Index funds and structured passive asset-class funds are similar in the way that rectangles and squares are similar. All squares are rectangles, but not all rectangles are squares. Comparatively, while all index funds are passively managed, not all passively managed structured asset-class funds attempt to replicate the returns of popular retail indexes, like the S&P 500 or the Russell 2000.
Instead, such nonindex passive funds tend to use academic definitions of asset classes to structure portfolios for the purpose of minimizing the weaknesses of indexing. Those weaknesses, which result from the desire to mitigate what is called “tracking error” (returns that deviate from the return of the benchmark index), include:
- Sensitivity to risk factors that vary over time.
- Because indexes typically reconstitute annually, an index fund loses exposure to its asset class as stocks migrate across asset classes during the course of a year. Structured passive portfolios typically reconstitute monthly, allowing them to maintain more consistent exposure to an asset class. This allows them to capture a greater percentage of the risk premiums in the asset classes in which they invest.
- Forced transactions as stocks enter and leave an index can result in higher trading costs.
- Risk of exploitation through front-running.
- Active managers can exploit knowledge that index funds must trade on certain dates. Structured portfolios avoid this risk by not trading in a manner that simply replicates the return of the index.
- Inclusion of all stocks in the index.
- Research has found very low-priced (“penny”) stocks, stocks in bankruptcy, extreme small growth stocks and IPOs have poor risk-adjusted returns. A structured portfolio can exclude such stocks by using a simple filter to screen them all out.
- Limited ability to pursue tax-saving strategies, which include avoiding the intentional taking of any short‐term gains and offsetting capital gains with capital losses.
Examining Factor Exposure
Another advantage that structured funds can bring, in return for accepting tracking error risk, is greater exposure to certain factors. Again, there’s persistent and pervasive evidence of a return premium related to factors, such as size, value, momentum, profitability, carry and term.
For example, a small value fund could be structured to own smaller and more “valuey” stocks than a small-cap value index fund might contain. It can also be structured to gain more exposure to highly profitable companies. In addition, the fund can screen for the momentum effect, where it avoids buying stocks exhibiting negative momentum and delays selling stocks with positive momentum.
A Table Tells The Tale
The following table, with data from Morningstar, shows the various metrics for three passively managed small value funds from three different fund families: an index fund from Vanguard and the structured funds from Dimensional Fund Advisors (DFA) and Bridgeway. (Full disclosure: My firm, Buckingham, recommends Dimensional and Bridgeway funds in constructing client portfolios.)
|Fund||Date||Weighted Average Market Cap||P/E||P/B||P/S||P/CF|
|Vanguard Small Value (VISVX)||2/28/2015||$3.0B||17.3||1.7||0.9||7.9|
|DFA Small Value (DFSVX)||1/31/2015||$1.3B||14.8||1.2||0.6||6.1|
|Bridgeway Omni Small Value (BOSVX)||12/31/2014||$0.6B||13.3||1.1||0.6||3.9|
The table provides the weighted average market capitalization for each fund to demonstrate their relative exposure to the size premium, as well as four different value metrics (price-to-earnings, price-to-book, price-to-sales and price-to-cash flow) to show their relative exposure to the significant premium value stocks have provided.
Unfortunately, the as-of dates for the data are not exactly the same. However, that shouldn’t be an issue in this case, because the returns have not varied much year-to-date and thus shouldn’t impact the data to any significant degree.