May 27, 2014

by Larry Swedroe

An overwhelming body of evidence demonstrates that the majority of investors would be better off by adopting indexed investment strategies. A total-stock-market (TSM) index is fine for many investors. But indexed investors who desire certain types of exposure face a number of problems – which are solved with what I call “structured portfolios.”

The benefits of indexing relative to active management are clear:

  • Low expense ratio
  • Low turnover, resulting in relatively high tax efficiency and relatively low transaction costs
  • No risk of style drift
  • Minimal cash drag
  • Total transparency

While indexing provides all of the above benefits, it does come with some negatives, which I’ll discuss below, because the sole goal of index funds is to replicate the indices they are tracking.

Structured portfolios incorporate the benefits of indexing while minimizing its negatives. I’ll begin with an explanation of structured indexing. I’ll then discuss how several structured-index portfolios performed relative to a comparable traditional index fund. I’ll conclude with a discussion of how advisors can choose the right fund for their clients.

The nine weaknesses that structured portfolios avoid

Index funds and structured 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 structured asset-class funds attempt to replicate the returns of popular retail indices like the S&P 500 or the Russell 2000. Instead, they tend to use academic definitions of asset classes and design portfolios in ways that minimize the weaknesses of indexing. I’ll examine nine such weaknesses:

  1. Sensitivity to risk factors varies over time. Because indices typically reconstitute annually, they lose exposure to their asset class or factors (such as beta, size, value, momentum or profitability) over time as the performance of stocks causes those stocks to migrate across asset classes during the course of a year. Structured portfolios typically reconstitute monthly, allowing them to maintain more consistent exposure to their asset class or factor. That allows them to capture a greater percentage of the risk premia in the asset classes or factors in which they invest. For example, after the annual reconstitution of the Russell 2000 in June, more than 96% of its holdings were in the bottom 10% of stocks ranked by market capitalization, on average. Eleven months later, that figure was down to around 88%. In contrast, the DFA Small Cap Fund averaged 96% for both months.
  2. Forced transactions result in higher trading costs. Imagine the following scenario for an index fund that buys and holds the stocks ranked 1,001–3,000 by market capitalization in the Russell 3000 index: A stock is ranked 1,001 in June, but when the index is reconstituted toward the end of June, the stock is ranked 999. The fund now must sell the stock. One year later, it is again ranked 1,001. The fund must again buy the stock.To reduce this costly, nonproductive turnover, a structured fund uses “hold ranges.” It might buy only the stocks with a ranking of higher than 1,000 and create a hold range for stocks with a ranking just below that figure. For example, the fund might continue to hold stocks (but not buy any more) as long as they were ranked between 800 and 1,000. If a stock’s ranking moved to a figure of less than 800, then it would be sold. Similarly, stocks can easily move from value to growth and back again. Not only do hold ranges reduce costly turnover, but they also improve tax efficiency.

    Both Russell and MSCI have mitigated this weakness to a great degree by implementing no-trade bands around the index breakpoints, helping to reduce unnecessary turnover.