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.  

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.