individual active fund or group of active funds. And you put this all together and investors enjoy the benefits of individual index funds because they tend to be diversified, they tend to be low-cost, but they're able to put them together for the purposes of their own active portfolio construction.

And that's a trend that we have seen, not only here in the US, but again we have built these charts for Canada, Australia, the UK, and we see the same trend; that if you looked at the true passive fund that tracks the index, that's different than the experience of an asset-weighted portfolio of all index funds put together.

At the outset I reviewed the benefits of indexing and we think that those benefits will endure. I just reviewed the very definition of indexing and taking that all together, we seem to think that investors are using individual index funds to build active strategies.

The last part of the presentation I want to talk about is more along the lines of defending indexing, and I say defending because we hear various assertions about the alleged ills that indexing is bringing upon the market, and I'd like to touch on some of the more common ones.

The first one is price dispersion, or what some might call the active opportunity set. If we think about how active management adds value, it adds value because it purchases or it actually overweights a stock that subsequently outperforms, and it underweights a stock that subsequently underperforms, meaning active management doesn't add value because a stock goes up or down, it has to be overweight a stock that subsequently outperforms.

The grey bars here are showing price dispersion of the Russell 3000 Index, and that's defined as what percentage of the constituents in this index either out or under-perform the index by ten percentage points? I'll pause and think about that for a second; out or under-perform the market by ten percentage points, not 10%, ten percentage points.

In light of that, the navy blue line, the one that's kind of going up at a 45 degree angle, is the percentage of US equity funds that are in passive funds. Clearly the trend tells you that investors in the mutual fund space in the US are adopting more and more index strategies, but when we look at that price dispersion of stocks in the market place, that trend is sitting around two thirds, 70%, all the way back to the early 90s.

That tells us that the dispersion of security returns, or what we might deem the opportunity set for active, is essentially unchanged right in the face of a very upward trend of investors adopting the use of index funds.

We place that same trend line but up against a new measurement; this is market volatility, and this is simply showing again going back to 1993, what's the market standard deviation, market volatility over that time? I think we can all easily pick up the spike somewhere around the tech bubble, from 1999 to turning around through to the 2002 bear market, and then again the next spike that happens around the GFC, but really no connection when you look at what is the uptake in the use of index funds up against market volatility; there doesn't appear to be any connection, and if we built this chart back another 50, 60, 70 years, we'd find that market volatility long before index funds were even invented.

Another common theme is trading volume, and I had a slide up front that talked about what proportion of the trading volume in US equity markets is attributable to the portfolio management activity of index-based strategies?

That number is somewhere around 5%, meaning if we looked all around the world, included pension funds, registered funds, separately managed accounts, trading activity of index-based strategies is probably around 5%.

This chart takes a little more particular look at registered US equity funds that have the US equity mandate; so the 5% earlier on was kind of all index strategies; this in particular is mutual funds in the US that are US equity funds.

And we see their proportion of trading in US markets back since 2004; the latest figure for that is about 1.3 meaning if we think about the trading activity attributable to index funds, or the portfolio management activity of index funds, in the US it's a very, very, very small number and has been consistently a small number; that's the bear minimal sort of blue shaded tip of the bar.

The dark grey bar is actually showing active mutual funds in the US, and even that number is somewhere around 8-12% over the past several years. That leaves us with the very light grey bars, which in a short way of putting it is everything else; market makers, hedge funds, pension funds, individual investors, high frequency traders, it's literally just everybody else.

Therefore when we think about price discovery and the effect that index funds or index strategies holistically have had on trading activity in US markets, this would say that the impact that index funds have on US markets is a very, very minimal amount with respect to making sure price discovery is vibrant and it really hasn't been that very large over a longer period of time.

Now the topic of ETFs comes up all the time because we see numbers relate to the trading volume of ETFs and does it have an impact on market volatility? I think one of the most important aspects of ETFs is realising that the trading activity, or the trading volume of ETFs, really reflects shares of that ETF traded between two individuals or investors or institutions. It's important if you hear the number of ETFs account for 25% or 30% of trading volume?

Well that's because that trading volume is the shares of the ETF itself, not the portfolios of those ETFs trading their underlying securities. And we should think about the fact that out of every dollar traded in an equity ETF in the US, over 90 cents of that is just two investors trading the shares with each other.

For bond ETFs the number is well over 80%; that's just the percentage of ETF trading volume; it is just the shares being traded between two investors; to flip that another way, that means in the equity space, that's maybe 6% or 7% of the trading volume of an ETF that actually results in underlying trading in the markets.

And that's a very important concept - we see big numbers of trading volume of the shares of an ETF itself, but that's really reflective of just trading volume of investors trading those shares of the ETF with each other, not trading underlying markets.

So if I put that all together, we think number one - indexing has clear benefits that we believe will endure. I talked a little bit about the rationale for why indexing works, there was the zero-sum gain, and you know, the reasons why investors may want to index and I highlighted, for example, relative price performance or implementing that asset allocation gives you a higher degree of certainty of capturing the performance of that asset class. That's why we think indexing has clear benefits that we believe will endure.

Two, we think investors have been using index funds to implement active strategies, whether it's using individual index pieces, and/or introducing non-market-cap-weighted index funds. We think these are investors embracing the broader diversification and the lower costs of these products, but who still build more holistically active portfolios.

And three, we think no connection has been found between the growth of indexing and adverse market impact and hopefully I was able to show that through some of the more common assertions with respect to market volatility, price dispersion and the trading activity of ETFs. Leo, I'm happy to pause and apparently put some important information up on the screen before we proceed.

Leo Schulz: Actually if you could just go back to your summary, Jim, if that's all right. Thank you very much for a really, really interesting presentation and lots of very interesting insights. We have had some questions, which I'll just sort of wrap up in a couple of points for what we'll have time to cover now.

You talked about the efficiency of markets and you were saying index funds are not predicated on the efficiency of markets but if we can think a little bit about the efficiency of markets; is there an impact on the efficiency of markets, and does that improve the chances or the opportunities for active fund managers, or does it have no effect?

James Rowley: I would probably answer the question with two points. Number one is just to reiterate zero-sum principles, that you know every pound that outperforms has to be offset by a pound that underperforms.

But where the efficiency argument takes place, and we could view it almost like a pendulum effect so to speak, which is to say zero-sum principles don't change, but if we pivoted to the concept of efficiency, and you took a look at any one individual stock for example, you might think does indexing have any effect on an efficient price for a given stock?

And if some were to say, well, too many assets in index funds, you know, are going to lead to less efficient prices because index funds don't trade much, there aren't enough market participants. To that I would say then maybe the pendulum starts to swing to let's say the stock having less of an efficient price. Well, if that were the case then we would expect very astute active management to be able to identify that, step in, do the buying or selling that is required, to move that stock's price back to its more efficient mark, or its more proper intrinsic value.

Leo Schulz: Really, index funds participate in a free market, don't they, and free markets operate in a certain way, and when the pricing becomes less efficient then as you say, people move in and make up the difference.

Just on another related point, Jim, I thought it was really interesting what you were saying about indexing and its growth and whether it's 10% or 20% or 30% or 40%, but of course that it's the indexing is spread across a lot of different asset classes, and bond funds and equity funds worldwide, so the concentration when you put it into one number, the concentration is never quite just simple. But is there, I was just thinking about the future of indexing, Jim, and you talk about it being an enduring benefit, is there a limit to the extent to which index funds can continue to grow at a pace, and outpace the market altogether as it were?

James Rowley: You know, I don't know that I've ever looked at it and said there's a limit to it because I could kind of flip the context around, and we have this sort of base case that says well you know, indexing is growing to the point of, I don't know, a point that might be too much. Well, how do we know that we didn't start out with the world of active management being too much?

And that shouldn't be construed in a negative way but the market started out being a predominantly active game and we know look, not all managers are good, not all prices being made are good, and you know if we think about investors being able to make choices on quality and price and they're doing so with indexing, you know, it might very well be healthy that investors are adopting more index-based strategies in their portfolios.

And much of the concerns that we might hear about indexing, I can say again to reiterate some of the points made before, is look - these are investors choosing quality at low price, and they're doing so because they wish to implement their asset allocation using index funds and it may very well be a very active strategy that they're building with that.

And I've talked to clients and advisers and institutions frequently who would tell you that they themselves don't even build a market-cap-weighted portfolio because to them, a strategic asset allocation might be an overweight to emerging market, so it might be an overweight to small cap, and from that perspective that is active management.

That is price discovery because that is an example of investors choosing a particular sub asset class over another, and benefit now as investors get to do it with diversified pieces, with low-cost pieces, pieces that have a high degree of relative performance predictability; they get to do that and they get to put that together to build active portfolios, and I think that's a very good thing for investors.

Leo Schulz: Some very interesting insights today from James Rowley, head of active/passive portfolio research at Vanguard Europe. I think the key take away here is that active and passive investments both have their places in a well-constructed portfolio, and that passive strategy should continue to offer low-cost broad market access for our clients for a long time to come.

We'll be back next month at 2pm on Tuesday 20 March; the topic will be the power of bonds, and we'll be looking at prospects for the fixed income market. Our guests will be Christie Gonçalves, a European government bond trader in our fixed income group, and Alexis Gray, a senior economist at Vanguard Europe.

We are currently offering adviser workshops in the active/passive choice, fixed income and adviser's alpha. Workshops are conducted around the country and generally last a couple of hours; if you would like places at any of these, please do contact your representative or write to, or telephone 0800 917 5508. That's us for today; Jim, thank you very much for joining us, and thank you to all our listeners; good-bye.

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