Prudent investors begin their investment journey by creating an investment plan in the form of an investment policy statement (IPS). The IPS defines the investor's goals and the specific asset allocation they will use to achieve those goals. Once the asset allocation is determined, the next decision is the choice of investment vehicles that will be used to gain exposure to each of the respective asset classes. For passive investors, the choice is much simpler than it is for active investors, because the universe of funds from which to choose is much smaller. However, even for passive investors, the choice is not as simple as just looking at the expense ratios of the various alternatives and choosing the cheapest alternative. The reason is that not all "index" funds are created equal.

While the expense ratio is an important consideration, it should not be the only one. The reason is that a fund manager can add value in several ways that have nothing to do with "active" investing (active investing being defined as the use of either technical or fundamental analysis to identify specific securities to either over- or underweight). Let's explore some of the ways a fund can add value in terms of portfolio construction, tax management and/or trading strategies.

1. Choice of Benchmark Index or How a Fund Defines its Asset Class

This impacts returns in several ways:

• Turnover, which impacts trading costs and tax efficiency. Some indexes have higher turnover than others. And some indexes have buy-and-hold ranges that are designed to reduce the negative impact of turnover (both on transactions costs and tax efficiency).
• Exposure to the risk factors of size and value (the greater the exposure, the higher the risk and expected return of the fund).
• Correlation of the fund to the other portfolio assets (the lower the correlation, the more effective the diversification).
• Some indexes are more opaque than others, preventing actively managed funds from exploiting the "forced turnover" that is created when indexes are reconstructed (typically annually). The lack of opaqueness has historically created problems for index funds that replicated the Russell 2000 Indexes.
• A fund can add value by incorporating the momentum effect by temporarily delaying the purchase of stocks that are exhibiting negative momentum and by temporarily delaying the sale of stocks exhibiting positive momentum.
• A fund can screen out certain securities (even if they are within the defined index) that have characteristics that have demonstrated poor risk/return characteristics (e.g., stocks in bankruptcy, very low-priced stocks, IPOs). For example, while utilities and real estate stocks typically have high book-to-market ratios (and, therefore, are found in most value indices), they have very low betas (exposure to equity risk). The result is that their inclusion in value indexes that use book-to-market as the screen creates a drag on returns. In addition, the inclusion of real estate in value funds will make the fund less tax efficient (since the dividends from REITs are nonqualified and thus taxed as ordinary income).
• How often an index reconstitutes can impact returns. Most indexes (e.g., the Russell and RAFI Fundamental Indexes) reconstitute annually. The lack of frequent reconstitution can create significant style drift. For example, from 1990 through 2006, the percentage of stocks in the Russell 2000 in June that would leave the index when it reconstituted at the end of the month was 20 percent. For the Russell 2000 Value Index, the figure was 28 percent. The result is that a small-cap index fund based on the Russell 2000 would have seen its exposure to the small-cap risk factor drift lower over the course of the year. For small value funds based on the Russell 2000 Value Index, their exposure to both the small and value premiums would have drifted lower. The drift toward lower exposure to the risks factors results in lower expected returns.¹ To avoid this problem, the funds of Dimensional Fund Advisors (DFA) reconstitute their asset class definitions daily.

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