How to evaluate index and passive funds
(MoneyWatch) Index and other passively managed funds have been slowly gaining popularity among investors. However, comparing similar index funds can be difficult and goes beyond simply looking at the expense ratio.
Certainly, the expense ratio is a big consideration, but it's important to look at what you're getting in return. With index funds, you're not only looking for low-cost exposure to the market, but also individual market factors, such as the size and value factors. (These factors show how much exposure the fund has to the size and value premiums, which are the higher expected returns of small-cap and value stocks.)
For example, just because one small-cap value fund is cheaper doesn't automatically mean it's the better choice. If the other fund has more significant exposure to the size and value factors, it may be the better fund for your portfolio.
Like pain? Check your portfolio
Rejoice! Passive investment is gaining momentum
Who's smarter -- active or passive investors?
As an example, let's look at two such funds: the DFA US Small Cap Value Portfolio (DFSVX) and the Vanguard Small-Cap Value Index (VISVX). The table shows the funds' expense ratios and their degrees of exposure to the market, size and value premiums for the period June 1998-December 2011 (the period since the Vanguard fund's inception).
The point isn't to say that one fund is better than the other. The lesson here is that not all passive funds are created equal, and you shouldn't simply look at the expense ratio and end the evaluation. Instead, determine how much exposure you need to the market, size and value premiums and find the least expensive way of getting that exposure.
Image courtesy of Flickr user 401(K) 2012
Popular on MoneyWatch
- TGI Fridays nailed for doctoring booze
- Amy's Baking Company could face legal 'nightmare'
- Reverse cell phone lookup service is free and simple
- Top 10 professional life coaching myths
- Amy's Baking Company: Post-meltdown PR campaign
- Meat labels getting facelift under new USDA rules
- The Donald prevails in fraud suit
- Turn off Windows 8 with one click
Curious as to why you leave out MOM? Is it the non-risk story or something else.
One could certainly add MOM as another factor.
Note value and MOM are negatively correlated. However, DFA actively screens to avoid buying stocks with negative MOM and that has reduced their negative exposure of typically about -0.4 to about 0. Haven't run Vanguard's figure but my guess it's negative since they don't screen for it. That would be an expected drag if you assume MOM will continue to exist.
Hope that helps
Larry
Also the R2k is an awful benchmark, well none as inappropriate for an index because of its transparency allows active managers to game the system, trading ahead of the indexers. Example 79-11 R2k returns 11.2% while CRSP 6-10 returns 12.7. Easy to see how if you use R2k as your benchmark you show outperformance, when in fact it never happened.
What you have to run active funds through a three factor regression model analysis to see if there was alpha
Best wishes
Larry
https://www.am-a.com/company/research/wp_active_passive2010.pdf
It comes to the conclusion that active investing is the proven way to invest in most markets and in down bear markets. The study does use the Russell indexes. My gut tells me something is wrong with this study.
For example you cannot look at large cap funds and compare all of them to an S&P 500 Index. You need to run a factor regression, or at very least compare them to appropriate benchmark. So if say value beats growth for the period studied a large value fund would appear to outperform if you benchmark against the S&P but might not if benchmark against the Fama French large value index. Same for small stocks.
Literally there are no studies I am aware of that show any ability of active funds to persistently win in any asset class. At least with persistence beyond the randomly expected
Best wishes
Larry