Structured Portfolios: Solving the Problems with Indexing 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 Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.
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. 3. Index funds risk exploitation through front-running. An example of the cost of front-running is the Russell 2000, which reconstitutes its index each June. On June 13, 2014, Russell will announce its preliminary additions and deletions. On June 20 and again on June 27, it will update the list of additions and deletions, with the reconstitution final after the 3 p.m. close. Obviously, most of the changes are well known ahead of the actual reconstitution when index funds would trade. Active managers can exploit the knowledge that index funds must trade on certain dates. Structured portfolios avoid this risk by not simply replicating the return of the index. Aware of these problems, Russell has made some changes: 2002: Share changes exceeding 5% of the index are made on a monthly basis. 2004: IPOs are included once per quarter. 2007: There is a transitional index in the month of June, so not all trading happens on one day. 2007: Buffer zones are instituted around market capitalization ranges to reduce turnover. Unfortunately, as the evidence in the table below shows, there doesn t seem to have been any improvement in relative returns. The table compares the Russell 2000 to comparable indices from the Center for Research in Securities Pricing (CRSP) at the University of Chicago. Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.
Period Russell 2000 Annualized Return (%) CRSP 6-8 Annualized Return (%) CRSP 6-10 Annualized Return (%) 1979-2001 13.7 15.7 15.2 2002-2007 8.9 10.7 10.9 2007-2013 7.2 9.6 9.1 As you can see, the choice of an index to replicate (or benchmark against) makes a great deal of difference. A small-capitalization index fund tied to the Russell 2000 index would have dramatically underperformed a small- capitalization fund tied to the similar CRSP indices. 4. Inclusion of all stocks in the index. Research has found that very low priced ( penny ) stocks (note that the Russell does exclude all stocks priced under $1), stocks in bankruptcy and IPOs have poor risk-adjusted returns. A structured portfolio could exclude such stocks using a simple filter. 5. Index funds have limited ability to pursue tax-saving strategies. Structured portfolios can offset capital gains with capital losses and avoid intentionally taking short-term gains. Excluding real-estate investment trusts (REITs) also improves tax efficiency. 1 6. Ability to preserve qualified dividends. To preserve qualified-dividend status, a fund must own the stock for more than 60 days of a prescribed 121-day period. That period begins 60 days prior to the ex-dividend date. To avoid tracking error, an index fund could be forced to sell shares before the holding period requirement is met. A structured portfolio does not face this constraint. 7. Limit securities lending revenue to the expense ratio. When lending securities, otherwise qualified dividends become non-qualified, losing their preferential tax treatment. However, from a tax perspective, securities-lending revenue can be used to offset the expense ratio of the fund. A fund company can offer a tax-optimized structured portfolio that limits its revenue from securities lending to an amount sufficient to offset the expense ratio. An index fund cannot implement this method of tax optimization without creating tracking error. 8. Screen for momentum and other factors. Companies such as Dimensional Fund Advisors (DFA) and Bridgeway have successfully incorporated momentum screens into their fundconstruction strategies. This allows the funds to avoid buying stocks that fall into their buy range but are exhibiting negative momentum. (Full disclosure: My firm, Buckingham, recommends DFA and Bridgeway funds in constructing client portfolios.) The funds will wait until the negative momentum ceases before purchasing a stock. At the same time, hold ranges allow the funds to benefit from positive momentum. Patient trading strategies (using algorithmic programs) allows them to give priority to stocks with the least favorable momentum when selling shares. Indeed, structured portfolios can screen for any factor. Some funds have been incorporating profitability as a factor, a practice that has been reviewed in a different publication. 9. Avoiding forced trades. Structured funds can engage in patient trading activity that allows them to sell liquidity and earn a premium by purchasing stock at a discount. The opportunities arise (specifically in small- and especially micro-capitalization stocks) from the desire of active investors to quickly sell more stock than the market can absorb at the current bid. This can be a Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.
large benefit during periods of crisis, as long as the fund itself is not subject to investors fleeing the fund in a panic. Examining the performance of structured portfolios A well-designed structured portfolio maximizes the benefits of indexing while minimizing, or even eliminating, the negatives. Another advantage that structured funds bring is that in return for accepting tracking-error risk, they can gain greater exposure to the factors that have historically offered risk premia. For example, a small value fund could be structured to own smaller and higher-value stocks than a small-capitalization index fund might have. The following table, with data from Morningstar as of April 28, 2014, shows the various metrics for three small-value funds from three different fund families the index fund of Vanguard and the structured funds of DFA and Bridgeway. The table provides the weighted average market capitalization to show the relative exposures to the size premium and the four different value metrics (price-toearnings, price-to-book, price-to-sales and price-to-cash flow) to show the relative exposure to value premium. Unfortunately, Morningstar doesn t provide consistent data for each fund, so the data are for slightly different time periods. However, prices were relatively unchanged during the period. Thus, the differences in dates don t matter much, especially since the differences in the metrics are so great, as you ll see. Vanguard s data is as of March 31, 2014, DFA s is as of Jan. 31, 2014, and Bridgeway s is as of Dec. 31, 2013. Fund Vanguard Small Value (VISVX) DFA Small Value (DFSVX) Bridgeway Omni Small Value (BOSVX) Weighted Average Market Cap P/E P/B P/S P/CF $2.7B 16.5 1.7 0.9 7.6 $1.2B 15.1 1.3 0.7 5.2 $.6B 15.0 1.2 0.6 3.5 The Vanguard fund holds stocks that are more than twice as large as the stocks held by DFA, and Bridgeway s holdings are much smaller than DFA s (half as large). Those differences are created by the structure of the funds the definitions they use to determine buy, hold and sell ranges. The smaller the market cap, the greater the expected return over the long term, at least on a risk un-adjusted basis. Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.
One should expect that when small stocks outperform large stocks, Bridgeway s fund will have the highest return and Vanguard s the lowest, with DFA in the middle. One should expect the reverse when large stocks outperform small stocks. This won t always be true, because DFA and Bridgeway both incur lots of tracking error to achieve their goals of having the highest long-term returns. And these are small-value funds, not small-cap funds. In the case of each of the four value metrics, Vanguard s small-value fund owns stocks with relatively higher values than does either DFA or Bridgeway in some cases the differences are quite large. And with the exception of a small difference in the price-to-book ratios, Bridgeway s fund owns stocks that have relatively lower values than does DFA s fund. This shouldn t be a surprise because the DFA small-value fund relies on the book-to-market ratio to screen stocks, while Bridgeway uses four metrics, with its own weighting scheme. Bridgeway s fund, by design, has the most exposure to both the size and value premia. Thus, when value stocks outperform growth stocks, one should expect Bridgeway s fund to have the highest returns and Vanguard s the lowest (depending on what the small premium is doing as well), and vice versa. With the data and concepts in mind, let s now take a look at how the funds have performed in the past five calendar years (2009-2013). I ll also look at the returns of Vanguard s 500 Index Fund (VFINX). Some notes: Bridgeway s fund has an inception date of Aug. 31, 2011, so we don t have much data for it. Also, when a fund is new and relatively small, the amount of tracking error it can experience is high because it won t have as much diversification across the stocks in its asset class until it has more assets under management. Also, Vanguard s value funds include REITs, while DFA s and Bridgeway s funds do not, because those firms treat REITs as a separate asset class. That can cause and explain some of the differences in performance. In 2009, VFINX returned 26.5% and VISVX returned 30.3%. Since small value stocks outperformed, we should expect to see DFSVX outperform VISVX it did, returning 33.6%. In 2010, VFINX returned 14.9% and VISVX returned 24.8%. Since small value outperformed again, we should expect to see a repeat performance. DFSVX returned 30.9%. In 2011, VFINX returned 2.0% and VISVX returned -4.2%. Since small value underperformed, we should expect to see DFSVX underperform VISVX. DFSVX returned -7.6%. In 2012, VFINX returned 15.8% and VISVX returned 18.6%. Since small value outperformed, we should again expect to see DFSVX outperform VISVX. DFSVX returned 21.7. Bridgeway s BOSVX returned 17.7%. In 2013, VFINX returned 32.2% and VISVX returned 36.4%. Since small value outperformed, we should again expect to see DFSVX outperform VISVX. DFSVX returned 42.4%. And BOSVX outperformed both, returning 44.6%, as we should have expected. The only outlier in the data was the underperformance of BOSVX in 2012. The likely explanation is a random tracking error. Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.
There are a couple of important takeaways. All three passively managed funds did their jobs well. The differences in performance were explained by the funds structures how they re designed what s known as Dunn s Law. The law is that when an asset class does well, you should expect the fund with the most exposure to that class to have the highest return. And when an asset class does poorly, you should expect the fund with the most exposure to that class to underperform. Choosing the right fund Your choice of fund should be based on how much exposure you want to various risk factors and on the fund s expense ratio. Weigh both criteria. It might be that a fund with a higher expense ratio is a better choice, as it might have more exposure to the factors you desire. It s not just cost, but cost per unit of expected return (and risk) that matters. For example, VISVX has an expense ratio of 0.24% (Vanguard s Admiral Shares version costs just 0.10%) and DFSVX has an expense ratio of 0.52%. The higher costs of the DFA fund have been more than offset by the fund s greater exposure to certain factors and its focus on adding value by minimizing the negatives of pure indexing. For the 15-year period ending April 25, 2014 (the day before I wrote this), DFSVX returned 12.26% versus 10.35% for VISVX. BOSVX has an expense ratio of 0.6%, but its greater exposure to the size and value effects should allow it to produce the highest returns of the three funds. When it comes to TSM funds, there really are no negatives of any great significance. With that said, there is one thing for advisors to consider. While a TSM fund owns lots of small and value stocks and thus is highly diversified across asset classes and by number of stocks, it has by definition no exposure at all to other factors (besides beta). So it's undiversified by factors (which may not be a concern). The reason is that while a TSM fund is long small and value stocks, providing positive loadings on those factors, it also owns large and growth stocks, providing an exactly offsetting negative loadings on those same factors. That leaves investors with exposure to just the single factor of beta. Indexing is a wonderful strategy. However, the need to minimize tracking error comes with some costs. By accepting tracking-error risk, structured portfolios can enhance some of the benefits of indexing and deliver superior returns. Larry Swedroe is director of research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country. Page 6, 2018 Advisor Perspectives, Inc. All rights reserved.