Swedroe: The Purity Hypothesis

November 18, 2013

Indexes do a better job of giving pure exposure to asset classes, and it shows in returns, Swedroe says.

The purity hypothesis states that when an asset class does well, index funds will outperform active managers in that asset class. The reason is that an index fund will tend to have a purer exposure to the asset class, while active managers tend to style-drift.

For example, active large-cap managers tend to hold stocks with a smaller weighted average market capitalization than a large-cap index. And active small-cap managers tend to hold larger stocks than a small-cap index.

Thus, when large-caps outperform small-caps, the index will tend to outperform the majority of active managers because the active funds have less exposure to large-cap stocks. The same is true for value and growth stocks. When value outperforms, the index will tend to look better than active value managers, and vice versa.

The purity hypothesis provides us with important insights, allowing us to better understand the performance of mutual funds, even similar passively managed funds, in the same asset class.

The following table, with data from Morningstar as of July 31, 2013, shows the various metrics for three passively managed, small value funds from three different fund families—the index fund of Vanguard, and the structured funds of Dimensional Fund Advisors (DFA) and Bridgeway. (Full disclosure: My firm, Buckingham, recommends DFA and Bridgeway funds in constructing client portfolios.)

The table provides the weighted average market capitalization to show the relative exposures to the size premium, and four different value metrics (price-to-earnings, price-to-book, price-to-sales and price-to-cash flow) to show the relative exposure to the significant premium that value stocks have provided.

Fund Weighted Average
Market Cap
Vanguard Small Cap Value (VISVX) $2.4B 16.5 1.6 0.8 6.0
DFA Small Cap Value (DFSVX) $1.1B 15.4 1.2 0.6 4.6
Bridgeway Omni Small Cap Value (BOSVX) $.6B 13.4 1.2 0.5 3.2


As you can see, even though the three funds are in the same small value asset class, and fit in the same Morningstar style box, there are significant differences in their holdings.

What you should be noting is that the Vanguard fund holds stocks that are much larger than the stocks held by DFA, and Bridgeway’s holdings are much smaller than DFA’s. Those differences are created by the structure of the funds—the definitions they use to determine buy, hold and sell ranges. The smaller the market cap, the greater the expected return over the long term.


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