While indices are usually thought of as neutral measures of how a market is performing, they are in fact constructed in a particular way: weighted by market cap and rebalanced every six months.
Academics from Cass Business School recently published research showing that investing in the stock market in such a way gave poor returns when compared with a number of other metrics.
This means that it should be possible to produce "passive" funds that beat traditional index trackers by constructing a portfolio using different metrics to weight stocks.
Dimensional Fund Managers have been doing this for a number of decades, and have a range of funds that use a number of different measures to select stocks and to weight their portfolios.
Jed Fogdall (pictured), co-head of portfolio management at the firm, explains that the company has been using academic research to select its stocks since the 1980s.
The firm uses research carried out both internally and externally to find out factors – or dimensions – that produce better long-term returns. The first insight was the better growth potential in smaller companies, while the firm has also found that value stocks outperform growth stocks over the longer term.
Both metrics are used to weight stocks on the Dimensional Core UK Equity fund, which invests in the FTSE All Share.
The fund has the cost of a tracker, with ongoing charges of just 0.36 per cent, and has 405 holdings compared with the 602 stocks on the FTSE All Share index.
The portfolio is weighted towards small cap stocks and value stocks to enhance returns, and data from FE Analytics shows this has been successful.
The fund has beaten the FTSE All Share and the Vanguard FTSE UK All Share tracker – probably the most respected tracker on the market – over one, three and five years, according to data from FE Analytics.
Performance of funds vs index since Dec 2009
Source: FE Analytics
Fogdall says research shows that tilting a fund towards low price-to-book values is particularly effective.
The price-to-book measure relates the cost of a share to the value of the asset held by the company rather than to the earnings, as is done in the more common price-to-earnings ratio.
"With dividend yield, or P/E [price to earnings] or P/B [price-to-book], a lot of the time you get a similar result on paper, but in practice, because book value changes less frequently than earnings, you get a more stable valuation, therefore lower turnover and costs to investors," Fogdall said.
He adds that one of the key advantages of the dimensional approach – and one of the key differences with tracker funds – is that the managers do not have to rebalance all of their portfolio at certain fixed points in the year.
This is costly for passive funds and adds to the underperformance of an index that is common among trackers.
"If you are market-cap weighting, it can be very expensive to get the exact weights. An index tracker has to be very aggressive if they want to avoid tracking error," he said.
Fogdall explains that the "immediacy risk" is removed with the dimensional approach, which involves a lot of research to find the most cost-effective way and time to trade.
This means that the portfolio, while not being actively managed per se, can time its sales and purchases to get the best price.
The result is a range of portfolios that sit between active and passive.
"I would say in terms of similarities to an index, we have broad diversification, we are not taking idiosyncratic risks in terms of the stocks we have picked," he said.
"The big difference is we are not tied to any particular rebalancing frequency and we make our own decisions in terms of how our portfolios are rebalanced."
"We sit between active and passive because we are not tracking an index but we share some of their qualities."
The company runs an emerging markets fund that could be an interesting option given the recent soft-closure of some of the leading funds in the sector, run by Aberdeen.
The Dimensional Emerging Markets Core Equity fund has also beaten the MSCI Emerging Markets index and the average fund in the sector over one, three and five years, according to our data.
Over the longer timeframe it has made 38.22 per cent while the benchmark has made just 20 per cent.
Performance of fund vs benchmark and sector over 5yrs
Source: FE Analytics
Fogdall explains that the fund buys almost anything in the universe – it has 3,057 holdings – but uses the information to weight stocks differently than by market cap and to overweight certain parts of the market, such as smaller and undervalued companies.
The country weightings are sometimes very different from the index, which is one "active" feature.
"In emerging markets, the research has told us some countries are more volatile and there’s more individual country risk."
"Our investment committee has decided that 20 per cent in one country is too much."
The ongoing charges on the fund are just 0.79 per cent.
The company also runs a smaller companies fund in the UK – Dimensional UK Small Companies.
This portfolio takes the MSCI UK Small Cap index as its basis, but Dimensional defines its own small cap market rather than sticking to this index.
It buys the smallest 10 to 15 per cent of stocks on the UK market, but eliminates some that it finds undesirable – those that are considered to be in severe distress, for example.
The stocks are then weighted using Dimensional’s own screens.
"In simple terms, we hold 300 stocks in the smaller cap portfolio and maybe half are a little bit overweight and half a little bit underweight," Fogdall said.
The fund has substantially outperformed the average smaller companies fund over five years, returning 74.52 per cent while the sector has made 51.78 per cent; the fund is in the top quartile over that time.
Performance of fund vs sector over 5yrs
Source: FE Analytics
This is an excellent result for what is essentially a passive strategy – and it has to be remembered that there are no trackers for the smaller cap end of the UK market.
The fund is also top quartile over the past year, although it slips into the third quartile over three years – still beating the average fund, however.
The ongoing charges are 0.66 per cent.
Fogdall explains that the company’s US funds are using a new metric that Dimensional hopes to roll out onto its UK and emerging markets funds soon, subject to investor approval.
He explains that there has been a research breakthrough on the expected profitability of stocks.
"The third dimension that we are in the middle of now is profitability, expected future profitability," he said.
"And the interesting thing there is it’s not observable. The breakthrough there we have been participating in has been finding a reliable proxy for expected profitability."
"Now we have something we can use in our portfolios. Profitability tends to be persistent through time, and what that means is with a good proxy for today’s profitability you can make some inferences about future profitability, and part of the research has been to look at different measures of profitability to come up with one that satisfies the criteria that I alluded to before: it’s comprehensive and is represented in all the sectors we are trying to look at."
Fogdall says he is unconcerned whether investors consider his funds active or passive, as long as they appreciate the strategy.
"There are no surprises with the Dimensional approach. We tell investors what the portfolio will look like and that’s what it looks like through time."
Dimensional funds are available through certain, but not all, platforms.
