How Vanguard Index Funds Work

Vanguard index funds use a passively managed index-sampling strategy to track a benchmark index. The type of benchmark depends on the asset type for the fund. Vanguard then charges expense ratios for the management of the index fund. Vanguard funds are known for having the lowest expense ratios in the industry. This allows investors to save money on fees and help their returns over the long run.

Vanguard is the largest issuer of mutual funds in the world and the second-largest issuer of exchange-traded funds (ETFs). John Bogle, Vanguard's founder, began the first index fund, which tracked the S&P 500 in 1975. Index funds with low fees are appropriate investments for the majority of investors. Index funds allow investors to gain exposure to the market in a single, simple and easy-to-trade investment vehicle.

Passive management means the fund or ETF merely tracks the benchmark index. This is different from active management where a fund manager attempts to beat the performance of an index. For most active equity mutual funds, the benchmark index is the S&P 500.

Fees for active management are generally higher than for passively managed funds. Actively managed funds have higher trading costs since there is a greater turnover in fund holdings. These funds also have the additional costs of compensation for the fund management. These factors lead to increased fees compared to passive funds.

Many actively managed funds fail to beat their benchmark indexes on a consistent basis. Higher fees combined with subpar performance leads to inferior results. Academic studies have shown higher fees alone lead to subpar performance for most active funds. Even if a fund manager is successful for a period of time, future success is not guaranteed. The risk of subpar performance is a major reason why passively managed index funds are a better option for most investors.

Vanguard uses index sampling to track a benchmark index without necessarily having to replicate the holdings in the entire index. This allows the company to keep the fund expenses low. It is more expensive to hold every stock or bond in an index. Further, indexes do not have to allow for the inflow and outflow of funds like ETFs and mutual funds. Vanguard uses the index sampling technique to deal with the natural movement of capital for its funds while still replicating the performance of the benchmark index. Vanguard does not divulge its specific sampling technique.

Other common sampling techniques divide the index into cells that represent the different characteristics of the benchmark index. For a large stock index, the manager may divide the stocks in the index by different categories. These categories could include sector, price to earnings (P/E) ratio, country, volatility or other individual characteristics. The fund manager buys stocks or assets that mimic the performance of the components of the index.

The index sampling technique has the risk of a tracking error. A tracking error is the difference between the net asset value (NAV) of the fund’s holdings and the performance of the benchmark index over time. The greater the tracking error, the larger the discrepancy between the fund and the index.

Vanguard funds charge expense ratios as their compensation for the management and issuance of the fund. The expense ratio is calculated by taking the fund’s operating costs and dividing them by the assets under management (AUM). Vanguard’s expense ratios are some of the lowest in the industry. The expense ratios for its mutual funds are generally 82% less than the industry average.

Expense ratios can have a significant impact on returns over time. Vanguard notes that for a hypothetical investment of $50,000 over 20 years, and investors could save around $24,000 in expenses, assuming a 6% annual rate of return. This is a substantial amount. Investors should, therefore, seek to invest in funds with low expenses.