Considerations for Selecting an Index Fund Manager

Index funds are passive investments that are designed to mimic the makeup and performance of an underlying market index, such as the S&P 500, at a reduced fee level. According to the Investment Company Institute (ICI), a Washington, D.C.-based mutual fund industry research group, 36% of households in 2018 who owned mutual funds owned at least one equity (stock) index fund. A total of 497 index funds in 2018 had in aggregate assets more than $3.3 trillion. $156 billion in new assets flowed into index funds in 2018 (according to the ICI factbook), distributed as follows:

• 40% invested in world stock indexes (i.e. FTSE 100–London, Nikkei 225–Tokyo, etc.)
• 37% invested in domestic stock funds (i.e. NYSE Composite, Russell 2000, etc.)
• 23% invested in bond or funds made of hybrid indexes (i.e. world and domestic stock funds)

As index funds remain popular among all mutual fund investors, and have grown in usage within retirement plans, it is important to understand the motivation for investors to make these investments. It is equally important to understand what decision-making framework must exist to select an index fund manager to manage investor’s expectations, balancing returns and risks.

Why Investors Choose Index Funds

Passive management takes place in index funds, as compared to active management found with most domestic and world equity mutual funds. This is because the underlying premise to index funds is their design to mimic the composition and performance of an underlying index. Once the securities making up a chosen index are selected and placed in the portfolio, fewer trades are performed (although other activities such as strategic hedging takes place to keep the portfolio’s performance in balance). Fewer trading activity results in management fees lower than those found in those equity mutual funds actively investing. This translates, theoretically in a lower cost of doing business and a higher potential return for index mutual fund investors compared to the higher fees and more volatile performance of active managers.

What is also compelling for investors in an index fund is the relative safety these funds offer – passive management reduces the amount of interaction a manager has with the fund’s holdings, which in turn means an investor may peg their investment objectives closely to the type of investments that the index holds and reduce the potential for unintended market exposures and potential underperformance through active management.

Considerations When Selecting an Index Fund Manager

Considering an index fund manager requires a look at several factors. These factors, when taken in totality, help an investor take a more objective decision-making approach to the process as opposed to one that is either emotional or reactionary or based on the prevailing returns that the index is providing. Whereas the philosophy should be to buy low and sell high, investors in fact traditionally buy high and sell low. This, roughly translated, means investors tend to chase returns and as a result forego a more analytical approach to evaluating a fund and, more specifically, prevent investors for seeing the forest for the trees, when it comes to maintaining a long-term outlook.

Some of the considerations may include:

• Comparative fee and expenses;
• Portfolio management capabilities to mimic the composition and performance of the underlying benchmark; and,
• Securities-lending program that lends issues within the portfolio for added income to keep the overall performance in-line with the underlying index’s overall return.

Why it is Important to have a Selection Criteria for Your Index Fund Manager

Index funds are passively managed investments, which would seem to suggest that there is no difference between index fund manager if all their job entails is to mimic the holdings of the underlying index and buy stocks. This would be a very myopic view of the role of an index fund manager and the work they do in behalf of their fund investors.

Index funds, unlike a market index, particularly one which is an open-end investment company or mutual fund, has redemptions, exchanges, and new assets flowing through every day. The periodic re-constitution of a benchmark also requires additional trading. This movement of assets in and out of the fund will cause it to fall out of balance and potentially underperform its prevailing index. Determining the appropriate concentration of stocks within the fund and balancing risk with potential reward does require some knowledge on how markets work, effective trading strategies and perhaps the employment of leveraging strategies (i.e. options hedging) to maintain order and balance to the fund overall.

The manager of an index fund may also choose to lend its securities in order to generate additional income to reduce the performance drag of its already reduced fees. Securities lending introduces additional risks, such as counterparty, liquidity and market risks, that must be carefully evaluated by the manager in its oversight of a securities lending agent.

The expertise of the manager and ability to proactively (not reactively) manage the fund in these ways means better potential results for the investor.

Conclusion

Employing a criterion which seeks to determine an index fund manager’s ability to perform should be as important a part of the decision-making process as the fund itself. It is important to consider all the factors that go into deciding which index fund manager to go with. A decision-based process for evaluating the merits of the manager goes a long way toward stabilizing the variability of returns within one’s portfolio.

PlanPILOT is an independent registered investment advisor (RIA), not tied to any funds or investment banks. We help clients control their risks in operating retirement plans and help them deliver the benefits intended. We also review fund lineups and score investments, highlighting any recommended changes.We encourage you to contact us if you would like to learn how PlanPILOT can help you.

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