Portfolio construction is substantially a function of two key decisions. The first is the split between risky assets such as stocks and more stable assets such as bonds. More stocks, more expected return, but with greater turbulence when skies are grey. The second is strategy: specifically, within the major asset classes, which securities to own and, critically, how best to acquire them.

APW - index funds v2

Longstanding clients of B|O|S have heard at length our preference for investment vehicles that offer broad diversification at low cost. And some may believe, albeit incorrectly, that their investment portfolios are constructed exclusively of index funds, which are baskets of securities that rigidly follow predetermined market indices. After all, if no one can reliably time the market and stock picking is a loser’s game, as B|O|S believes, why provide a given fund manager any discretion to deviate from the index they are assigned to follow?

The data has long suggested to us that, within certain asset classes, some managed funds, despite being a bit more expensive than their index fund counterparts, have been able to generate higher returns over time. In finance, the excess return is referred to as positive alpha, which is defined as the incremental return provided by the fund manager (again, relative to simply owning the comparable index). Alpha can work both ways, of course, and when the fund manager’s actions result in lower returns, relative to benchmark, it is referred to as negative alpha.

On the stock side of the portfolio, we have found that it is possible to earn positive alpha, measured over long time periods, in managed small company and value stock funds (both in U.S. and foreign markets). This is one of the key reasons we have used these funds in client portfolios for many years. By contrast, the data suggests that positive alpha is difficult to achieve in asset classes such as large company stocks (major blue chip companies), REITs, and technology stocks. And as a result, we prefer to use lower cost index-based funds to represent these areas of the portfolio.

Diving under the hood, there are several ways that small and value stock managers outperform their respective indices. For starters, successful small companies grow up to be mid-cap companies and value/cheap companies that turn the financial tide eventually cease to be “cheap,” thereby requiring reconstitution of the respective indices to preserve their “small” and “value” orientations. The Russell indices are the most widely-followed and tracked indices for U.S. small and value stocks and these indices are reconstituted on the same date annually, with changes announced well in advance. While index funds that track the Russell indices are compelled to wait until the reconstitution date to make the required changes, other investors can “front-run” these changes to avoid predictably negative pricing pressure on the individual stocks exiting the indices. Another driver of potential positive alpha is the discretion managed funds have in selling stocks that have recently appreciated. For example, when a small cap stock grows beyond the top of the small cap range due to strong recent performance, managed fund managers can choose to continue holding the stock for a while to capture more of its positive momentum. The index fund manager doesn’t have this same flexibility. Yet another strategy managed funds utilize is referred to as “patient trading.” Since managed funds are not required to hold specific stocks, they can take advantage of opportunities that arise in the marketplace. For example, if an investor is trying to sell a large holding of a small cap stock, the managed fund manager can facilitate this transaction by offering to purchase the shares at a below-market price.

Finally, managed funds can be structured to seek to provide higher expected returns by increasing the fund’s “potency.” Since, over the long run, small company stocks have outperformed large company stocks and value stocks have outperformed growth company stocks, small cap funds that place greater weighting on the smallest companies and value funds that place greater weighting on the cheapest (or “deepest value”) companies, to no surprise, tend to outperform their respective benchmarks over time. This component of higher expected returns is generally considered to represent compensation for taking greater risk so it is not technically considered alpha.

On the bond side of the portfolio, there are also compelling reasons to use some managed funds but for different reasons. Principally, while it makes sense to have a larger investment position in the common stock of Apple than in the common stock of Peet’s Coffee simply because Apple represents a much higher share of total market value, it doesn’t necessarily make sense to own a larger position in Italian debt simply because Italy issues more debt than, say, Switzerland. More debt is not always symptomatic of economic strength. The same goes for state by state municipalities.

Ultimately, we are careful observers of data and use it as a guide to critically assess investment strategies that can potentially add incremental, net-of-fee, net-of-tax return for clients over the long haul. As it is truly difficult to “beat the market,” which is to say, outperform a given index benchmark, index funds are often the best way to gain portfolio exposure to a particular asset class of stocks or bonds. As our clients know, we are intrinsically skeptical of the notion that an investor can expect greater net returns from investments with higher costs. But, sometimes paying a little more in expenses can be well worth it.

Filed under: Investing

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