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.
What you should note here is that the Vanguard fund holds stocks that tend to be much larger than the stocks held by the DFA fund. And the Bridgeway fund holds stocks that tend to be much smaller than the stocks held by the DFA fund.
Those differences are created by the structure of the funds—the definitions they use to determine buy, hold and sell ranges. And as the size premium tells us, the smaller the market cap, the greater the expected return over the long term.
In addition, we should generally expect to see that when small stocks outperform large stocks, Bridgeway’s fund will have the highest return and Vanguard’s the lowest, with DFA’s fund in the middle.
It’s not that Bridgeway is a better-run fund; it has the most exposure to the size premium. Conversely, we should expect the opposite when large stocks outperform small stocks. This won’t always be true because DFA and Bridgeway both incur lots of random tracking error in order to achieve their goal of obtaining the highest long-term returns. Also, these are not small-cap funds, but small value funds.
You can further observe that, in the case of the four value metrics, Vanguard’s small value fund owns stocks with relatively higher prices than either DFA or Bridgeway. And in some cases, the differences are quite large. With the exception of a small difference in the price-to-book ratio, the Bridgeway fund owns stocks with relatively lower prices than the DFA fund.
This shouldn’t be a surprise, because DFA’s small value fund uses a single book-to-market screen, while Bridgeway uses four metrics and its own weighting scheme.
Bridgeway’s fund has the most exposure to the value premium. Again, that’s by design. As a result, when value stocks outperform growth stocks, we should expect the Bridgeway fund to have the highest returns and Vanguard’s fund the lowest (depending of course on what the size premium is doing at the time) and vice versa.
The Thing About REITs
There’s one other important factor to consider. While the Vanguard fund includes exposure to REITs (about 10 percent), the DFA and Bridgeway funds don’t. There are a number of good reasons for excluding REITs:
- First, REITs are highly tax inefficient. Thus, in general, they should only be held in tax-advantaged accounts.
- Second, REITs have significantly lower expected returns than small value stocks. From 1978 through 2014, the Dow Jones Select REIT Index returned 12.7 percent on an annualized basis versus 15.2 percent for the Fama-French U.S. Small Value (ex-utilities) Index.
- Third, if investors want exposure to REITs, they can own them directly through a REIT fund, such as Vanguard’s. That way, an investor can specifically target how much exposure they have to REITs. The differences in exposure to REITs can have a significant impact on the returns of the fund.
Comparing REIT Returns
For example, in 2013, Vanguard’s VISVX returned 36.4 percent. The performance of the fund was negatively impacted by the performance of REITs that year. Vanguard’s REIT Index Fund (VGSIX), in fact, returned just 2.3 percent that year. The DFA and Bridgeway funds weren’t negatively impacted because they excluded REITs.
The reverse was true in 2014. VISVX returned 10.4 percent, and its performance was positively impacted by the return on REITS. Last year, VGSIX, the Vanguard REIT fund, returned 30.1 percent.
With the data and theory in mind, let’s now take a look at how the funds have performed.
Did we get what we expected?
We’ll examine the funds’ returns for the last six calendar years (2009-2014). To measure the results against our expectations, we’ll also examine the returns of Vanguard’s S&P 500 Index Fund (VFINX). Note the Bridgeway fund has an inception date of Aug. 31, 2011. We will include it in the analysis beginning in 2012. Also note that, when a fund is new and relatively small, the amount of tracking error it may experience can be quite high. This occurs because it won’t have as much diversification across the stocks in its asset class until it has larger assets under management.
In 2009, VFINX, the S&P 500 fund, returned 26.5 percent, and VISVX, the Vanguard small-cap value fund, returned 30.3 percent. Since small value stocks outperformed, we should expect to see DFSVX outperform VISVX. It did, returning 33.6 percent.
In 2010, VFINX returned 14.9 percent and VISVX returned 24.8 percent. Since small value outperformed, we should expect to see a repeat performance. That’s what happened, as DFSVX returned 30.9 percent.
In 2011, VFINX returned 2.0 percent and VISVX returned -4.2 percent. Since small value underperformed, we should expect to see DFSVX underperform VISVX. And that’s what happened, as DFSVX returned -7.6 percent.
In 2012, VFINX returned 15.8 percent and VISVX returned 18.6 percent. Since small value outperformed, we should again expect to see DFSVX outperform VISVX. Again, that’s what happened, as DFSVX returned 21.7 percent. Bridgeway’s BOSVX returned 17.7 percent. Given the fund’s greater exposure to the size and value factors, we should have expected BOSVX to outperform.
An Anomaly Uncovered
However, remember that issue with tracking error and new funds? That said, BOSXV’s performance is our first “anomaly.” We didn’t get what we expected.
In 2013, VFINX returned 32.2 percent and VISVX returned 36.4 percent. Since small value outperformed, we should expect to see DFSVX outperform VISVX. That’s what happened, as DFSVX returned 42.4 percent. BOSVX outperformed both, returning 44.6 percent, just what we should have expected. As we mentioned earlier, VISVX’s performance was negatively impacted in 2013 by the 2.3 percent return on REITs.
In 2014, VFINX returned 13.5 percent and VISVX returned 10.4 percent, aided by the 30.1 percent return on REITs as measured by the performance of VGSIX. Since small value underperformed, and REITs dramatically outperformed, we would expect to see DFSVX underperform VISVX. Once again, the expected happened. DFSVX returned 3.5 percent. And Bridgeway, with even more exposure to the underperforming factors of size and value, returned just 0.8 percent.
A Single Outlier
Looking at six years of data, we find only a single outlier within the data—the underperformance of BOSVX in 2012. As explained, there’s a likely explanation in random tracking error.
We see the same type of results if we examined the performance of the iShares Russell 2000 Value ETF (IWN | A-79). Using Morningstar data as of March 18 for IWN, the fund, while having a similar average market cap to DFA’s fund, is much less “valuey.” Its prices-to-earnings ratio (17.8 versus 14.8), price-to-book ratio (1.4 versus 1.2), price-to-sales ratio (1.0 versus 0.6) and price-to-cash flow ratio (8.3 versus 6.1) are all higher than DFA’s valuations.
And in every single year in which small value outperformed the S&P 500 Index, DFSVX outperformed IWN, and vice versa.
There are two important takeaways. The first is that all three passively managed funds were doing their jobs well. The differences in performance weren’t explained by good or bad management. Instead, they’re explained by the fund’s structure—how they are designed.
The second is that asset pricing models (such as the Fama-French three-factor model) work very well. They are able to explain the differences in the performance of diversified portfolios to a very high degree.
When an asset class does well, you should expect the fund with the greatest exposure to whatever factors explain that asset class’ outperformance to have the highest return. And when an asset class does poorly, you should expect the fund with the most exposure to those factors will underperform.
Making The Right Choice
The lesson I hope you walk away with is that you don’t want to be like investors in actively managed funds, chasing returns. Instead, the choice of the fund you use should be based on other considerations, including how much exposure you want to certain factors, the design of the fund and, of course, a fund’s expense ratio.
When making the decision, you want to be sure you weigh all factors. It might be that the fund with a higher expense ratio is the better choice. It might, for instance, have more exposure to the factors that determine returns and carry premiums. In other words, it’s not just cost, but cost per unit of expected return (and risk) that matters.
Let’s use an example.
While VISVX has an expense ratio of 0.24 percent (the Admiral shares version costs just 0.10 percent) and DFSVX has an expense ratio of 0.52 percent, the higher cost of the DFA fund has been more than offset by its greater exposure to the factors and its focus on adding value by minimizing the negatives of pure indexing.
For the 15-year period ending March 19, DFSVX returned 11.00 percent versus 10.56 percent for VISVX. Lastly, BOSVX has an expense ratio of 0.6 percent, but its greater exposure to the size and value effects should allow it to produce the highest returns of the three funds.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.