How Dimensional Is Going Beyond Indexing

Is indexing passive? Let's look at US large cap value indexes from the major index providers. The table shows the annualized tracking error between these indexes. This is index versus index. The average tracking error is 2.5% per year. There are active strategies with similar or less tracking error to these indexes. Investors should be asking themselves, why are the index returns so different from each other? And which, if any, of the indexes is passive? Some people will say these returns might cancel out with each other. The range of outcomes here is about 1% per year. That's a big difference. I've seen investors change indexes to save a couple basis points of fees. But if you lose out on 100 basis points of return, you're worse off, even with lower fees. The point isn't that one of these indexes is better or worse than the others. The point is that active decisions are being made in the index design and rebalancing, and those decisions impact your returns. The big questions investors should ask themselves are, do you really understand all the investment decisions that your index is making? And are you doing enough due diligence on your index providers, or are you giving them a free pass?

Who writes the rules for indexes? People do, of course. Specifically the people that sit on index committees. While index rules might seem mundane, they affect trillions of dollars of investment. Index rules are really material investment decisions. One of those decisions is how much of the investible universe should the index cover? Let's look at an example. We'll look at the coverage that MSCI has in their Emerging Markets Investible Market Index. And let's take the two largest countries in emerging markets by market value. Those are China and India. Overall, the index has 24% weight in China and 18% weight in India. But let's break down the index into its two components, large caps and small caps, to see how much of the total market coverage are you getting. For China, the large cap index has 27% weight, but the small cap index only has 7% weight. That's a 20% underweight to China in small caps. Now let's look at India. The large cap index has 17% weight, but the small cap index has 26% weight. That's a 9% overweight to India in small caps. These are big differences. This inconsistent coverage within two of the largest countries, is the result of active decisions. Indexes are not the same thing as the passive market. So, a big question for investors is, "Who are the people designing your indexed investments?" Specifically, do you know how many indexes they oversee, if they've ever managed money before, and what research underpins their investment decisions?

Is the S&P 500 index a form of passive investing? Let's look at an example. Their index committee didn't add Tesla until it was the sixth largest US company. In January of 2020, Tesla was already the 60th largest U.S. company, but it was not in the S&P 500 index. In July, Tesla announced positive earnings. That was a big deal. Why? It meant Tesla now satisfied S&P's profitability screen. This screen is a form of active stock selection. That's not passive investing. But Tesla wasn't added to the index for another five months. Why? You'll have to ask S&P. What happens next then once their committee does finally decide to add a stock? Well, typically, they announce the addition five days before they add it, but for Tesla, they broke their convention and they announced it a month beforehand. After that announcement, the stock rocketed higher. It gained 71% between the announcement and the addition to the index. Unfortunately, the index missed all these returns. Now, is that surprising that the stock went up? What do you think might happen to a stock's price when everyone knows that billions of dollars are gonna show up in a month and buy that stock? You might reasonably expect upward pressure on the price. And the Tesla example is not an outlier. In 2023, for example, the S&P 500 added 12 stocks. This included well-known names like Uber and Lululemon. It took the S&P 500 index committee a long time to eventually add these stocks. The average waiting period was about 30 months between when a stock became one of the 500 largest and eventually being added to the index. During these waiting periods, each of these additions, all 12, outperformed the rest of the S&P 500. Both the S&P 500 index and the index funds that track it missed out on these returns. Some big questions for investors are, if your index fund is missing returns, how would you even know? And if you're using the same index as an investment and a benchmark, you may have a significant blind spot.

Are the goals of index investing aligned with your investment goals? The goal of index managers is to minimize tracking error to the published index, but what is your goal as an investor? It's likely to get the best return for a given level of risk. Those two things, minimizing tracking, error and getting the best return, those are not necessarily the same. After all, you can't spend low tracking error, but you can spend better returns. Since your goals and indexers' goals might be different, what questions should you be asking? First, have you done enough due diligence on the index publisher? Do you understand how their rules regarding stock selection, market coverage and rebalancing impact your investments? Second, what's the total cost of ownership of your index fund? Index investing is low fee, but not necessarily low cost. There are hidden costs, and those come from trading, securities lending, style drift, and other sources. Do you really understand all the hidden costs of index funds? And third, are you using the same index as an investment and as a benchmark? Since indexes are not the same thing as the passive market, and we've seen that there are significant return differences between indexes of the same asset class, how would you know if your index is leaving money on the table? If you're comparing the index to itself, you have a significant blind spot. Why do indexes use stale data? Why do they only rebalance a couple times per year? Why do they publicly announce their trades ahead of time, allowing traders to run in front of them? And why do index trackers force billions of dollars of trades into just a few minutes? Dimensional's improved upon this old stale model of indexing by using a daily rules-based approach, Dimensional keeps the best parts of indexing, which are broad diversification and low fees, and we improve upon the bad parts. We use daily data. We keep our trades confidential, and we trade flexibly to reduce implicit trading cost. The results? They speak for themselves. Over the past 20 years, more than 90% of Dimensional's equity funds have beaten their benchmark index, net of fees.

Index investing is pretty good, but it's not great. You can keep the good parts and improve upon the bad parts. What should you keep? You should keep broad diversification and low fees. Also keep a rules-based approach that's transparent. Now, what should you improve upon? First, you should use daily data. When value indexes are still holding on to growth stocks, or small cap indexes are still holding on to large cap stocks, they don't do anything about it until their next scheduled rebalance. This could be months away. Dimensional recategorizes all securities daily, and this helps us provide consistent style exposure. Second, don't let cash flows go to waste. Nearly every day, portfolios are receiving cash from things like corporate actions such as dividends or from client applications and redemptions. Indexers use those cash flows to minimize tracking error to a stale index. Dimensional uses those cash flows to rebalance towards a set of stocks that's updated daily. And third, you should spread out your trading over time, and please, keep it confidential. Index publishers, they publicly announce their trades days or weeks in advance. Then index managers who are tracking those indexes force through billions of dollars of trades all at the same time. This is a recipe for high trading costs. It's like waiting until Valentine's Day to buy dozens of roses. You should expect to pay a higher price than normal. Instead, Dimensional spreads out our trading across the entire year, and we don't publicly announce our trades ahead of time. Then we trade flexibly to reduce implementation costs associated with trading. This is a form of implementation advantage that indexing cannot provide. Dimensional keeps the good parts of indexing and improves upon the bad parts. So let's look at the performance track records. Across the fund industry, most funds have not beaten their benchmark index. Only 18% of equity funds beat their index over the past 20 years. This is why I said indexing's pretty good, but I also said it's not great. Dimensional has had a clear advantage over indexes. 92% of our equity funds beat their index net of fees over the past 20 years. This is no surprise. The founders of Dimensional worked on the first index funds and when they created Dimensional, they did so to improve upon indexing. Our strategies are rules-based, transparent, and low cost. If your goal is to get the best return, Dimensional has had a clear advantage over indexes.