Indexes do not offer pure passive strategies

Indexes are sold as ‘passive’ strategies but in fact index providers make multiple active choices with regards to which stocks to include and exclude, which weight give to each stock and how often to rebalance, leading to investors holding assets which do not necessarily align with their investment goals.

The market analysis from Warwick Schneller at Dimensional focused on index discrepancy and has found that those invested in the passive strategies often faced some of the challenges their counterparts selecting a traditional active manager.

Further to that, indexes not only do not offer pure passive asset class exposure but they also force investors to try to time which index is going to do better.

Schneller’s analysis, which focused on the small cap sector, proved that there were sizeable return differences between the three indices, which all targeted the same small caps asset class in Australia over the 20-year period to the end of 2022.

“For example, in 2022 the S&P/ASX Small Ordinaries Index (Total Return) underperformed the MSCI Australia Small Cap Index (gross dividend) index by seven percentage points. One year prior, and the situation was reversed, with the S&P version of small caps beating the MSCI version by five percentage points,” he said.

“The point here isn’t that one index is better than one another, or that you should try to time which index is going to do better. The point is that indexes are not pure passive asset class exposures. We can see this with the average return difference in a year being six percentage points.

“Index providers are all making active decisions. It’s not reality. It’s just a version,” he said.