Thursday, May 5, 2011

The Anniversary of the Retail Index Fund

In 1976, Vanguard pioneered the index fund by offering it to retail investors for the first time. The company has not looked back and is now the leading manager of index funds and consistently one of the top 3 investment managers in the world by assets with $1.6 trillion under management as of February 2011. I'd like to take time in this post to reflect on what the availabilty of the index fund has meant to individual investors by posting an interview with two of Vanguard's experts - Sandip Bhagat, head of Vanguard Quantitative Equity Group, and Kenneth Volpert who oversees Vanguard's bond funds.

The whole interview is well worth reading but the best part about the interview is that both experts point out that the rise of new "fundamental" or "intelligent" indexes is not truly passively managed investing. In short, this is just another way for Wall Street to sell us an actively managed product that is likely to fail in its attempt to outperform the true passively managed index fund. As Mr. Bhagat notes, "
The point is that any portfolio configuration that goes beyond the size of a company's market-determined value does not represent a passive approach to investing. It brings with it a belief that the market's prices are incorrect, and that some other factors merit more attention. "

This is key because many retail investors assume that a fundamental index offers a better way to capture the "true" value of a basket of stocks. Therein lies the problem - the true value of a company is really what the stock market dictates it is based on its current trading price. Yes, the future value of a company may be drastically different, but we cannot predict or know the future with certainty. The information that is used to create fundamental indexes is often based on earnings reports or other information that happened in the recent past. By attempting to place a fundamental value on stocks, the fundamental "index" winds up becoming nothing more than an actively managed impostor as stocks are changed based on earnings and other data.

Wouldn't it make more sense to simply take the reflection of the collective knowledge of every investor in the world - the price of a stock in the here and now - and build a true index around that? That's precisely what Vanguard did in 1976 and why they have been so successful. Need more proof? Since its inception in 1976, the Vanguard 500 Index (VFINX) has returned 10.79% on average, annually. What has your actively managed fund done for you lately?

No comments:

Post a Comment