James J. Rowley, Jr., is Vanguard’s global head of investment implementation research and a member of the senior leadership team of the Investment Strategy Group. Among his areas of expertise are investment strategies, including indexing, active, and factor, as well as investment products, including mutual funds and exchange-traded funds (ETFs). Jim and his team conduct research and provide thought leadership on issues related to indexing, ETFs, active management, alternatives, factor strategies, and ESG (environmental, social, and governance).
Jim joined Vanguard in 2005 and has held positions of increasing responsibility on the firm’s ETF Product Management Team and in the Investment Strategy Group. Before joining Vanguard, Jim worked at Gartmore Global Investments, Lehman Brothers, and Merrill Lynch.
Jim’s research has been published in The Journal of Portfolio Management and The Journal of Beta Investment Strategies (formerly The Journal of Index Investing), and he has presented to global regulators, policymakers, industry peers, and investors. He is also frequently interviewed by the financial media.
A CFA charterholder, Jim is a past president of the CFA Society of Philadelphia and is an advisory board member of The Journal of Beta Investment Strategies. Jim earned a B.S. from Villanova University and an M.B.A. from New York University.
Andy Maack is a Principal and the Head of US Trading in the Vanguard Equity Index Group (EIG). He leads index portfolio management and trading functions for the U.S. trading desk.
Mr. Maack joined Vanguard in 2002 and has worked within the Investment Management Division since 2004. He founded Vanguard’s FX trading desk where he served as the global head, supporting Vanguard’s FX needs for equity and fixed income portfolios globally. Prior to leading FX, Andy was a senior equity index portfolio manager. Early in his career he was a municipal bond trader and held several roles in the Retail Investor Group.
He is a CFA® charterholder and earned a B.S. from Indiana University of Pennsylvania and holds an M.B.A. from The University of Pennsylvania’s Wharton School of Business.
What if index funds weren’t as “passive” as you think? In this episode of the Rational Reminder, we are joined by Jim Rowley, Global Head of Investment Implementation Research, and Andy Maack, Head of US Equity Portfolio Management at Vanguard. These two experts offer a rare, behind-the-scenes look into what it really takes to run some of the world’s largest index funds—and it’s far from “set it and forget it.” From real-time trading decisions to managing $7 trillion globally, Jim and Andy walk us through how Vanguard implements index strategies with a precision that rivals any active manager. They challenge the traditional labels of passive versus active and show how thoughtful implementation, securities lending, FX execution, and IPO participation can add real value for investors—even in low-cost index products.
Key Points From This Episode:
(0:04) Why Vanguard’s team was the ideal follow-up to Marco Sammon’s index research
(1:55) Why index funds aren’t as simple as they seem: rebalancing, risk, and strategy
(2:50) “Passive” is a misnomer: why index fund management involves active decisions
(4:42) What excites Jim and Andy about index fund implementation
(7:16) Risk-managed opportunities: how Vanguard adds value during secondary offerings
(8:02) Debunking the active vs. passive label—think in terms of strategy characteristics
(9:41) The subjective calls behind index construction and market definitions
(12:00) The goal of a market-cap weighted index fund and how Vanguard tracks it
(13:28) Why tracking error matters—and when it becomes a business risk
(15:48) Indexing’s advantage: predictable relative performance for portfolio construction
(16:15) The real complexity of daily index fund trading and execution strategy
(17:16) Vanguard’s unique approach: PMs and traders are the same person in equities
(18:52) The scale of VTI: how 24 global PMs manage trillions across time zones
(20:48) Why Vanguard’s culture treats every trade like it’s client money
(22:24) Andy’s story of building Vanguard’s FX desk and the hundreds of millions saved
(24:04) Quant vs. human judgment in index implementation—why both matter
(26:50) How fixed income index funds balance risk, liquidity, and security selection
(27:46) Tools traders use to minimize price impact: algos, limits, and timing strategies
(29:09) How index rebalancing impact has decreased thanks to market evolution
(31:36) The hidden mechanics behind index inclusion/exclusion and price effects
(33:40) Do index funds distort prices? Vanguard’s view on elasticity and ownership
(35:55) Stock dispersion and the case for continued price discovery
(38:09) Why using passive funds doesn’t mean being a passive investor
(43:15) Jim’s research: how “passive” funds are actively deployed by advisors
(50:43) How Vanguard handles IPOs, buybacks, and market composition shifts
(54:45) Active corporate action management: cash mergers, elections, and strategy
(55:27) Responding to Marco Sammon’s critiques on market timing and turnover
(58:55) What would change if rebalancing were less frequent?
(1:00:34) How securities lending and market advocacy add ongoing value
(1:04:42) Should Vanguard launch a flexible, non-indexed total market fund?
(1:06:26) Andy’s biggest concern: system risks and rebalance day challenges
(1:07:08) Jim’s biggest concern: index funds aren’t a free pass—investors still need discipline
(1:08:03) Defining success: alignment with investors and living a balanced life
Read The Transcript:
Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision making from two Canadians. We're hosted by me, Benjamin Felix, CIO at PWL Capital and Dan Bortolotti, Portfolio Manager at PWL Capital. Welcome to episode 368.
I had gone back and forth with someone at Vanguard after we had had Marco on the podcast because obviously Marco was talking about some of the problems with index funds and Vanguard being one of the largest index fund providers in the world. We thought it'd be really interesting to hear their perspective on some of that type of research. We ended up getting, I think, I was saying to the guys after we finished recording with them, that they're, I think, quite literally the two best people in the world to address Marco's point.
We talked to Jim Rowley, who's the Global Head of Investment Implementation Research at Vanguard. He leads a team that conducts research and provides thought leadership on a wide range of issues, including, as the title suggests, investment implementation. Andy Maack, who's the Head of US Equity Portfolio Management at Vanguard.
He's leading their portfolio management and trading teams for equities. It's between the research side and the implementation side. These guys just have incredible perspectives.
Andy's been at Vanguard since 2002. Prior to his current role leading equity index portfolio management, he founded Vanguard's FX desk, foreign exchange desk. He talks a little bit about that during the conversation.
Jim has a couple recently published academic papers on index fund related topics that we also talked to him about. I thought it was an incredible conversation with two people who have clearly a ton of wisdom and experience specifically related to index fund portfolio implementation.
Dan Bortolotti: Yeah. I think if there's anyone out there that thinks managing an index fund is super straightforward, you enter the number or the stocks and their weights into a computer and it does the rest on its own, you're going to be disabused of that idea pretty quickly. It's very clear, especially for the enormous funds that Vanguard manages.
The amount of management goes on, the trading that goes on to maintain those funds is pretty enormous. Interestingly, as they're going to talk about, a lot of it is not just mechanics. There's a lot of strategy and judgment involved that can be used to enhance returns for fund investors, not based on which stocks they select, but just simply based on the mechanics of when to make the trades, how to make the trades to minimize market impact.
It was a real interesting glimpse into just what goes on behind the scenes.
Ben Felix: Into how active index fund design or index design and index fund implementation really is. We talked a little bit about that too, about whether passive is a good name for index funds and whether the passive and active are good names for investment products in general. Jim does not think so and he explains why.
This is an episode where you get to see from the guys that are researching it and doing it, how complex index fund implementation is. We did, for people who are wondering, we do talk about Marco's research specifically, how they process something like that, how they think about it. Jim had reviewed Marco's paper.
He's actually mentioned in the current version as someone who has provided comments. He said he talked to Marco a few days before we recorded this. We talked about that, but we also talked about a whole bunch of other stuff.
It's a really interesting conversation with probably the best people in the world to talk to about implementing index funds. Anything else?
Dan Bortolotti: Yeah, it's interesting to see too how practitioners like Jim and Andy actually pay very close attention to what academics are saying and they have this great ongoing dialogue. How can we improve what we do based on things that the academic community is pointing out? It sounds like an open dialogue, a very constructive one.
As investors, I think we all benefit from that collaboration.
Ben Felix: From what these guys described, it sounds like Vanguard just has an incredible culture that's focused on making their funds the best that they can possibly be, based on how they implement them. That was also an interesting tidbit. Anything else?
Dan Bortolotti: No, let's get to it.
Ben Felix: All right. Let's go to our episode with Jim Rowley and Andy Maack.
Jim Rowley and Andy Maack, welcome to the Rational Reminder Podcast.
Jim Rowley: Thanks for having us.
Andy Maack: Yeah, thanks for having us.
Ben Felix: Super excited to be talking to you guys. To kick this off, index funds have a reputation for being boring. What do you guys think is the most exciting part of index fund implementation that most index fund investors probably are not aware of?
Andy Maack: Yeah, I think it's a couple of things. One, just the amount of activity that an index does on a daily basis to maintain the market weighting is significant. We process probably over 20,000 corporate actions every given year.
A lot of those don't necessarily require action, but they require some type of attention. Every day, the index is making some type of change to its composite to better match the market. The second thing would be we actually take risks in our index funds against the benchmarks.
Albeit small risks, we're looking for asymmetric risk return opportunities to actually add a little bit of value back to the performance against the benchmarks.
Jim Rowley: Ben, I'd like to give a shout out here to fixed income because I think a lot of times when we talk about indexing or index fund investing, I think everybody just defaults to equities for some reason. I think what's really interesting in the fixed income space is you've probably heard this claim before that, well, it's different in fixed income and because funds are sampled, they're not able to track the market well. It comes from this notion that portfolio managers seemingly randomly pick individual bonds and it's not good enough to track the index.
But what most investors don't know is that to implement a sampled or an optimized fixed income fund, they don't do bottom up construction. They do top down construction. And so there's great thought about matching, you've talked on this program before, systematic risk factors.
Number one being you want to buy bonds that you're going to match the average duration of the index itself. And then you're going to figure out ways to match risks at duration along the curve. Do you have the right proportion of two year bonds, 10 year bonds, 30 year bonds, et cetera.
You want to make sure you have the right proportions of corporates versus treasuries versus mortgage backs, et cetera. So what you end up with is this really great opportunity to match an index and Vanguard published a research note not long ago called, it's a balancing act for fixed income funds, balancing between tracking error and transaction costs. And it does a great job of describing how the process of top down bond index fund implementation is done.
Ben Felix: Yeah, interesting. And you mentioned taking a little bit of risk and some of the value added on implementation. Do you have examples of what that might look like?
Andy Maack: Sure. One, we want to be very cautious whenever taking risks in a portfolio. We're not going necessarily long or short any individual names from an active management perspective.
But again, we are looking for those asymmetric risk return opportunities. Some of those exist in secondaries in the syndicate market. So a company is issuing new shares.
The index is going to make the change at the close of business that day. However, we have an opportunity being existing shareholders to purchase those securities in the morning, typically at a two to 3% discount from its previous close. Now the index is buying at the close, we're buying in the morning.
We need that discount to hold throughout the day in order to add a little bit of value against where the index would buy.
Dan Bortolotti: What is your view on the labels passive and active as they're applied to investment products?
Jim Rowley: Recently, a lot of published work and discussions is trying to remind investors, you want to think about characteristics, not labels. And I think for some reason in the industry, we've gone along this path of this binary categorization of if something is legally and technically an index fund, it's as if it's this uniform shared monolithic strategy. And if you're not that, you're active.
And a good simple example of this might be, think about two funds. One is technically an index fund or passive and the other one's an active fund. And I say to you, the active fund has all 500 securities in the S&P 500, and they take very little overweights and underweights across all 500 names.
And then the other fund that's technically an index fund is highly sampled or optimized and it holds 200 securities. Think about what do we all think the characteristics of the risk return outcome of those two funds might be? Because I would say based upon the characteristics of this example active fund I gave, I bet it's going to end up tracking the index or have a low level of active risk reasonably well vis-a-vis the technical index fund that is highly sampled.
And I know that's an exaggerated example, but it's one of my better ways of trying to illustrate why I wish we would look past the labels a little bit and think along terms of characteristics and objectives.
Ben Felix: Yeah, that makes a lot of sense. Can you talk about some of the active decisions that go into creating an index fund that we would usually call passive?
Jim Rowley: What's great about nowadays when you think about index construction methodologies is we can all go online and look at pretty much every index provider's stated methodology is the way that they build an index. And I think in many ways, the starting point for saying, who makes it into the family, if you will? Let's take US equities, for example.
There's a process that is trying to identify, well, what firms should be called a US firm based upon domicile? What's their tax jurisdiction? Where's their headquarters?
Where's their primary area of operation? So the first step is even who qualifies. There's other considerations like, what's the minimum level of liquidity that a stock should have to be considered?
There's a minimum level of investability. And maybe you're of the show, you've addressed the concept of a float adjustment. And then when you think about Crisp might have their way of doing that, and Russell might have their way of doing it.
The first step is kind of those, if you want to call them subjective decisions to figure out who even makes it into the opportunity set. And then that second level is making the decision, where do I make my cutoff for large versus mid or mid versus small or growth versus value? And then based upon your index provider, you just get, we can call them subjective active decisions to figure out where the family tree gets compartmentalized.
Andy, I don't know if you want to add to that.
Andy Maack: No, I think you hit it right on the head there. Minor differences when it comes to when to include secondaries, whether it's a dollar amount threshold, a float differential, IPOs, some fast track within five days, others, and the rebalance. So minor decisions around when to include.
Jim Rowley: Actually, one more obvious difference is something, you look at a provider like Crisp, they make their inclusions and their cap size cutoffs on a proportion of market cap basis. Somebody like Russell makes it on a discrete count base. And it's probably a big philosophical argument there about what's right or wrong.
But in each case, that's that index provider's definition of the market or the relevant sub markets.
Ben Felix: That's really interesting to think about. Okay, so given on index, whether it's Crisp or Russell or whatever, what is the main objective of a market cap weighted index fund?
Jim Rowley: I'll cheat a little bit if you don't mind, Ben. I'll go back to the goal of the index itself. The index itself is to represent the investable opportunity set.
I'm pretty sure you've all mentioned some of Gus Sauter's work, ideal index construction. And from Gus's perspective, it was this idea of what reflects the way that active managers actually act in real life. That is the investable opportunity set that is applicable or available to them.
And then from the fund's perspective, it is simply to as best as possible, track the performance of that index with what we might say, tight tracking, meaning with little to no risk in terms of achieving that return.
Dan Bortolotti: Now, how closely do Vanguard's funds tend to track their benchmark indexes? And as an extension of that, which of the indexes are the most difficult to track?
Andy Maack: It definitely depends on the index and the ease of accessing the different markets that that index is invested in. If you take a highly commoditized products, large cap index like the S&P 500, those products tend to track extremely close. Even a basis point of mistracking over the year could be considered not a great outcome for us as index providers.
But if you start going down further in the hardest to track, it would be something like an emerging markets product where maybe access to different markets is difficult, or there's special withholding taxes where tracking the index becomes very difficult.
Ben Felix: What are the implications? What happens if a fund does have meaningful tracking error?
Andy Maack: In a highly commoditized product like the S&P 500, shareholders could look to other products. There's other ones that exist in the market. And if tracking error is one of their major concerns and you mistrack, you could easily see shareholders going to another investment.
Again, it's something that is more difficult, like an emerging markets product. I think, again, it's comparing the different products that are out there, trying to make the best decision for you and your portfolio. But ultimately, if you had consistent tracking error and underperformance, I think shareholders would shy away from those products.
Jim Rowley: And I think what's really critical with this conversation is, again, maybe going back when we were talking about this binary labeling of active and passive, I think with that in the industry, we've always seemed to focus on single fund issues. And I think in many ways, we lose perspective of what does it mean for my portfolio at large? And to me, one of the biggest reasons to use an index fund is the concept of relative performance predictability.
It's a fancy term for saying, am I getting the risk return experience that I should be getting? It's important because as investors, we all do our asset allocation. And it could be any asset allocation.
It could be super broad, or you could be very specific about a specific allocation to large caps, mid caps, small caps, et cetera. The index fund investor is saying, I've done all that modeling work. I know the asset allocation that's right for me.
I'm going to implement it with index funds if I'm saying to myself, I just want the experience of the large cap space with a high level of predictability of the relative performance. To go active in that way is to say, well, I've done my modeling in the large cap space, for example, but I'm willing to take the risk of perhaps underperforming or incurring larger amounts of tracking error for the potential benefit of outperforming. And so in many ways, this concept of, do I want to implement with active or passive, it's a personal preference.
Do I just want that experience of a high degree of relative performance predictability, or am I willing to incur a little bit of the tracking risk? But again, this is this important idea of sometimes we got to get out of the product by product comparisons and think to ourselves, what does it mean to my portfolio at large?
Ben Felix: It makes a lot of sense. We like that about index funds too, is you get the market return or the index return, and you're not worried about plus or minus based on active risk. But it's also a great point that some people might look at the data and say, I do want to take the active risk, and that's their choice.
Yeah, it's interesting to think about. Andy, can you talk about the level of complexity involved in the trading happening behind the scenes in an index fund? I think people just take for granted that index funds exist, but I think there's a lot more complexity than people realize.
Andy Maack: It can definitely range from very simple to extremely complex, depending on the situation. If you just get a little bit of cash flow in on any given day, you could just simply buy futures contracts and equitize that almost immediately without much thought or effort, to ranging from extremely difficult during our quarterly rebalances, where we have a significant amount of flow going back and forth. We're netting, we're aggregating, we're trying to predict what will happen to price action.
A lot of what we do is try to mitigate impact for the clients. We're not necessarily just going out and blindly putting something on the closing bell, because that's our print and that's our benchmark. We want to make sure that our execution is what is best for the clients of the portfolio.
That might mean a couple of different strategies. It might mean trading a little bit before, it might mean trading after, using protective orders around the bell to not have as much impact. It definitely varies by situation, but it can get pretty complex.
Dan Bortolotti: How do the portfolio managers and traders work together to implement an index fund? What are the roles of each?
Andy Maack: We're very unique and I don't know anyone else actually does what we do here at Vanguard, but our portfolio managers and traders are one in the same. The people that are named on the portfolio are the exact same people that are trading on behalf of that fund. We believe that that gives our PMs an advantage to really understand why they're trading something and helps them in that execution of how to actually do it.
Then they can react much quicker to any type of changing information or change in the market without having to go try to find a PM or a group of portfolio managers to get consensus on.
Jim Rowley: Then on the fixed income side, obviously the portfolio manager is responsible for the strategy of the fund. When cashflow comes in, they're going to hand off that cashflow assignment to dedicated traders in a various sector. For every dollar that comes in of cashflow, there's a proportion that goes to the treasury's trader, a proportion that goes to the corporate's trader, the ABS trader or the structured trader and the mortgage-backed securities trader.
A little bit of a strategist at the PM level and then dedicated specialists according to sector when it comes to trading and finding liquidity.
Ben Felix: The PMs deciding who's getting allocated what and then they're making the trades. That structure sounds like what I've seen in other fund companies, but it's pretty interesting that in the equity side, the PM and the trader is the same role. I didn't realize that.
Makes sense though. If we take a fund like VTI, a huge index fund, how many PM slash traders are involved with managing a fund like that?
Andy Maack: We take a bigger step back to give you a sense of the desk here. We manage over $7 trillion on the desk. About 5 trillion of that is domestic with about 2 trillion international.
There's 24 portfolio managers and traders on my team. Five of those individuals are out in Arizona. They're an extension of a desk, but they also serve as a contingent site in case we lose this office or we get some type of weather or outage.
We then have 12 portfolio managers and traders in London and then 12 portfolio managers and traders in Australia. We take advantage of a pass-the-trade model. If an order is generated here, but is to be executed in Japan, that order is passed to another Vanguard trader that actually handles that order.
That's true regardless of asset class, whether it's FX, whether it's fixed income, equities. We take pride in that there's always a Vanguard trader portfolio manager that is at the helm of that trade, making sure that execution is done in the way that we expect it to be done. Then getting back to your specific question on VTI, we have named portfolio managers who are responsible for those funds.
However, we do take a team approach when it comes to executing on behalf of the portfolios. If there was a single index change that was happening in a name, it might not be the actual PMs that are executing that. It would be a team that was responsible for figuring out what the trading strategy is, what the risk is, how to go out and execute that.
Then they would get approvals from the appropriate channels on, yeah, this is a strategy. Let's go.
Ben Felix: Man, wow. Do you guys ever sit back and just think about how insane those numbers are?
Andy Maack: To be honest, I don't think I could actually write it on a piece of paper right now if you gave me the opportunity.
Dan Bortolotti: I had not realized that you had people all over the world like that. The sun never sets on Vanguard. There's always somebody awake and at the helm.
I did not know that. That's fascinating.
Jim Rowley: For me, being in a research department, but I get the chance to go up on the trading floor, it is amazing how everybody treats it like it is their family's money. It matters at Vanguard. When Andy is up there with his colleagues, they are there to look out for the clients and their retirement money, their vacation money, their tuition, whatever it is.
It is real here that people treat... Andy talked about the risks as an everyday thing, and we take that immensely seriously. Yeah.
Andy Maack: An interesting story is I was on the trading desk. This is probably 15 years ago or so. We were transitioning from MSCI to FTSE.
It meant a big trade in Korea because Korea was now going to be considered developed. It was going from a large weight in the emergings to a smaller weight in the develops. We had a massive sell of Korean won.
Back then, Korean won was standing instruction. It was a very expensive currency to trade. It was a restricted market.
Long story short, I was able to actually go over to Australia, go to Singapore, go to Korea, talk to portfolio managers, traders over there, and we were able to trade the FX ourselves, saving clients significant amount in currency executions. But I think for that one example, there's another 20 where we're constantly going out trying to create better market structure, better trading, more transparency. We worked with a lot of exchanges as well on their methodology to try to just enhance the way that they trade to have better price discovery, more liquidity.
Sure, it helps our shareholders, but it actually helps the entire ecosystem as well, and we really do care about that.
Ben Felix: You led FX before securities trading, right?
Andy Maack: I did, yes.
Ben Felix: Yeah, that's a cool story.
Andy Maack: Yeah, it was interesting. Probably 20 years ago, FX was somewhat of an afterthought for a lot of portfolio managers. Many of them had it on standing instructions with the custodian banks.
We did a little bit of it ourselves, and I was able to come onto the trading desk, and it was assigned to me by one of the PMs who just didn't probably want to do it anymore, and just was able to ask a lot of questions around, why are we doing this? How are we doing this? What are the systems that are out there?
How can we do a better job? Which ultimately led to us doing a lot of self execution, using algorithms to break up large orders, which then ultimately led to a creation of an FX desk that is now global. It was a really cool experience.
Ben Felix: That's incredible. How much cost savings or otherwise benefit does Vanguard get from something like that?
Andy Maack: Significant. I think the FX market has come a long way. We really pushed for more transparency, timestamps, things like that, but I think from the beginning of time, especially with custodian banks, you could probably read about it in papers, they did not give good executions to clients, especially those clients that weren't paying attention.
The fact that we can take it in-house, we can use algorithms to cut up a billion dollar order into thousands of smaller pieces and not necessarily demand liquidity is really significant for our clients. It's something we've probably saved hundreds of millions of dollars on over the years, if not more.
Ben Felix: Man, that's so cool. How much of an index funds implementation, like we're talking about the portfolio managers and their roles, how much of an index funds implementation is quantitative, just rules based versus based on human judgment from the portfolio manager?
Andy Maack: It's probably a good combination of both. I think you can't necessarily rely on either to be really good. If you looked at just quantitative approaches to trading, take any rebalance, for example, there's not a cost analysis model that's going to accurately predict the amount of liquidity that's going to show up on those days.
If you had to trade a name and let's say you might have had 35 days of average daily volume in that name, and you're going to trade at the close, you're going to break every model out there. It's going to say you're going to have thousands of basis points of impact. In reality, that's not necessarily what we see.
We actually see in some cases, a stock that you have by demand actually falls on those rebalance days because the liquidity has been already predicted by the market and they're ready to actually offset that. You definitely can't rely on either. I would say it's probably about 50-50.
Quantitative measures are great in certain situations. We have a TCA team here at Vanguard that really helps us model a lot of our executions. One of the things we've done is we've created algorithmic wheels.
This is where our portfolio managers would use algorithms. Those algorithms would go out to the market and execute, but it was really hard to compare one algo with another algo, especially just using human judgment. We've been able to quantitatively work with those to identify what the best algos are for different markets, so large cap, small cap, mid cap algorithmic wheels, and really get our execution better.
Jim Rowley: On the fixed income side, what might be interesting to most is within our fixed income index funds, as it relates to this question, going back to what I had said earlier about cashflow comes in and the index fund is trying to match systematic broad-based risks of the index. You can think of a scenario where the portfolio manager might say something like, okay, I need an allocation to 10-year AA rated banks because that's the big macro risk factor that I need. Then the traders might say, well, there's four bonds available that meet those characteristics.
From the portfolio manager's perspective, he or she is good because it matches the systematic risk factors. The trader said liquidity is pretty good. We can now send it off to credit research and ask our credit research department, any four of these, which one do you like best?
Which one do you like least? You've got this really pretty cool combination, I think, that probably most don't realize if there's this active element in managing an index fund, but it also relates to that quantitative versus human judgment as well.
Ben Felix: That's so interesting. When they're looking at the different options to fill that allocation, are they looking at what? Like expected returns or liquidity?
What characteristics do they care about?
Jim Rowley: You pretty much have an intersection of all three. Again, if we think about the portfolio manager as he or she being responsible for what are the broad-based risks I need to fill in the portfolio right now. It's up to the traders to say, well, what liquidity is out and available there if we want to fill that spot with a certain select group of bonds?
It's up to credit research to say, hey, well, given these are the risk characteristics you need and you tell me these are the list of applicable bonds for which you can find liquidity, I'll tell you based on credit analysis and relative value in that space, which name I prefer the most and which name I prefer the least.
Ben Felix: So interesting. I imagine listeners will be surprised to hear that that level of activeness is going on behind the scenes in index fund implementations. Just so cool.
We talked a little bit about index rebalancing and we'll talk a little bit more about that, but when that happens, what tools do traders have available to them to minimize their price impact when they're trading securities?
Andy Maack: Yeah. One I mentioned is the algorithmic wheels working with our TCA teams, but also tools that we deploy a lot is limit on close order. We might be benchmarked to the closing print that day, but we're not just going to necessarily blindly put a market order out there and get filled at whatever that closes.
We're going to put limits on those orders, so we're not going to have impact above a certain dollar amount. But again, I think when I talked earlier that we do take risks in the portfolio, this is exactly where we could take some potential risk in a trading strategy with the motivation to not have unnecessary impact on a security. And that may look like, again, trading a little bit early.
It might look like limit on close orders on the bell and then potentially having some residual that you need to trade in the next couple of trading sessions afterwards. But yeah, it's something we definitely take very serious and we do not want to be the prince in the market that looks terrible because ultimately that is not a good outcome for our shareholders.
Dan Bortolotti: And how has the growth of indexing made that more challenging? It's pretty difficult now to not maybe move the market when you're talking about funds that may have hundreds of billions of dollars under management and are making enormous trades. Has that become more challenging as the funds have grown?
Andy Maack: I actually think it's less challenging today than it was in the past. And even though indexes has grown significantly, so has the awareness of indexing and funds that follow. So what we tend to see is active managers, hedge funds, other participants using index rebalances, index changing as a moment for extreme liquidity.
So we might see a lot of times that certain names were getting caught up from an active shop saying, hey, are you guys going to be out there in this name? So you see that as well. And then I also think the evolution of rebalancing and the awareness of it has actually provided significant more liquidity and actually smoothed out impact from indexing over time.
And what I mean by that is, let's say 20 years ago, we were the only ones that were rebalancing. Nobody was aware of it. We would have to buy certain names and we're benchmarked to that day's close.
So you'd potentially start buying earlier in the day, start having impact. But to get done, you need to course sellers to sell. What happens?
Price goes up, you get filled, the next day price comes down. And that all happened in a one day period. Then what you saw is actually banks, when they were able to take more risk, they were getting in prepositioning in this index changes maybe three weeks before.
So you saw that gradual increase in the security prices become less. And now what you're seeing in the market is other players are getting into those trades sometimes months in advance. They're predicting what the index is going to do.
So you see an even more smooth amount of impact because that trading that happened in one day is now happening over three days. And you don't see the impact directly from indexes as much anymore at all.
Ben Felix: That sounds like we had Marco Sammon on this podcast a while ago and he talked about his paper, The Disappearing Index Effect, which basically documents that. So it sounds like you just explained practical on the ground perspective of why that's been happening.
Jim Rowley: Yeah, you beat me to it, Ben. I was going to mention the paper.
Dan Bortolotti: I guess one of the places that you may see the biggest impact is when individual companies are included or excluded from an index. So that reconstitution that happens from time to time. How is a company stock price affected when it is added or deleted from an index?
Jim Rowley: A couple of ways that I think, at least on the research side, we think about this is maybe going back to Andy's point where everything was kind of a, you're in the S&P or you're not in the S&P type of world. And I think, again, nowadays, this idea that index providers have what I might call a full family. You have the US total market.
Typically, a stock is entering one subcomponent index, it's exiting another. Meaning stocks migrating up to the S&P 500, they're leaving the 400. Or if they're being removed from the 500, they're being added to the 400.
And you have this effect now, it's two way buying and selling. One stock being sold from one index means you now have buyers on the other side. And that's not just index funds making those trades.
Going back to the premise of Gus Sauter and indexes should reflect the way that active managers actually act. They're faced with these decisions based upon the strategies that they run, what in their world qualifies as large versus mid versus small. And Gus was pretty clear about that in the real world, an active manager doesn't have this hard line in the sand where he and she says, oh, the stock is below a billion dollars, it's out, I'm cutting it.
They have what index providers call buffer zones as well. But either way, these migrations of stocks across subcomponents of indexes, it's not just a day in the life of index funds migrating those stocks, it's a day in the life of active managers making those decisions, how do they migrate stocks, whether it's across the cap size continuum or the growth value continuum.
Ben Felix: That's obvious now that you've said it, but not something I thought about before. That's a really, really interesting point. That's also part of Marco's paper, I think.
Index to index migration, because there are now so many indexes and index funds, that's one of the reasons we've seen that decreasing index recomposition effect. Just on other impacts of the growth of index funds, we've seen research from Valentin Haddad suggesting, he was also on this podcast a while ago, suggesting that index funds have decreased the price elasticity of stocks. Is that something that you guys track or measure or think about?
Jim Rowley: I'll say my group doesn't track that explicitly, but in many ways, when these phenomena come up, I have a different area of research that I cover, and it's the concept of a stocks return dispersion. Maybe I'll start it off by saying for both of you, if you thought about the Russell 3000 index, my team and I have looked at this since about 1990, and I said, on average, what do you think the percentage of stocks in the Russell 3000 in a calendar year that either outperform the index's return by 10 percentage points or more, or lag the index's return by 10 percentage points or more? Just water cooler trivia for you both.
What's the percentage of stocks?
Ben Felix: That's going to be a big proportion lagging, I think, smaller proportion with more outperformance. That's like JP Morgan's study that looks at these data, I think.
Jim Rowley: If I said it's pretty consistent, it's about 70% of the stocks either do better than 10 percentage points off the index or worse than 10 percentage points off. The way that we see that is, when we think about what active management is all about, active management is about identifying and being overweight, the stocks that outperform, and it's identifying and being underweight, the stocks that subsequently underperform. When we think about this growth of indexing over the course of the past 25 years, and then I think about, well, what's the dispersion of stock returns have been?
It seems like there's ample opportunity for active management to take advantage of stocks that are both outperformers and underperformers.
Andy Maack: If you look at the REIT index, which is one of the highest index sectors out there, if you look at the top performing 10 names, they're probably up over 32%. The bottom 10 names are down over 25%. I think there's a lot of room out there for active managers to find the value in these indices.
Ben Felix: You guys are saying that dispersion has been pretty constant since the 1990s?
Andy Maack: Correct.
Ben Felix: Huh.
Dan Bortolotti: Sounds like it's a stock picker's market.
Jim Rowley: Always and never.
Ben Felix: How do you think that high index fund ownership share affects the behavior of stock prices? We just talked about dispersion there, but are stock prices getting more volatile? Are they getting more sensitive to flows?
Jim Rowley: For me, one of the most interesting, and I wish I had the visual here, is research we've done on what does proportion of ownership look like in the US stock market? I know that when I show this chart, most are flabbergasted when they see it. Maybe I'll do my best to describe it here.
Imagine I'm showing you a dot plot where the x-axis is simply Russell 3000 stocks. It's number one, two, three, all the way to number 3000. Then your y-axis is simply plotting for that given stock, what's the proportion of its shares that are owned by something that is legally and technically called an index fund?
If all investors were truly passive, it would be a flat horizontal line because in a market cap weighted indexing world, all stocks have the same proportion of its shares owned, but that's not what we see. We get this bode effect where as you start small and approach mid, there are increasing proportions of ownership. Then that level crests and it actually starts to fall as you move towards the large cap space, which meaning this idea of index funds only own the largest and somehow make the largest larger.
Turns out the greatest amount of ownership is more in the mid cap space.
Ben Felix: Whoa, that's interesting.
Andy Maack: I always think more from a practitioner's perspective, but around 18 billion shares trade on any given day, about $750 billion notional. Index is probably somewhere around 1% to 3% any given day. The vast majority of trading that happens in any exchange on any day is active.
There is definitely price discovery that is happening in real time each and every day that has nothing to necessarily do with index or index holdings.
Ben Felix: I don't know if you guys are aware of Mike Green. He hammers on these ideas a lot. We had him on this podcast a while ago.
The thing that he convinced me of a little bit is that it's not necessarily price discovery that's the issue. It's that prices are getting more sensitive to flows because of decreasing price elasticity with increasing indexing. That's the concern more so than a more traditional measure of market efficiency.
I don't know if you guys think about that.
Jim Rowley: It's interesting. I was just recently listening to the podcast Vanguard versus DFA. Part of the commentary that was going on about it from articulating the discussion correctly was this preference for investors to be picking risk factors rather than picking individual stocks.
It resonated with me because I go back to my early days at Vanguard working specifically in our ETF product management group. Working with financial advisors, what we maybe now take for granted way back in 2008, 9, 10, advisors were building their portfolios, their active portfolios, but all the pieces in the portfolio were index ETFs, like traditional market cap weighted index ETFs. It was clearly evident to me that whether we want to call that price discovery or not, if Andy's a DFA-er and he's heavily tilted towards small cap value and Jim doesn't like that at all, I'm heavily tilted in my portfolio to large cap growth, even though our portfolios might be both nothing but index funds.
That's relative valuation in action. We're both imposing our views of what we think the market will both give us in our portfolios and using index funds. To me, that's still the very nature of relative valuation and even price discovery.
He prefers small in value and I prefer large in growth. We're an active market.
Andy Maack: Anecdotal, but I would point to some events like Silicon Valley Bank when that happened. Within two days, that stock had fallen 97% and there wasn't a market for it. It didn't matter who was holding it.
That was pretty much gone. I think real events, real news, real active positions still drive prices.
Ben Felix: We've been talking about this idea of price discovery and how our index funds affecting prices. This question really comes from our episode with Mike Green. His concern is, as I mentioned, decreasing price elasticity, which is causing prices to go up.
We already addressed this a little bit, but I'm going to ask it anyway. Causing prices to go up now, and that in some future state where index funds start having outflows because of the decreased price elasticity, there would be big price declines as money left index funds to something else. Do you guys think about that scenario and does it concern you at all?
I'm super interested to hear both of you, but Andy's perspective on actually executing these trades.
Jim Rowley: Maybe my views are a little tilted because I'm more in the research space and Andy's actually on the desk. The first thing I think of is somewhere embedded in that thought process is that somehow only index fund investors sell and active fund investors don't sell, which we know the opposite to be true. The propensity for shareholders and index funds to trade and transact is less than the propensity of those inactive.
I always maybe challenge the notion a little bit that, first of all, index funds are not an asset class and history demonstrates that even the assumption that only index funds would sell seems a little far-fetched. But then the second part I think about is, to me, those concerns are rooted in the active manager community. I don't know if it's a fear factor or what their incentives are, but again, active management is a relative game, not a nominal game.
Good active management doesn't necessarily care if prices are going up or down. It's given they're going up or down, can I do better and add relative value? That's the nature of active management.
I don't know, Andy, if you have anything on top of that.
Andy Maack: What's an outflow? No, just kidding. The vast majority of my career here at Vanguard, we've definitely seen a lot of inflows into the portfolios. One thing I just feel is our clients tend to be very resilient.
So even during whether it was COVID or the GFC, we saw a lot of inflows. I don't know if we saw a significant amount of outflows that were coming out of our funds in droves. To me, it would have to be some type of bigger, broader economic scare that would probably be the catalyst behind that.
And you'd hope there'd be somebody that would be out there buying. But if nobody's buying and everybody's selling, then yeah, you're going to have a crash in the market. We saw a couple of those in the last 15 years, 44% down in a year and a half in the GFC, some significant outflows.
But ultimately, I think clients are resilient around the world. They see buying opportunities and I don't necessarily think it's going to be index holders that are the catalyst behind those type of moves.
Dan Bortolotti: Now, you guys have touched on this already in a couple of ways. We've talked about index funds and their so-called label of being passive. But how passive is the way investors are actually using these funds?
Jim, you'd mentioned that portfolio managers, for example, might use passive funds as building blocks in an active portfolio. Presumably, retail investors at the individual level are often doing the same thing. Are you able to measure that at all?
Do you know how your end investors are using your funds or is that not something you have any visibility to?
Jim Rowley: It's tricky because, again, if I thought about what's maybe something most don't know about Vanguard is our biggest business is the one that serves financial advisors. I know Vanguard's origins come from a direct retail investor. But in terms of the business, that's the biggest.
And I referenced before where I got my start in Vanguard is the one that serves third-party financial advisors. And it was there I got that first experience of seeing just the firsthand, wow, they're great. They're using Vanguard index ETFs, but that's clearly an active portfolio that they're building.
And you get a real good sense of trends in the financial advisor community and the way that they think about active management. And as you guys have discussed before, wanting to build portfolios on the basis of risk factors, not explicitly stock picking. And it's influenced my research career, even with, I think it's a 2022 article in the Journal of Beta Investment Strategies, how investors use passive for active.
I've been seeing this for the better part of 15 years.
Ben Felix: Can you talk about that paper and how you guys measured the fact that index funds are being used actively? Because that was a pretty cool research idea.
Jim Rowley: Yeah, thanks. Maybe the simple way to do it is say, we take a look at US equity funds. And it's pretty easy in Morningstar to start out with, again, the binary categorization, something that's legally and technically an index fund.
And then if it's not, it's an active fund. And we build three portfolios. From the index fund category, we try to identify funds that are strategically, again, it's the characteristic of the fund, a total market index fund.
And whether it was a Russell or a Crisp or a S&P total market, but funds whose objective it is to track the total US stock market. And then from that same sample of index funds, once we've carved away total market index funds, we're left with the other group, which we call non-total market index funds. And yes, to answer, I know the question's probably popping into some people's head.
The S&P 500 is a non-total market index fund. So we have an asset weighted portfolio of total market index funds, an asset weighted portfolio of non-total market index funds. And we have a portfolio of active funds.
And what our hypothesis was to say, hey, if you look at the monthly performance of the asset weighted portfolio, as expected, the portfolio of total market index funds tracks the total market index. I think we picked Dow Jones total stock just by default as a third-party neutral index. And the dots sit right on zero in terms of what their excess return is.
And we would all say, well, that's what's expected. Probably in retrospect, maybe I should have not put the labels on the portfolios in the research paper and just showed the two lines of active funds and non-total market index funds. You see them moving around plus or minus over the course of that time period.
And you'd look at them and say, well, both of them look like active experiences. I really don't know which one for sure is made up of what we would call conventional active funds and which one is made up of non-total market index funds. But the aggregate asset weighted experiences, they both have this active experience of bumping up and down plus or minus around zero.
Ben Felix: It's like the total asset weighted portfolio of non-total market index funds behaves like a portfolio of active funds, which suggests that investors are using those non-total market index funds in an active way.
Jim Rowley: And what's maybe ironic, it's a little bit bizarre, but I know you've talked about Sharpe and the arithmetic of active management. In that paper, we break our sample down into two time periods. There's a pre-2009 and a post-2009.
And we do that because somewhere in 2009 is the point in time where if you were to look at the community of non-total market index fund assets, prior to 2009, the S&P 500 index fund assets were more than 50% of that group. And then post-2009, S&P 500 index fund assets are less than 50%. But when we then said in both those time sets, just simply what's the mean monthly return of all three of those portfolios?
And I don't know the exact numbers, but they're basically all equal. If we view funds as a proxy for the total market, they're obviously not all assets in the market, but using it as a proxy as Sharpe predicted, gross of expense ratios, the mean monthly return of the asset weight, those three asset weighted portfolios, they're pretty much sitting on top of one another. The difference is the tracking over the course of time.
Ben Felix: Yeah, that's interesting. We hear about the share of index funds owning such a large portion of the stock market and how that's been increasing. And that's one of the things people worry about, like we were talking about earlier.
How does the market share of total market index funds compare to that of non-total market index funds?
Jim Rowley: The shorter answer is it's far less.
Ben Felix: Far less in total market?
Jim Rowley: If we went back to assets, you would find that total market index funds have far less in total assets vis-a-vis assets in non-total market index funds.
And to me, that's one of those critical discussion points, whether it's academic research or just the discussion in media headlines or in the practitioner industry is, oh, it's passive or active. And my thought is there are hundreds, if not thousands, if not tens of thousands of index funds around the world. And even if we then break them down into their subcategories of strategies and objectives, and then we add in there, there's probably different index providers within the same strategic space.
You realize that the world is going to passive. It's really not anything about that. These are, dare I say, they're tools for active management.
But I wouldn't want anyone to think that's a bad thing when we all have unique preferences in our personal lives that dictate, well, what's the type of portfolio that I want to set up? And done well, using these different strategies is a benefit to all of us. Generally speaking, they're providing great diversification benefits at low cost.
They're still the responsibility of how you put them together in a portfolio. But when we take a step out and we realize that most of what investors are using and how they're building it, they're not, quote unquote, being passive by just simply owning the total market.
Dan Bortolotti: Andy, I think it was you that mentioned earlier that at one point you had transitioned from MSCI to FTSE indexes for one or more of your groups of funds. How frequently do the underlying indexes change for your funds and what goes into that process? What would encourage you to switch from one index provider to another?
Andy Maack: Yeah, it's happened a couple of times during my career. I've been at Vanguard 23 years and I think I've seen it maybe a handful of times. It could be methodology, it could be fees, it could be preference from shareholders, but it's a number of different factors that probably weigh in on it.
Probably fees being one of the best and one of the biggest. We want to make sure we're not overpaying and making sure our clients have the best chance for success.
Ben Felix: We're going to ask some questions related to a paper from Marco Sammon, another paper from Marco Sammon on changes in market composition and how that affects index fund returns. How do Vanguard's funds incorporate changes in market composition stemming from things like buybacks, share issuance, IPOs, whatever else happens like employee stock compensation, all that kind of stuff?
Andy Maack: Every index provider is slightly different, but for the most part, they're trying to make those changes as soon as they occur. For a secondary offering, if it's greater than 5%, it's happening that day's close of business, which is great for us because like I said earlier, we have the opportunity to participate in that secondary buy directly from the company, typically at a discount from the previous night, but we're also not having any impact on the security by purchasing it since we're buying it from the company. IPOs, depending on the index provider, I think Russell might be the longest at their quarterly rebalance.
CRISP, if it's fast-tracked and meets certain criteria, it's going to be at it within five days, but ultimately, that's another one of the value-add strategies that I talked about earlier. We're going to participate in most IPOs for the portfolios and hold that IPO until it's included into the benchmark. We tend to see outperformance from holding those IPOs as a whole, and again, it's a liquidity opportunity for us to get into that security without any impact into the name.
Buybacks, they'll tend to be on quarterly rebalances, and then depending on the different index provider, that could be an annual reconstitution with Russell, it could be a quarterly with CRISP. One of the things that's unique about CRISP is that they actually take their rebalance and they spread it over five days. That way, we're able to minimize the amount of trading that we're doing on any given day to try to lessen the amount of impact that we're having on any security.
Ben Felix: On IPOs, you're participating in the IPO or buying it on the secondary market?
Andy Maack: We participate in the IPO in the primary market.
Ben Felix: Wow. Okay.
Andy Maack: We typically would not participate in the secondary market after they start trading until they're added to the benchmark.
Ben Felix: Interesting. Okay. Which IPOs do you participate?
How does that happen?
Andy Maack: We evaluate all of them depending on the name and the size and its likelihood of being included. We'll determine whether or not we participate in that IPO. We're not necessarily making a call to say this is a great company or not.
We're saying this IPO based on these characteristics will be added to this benchmark. We will need to buy this security in five days from now. This is a liquidity opportunity and historically IPOs have actually held the IPO price up into inclusion time.
Ben Felix: Did not realize that. That seems like a great thing for index fund investors. I'm assuming it is much better than buying in the secondary market at least.
Andy Maack: Yeah. To give you perspective, even in the secondary markets where we're participating and buying directly from the company at a discount, we see that strategy on average adding about one to two basis points a year of performance back to the portfolio. We see that obviously every year is different depending on the market, but that's something that we typically do that adds value year over year to the funds.
Add a little bit back of the expense ratio to some of these products.
Ben Felix: That's incredible. We had Gerard O'Reilly from Dimensional on fairly recently talking about a whole bunch of the stuff that they do on implementation. One of the things he talked about that was interesting that I hadn't really realized was what they do around cash mergers, where they'll take special precautions around not adding further positions to a cash merger because that stock starts to behave like cash.
Does Vanguard think about that kind of thing?
Andy Maack: Yeah, absolutely. We look at every single change, whether it's cash, cash and stock, especially in corporate action space, and try to figure out what is best to do as far as holding, selling, or trading that stock. Where the biggest opportunities come into play are a lot of the complex corporate actions, cash and stock, ones where you're elected.
That's where we try to evaluate very closely which is better, cash, which is cash and stock, all stock. We're trying to anticipate what that exchange ratio would be to try to add a little bit of value in the portfolios. We've been very successful in that space as well.
Ben Felix: It's crazy how much thought goes into this stuff. I really don't think most investors in Vanguard's products realize. On Marco's paper, they basically show or they suggest that index funds are bad market timers is what they call it because of the way that they respond to changes in market composition.
They suggest in the paper that it could come with pretty meaningful costs. I think they estimated around 60 basis points annualized. They show that if you delay incorporating changes in market composition by up to two years, you can eliminate a lot of that cost.
I thought that paper was fascinating. How does Vanguard incorporate that kind of research or consider that kind of research into the portfolio management process for index funds?
Jim Rowley: I did a couple of days ago talk to Marco about it. Maybe I'll offer three points. Hopefully, Marco listens.
I don't think he'll disagree with what I'll say here. Number one, I would say to be clear, the paper is about index construction methodology, not index funds themselves. Marco does a great job in there of saying they use index funds because the index funds themselves do a fantastic job of being the real life version of this on paper index.
The second thing that's important is when we have these wonky discussions about indexes and construction and moving parts is, okay, the window of when new issues are implemented, it's one of those real life decisions that has to be handled. When we think about Marco's work and saying, well, maybe if you delayed the window, the fund could realize better performance. That then gets us into this existential question of, but that would mean the index fund is taking on more active risk because the index methodology as is right now is this window.
Because I could even make this theoretical case, why isn't even five days? If this idea of an index fund should reflect the investable opportunity set, then in theory, there's no reason the minute a stock goes new issue, that's the market. It should be included by the index provider right now today.
Then the third thing that I mentioned to Marco, and I just thought about this for a little bit, was we've all contemplated this idea that insiders know best. I don't mean nefarious dealings. I just mean you're a corporate CFO or a treasurer and you decide to issue new stock or you decide to buy back stock.
Chances are you want to issue new stock because you think your stock is overvalued. You have information the rest of the market doesn't. If you're buying your shares back, maybe you probably think the shares are undervalued.
What I mentioned to Marco is to see that finding for index funds because they're reflecting the index's methodology to recognize or realize negative abnormal return of what they buy versus what they sell, kind of makes sense that a company would issue new shares that are overvalued and therefore when they're issued, those who consume and buy realize a negative abnormal return. I'm not saying that explains the entire effect, but it jumped out as me that result makes sense when we think about it that way.
Andy Maack: A lot of paper talked about excess turnover. If you look at broad market index funds, the turnover is really low. You're talking maybe 5% a year or so, maybe a little bit higher than that.
But if you think about that type of turnover, even if the utter performance was there, it's not that significant. I think from a practitioner perspective, I would say, wow, if we had a rebalance that was two years out, that could be a very, very sizable rebalance. Are you just trading then impact costs for these other costs and how does that play out in the market?
That's how I would think about that. If you go style, so if you go growth or value where you tend to have the highest amount of turnover, sometimes 54%, I would tell you that you're in that portfolio because you already are making an active bet and you want your portfolio to reflect that active bet as soon as possible as opposed to having a jumbled portfolio of growth and value securities. But watch your turnover in your funds.
I think it does matter. Reduces transaction cost, taxes and impact.
Dan Bortolotti: What do you think some of the practical trade-offs would be if you did decide to reduce the rebalancing frequently in order to address some of these concerns that Marco raises in his papers? Is it something that practically can be done? Does it reduce cost?
Andy Maack: One, at least initially, we wouldn't necessarily be able to participate in the secondary offerings, which we have shown historically has added value to the benchmark and also reduced transaction costs. I think that would be initially the first and I think it would make our rebalances when they happen significantly bigger, which depends. Does liquidity show up?
It shows up today on our rebalances, so it would probably show up in the future. But I think that would be the unknown for me and then not being able to participate in IPOs in the public offering. Cash tenders, I'd have to see how it would ultimately work, but I think it would make things a lot more challenging.
And in fact, what we've actually seen from index providers is actually going the other direction. I think Russell just announced that at least their styles, they're going to a semi-annual rebalance from an annual rebalance. So their best thinking is get the index as close to the market as soon as possible.
Ben Felix: I don't want to act like I'm trying to squeeze more out of Vanguard because you guys have already done so much for investors. But other than fee reductions, which you guys have obviously been so incredible with, and I mean, revolutionized the investment industry with, but they don't have much further to go. And Andy, you've mentioned a whole bunch of items, but I still want to ask the question, how can Vanguard continue to increase the value it adds other than fee reductions, which are basically zero now?
How can Vanguard continue to increase the value it adds for index fund investors?
Andy Maack: One of the ways we do that today is through our securities lending program. So we have, again, a global team of security lending folks in the US, London, and Australia that are out loaning our securities and they add a significant amount of value back to the fund. I think we're unique in that we don't have any split, like Vanguard doesn't take a share of that.
It covers the cost of that program. But after that, a hundred percent of the revenue is put back into the portfolios. I do think that makes a significant difference.
And we kind of take pride in ourselves if we can add back the expense ratio of these products via the value add strategies plus securities lending. That means a lot to us as fund managers. Some of the other ways we're doing that is through advocacy.
We touched a little bit on working with exchanges in other countries to try to make them more efficient, more transparent, more fair. We're always trying to access different markets to get price transparency. So I think just being a good global citizen of all investors at the end of the day.
Jim Rowley: And if your listeners might have some interest in sort of the quantification of what Andy talked about with securities lending on the Vanguard corporate website, where we have a lot of our thought leadership published, can search for understanding securities lending in three charts. It does a great description of showing number one, just what's the amount of basis points of value added back for large, mid and small cap funds, both Vanguard and then in the industry, ex Vanguard. And then the second chart is showing a little bit of differences or the outcome of the differences of lending philosophy.
Vanguard tends to be what's called a value lender. We have a tendency to lend out less. We focus on stocks that are more difficult to borrow.
And the charts then best way to describe it would be given the dollar is out on loan, how much are the funds earning? And Vanguard funds are earning percentage points of return. And again, for listeners who think, oh my gosh, Vanguard is taking a lot of risk.
No, that's not the total amount. Again, it's the given you put a dollar out because of we're lending securities that are difficult to borrow. It's a huge value program.
And then the third chart series is what Andy talked about is, given the funds earn large caps are like low single digit basis points, mid caps are mid to high level single digit basis points and small caps might approach double digits. You think to yourself, okay, how much of the expense ratio of the fund can be offset? And you get a really good sense of if X percent is the expense ratio, Vanguard funds make it up half that difference, 40%.
I don't remember the numbers exactly, but again, understanding securities lending in three charts based upon what Andy talked about, just some really cool visuals to get a sense of what is that value, Ben, that you're talking about with index funds. What are other ways value can be realized?
Ben Felix: We'll dig that chart up and put it in the YouTube video too.
Dan Bortolotti: What strikes me, you could take all of these value add strategies that you've discussed and employ them all. It seems to me that on some level, if you are tracking an index and low tracking error is a number one priority, you're a little bit constrained in what you can do and with those value added strategies. I wonder, it would be fun to think about creating a total market fund.
I wouldn't go so far as to call it full blown active where the portfolio manager had discretion to pick up stocks. They would need to hold the universe of stocks, but they could have a little bit more freedom at the margins and it wouldn't necessarily be the goal. For example, if you had eight, 10 basis points of tracking error in one quarter or one year even, that would be tolerable as long as the expectation was you would be able to use those strategies to outperform VTI over some longer period of time.
I don't know if that's just describing an active fund, but I'm seeing it as more only slightly active and much more towards the passive end of the continuum.
Jim Rowley: I think what you've just described was my minor tirade earlier on about characteristics not labels. I think that perfectly describes what I was trying to talk about is I'm not sure why we necessarily constrain ourselves into this binary world of active or passive. What you've just described is it's characteristics and objectives and there's probably a market out there for investors who would be looking for the exact strategy as you described it.
Ben Felix: DFA does have a fund called DFUS, which is their US total market ETF. It's like that. Do you think Vanguard would ever consider doing a non-indexed total market fund that like Dan said, really gets to leverage all the value-added stuff that you guys are already doing?
Jim Rowley: We can take it back. Look, we're always interested in when we think about new products, what products have enduring investment merit. Obviously, we're going to put a lot of consideration into what risk premium could be harnessed.
Does it offer diversification? Can it be implemented at low cost? Obviously, we have an enormous active fund franchise here at Vanguard and I'm not going to say no, we'd never consider it because if the characteristics are there, absolutely, we'd consider it.
Dan Bortolotti: We want one basis point, by the way, if you use the idea.
Ben Felix: I think it's such an interesting idea just because in the case of dimensional, they're doing lots of cool stuff on implementation too, but most of their funds other than that one US market ETF obviously have the factor tilts. There are lots of investors that I think want great implementation without being constrained by an index, but don't necessarily want the tracking error that comes with factor tilts. The second to last question for you guys, what's the biggest concern?
We've talked about a lot of the value-added stuff that Vanguard is doing. What's the biggest concern that each of you have about index fund implementation and trading?
Andy Maack: For me, it's things that are outside of my control that go wrong, especially on rebound days. It just tends to be a very large amount of trading for us. Maybe from a systems perspective, a couple of years ago, we had an exchange that went out for a period of time during one of the rebalances.
We're very conservative with our orders, especially around those days, so we got them out even that day well before the outage. I think it's things like that that occur that are somewhat outside of your control, outside the norm that cause a lot of commotion and potential issues that just keep me up at night. Again, we're big, a lot of trading goes on, and it's really around those rebound days that keep me up at night.
Jim Rowley: I would just want to comment on the idea of the products then being used by investors. I think Jason Zweig had an article in the Wall Street Journal the other day. Basically, what it's speaking to is just because something's labeled an index fund doesn't make it safe.
It doesn't automatically make something a panacea and nothing can go wrong. For investors who are building portfolios, you still have the responsibility of the good old basics of asset allocation and diversification and risk. Whether it's an index fund or an active fund, that's just a piece that goes into something bigger.
With that portfolio construction, again, focusing on characteristics and not labels, there's a lot of responsibility and do that. The tools are means to an end.
Dan Bortolotti: All right. Well, if you have listened to some past episodes of the podcast, you know we always wind up with the same question. We'll take each of you in turn.
How do each of you define success in your own lives?
Andy Maack: From a personal perspective, it's really around experiences. I'm not somebody who has watches or flashy things. It's really about creating memories that I really enjoy.
Then from a professional perspective, if you ask my 22-year-old self when I started here at Vanguard, it was easy. It was $100,000 a year. That was it.
It was $100,000 a year and that was success. I think what I've realized and what I've really come to appreciate after 23 years at Vanguard is how much aligned we are with our shareholders. I think our former CEO, Tim Buckley, on his first day, said his dad had given him some advice when he started his work.
He said, you can either save lives or help people live better lives. Anything else and you're wasting your time. I think that statement really resonated with me that although we don't save lives here, I do think we help people live better lives through retirement and college savings and first-time home buying.
Just having that structure that perfectly aligns our clients' best interests with Vanguard's best interests gives me so much peace of mind at night. I've never been put in my entire career to say, hey Andy, do this and it benefits Vanguard. Do this and it benefits your clients.
Those things have always been one and I really appreciate that and I think it makes my life way less complicated.
Jim Rowley: I think the word for me is balance because somewhere between, we might all call it work-life balance, but I'll pick up, Andy, what you said. If somebody asked, Jim, what's the number one thing you like about working at Vanguard is I do public speaking. I come on shows like this.
I write published research. Whatever I have written or said in public representing Vanguard, I do with my own money and I tell my family to do it their money. There's nothing I've ever done where publicly I do it for Vanguard, but I go home and say, oh, but everybody just do this because this is what I do at home.
I love what we do at Vanguard. I love being a part of this company. My balance is at home.
I have a wonderful wife who has a fantastic career. My two kids, one's old enough to have started his great professional career. My daughter is a senior to be in college and to me, the word balance is important because crew members at Vanguard, the crew on our research team, I always tell them, if you're happy and healthy and things are going well at home, you'll be motivated and engaged at work.
I'm a big believer in you want both of those to be in good balance because each one feeds into the other for an aggregate better life.
Dan Bortolotti: Thanks for sharing that, guys. I think I speak for a lot of people in saying there's no question that Vanguard's presence in the industry has bettered the lives of millions of investors for decades. We're finally starting to, well, not starting, I guess 15 years now, we have seen that effect come here to Canada.
I think for a long time, we've looked south of the border and said, it would be great if Vanguard would come here. When they finally did, I think it's had a profound impact on the ETF industry. Thank you for that.
Andy Maack: That's great.
Dan Bortolotti: Thank you.
Ben Felix: Awesome, guys. This has been a great conversation. We really appreciate you coming on the podcast.
Jim Rowley: Thanks for having us.
Andy Maack: Thanks for having us, yeah.
Disclosure:
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