What should I look for in an index provider?

 

In 2002, in his seminal article on indexing, then Vanguard Chief Investment Officer Gus Sauter argued that the best indexes aren't those that deliver the highest returns. The best indexes are those that accurately measure the performance of the style they are designed to track.

Outlined below, the index construction guidelines Mr. Sauter developed have been adopted by most index providers and serve as a road map for investment professionals when choosing benchmarks for their clients.

Objectivity. The benchmark's construction should be transparent and determined objectively.

Accurate reflection of the market. The benchmark should be the most accurate representation of the target market or market segment and include only shares available on the open market.

Market-capitalization buffer zones. Market-cap divisions should overlap with no hard cutoff points.

Multifactor style analysis. Growth and value stocks should be categorized using multiple criteria.

Timely and efficient construction. The benchmark's rebalancing approach should reflect market changes in an orderly fashion.

The benefits to index funds of smart benchmark construction:

  • Lower portfolio turnover.
  • Lower transaction costs.
  • Potential for greater tax efficiency.
  • Efficient asset allocation with limited overlap.
  • Ability to choose benchmark based on preference, cost, and accessibility.
  • History of competitive performance relative to active management.

All investing is subject to risk, including possible loss of principal.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. 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.

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