The six key components for choosing an index asset manager
Indexing may appear straightforward, but the reality is, there are important differences among index asset managers.
Whether you're evaluating your existing index asset managers, looking to hire an index asset manager, or simply performing due diligence, there are six key components you should focus on before making your final decision.
1 Commitment to indexing
Is indexing a core competency of the firm?
Index asset managers that are committed to indexing are motivated to provide a high level of service to investors and continually work to improve their indexing methodology and processes.
2 Securities-lending practices
What is the risk-reward alignment?
Securities lending is a well-established investment strategy that offers an additional source of revenue for many mutual fund providers. Loans, secured by collateral, are made to borrowers in order to generate incremental returns. Be mindful of the risk-reward trade-off and the significant differences in how securities lending is handled among providers.
In securities lending, investors bear the risk. Ensure your index fund provider allocates the rewards to investors as well.
What percentage of the portfolio is on loan at any given time?
Securities lending, when done prudently and with investors' best interests in mind, can boost fund performance and offset costs. Ask your provider what percentage of the portfolio is on loan at any given time? The higher the percentage on loan, the more risk to investors, not the firm.
3 Long-term performance
Does the index fund manager have a long history of tight tracking error?
Tracking error was once the gold standard of evaluating an index fund’s performance. Index fund performance has evolved beyond looking at tracking error as index fund providers focus on creating better outcomes for their investors. This includes a focus not only on tracking error, but also on benchmark construction and the impact on the market when executing trades.
Has the index asset manager weathered several market cycles and maintained strong performance?
Leading index asset managers invest heavily in their indexing operation and have the track record to justify the investment, particularly during periods of extreme market volatility. It's during periods of stress that index leaders showcase their value through efficient trading and tight tracking error.
Does the firm have an on-the-ground, global operation?
Top index fund managers invest heavily in people and technology across the globe.
5 Long-term costs
Is the firm committed to low costs across the board for the long run?
Some index fund providers offer low-cost products as a marketing gimmick, assuming that any loss they take on the product can be made up with profits on the rest of their product lineup or with other fees on the "low-cost" product. Make sure the provider is committed to low costs and isn't simply trying to get you as a customer only to raise its costs at a later date.
What's the cost of switching providers?
Expense ratios are a key factor in your evaluation, but there are subtleties to consider beyond the expense ratio. When the cost differential between funds is small, execution and an index fund manager's experience become more important drivers of investment results.
6 Aligned interests
Who owns the firm?
Most index fund providers have shareholders to whom they have to answer when the time comes to issue earnings reports. The firm’s duty to those shareholders can sometimes conflict with the interests of the investors in the firm’s products. Find out if the firm is a public or private company and how its ownership structure affects its business decisions.
How does the ownership structure drive pricing strategies, product development, and securities-lending policies?
Your index asset manager's incentives should be aligned with your interests.
For more on how Vanguard measures up on these six key components, download our brochure, which you can share with your clients.