Active indexing: Being passive-aggressive with ETFs Jim Rowley, CFA Senior Investment Analyst Vanguard Investment Strategy Group FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION.
Agenda Evolution of active choice with ETFs Portfolio-tilt analysis Challenges of active management FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 2
ETF asset and product growth $3,000 6000 $2,500 5000 Assets (in billions) $2,000 $1,500 $1,000 4000 3000 2000 Number of products $500 1000 $0 1999 2001 2003 2005 2007 2009 2011 2013 0 U.S.-listed assets U.S.-listed products Worldwide ex-u.s. assets Worldwide ex-u.s. products Source: Vanguard calculations, using Bloomberg data as of December 31, 2013. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 3
Active indexing: Key concepts for investors Systematic exposures rather than security selection are viewed as the source of potential outperformance Investors have predetermined allocation to such exposures Exposures maintained in strategic, long-term manner, rather than tactical, short-term manner Systematic exposures explain the outperformance exhibited by alternatively weighted indexes FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 4
Summary of portfolio-tilt analysis framework Comparison Representation of broad market Alternatively weighted strategy Market-cap-weighted strategy combinations 1 Russell 3000 Index FTSE RAFI US 1000 Index Russell Indexes 2 S&P Composite 1500 Index 3 Dow Jones U.S. Total Stock Market Index S&P 500 Equal Weight Index Dow Jones U.S. Select Dividend Index S&P Indexes Dow Jones U.S. Total Stock Market Indexes Source: Vanguard. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 5
Comparing style consistency Russell index combinations and FTSE RAFI US 1000 Index Value Blend Growth Russell 3000 Value Index Russell 3000 Index Large Mid FTSE RAFI US 1000 Index Small Russell 2000 Value Index Russell 2000 Index Source: Created with Zephyr StyleADVISOR. Notes: Figure shows style windows from January 1986 through January 2014. Each window represents a 36-month period. The circles represent the style windows for combinations of Russell indexes. Each market-cap-weighted strategy (MWS) combination begins with a 100% allocation to the Russell 3000 Index and makes 20% incremental allocations to various subcomponent size and style indexes until the allocation becomes 100% invested in the size or style index (allocations are rebalanced annually). The red dots represent the style windows for the FTSE RAFI US 1000 Index. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 6
Comparing style consistency S&P index combinations and S&P 500 Equal Weight Index Value Blend Growth S&P 500 Equal Weight Index S&P Composite 1500 Index Large Mid S&P MidCap 400 Value Index Small S&P SmallCap 600 Value Index S&P SmallCap 600 Index Source: Created with Zephyr StyleADVISOR. Notes: Figure shows style windows from July 1995 through January 2014. Each window represents a 36-month period. The circles represent the style windows for combinations of Standard & Poor's indexes. Each MWS combination begins with a 100% allocation to the S&P Composite 1500 Index and makes 20% incremental allocations to various subcomponent size and style indexes until the allocation becomes 100% invested in the size or style index (allocations are rebalanced annually). The red dots represent the style windows for the S&P 500 Equal Weight Index. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 7
Comparing style consistency Dow Jones index combinations and Dow Jones U.S. Select Dividend Index Value Blend Growth Dow Jones U.S. Large-Cap Value Total Stock Market Index Large Dow Jones U.S. Total Stock Market Index Mid Small Dow Jones U.S. Mid-Cap Value Total Stock Market Index Dow Jones U.S. Select Dividend Index Dow Jones U.S. Small-Cap Total Stock Market Index Source: Created with Zephyr StyleADVISOR. Notes: Figure shows style windows from January 1992 through January 2014. Each window represents a 36-month period. The circles represent the style windows for combinations of Dow Jones indexes. Each MWS combination begins with a 100% allocation to the Dow Jones U.S. Total Stock Market Index and makes 20% incremental allocations to various subcomponent size and style indexes until the allocation becomes 100% invested in the size or style index (allocations are rebalanced annually). The red dots represent the style windows for the Dow Jones U.S. Select Dividend Index. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 8
Cost advantage of market cap ETFs Weighted average expense ratios 0.70% 0.60% 0.50% 0.40% 0.30% 0.20% 0.10% 0.00% Capitalization Fundamental Fixed weight Passive Screened Quantitative Selection Weighting Sources: Vanguard calculations using data from Morningstar, Inc., and ArcaVision. Notes: Strategy box classification is determined by an index s construction methodology rather than its style. Expense ratio and asset figures are from Morningstar as of January 31, 2014. Bid-ask spreads reflect year-to-date data from ArcaVision as of January 31, 2014. Morningstar data include U.S. ETFs that were included in an equity style box category and in an index strategy map category, but exclude funds of funds. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 9
Cost advantage of market cap ETFs Weighted average bid-ask spreads 0.35% 0.30% 0.25% 0.20% 0.15% 0.10% 0.05% 0.00% Capitalization Fundamental Fixed weight Passive Screened Quantitative Selection Weighting Sources: Vanguard calculations using data from Morningstar, Inc., and ArcaVision. Notes: Strategy box classification is determined by an index s construction methodology rather than its style. Expense ratio and asset figures are from Morningstar as of January 31, 2014. Bid-ask spreads reflect year-to-date data from ArcaVision as of January 31, 2014. Morningstar data include U.S. ETFs that were included in an equity style box category and in an index strategy map category, but exclude funds of funds. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 10
Challenges of active management: The greater the tilt, the greater the peak-to-trough 12-month rolling excess return of various weightings of the Russell 2000 Value and Russell 3000 Indexes 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% December 1979 January 2014 80% 3000 /20% 2000 Value 60% 3000 /40% 2000 Value 40% 3000 /60% 2000 Value 20% 3000 /80% 2000 Value 100% 2000 Value Past performance is no 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. Note: Figure reflects monthly data from December 1979 through January 2014, in rolling 12-month increments. Sources: Vanguard calculations, created using Zephyr StyleADVISOR. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 11
How will clients react when a strategy is out of favor? On average this portfolio has added alpha for a client This hypothetical illustration does not represent the return on any particular investment. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 12
Adding a broad-market index fund can temper the drawdown On average this portfolio has still added alpha This hypothetical illustration does not represent the return on any particular investment. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 13
Conclusion Attempts to outperform can be done on the basis of systematic exposures rather than security selection Market cap ETFs may provide greater style consistency with lower costs Active indexing with ETFs has transferred a source of active management to the advisor FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 14
Important information For more information on Vanguard funds and Vanguard ETF Shares, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing. Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling. All investing is subject to risk, including possible loss of principal. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Prices of mid- and small-cap stocks often fluctuate more than those of large-company stocks. Past performance is no 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. Diversification does not ensure a profit or protect against a loss. Morningstar data 2014 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. CFA is a trademark owned by CFA Institute. Vanguard Marketing Corporation, Distributor. 2015 The Vanguard Group, Inc. All rights reserved. U.S. Patent Nos. 6,879,964; 7,337,138; 7,720,749; 7,925,573; 8,090,646; and 8,417,623. PID573473 (532165_DOLU12/31/2015) FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 15
Appendix FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 16
Asymmetric payoff for active management risk Three-year annualized excess returns: Three years ended December 31, 2013 15% 10% Range of active fund excess returns 5% 0% -5% -10% -15% -20% Large Blend Range of index fund and ETF excess returns Large Growth Large Value Mid Blend Mid Growth Mid Value Small Blend Small Growth Small Value Please reference the appendix for index performance data. Note: Fund returns are net of expenses, but not of any loads. Sources: Fund data provided by Morningstar and index data provided by Russell. Russell indexes include blend: Russell 1000 Index, Large growth: Russell 1000 Growth Index, Large value: Russell 1000 Value Index, Mid blend: Russell Midcap Index, Mid growth: Russell Midcap Growth Index, Mid value: Russell Midcap Value Index, Small blend: Russell 2000 Index, Small growth: Russell 2000 Growth Index, and Small value: Russell 2000 Value Index. Results are consistent using indexes provided by Standard & Poor s and MSCI. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 17
Cost advantage of market cap ETFs Weighted average all-in cost (One year) 0.75% 0.72% 0.67% 0.75% 0.60% 0.45% 0.47% 0.41% 0.43% 0.30% 0.23% 0.25% 0.15% 0.15% 0.0% Capitalization Fundamental Fixed weight Passive Screened Quantitative Selection Weighting Sources: Vanguard calculations, using data from Morningstar, Inc., and ArcaVision. Notes: Strategy box classification is determined by an index s construction methodology rather than its style. Expense ratio and asset figures are from Morningstar as of January 31, 2014. Bid-ask spreads reflect year-to-date data from ArcaVision as of January 31, 2014. Morningstar data include U.S. ETFs that were included in an equity style box category and in an index strategy map category, but exclude funds of funds. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 18
Popularity of nonmarket-cap and active ETFs depends on metric Market share by product count Market share by AUM 47% Market-cap-weighted 31% Nonmarket-cap-weighted 22% Active 84% Market-cap-weighted 13% Nonmarket-cap-weighted 3% Active Notes: Classifications based on Morningstar s index strategy map. ETF product and AUM totals are 1,534 and $1.7 trillion, respectively. Sources: Vanguard calculations, Morningstar data as of December 31, 2013. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 19
Market-cap ETFs capturing majority of flows ETF cash flow by weighting strategy 200 180 160 5 14 29 10 Cash flows ($billion) 140 120 100 80 60 40 20 6 5 36 43 52 2 6 1 8 19 20 7 6 76 74 77 7 12 27 16 86 90 156 164 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Market-cap weighted Non-market cap weighted Active Note: Classifications based on Morningstar s index strategy map. Sources: Vanguard calculations, Morningstar data as of December 31, 2013. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 20
Back-tested data is an unreliable indicator of performance 87% of the indexes outperformed per back-tested data, but only 51% outperformed post-launch Sources: Vanguard, using index-return data from Bloomberg. Index-live-date data from index-provider and ETF-sponsor websites. Notes: Analysis includes data from 370 indexes versus the total U.S. stock market (as measured by the Dow Jones Wilshire 5000 Index before April 22, 2005, and the MSCI US Broad Market Index thereafter). Dashed vertical line in figure separates before and after performance. Past performance is no 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. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 21
Correlations are dynamic Correlation of Russell 1000 Index constituents 0.80 0.70 0.60 Correlation 0.50 0.40 0.30 0.20 0.10 1 26 51 76 101 126 151 176 201 226 251 Trading day in the year 2007 2008 2009 2010 2011 2012 2013 Source: Vanguard. Note: Figure shows 63-day average pair-wise correlations of Russell 1000 Index constituents. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 22
Correlation indicates direction, not magnitude Correlation of 1.00 Correlation of 0.52 5% 10% Monthly return 0% Monthly return 5% 0% -5% -5% Jan Feb Mar Apr May June July Aug Sep Oct Nov Dec Jan Feb Mar Apr May June July Aug Sep Oct Nov Dec Stock A Stock B Stock A Stock C Annualized returns Stock A Stock B "Index" A&B Relative returns Stock A Stock B 17.6% 1.6% 9.6% 8.0% 8.0% Annualized returns Stock A Stock C "Index" A&C Relative returns Stock A Stock C 17.6% 24.2% 20.9% 3.3% 3.3% This hypothetical illustration does not represent the return on any particular investment. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 23
Dispersion has been fairly consistent Percentage of stocks that outperform or underperform by at least 10 percentage points 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2007 2008 2009 2010 2011 2012 2013 Dispersion (Left) Russell 1000 Index return % (Right) 50 40 30 20 10 0-10 -20-30 -40-50 Sources: Vanguard calculations, using data from FactSet. Past performance is no 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. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 24
ETFs do not trade like single stocks... Traditional market impact is not the same for ETFs High Market impact Baskets ETFs Low Smaller Trade size in dollars Larger Source: Vanguard. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 25
... because liquidity of underlying securities is important Trading $47 million of VIOO (27x its $ADV) does not have a significant impact on the underlying securities Stock Weight in ETF ADV Shares needed for creation Creation shares as percent of ADV FEI Co. 0.59% 299,575 2,974 0.99% Questcor Pharmaceuticals, Inc. 0.57 2,199,749 4,016 0.18 Toro Co. 0.55 213,545 4,096 1.92 Kate Spade & Co. 0.53 1,868,634 8,716 0.47 Teledyne Technologies Inc. 0.52 167,539 2,670 1.59 PolyOne Corp. 0.52 669,652 6,904 1.03 Centene Corp. 0.50 533,221 3,895 0.73 West Pharmaceutical Services, Inc. 0.50 452,890 4,974 1.10 Cognex Corp. 0.49 498,413 5,863 1.18 EnerSys Inc. 0.49 265,860 3,398 1.28 Sources: NYSE Arca and Vanguard, as of January 31, 2014. Notes: We use a creation size of 10 units, or 500,000 shares of VIOO. This analysis assumes that trade is executed at closing stock prices as of January 31, 2014. ADV = average daily volume during the month of January 2014. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 26