A final look at why a ‘core’ fund in a structured portfolio could be a great call.
This is the fourth in a series of articles about using structured portfolios to minimize the negatives and maximize the positives of indexing. You can find the first three articles here, here and here. A version of this article originally appeared on Advisor Perspectives here.
We now turn our attention to another way in which structured portfolios can add value over index funds; namely, by creating “core funds.”
Core portfolios combine multiple asset classes into one fund. The following provides a good example of why a core approach is superior to a component approach, and is the most efficient way to hold multiple asset classes.
The Russell 3000 can be broken down into four components: the stocks that make up the Russell 1000 Growth index; the stocks that make up the Russell 1000 Value index; the stocks that make up the Russell 2000 Growth index; and the stocks that make up the Russell 2000 Value index.
I once observed a case where an institution held all four components in exactly the same market-cap weighting as did the Russell 3000. In other words, they owned the same stocks in the very same proportions as the Russell 3000, only in four funds instead of one.
This makes no sense. When the indexes reconstitute each June, each of the four component index funds will have to sell the stocks that leave the index and buy the stocks that enter the index. That incurs transactions costs, which can be particularly large when the entire market knows you have to trade. This is especially so for smaller stocks. In short, the benefits of owning the single fund are obvious.
A second example of a core fund is the Vanguard Total International Stock ETF (VXUS | B-100), which combines holdings in developed and emerging markets. This is a significant improvement for investors who previously were forced to hold the two components separately.
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.