Paula Fuchsberg: Indexing has grown considerably over the last few decades, transforming the industry and how people invest. Despite its benefits, that growth has more recently sparked debate and claims of potential adverse effects on the markets. What’s the real story about indexing?

Hello, I’m Paula Fuchsberg, and welcome to Vanguard’s Investment Commentary Podcast series. In this month’s episode, which we’re recording on May 21, 2018, we’ll look past the rhetoric and examine the historical evidence about index investing.

Joining me is Jim Rowley, the head of active/passive portfolio research in Vanguard Investment Strategy Group. Welcome, Jim.

Jim Rowley: Thanks, Paula, how are you?

Paula Fuchsberg: I’m great. Jim, you’ve coauthored a research paper titled Setting the record straight: Truths about indexing, and you’ve also been spreading this message in other ways. Why did Vanguard, which has been an indexing pioneer and a low-cost leader, feel it had become necessary to address this debate head-on?

Jim Rowley: It seemed like maybe a year and a half, maybe two years ago, as indexing has become more and more popular, it also started grabbing some headlines that maybe weren’t so favorable to indexing. And many of the headlines and the stories had misunderstandings about how indexing works and why. We felt that some of the data usage was superficial in nature, and that there were a lot of faulty assertions related to indexing. And, as the name of the paper implies, we felt that it was our right to sort of set the record straight on indexing.

Paula Fuchsberg: And you break down your indexing discussion into specific sections. Can you lay out what those are?

Jim Rowley: We have three sections to the paper: advocating for indexing, defining indexing, and defending indexing. And we felt it was important to start out with the advocating for indexing, because it always seemed when I was out on the speaker circuit or any type of Q&A, I would get the question, “Hey, Jim, we know that indexing is really good for investors, but … ” And they would move on to maybe the downside.

And I would say, “Well, before we move on, can we stop and actually discuss why we want to advocate for indexing and what the benefits are?” That was a really important place to start for us.

Two, we say defining indexing because the headlines will always talk about the assets and the cash flow going into passive products. And that may be true, but some of our research and analysis showed that that’s not such a simple way to measure the growth of passive.

And then third is defending indexing. I know in many ways, from a public-speaking standpoint, you don’t want to reassert the negative about something, but in many ways it got to the point where it was a pretty easy way to take a point/counterpoint approach to these negative assertions. And we think the paper does a pretty good job with some pretty simple pictures to just point/counterpoint our way through and help investors understand what we think our opinion is.

Paula Fuchsberg: So let’s start with advocating. What’s the key empirical argument for why indexing works?

Jim Rowley: Despite what many believe—and that might be that indexing works because of efficient markets—indexing actually isn’t predicated on market efficiency. It’s predicated on zero-sum game theory. And what [the] zero-sum game says is that all the dollars in a particular market, in aggregate, give you the return of that market, meaning the average of all those dollars is the market return.

And if you think about your laws of math and how an average might work, for every dollar that does better than the average, it has to be offset by a dollar that does worse than average. Then you think about that in terms of stock-picking or bond-picking. For every dollar that’s an outperformer, it has to be offset by a dollar that’s an underperformer.

And that helps you understand that indexing gives you the market average return. And when you relate that to sort of the average active dollar invested, because indexing tends to be lower-cost than active, what ends up happening is, the average index investor does better than the average active investor. And that’s because indexing is predicated on [the] zero-sum game, not market efficiency.

Paula Fuchsberg: And how does that theory translate into the benefits of indexing?

Jim Rowley: One of the biggest benefits I find is what you call relative performance predictability. And what that means is, as I, as an investor, wish to implement my asset allocation, I would design it with large-cap[italization] stocks, mid-cap stocks, maybe international stocks. I want to implement my asset allocation. And when I do that, I want to achieve the risk/return characteristics or experience of that asset class.

Index funds are designed to track a particular market index. The index fund should deliver for me the risk/return characteristic of the market. It has a high degree of relative performance predictability. Active has less relative performance predictability because with active management, when you use funds to implement your asset allocation, active could do better than that market in particular. Active could also do worse than that market in particular.

And that’s why, from that standpoint, there’s less relative performance predictability with active. There’s much more of it with indexing. And to me, as I implement my asset allocation, that’s a big benefit.

Paula Fuchsberg: And you also argue that the debate shouldn’t be framed strictly in terms of active versus passive investing. Can you explain?

Jim Rowley: It’s an easy way to do the analysis to say, “Hey, look at all the assets going into passive. Look at all the cash flow. Let’s take a look at these products.” But one of the other ways that Vanguard has tried to do this is to rip up those labels and start over and put funds in categories according to their cost profile. And anybody who’s familiar with our “costs matter” research at Vanguard know we’ve [taken] active and passive funds and then broken them out by their cost quartiles—lowest-cost, second-lowest-cost, third quartile, fourth quartile, et cetera—and shown the cash flows into products by those categories, whether the products are active or passive.

And that research has shown that cash flow is going into the lowest-cost products, which tells me that maybe it’s not so much about the labels “active” and “passive.” Maybe it’s about investors embracing the importance of low-cost investing.

Paula Fuchsberg: Moving on to defining indexing, is there an agreed-upon definition of the indexing marketplace, or does that vary by the party that’s defining it?

Jim Rowley: I think the traditional way to define indexing is if you looked at a particular market, say large-cap U.S. stocks, you would say that an index fund’s job is to just simply replicate the performance of that part of the market, and an index fund delivers that.

But when you put that index fund in an investor’s portfolio alongside all the other products, what you find out is investors have been using index funds to build active portfolios. A really simple way to think about that would be: You could say, “I’m going to fill the U.S. stock part of my portfolio with a 100% small-cap index fund.” Now, on one hand I could say, “Well, that’s a 100% passive portfolio.” But if all I own is small-cap U.S. stocks, I can also make the argument that’s a fully active portfolio, meaning investors are using index fund pieces to build active portfolios.

Paula Fuchsberg: And when it comes to defending indexing, what negative assertions out there seem most prevalent, and what factual evidence do you present to counter those?

Jim Rowley: We have five in the paper. I won’t give them all away—I’ll ask that the listeners take a look at the paper itself—but maybe two in particular. One is the concept of dispersion. One of the negative assertions is that the growth of passive is leading to more or less correlated markets, and we like to say, “Well, when it comes to trying to outperform the market or stock-picking, correlation doesn’t necessarily matter. It’s the dispersion, or how differentiated individual stock returns happen to be relative to the market.” That’s the more important concept, dispersion.

And the second thing we take a look at is with ETFs. There’s a lot of attention placed upon ETFs because of their popularity, their cash flow, and, in particular, their trading volume. And investors—or those who are paying attention to the market—would see the massive amounts of trading volume in ETFs that somehow must be going to the underlying markets and disturbing or roiling those markets.

And what our research shows—and not just ours; others in the industry would show the same thing—[is] that when you look at the trading volume in ETFs, let’s say [for] every dollar traded in U.S. equity ETFs, more than 90 cents on that dollar is just two investors trading the shares of that ETF with each other. Or put another way, the trading of those shares of the ETF do not go to the underlying markets. They’re just shares traded between investors A and B.

Paula Fuchsberg: So how are indexing critics, or perhaps skeptics, responding to this evidence? What kind of reaction have you gotten?

Jim Rowley: I’d like to think they’re actually pleasantly surprised. I think many of these negative assertions are conceptual, theoretical, and they just get lobbed over the fence at indexing. And in all my travels and public speaking, here we have this wonderful presentation that takes all these assertions head-on with data and research and analysis. And that’s why I say I think there’s a pleasant surprise feeling that, instead of coming back with concepts and theory, we come back with actual data, actual research. And I think many are very satisfied and pleased to see that we’ve put this much thought into it [to] be able to counter it effectively.

Paula Fuchsberg: Any final thoughts you may have, Jim, for an advisor or investor on this topic, given the attention this debate has received?

Jim Rowley: I would ask that investors get not too hooked on the labels “active” and “passive.” I think that can be a little bit distracting in many ways. We want investors to focus on the things they can control, things like their asset allocation, their cost structure. And the labels “active” and “passive” aren’t quite as important because, at the end of the day, what’s most important for your portfolio is setting the right asset allocation, making sure you’re broadly diversified, and making sure you’re implementing with low-cost funds, whether they’re active or passive.

Paula Fuchsberg: Jim, you’ve provided a lot of practical and helpful information. Thank you so much for sharing your insights.

Jim Rowley: Thanks for having me.

Paula Fuchsberg: And we hope you’ve enjoyed this Vanguard Investment Commentary Podcast. To read the paper we discussed, Setting the record straight: Truths about indexing, visit

And be sure to check back with us each month for more insights on the markets and investing. Remember, you can always follow us on Twitter and LinkedIn, or visit our website at any time. Thanks for listening.


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