Passively Managed Funds

We use passively managed mutual funds to create low cost, low risk, tax-efficient portfolios that are globally diversified. There are two different types of passively managed mutual funds: index funds and passively structured funds. While our investment philosophy uses some index funds (from companies like The Vanguard Group), we primarily use passively structured funds only available through top-tier firm Dimensional Fund Advisors (DFA).

Index fund managers build portfolios to mirror the performance of well-known market benchmarks. These include the Standard & Poor’s 500 Composite Index (S&P 500), the Russell 2000 Index, or the Morgan Stanley Capital International EAFE index. Index managers don’t attempt to forecast the stock market or try to distinguish between “attractive” and “unattractive” securities. Instead, an index manager buys every security in the index, resulting in a portfolio with hundreds of stocks. Portfolio adjustments are made only in response to changes in the underlying universe or index.

Similar to indexing, passively structured investment strategies share a common belief in “efficient markets”—that market prices are the best estimate of value. Meaning, neither strategy attempts to “beat the market” through superior security selection. The difference between the two strategies is passively structured mutual funds aren’t designed to match the performance of well-known indexes. Indexes for equity or fixed income securities were often developed as simple signposts of financial performance and were not intended to serve as actual investment strategy blueprints.

Rather than mirror an index, passively structured funds capture specific risk factors in the market. Academic research has focused on identifying risk factors investors care about in determining security prices. Bearing risk is what investors get paid for—the more clearly we can define risk, the better we can predict the expected returns that come with it. Passively structured funds may not necessarily match familiar equity or fixed income indexes, but they often represent a more scientific approach to designing the asset class “building blocks” used to develop a total portfolio. (An asset class is defined as a group of securities that share a common risk factor.) By starting with a clean sheet of paper, a passively structured approach can account for unique characteristics of a particular asset class that make an indexed strategy less appealing.

For example, small cap stock strategies are best served by a passively structured approach because they’re difficult to index without costs swamping their higher expected returns. Indexing a portfolio of several thousand small company stocks may not be the optimal approach, since turnover and transaction costs are sharply higher for small companies than large ones. Alternatively, a passively structured approach prioritizes the minimizing of trading costs rather than “tracking” or replicating the index. Stock weightings are relaxed relative to an index, allowing moderate overweighting or underweighting in specific securities. Stocks are purchased when they become available at attractive prices, avoiding the problem of “paying up” for certain stocks simply to match a theoretical index. This means a passively structured mutual fund can add to investment returns by lowering transaction costs.

Most investors who believe in using index funds are completely unaware of the important distinctions between Vanguard and DFA. First, Vanguard funds are available to all advisors and retail investors, but DFA only offers its mutual funds to institutions (like corporate pension funds) and a select group of fee-only financial advisors. Since DFA funds are not available to most advisors and retail investors who might engage in “market timing,” these funds protect against the “hot money” that causes numerous problems for retail funds. This is just one example of how DFA funds provide institutional benefits generally available only to large institutional investors (i.e. pension plans, charitable foundations, etc).

Second, while Vanguard and DFA both offer low-cost passively managed funds, Vanguard primarily offers index funds. DFA offers passively structured funds designed to capture the returns of academically defined asset classes globally. Since most of the Vanguard index funds are not designed to capture these academically defined asset class risks, it’s difficult for investors to build a globally diversified portfolio with Vanguard funds alone.

Third, DFA offers a “tax-managed” family of passively structured mutual funds that should be used in taxable accounts. These tax-efficient funds provide extremely valuable tax benefits not easily duplicated by Vanguard index funds.

We believe access to DFA funds is essential to building globally diversified portfolios that provide exposure to targeted asset classes. For this reason (and many others), we strongly believe most investors should hire professional advisors like Sparrow Wealth Management who are approved to work with DFA mutual funds.

• Visit the DFA website
• Read the 2017 article from Wall Street Journal called “The Active-Passive Powerhouse”
• Read the 2014 article from BARRON’S called “Market Beaters”
• Read the 2001 article from Bloomberg Personal Finance called “Personal Wealth”
• Read the 1998 article from FORTUNE called “How the REALLY Smart Money INVESTS”
• Read DFA’s brochure Global Investment Solutions