The Limits Of Looking For The Perfect Index Fund

SmartMoney frets that innovation in index fund design may be going too far. “Financial firms are racing to improve the classic index fund. But are they improving it to death?” wonders Rehma Kapadia. Perhaps, although it’s important to keep the indexing wars in perspective when it comes to real world money management. If you’re choosing index funds, you should choose carefully, of course. Beware of new-fangled products that promise the moon. But there’s a point of diminishing returns by diving ever deeper into the minutiae of fund design in an effort to identify the absolute best products, or the worst. Most of your analytical efforts should be directed at the far-more crucial aspect of investing: asset allocation design and management. That doesn’t mean you can ignore individual fund analysis, but don’t let it overwhelm your research efforts.

Indeed, the primary goal of evaluating funds is avoiding the egregious offenders. These dogs are easy to spot. Ignoring the plain-vanilla S&P 500 index fund that charges 50 basis points, for instance, is a no-brainer when you can buy, say, the Vanguard S&P 500 ETF (VOO) with an expense ratio of just 0.06%.
The decisions can and do get a lot tougher, however. The black-and-white choices quickly give way to a thousand shades of gray as you survey the expanding spectrum of fund possibilities. One of the more topical examples is the debate over the pros and cons of alternative weighting systems for indexing vs. the standard market-cap design. Some of these alternative benchmark efforts are, well, junk. But others are reasonable, perhaps even superior. The problem is that it’s not always obvious which is which.
One of the more impressive alternatives is Research Affiliates’ fundamental indexing system, which has proven to be a worthy competitor to the conventional benchmarks in recent years, as I discussed earlier this year. That’s no assurance of future success, of course, but neither can superior performance be ruled out. True, fundamental indexing products generally cost more than some market-cap competitors, but not outrageously more.
Cost is important and it should be a factor for choosing index funds. The indexing strategy is no less critical. But if we’re talking of reasonably priced funds that are focused on capturing a relatively broad definition of the target beta, there’s a point when the debates over index design become counterproductive.
If you’re focused on building and managing a globally diversified portfolio based on the major asset classes—as you should be—the indexing wars can become a distraction. By all means, do your homework before buying an index fund, particularly those with claims of building a better mousetrap vs. the default market-cap weighting system. If you’re unsure of why you’re paying more for an alternative design, look elsewhere. But don’t spend too much time trying to solve the mystery of which design will win. Assuming that you hold low-cost products that are broadly diversified, the bigger bang for your buck resides in the asset allocation choices.
The critical variables for such portfolios are how you weight the various asset classes and how often, and when you rebalance the mix. This is where you should spend most of your time and effort. The return and risk profile of your portfolio may soar or sink, but that’s not likely to be determined by your choice of index design if you stick with reasonable choices.
Numerous studies over the years, such as this gem from 2000, advise that asset allocation is where the action is. There’s simply too much evidence to assume anything less. Let’s put it this way: You can’t afford to stumble on the design and management of the portfolio mix. By contrast, if your index fund choices–or actively managed fund choices, for that matter–aren’t the absolute best products, that’s far from fatal if you do reasonably well with the asset allocation.
Of course, if you’d rather avoid the complications of sorting through funds you can opt for the default choice: market-cap weighted index funds. And since these are commodity products, you can further simplify your life by picking the lowest-cost offerings. They may not be the absolute perfect design that blows away the competition each and every year, but they’re likely to capture the lion’s share of the target beta in the long run. Armed with that confidence, you can focus on optimizing asset allocation.