A common mistake made by many passive investors is that they view all index funds in the same asset class as “commodities(1)”, often considering only the expense ratio when making their investment choices. However, not all index funds are alike, and not all passively managed funds (what I refer to as “systematically structured portfolios”) are index funds.
Index funds and systematically structured portfolios that define their eligible universe and do not engage in individual security selection or market timing(2) are as similar as a rectangle is to a square. All squares are rectangles, but not all rectangles are squares. Similarly, while all index funds are passively managed (there is no individual stock selection or market timing), not all systematically structured funds attempt to replicate the returns of popular retail indexes like the S&P 500 or the Russell 2000. Systematically structured portfolios tend to use academic definitions of asset classes, building portfolios that seek to minimize the weaknesses of pure indexing. Those weaknesses, which result from the desire to minimize what is called “tracking variance,” or “tracking error” (returns that deviate from the return of the benchmark index), include:
Sensitivity to risk factors varies over time. Because indexes typically reconstitute annually, they lose exposure to their asset class over time, as stocks migrate across asset classes during the course of a year. Structured passive portfolios typically reconstitute monthly, allowing them to maintain more consistent exposure to their asset class. That allows them to capture a greater percentage of the risk premiums in the asset classes in which they invest.
Forced transactions as stocks enter and leave an index, resulting in higher trading costs.
Inclusion of all stocks in the index. Research has found that very low-priced (“penny”) stocks, stocks in bankruptcy, extreme small growth stocks with high investment and low profitability, and IPOs have poor risk-adjusted returns. A structured portfolio could exclude such stocks, using a filter to screen them out.
Limited ability to pursue tax-saving strategies, including avoiding intentionally taking any short‐term gains and offsetting capital gains with capital losses.
Another advantage of systematically structured funds is that, in return for accepting tracking variance risk, they can gain greater exposure to the factors for which there is persistent and pervasive evidence of a return premium (such as size, value, momentum, profitability/quality, carry, term). For example, a systematic small-cap value fund could be structured to own smaller and more “valuey” stocks than a small-cap value index fund. It can also be structured to have more exposure to highly profitable companies, and it can screen for the momentum effect(3).
An often-overlooked disadvantage of index funds may result from the view that they tend to have low turnover and thus low trading costs. However, funds that attempt to replicate public indexes run the risk of exploitation through front-running—high-frequency traders and other active managers can exploit the knowledge that they must trade on certain dates. Structured portfolios avoid this risk by not trading in a manner that simply replicates the return of the index.
The Cost of Replication
Sida Li contributes to the literature on trading costs of exchange-traded funds (ETFs) with her November 2021 study, “Should Passive Investors Actively Manage Their Trades?” Her database covered all unlevered ETFs listed in the U.S. and Canada with no survivorship biases and the period 2012-2020. She began by noting that the passive investment strategy implicitly assumes that an investor holds a static buy-and-hold portfolio and that the portfolio constituents remain constant. In reality, passive funds need to trade in response to index constituent changes, IPOs, mergers, and acquisitions, and delistings—the median portfolio turnover rate in 2020 of a U.S.-indexed equity ETF was 16 percent. Therefore, even if an investor chooses to buy and hold an ETF, the ETF manager needs to trade on behalf of the investor.
Li identified three types of ETF trading strategies: a “sunshine trading” strategy; camouflaging when to trade (she called them “opaque ETFs,” as they only post holdings at month’s end instead of daily); and camouflaging what to trade (ETFs that invent their own indices to track, which she called “self-indexing,” and are required to disclose their positions daily). An example of a self-indexing ETF is the Schwab 1000 ETF, which tracks the Schwab 1000 Index and is 99 percent correlated with the S&P 500 Index. Unlike S&P indices—or any other index from index companies, such as FTSE Russell, MSCI, etc.—the Schwab 1000 Index does not offer subscriptions to external investors, nor does it announce the stocks to be rebalanced before a rebalance is executed. As a result, this ETF’s rebalancing trades are less transparent and less crowded. Following is a summary of her other main findings:
Fifty-six percent of ETFs tracked public indices and preannounced their rebalancing trades, trading entirely on reconstitution days at closing prices. Their large, uninformed trades paid 67 basis points (bps) in execution costs, a figure that is three times higher than what was paid in similar-sized institutional trades. There was also a reversal of 20 bps after they traded.
Camouflaged trading ETFs (performed by the opaque ETFs) spread out their trades across 10 days and saved 34 bps per trade or 7.3 bps per year.
Thirty-seven percent of ETFs used self-designed indices to avoid preannouncements of rebalancing stocks and saved 30 bps per trade and 9.6 bps per year. The alternative rebalancing schedule did lead to a tracking error of 10.6 bps per year and an information ratio (a measurement of portfolio returns beyond the returns of a benchmark, usually an index, compared to the volatility of those returns) of 0.69.
Investors should note that the savings from “intelligent” trading are not insignificant. Given that the AUM (assets under management) weighted-average expense ratio of U.S. equity ETFs was only 15.1 bps per year, the 9.6 bps execution cost reflects a hidden cost of 60 percent in management fees. As Li noted: “Vanguard believes that the daily reporting of ETF holdings can encourage frontrunning and free-riding by opportunistic traders. Therefore, Vanguard ETFs publish only month-end portfolio data with 15-day lags.” Thus, Li classified them as “opaque ETFs.”
While Li only examined ETFs, her findings are just as relevant to mutual fund investors.
When considering which index or systematically structured (passive) mutual fund or ETF to utilize to gain exposure to an asset class (or factor), there are many considerations beyond just the fund’s expense ratio. For example, Li found that trading costs can vary depending on the degree of transparency of the fund’s trading strategy. And then there are the negatives described earlier that are incurred by funds that have index replication as their main objective. And, as also discussed, you should consider the degree of exposure, aka Active Share, a fund has to the factors/asset class you are investing in. The differences in exposure to factors such as size, value, profitability/quality, and momentum can lead to significant differences in expected (and realized) returns. Thus, even when considering two passively managed funds from the same asset class, due diligence should go well beyond just the expense ratio.
Finally, when considering between a mutual fund and an ETF, while an ETF is likely to be more tax-efficient(4), an ETF also incurs explicit trading costs when buying/selling that might be higher than the indirect trading costs incurred by a mutual fund.(5) While a mutual fund trades at its net asset value (NAV), when trading an ETF, you must consider not only the bid-offer spread but also the fact that you might be paying slightly above the NAV when buying, and you might receive less than the NAV when selling. This is particularly true for ETFs which hold less liquid underlying securities and when there are events that impact market liquidity. That said, mutual funds only trade at NAV at the end of the day, so unless you put your order in at the close, the NAV you’re executed at could be materially different than when you placed your trade.
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A mutual fund will still incur trading costs when they deploy the new cash to buy/sell securities, whereas an ETF is delivered securities and does not incur the trading costs because they are borne by the authorized participants.
As Chief Research Officer for Buckingham Strategic Wealth and Buckingham Strategic Partners, Larry Swedroe spends his time, talent and energy educating investors on the benefits of evidence-based investing with enthusiasm few can match. Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has since authored seven more books: “What Wall Street Doesn’t Want You to Know” (2001), “Rational Investing in Irrational Times” (2002), “The Successful Investor Today” (2003), “Wise Investing Made Simple” (2007), “Wise Investing Made Simpler” (2010), “The Quest for Alpha” (2011) and “Think, Act, and Invest Like Warren Buffett” (2012). He has also co-authored eight books about investing. His latest work, “Your Complete Guide to a Successful and Secure Retirement was co-authored with Kevin Grogan and published in January 2019. In his role as chief research officer and as a member of Buckingham’s Investment Policy Committee, Larry, who joined the firm in 1996, regularly reviews the findings published in dozens of peer-reviewed financial journals, evaluates the outcomes and uses the result to inform the organization’s formal investment strategy recommendations. He has had his own articles published in the Journal of Accountancy, Journal of Investing, AAII Journal, Personal Financial Planning Monthly, Journal of Indexing, and The Journal of Portfolio Management. Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television shows airing on NBC, CNBC, CNN, and Bloomberg Personal Finance. Larry is a prolific writer and contributes regularly to multiple outlets, including Advisor Perspective, Evidence Based Investing, and Alpha Architect. Before joining Buckingham Wealth Partners, Larry was vice chairman of Prudential Home Mortgage. He has held positions at Citicorp as senior vice president and regional treasurer, responsible for treasury, foreign exchange and investment banking activities, including risk management strategies. Larry holds an MBA in finance and investment from New York University and a bachelor’s degree in finance from Baruch College in New York.
Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. Past performance is not indicative of future results, which may vary. There is a risk of substantial loss associated with trading stocks, commodities, futures, options and other financial instruments. Full disclosures here.