Episode Transcript
Arne: Hello and welcome to Index to FTSE Russell. My name is Arne Noack. I'm the head of equity and multi-asset product at FTSE Russell in the Americas. And I have the pleasure of being joined today by Andre Kotlyarenko, senior product manager at Vanguard. We'll be spending the next ten minutes or so to dive a little bit deeper into Vanguard's product offering linked to the Russell US Equity Index series. Andrey, thank you so much for joining us.
Andrey: Thanks for having me, Arne.
Arne: So Andrey, we have a couple of ETFs together. Thank you for the partnership. And obviously, indexing is super relevant. And I wanted to ask you a couple of questions. So maybe we ease in and on a very high level basis, share with our audience today, why is it really relevant to consider what index is being tracked by the ETF?
Andrey: Now Arne, that's a very great question and something we address with our clients quite frequently. Over the decades, clients have been conditioned to think about the cost, right? Expense ratio is the main driver of their decision making. However, it's not the only driver that should be part of their decision process. If we think about the overall performance of the product, that can have meaningful implications for the client's overall portfolio and the index that's been tracked by an ETF or a mutual fund plays a very significant role in that. You can think of an index as a DNA of the product. It determines which securities are included, it determines what weight they will be included in, and it also determines how it may potentially evolve over longer periods of time. Because of that, it is also important to understand how those decisions are made, right? If we think about overall portfolio construction, oftentimes there are various products that have to interact with each other and how they do it, often determined by the methodology that supports those products. So just to give you a quick example, right? If we think about Russell 1000 versus S&P 500. If someone is trying to get a direct exposure to a large cap segment of the market, oftentimes they may think, okay, I just need to pick something up that has large cap in their investment objective and I will get the exact exposure that I'm looking for.
Andrey: However, as it's maybe signalled by the naming convention, Russell 1000 is top 1000 names. S&P 500 is about top 500 names in the market. What that actually means in practicality, Russell 1000 represents about 94% of the overall market capitalisation, with S&P 500 covering about 85 to 86% of market capitalisation. That nuance difference can actually have pretty meaningful implications, especially over times of high volatility. So as clients try to build an overall portfolio with the overall exposure to weather, US market or international market, they have to be very careful of how these products are interacting with each other, especially if they're using products from different index families. What they may end up at the end if they're not careful with that is actually either mismatches, some gaps in the portfolio or overlaps in the securities that they're selecting that may impact their longer term performance outcomes. This is where Russell's approach to construction methodology actually serves clients very well, because of their very transparent rules-based approach to building these indices. Clients can simply pick up those methodologies and have a clear understanding of what's included in the product, what segment of the market it's covering. And potentially, what are some of the longer term implications of that exposure?
Arne: Those are very great points. So let's double click a little bit on that. You already mentioned the Russell 1000 as an example, for an index that captures the largest 1000 stocks here in the US. And often people associate index investing with really broad benchmarks, broad portfolios. The Russell 3000 is even broader than the Russell 1000. But then there are a number of investors who really want to build their own portfolio and consider index investing or construction of portfolios in a more modular approach. How do you think about that from a Vanguard perspective, and how far can Russell Indexes help with that?
Andrey: Yeah, I mean, another great topic that we cover quite a bit. And if we think about over the last decade or so, ETFs are becoming a lot more prevalent in the market space and typically a preferred vehicle for a lot of the retail consumers and professional investors. With that in mind, they also provide a much easier and quicker access to various segments of the market. So one of the trends that we started seeing more recently is growing preference to move away from just the broad market coverage, like total stock market in one single package to gaining a little bit more granular exposure to the US market, as well as to international markets in some cases as well. So the way we can approach it, and this is where Russell plays a significant role with their very modular approach to the construction. Right? So for the clients that have a preference for broad market selection or the clients that would like to get a little bit more granular exposure, Russell has something to offer that fits both of those needs. Russell 3000 covers total stock market. If you're trying to break out your sizes into large, mid and small, you have Russell 1000. For large cap you have Russell 2000 for the small cap, you also have Russell mid cap that can be paired together with Russell 200 to get the overall exposure to the large cap segment.
Andrey: The same works for the styles as well. A lot of the clients try to get segmented access to the styles, growth and value. And that's no surprise because growth and value typically perform differently over various periods of time. So clients can express their longer term strategic view or shorter term tactical views by gaining access to individual segments of the market and at times, overweighting or underweighting those various segments, depending on what their particular views and expectations of the economic outlook may be. In addition to having more of a longer term strategic objective, the additional flexibility through modular access to the market gives them an opportunity to be more tax efficient and take advantage of various tax efficiency tools like tax loss harvesting. This way, they don't have to sell the entire market to capitalise. They can actually pinpoint a specific segment of the market that may be appreciated or depreciated over various periods of time and capitalise on tax efficiency. And as I mentioned with the Russell's rules-based approach, it is very easy to understand and it's very transparent what segment of the market you're getting access through various products and how that potentially may fit into your overall portfolio.
Arne: Those are very clear examples. Thank you for those, very relevant to see how the segmentation can work. So if we bring in a very highly relevant topic at the moment, which is market concentration, concentration of the large indices on the US mega cap names, how can the Russell Indices and Vanguard's products potentially help with that?
Andrey: Yeah. This topic has been in headlines for quite some time, especially what we experienced over the last several years with the meaningful appreciation of the tech stocks. Right. At this point. If you look at S&P 500, the top ten securities are now representing close to 40% of the overall market capitalisation, which for some clients may cause meaningful concern. One thing to keep in mind, while concentration in the market is certainly concerning. It is not new. In history, there were various periods of time when certain segments of the market appreciated faster than some of the other segments, causing some of that concentration. However, I don't want to undersell the potential impact of market concentration and some of the concerns that various investors may have. So for those that actually want to address that in their portfolio. Once again, the modular approach that Russell offers gives him an ability to use various tools to maybe shift a little bit away from the more concentrated large cap segment of the market and shift their exposure more towards either small cap or mid cap by strategically overweighting their strategies. Once again, you have to have a very clear understanding of how those products are actually constructed and what outcome will look like once you build your overall portfolio and how it may impact your strategic outlook for the longer term.
Arne: So, Andrey, you've really helped us understand some of the key points of why index and index choices are relevant for ETF investors. If we zoom out and think about the ETF as a wrapper, what are some additional points that investors should consider when choosing an ETF?
Andrey: Yeah. So when we started this conversation, I mentioned that clients are being conditioned to think in terms of the expense ratios. It still continues to be a very important factor in the decision making when deciding which product you want to choose for your portfolio. Over the last five or so years, there's been pretty meaningful compression when it comes to pricing of various ETF products, especially the ones that are tracking more passive approach. However, even with the funds that have the same index on the back end, you may still have a pricing range of anywhere from 5 to 10 basis points, which may have meaningful implications for portfolio performance over longer periods of time. So it's still important to look at the expense ratio and not only understand what you're getting as a product, but also how much are you paying for it. Now, because the migration has been predominantly to ETFs at this point. It's also important not to overlook another aspect of cost. And that's the spread of trading, right? Especially if your portfolio is positioned a little bit more tactically, that may potentially have a little bit larger level of turnover. The cost of getting in and out of that ETF may have significant implications to the performance outcomes.
Andrey: So you want to make sure that you're looking at high quality products at a low cost and a low spread. And this is where Vanguard shines through with our history. Right. We were the ones who pioneered the low cost of investing. And we continue doing this by returning value back to the shareholders and continuously lowering the expense ratio. So our Russell products are some of the lower priced products in the marketplace, as well as they're trading at very, very tight thresholds. Now, beyond the expense ratio and beyond the index construction, you also want to understand what value does the asset manager bring to the marketplace to justify the fees that they're charging for their services? And this is once again where Vanguard shines through with some major differentiation points. And one of those, which is probably one of the key differentiation points comes from our unique structure, ownership structure. This is where our interests are in perfect alignment with the shareholder best outcomes, as it is witnessed by long-term history of reducing expense ratios. As our scale was getting larger, we're not doing it for competitive purposes.
Andrey: We're really doing it because it's the right thing to do for the shareholders. In addition to the unique structure, we also have highly experienced, very sophisticated portfolio management team. We've been doing indexing for over 50 years at this point. So that accumulated a lot of expertise, a lot of experience, majority of the portfolio managers have been on the trading desk for 10, 20, 30 years, which accumulates a lot of knowledge in the area of indexing. And they're able to apply a lot of that knowledge and expertise, not only to track the indices as close as possible, which we've been doing really well over the years. But in addition, take advantage of various opportunities like corporate actions or index rebalances to control for the cost of trading, and also add some value back to the portfolio based on how we execute those trading strategies. And then finally, another thing to keep in mind is a large segment of our clients are taxable shareholders. So taxes are top of mind for them. And our portfolio managers have been able to use their trading techniques and skills to maintain a very high degree of tax efficiency across our strategies.
Arne: That's great. Very relevant. Thank you for sharing those insights with us. And Andrey, you clearly, as well as the team at Vanguard, have deep experience and expertise when it comes to index investing and ETFs. Where should investors go if they want to find out more?
Andrey: Yeah. Great question. Vanguard.com has a lot of meaningful resources. It has a lot of details on the product themselves. It has a lot of thought leadership, our views on the economy. It also has a lot of various tools that can help advisors and more professional investors to build very effective portfolios and strategies for their clients. And they can always also call our phone number, as well as reach out to their dedicated resources that are aligned to their accounts.
Arne: Andrey, thanks for the insights and knowledge that you shared with us today, it was great to have you.
Andrey: Thanks for invitation, it's been a lot of fun.
Arne: Thanks all for joining us at Index to FTSE Russell. Hope to see you next time.
