The continually rising popularity of passive funds relative to their active counterparts is a topic of hot debate in the industry.
Clients have latched onto the appeal; they are investing more cheaply, often more successfully, and they are removed from the responsibility of investment. Investors do not need to choose a manager, and they don’t need to choose stocks that they believe in, because they have bet on an index which encapsulates the investment world.
But Wei Dai, head of research at Dimensional Fund Advisors, says this is where investors get it wrong. Not all indices are created equally, even when they are measuring the same asset class.
Within just the world of US small caps, three main indices that companies use include the Russell 2000, the S&P Small Cap 600, and the CRSP US Small Cap index. Annually, Dai said there is an average five percentage-point difference of return.
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“At 5%, we could be already talking about the difference between asset classes, like equities versus fixed income. But here, we’re talking about the same market, just the US market and the small cap universe, and you see that difference,” Dai said.
“Year on year, that can be even bigger. We can see as much as a 12% difference. In terms of the ordering, which ones perform better than others, it changes all the time. The point is not about whether one index is better than others in terms of capturing the market. It’s more that there must be a lot of decisions being made by the indices. And those decisions matter, because you see that in the different investment outcomes.”
This has led Dimensional towards a wider investment universe, especially looking towards small-cap stocks. While the IMI version of the MSCI All Country World index holds about 8,000 stocks, Dimensional’s universe sits closer to 10,000.
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“There’s a lot that’s baked into the methodologies of those indices. From that perspective, the index fund managers are outsourcing those investments to index providers,” Dai says.
“Investors need to be fully aware of those decisions and critically ask if all those decisions are made for the best interest of the investors.”
Part of this comes through the way that indices operate. They aim to be trackable, which often limits their rebalancing to once a year, or possibly once a quarter. And because this information is published, others know when the rebalance is happening. This can lead to a significant spike in trades happening on a single day, with trading volume for that day nearly 40 times what it typically is, and trading at close near 100 times.
“It’s like buying roses on Valentine’s Day,” Dai says. “You’re not going to get a good price.”
Because Dimensional does not operate as a benchmark, it can instead make adjustments daily while keeping the wide breadth of stocks that would typically be found in a passive investment.
“We are spreading that turnover across all trading days, and we have flexibility in terms of what we want to trade. In the end, our approach is different from traditional active [managers]. We’re not thinking about picking individual stocks. We’re more capturing systematic factor premiums. So that gives us a lot of flexibility.
“This means there are similar stocks in terms of their market cap or in terms of relative profitability characteristics that we can treat over a short period of time as substitutable. Therefore, when we are in the markets, we are happy to take any stock where we can get the best execution done. When you give our traders that flexibility, you really empower them to get the best execution.”
However, this approach that differs from a typical active strategy can bring some challenges in terms of relating to investors.
Dai says this is often brought to their attention by advisers, whose clients sometimes are looking for an experience, which can come along with stocks they can follow, as well as an investment that performs well.
“There is always the temptation to look at the shiny products, or to be able to talk to your neighbours about stocks and things in the headlines. I think in the end, a lot of the education we have with clients is really to think about what the goal is for their portfolio,” Dai says.
“It’s often what gives them the best investment outcomes. Oftentimes, if you think about those individual stocks, people like to talk about what the prospects are of those companies, and whether this company is good or what will happen with their business and so on. But I think there’s a misunderstanding that identifying a good company is not the same thing as identifying a good investment.”