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INDEXING VS. EVIDENCE-BASED INVESTING

Overview: Many investors may believe that evidence-based investing means simply buying index funds.

However, there are some key differences between index investing and evidence-based investing. The following article discusses some of those differences.

Many investors realize that an evidence-based investment approach offers many benefits when compared with an active investment approach. Evidence-based investing involves buying and holding market components, whereas an active investor or fund manager tries to pick the next winning stock or time where the market is headed next.

An evidence-based approach offers these major benefits:

  • By holding entire market components, the investor maximizes the benefits of diversification.
  • By “tilting” the portfolio to riskier or less risky components, the investor can expect to capture the highest market return given his or her risk tolerance.
  • The investor maintains control over his or her portfolio’s components (by avoiding active funds’ tendency to style drift without the investor’s knowledge).
  • Expenses can be minimized.
  • Tax efficiency can be maximized.

To implement an evidence-based investment approach, investors can choose from:

  • Index mutual funds
  • Exchange-traded funds (ETFs)
  • Evidence-based funds

Investors may wonder, “Why shouldn’t I just buy index funds instead of evidence-based funds? What is the benefit of evidence-based management versus ‘index’ investing?”

The historical evidence has shown that index investing and evidence-based investing are superior strategies to investing in individual stocks or actively managed mutual funds. But building a portfolio of evidence-based funds expands upon the benefits of index investing while minimizing some of its potential negatives.

Evidence-based equity funds invest in a group of stocks with similar risk and return characteristics. These characteristics can be as broad as “U.S. stocks” or “international stocks,” or they can be as specific as “U.S. large-cap momentum stocks” or “international small-cap value stocks.” An evidence-based fund manager creates a set of objective rules that guide which stocks are selected as part of the strategy as well as the target weight of each stock in the portfolio. The funds are managed in a rules-based manner and are not reliant on an individual person or management team’s beliefs about the overall market or individual stocks.

Evidence-based funds retain the benefits of indexing. They are relatively low cost, low turnover and tax efficient. However, they improve on the index model through additional strategies. Let’s look at some of the ways an evidence-based asset class fund can improve returns.

Creating Buy-and-Hold Ranges

Index funds must sell a stock when it leaves the index. For example, if a small-cap stock increases in market capitalization so that it is no longer part of the small-cap index, the fund tracking that index must sell it. This creates turnover and tax inefficiency.

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