Asset Class Investing

Asset Class Investing is Superior to Indexing

There are two main types of passive investing: asset class investing and indexing. Indexing is a great alternative to investors without access to asset class mutual funds. However, if given a choice, asset class investing is superior.

Asset class investing involves the application of academic principles. Academics have defined the major asset classes, such as large growth and value, small growth and value, international value, international small growth and value, and emerging markets growth and value. These asset classes are defined very clearly through a rigorous screening process. Instead of investing in a sampling of these asset classes such as the Schwab Large Value for large cap value exposure, you would instead invest in every stock classified as large value by an academic definition. Also, for asset classes like large value and small value, there are no comparable indexes that can capture the premiums you should expect by investing in pure value and pure small companies as defined by academia.

Indexing relies on commercial benchmarks to define investment strategies, and as such is constrained by the commercial definition of that benchmark. If an index fund is set up to follow the S&P 500 Index, for example, an investor in that fund can expect investment returns that are relatively similar to that of the index. Whenever the S&P 500 Index reconstitutes itself and new stocks are added while other stocks are removed, the index fund must make those same changes. Because announcements concerning reconstitution of indexes occur months before the changes actually occur, investors in an index fund might capture the declining stock price of a company that is being removed from the index while missing the increasing stock price of a company that is to be added.

Asset class investors do not face this issue. Asset class funds that are passively managed will buy a company once it meets the criteria set forth for that fund. As such, as soon as a company’s market capitalization is large enough, for example, to be considered a “large growth” company, the stock is purchased by the fund. In this way, investors capture the return generated by all stocks in a particular asset class, not just the ones that are selected by a manager or are pre-selected due to their inclusion in a commercial index.