Indexing offers many advantages for investing, but not all index funds are created equal. For the leading index products, low cost is a big attraction. But in a world where indexing choices have exploded, caveat emptor applies. “Most investors assume, however, that indexing automatically means getting a cheap fund and certainly one that’s cheaper than an actively managed fund, Morningstar’s John Coumarianos advises. “However, this isn’t necessarily the case.”
Quite true. Some index funds are grossly overpriced. Of the nearly 2,000 index products (ETFs, ETNs and open-end products) in the June edition of Morningstar’s Principia software, more than 600 have a net expense ratio of 1% or higher and nearly 200 charge 2% or more.
But while you should never overpay for indexing, it’s also true that you can go to extremes in seeking out the absolute lowest price at all times in exclusion to other factors. It’s tempting to think that picking the lowest-cost index fund always brings you the best choice. That’s true sometimes, perhaps often, and it certainly making indexing investing easier. But relying on it as a hard-and-fast rule that never fails is asking for trouble. That’s especially true when you’re analyzing funds that focus on a particular slice of a broadly defined asset class.
One example is the world of small-cap value (SCV) funds. There are a number of choices, but picking a fund is tricky in this corner of equities, and expense ratios are just the tip of this iceberg. The next issue of The Beta Investment Report analyzes the possibilities by first zeroing in on the short list of conventional SCV index funds. Among the ETFs, one stands out for its low cost. But it’s not obvious that this is the best choice.
Why? The answer starts by running factor analysis on the monthly returns for the funds on the short list. In particular, analyzing a fund’s return via multiple regression against the value, small-cap and broad market factors reveals a fuller profile of what’s driving each portfolio. This analysis of SCV index funds shows that one ETF stands out as providing a deeper, richer exposure to the small-cap value beta—an exposure that’s not exactly conspicuous simply by looking at raw returns or reading the usual suspects for fund summaries.
Meantime, this SCV fund isn’t the lowest-cost choice. Is it the best choice? Perhaps, although much depends on what the investor is looking for. For instance, if you’re trying to boost the expected return of your overall equity allocation by overweighting small-cap value, the fund with the stronger exposure to the SCV beta is compelling. Of course, SCV has a history of beating the broad market (and most other equity styles) over time for a reason: higher risk, as implied by some interpretations of the Fama-French three-factor model.
True, SCV over the long term doesn’t always register higher return volatility, the traditional definition of risk. But in the short term, SCV has been known to lose more than the broad market in bear markets, which tends to be compensated with higher returns of some magnitude when the market recovers. But not every investor wants SCV in the extreme. For those who have a lower risk tolerance, a tamer version of SCV indexing may be appropriate.
Yes, the price of entry is a key benefit of indexing, but it’s not always the only variable to consider.