Imagine receiving this pitch:

“I have an investment strategy for you. It aims to provide a rough representation of the market. It is mostly rules-based, with some exceptions. We have no say in what we buy or sell. We outsource these decisions to another entity. They will tell everyone what we are going to buy and sell, weeks in advance. We have no flexibility on timing; we need to trade alongside our competitors exactly when told. We cannot adjust the portfolio until the entity says so, which could be in 3, 6, or even 12 months. Finally, this entity has no fiduciary duty to you. How does that sound?”

This captures the essence of index investing. If an investor were to think of the most efficient way of building a broad market portfolio today, with a blank sheet of paper, it is hard to imagine that they would land on an approach that hinges on an index middleman. Indices were historically designed as barometers, not as investment portfolios. Institutions are now recognising that this model, which is over 50 years old, leaves returns on the table.

Index investing is sometimes conflated with passive investing. This is a misconception. Index investing is just one form of passive investing—one that we believe involves unnecessary shortcuts and rigidities. Rebalancing quarterly or annually is not good enough. Concentrating trading into a few days per year is not good enough. Discarding information about short-term drivers of returns is not good enough.

The cost of these inefficiencies adds up. We estimate the hidden cost of indexing to be 8 to 21 basis points in US all cap equities, a number that exceeds the typical fees paid by institutional investors using index strategies. The impact gets larger as we focus on small caps and look to other markets, reaching 65 to 205 basis points in emerging market small caps.

Dimensional, a $1 trillion systematic active manager, shares some DNA with index investing. Our co-founder, David Booth, was part of the team that designed the very first institutional index funds in the early 1970s—years before the first retail index mutual fund and nearly two decades before the first ETF. In light of the alternatives available historically, index investing has been a net positive for investors.

But we believe it’s time for an update. Dimensional already manages over $100 billion in strategies designed to provide market-like exposures. These strategies are diversified, transparent and cost-effective. The philosophy—embracing market prices—is passive, but our implementation is active, free from the challenges and constraints associated with rigidly tracking an index.

In this article, we highlight some of the ways that we have supported institutional investors to go beyond indexation.

Read the full ‘Thought Leadership’ article at the link below