Last Updated Jun 6, 2011 10:31 AM EDT

(This week, we’re looking at the differences between indexing and passive management. Today, we’ll cover the basic differences.)

Let’s begin with a definition: An asset class is a group of securities that have similar risk characteristics, so we’ll use equities as our example. Equities are an asset class, but within the class are the asset classes of domestic and international stocks, value and growth stocks, and small-cap and large-cap stocks. We can differentiate further by having asset classes such as small-cap value and large-cap growth.

While index funds generally represent a specific asset class (or even sectors such as technology or energy), we can create an asset class fund for which there’s no index. All we need do is create our own definition, such as the largest 50 stocks or the smallest 500. Both of these funds would be passive asset class funds, but there would be no index for them either to replicate or against which it could benchmark. What, if any, advantages do passive asset class funds have?

Index funds seek to:

• Replicate the indexes they’re tracking
• Minimize tracking error (have a different result than the index itself)

Passive asset class funds (or what might be better called structured portfolios) have the advantage of not trying to replicate an index. Instead, they focus on attempting to achieve the greatest returns (and if tax-managed, the greatest after-tax returns) for a given level of risk. This difference in objective allows passive asset class funds to maximize the advantages of indexing (such as low cost, low turnover, tax efficiency) and minimize or eliminate the disadvantages of indexing (such as forced turnover, inclusion of all securities within the index). Let’s look at some examples.

Initial Public Offerings Studies have found that IPOs make poor investments for all but those who get the initial allocation and flip the stock quickly. Yet, if a recent IPO is in index, an index fund will buy the stock. A passive asset class fund can avoid this problem by establishing a screen that has a minimum listing period.

Penny Stocks Like IPOs, very low priced stocks have performed poorly, perhaps because they carry a lottery premium similar to that found in IPOs. Investors buy these penny stocks hoping to win the lottery. Thus, a passive asset class fund could screen stocks with prices below a minimum (such as $2).

Stocks Prone to Delist You would be astonished at the rate very small-cap stocks delist from exchanges. Obviously, funds would improve their performance if they could screen to reduce the impact of delisted stocks. A passive asset class fund might require tougher listing standards than the exchanges, such as greater financial strength in the form of a higher minimum net worth and a longer operating history. It might also screen stocks currently in bankruptcy. By reducing the impact of delistings, returns can be improved.

Liquidity Small-cap stocks have greater trading costs than large-cap stocks. These costs come in the form of greater bid/offer spreads and greater market impact costs (at least, for active managers). To ensure there’s enough liquidity to buy and sell efficiently, a passive asset class fund might require there be at least four market makers in any stock.

Forced Turnover Index funds have forced turnover — they sell stocks when they leave the index and must buy stocks when they enter. The transparency and forced trading allows active managers to exploit indexers. This well-known problem caused Vanguard to eventually abandon the Russell 2000 as its benchmark and eventually led Russell to change its reconstitution rules.

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