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Walter H. Lenhard, CFA — Senior Investment StrategistVanguard Quantitative Equity Group
The evolution of indexing: An active / passive discussionMarch 9, 2011
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Indexing philosophy
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• The success of index investing does not depend on market efficiency
• Beating the market is extremely difficult
• Costs matter
• By consistently earning the return of the broad market,
you have the potential to outperform most investors
Indexing philosophy
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The zero sum game means that after cost, a majority of dollars will underperform the costless market benchmark
• The holdings of all investors aggregate to form a market
• Outperformance by one, necessarily means underperformance by another
• The key to increasing the likelihood of remaining on the winning side is by lowering costs (but maintaining skill)
Source: Vanguard.
Distribution of fund returns
Tax impact
Expense ratio impact
After all costs, fewer dollars exceed the benchmark
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Most equity funds lagged the broad market over 15 years
General equity funds versus the Dow Jones Wilshire 5000 Composite Index over 15 years
Sources: Lipper Analytical Services, Wilshire Associates, and Vanguard.Past performance is not a guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.As of December 31, 2010.
103
10
43
111
183
236
165
135
71
4838 26
<-6 -5 to -6 -4 to -5 -3 to -4 -2 to -3 -1 to -2 0 to -1 0 to 1 1 to 2 2 to 3 3 to 4 4 to 5 > 5
45% Better (483 funds)55% Worse (596 funds)
Wilshire 5000
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Most large-cap funds lagged the S&P 500 over 15 years
Large-cap funds versus S&P 500 over 15 years
Sources: Lipper Analytical Services, S&P, and Vanguard.As of December 31, 2010.
3 1 2 13
47
104110
79
41
15 5
< - 6 -5 to -6 -4 to -5 -3 to -4 -2 to -3 -1 to -2 0 to -1 0 to 1 1 to 2 2 to 3 > 3
S&P 500
33% Better (140 funds)67% Worse (280 funds)
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Large-cap funds vs. the S&P 500 Index
Percentage of large-cap funds outperformed by the S&P 500 Index
65% 67% 65%61%
71%
51%
43%
54%
46%
78%
85%
73%
88%
63%
50%
42%
66% 67%
73%76%
48%
71%
41%
61%
42%
70%
57% 57% 58%
Sources: Lipper Analytical Services, S&P, and Vanguard.Number of funds for each time period: 1–year, 2,391; 5–year, 1,767; 10–year, 1,044; 20–year, 173.As of ended December 31, 2010.
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Index fund history
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12
25
35
47
62
26 2725
35
40
28
33
61
34
56
0
10
20
30
40
50
60
70
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source: Investment Company Institute.
Net flow to index funds in billions of dollars from 1995 to 2009
Index fund history: Net flow to index funds
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4.0
5.1
6.5
8.28.9 9.0
9.710.5
10.911.3 11.1 11.2 11.5
13.013.7
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Percentage of equity mutual fund total net assets from 1995 to 2009
Equity index funds’ share continued to rise
Source: Investment Company Institute.
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Index fund management
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Replication versus Optimization
Key factors to consider:
• Portfolio size
• Index characteristics— number of securities, length of “tail”
• Transaction costs and other market-specific issues
• Nature and size of cash flow profile
• Index-effect in relevant market
Investment process: Which indexing technique
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Investment process: Equity indexing process
Reconciliation
Cash flow projection
Index updates
Optimizer generatestrade lists
Executetrades
Monitor performancePerformance attribution
Overnight compliance reporting
Pre-trade compliance
engine
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Weighted Median Market Cap $59.2B $59.2BDividend Yield 1.8% 1.8%Price/Earnings Ratio (1-year forward) 17.0x 17.0xPrice/Book Ratio 2.9x 2.9xEstimated 3–5 Years EPS Growth Rate 12.4% 12.4%Return on Equity 19.9% 19.9%Long-Term Debt/Capital 33.9% 33.9%Number of Securities 500 500
Portfolio Characteristics S&P 500 Index Fund
0%
5%
10%
15%
20%
25%
Consu
mer dis
cretio
nary
Consu
mer sta
ples
Energy
Financia
lsHea
lth ca
reIndus
trials
Techno
logy
Materials
Tele-co
mmunicatio
n
Utilities
Large-Cap Equity S&P 500 Index
Sector Weights
1Individual stock level
2Factor level• Sector weights• Market capitalization• Volatility• Style
Replication: Maximum overweight/underweight < 0.5 bpOptimization: Maximum overweight/underweight < 1.0 bp
Index Fund
3Portfolio level
Three levels of risk control:Goal is to minimize risk to avoid unintended bets
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Index methodology
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Clearly defined market segmentation
Sources: MSCI, Russell, and S&P. MSCI, Russell, and S&P market-capitalization ranges calculated by FactSet as of December 301,2 009.
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+ More Style Purity
- High Turnover
- Higher Cost
- Less Tax Efficient
- Less Style Purity
+ Lower Turnover
+ Lower Cost
+ More Tax Efficient
Lower Frequency Rebalancing
Higher Frequency Rebalancing
Index construction philosophy
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Timely and efficient construction
Source: MSCI.
Buffer zones for managing turnover
Buffer zones
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Sector weight
Source: FactSet as of June 30, 2010.
MSCI US Broad Russell S&P CompositeGICS Sector Market Index 3000 Index 1500 Index
Consumer discretionary
Consumer staples
Energy
Financials
Health care
Industrials
Materials
Information technology
Telecommunication services
Utilities
Total 100.0 100.0 100.0
11.0%
9.9
10.4
16.4
11.6
11.4
3.9
18.8
2.8
3.8
11.1%
9.7
10.2
17.1
11.6
11.5
4.0
18.4
2.8
3.7
10.7%
10.5
10.2
16.9
11.4
11.2
3.8
18.5
2.8
3.9
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Performance Convergence
S&P 500 2.24%
Russell 1000 2.51%
MSCI US Large Cap
3002.49%
5-year average annual returns through January 31, 2011
Large-Cap Indexes Growth Indexes Value Indexes
Source: Vanguard
S&P 500 Growth 3.44%
Russell 1000 Growth 3.91%
MSCI US Large Cap 300 Growth
3.81%
S&P 500 Value 0.92%
Russell 1000 Value 0.96%
MSCI US Large Cap 300 Value
1.05%
Past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
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Fair-value pricing
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• Vanguard funds employ fair-value pricing to reflect events after the close of a stock’s primary market or exchange
• But it can cause a temporary pricing discrepancy that’s normally corrected by the following day
• Fair-value pricing ensures NAV reflects true value, discourages market timing, and protects shareholders
U.S. markets closeEuropean markets close11:30 a.m. ET
Nestle
$55
4:00 p.m. ET
Nestle
$53
Fair-value pricing protects shareholders
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$45 FVP
Tokyo market closes 1 a.m., EST
London market closes 11:30 a.m., EST
New York market closes 4 p.m., EST
15-hour gap
4.5-hour gap
$50 $55 $40 FVP
Lehman declares
bankruptcy
Share price for British bank:
Much can happen in a few hours…
Fair-value pricing example
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Indexing in a client portfolio
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Indexed strategies can benefit clients and advisors
• The difficulty of active management
• The role of indexing in a client portfolio
• Combining active and passive strategies
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Data: 8,775 hiring decisions by 3,417 plan sponsors delegating $627 billion in assets. 869 firing decisions by 482 plan sponsors withdrawing $105 billion in assets. Analysis covers the period 1996 through 2003.
Excess Return Persistence
Institutional investment manager hire/fire decisions from 1996 to 2003
Amount of excess return
Years before manager change Years after manager change3 2 1 1 2 3
Fired firm 2.27 (2.06) (0.74) 0.98 1.47 3.30
Hired firm 10.39 7.04 3.42 0.42 1.12 1.88
Difference 8.12 9.10 4.16 (0.56) (0.35) (1.42)
Source: The Selection and Termination of Investment Management Firms by Plan Sponsors Amit Goyal, Sunil Wahal (Journal of Finance Volume 63, Issue 4, printed August 2008)
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Rankings of semiannual returns, 1982–2009
Worst
Best
Analysis of five possible portfolios in 56 semiannual periods during 1982–2009. A spliced index—the Dow Jones Wilshire 5000 Index through April 22, 2005, and the MSCI US Broad Market Index thereafter— was used as a proxy for a broad-market index portfolio. (Index performance does not reflect real-world operating costs, which could alter the results.) The active portfolios were combinations of Lipper fund category averages roughly approximating the market capitalization of the broad market. Past performance is no guarantee of future results. These hypothetical examples are not representative of any particular investment, as you cannot invest directly in an index or a fund-group average.
Sources: Vanguard and Lipper Inc.
Combining active portfolios with indexed portfolios combines risk control with the opportunity to outperform
The returns of active/passive combinations fell between those of all active and all indexed portfolios
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Clie
nt p
ulls
mos
t ass
ets
Upd
ate
resu
me US Stock
Market Return
On average this portfolio has added alpha for a client
But the advisor faces a risk of losing clients
Portfolio’s periodic returns
Clie
nt p
ulls
som
e as
sets
Clie
nt a
sks
ques
tions
How will clients react when a strategy is out of favor?
• No strategy works consistently year over year
• It’s during those periods where a strategy is out of favor where clients may not appreciate the long-term track record
• This is where indexing can help
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Adding a broad market index fund dilutes alpha, but can temper the drawdown
• Combining index and active strategies, maintains positive alpha, but truncates the extreme downside risk of active management
On average this portfolio has still added alpha
But the advisor faces a lesser risk of losing
clients
Portfolio’s periodic returns
US Stock Market Return
Clie
nt a
sks
ques
tions
Clie
nt p
ulls
som
e as
sets
Clie
nt p
ulls
mos
t ass
ets
Upd
ate
resu
me
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Indexing offers additional benefits in portfolio construction
• Greater control of asset class risks
• Diversification
• Style consistency
• Tax advantages
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Conclusion
• On average active management has not met investor expectations
• Index funds derive their long-term performance advantage from lower costs, style purity and the relative efficiency of the capital markets
• Despite the averages, opportunities do exist for active management to add value
• Combining index and active strategies can truncate downside risk and lead to improved client retention
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Disclosures
• All investing is subject to risk. Diversification does not ensure a profit or protect against a loss in a declining market. Prices of mid- and small-cap stocks often fluctuate more than those of large-company stocks. Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
• © 2011 The Vanguard Group, Inc. All rights reserved.