Image Source: As the annual studies demonstrate, index funds persistently outperform the vast majority of actively managed funds, even before considering taxes. With that said most investors are unaware that there are weaknesses of index funds that result from their strategy to replicate the return of an index. Those weaknesses, which result from the desire to minimize what is called “tracking error” (returns that deviate from the return of the benchmark index), can lead to constraints and implementation costs that hurt returns. The weaknesses that can be minimized or avoided include:
Another advantage of systematic funds, in return for accepting tracking error risk, is that they can gain greater exposure to the factors for which there is persistent and pervasive evidence of a return premium (such as size, value, momentum, profitability/quality, momentum, carry, and term). For example, a small-value fund could be structured to own smaller and more “value” stocks than a small-cap value index fund. It can also be structured to have more exposure to highly profitable companies, and it can screen for the momentum effect (avoiding buying stocks that are exhibiting negative momentum and delaying selling stocks with positive momentum).Rebalancing/ReconstitutionRebalancing of major indices is generally centered around three major events; the measurement date, announcement date, and effective date.Measurement Date: The index provider gathers the necessary data for the rebalancing, for market cap-weighted indices this includes the free float and closing price. Using this data, the index provider calculates the updated index holdings based on the index methodology.Announcement Date: The index provider announces the upcoming changes to the wider market. The index continues to be calculated using the previous index weightings until the effective date.Effective Date: The index provider updates the index according to the weightings published at the effective date. From this point onwards, index values are calculated using the updated index weightings.These events are generally staggered by a few days or weeks, depending on how the index is designed. While providing transparency and predictability, index-tracking products are designed to have as little deviation as possible from the index performance. Thus, they concentrate their trading on the effective date, demanding liquidity from the market—with negative consequences.Empirical Research on the Hidden Costs of Index ReplicationKaitlin Hendrix, Jerry Liu, and Trey Roberts, authors of the study “” examined the impact of trading costs that result from the reconstitution of an index. They measured the costs of index reconstitution from 2014 to 2023 for 10 US indices. In their analysis, they restricted adds and deletes to nonmigrating securities, i.e., stocks that are added to (or deleted from) an index and are not also deleted from (or added to) another index from the same index family on the same reconstitution date. By focusing on these “pure” additions and deletions, they were able to more cleanly identify the cost of demanding immediacy associated with tracking an index. They examined the reconstitution events for 10 widely tracked US equity indices—the S&P 500 index, S&P MidCap 400 (S&P 400) index, S&P SmallCap 600 (S&P 600) index, Russell 1000 Growth Index, Russell 1000 Value Index, Russell 2000 Index, CRSP US Large Cap Growth Index, CRSP US Large Cap Value Index, CRSP US Mid Cap Index, and CRSP US Small Cap Index—from 2014 through 2023. Their sample included a total of 3,488 additions and 2,517 deletions.Following is a summary of their key findings:
Their findings led Hendrix, Liu, and Roberts to conclude: “With respect to transaction costs, adhering to an index reconstitution schedule can result in relatively poor execution prices—buying higher and selling lower—which are in turn reflected in investors’ returns.”In their study on the the Russell 1000 Index over the period 2012-2021, the research team at direct index provider found that the hidden cost of rebalancing the Index was 7.5 basis points or a total loss to investors of $11 billion per year. Rebalancing a week before or two weeks after would have been more efficient.Investor TakeawaysAn index-tracking approach generally lacks flexibility, which detracts from performance, leaving returns on the table. Intelligent design can overcome such issues. For example, an S&P 500 Index could choose to rebalance one month ahead of the scheduled reconstitution, minimizing the impact of reconstitution. Direct index funds are already engaging in such strategies with ETFs.A superior approach, the one taken by such research-oriented investment firms such as AQR, Avantis, Bridgeway, and Dimensional would be to use a daily process that consistently focuses on owning stocks with higher expected returns and spreads turnover across all trading days with flexibility across stocks and quantities. Such an approach minimizes the cost of demanding immediacy from the market.More By This Author:Data-Driven Approach To Clustering Similar Macroeconomic Regimes Overvalued Or New Paradigm?Evergreen Private Equity Funds Attracting Assets
