Indices may be more active than you think

Each index provider makes its own methodological choices, which lead to a wide range of returns among indices designed to target the same asset class.

If you’re investing in index funds as a passive way to access the market, you may want to reconsider. Index funds do a great job of tracking their index, but how much attention do we pay to what’s in the index, who decides what’s in the index, and how those decisions are made? The truth is that the construction of indexes is complicated, opaque and arbitrary, and decisions about how they are made are not always in the best interests of the investors who follow them.

For many investors, buying an index fund seems like a smart, cheap and risky way to gain broad, passive exposure to an entire market or an asset class within it. But in a recent article, “Indices Acting Active: Index Decisions May Be More Active than You Think,” my colleagues looked at active decisions related to the design and management of indices and how much those decisions can cost.

There are three key areas that investors should pay close attention to. Does the index really represent the market? Does the index favor shares? And are there hidden costs with index investing?

Many index investors assume that their fund provides exposure to the entire market or asset class of their choice. But each index provider makes its own methodological choices, which lead to a wide range of returns among indices designed to target the same asset class. For example, the average annual return spread among four US market indices over the past twenty years has ranged from 0.2 to 3.2 percent, with an average spread of 1 percent.

In another example, a major index provider classifies South Korea as an emerging market, while another considers it developed. There is no one consistent approach to defining a market.

Index investing is usually characterized as the opposite of stock selection. In reality, choices about which stocks to hold, what weightings to hold them at, and when to rebalance are often made by arbitrary index methodology rules, or sometimes by an index committee.

Size isn’t everything

You might think that the S&P 500 includes the largest 500 U.S. stocks. But size isn’t everything. In January 2020, Tesla’s stock was trading around $100 per share, making it approximately the 60th largest company in the US by market capitalization. But Tesla did not yet meet all the criteria to qualify for inclusion in the S&P 500. (It needed four consecutive quarters of positive profits, among other things.) The day before its final addition in December 2020, Tesla’s shares were around $700 worth per share. share, making it the sixth largest company in the US. The Russell 1000 index included Tesla during this time.

Are index strategies at least cheap? Well, maybe not. It’s true that some index funds have very low expense ratios, but there are other cost and performance barriers that investors should consider.

Investors may think of indexing as a one-size-fits-all approach to investing, but the markets change every day. New companies go public, existing companies go bankrupt or disappear from the stock exchange, small companies become large, ‘value companies’ become ‘growth stocks’. Index providers must decide how and how often to rebalance an index, in a process called reconstitution.

For example, once a quarter, FTSE Russell announces which shares will enter the FTSE100 and which shares will disappear. To match the performance of the index, index funds must trade when the index is reconstituted. This happens periodically across most indices and means that there is a huge spike in trading volume around these events. This high demand is similar to the price hikes that infuriated people who bought Oasis tickets this summer, but the higher costs are virtually invisible to investors because they are hidden in the index returns.

We looked at the equal-weighted average trading volume from 2018 to 2022 for the S&P 500, Russell 2000, MSCI EAFE and MSCI EM indices and found that on reconstitution days, trading volumes of added or fallen stocks were multiples, sometimes around 20. or 30 times higher than typical daily trading volumes. This could mean higher trading costs for the index funds that trade on these days. Although trading costs are not reflected in expense ratios, they can reduce returns for investors.

Are you missing something?

Index fund managers are typically judged by how closely they track their target indices: their ability to minimize so-called tracking error. But a low tracking error does not mean that investors are taking advantage of all the returns the markets have to offer. By focusing on minimizing tracking error above all other considerations, you may be giving up flexibility and discretion that are crucial for more efficient trade execution and other return-enhancing investment decisions.

Index providers make crucial choices about which stocks to include, when to buy and sell, and how to manage operating costs. These decisions help shape investment exposure and returns for index investors, and it is important for investors to do their due diligence on the decisions index providers make.

Marlena Lee, global head of investment solutions, Dimensional Fund Advisors