A single fund will avoid having to sell and buy stocks from a country that migrates from an emerging to a developed market, as Israel recently did and as South Korea is one day expected to do. This not only minimizes transaction costs in markets where they can be quite high, but also avoids, or at least mitigates, the realization of capital gains.
Now consider an investor who owns four component U.S. index funds: a large company fund; a small company fund; a large value fund; and a small value fund.
A single fund that held the same stocks in the same proportions, if such a fund existed, would be the more efficient approach. Dimensional Fund Advisors (DFA) has created a unique family of core funds with various degrees of “tilt”—more than just market-cap weighting—toward small-cap and value stocks. The major benefits of the core approach are:
- Core portfolios minimize turnover created by the migration of stocks between both large and small funds and value and growth funds. This reduces transaction costs and improves tax efficiency
- Core portfolios minimize the transactions needed for rebalancing. This also reduces transaction costs and improves tax efficiency because the funds have the ability to rebalance with “other people’s money” (using cash flows). That results in the need to buy only the underperformers and avoids having to sell the outperformers.
- Core portfolios can rebalance using cash from dividends.
In the end, indexing is a wonderful strategy.
However, the need to minimize tracking error comes with some costs. By accepting tracking-error risk, structured portfolios can enhance some of the benefits of indexing. While I’m not a fan of the term “smart beta”—most of it is just marketing hype—well-designed structured portfolios can deliver superior returns compared with index funds.
Larry Swedroe is the director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.