Swedroe: Passive Investing Without Indexes

April 13, 2016

Most investors believe all passively managed funds within the same asset class should have the same, or at least very similar, returns. However, while all index funds and passive structured asset class funds are similar in the way that rectangles and squares are similar, they are also very different. All squares are rectangles, but not all rectangles are squares.

Similarly, 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, they tend to use academic definitions of asset classes and structure portfolios to minimize the inherent weaknesses of pure indexing. Those weaknesses, which result from the desire to minimize what is called “tracking error” (returns that deviate from the return of the benchmark index), include:

  • A sensitivity to risk factors that varies over time. Because indexes typically reconstitute annually, the index funds that replicate them lose exposure to their asset class over time 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 their desired 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 result in higher trading costs and less tax efficiency for the funds attempting to replicate that index.
  • Risk of exploitation through front-running. Active managers can exploit the 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 within the index. Research has found that very-low-priced (“penny”) stocks, stocks in bankruptcy, small growth stocks with high investment and low profitability, and IPOs all display poor risk-adjusted returns. A structured portfolio could exclude such stocks using a simple filter to screen them all out.
  • Limited ability to pursue tax-saving strategies, including approaches that avoid intentionally taking any short‐term gains and offsetting capital gains with capital losses.

The Price Of Tracking Error

Another advantage that structured funds can bring, in return for an investor accepting tracking error risk, is that they can gain greater exposure to certain factors for which there is persistent and pervasive evidence of a return premium (such as market beta, size, value, momentum and profitability/quality).

For example, a small value fund could be structured to own smaller and more “valuey” stocks than a small-cap value index fund might include. It can also be structured to have more exposure to highly profitable companies. And it can screen for the momentum effect (avoiding the purchase of stocks that are exhibiting negative momentum and that delay the sale of stocks with positive momentum).

While all these attributes are benefits, they come with a “price” in the form of the aforementioned tracking error. Investors seeking the advantages of structured funds must accept the fact that it’s a virtual certainty there will be periods (even very long ones) during which they underperform an index fund in the same asset class.

Investors enjoy it when the tracking error is positive—their passively managed structured fund outperforms an index fund in the same asset class—but when the tracking error is negative, they unfortunately exhibit a tendency to make the dual mistakes of confusing strategy with outcome and losing discipline (they become impatient).

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