CAHPTER 8
INDEX INVESTING
While Vanguard is famous for index investing, it is officially agnostic on active management versus indexing, so long as both feature low costs and low fees. It offers both approaches and is increasingly a global leader in both.
Vanguard manages more than 200 index funds and index-based ETFs, offering them individually to clients and as components of its increasingly popular Target Retirement and LifeStrategy funds (see Chapter 17). What began as Gus Sauter and one assistant has grown into an organization of 80, including several PhDs, who work with Rodney Comegys in the Equity Index Group.1 The group analyzes the many indexes they replicate both to anticipate small changes and to develop trading strategies to moderate any market impact the funds’ trading might have in the 40 different stock markets in which Vanguard now operates. “Continuous improvement, ideally every day, is part of the Vanguard culture,” said Comegys. “Indexing is a precision business.”2
One consistent objective is to minimize transaction costs, often by using futures to manage portfolio changes rather than suddenly buying or selling huge blocks of shares, or by spreading over several days or even weeks the full execution of a portfolio change made in response to a change in the index being tracked. Another objective is to reduce and even offset entirely the index funds’ small expenses with income earned from Vanguard’s conservative securities lending program (see Chapter 6).
Index fund investors often focus on tracking error; they usually expect a fund or ETF to stay within one or two basis points of the target index. Vanguard’s portfolio managers monitor their trading to avoid being either early or late on index-matching or too quick in effecting portfolio changes. Extra care is taken when managing index funds that represent small market segments or volatile foreign markets—especially those few markets that may tolerate “unusual” trading practices at or near their daily close.
Comegys and his senior staff travel the world to work with dozens of stock exchanges and their regulators, advising on ways to improve market efficiency and integrity. Since Vanguard is a large investor with extensive global experience and long-term focus, he and his colleagues are welcomed and listened to all over the world. Total index funds assets at Vanguard were $5.3 trillion in 2021.
Index funds are, by nature, buy-and-hold investors. Average portfolio turnover of the indexes Vanguard tracks runs only 3 to 4 percent a year. The average investment holding period for index investors is about 10 years. The holding period is understandably somewhat shorter for 401(k) investors who are older and near to or in retirement.
Indexing has become more and more highly sophisticated, particularly over the past decade. Trading is an all-day, global endeavor, so in every 24-hour period Vanguard passes control of its trading book around the world from Australia to Europe and then the United States. The firm’s trading partners in various stock markets are expected to provide “best execution” and consistently fair treatment. As broker-dealers have developed innovative algorithms to accumulate or distribute shares, a central question is which firms have the best trading tools. The volume of its business and the expertise of its index fund managers are so appealing that all major securities dealers want to be major service providers to Vanguard, even with its exacting requirements for excellent support by broker-dealers and its minimal per-trade commissions. The amount Vanguard pays in commissions is so low that it is proprietary information.
Vanguard’s experienced traders knew well in advance that a “mother of all trades” was coming their way on December 18, 2020, when Standard & Poor’s would make Tesla’s stock part of the S&P 500. It would put index funds’ expertise in trading to a severe test. Tesla was no ordinary stock. Prone to price gyrations, it had shot up nearly sevenfold during the past year—and over 40 percent just since S&P announced its intention to add it to the index. Tesla had not been added sooner because S&P required each newly included company to have at least four consecutive profitable quarters, a requirement aimed at keeping small, volatile stocks from fluttering in and out of the index. Tesla would be, on day one, the fifth largest stock in the index. The day it joined the S&P 500 would be the largest single day’s trading in the history of replicating the largest index. The index funds would need to make enormous purchases of Tesla. In addition, all the actively managed funds that were benchmarked to the S&P 500 might be active, too. Of course, an equally large dollar volume of the other stocks in the index would have to be sold to make room for Tesla and have sufficient funds to simultaneously pay for the purchase.
All the other companies managing index funds would have the same mandate to sell 500 other stocks and buy Tesla. Total required buying and selling: $57 billion of Tesla buying plus $57 billion of selling. In addition, non-index traders would be looking for opportunities to take advantage of the necessary trading spree. As Comegys said, “It was a game of cat and mouse.”3 The scale of the trading could not have been even imagined 20 or 30 years ago. The obvious question for managers: Could all that trading be done without throwing the markets into turmoil? Fortunately, December 18 would be what traders call a “quadruple witching day” when futures and options expire simultaneously, so market liquidity would be extra high.
For the traders, it was game theory—anticipation of anticipations of other traders’ anticipations of other traders. “Well in advance of that day, and particularly during the day, we had great information coming our way from sources on the Street,” Comegys said. Never a trader himself, he would be relying on his team, some with 25 years of trading experience, to plan their strategies, anticipate all potential difficulties, and prepare appropriate responses. Vanguard would not, of course, have any contact with the other major index fund managers.
The real test came at the NYSE closing bell. While Tesla shares were up 6 percent, the capacity of the market to provide liquidity was certainly proven. In the end, the Tesla trade was like Y2K in the computer world: lots of alarmist anticipation followed by a nonevent—another triumph for well-informed experts operating in a free market.
Gus Sauter had worked for five other employers before he arrived at Vanguard. In his first week, he realized that Vanguard had a uniquely strong culture: “I knew in my first week at Vanguard that this was the firm I wanted to retire from at the end of my career. Everyone worked hard and there was a singular focus on doing what was right for the investors in the funds. Most investment firms, whether public or private, want to maximize profits for the owners of the firm. That can create a conflict of interests with the investors in the funds, as higher fees are better for the owners of the management company but worse for the investors in the funds. Vanguard is unique in the mutual fund industry in that it is owned by the funds themselves, which are, in turn, owned by the investors in the funds. So there is no profit to be generated for some other ownership group. This structure is part of the reason Vanguard had such a strong culture and such dedication to the investors in the funds.”4
When Sauter joined in October 1987, Vanguard had one internally managed equity index fund, the Vanguard 500 Index Fund, which had $1.2 billion in assets. Two weeks later, when the S&P 500 index plunged more than 22 percent in a single day, the fund’s assets fell to $850 million. With his delight in ironic humor, he told the Vanguard board with a straight face, “Honestly, this is not my fault.”
Persuading brokers to sell the first index fund had been hard (see Chapter 3). In the fall of 1987, before the Crash, Vanguard had planned to launch a second equity index fund in December, and now it certainly did not want another launch failure or even a major struggle. So in addition to dealing with the Crash and its aftermath, Sauter spent his first two months at Vanguard developing the needed software. The index chosen was the Wilshire 4500 Extended Market Index, covering not 500 but approximately 4,500 stocks. Academic research had shown that the “small firm effect” implied that a widely diversified portfolio would earn a higher rate of return, but with more volatile pricing. The computer algorithm to manage an S&P 500 index fund is not complicated. In fact, for a mathematician it’s rather trivial. However, a different management technique is needed to manage an index fund tracking 4,500-plus stocks. A sampling process is used instead of the complete replication strategy used to manage an S&P 500 fund. Complete replication is simple, but sampling is far more complicated, requiring a much more complex computer model with a lot more math, and Vanguard did not have that model. “Looking back,” Sauter now wryly says, “you learn a lot under those baptism-by-fire conditions. We worked all the time: late nights and weekends.”
Sauter is modest about the surging growth in indexing: “Efficiency in pricing is what markets are supposed to do. And over time, that’s what they do. Over time, markets become more and more efficient as they grow, attract more and different participants who obtain more and better information, and develop increasing skill, acquire better tools—particularly computers—and develop better and cheaper market clearing processes. Investment management is Darwinian: always deleting the weaker competitors so the continuing crowd gets better and better.”
At the same time the equity group (then called Core Management, now the Quantitative Equity Group, or QEG) was developing the active quant lineup of funds, Vanguard ramped up its index offerings, launching Vanguard Small Cap Index Fund (1989), European Stock Index (1990), Pacific Stock Index (1990), Growth Index (1992), Value Index (1992), Balanced Index (1992), Emerging Markets Stock Index (1994) and Total International Stock Index (1996). In the middle of this proliferation, Jack Brennan approached Sauter and said, “Gus, we’ve decided to stop messing around. We’re going to launch the true one-stop-shopping index fund.” That was the Total Stock Market Index Fund, consisting of essentially all listed US stocks and launched on April 27, 1992.
In the month leading up to the launch, members of Jeremy Duffield’s Planning and Development Group, of which Sauter’s Core Management Group was a part, took guesses as to what the size of the assets would be at launch. For some perspective, the original S&P 500 Index Fund, launched in 1976, collected only $11.4 million, and 11 years later the second offering, the Extended Market Index Fund, gathered only $3.5 million. (For more perspective, the 500 Index Fund was launched on the heels of the significant 1973–74 bear market and the Total Stock Market Index Fund got off the ground shortly after the soft market of 1991.) To everyone’s surprise, the Total Stock Market Index Fund gathered more than $100 million on its first day. Today, the Total Stock Market Index Fund is the largest mutual fund in the world. Assets topped $1 trillion in November 2020.
In the 1990s, local newspapers liked to organize “investor weekends” for individual investors. They were typically held in a convention center with exhibitors offering all kinds of investments or investment services. There would also be multiple large rooms for concurrent sessions on various investment topics and typically a large convention hall for a couple of keynote speeches. These investor conferences were open to anyone who wanted to hear interesting speakers, explore the exhibits, and generally learn more about investing. Sauter was a regular participant: “One year I spoke at about 25 of them, usually as a member of a three-person panel paired with two active managers who had recently had great performance—otherwise, of course, they would not be invited to speak. I was asked to present and defend the case for indexing, which was still in its infancy, not well understood and definitely not widely accepted.”
He added: “The irony was that even though I had built and managed Vanguard’s equity index group, the two funds that I personally managed were both active quant funds. That fact never came up, but over time many people have asked how Vanguard could justifiably offer both active and index funds. And that’s because Vanguard’s true ‘religion’ is low-cost investing, not active or passive. Both active and passive can have a place in an investor’s portfolio, but only if they’re low cost.”5
Slowly but surely, indexing started to grow. In Sauter’s view, three major catalysts ultimately propelled it to equal billing with active investing:
• During the tech bubble in the last several years of the nineties, large-cap growth stocks, led by GE, Microsoft, Cisco, Intel, and others, helped the S&P 500, which is a large-cap index, outperform more than 90 percent of active mutual funds. At the time, the S&P 500 was synonymous with indexing, even though a total market index is a better representation of the market. Nothing attracts articles in the press—and cash flow—like major outperformance. That was the first huge spike up in indexed assets.
• When the tech, or dot-com, bubble burst at the beginning of the millennium, many investors were overweight in the once high-flying growth stocks. Many financial advisers had large positions of these stocks in their clients’ portfolios. What goes up must come down; those stocks crashed as the bubble burst. This painful lesson reinforced perhaps the largest proposition of Modern Portfolio Theory—investors can reduce risk without reducing expected returns by diversifying their portfolios. Advisers and investors realized the need to diversify. No fund is more diversified than a total market index fund, so another huge wave of cash flowed into index funds, and in particular, total market index funds.
• The global financial crisis of 2008 had a profound impact on how people viewed the future of investing. Many, arguably most, people believed that economic growth would, for years and years, be much slower than historic rates of growth. In that case, it was presumed that investor returns would also be much lower than historic norms. The expectation of lower returns meant that fees were increasingly recognized as important to investor profit, so investors sought low-cost funds. Since index fund fees are only a fraction of the cost of an average active fund, this made them especially attractive, and a third wave of cash flow—a veritable tidal wave—rolled into index funds.
Underlying these major events has been index funds’ outperforming most active funds for decades. Another is the increasing recognition, particularly at major corporations, that their fiduciary responsibilities under ERISA, the federal law that sets minimum standards for pension plans, were best met by using low-cost, widely diversified index funds.
When Vanguard’s total equity-indexed assets surpassed $3 billion—up from $1 billion when Sauter started in 1987—Bogle appeared in the doorway of Sauter’s office and said, “Gus, you wait, someday indexing will be really big. It will cross $10 billion in assets.” At that time Sauter wondered if it would happen in his working career. When he retired in 2012, Vanguard had more than 100 times Bogle’s hopeful estimate: $1 trillion in indexed assets. And indexing has since multiplied, to more than $5 trillion in 2022.