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Most of what you have heard about index funds is true. They beat the majority of actively managed funds over time. They are cheap. They are tax-efficient. They require no manager skill to own. The case for indexing is built on decades of evidence, and we believe that evidence deeply.
So it might seem contradictory when we tell clients that Arcadia does not always use traditional index funds as the core of our portfolios.
Here is why, and what we use instead.
Before getting into the limitations, it is worth being clear about what index funds solved.
For most of financial history, individual investors who wanted broad market exposure had to go through actively managed mutual funds. The funds employed teams of analysts and portfolio managers who researched companies, attempted to identify mispriced securities, and charged accordingly. The pitch was compelling: skilled professionals managing your money, selecting the best opportunities, avoiding the pitfalls.
The results, measured over time and across categories, told a different story.
Over the past 20 years, more than 90% of actively managed U.S. equity funds underperformed their benchmarks after fees. The minority that outperformed in one period tended not to sustain that outperformance in the next. Manager skill, real as it may be for a handful of practitioners, was nearly impossible to identify prospectively and nearly always offset by costs.
Index funds solved this problem cleanly. Rather than paying for manager skill that could not consistently overcome its own fees, index funds simply purchased all the stocks in a given index, passed the market return to investors at minimal cost, and generated less turnover (and therefore less taxable activity) in the process.
John Bogle's core insight, expressed through Vanguard and eventually adopted across the industry, was correct: for most investors, the best thing to do is own the market as cheaply as possible and stay the course. Decades of evidence support this.
So why not stop there?
Index funds solved the active management problem. But in doing so, they introduced a different set of structural limitations that are rarely discussed — because index fund providers do not have a financial incentive to discuss them.
Every major index periodically rebalances its composition. Companies are added and removed based on rules, and those changes are announced in advance. The problem is that the announcement itself moves prices.
When the S&P 500 announced it was adding Tesla in November 2020, the stock ran up dramatically in the weeks between the announcement and the actual addition. By the time the index fund had to buy Tesla per its rules, it paid substantially more than the pre-announcement price. The appreciation that occurred between announcement and inclusion was captured by traders who front-ran the trade, not by index fund holders.
This is not an isolated case. The pattern holds across market cycles: stocks added to major indices tend to run up before the addition date and drift downward afterward. Index fund investors systematically buy after the price has risen and sell after the price has fallen, a structural drag that shows up in returns over time.
Traditional index funds weight their holdings by market capitalization. The larger a company's market cap, the larger its weight in the index. This sounds neutral and objective. In practice, it means an index fund automatically buys more of stocks that have already appreciated and less of stocks that have declined in price, essentially chasing performance.
Today, roughly 40% of the S&P 500 is concentrated in just 10 companies. That is the highest concentration in at least 30 years. An investor who buys a simple S&P 500 index fund believing they are diversifying across 500 companies is actually making a very large bet on a handful of mega-cap technology stocks, whether they realize it or not.
Decades of empirical research, much of it conducted by Eugene Fama and Kenneth French (whose work earned Fama a Nobel Prize in Economics), has demonstrated that returns across stocks are not random. Certain characteristics are persistently associated with higher expected returns over time.
The factors with the strongest empirical support include:
Traditional cap-weighted index funds ignore all of this. They make no distinction between a cheap, profitable small company and an expensive, unprofitable large one. By deliberately ignoring the factors the research identifies as drivers of long-term return, index funds accept lower expected returns than they could achieve with a more deliberate approach.
The popularity of index funds has obscured what the term actually means. By some estimates, there are 2,000 to 3,000 index funds available in the United States today. An asset manager can create an index for virtually any investment concept, launch a fund to track it, and legitimately call it an index fund.
Even within legitimate asset class categories, the differences can be substantial. Three different index funds tracking U.S. small cap stocks can behave quite differently depending on which index they track, how they define the small cap segment, and how they handle reconstitution. The performance differences over time are not trivial.
Dimensional Fund Advisors was founded in 1981 with a specific mission: to translate academic research on expected returns into practical investment strategies. Avantis Investors was founded in 2019 by former Dimensional executives who wanted to build on that foundation with newer tools and structures.
Both firms occupy a space that is genuinely different from traditional indexing and genuinely different from traditional active management. They borrow the best elements of each and discard the worst.
Important disclosure: Past performance does not guarantee future results. The following data is presented for informational purposes only. All investing involves risk including the possible loss of principal.
With appropriate humility about past results, the Dimensional story is compelling. Over the past 20 years, approximately 78% of Dimensional funds have outperformed their respective benchmarks after fees. This compares favorably to the 90% underperformance rate for traditional active management over the same period.
Avantis has a shorter track record, having launched in 2019, but the early evidence is encouraging. Comparing the original Avantis equity ETFs to their closest Vanguard equivalents through the first several years of operation, Avantis has outperformed in each category by a meaningful margin, despite expense ratios that are modestly higher than Vanguard's.
The most consistent outperformance has come in asset classes where the value and profitability factors have the strongest theoretical support, which is precisely what the academic research would predict.
At Arcadia, our investment philosophy is built around a simple conviction: we believe in the evidence.
The evidence says that active stock picking and market timing do not work reliably over time. We do not pick stocks and we do not try to time the market.
The evidence also says that certain characteristics, including company size, relative price, and profitability, are persistently associated with higher long-term returns. We build portfolios that deliberately capture these characteristics.
And the evidence says that costs and taxes matter enormously over a 20- or 30-year retirement. We construct portfolios to minimize both.
This is why we use a combination of Avantis and Dimensional ETFs as the foundation of client portfolios, alongside individual securities and other low-cost instruments (including traditional index funds) where they fit. The result is portfolios that are broadly diversified, low-cost, tax-efficient, and positioned to capture the expected return premiums the research supports, without the structural inefficiencies that are baked into traditional cap-weighted index funds.
We want to be direct about what this is and what it is not. This is not a promise of outperformance. Markets are unpredictable, and any investment strategy will go through periods of underperformance relative to the benchmark. What we can say is that the approach is grounded in evidence, built for the long term, and designed to give your portfolio the best structural foundation we know how to build.
Index funds changed investing for the better, and the financial world owes a considerable debt to John Bogle and the generations of researchers who established the case for low-cost passive investing. We stand on that foundation. We simply believe the building on that foundation has gotten better.
If you would like to understand exactly how your portfolio is constructed and why we make the specific investment decisions we do, we would welcome that conversation.
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Disclosure: This article is for informational purposes only and does not constitute personalized investment advice. All investing involves risk including the possible loss of principal. Past performance does not guarantee future results. References to Avantis and Dimensional Fund Advisors are for illustrative purposes; Arcadia Private Wealth may hold positions in the securities or funds discussed. Please consult a qualified financial advisor for guidance specific to your situation. Arcadia Private Wealth LLC is a Registered Investment Advisor.
Grant Webster, CFP®, TPCP®
Founder, Wealth Advisor