Recently, a few colleagues and I were reminiscing about an ad that Gus Sauter, Vanguard’s retired chief investment officer, had hanging in his office for years. It depicted a monkey at a computer managing a portfolio. The ad’s message? Indexing is so simple a monkey could do it—the implication is, of course, that sophisticated investors require sophisticated strategies. Indexing? A solid strategy, some might have said, but one that’s not sophisticated enough for me.

Now, I don’t consider myself or Vanguard’s investors to be “less sophisticated”—Vanguard partners with many highly sophisticated investors around the world. But the fact remains that a lot of us (myself included) sometimes refer to indexing as a “simple” investment strategy. Simple to understand? Yes, indeed, in that the target is systematic beta instead of striving for alpha. Simple to execute? Not at all. In fact, I’d argue that while anyone can build a portfolio of individual securities and manage it over time (does the image of a monkey throwing darts come to mind?), very few can construct and efficiently manage an index fund for a host of reasons, starting with the technology requirements, required/necessary risk control, and strict attention to detail. I shudder to think what would happen to our investors’ trust if a monkey were in fact running their index funds!

Further, because an index fund is designed to (attempt to) replicate a given benchmark’s return, investors in index funds are primarily concerned with tracking error, or how much and how consistently a fund deviates from its targeted benchmark. Again, while indexing might seem like a simple and straightforward endeavor, the process can actually be highly sophisticated, with multiple moving parts, each of which can lead to tracking error alone or in concert. In the illustration below, for example, I’ve plotted the universe of S&P 500 Index funds according to their expense ratios along the x-axis and their annual excess returns versus the S&P 500 Index along the y-axis. While the relationship is fairly linear, it’s not perfectly 1 to 1.

The deviations from the expected relationship between expenses and excess return are due to the multitude of factors an index fund manager must account for on a daily basis, including (but not limited to):

  • Portfolio optimization process and implementation.
  • Managing index changes and corporate actions.
  • Cash-flow management.
  • Trading.
  • Securities lending.
  • Fair-value pricing (for international or global funds).

In fact, colleagues of mine in Vanguard Investment Strategy Group, Jim Rowley and David Kwon, recently published an article in The Journal of Portfolio Management that tackled this very issue. Their article is quite technical, but if you’re geeky like me, I strongly encourage you to read it!

The key point? Most investors are likely aware of the impact of expenses on an index fund’s expected excess return, but fewer may be as aware of the nuances of the portfolio management process itself. And of all the factors, fair-value pricing is the one that’s probably the most misunderstood and, therefore, the one most commonly raised by our clients, questioning trailing performance and/or tracking error of our international and global index funds. In many cases, their concern is that the FVP process is somehow detrimental to investors in the funds because tracking error is increased. That’s why I was thrilled to see a blog on FVP (Jim Rowley again), targeted to our financial advisor clients, and a video featuring Walter Lenhard of Vanguard Equity Investment Group discussing the process, benefits, and reality of FVP.