Roth: Retort To ‘Problems With Index Funds’

Nine answers to Larry Swedroe's nine problems with index funds.

Last month, Larry Swedroe wrote about the problems with index funds followed by more problems with index funds. In total, Swedroe noted nine problems. ETF.com asked me if I cared to take the opposing viewpoint, to which I quickly agreed, and the following is my counter to each of the nine points.

First, let me say I mostly agree with Swedroe's criticisms when it comes to narrower index funds such as those he used in his pieces. But I'm a believer in broad index funds and will use the largest index fund on the planet, the $347 billion Vanguard Total Stock Market Index Fund (VTSAX, VTI | A-100 and other share classes), to examine his points. Second, this isn't a piece debating whether factor investing is superior to market-cap investing (meaning, examining whether factor investing is receiving higher return as compensation for taking on higher risk).

Since I'm using a Vanguard fund to counter Swedroe's arguments, I interviewed Joel Dickson, global head of research and development in Vanguard's Investment Strategy Group. Below is my assessment of how Swedroe's nine problems relate to the total stock index fund and broad index funds in general.

1. Sensitivity to risk factors over time. Swedroe argues that indexes that reconstitute annually lose exposure to asset classes or factors, using the DFA Small Cap Fund to show superiority (DFSTX). In actuality, the mutual fund VTSAX always has the market exposure of every domestic equity asset class and factors.
2. Forced transactions result in higher trading costs. Dickson points out that VTSAX has a 4 percent annual turnover, minimizing trading costs. By comparison, DFSTX has a 10 percent annual turnover.
3. Index funds risk exploitation through front-running. Front-running is certainly a cost to the investor but, again, Dickson points out less trading is the best way to protect the investor from front-running.
4. Inclusions of all stocks in the index. Swedroe argues that penny stocks in bankruptcy and initial public offerings have very poor risk-adjusted returns. In actuality, Vanguard states that as of July 22, 2014, penny stocks represented about 0.01 percent of this index fund. Though it is true that IPOs have had lower returns in the past, we don't know the future.
5. Index funds have limited ability to pursue tax-saving strategies. Swedroe asserts funds like DFA can offset capital gains with capital losses. Dickson says Vanguard "will take losses as long as it can minimize the tracking error from the index." He supports this claim, noting that the fund currently has a 0.89 percent tax loss carry-forward.

6. Ability to preserve qualified dividends. Swedroe states that, due to IRS holding period regulations, index funds have less of their dividends qualified for the lower tax rate. Dickson points out that 94.35 percent of the VTSAX 2013 dividends were qualified. By comparison, the DFA small-cap fund pointed out by Swedroe only had 74.08 percent of its 2013 dividends qualified. Other DFA funds, however, do have higher proportions of qualified dividends.
7. Limit securities lending to the expense ratio. Swedroe points out that nonindex funds can limit their revenue from securities lending to maximize the qualified income. While true, one must remember the goal is to maximize after-tax returns rather than minimize taxes. Again, 94.35 percent of dividends from the Vanguard fund were qualified last year.
8. Screen for momentum and other factors. Swedroe said that companies like DFA and Bridgeway construct portfolios in this manner. Dickson was quick to state: "To me, this gets to the argument for active management." Whether these sources of return persist remains unknown. Even if they do, many believe it's compensation for taking on more risk.
9. Avoid forced trades. Swedroe notes that nonindex funds can patiently wait to trade, while index funds must immediately trade to avoid tracking error. The low 4 percent annual turnover of this fund argues otherwise.

My take is that there are right and wrong ways to build an index portfolio, and Swedroe is mostly right in talking about narrower index funds. But I don't think they hold much water when it comes to the broadest index funds like a total stock index fund, which, in my opinion, should be the core of a domestic equity allocation. In addition, the 0.05 percent expense ratio of the total stock index fund is much lower than the nonindex funds Swedroe mentions.

I do, however, agree with Swedroe that DFA is an outstanding fund family with very low costs. DFA funds are very effective in building portfolios with small-cap and value tilting. I think the debate between whether DFA or Vanguard is better is far less important than the need to keep a low-cost, diversified and disciplined portfolio.

Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for CBS MoneyWatch.