The Truth Behind Three Common Indexing Questions

The Truth Behind Three Common Indexing Questions

Indexing has become an undeniable force in the investment world. Consider: $1.4 trillion in net new cash flow and reinvested dividends went into domestic equity index funds and ETFs in the decade through year-end 2016, which is astonishing when compared with the $1.1 trillion in net outflows from domestic equity active funds in the same period.1

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Indexing’s rise didn’t happen by accident. For example, in my previous roles as global head of Vanguard Fixed Income Group and head of bond indexing, my teams and I were part of the effort to improve index fund management through a range of methods designed to help improve investor outcomes. That included everything from refining index sampling techniques to better approximating the fundamental characteristics of benchmarks to working closely with benchmark providers to strengthen index methodologies.

But the push to improve indexing does not stop there. In my new role as Vanguard’s chief investment officer, my global team and I are dedicated to staying abreast of new themes and issues in the investment world—especially those that directly affect indexing. We revel in exploring the details of what makes indexing tick and finding innovative ways to deliver more value to our clients. So we scour investment journals, attend conferences, and continue to refine our process. Our mission: to optimize the investment outcomes for our clients and investors overall and to do so at a low cost.

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It’s clear, then, that I am a firm believer in the value indexing delivers to both the investor and the market as a whole. Over the last few months, I’ve noticed indexing has received some criticism from a few commentators alleging indexing hurts price discovery, stifles competition via common ownership, and leads to higher volatility. I believe those claims are inherently false. Let’s walk through these claims one by one and set the record straight.

Hurting price discovery?

The concern about indexing hurting price discovery is a naive view. Price discovery is driven by active managers, Vanguard included. I know from my years as a bond guy the vital role that active managers play in keeping security prices aligned with their value. So the thought that indexing could somehow get in the way of that is troubling for me. But the truth is that even though indexing has grown in popularity in recent years, it’s still a small part of overall trading volumes (i.e., portfolio managers’ trading of index funds’ underlying securities). Since indexing represents about 5% or less of equity daily volumes, as shown in the chart below, there is still considerable price discovery and liquidity provided by active managers.

Breakdown of overall individual stocks’ trading volume

Sources: Vanguard and Bloomberg, 2017.

By Greg Davis of Vanguard, read the full article here.

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