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6 Qualities of Great Index Funds

To understand your fund, get to know its underlying index.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. When it comes to choosing an index fund, it's critical to understand how the index your fund tracks is constructed. Here with me to discuss the traits that good indices share is Ben Johnson. Ben is Morningstar's global director of ETF research. Nice to see you, Ben.

Ben Johnson: Thanks for having me, Susan.

Dziubinski: Let's start out by talking about why is it important for investors to understand how the indices their funds tracks are constituted and made up?

Johnson: Well, if you think of indexes. Indexes are really the DNA of an index fund. They're a set of instructions that specify what the makeup of that portfolio is going to be. Which securities are in? Which securities are out? How they will be weighted? And how that index will be maintained? Which, ultimately, will dictate the risk and the return profile of that portfolio over a long period of time. So understanding that index methodology, that process, as we think about it within the context of assigning Morningstar analyst ratings to index funds, is critical. So critical, in fact, that we accord Process an 80% weighting in our scoring rubric when it comes to assigning Morningstar Analyst Ratings to index mutual funds and index ETFs.

Dziubinski: Now, you've recently identified, in a recent column, about six traits that you think good indices share, so let's walk through those traits today. The first one is that an index is representative of the style or the opportunity set that it's trying to capture. Unpack that trait for us.

Johnson: Well, when we look at representativeness within the context of broad-based market-capitalization-weighted indexes, we want to understand how wide is the net that they're casting. How much does it reflect the opportunity set within that particular Morningstar Category, which is ultimately how we're framing the context within which we are setting our Morningstar Analyst Ratings. If it's narrower, if it only captures a portion of that investment opportunity set, we tend to have a dimmer view, because it leaves out certain areas of the market that might be fair game for their actively managed peers. Areas where those actively managed peers might be able to reliably add value.

If you look at a category like the intermediate core bond category, for example, most of the index funds in that category are underpinned by the Bloomberg Barclays Aggregate Index, which, by definition, leaves out sub-investment-grade-rated securities that active managers can dabble in to add value at the margin. That informs our understanding. That's an example of what we mean when we say representativeness. Now a broadly representative portfolio would be something like the Vanguard Total Stock Market Index, which is underpinned by the Crisp US Total Market Index, which sweeps in, virtually, every single investable stock that trades in the United States of America. That is very adequately representative of the opportunity set to U.S. stock-pickers.

Dziubinski: Now, we also think it's important, in building on what you just said, that an index be diversified. How so?

Johnson: Well, diversification, as the saying goes, is the only free lunch in investing. We don't know which stocks are going to be the best performers in the future. We don't know which bonds are going to deliver the goods. So the wider the net that you can cast, the more likelihood that, when you pull that net in, in that net you will find the handful of names that drive a disproportionately large amount of a particular market's returns. Now, that's particularly the case, obviously, in stock markets, and less so in fixed-income markets. But you see that in, I think, a very clear fashion over the course of the past 10 years or so, where a small handful of names, pick your acronym du jour--I think the most recent one I saw following Facebook's name change is Mahna Mahna, which conjures up the memories of the Muppet theme song. But those names have really been the ones that have pushed markets higher. And by virtue of not owning them, or underweighting them, many active managers have struggled to keep up with broadly diversified representative indexes.

Dziubinski: Now, you also think it's important that an index be investable. Why is it important and what do you mean by that?

Johnson: Well, ultimately indexes have evolved. They've evolved from things that were meant to measure the markets to give us an understanding of how a particular corner of the market is performing, to things that allow us to mimic the markets to invest in these index funds. So to be able to invest in them, they must be investable. So many indexes will have certain screens in place to ensure that the stocks, the bonds, any securities that they're going to invest in, are investable. That there's enough liquidity. That there's enough of that particular stock as measured by market cap. That bond is measured by its total issuance there, such that the index can own it, and own it without having undo impact on the price of that stock or bond. So investability is critical, I think, especially when it comes to the price impact of index funds owning certain securities.

Dziubinski: And then you also say that transparency is important too. Why?

Johnson: Well, because “black boxes” always send up red flags first and foremost. Transparency, knowing the DNA of that index, and that index fund or index ETF, is critical to understanding it, and to knowing what to expect. Any time you are reading an index methodology, which is really stop number one when we're doing due diligence on index strategies, if it reads something like the driver's manual to a Klingon battleship, you should probably run away screaming because complexity, a lack of transparency, rarely is good for investors. The more clear, the more transparent the rules, the better you are going to be able to understand that particular structure, that particular index, and the better you are going to be able to understand what you should expect from that index and that fund by way of future returns, future performance. How it might perform in certain market conditions versus other market conditions.

Dziubinski: And you also say that an index should be sensible. What does sensible mean to you?

Johnson: Well, sensible is, Does it pass the sniff test? When you look at its certain rules, they might not necessarily make sense. They might not intuit from an economic perspective. And the poster child for this is really the Dow Jones Industrial Index. I hate to pick on it because it's one of the oldest indices of all. But back in the day, that index had to be price-weighted, because we were still doing math on abacuses. I mean, I exaggerate, but just the computing power that underpins the current index ecosystem, ETF ecosystem, it wasn't there back in the late 1800s. So price-weighting, weighting on the basis of stock prices as opposed to market capitalization, which has long since become the convention--it really isn't a sensible approach to say that Berkshire Hathaway A Shares should represent nearly all of a portfolio, because look at how big that handle is. It's measured in the hundreds of thousands of dollars. It doesn't intuit. It doesn't pass that sniff test. So if something doesn't look sensible, you might do well to think twice before investing.

Dziubinski: And then, lastly, you say that indices should be turnover-conscious. Walk us through the implications of turnover and why it's important when it comes to being an index fund investor.

Johnson: Because turnover, ultimately, comes at a cost. And what we know about costs is they compound to our detriment as investors. The more turnover you see in a particular index, the more there is going to be friction when it comes to managing that portfolio. And that friction is really a headwind for investors. It pushes against long-term returns. Sensible benchmarks, well-constructed benchmarks, are very conscientious about the level of turnover, how they turn over the fund, when they trade, how they trade, how much they trade, so as to tread gently on markets to avoid pushing prices against them. And to keep transaction costs at a minimum. And this becomes all the more important the bigger that index funds get. If you look at an example that I alluded to before in the Vanguard Total Stock Market Index Fund, that is now a trillion-dollar-plus fund. It's got very big feet and needs to tread very lightly. So indeed, if you look at the way that the methodology for that fund has evolved, years back that portfolio went to rebalancing over one trading day to spreading rebalancing over a period of five trading days.

And we've seen other indexes take similar approaches in more recent history, as the funds that track them attracted more assets. And I think we're going to continue to see more innovation with respect to how index funds manage their footprints, how they try to tread more gently in markets to minimize market impact, to minimize transaction costs, in the future.

Dziubinski: Well, Ben, thank you so much for your time today. It sounds like when it comes to passive investing, a passive fund is only going to be as good a its index, so it's important to peel back the onion here. We wish-

Johnson: You're absolutely right.

Dziubinski: We appreciate your time. I'm Susan Dziubinski. Thank you for tuning in.

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Morningstar, Inc. does not market, sell, or make any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.