Why Vanguard uses transition indexes

November 12, 2018

 
Rich Powers

Rich Powers
Head of ETF Product Management

Using custom indexes to reflect pending changes to existing benchmarks and taking time to incorporate those changes can potentially reduce a fund's costs and tracking error, as well as mitigate the market impact of the changes and prevent front running.

One of the challenges of investing is making sure the funds your clients own accurately reflect the market you want them to invest in, especially when index providers reorganize indexes to better represent a given opportunity set.

Vanguard approaches this periodic challenge by using transition indexes to more smoothly manage exposure when index providers move constituents from one index to another. We believe our approach is practical and helps minimize tracking error, which can detract from returns.

These sorts of changes can occur as often as once a year, and we stand at the ready to use transition indexes to make sure you and your clients make it through these changes smoothly.

Prepare for the annual review

Each year, MSCI and S&P Dow Jones Indices review their jointly run Global Industry Classification Standard (GICS), which provides a widely followed framework for classifying companies into sectors and industries. These reviews, which take place every autumn, ensure that the GICS classification structure continues to appropriately represent global markets.

For example, in September 2016 GICS sectors were updated to include real estate, which was officially broken out as the 11th dedicated sector. Previously, real estate was part of the financials sector. This resulted in changes to benchmarks that track the financials and real estate sectors.

More recently, after last fall's annual review, the telecommunication services sector was expanded to reflect the blurring lines between media, communications, and content industries. Telecom companies are broadening their scope by offering customers bundled communications services, including cable, internet, phone, and entertainment.

For example, the recent merger of AT&T and Time Warner resulted in a company that touches all three industries. Similarly, information technology companies such as Facebook and Alphabet also provide communications and content services.

In September, these companies were reclassified into the new GICS communication services sector, which reflects the evolution of how we use and interact with technology. These changes will be implemented in MSCI equity indexes in November.

We largely completed our transition to the new and reconstituted GICS sectors at the end of August, ahead of the November implementation date, as we discuss below. See the figure below for the new GICS sector weights for the broad U.S. stock market.

Focus on sectors

If some of your clients have sector exposures, these annual GICS reviews matter. Sector ETFs access a focused part of the overall market, such as energy or health care. They frequently serve as tools for investors to manage risk or to overweight pockets of the investable universe.

Focus on sectors

*Renamed Communication Services after GICS restructuring.

Source: Vanguard.

For example, if the core of an investor's portfolio is a fund that covers the broad market, such as a Total Stock Market ETF, then the investor can use sector exposure to overweight areas within the market he or she believes might offer higher returns or risk-adjusted returns.

It is important that the index a sector ETF tracks accurately reflects the market dynamics and composition of a given segment of the economy.

Vanguard's take

GICS revisions are the result of industrywide consultation with members of the global investment community. At Vanguard, our Broker and Index Relations Team and our portfolio managers engage with all our index providers.

We take a deliberate and thoughtful approach to managing benchmark changes to ensure that we keep trading costs low, optimize our effort to track benchmarks tightly, and minimize the potential for any capital gains distributions.

The value of transition benchmarks

Vanguard's engagement with the index providers continues through the creation of transition benchmarks.

Historically, Vanguard has worked with index providers to create transition benchmarks. By comparison, some index fund managers make their fund changes on the day the sector updates are actually implemented.

Transition benchmarks can help ensure an orderly transition and can reduce costs and tracking error, mitigate market impact, and prevent front running. Vanguard has a long history of successfully using transition benchmarks when meaningful changes were happening to an index's underlying constituents. For example, we did this for our real estate, emerging markets, and developed markets funds.

Inside the communication services sector transition

For the communication services sector update, we made the transition over four months.

The Vanguard U.S. Sector ETFs began the communication services sector transition on May 3, 2018, and it was mostly concluded by August. Vanguard will finish implementing the transition of 32 stocks announced in November when we move from the transition benchmarks to the final MSCI benchmarks.

During the transition, we sold portions of existing holdings while buying companies that were newly added to the transition benchmarks.

Indexing, as it turns out, is not quite as simple as it seems. That said, we believe that these sector updates provide investors with more representative exposures to changing industry dynamics.

At Vanguard, we have a tenured team, a time-tested process, and an enduring mission to take a stand for all investors. And as that relates to index evolution, we believe that using transition benchmarks is the best approach to enact these changes in our funds in the most practical way.

Illustration of the transition of IT and consumer discretionary securities toVanguard Communication Services ETF

Illustration of the transition of IT and consumer discretionary securities to Vanguard Communication Services ETF

Source: Vanguard.

Download the complete Fall 2018 issue of ETF Perspectives

Notes:

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

 

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