Index funds sure make a lot of sense, but that doesn’t mean they’re perfect.
This is the first in a series of articles about using structured portfolios to minimize the negatives and maximize the positives of indexing. A version of this article originally appeared on Advisor Perspectives here.
An overwhelming body of evidence demonstrates that the majority of investors would be better off if they adopted indexed investment strategies. And while a total-stock-market index is fine for many investors, indexed investors who desire certain types of exposure face a number of problems. These problems can be addressed with what I call “structured portfolios.”
The benefits of indexing relative to active management are clear:
- Low expense ratio
- Low turnover, resulting in relatively high tax efficiency and relatively low transaction costs
- Limited risk of style drift
- Minimal cash drag
- Total transparency
Indexing provides all of the above benefits, but it does come with some negatives because the sole goal of index funds is to replicate the indices they are tracking. Index replication and the minimization of tracking error to avoid results different than the index itself come with costs.
Structured portfolios incorporate all the benefits of indexing while minimizing its negatives. Let’s begin with an explanation of what I mean by structured asset class investing.
Index funds and structured asset-class funds are similar in the way that rectangles and squares are similar. All squares are rectangles, but not all rectangles are squares. Similarly, while all index funds are passively managed, not all structured asset-class funds attempt to replicate the returns of popular retail indexes such as the S&P 500 or the Russell 2000.
Instead, they tend to use academic definitions of asset classes and design portfolios in ways that minimize the weaknesses of indexing. I’ll eventually examine nine such weaknesses. The first three appear below:
- Sensitivity to risk factors varies over time. Because indexes typically reconstitute annually, they lose exposure to their asset class or factors (such as beta, size, value, momentum, profitability) over time as performance causes stocks to migrate across asset classes during the course of a year. Structured portfolios typically reconstitute monthly, allowing them to maintain more consistent exposure to their asset class or factor. That allows them to capture a greater percentage of risk premiums in the asset classes or factors in which they invest. For example, after the annual reconstitution of the Russell 2000 in June, on average, more than 96 percent of its holdings are in the bottom 10 percent of stocks ranked by market capitalization. Eleven months later, that figure is down to around 88 percent. In contrast, the DFA Small Cap Fund averages 96 percent both in June and 11 months later.
- Forced transactions result in higher trading costs. Imagine the following scenario for an index fund that buys and holds the stocks ranked 1,001-3,000 by market capitalization in the Russell 3000 index: A stock is ranked 1,001 in June. When the index is reconstituted toward the end of June based on data from the end of May, the stock is ranked 999. The fund now must sell the stock. One year later, it is again ranked 1,001. The fund must again buy the stock. To reduce this costly, nonproductive turnover, a structured fund uses “hold ranges.” The fund might buy only stocks with a ranking of higher than 1,000, and also create a hold range for stocks with a ranking just below that figure. For example, they might continue to hold stocks (but not buy any more) as long as they were ranked between 800 and 1,000. If a stock’s ranking moved to a figure of less than 800, then would it be sold. Similarly, stocks can easily move from value to growth and back again. Not only do buy-and-hold ranges reduce costly turnover, but they also improve tax efficiency. Both Russell and MSCI have mitigated this weakness to a great degree by implementing no-trade bands around the index breakpoints, helping to reduce unnecessary turnover.
- Index funds risk exploitation through front-running. An example of the cost of front-running is the Russell 2000, which we know reconstitutes its index each June. Last week, Russell announced its preliminary additions and deletions. On June 20 and again on June 27, it will update the list of additions and deletions, with the reconstitution final after the close at 3 p.m. Eastern time. Obviously, most of the changes are well known ahead of the actual reconstitution when index funds would trade. Active managers can exploit the knowledge that index funds must trade on certain dates. Structured portfolios avoid this risk by not simply replicating the return of the index.