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Warren Buffett again backs Vanguard ETF

Kevin McDevitt  |  14 Mar 2017Text size  Decrease  Increase  |  
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Warren Buffett once again extolled the virtues of passive funds in his recent Berkshire Hathaway shareholder letter.


Warren Buffett once again extolled the virtues of passive funds in his recent Berkshire Hathaway shareholder letter and reiterated his recommendation of Vanguard 500 Index as his preferred vehicle.

Buffett also idolises Vanguard founder Jack Bogle, who introduced the first retail S&P 500 index fund in 1976.

What strikes me is not that Buffett recommends indexing for most investors, but that he recommends an S&P 500 fund in particular.

For years, the S&P 500, which celebrated its 60th anniversary on 4 March, was synonymous with indexing. A whole ecosystem has sprung up around the benchmark. There are futures, options, and other instruments that all reference this index.

But as time has gone on, a general consensus seems to have emerged that while adequate, an S&P 500 fund is not necessarily the best building block for a portfolio. Of course, the answer also depends on an investor's individual circumstances.

Yes, it captures about 80 per cent of the US equity market's capitalisation, but it's not the broadest representation of the market. Its constituents are selected by a committee, which adds a layer of subjectivity and, dare I say, active management.

Bogle himself has argued for years that the Vanguard Total Stock Market Index, which currently tracks the market-cap-weighted CRSP US Total Market Index, is a better option than Vanguard 500 Index as it captures a broader swath of equities.

Plus, with the explosion in popularity of ETFs and low-cost investing generally, indexing has seemingly moved beyond the S&P 500.

Launches in recent years have segmented the equity market in countless ways, giving investors the flexibility to customise their portfolios in innumerable ways.

The power of brand

How relevant is the S&P 500 today? Despite all the changes, it endures. S&P Global, the index's owner, claims there are about $2.2 trillion in assets indexed to the S&P 500. That represents about half the assets in US equity index funds.

One might argue that this says more about the stickiness of assets than of current popularity. But inflows remain robust.

S&P 500 funds, both open-end and ETFs, collected an estimated $100 billion in inflows during the past 12 months through February, which was nearly a third of the $303 billion group total.

Beyond the index's investment merits, this speaks to the power of the S&P 500 as a brand. Another measure of a brand's strength is its ability to withstand potential substitutes. Vanguard arguably tried to find an alternative in 2004 amidst a spat with the index's parent over licensing fees.

Vanguard at the time introduced a similar large-cap index fund, which today tracks the CRSP US Large Cap Index. The fund's portfolio closely resembles the S&P 500.

Since inception, Vanguard Large Cap Index has an R-squared, a measure of correlation, of 99.9 relative to the S&P 500. The fund's and the index's January 2017 holdings showed a common holdings score of 95.3 per cent.

But this alternative to the S&P 500 hasn't quite caught on, at least by Vanguard's standards. Thirteen years after its launch, Vanguard Large Cap Index has $14.8 billion in assets as of February 2017.

That would be a huge success for most companies, but not in this case, considering that the fund is dwarfed by the combined $531 billion in Vanguard's S&P 500-linked funds.

Vanguard patched things up with S&P and perhaps acknowledged the power of the S&P 500 brand when it launched Vanguard 500 ETF in September 2010. The index's parent company may have recognised this same power when it changed its corporate moniker last April from McGraw Hill Financial to S&P Global.

But the S&P 500 brand looks like an exception; such stories are rare in the indexing space. As Vanguard showed with its moves to CRSP and FTSE, asset managers have realised that in many cases their brand trumps that of the benchmark underlying their funds.

In general, powerful brands are increasingly rare in the asset management industry. The greater emphasis on fees, the inability to differentiate, and the advent of automated advice have contributed to the commoditisation of financial services.

Many of these changes have been to investors' benefit. Insiders may disagree, but an industry where participants compete largely on price is the hallmark of a commodity business.

So, it's perhaps ironic that one of the strongest brands left in the industry is one tied to an index, the original catalyst behind much of today's commoditisation.

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Kevin McDevitt is an editorial director with Morningstar, based in the US.

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