Index Wars By: Gabriel PotterMBA, AIFA® 2018.12.21

Passive Investment Selection

It is no surprise passive investment managers – those that recreate stock market or bond indices as an available investment – have been taking market share aware from active investment managers.  Index-based mutual funds have reached $6 trillion while index-based ETFs are $5 trillion.  We’ve written articles and blog posts about this phenomenon for years, most recently in our September 2018 weekly post, “Race to the Bottom.” 

In broad terms, the overarching reason for choosing a passive investment is to limit costs.  When an investor has decided to follow a passive investment strategy – i.e. basing their investments on a tracked index – there are fewer remaining criterion upon which to sort potential candidates, especially compared to the diversity of approaches and product philosophies found in the wide spectrum of active managers.  For instance, imagine you would like to invest in a US Large Cap S&P 500 Index mutual fund.  There are dozens of these S&P 500 funds, with multiple share classes, from a diverse set of managers including DWS, Dreyfus, Fidelity, Great-West, Invesco, iShares, Mellon, Mainstay, MassMutual, Nationwide, Principal, QS, Rydex, SEI, State Street, T. Rowe Price, Vanguard, and many more.  How do you choose?

Cost Cutting and Business Models

Passive index-based investments are generally cheaper than actively managed funds.  Since the investor has already decided cost is an important criterion, what happens if the same investor makes cost their only, or at least the primary, criterion?  Who is cheapest?   The largest investment firms are aware that low-fees are a critical element for a successful index-based fund, so they have taken extraordinary cost-cutting measures to further slash prices.

Vanguard is a name familiar to most retail investors - i.e. ordinary individuals - as one of the largest provider of index funds and ETFs, but even they must work to attract and retain assets.  For instance, the company periodically rotates the investment index families they target.  For instance, their products used to track the industry-standard Russell indices, then moved to MSCI indices, and finally landed on lesser known CRSP indices in their ongoing efforts to find cheaper index licensing options.  On brand name recognition and the size of purely passive products (i.e. assets under management), nobody beats Vanguard.

This brand name recognition has been invaluable for Vanguard, but competing investing giants have been threatening their hegemony.  Charles Schwab and Blackrock (iShares) have been fighting a cost-cutting war against Vanguard; they’ve been releasing index funds and ETFs which target retail investors.  In other words, they’ve created index funds and ETFs available at low minimum investment levels for an extremely low cost.   

Fidelity is well known to retail investors as a full-service financial services firm and they are known to institutional investors as the largest recordkeeping firm of retirement assets.  As an investment shop, Fidelity had been known as a company behind many actively managed (i.e. more expensive, but more flexible investments) products, so they had been reluctant to cannibalize their existing actively managed products by selling passive products.

This initial stance has shifted.  Fidelity ultimately determined there is a synergy between attracting retail investments (even passive investments, which do not raise much revenue for the firm) and attracting institutional assets, or even cross-selling other investment services, like financial advisor relationships, to retail customers.  Fidelity has become tired of losing market share to their passive competitors.  Thus, over the past decade, they have worked hard to create, expand, and rebrand their passive, index-based investment products. 

In terms of cost cutting, Fidelity has taken the low-fee approach to its ultimate terminus:  zero fee index funds.  In August 2018, Fidelity rolled out their “Zero” funds which give exposure to the total US market and total international stock market.  Collectively, these costless funds have accumulated $1 billion in assets in the first month of their existence.  Moreover, Fidelity has moved re-priced several existing index funds to directly undercut competitor prices by unusually small increments – half-basis points (i.e. one half of one hundredth of a percentage point).  Fidelity can absorb the minimal losses for managing low-cost, or no-cost, index funds to maintain its position as a dominant recordkeeper, full service asset custodian, and trusted advisor for retail investors.

Other index fund providers

That’s what some of the largest passive-investment heavyweights are doing, but there are dozens of competing products.  How did the small and mid-tier shops attract assets? 

Historically, we must understand that many index products were created specifically to cater to investors that were already on a specific trading platform, whether it’s an institutional 401(k) recordkeeping plan or a retail-market platform for individuals.  For many years, closed-architecture – wherein an investor is incentivized (or forced) into only using firm proprietary investments – was the standard for many trading platforms.  For instance, a well known financial company, like MassMutual, had clients of every kind on their trading system.  So, if Mass Mutual clients wanted access to an index fund, it was obligatory for MassMutual to create one for their clients. 

The concept of open-architecture – wherein an investor may access financial products from many firms, not merely those proprietary to the custodian – is a relatively new concept.  However, open-architecture is the best-practice service standard for most financial institutions today.  As time and standards advance, platforms become more “open” to competition, and financial institutions finally had to bring their investment product prices down to competitive levels.  Thus, if the small and medium size passive fund providers want to retain or attract assets, they must provide a benefit, like an on-platform sales discount or revenue sharing arrangement. 

Let us explain.  Imagine you oversee a 401(k) retirement plan on MassMutual’s platform and, due to their open-architecture; you can select any index-fund you like for your plan.  However, if you use a Mass Mutual index fund, the fees generated by that investment might be used to offset other plan administration costs.  These revenue sharing arrangements might end up working for your favor; the least expensive index fund might not actually be your best choice once these revenue sharing credits are worked into your analysis.  

Alternatively, several retail-focused trading platforms, like E-Trade and TD Ameritrade, have created sponsored deals with low cost index providers.  For example, TD Ameritrade offers costless $0 trading on several State Street index-based ETFs. 

Other ways to distinguish index funds

Thus far, we’ve been speaking of passive based index funds and ETFs as if they were perfectly interchangeable.  That is roughly true, but there are a few caveats.  While we have spent some time assuming fees are the primary distinguishing characteristic, there are other factors at play.  Here are just a few potential points of divergence between index-based, passive investments:

First, different index-funds are allowed to reconstitute (i.e. change the underlying securities in the fund) at different rates so that when there are changes to the index, the managers may exercise a little active intelligence in their trading strategy and timing.  In fact, there are alternative strategies built upon the exploitation of required index-fund reconstitution.

Second, there is the practice of securities-lending, wherein an index fund can loan a security to another firm for collateral in the short term to generate additional returns. 

Third, there is cash management.  In 2008, a few major index bond-funds drastically underperformed their peers, even though their underlying bonds precisely tracked index performance.  The problem arose from the residual allocation of cash (0%-5%) in the portfolio.  The cash was invested in short-term money-market equivalents, like commercial paper and short term corporate debt, which crashed during the nadir of the 2008 financial crisis.

Fourth, index funds and ETFs can be operationally different.  One might use derivatives & futures for exposure while another might fully owns the underlying securities outright.  The underlying costs of these strategies differ, particularly when the underlying index includes relatively illiquid securities, like exotic, thinly-traded, or international positions.   

Fifth, there are technical reasons wherein a trader might prefer some types of index funds or ETFs, including the price efficiency of the associated options and derivative market or daily liquidity concerns. 

 What can we do?

So, even purely passive index-based investments are a little more complicated than you might originally assume.  There are details, both operational and practical, which should be considered.  What can we at Westminster Consulting do for our clients given this reality?

First, we maintain frequent communicate with our clients’ recordkeeper and custodians.  If there are special deals or synergies we can take advantage of on behalf of our clients, we want to know about it. 

Second, we have just begun to increase the level of detail on our fee analysis sheets.  For years, the industry standard on fee reporting was measured in basis points – one hundredth of a percent.  Since investment management firms are now competing over smaller increments, we have been begun to include additional digits in our reporting.  Our clients and consultants will be able to see how these investments are competing for assets. 

Finally, and perhaps most importantly, we pay attention to what your passive investments actually are and how they operate.  While other investors may presuppose these investments to be materially identical, we do not.  It is our duty to understand the differences between various passive investments and to explain significant differences, when material, to you.

DISCLOSURES & DISCLAIMERS:

The information contained herein has been obtained from sources that we believe to be reliable, but its accuracy and completeness are not guaranteed.  Westminster Consulting, LLC reserves the right at any time and without notice to change, amend, or cease publishing the information.  It has been prepared solely for informative purposes.  It is made available on an "as is" basis.  Westminster Consulting, LLC does not make any warranty or representation regarding the information.  Without prior written permission from Westminster Consulting, LLC, it may not be reproduced, in whole or in part, in any form. The information in this document is confidential and proprietary to Westminster Consulting, LLC including its business units and may be legally privileged. Any unauthorized review, printing, copying, use or distribution of this document by anyone else is prohibited and may be a criminal offense. Indices mentioned are unmanaged and cannot be invested into directly.  Past Performance does not guarantee future results.

 

 

 

 

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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