The indexing revolution: Gus Sauter on indexing

Rebecca Katz: So, Gus, I thought we would start with you, and maybe you could take us through with an index fund actually is, and then a little bit about the evolution of index funds over time.

Gus Sauter: Sure. Thanks, Rebecca. The concept of indexing was developed really in academia in the 60's and 70's, and all this theory went into it, and basically it boiled down to that the most prudent way to invest in the stock market, or the bond market for that matter, was through an index fund. In other words, buying the entire market.

So, this idea of an index fund was created. And the idea really was, invest in a very low-cost way of gaining exposure to the market. So an index fund was run by a computer. There are people that do the trading and make sure the computers are running correctly. But it's very low-cost, and therefore has a very low expense ratio associated with it. And so, whereas the first index fund concept was really the total market, indexing has been taken to narrower segments than that. So, it used to be just the total stock market; then it became segments of the stock market, but also bonds as well, and segments of the bond market.

But today we've got probably more index funds than we need, and they really have provided competitive returns, and that's because of the cost advantage. If you'll look at the monitor here, you'll see that the cost of running, say, a large-cap U.S. equity fund, an index fund, historically has had lower costs than an actively managed fund. And you can look at different types of investments on the screen now, and you'll see that in all cases, the index fund is substantially less expensive than the actively managed funds in terms of the expense ratio.

So, is this important, the fact that you're getting exposure to the market in a low-cost fashion? A lot of people say, well, yeah, I bet you get what you pay for, and really I'd rather go with an active manager who's doing a lot of research and who's going to add value for me and overcome even their high cost of management.

So, it turns out that there's a simple layman's argument as to why indexing is still very, very competitive. And if we can put up the next slide on the screen, you'll see that the argument rests on the assumption or the realization that outperformance is a zero-sum game. In other words, in aggregate, investors own the market. Take all of our holdings, take all investors in the world, and add our holdings together, and what do we own? We own the market. So as investors, we can only get the market rate of return. Now, some of us may outperform the market, but others have to underperform the market, obviously, if we're collectively getting the market.

Rebecca Katz: You've explained this as, so, "if we go buy IBM stock, you win and I lose—or vice versa."

Gus Sauter: Yes, well, if one person identifies a stock that's cheap, and they add it to their portfolio, and they're right and they outperform, somebody else has to sell it to them. So in that case, the person that sold it to them would lose and so they would underperform the market.

So, before costs, half of us might outperform the market, half might underperform the market, but a lot of us would be right around the market rate of return. The problem is, there are actually quite high costs to investing. You saw other costs on the prior slide that showed the costs of expense ratios. But there's another cost as well, and that's transaction costs. Indexing is largely a buy-and-hold strategy, so transaction costs are low. Active management has a lot of turnovers, so transaction costs are high.

And so it turns out that the outperformers—marginal outperformers before costs become underperformers after costs. And that's what you saw on that chart—that the chart was ever shifting to the side, and that was indicating that costs were taking away returns from investors. So, after costs—really a majority of investors almost have to underperform the marketplace. It still allows for the fact that some investors can outperform, but they have to do it at the expense of other investors, and they have to do it so well that they overcome the costs of investing.

Disclosures

• All investments are subject to risk. Past performance is no guarantee of future results. The information provided here is for educational purposes only and isn't intended to be construed as investment advice.
• Past performance is not a guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
• Opinions expressed by our guests do not necessarily reflect those of Vanguard or its management.
• For the table labeled "The performance challenge," equity benchmarks are represented by the following indexes: Large Blend: S&P 500: 1/1995-11/2002, MSCI Prime Market 750: 12/2002-current; Large Value: S&P 500 Value: 1/1995–11/2002, MSCI Prime Market 750 Value: 12/2002–current; Large Growth: S&P 500 Growth 1/1995–11/2002, MSCI Prime Market 750 Growth 12/2002–current; Mid Blend: S&P Midcap 400: 1/1995–11/2002, MSCI Mid Cap 450: 12/2002–current; Mid Value: S&P Midcap 400 Value: 1/1995–11/2002, MSCI Mid Cap 450 Value: 12/2002–current; Mid Growth: S&P Midcap 400 Growth: 1/1995–11/2002, MSCI Mid Cap 450 Growth: 12/2002–current; Small Blend: S&P Small Cap 600: 1/1995–11/2002, MSCI Mid Cap 1750: 12/2002–current; Small Value: S&P Smallcap 600 Value: 1/1995–11/2002, MSCI Small Cap 1750 Value: 12/2002–current; Small Growth: S&P Small cap 600 Growth: 1/1995- 11/2002, MSCI Small Cap 1750 Growth: 12/2002–current.