The Dirty Little Secret About Index Funds

If you read this blog regularly, you know that we advocate a passive, low-cost, diversified investment portfolio.  Most people equate that to index funds.  For the majority of investors, index funds are a great alternative to their actively managed counterparts.  But not everything about index funds is perfect.  About 10 years ago we started to hear about some of the "front-running" that happens with index funds.  Bloomberg has an article out called:  The Hugely Profitable, Wholly Legal Way to Game the Stock Market:

Over a course of a year, front-running — of stocks going into and coming out of indexes — costs investors in S&P 500 tracker funds at least 0.2 percentage points, according to research published last year by Winton Capital Management Ltd., a quantitative hedge fund that analyzed data from 1990 to 2011. That’s equal to $4.3 billion in lost income in 2014.

study in 2008 by Antti Petajisto, now a money manager at BlackRock Inc., estimated the impact could boost the expense of owning an index fund by as much as 0.28 percentage points.

While that might not sound like a lot, the added cost would be almost three times the stated 0.11 percent management fee for the $213 billion Vanguard 500 Index Fund, the largest S&P 500 tracker fund of its kind. By comparison, actively managed stock funds charge an average 0.86 percent annually, data compiled by Investment Company Institute show.

“The moment you say index, you’re telling the world you’re going to be trading on this particular day,” said Eduardo Repetto, co-chief executive officer at Dimensional Fund Advisors, a fund firm that designs passive strategies that differ from traditional index funds by giving higher weightings to factors such as profitability. “If you have zero flexibility when you trade, it’s going to cost you money.”

When an index reconstitutes, it removes a group of stocks and adds another group.  If you are a hedge fund or trader and you can guess in advance which stocks they will be, you can buy (or sell) them in advance of billions of dollars moving into (or out of) these specific securities.  This is one of the reasons we choose to use a passive alternative to index funds.  Here is another excerpt depicting a real-life example:

It might be tempting to blame savvy Wall Street types for taking advantage of mom-and-pop investors, but one of the big reasons front-running exists is because providers of popular benchmarks such as the S&P 500 usually telegraph changes ahead of time. Another stems from the pressure that passive fund managers face to track those benchmarks as closely as possible, even if it means sacrificing potential returns.

Take American Airlines Group Inc., which joined the S&P 500 after markets closed on March 20. Because the addition of the carrier was announced four days earlier, nimble traders had plenty of time to get in front of the less fleet-footed. American jumped 11 percent over the span.

The cost was ultimately borne by index funds, which sparked an $8 billion buying frenzy in the two minutes right before the close — an amount equal to more than two weeks of the stock’s typical volume, data compiled by Bloomberg show.

Don't get me wrong.  Index funds, when compared to actively managed funds, get you 80% of the way there.  The other 20% are some of the fringe activities that can be done to improve returns- developing a patient trading strategy, overweighting known risk premiums like small and value stocks, and other small moves like securities lending and not being a slave to tracking error.  Improving portfolios, one small step at a time by the factors presented above, can have substantial positive impact on portfolio returns.  

Predictions Are Worthless

I am not sure what our fascination about predictions are all about.  Whether it is political elections, sports, or the financial markets, everyone seems to be willing to stop and listen to someone who is willing to make a prediction.  Rarely do we ever go back to evaluate how those predictions pan out.  With regards to investment predictions, every once and a while I like to go back and check the accuracy of those prognosticators against the investment markets to see how they have held up.  One of the most famous is Jeremy Grantham, founder of GMO, a multi-billion dollar asset management company.  He periodically publishes a 7 year market prediction and gained quite a bit of notoriety for accurately predicting much of the investment returns in the early part of the 1990s.  As we approach the end of his 7 year forecast from June 30, 2008, I thought it would be helpful to evaluate his predictions (caveat- the index returns go through 5/31 while the GMO forecast is through 6/30):

Asset Class Index GMO Forecast Actual Return
US Large Cap Stocks S&P 500 3.2% 9.85%
US Small Cap Stocks Russell 2000 2.1% 10.46%
Int'l Large Cap Stocks MSCI EAFE 5.8% 2.42%
Int'l Small Cap Stocks MSCI EAFE Small  6.2% 5.69%
US REITs DJ Select REIT 2.7% 8.4%
Emerging Mkt Stocks MSCI Emerging Mkts 6.8% 1.25%

So, if you had taken GMO's advice and overweighted the areas they predicted would perform the best, you would have put most of your money in emerging market stocks and international stocks.  The asset classes where they predicted the worst performance (US stocks and REITs) have been the best places to invest.  The point is, no one has a crystal ball.  Those that have been right in the past have no better chance of being right in the future.  Once you realize this, you'll be a much better investor, immune from the siren song of predictions.  

Invest Like Norway, Not Yale

David Swenson, the chief investment officer of the Yale endowment fund, has gained notoriety over the past several decades for his management of the Yale endowment fund.  In the early 1990s he decided to place a gigantic chunk of the endowment into alternative assets like real estate, hedge funds and private equity.  The results were spectacular.  From 2000 to 2012 Yale's endowment returned about 12% annually while US stocks averaged 2% during the same period.  Not only have other institutions followed suit, but so have individual investors.  Retail mutual funds investing in alternative strategies have exploded, aided in part by the success of endowment funds like Harvard and Yale.  Instead of being some fringe investment strategy, alternatives have become mainstream, with over $300 billion in these products.

While Yale has focused on alternatives, Norway has gone the opposite direction.  Here is an article from 2013 in the WSJ:

Now, let's turn to Norway. Its huge Government Pension Fund Global keeps roughly 60 percent of its assets in publicly traded stocks (half in the U.S.), 35 percent in bonds and up to 5 percent in real estate. How much does the Norwegian portfolio hold in hedge funds? Nothing. Venture capital? Nada. Commodities? Zip. Private-equity funds? Zero.

"The Yale model would not work for us," says Norwegian spokeswoman Bunny Nooryani, because "the fund is too large to implement that type of strategy." With two-thirds of $1 trillion to invest, building a meaningful portfolio of non-liquid assets would be far too cumbersome and costly. And yet the Norwegian fund has fared quite well. It has gained an annual average of 4 percent since 2000, or double the return on U.S. stocks. Since 2009, it has earned 4 percent annually, while Yale earned an average of just 1 percent a year.

The Norway portfolio is "diversified in everything," says Antti Ilmanen, an analyst at AQR Capital Management in Greenwich, Conn., who serves on the fund's advisory board. It owns shares in nearly 9,000 companies and holds approximately 1 percent of every significant stock on earth.

The Norwegian fund has another advantage, says Elroy Dimson, a finance professor at London Business School who also is on its advisory board. "Norway is willing to suffer a lot and do worse than other major investors when markets are going down," he says. The giant fund loads up on smaller stocks and on so-called value stocks, which trade at lower prices in the short term. When markets fall, these companies tend to fall even farther—but that sets them up for higher performance in the long run, according to decades of research by Dimson and other experts.

Does anything sound familiar here?  Extremely broad diversification, focus on small and value companies, low cost.  This approach is the one touted by Greenspring on behalf of its clients.  In fact, the nearly $1 trillion Norway Pension Fund is invested almost identically to Greenspring clients.  It is somewhat comforting to us to know that the largest institution in the world has adopted the same approach.  I thought it would be interesting to go back and see how things have fared for both institutions since the financial crisis and ensuing recovering.  From the period of June 30, 2007 to June 30, 2014 the Yale Endowment has averaged 5.71% per year.  During that same period, the Norway fund has averaged 5.23%.  A nearly identical return, but the Yale endowment has experienced 34% more volatility than the Norway Fund.  

Before you take this data and assume that you can't hurt yourself by investing in alternatives, please remember that Yale has $24 billion in assets and an investment office of 28 professionals working on this fund.  That gives them significant access and leverage in pricing.  Two factors that will be working against you.  In addition, there is a train of thought that Yale's outperformance will be difficult to continue.  Because so many institutions have followed their lead, the opportunities available to them will not be as favorable due to other organizations competing for the same deals.  Conversely, it is not that hard to invest like Norway.  It can be done through mutual funds or ETFs and at a very reasonable cost.  We believe Norway's approach, which is certainly less sexy than Yale's, will be the best alternative for investors in the future. 

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.