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Robert M. Cheney, CFA, CFP®



Featured Wealth Management Article

Index Investing Is Great Progress for Investors - But Is There Something Better Still?

by Robert M. Cheney, CFA, CFP® Dated 3/8/2017

American investors have been giving up on stock picking and market timing and following along as endowments, pension funds, and other institutional investors all flood into passive investment funds.  These passive funds track an equity or bond index on autopilot and have significantly lower fees than actively-managed funds which attempt to beat the market but are generally unsuccessful at doing so.


Over three years ended August 31, 2016, investors added approximately $1.3 trillion to passive mutual funds and exchange traded funds (ETFs) while taking out more than a quarter trillion dollars from actively-managed funds, according to Morningstar.  Matching the performance of an index is significantly cheaper than the costs for research and portfolio management to attempt to beat an index and for this reason, the costs of passive funds are a fraction, sometimes as little as 1/30th, of fees for actively-managed funds.


Passive funds are not only attractive on a fee basis, their performance has been superior as well.  Standard and Poor’s conducts their annual SPIVA (Standard and Poor’s Indices Versus Active Funds Scorecard) study and regularly finds that only about 20% of active equity managers and about 30% of active bond managers beat their index over a ten-year period.  These studies do not show that active managers are unable to beat the market, but that very few manage to do so, and those who do beat the market are always changing over time so that an active manager who beat his index one period often becomes part of the majority who failed to beat their index in the next period.  If your financial plan is based on historical market return assumptions, and this is the outcome for active managers, would you want to implement your plan with those odds?


That the investing public has embraced passive investing is great news for investors and their likelihood for success with their retirement savings.  Investors moving from accounts at big brokerage firms comprised of active funds or a wrap account that might have total fees of 2.0% or more to a passive portfolio with a small fraction of those fees will mean more savings remaining and compounded for retirement.  However, the transition may be accomplished with investors deciding to handle their investments on their own or utilizing an on-line “robo-advisor” which mean little other financial planning and wealth management services are available to the investor.  At many big brokerage firms, using index funds with a financial advisor is not even an option due to the low profitability of index funds compared to their other fund offerings.  And those advisors who do provide index funds to clients ensure that the clients will receive performance of the index funds minus approximately 1.0%, the amount of the advisory fee, and this may not be a completely desirable outcome either.


It is interesting to reflect on history; indices were not originally invented to be investments.  They were invented to be benchmarks to measure the relative performance of active managers in the 1950s and 1960s when the few fund managers did have strong performance. As the active managers began to regularly underperform the indices, people began to ask themselves in the 1970’s, “Why don’t we invest in the indices if they are doing better than the managers?”  It is great that the investing public is adopting this trend but it is important to consider whether there is still further progress to be made.  


In fact, there may be options within the passive funds category that will offer investors the ability to get strong performance, lower fees, and the extended wealth management services that many investors require.  Index investing and Asset Class Investing are two different ways to implement a passive investing approach.  While the two have similarities – like lower fees and strong performance relative to active funds, no market timing, broad diversification and tax efficiency – there are some important differences.


Asset Class Investing is based on asset classes – groups of securities with similar risk characteristics, like small company stocks, large company stocks, and international bonds.  Asset Class Investing attempts to capture the performance of a specific market segment, while index investing attempts to replicate the performance of an index.


Asset Class Investing can be more flexible than index investing because managers are free to trade when there is an advantageous price, both when they are buying and selling; index fund managers must buy a stock or bond only on the day that it’s added to or excluded from the published index.  All index fund managers must do all trades on the same day to avoid tracking error, which may result in paying a higher price due to the short-term demand for the security being added to an index or selling at a lower price due to the short-term supply for the security being excluded from an index.


Asset Class Investing can be more precise than index investing because it seeks to maintain a consistent risk exposure to a given market segment. The companies in that market segment change over time and an asset class is updated to reflect that in real time.  Some companies may appear to be part of a market segment, but they may not have the same risk characteristics so they may be excluded from an asset class.  Most index funds update their portfolios as infrequently as once a year so they aren’t as real-time with updating the companies that make up that market segment.


Asset Class Investing can also incorporate factors of return demonstrated through academic research to add return to a diversified portfolio.  Drawing on decades of investing research and the work of Nobel Laureates including Eugene Fama of Fama and French fame, Asset Class Investing pursues the known factors of return when constructing funds.  These factors that offer superior returns are small capitalization companies, value companies, and high-profitability companies.  These factors are known in finance as the Fama-French Three-factor Model.


With investors’ increased longevity and longer retirement periods, the way that retirement portfolios are implemented has never been more important and investors need to maximize their likelihood for success.  If you simply invested all your money in a market index fund that tracks the S&P 500, you could be missing out on the potential long-term benefits of a globally diversified Asset Class Portfolio.  Let’s assume you had unlucky timing and invested at the beginning of 2000, near the top of the boom, through 2015 and invested in the S&P 500 Index and compare that to investing in a “moderate” globally-diversified Asset Class Portfolio that is 65% stocks and 35% bonds.  This is a difficult period to have been invested since there were two bear markets during the period, one being the second worst bear market on record.  Over this period, the Moderate Risk Asset Class Portfolio had an annualized net rate of return of 5.03% while the S&P 500 returned just 4.06% per year.  There was also almost a third less volatility in the Asset Class Portfolio than the S&P 500: 10.81% standard deviation for the Asset Class Portfolio versus 15.13% standard deviation for the S&P 500. The Asset Class Portfolio return is after both the funds’ internal expenses and 0.90% of fees.1


These Asset Class Portfolios are only available to individual or institutional investors from a comprehensive financial advisor that is not only thoroughly educated on this portfolio management approach but also encompasses the other services of broad wealth management like financial planning, risk management, tax strategy, and asset and estate protection.  Although portfolio management is significant, it is very important for investors not to miss the forest for the trees.  Portfolio management does not equate to comprehensive financial planning or wealth management.  Portfolio management is just one service in overall financial planning or wealth management and the other services are meaningful as well.


Vanguard has performed ongoing studies in their “Advisor’s Alpha” series to quantify the value of comprehensive financial advice provided by good advisors relative to average advisors.  Vanguard calculates that the additional return from working with a good advisor to be 3.0% annualized return and is comprised of 1.5% additional return from behavioral coaching, 0.4% from cost-effective implementation, 0.35% from rebalancing the portfolio, with other services like asset allocation, asset location, and spending strategies making up the balance.2  Not surprisingly, stock selection and market timing are not services adding value.  I agree that behavioral coaching, keeping a client dedicated to their long-term objectives through any economic and/or market conditions - and regardless of the client’s natural human instincts (cognitive errors), is a very important and under-rated service.  However, there are value-added services that I would add to their calculation which can significantly enhance the value of advice like tax planning, both inside the portfolio and for income and estate taxes, high levels of client service, and the real value that is hard to quantify from the confidence achieved through financial planning – knowing where you are relative to your financial goals.


Just as a reduction in fees, or improved performance, can compound over the long-term and mean significant additional savings for financial goals, value added by a good financial advisor, as quantified by Vanguard, when compounded over the long-term, can also mean a dramatic improvement in savings for financial goals.  I argue that it is this combination of both sensible portfolio management using an Asset Class Portfolio teamed with all the services of comprehensive wealth management that will give investors the best likelihood for success in pursuing their financial goals. 

1 Source: Loring Ward, “Solving The Investment Problem: The Fundamentals of Asset Class Investing,” 2016.

2 Source: Vanguard Research, “Putting a Value on Your Value; Quantifying Vanguard Advisor’s Alpha” September, 2016.

Investing involves risks including the potential loss of principal. No strategy can assure success or protects against loss. Past performance is no guarantee of future results.  Diversification and asset allocation do not guarantee a profit nor protect against loss in a declining market.  They are methods used to help manage risk.  The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. Indices are unmanaged and cannot be invested into directly.