‘Passive’ Doesn’t Always Mean ‘Index’
DFA, strategic beta funds prove that traditional indexing isn’t the only passive method.
From: news.morningstar.com
Question: Index funds are sometimes referred to as passive funds. Are they one and the same?
Answer: The terms “passive fund” and “index fund” are often used interchangeably, but they’re not quite synonymous. In a nutshell, all index funds are passive, but not all passive funds are index funds, at least not in the traditional sense. So, what’s the difference?
First, let’s talk about what we mean when we use each of these terms. The term “index fund” is pretty straightforward. It refers to any fund, be it a traditional mutual fund or an exchange-traded fund, whose portfolio is managed so that it matches the holdings of a traditional index, such as the S&P 500 or the Barclays U.S. Aggregate Bond Index. The term “passive fund” is often used to differentiate funds from those that use active strategies–that is, in which a fund manager picks specific securities he or she thinks will help the fund outperform its benchmark. In a sense, a passive fund is one in which no active security selection is taking place. Rather, a system or formula is applied to manage the fund’s portfolio.
Because index funds follow such a routine–after all, they attempt to mirror an index and nothing more–they are considered passive funds. And since the vast majority of passive funds track traditional indexes, it’s not uncommon to hear someone refer to passive funds when they mean traditional index funds, specifically. However, there are some funds that are, or may be considered, passively managed but aren’t traditional index funds. They invest using carefully honed criteria or formulas without a human making portfolio decisions on each and every holding, yet they don’t track a traditional index.
Such passive, nontraditional index funds come in a few different flavors based primarily on the systems they use to invest. Below are some examples.
DFA funds: Among the best-known practitioners of the passive approach are Dimensional Fund Advisors, also known as DFA. The firm offers a diversified lineup of funds that are run using predetermined criteria based on its extensive body of research. Rather than track commonly used indexes, DFA creates its own. Morningstar’s fund analyst team describes DFA’s process this way: “The firm’s portfolio managers apply passive screens to emphasize securities with characteristics that have historically been associated with higher expected returns, including small market capitalizations and low valuations.” (Morningstar’s John Rekenthaler wrote about the rise of DFA and the blurring of the line between active and passive funds here.)
To cite one example, Gold-rated DFA US Small Cap (DFSTX) is designed to capitalize on the small-cap premium (research shows that small-company stocks tend to outperform large-company stocks over long time periods) by owning only those that fall outside the 1,000 largest-capitalization U.S. stocks. It also underweights overpriced, less-profitable stocks among this group. Because it doesn’t track an index, this strategy also means the fund trades on its own timetable rather than joining the crowd trying to buy stocks that are added to or sell those removed from a widely tracked index, thus avoiding overpaying for or underselling them. (One could argue that decisions such as these veer into the realm of active management, though the overall approach is generally passive.) Although DFA funds tend to charge low fees, they are available to retail investors only through financial advisors preselected by DFA.
Strategic beta funds: Approaches similar to those used by DFA have become increasingly popular in recent years but under a new name: strategic beta–sometimes called “smart beta.” Strategic beta funds are designed to exploit certain market factors, such as value, momentum, or volatility. And, like DFA funds, strategic beta funds track custom benchmarks designed to capture one or more of these factors. Here, again, funds are managed based on a given set of criteria but without tracking a traditional index. Some argue that by overweighting certain factors, strategic beta funds are essentially applying active-management strategies but doing so through a formula or an algorithm, making them something of an active-index hybrid. After all, many active managers apply similar screens based on similar factors in order to identify securities that meet a given criteria. While traditional index funds are market-cap weighted, strategic beta funds often weight their holdings using some other method–such as by the degree to which their target factor is present. (Morningstar’s Susan Dziubinski recently offered a primer on strategic beta funds, which you’ll find here.)
Quantitative funds: Similar in nature to strategic beta funds, some funds use quantitative models to identify stocks with particular characteristics, although in some cases managers may override the formula and make an active call on whether to own a security. For example, the managers of Schwab Core Equity (SWANX), a large-blend fund, use a quantitative model that takes into consideration company fundamentals, stock valuation, momentum, and risk, then adjust the rating based on the degree to which the stock helps them meet the fund’s mandate. Even after all that processing, the fund’s managers will, on occasion, override the results–for example, if they feel the backward-looking formula fails to capture information about recent corporate actions, or to adjust the fund’s sector weightings relative to its S&P 500 benchmark.
Vanguard’s tax-managed funds: This is another group of funds that might be considered passive but are not traditional index funds, although they are probably closer to traditional index funds than the fund types mentioned above. Vanguard, by far the largest provider of index funds as measured by assets, offers tax-managed balanced, capital-appreciation, and small-cap fund types. In each case, the fund starts out with a traditional-index-fund approach, but the portfolio is tweaked to enhance tax efficiency. For example, Vanguard Tax-Managed Capital Appreciation (VTCIX) is designed to match the characteristics of the Russell 1000 Index but uses sampling rather than full replication of that index. This means the fund can overweight low-yielding stocks to help reduce the tax impact of dividends on its shareholders who hold it in taxable accounts. The fund also keeps turnover to a minimum and, when selling holdings, gets rid of high-cost-basis shares first to reduce the capital gains impact to its shareholders.
Ultimately, the distinction between the terms “passive fund” and “index fund” is less important than understanding the way each fund type operates. For all practical purposes, the terms themselves may be used interchangeably; but if someone mentions that they have a passive fund they want to sell you, it would be in your best interest to find out if it is a true traditional index fund or something else.
