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Index vs. Evidence-Based Investing: Why Settle for Better?
Part of our job here at Hill Investment Group is to keep a relatively close eye on financial industry news, so our clients don’t have to (unless they find it interesting). One technical tidbit caught our eye recently when Vanguard’s advisor news channel reported on how its index funds will be impacted by a change to the way the Center for Research in Security Prices (CRSP) will be reconstituting its indexes.
Wow, that’s a lot of jargon. Let’s translate.
Most investors are familiar with the broad strokes of index investing. An index fund identifies a slice of the market to invest in – such as U.S. small-company value stocks. The fund manager then picks an index that tracks that same swath, and buys up essentially everything that index is holding. For the past several years, Vanguard has been using CRSP indexes to fulfill that role.
Mostly, that’s a relatively sensible way to go about investing. CRSP indexes are at least as robust as any others for tracking particular markets. And index funds are certainly better than active managers, who spend their time and your money trying to dodge in and out of markets, without adding expected extra worth.
If there weren’t an even better – let’s say best – way to go about it, we’d probably be all in on index funds ourselves (and there are times we use them, when we feel they are the ideal tool for the job at hand). But, instead of investing in funds that follow indexes that follow a swath of the market … we typically prefer funds that skip the index “middle man,” and buy into the vast majority of a market swath directly. Dimensional Fund Advisors is one such fund manager, and the longest-tenured among them, having been around since 1981.
Vanguard’s recent announcement speaks to one reason we prefer the more direct approach. One bugaboo index funds face is what to do whenever its underlying index “reconstitutes,” or changes the securities it’s tracking. Every index does this from time to time. For example, say a small company becomes a big company. A small-cap index must then stop tracking its stock and, usually, pick a different one to track instead.
That means any index fund tracking that index must actually sell and buy those same swapped-out securities – and relatively quickly if it wants to keep accurately reflecting its target index. You may already be a step ahead of me if you recognize that this creates some pricing challenges. If several index fund managers are all trying to sell and buy the same securities at around the same time, the trades can end up costing more than if there weren’t an essentially artificial supply-and-demand issue at play.
To help alleviate (although probably not eliminate) that challenge, CRSP has announced it will spread its reconstitution activities across five days instead of just one.
Again, that’s a sensible idea, and it may help some. But remember, fund managers like Dimensional allow us to avoid the reconstitution challenge entirely by more directly tracking the small-cap value market (and many others). This is a topic for another post, but direct tracking also offers other advantages over being tied to an index. Suffice it to say here that not all small-cap value funds are equally as effective at capturing the expected premiums available from this relatively narrow market.
So, with respect to Vanguard’s recent announcement, “better” is nice. But when the choice is, “better or best?” … we still prefer best.