Not All Passively Managed Funds Are Created Equal

Includes: EFA, IWN, VB, VBK, VBR, VTI, VWO
by: Larry Swedroe

Prudent investors begin their investment journey by creating an investment plan in the form of an investment policy statement [IPS]. The IPS defines the investor’s goals and the specific asset allocation they will use to achieve those goals. Once the asset allocation is determined, the next decision is the choice of investment vehicles that will be used to gain exposure to each of the respective asset classes. For passive investors the choice is much simpler than it is for active investors because the universe of funds from which to choose is much smaller. However, even for passive investors the choice is not as simple as just looking at the expense ratios of the various alternatives and choosing the cheapest alternative. The reason is that not all “index” funds are created equal.

While the expense ratio is an important consideration, it should not be the only one. The reason is that a fund manager can add value in several ways that have nothing to do with “active” investing (active investing being defined as the use of either technical or fundamental analysis to identify specific securities to either over or underweight). Let’s explore some of the ways a fund can add value in terms of portfolio construction, tax management and/or trading strategies.

1. Choice of Benchmark Index or How a Fund Defines its Asset Class

This impacts returns in several ways.

  • Turnover, which impacts trading costs and tax efficiency. Some indices have higher turnover than others. And some indices have buy and hold ranges that are designed to reduce the negative impact of turnover (both on transactions costs and tax efficiency).
  • Exposure to the risk factors of size and value (the greater the exposure, the higher the risk and expected return of the fund).
  • Correlation of the fund to the other portfolio assets (the lower the correlation, the more effective the diversification).
  • Some indices are more opaque than others, preventing actively managed funds from exploiting the “forced turnover” that is created when indices are reconstructed (typically annually). The lack of opaqueness has historically created problems for index funds that replicated the Russell 2000 Indices.
  • A fund can add value by incorporating the momentum effect by temporarily delaying the purchase of stocks that are exhibiting negative momentum and by temporarily delaying the sale of stocks exhibiting positive momentum.
  • A fund can screen out certain securities (even if they are within the defined index) that have characteristics that have demonstrated poor risk/return characteristics (e.g., stocks in bankruptcy, very low priced stocks, IPOs). For example, while utilities and real estate stocks typically have high book-to-market ratios (and, therefore, are found in most value indices) they have very low betas (exposure to equity risk). The result is that there inclusion in value indices that use book-to-market as the screen creates a drag on returns. In addition, the inclusion of real estate in value funds will make the fund less tax efficient (since the dividends from REITs are non-qualified and thus taxed as ordinary income).
  • How often an index reconstitutes can impact returns. Most indices (e.g., the Russell and RAFI Fundamental Indices) reconstitute annually. The lack of frequent reconstitution can create significant style drift. For example, from 1990 through 2006 the percentage of stocks in the Russell 2000 in June that would leave the index when it reconstituted at the end of the month was 20 percent. For the Russell 2000 Value Index the figure was 28 percent. The result is that over the course of the year a small-cap index fund based on the Russell 2000 would have seen its exposure to the small-cap risk factor drift lower over the course of the year. For small value funds based on the Russell 2000 Value Index, their exposure to both the small and value premiums would have drifted lower. The drift toward lower exposure to the risks factors results in lower expected returns.[1] To avoid this problem, the funds of Dimensional Fund Advisors [DFA] reconstitute their asset class definitions daily.

2. Patient Trading

If a fund’s goal is to replicate an index, it must trade when stocks enter or exit and index and it must also hold the exact weighting of each security in the index. A fund whose goal is to earn the return of the asset class and is willing to live with some random tracking error can be more patient in its trading strategy, using market orders and block trading that can take advantage of discounts offered by active managers that desire to quickly sell large blocks of stock. Patient trading reduces transactions costs and block trading can even create negative trading costs in some cases.

3. Tax Management

While indexing is a relatively tax efficient strategy (due to relatively low turnover) there are ways to improve the tax efficiency of a fund. The first is to harvest losses whenever they are significant. The second is to eliminate any unintentional short-term capital gains (those that are not the result of acquisitions). The third is to create wider buy and hold ranges in order to reduce turnover.

Unfortunately, most of the investing public is unaware of many of these differences, which collectively can have significant impacts on the returns of funds that on the surface appear to be substantially similar. While most professionals/advisors are aware of these differences, there is another way for an aggressive firm to add value that is often overlooked. It involves the temporary lending of a portfolio’s securities.

4. Securities Lending

Securities lending refers to the lending of securities by one party to another. Securities are often borrowed with the intent to sell them short. In the international markets there is another reason for securities lending to occur that has to do with the ability to utilize the foreign tax credit. Thus, the opportunities to add value are greater in foreign markets. As payment for the loan of the security, the parties negotiate a fee. Some mutual funds are more aggressive than others in this area. The following tables compare the security lending fees generated by the funds of DFA with the fees generated by similar Vanguard funds and similar ETFs. While DFA generates more fees in all fund categories, the differences are minor (one to four basis points) for U.S. total market funds, U.S. large cap funds, U.S. large value funds and U.S. REIT funds. That is because the opportunities to generate fees is small in these areas. So the tables focus on the asset classes of U.S. small and small value and international funds.[2]

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The following is one example of why it is a mistake to only look at the fund’s operating expense ratio. The DFA International Small Company Fund has an expense ratio of 55 basis points and it generated 40 basis points in securities lending fees. Thus, we might consider that the fund’s “net” expenses were just 15 basis points. The Vanguard International Explorer Fund has an expense ratio that is significantly lower at just 35 basis points. However, it generated just 12 basis points in lending fees. Thus, its “net” expenses of 23 basis points exceeded the 15 basis points “net” fee of the DFA fund. The similar net figures for the DFA Micro Cap (expense ratio of 52 basis points) and Small Cap (expense ratio of 38 basis points) Funds are 10 basis points in each case. Even though the Vanguard Small Cap Index Fund had a significantly lower expense ratio of just 23 basis points, its net expense ratio was an almost identical 9 basis points.


There is only one way to see things rightly, and that is in the whole. While ETFs and the index funds of Vanguard are often the cheapest in terms of expense ratios, when evaluating similar passively managed mutual funds it is important to consider not only the operating expense ratio, but also all the ways that a fund can add value. A little bit of extra homework can pay significant dividends.

  1. Dimensional Fund Advisors.
  2. Data is based on latest annual report. Dimensional data is for year ending November 2007. For Vanguard funds the data is for year ending December 2007. For iShares the data is for year ending March 2007.