There are many management styles when it comes to investing your money, but two are most common- Active and Indexing. Understanding management styles can help you identify which is best for you and your financial goals.
Traditional managers fall into two groups – active and indexing.
Active managers normally have a goal of outperforming a benchmark or index, and they aim to do so by looking for market inefficiencies or mispriced assets. This results in a lot of buying and selling, and decisions are normally based on predictions of where the manager thinks the market is going. This style leads to frequent trading, higher turnover, increased costs and lack of diversification.
Rather than trying to beat the market, an index managers goal is to closely track the index results. This style is also known as passive management, because there is a lot less trading. Although index managers will have less buying and selling activity, this style can still lead to forced trading.
Index managers are judged by their ability to track the index. As indexes change the list of stocks once or twice a year, index fund managers are forced to buy and sell the same securities... all at the same time as the other index managers tracking the same index. With hundreds or thousands of index funds all attempting to place the same trade at the same time, index managers are consequentially affecting the price of that security and driving the cost up. This results in buying and selling at the worst possible time and price.
What About Style Drift?
An additional issue to consider is style drift. Style drift is when an investment drifts out of the category that was originally intended. A traditional index, representing one asset class, may review and adjust their holdings only once a year. During the course of the year many stocks may drift from the asset class, for example, small companies may become mid companies, or mid companies could grow to large.
Since the index does not make an adjustment until the next scheduled review, style drift could lead to investors holding positions that are not appropriate for the targeted asset class, or even holding positions of the same stock that may have drifted into another category already owned by the investor through a different fund.
A Different Alternative to Indexing; the Dimensional Approach and Evidence-Based Investing
There is a better way to capture an asset class. Unlike a pure indexing approach, Dimensional Fund Advisor’s (DFA) approach allows a flexible portfolio composition and does not force managers to buy or sell securities at a certain time or price. DFA funds may have many of the same companies in their funds as the traditional indexes, but they are free to add or exclude certain companies when and if they choose to do so.
DFA has its own definition of asset classes, built with flexibility. Starting with the total market, Dimensional applies a quantitative sort that identifies the desired asset class by market capitalization, book-to-market, or other risk characteristics. This results in an initial universe offering more precise exposure to the underlying risk factor. Dimensional then applies qualitative screens to exclude securities that do not exhibit the general characteristics of the defined asset class. This includes stocks that research has documented to have lower expected returns. For a US strategy, questionable securities may include foreign stocks, ADRs, REITS, and closed-end investment companies. This reduced set is the eligible universe.
DFA further reduces the universe by eliminating certain securities that may compromise the return. For example, stocks that may result in adverse selection in the portfolio. Examples are stocks from recent IPOs, those experiencing financial difficulty or distress, and those in bankruptcy. Additional examples include stocks that are involved in a merger, the target of a merger, or in a corporate action.
DFA excludes stocks that may be difficult to trade, or that trade too expensively. These include stocks that may become delisted, those with insufficient liquidity, and/or those with a limited operating history. In addition, limited partnerships and stocks with inadequate data can be excluded as well.
Dimensional is not in the active or index category, some call it enhanced indexing, some call it evidence-based investing.
If you are interested in learning more about management styles and evidence-based investing, we would love to answer any questions you might have. You can contact us here, and a member from our team will get back with you as soon as possible.
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Wealth Advisor & Founder