Smart investors begin their journey by developing an investment plan, or investment policy statement, that includes an asset allocation table. After the plan has been prepared, the next step is to select proper investment vehicles for providing the appropriate exposure to the desired asset classes.
A common error among investors who follow a “passive” investment strategy is to assume that all passive funds in the same asset class are basically identical. In other words, they mistakenly believe these passive funds are “commodities,” or substitutes for one another.
If passive investment products were commodities—in the economic sense, not the physical one—the only criteria needed to make a decision when choosing among them would be cost; in this case, the fund’s expense ratio. However, as we’ll demonstrate, two funds in the same asset class can actually look very different. The differences have implications not only in terms of risk and expected returns, but in terms of how their addition impacts the risks of an overall portfolio.
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