We talk to Dimensional Fund Advisors about why index investing in the conventional sense raises a number of challenges that aren't widely appreciated.

For more than two decades, the rise of “passive investing” has been a strong wealth management theme. The idea of trying to beat a market benchmark in the long term to earn “Alpha” by picking stocks was regarded as a mug’s game, so the argument went. Active management fell out of favour to some extent as stocks were lifted on a tide of cheap money after 2008. Exchange-traded funds are now an established portfolio building block.

Starting with the likes of US asset management giant Vanguard, led by its visionary founder, the late John C Bogle, there is now a large index fund market. And the ETFs and exchange-traded products (ETPs) is considerable. According to ETFGI, a firm that monitors the sector, these entities held $15.44 trillion of AuM as at the end of April. While it is true that some ETFs can be set up to capture various drivers of return and inject an element of “active” into the recipe (“smart Beta”), overall, the sector is still seen as a “passive” area. Part of the sales pitch for ETFs and suchlike is that they are, other things being equal, cheaper in fees than for an actively managed fund.

But there is a fly in the ointment. According to Dimensional Fund Advisors, a US-based firm that stresses its systematic investment approach, the way that indices used by ETFs are re-set during a year to allow for firms entering or leaving an index means that investors can lose out. In a way, this runs in parallel with rising worries about “concentration risk.” For example, the “Magnificent Seven” tech stocks have disproportionately driven US equity returns in recent years. (See related articles about Dimensional regarding its Singapore business, and its investment philosophy.)

Changes
Around the half-way point of the year, S&P and Russell indices of equities are due to be re-set (or may have already have been at the time of going to press). This “reconstitution” of indices creates a problem if this only happens once or twice a year. 

Dimensional cites the case of Tesla. In 2020 the electric carmaker surged to become the sixth-largest US company before finally entering the S&P 500. Funds tracking that index missed most of the upside, not due to poor management, but delayed eligibility rules in the index. 

The firm examined the equal-weighted average trade volume from 2018 to 2022 for the S&P 500, Russell 2000, MSCI EAFE, and MSCI EM indices, and found that on reconstitution days, trading volumes were many multiples, sometimes around 20 or 30 times, higher than typical daily trading volumes in those stocks. These trading volumes add to costs and cut what investors ultimately receive.

Shining a light
Mamdouh Medhat, PhD, a London-based research director and vice president at Dimensional, said the issues created by index investing deserve more attention. 

“They [index investing approaches] tend not to give investors what they thought they were getting, and returns are left on the table,” he told WealthBriefing in a call. “There are active decisions everywhere in what index providers and managers do.”

A problem is that index fund providers want to minimise tracking error – the gap between an index and the fund replicating it – as much as possible. Some indices are rebalanced only twice or even once a year. By crowding all the changes into one day, the level of turnover and associated market moves can dent returns. Unfortunately, this does not show itself in the total expense ratio (TER) on an ETF that the client sees, Medhat said.

While index providers might try and build a kind of “overlay” policy to counteract the effect of a big rush of trades on reconstitution days, that does not address the underlying issue, Medhat continued.

“We know that the [index] sector is very much aware of the [reconstitution] problem,” he continued. “We don’t think indexing is evil but there are ways that go beyond it.”

An explanation
The solution for investors, according to Medhat, lies in investment strategies that prioritise fund performance, rather than zero tracking error. “The fundamental problem is that an index and an investment strategy are two different things. Indices are designed to represent an asset class and be easy to replicate. An investment strategy is all about the right outcome for the investor.”

Medhat provides an example of when these two objectives are at odds: “Index providers must disclose which stocks will be added or deleted from their indices before reconstitution events. This causes a surge in trading these stocks – which moves prices. In the 20 days before an event, that movement averages around 4 per cent, with a similar reversal in prices after the event.”

The researcher points out that index funds are bound to make those trades even though it means they are knowingly buying high and selling low. In contrast, Dimensional’s strategies are unconstrained by zero tracking. “We are free to trade stocks only when we think they will improve the expected return of a portfolio, rather than when a third party tells us to,” Medhat said. 

Style drift
Another concern, the firm says, is that without constant adjustments of investments to suit a stated index, the client ends up with “style drift” – for example, holding a set of securities that have drifted to become, large-cap stocks rather than the mid-caps they originally thought they were buying into.

“Stock prices change all the time so to maintain exposure to your chosen asset class, you should rebalance your portfolio more regularly than most indices. In 2022, Meta moved from growth to value and back to growth in between reconstitution events. Some index tracking funds, supposedly focused on value stocks, missed the buying and selling opportunities this presented.”

Who decides what’s in the index?
Dimensional said its research shows that index providers that link their products to the same market benchmark can give different returns – often by several full percentage points that compound up.

In an article from September 2024, entitled It’s Time to Rethink Index Funds. They Could Be More Active Than Investors Think, it said: “Many investors want low-cost exposure to the market and may assume that an index fund is a good way to get it. But each index provider makes its own methodology choices, which can lead to a wide range of returns among indices designed to target the same asset class. For example, the average annual spread in returns among four US total market indices over the past 20 years ranged from 0.2 per cent to 3.2 per cent, with an average spread of 1 per cent. In other words, there is no single, consistent approach to defining a market.”