Making Indexing Less Vexing: Considerations for Passive Investing

Written by Principal & Director Kristy LeGrande, MBA, CFA and Vice President Ryan Murphy

Jack Bogle, Founder of the Vanguard Group, devised the first index-tracking mutual fund in 1975. His invention would democratize investing, providing everyday investors access to low-cost, diversified investment options. In January 2019, Jack Bogle passed away at the age of 89, but his fight against high fee investments persists. In April, assets invested in passive U.S. equity funds equaled that of active U.S equity funds for the first time, a symbolic milestone for Bogle’s campaign. Since 1975, passive investing has assumed new shapes. With investors facing an expanded menu of passive investment options, discerning their merits requires careful consideration of investment vehicles, fees, liquidity, tax characteristics, and customization.

Vehicles

During its 44-year history, passive investing has evolved into different forms. Bogle’s indexed mutual fund is no longer the only game in town. Today, different fund vehicles, including exchange traded funds (ETFs), collective investment trusts (CITs), and customized indexing through separate accounts, are viable alternatives for indexed exposure. Each passive investment vehicle possesses its own advantages and disadvantages, as demonstrated below:

Fees

Passive investment fees are in a race to zero. Indexed investment providers continue to undercut each other’s fees, in the fight for headlines, investor assets, and platform customers. For investors, fees are a crucial consideration when evaluating both investment providers and vehicles (mutual fund or ETF, etc.). There is no hard and fast rule for which investment vehicle is cheaper, as fee structures vary across investment providers; comparisons need to be made on a case-by-case basis. For retirement plans considering CITs, the typical lower fees associated with the CIT must be weighed against the vehicle’s shortcomings, including, but not limited to, reduced transparency and portability (i.e. whether the CIT may be transferred to a different retirement plan).

Liquidity

Indexed investment vehicles have different liquidity profiles. When comparing mutual funds to ETFs, key liquidity differences include trading and settlement. While ETFs trade intra-day on a secondary market, mutual fund transactions occur directly with the fund company and are executed once daily following the market’s close. ETFs uniquely pose additional risks of limited trading volume (i.e. liquidity risk) and price deviation from net asset value. These risks are largely mitigated by investing in large, established ETFs managed by reputable providers.

With regards to settlement, mutual funds have the advantage, providing settlement within one trading day of the transaction date (T+1), compared to two trading days (T+2) for ETFs. For retirement plan participants invested in a CIT, the vehicle’s liquidity profile typically mirrors that of mutual fund, through daily valuation and trading. Lastly, customized indexed separate account liquidity depends on the liquidity of its underlying stock holdings. Stocks, like ETFs, settle within two trading days of their transaction date (T+2). Therefore, provided its stock holdings are sufficiently liquid, customized indexed separate accounts can be liquidated in two trading days.

Tax Considerations

While passive investing’s buy-and-hold approach improves tax efficiency relative to active investing, tax efficiency varies across passive investment options. When comparing mutual funds and ETFs, ETFs are generally more tax efficient due to their ability to facilitate in-kind redemptions. Through in-kind redemptions, ETFs can satisfy redemption requests through the delivery of individual securities, as opposed to cash. In doing so, the ETF can offload highly appreciated securities to redeeming investors, reducing the fund’s embedded tax gain and likelihood of a capital gains distribution. These transactions are typically restricted to redemptions of significant size. In contrast, indexed mutual funds are often forced to sell securities and realize gains to fulfill redemption requests*. For highly tax conscious investors, a customized indexed separate account may provide tax benefits in excess of an ETF, as discussed in the following section.

Customization

Passive investment options continue to adapt to consumer demand. For investors seeking vanilla index exposure, low cost mutual funds, ETFs, or CITs are often suitable. However, investors may desire additional features from their indexed exposure may benefit from a customized indexed separate account. For example, taxable investors may want to have their index manager provide opportunistic tax-loss harvesting of their customized indexed separate accounts to improve after-tax returns. Customized indexed separate accounts can also allow for the owner of the accounts to make donations of highly appreciated securities. Furthermore, through customized indexing, investors may modify the composition of the underlying index, typically by excluding specific securities in pursuit of an ESG (environmental, social and governance) or SRI (socially responsible investing) mandate. In exchange for customization, investors pay a surcharge over vanilla indexing and assume heightened tracking error (differences in performance between their separate account and the performance of the underlying index).

Four decades ago, passive investing was in its infancy and only accessible through a mutual fund vehicle. Today, passive investments are abundant, and Jack Bogle’s indexed mutual fund format has serious competition. Passive investing is commonly associated with simplicity, but at times it can feel just the opposite. Understanding the nuances of indexed investment options can lead to more desirable investment outcomes. As passive investing continues to garner greater market share, it is in investors’ best interest to become more familiar with developments in the passive investment landscape.

*Note: Vanguard indexed mutual funds are an exception to the notion that indexed mutual funds are less tax efficient than indexed ETFs. Vanguard has patented a fund structure that bolts its indexed ETFs onto its indexed mutual funds as a separate share class. Through this innovation, Vanguard mutual funds are as tax efficient as its ETFs for all intents and purposes.