While low-cost index funds are revolutionary tools, their rigid adherence to benchmarks creates structural inefficiencies that flexible total-market strategies can exploit.

The Dogma of the Index

Low-cost total market index funds are among the greatest innovations in financial history. Rooted in Modern Portfolio Theory and the Efficient Market Hypothesis, they provide a scientific, evidence-based way to capture market returns while minimizing the high fees and poor performance of traditional active management. For most investors, a fund like the Vanguard Total Stock Market ETF (VTI) is an ideal tool. However, the success of indexing has led to a certain dogmatism. Many investors view the index as a perfect representation of the market, assuming that any deviation from it is a step toward the pitfalls of active picking.

This perspective overlooks the fact that an index is a human-constructed model, not the market itself. Because an index must follow rigid, transparent rules to remain trackable, it introduces structural inefficiencies. By examining the nuances of how these funds operate, we can see that while index funds are incredible, there is still room for improvement. The goal is not to return to the world of concentrated stock picking, but to apply more up-to-date empirical theory to the broad-market framework.

The Rebalancing Trap

The most significant hidden cost of indexing lies in rebalancing. Most total market indexes rebalance quarterly to reflect changes in market composition, such as initial public offerings (IPOs), new share issuances, and buybacks. This creates a problem of adverse selection. Generally, firms issue new stock or go public when they believe their share price is high, and they buy back stock when they believe it is low. Because index funds are mandated to match the index, they are forced to buy when firms issue and sell when firms buy back.

Recent research suggests this mechanical behavior acts as a form of unintentional, poor market timing. A 2025 paper on index rebalancing found that portfolios mirroring these trades have a negative 3.5% annual return, imposing an estimated 60 basis point drag on the index itself. This is an implicit cost; you won't see it on a fee table because it is baked into the index's performance. By contrast, a fund that does not track an index, such as the Dimensional US Equity Market ETF (DFUS), can use 'lazy' or flexible rebalancing. By delaying the purchase of IPOs or waiting to incorporate market changes, a fund can avoid buying into overvalued issuance, potentially boosting returns by 40 to 60 basis points per year.

Filtering the 'Small Crap' Growth

Beyond the timing of trades, the composition of a total market index can be improved through evidence-based exclusions. While VTI holds nearly every investable stock in the U.S., DFUS excludes specific categories known for poor historical returns: small-cap growth stocks with weak profitability and aggressive investment. These are often colloquially referred to as 'junk' or 'small crap' growth stocks. While these exclusions mean the fund holds roughly 1,000 fewer securities than a total market index, those missing stocks represent only about 1% of the total market capitalization.

Critics often argue that excluding any segment of the market is a gamble, but the data suggests otherwise. Over recent periods, these excluded small-cap stocks have returned roughly -10% annualized. By removing them, a fund can improve its expected return profile without losing the benefits of broad diversification. Similarly, some funds choose to exclude Real Estate Investment Trusts (REITs) as a product design choice. Even when adjusting for the lack of REITs, the outperformance of a flexible strategy over a rigid index often persists, suggesting that the primary driver of excess return is the avoidance of adverse selection and poor-quality factors.

The Reality of Tracking Error

If a flexible, non-indexed total market strategy is structurally superior, why doesn't everyone use it? The answer lies in tracking error. When you invest in a total market index fund, your returns will match the headlines. When you invest in a strategy like DFUS, your returns will inevitably differ. There will be years where the 'junk' stocks you excluded soar, or where the index's rigid rebalancing happens to catch a momentum swing that a flexible strategy misses.

This divergence can be psychologically taxing. Even if the long-term expected returns are higher, many investors find it difficult to stay the course when they see a well-known benchmark outperforming their portfolio. This is the 'cost' of being different. For those who cannot stomach the possibility of underperforming the S&P 500 or the CRSP Total Market Index for a few years, a standard index fund remains the best choice. However, for the disciplined investor willing to update their beliefs based on newer empirical evidence, the move from a rigid index to a flexible, total-market approach represents a meaningful structural upgrade.