Ferri: Confessions Of An Index Investor

August 01, 2014

 

Capturing beta is best accomplished with an actively managed fund in some asset classes. This is because the market indexes tracked by index funds don’t capture as much of the market as an actively managed fund, and the index fund can be more expensive than the active fund. Municipal bonds are a good example.

The largest municipal bond index fund is the iShares National AMT-Free Muni Bond ETF (MUB | B-75). This ETF has an expense ratio of 0.25 percent and holds 2,185 securities as of July 24, 2014.

In contrast, the actively managed Vanguard Intermediate-Term Tax-Exempt Fund Admiral Shares (ticker: VWIUX) has half the expense ratio at 0.12 percent and holds almost double the number of bonds at 4,121 as of June 30, 2014. The duration of MUB is longer term than VWIUX, meaning there is more risk, while the SEC yield of the two funds is nearly identical.

Overall, I consider the actively managed VWIUX to be a better representation of the intermediate-term municipal bond market than MUB, even though the iShares ETF is tracking an index. That’s why I prefer to use VWIUX in portfolios rather than MUB.

Investing in factors creates more complexity than capturing market beta. A factor is a noncap-weighted risk premium that has occurred between pairs of stocks such as growth versus value and small-cap versus large-cap.

Beta is still the most important risk factor in the Fama-French three-factor model because it still accounts for 70 percent of the typical diversified portfolio return. However, two other factors—size of the stocks in a portfolio; and the price-to-book value of the stocks—can make a significant difference in portfolio returns. Capturing value and size premiums does not require an index fund.

I use nonindex tracking funds from Dimensional Fund Advisors (DFA) to capture size and value premiums in my portfolio. That’s because these funds provide concentrated risk factors, and this gives me the most exposure per dollar of fee paid.

There are low-cost alternatives to DFA that I also recommend. See my previous blog, To Tilt or Not to Tilt?, to learn more about using other factor funds to capture risk premiums.

I’m an index fund investor, but I’m not a purist. My goal is to capture the risks I’m seeking at the lowest cost feasible. Often, the best way to invest in a risk is with an index fund, but sometimes it’s best to use an active fund and/or a quant fund. The trick is to know the risks you’re seeking and know how much it costs to gain access to those risks using different methods.

 


 

Rick Ferri, CFA, founded Portfolio Solutions and is a leading expert on low-cost index fund investing. He has also author six investment books.

 

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