Index Funds with Higher Expected Returns

Our last article presented a rather contrarian approach to investing in an arena where the goal is usually to ‘beat the market’ or outperform some benchmark. Instead, we described an investment approach that aims to simply capture the average return of the market by investing in an index fund, which holds fractional amounts of each of the securities the index tracks.  This ‘passive approach’ strips both stress and expense from the investment process, because research shows that the vast majority of active money managers do not add value by outperforming the index through their strategies of picking individual securities or timing the market, or a combination of the two.

Most commonly, index funds track the market capitalization weighted index (in which companies are weighted according to the market value of their outstanding shares), with larger companies accounting for a greater portion of the index (the S&P 500 is an example). Investing in these ‘plain vanilla’ funds is a sound approach for many people. But sophisticated fund providers (for example, Dimensional Fund Advisors, who have teamed with academic researchers and been at the forefront of the evolution of index fund design and implementation) also structure index funds which can be used to target higher expected returns. This allows for the design of a portfolio that is customized to an individual investor’s risk preference (as always, targeting higher expected returns means taking on more risk). If you think of traditional investing as holding a basket of individual securities, an equivalent image would be holding a basket of differently weighted index funds designed to achieve your financial goals.

The mindset to investing in index funds involves two key concepts: markets work and prices are fair. Because public capital markets are extremely competitive, with millions of voluntary trades in the market place every day, new information is very quickly reflected in stock prices: in other words, the current price reflects the expectations of all market purchases at any given time. However, not all stocks have the same expected return. A great deal of research been done to discover what drives difference in expected return amongst stocks, and three factors seem to be the most compelling:

  1. Company size: Portfolios designed with companies that are smaller tend to have higher expected returns.
  2. Relative price: for example, comparisons based on book value or earnings. The lower the price you paid, the higher the expected return
  3. Profitability of the companies: Higher profitability is associated with higher expected return.

To design a portfolio for an individual investor who wants to capture some of these sources of higher returns, along with the ‘plain vanilla’ funds, these factors would be reflected in different weights in a portfolio (depending on that particular investor’s ability and willingness to assume risk, and what the portfolio is intended to achieve).

Once the portfolio is designed, maintaining its design or structure is very important. An index provider sets the criteria for, say, a small company index (the Russell 2000, for example), and lists the stocks that are in the index based on that definition. However, prices are constantly changing, so that soon a number of companies in the index no longer meet their definition of a small company; over time, this results in a type of ‘style drift’, so measures must be taken to avoid a deviation from the investment strategy of funds tracking that index.

When you invest in index funds, you benefit from the power of the markets to reflect the collective knowledge of millions of market participants in its pricing. This allows you and your advisor to focus on your long term financial goals and the strategy you are going to use to achieve them. It makes the investment process more objective, which makes it easier for you to stick to disciplined investment behaviour.