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.”