Taking Indexing "To The Next Level"



by Eric D. Nelson, CFA

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Most of us appreciate that our investment portfolios must grow at a rate well in excess of inflation to achieve our future long-term goals.  To succeed here, you must first understand what you are trying to accomplish, sketch out an asset allocation that provides you a reasonable likelihood of achieving success, and then resist the urge to tinker and tweak your mix along the way.  The perils of getting these steps wrong are topics for another day, because the final step is often the most challenging: deciding how to implement your asset allocation.


The conventional approach, both in terms of assets and allure, is “active management.”  It entails buying mutual funds or separately managed accounts where an investment manger attempts to select only the best stocks or bonds, while excluding all others.


As is so often the case, nothing fails like convention.  Which is why a different brand of investing has gained popularity: "indexing."  This approach doesn’t rely on a superstar manager, but instead seeks to own every stock or bond in the market inside mutual funds that charge the lowest possible expense ratios.


But expense ratios paid are just one small factor of total returns, with a stock or bond portfolio's underlying characteristics and how efficiently it can be managed carrying much more weight.  And it is here that a third school thrives: "structured investing."  


Structured mutual funds exhibit much of the diversification and cost benefits of traditional index funds, yet are formed and managed explicitly to target areas of the stock and bond markets that have historically demonstrated higher risks and higher returns.  These areas include smaller and more-value oriented companies in the stock markets.  In the bond markets, structured funds seek to adjust average portfolio maturities in response to the shape of yield curves: holding slightly longer-term maturities (up to 5 years) when yields are noticeably higher, staying with short-term holdings or cash when yields across the spectrum are flat or inverted.  And most importantly, structured portfolios are implemented and maintained with an eye towards avoiding unnecessary turnover and trading costs, lowering the total cost of investing. 


Which approach has gotten the most out of investment markets?  Table 1 lists the 10YR annualized returns of each in the “core” asset classes that should make up most long-term portfolios.


Table 1: 10YR Annualized Returns Through June 30th, 2014

Asset Class

Active Fund Return

Index Return

Structured Fund Return

US Large “Market”




US Large Value




US Small Value




Int’l Large Value




Int’l Small Value




Emerging Mkts Value




Short-Term Bonds





As expected, active management proved to be the worst option.  The average active mutual fund trailed its index in 5 of the 7 categories.  Even this paints active management in an overly favorable light when we consider active mutual fund databases only report the mutual funds who have survived over the last 10 years.  As many as 40% of funds that were in existence a decade ago have done so poorly that they have been closed and their records wiped from the books.  Estimates find this “survivorship bias” in active management reports could cost them 0.5% to 1% per year in returns.


But index funds weren’t and aren’t the optimal investing approach.  In each category, we find that the return of the corresponding structured mutual fund exceeded that of the index—in many cases by 1% or more.  And this is before we debit the index returns by the 0.1% to 0.4% that actual index funds charge for management.  


By combining the best attributes of indexing: low expenses and broad diversification, structured investing also benefited from these time-tested principles.  By also focusing more intensely on value-oriented stocks, or smaller-cap stocks, or both, and by paying particular attention to the costs of buying and selling to maintain each portfolio's profile, structured investing managed to take indexing “to the next level.”


One final caveat: there is a self-serving aspect to this note that warrants explanation.  Most structured funds, such as the DFA funds reported in Table 1, are only available for those investors aligned with a fee-only investment advisor.  This comes with additional management fees of 0.5% to 0.75% per year.  But these fees don’t pay for “access” to superior mutual funds, they rightfully pay for the services described in the first paragraph: helping you discover and refine the purpose for your wealth, creating an asset allocation with the highest probability of achieving your long-term goals, and insuring you stick with that plan through thick and thin.  That the actual funds used to implement this plan have produced returns of 1% to 2% more than common alternative investment approaches is icing on the cake.  It simply means that all those important and value-added services are delivered for free (as the relative structured fund returns have been greater than typical advisory fees charged).  It’s a compelling package for sure, no matter how you cut it.



Source of data: Barron’s Quarterly Mutual Fund Section (for active mutual fund data), DFA Returns 2.0


US Large “Market” = S&P 500 Index; DUSQX (DFUSX prior to 7/2013)

US Large Value = Russell 1000 Value Index; DFLVX

US Small Value = Russell 2000 Value Index, DFSVX

Int’l Large Value = MSCI EAFE Value Index, DFIVX

Int’l Small Value = MSCI EAFE Small Value Index, DISVX

Emerging Mkts Value = MSCI EM Value Index, DFEVX

Short-Term Bonds = Barclays Gov’t/Credit 1-5YR Index, DFGBX


Past performance is not a guarantee of future results.  There are limitations inherent in model performance; it does not reflect trading in actual accounts and may not reflect the impact that economic and market factors may have had on an advisor’s decision-making if the advisor were managing actual client money.  Model performance is hypothetical and is for illustrative purposes only.  Model performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted.  This content is provided for informational purposes and  is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.