Look beyond cost when selecting an index fund manager

April 9, 2019

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Selecting an index fund manager who can skillfully manage to a benchmark requires that investors consider a number of factors.

However, some firms have announced ultra-low or even zero expense ratio index funds in an attempt to propose that index funds are a commodity solely differentiated by price. These firms further suggest that fiduciaries such as retirement plan sponsors are obligated to choose the lowest-cost option.

Such claims are inaccurate, as we explain in a new Vanguard paper, Beyond expense ratio: A contemporary guide to index fund manager selection. The paper provides a framework to help investors select the best index fund manager, suggesting key factors that plan fiduciaries should consider.

Read white paper  

Fiduciaries and investors generally should create and utilize a decision-making framework that takes into account organizational incentives, portfolio management capabilities, securities-lending programs, and a few modest additional considerations.

A contemporary decision-making framework for selecting an index fund manager

Framework for selecting an index fund manager graphic

Source: Vanguard.

We aren't saying that cost isn't important. However, as a result of price compression, savings achieved by switching to the lowest-cost product have been minimized, meaning investment selection cannot focus on cost alone.

Consider that, as index fund expense ratios drift toward 0%, it becomes more challenging to select an asset manager who can provide investors with exposure that closely mirrors the risks and returns of a benchmark index—the primary objective of an index fund.

Expense ratio differences that have a material impact on a fund's relative performance at 50, 20, or even 10 basis points, verge on irrelevance at 1 to 2 basis points. At these levels, performance—and due diligence—depends on less visible and more complex elements of index fund management.

Our paper explores the relevant qualitative and quantitative criteria for selecting an index fund manager, and identifies questions that investors and fiduciaries should consider in addition to expense ratio.

Note: All investing is subject to risk, including the possible loss of the money you invest.