A Comparison of Passively Managed, Small-Value Funds

Small-value investors can choose between index funds and passively managed, structured products. While index funds have lower costs, they don’t offer the same degree of exposure to the small-cap and value factors. Here is how that difference has played out in three prominent funds over the last eight years.

Index funds and structured, passive asset-class funds are as similar as a rectangle is to a square. All squares are rectangles, but not all rectangles are squares. Similarly, while all index funds are passively managed (there is no individual stock selection or market timing), not all passively managed, structured asset-class (or factor-based) funds attempt to replicate the returns of popular retail indexes like the S&P 500 or the Russell 2000. Structured portfolios tend to use academic definitions of asset classes, building portfolios that seek to minimize the weaknesses of indexing. Those weaknesses, which result from the desire to minimize what is called “tracking error” (returns that deviate from the return of the benchmark index) include:

  • Sensitivity to risk factors varies over time. Because indexes typically reconstitute annually, they lose exposure to their asset class over time, as stocks migrate across asset classes during the course of a year. Structured passive portfolios typically reconstitute monthly, allowing them to maintain more consistent exposure to their asset class. That allows them to capture a greater percentage of the risk premiums in the asset classes in which they invest.
  • Forced transactions as stocks enter and leave an index, resulting in higher trading costs.
  • Risk of exploitation through front-running. Active managers can exploit the knowledge that index funds must trade on certain dates. Structured portfolios avoid this risk by not trading in a manner that simply replicates the return of the index.
  • Inclusion of all stocks in the index. Research has found that very low-priced (“penny”) stocks, stocks in bankruptcy, extreme small growth stocks and IPOs have poor risk-adjusted returns. A structured portfolio could exclude such stocks, using a simple filter to screen them all out.
  • Limited ability to pursue tax-saving strategies, including avoiding intentionally taking any short‐term gains and offsetting capital gains with capital losses.

Another advantage of structured funds, in return for accepting tracking error risk, is that they can gain greater exposure to the factors for which there is persistent and pervasive evidence of a return premium (such as size, value, momentum, profitability, momentum, carry, term). For example, a small-value fund could be structured to own smaller and more “valuey” stocks than a small-cap value index fund. It can also be structured to have more exposure to highly profitable companies, and it can screen for the momentum effect (avoiding buying stocks that are exhibiting negative momentum and delaying selling stocks with positive momentum).