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.
Similarly, while all index funds are passively managed, not all passively managed structured asset class (or factor-based) funds attempt to replicate the returns of popular retail indexes like the S&P 500 or the Russell 2000.
Structured portfolios tend to use academic definitions of asset classes, building portfolios that seek to minimize the weaknesses of indexing. Those weaknesses, which result from the desire to minimize what is called “tracking error,” include:
- Sensitivity to risk factors that vary over time. Because indexes typically reconstitute annually, they 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 asset class. That 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, resulting in higher trading costs.
- 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 in the index. Research has found that very low-priced (“penny”) stocks, stocks in bankruptcy, extreme small growth stocks and IPOs have poor risk-adjusted returns. A structured portfolio could exclude such stocks, using a simple filter to screen them out.
- Limited ability to pursue tax-saving strategies, including avoiding intentionally taking any short-term gains and offsetting capital gains with capital losses.
Another advantage of structured funds, in return for accepting tracking error risk, is that they can gain greater exposure to the factors for which there is persistent and pervasive evidence of a return premium (such as size, value, momentum, profitability, momentum, carry, term).
For example, a small value fund could be structured to own smaller and more “value-y” stocks than a small-cap value index fund. It can also be structured to have more exposure to highly profitable companies, and it can screen for the momentum effect (avoiding buying stocks that are exhibiting negative momentum, and delaying selling stocks with positive momentum).
Sizing Up The Numbers
The following table, using data from Bridgeway as of Dec. 31, 2018, shows the various metrics for three passively managed small value funds from three different fund families—the index fund of Vanguard and the structured funds of Dimensional Fund Advisors and Bridgeway.
The table provides the weighted average market capitalization to show each fund’s relative exposure to the size premium, and four different value metrics—price-to-earnings (P/E), price-to-book (P/B), price-to-sales (P/S) and price-to-cash flow (P/CF)—to show the relative exposure to the significant premium provided by value stocks. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Bridgeway and Dimensional funds in constructing client portfolios.)
The Vanguard fund has a much larger average market cap and significantly higher valuations relative to each metric than the Dimensional fund, and the Dimensional fund has a much larger market cap and higher P/E and P/CF valuations than the Bridgeway Fund (and the same P/B and P/S ratios).
Is Performance A Match?
With the data and concepts in mind, let’s now take a look at how the funds have performed—did we get what we expected? Since the first full year for Bridgeway’s fund was 2012, we will examine the returns for the last seven calendar years (2012–2018). To see if we got what we expected, we will also look at the returns of Vanguard 500 Index Fund (VFINX). The following returns data is from Morningstar.
Note that Vanguard’s small value fund includes about 12.5% of real estate investment trusts (REITs), while Dimensional’s and Bridgeway’s funds do not, because REITs are treated by those firms as separate asset classes. That can create/explain some of the differences in performance.
- In 2012, VFINX returned 15.8% and VISVX returned 18.6%. Since small value outperformed, we should again expect to see DFSVX outperform VISVX—and that’s what happened, as DFSVX returned 21.7%. Bridgeway’s BOSVX returned 17.7%. Given its greater exposure to the size and value factors, we should have expected BOSVX to outperform. The likely explanation is that, with a new fund, the risk of tracking error is greater as the fund builds its positions.
- In 2013, VFINX returned 32.2% and VISVX returned 36.4%. Since small value outperformed, we should again expect to see DFSVX outperform VISVX—and that is what happened, as DFSVX returned 42.4%. BOSVX outperformed both, returning 44.6%, as expected. Vanguard’s performance was hurt by the performance of REITs.
- In 2014, VFINX returned 13.5% and VISVX returned 10.4%. Since small value underperformed, we should expect to see DFSVX underperform VISVX—and that is what happened, as DFSVX returned 3.5%. BOSVX underperformed both, returning 0.8%, as expected. VISVX also benefited from the strong performance of REITs.
- In 2015, VFINX returned 1.3% and VISVX lost 4.8%. Since small value underperformed, we should expect to see DFSVX underperform VISVX—and that is what happened, as DFSVX lost 7.8%. BOSVX also underperformed VISVX, losing 6.6%, though it unexpectedly slightly outperformed DFSVX. VISVX again benefited from the relative performance of REITs.
- In 2016, VFINX returned 11.8% and VISVX returned 24.7%. Since small value outperformed, we should expect to see DFSVX outperform VISVX—and that is what happened, as DFSVX returned 28.3%. And as we should have expected, BOSVX outperformed both, returning 34.5%. The performance of VISVX was negatively impacted by the performance of REITs.
- In 2017, VFINX returned 21.8% and VISVX returned 11.7%. Since small value underperformed, we should expect to see DFSVX underperform VISVX—and that is what happened, as DFSVX returned 7.2%. BOSVX underperformed both, returning 6.0%, as expected. REITs hurt VISVX.
- In 2018, VFINX returned -4.58% and VISVX returned -12.3%. Since small value underperformed, we should expect to see DFSVX underperform VISVX—and that is what happened, as DFSVX returned -15.1%. BOSVX underperformed both, returning -17.2%, as expected. VISVX benefited from the relative performance of REITs.
Note how well the exposure to the factors of size and value explain the relative performance of the three funds. There were just two outliers in the data—the underperformance of BOSVX in 2012 and its outperformance relative to DFSVX in 2015 (in both cases, the likely explanation is random tracking error).