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The Benefits of Passive Management Without Indexes

(This week, we're looking at the differences between indexing and passive management. Today, we'll discuss how being passive but moving completely away from indexes can create even more value for investors.)
Over the past few days, we've seen the differences between index funds and passive asset class funds. These differences also provide examples of how passive asset class funds might end up with portfolios whose holdings are significantly different from the universe of initially eligible securities and market-cap weighting. If the screens the fund chooses are based on solid academic evidence and commonsense rules (resulting in a well-structured portfolio), the end result should be superior returns and tracking error to a benchmark that is purely random. (Some years the error will be randomly positive and some years it will be randomly negative, and in the long term it will average close to zero.)

Additional Risk Exposure There's another point on passive asset class funds versus index funds. Since a passive asset class fund can be created to gain any degree of exposure to the size and value risk factors, investors wishing to own a fund with more exposure to the risk factor of size than either the Russell 2000 Index or the S&P 600 Index offers might seek to buy a passive asset class fund that owns microcap stocks. Similarly, an investor might want more exposure to the value risk factor than an index fund might offer. Passive asset class funds might be available which would accomplish that objective. Not only would these funds offer greater exposure to the aforementioned risk factors of size and value, but they would also offer greater diversification to the overall portfolio.

Passively managed funds can also add value by being multi-asset class, all-in-one type funds. For example, Vanguard has a multi-asset class fund in its Total International Stock Index Fund (VGTSX), which includes both developed and emerging markets.

Dimensional Fund Advisors (DFA) has created a unique family of core funds with built-in "tilts" to small-cap and value stocks. The two main benefits of a single-fund approach are:

  • Lower transaction costs, such as commissions, bid-ask spreads and market impact
  • Lower capital gain distributions
Both derive from lower turnover. Core funds reduce the turnover that occurs from forced selling as stocks migrate from one asset class to another:
  • Small stocks become large stocks (and vice versa).
  • Value stocks become growth stocks (and vice versa).
  • Emerging market countries become developed market countries.
Another important benefit of multi-asset class funds is that they reduce (if not eliminate) the need to rebalance, which can create trading costs and realization of capital gains. Core funds self rebalance using cash flows and dividends.

To summarize, index funds are great investment vehicles. However, for many investors the additional potential benefits of passive asset class investing will outweigh what should be any random tracking error and the slightly higher expenses required to run these more sophisticated funds.

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