Swedroe: More Problems With Index Funds

Looking at the shortcomings of index funds might be worthwhile for some investors.

This is the second in a series of articles about using structured portfolios to minimize the negatives and maximize the positives of indexing. You can find the first article here. A version of this article originally appeared on Advisor Perspectives here.

Earlier this week, I wrote about three weaknesses of index funds that structured portfolios avoid: varied sensitivity to risk factors over time; higher trading costs from forced transactions; and risk of exploitation through front-running.

There are other issues related to indexing versus structured portfolios that are worth mentioning, so here goes:

1. Inclusion of all stocks in the index. Research has found that very-low-priced “penny” stocks in bankruptcy and in IPOs have poor risk-adjusted returns. Note that the Russell indexes exclude all stocks priced under $1. In any case, a structured portfolio could exclude all such stocks using a simple filter.
2. Index funds have limited ability to pursue tax-saving strategies. Structured portfolios can offset capital gains with capital losses and avoid intentionally taking short-term gains. Excluding real-estate investment trusts (REITs) also improves tax efficiency. It’s worth noting that Vanguard’s value index funds include allocations to REITs, which makes them less tax efficient if those funds are held in taxable accounts. Dimensional Fund Advisors (DFA) and Bridgeway exclude REITs from their value funds, treating them as a separate asset class. (Full disclosure: My firm, Buckingham, recommends DFA and Bridgeway funds in constructing client portfolios.)
3. Ability to preserve qualified dividends. To preserve qualified-dividend status, a fund must own the stock that earns the dividends for more than 60 days of a prescribed 121-day period. That period begins 60 days prior to the ex-dividend date. As a side note, the same creation/redemption process that helps ETFs minimize the realization of capital reduces the ability to preserve qualified dividends. To avoid tracking error, an index fund could be forced to sell shares before the holding period requirement is met. A structured portfolio does not face this constraint.
4. Limit securities-lending revenue to the expense ratio. When lending securities, otherwise-qualified dividends become nonqualified, losing their preferential tax treatment. However, from a tax perspective, securities-lending revenue can be used to offset the expense ratio of the fund. A fund company can offer a tax-optimized structured portfolio that limits its revenue from securities lending to an amount sufficient to offset the expense ratio. An index fund cannot implement this method of tax optimization without creating tracking error.
5. Screen for momentum and other factors. Companies such as DFA and Bridgeway have successfully incorporated momentum screens into their fund-construction strategies. This allows the funds to avoid buying stocks that fall into their buy range but are exhibiting negative momentum. The funds will wait until the negative momentum ceases before purchasing a stock. At the same time, hold ranges allow the funds to benefit from positive momentum. Patient trading strategies (using algorithmic programs) allows them to give priority to stocks with the least favorable momentum when selling shares. In addition, DFA has begun to add a gross profitability screen to its value funds to try and capture incremental returns from exposure to that factor. Bridgeway’s Omni Small Value funds already gain some exposure to the profitability factor through the use of its multiple value factor strategy, which includes screens for price/earnings, price/cash flow and price/sales in addition to price/book.
6. Avoid forced trades. Structured funds, which have accepted the risk of tracking error, can engage in patient, block trading activity that allows them to “sell liquidity” and earn a premium by purchasing stock at a discount. The opportunities arise (specifically in small- and especially micro-capitalization stocks) from the desire of active investors to quickly sell more stock than the market can absorb at the current bid. This can be a large benefit during periods of crisis, as long as the fund itself is not subject to investors fleeing the fund in a panic.

The bottom line is that a well-designed, structured portfolio maximizes the benefits of indexing, while minimizing—or even eliminating—the negatives.

And there is yet another advantage that structured funds can bring. In return for accepting tracking error risk, they can gain greater exposure to factors that have been shown to carry premiums. For example, a small value fund could be structured to own smaller and more “valuey” stocks than a small-cap index fund might.

Larry Swedroe is the director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.