Can The Traditional Indexing Approach Be Improved Upon?

Jordan Edwards, CFA, CFP® | June 15th, 2017


In last month’s blog, we explored the challenges faced by actively-managed equity funds and why so few manage to outperform their benchmark indices. The difficulty involved in overweighting stocks that outperform the broad market along with the hurdle rate of higher fees helps explain why less than 10% of active managers have beaten their benchmarks in many market segments over the most recent 15-year cycle. Simply holding low-cost funds which replicate traditional market indices would have led to better results for the vast majority of investors.

However, while evidence suggests the traditional indexing approach is superior to the stock-picking or market-timing of active managers, investors rightly question whether they can improve on this method further.

Most market indices are based solely on the size of the underlying companies (the Dow being a notable exception). For example, the S&P 500 index is simply comprised of the largest 500 companies in America based on market-capitalization — the bigger the company, the greater the impact on the index. Because of this, about 50% of the total value of the S&P 500 is concentrated within the largest 50 companies. For index fund investors tracking these traditional indices, this means that the largest (and often the most expensive) companies drive a huge percentage of overall returns.

However, starting in the early 1980’s, financial academics such as Eugene Fama, Ken French, Rolf Banz and many others identified certain types of stocks that tend to perform better than the broad market. These outperforming stocks tended to have characteristics which run counter to the traditional indexing approach. For example, smaller company stocks tend to perform better than large company stocks over the long-term.  Similarly, lower cost or “value” stocks tend to perform better than “growth” companies, or companies that are more expensive relative to earnings or book-value.  We can think of these characteristics or “factors” as premiums investors require as compensation to take the additional risk of owning smaller or lower-cost companies.

While a portfolio which is more heavily weighted towards value and small-company stocks tends to outperform the broad market over long periods of time, it will experience tracking error. Tracking error is the difference in returns between an index and a portfolio that compares itself to that index. For example, if a portfolio of large U.S. stocks gains 12% while the S&P 500 gains 10%, the tracking error is 2% (12%-10%). If an S&P 500 index fund deviated from the actual returns of the S&P 500 by this much, it would soon go out of business, as an index fund’s goal is to have essentially no tracking error. However, it is not usually an investor’s goal to perfectly track traditional market indices, but rather to be properly compensated for the amount of risk being taken.

A portfolio which owns all of the same companies as a traditional index fund but owns a larger percentage of the companies with factors that have tended to outperform over time can lead to higher returns without the need to employ an army of high-cost analysts and managers. However, investors need to be prepared for periods in which such a portfolio underperforms the broad market in the short-term. It can sometimes take years to realize the higher expected returns from such a strategy. For investors willing to accept tracking error from an index (and the corresponding emotional difficulty of adhering to the strategy), it is possible to capture superior returns.

Another argument for this strategy lies in the fact that traditional index funds are inefficient because they are forced to buy and sell certain stocks solely due to underlying index changes. This happens each year and is referred to as “index reconstitution.” For example, if 20 companies were to be removed from the S&P 500 and replaced with 20 different companies, any index fund tracking the S&P 500 would have to sell all 20 of the outgoing stocks and purchase all 20 of the incoming stocks. To make matters worse, market participants know well-ahead of time which stocks will be removed and which will be added. Because index funds are forced to trade on specific days to keep tracking error at zero and everyone in the market knows this, index fund returns are materially reduced.

Even though the evidence suggests index-fund investing is superior to actively-managed approaches, Avier pursues a more flexible approach. Whereas Vanguard is the clear leader in traditional indexing, Dimensional Fund Advisors (DFA) dominates this “flexible indexing” approach. Since their inception in 1981, DFA has structured portfolios to achieve the best results for their investors. Using the same 15-year time period as the SPIVA scorecard we referred to earlier, the results speak for themselves:

The chart on the left shows that at the beginning of the 15-year period, there were 2,758 U.S. equity mutual funds available to invest in. By the end, only 43% of those funds had survived. More than 50% of those funds either failed and closed down or merged into more successful funds. This doesn’t tell the whole story, however. Only 17% of those funds managed to outperform their benchmarks (in many market segments, it was even worse than that). At the start of the same time period, DFA had 22 funds available for investing. All of the funds survived and 20 of the 22 managed to outperform their benchmarks. This is a remarkable accomplishment and speaks to the rigor of DFA’s academic approach to investing. Source: SPIVA U.S. Scorecard

While we believe the traditional index fund approach is a better option for investors than expensive actively-managed solutions, we believe a more flexible approach leads to even better results. To discuss ways to improve your investment approach, please feel free to give us a call at (425) 467-1011 or email us at info@avieradvisors.com.

Posted by Lars Phillips on June 13, 2017