The Problems with Market-Cap Weighted Index Funds
New research quantifies the implicit cost that investors incur when index funds, such as those tracking the S&P 500, are rebalanced. Those costs may be avoidable by adopting trading strategies that introduce the possibility of tracking error.
Before reviewing that research, let’s look at how systematic funds have reduced those and other implementation costs.
Prudency demands beginning your journey by creating a plan in the form of an investment policy statement (IPS). The IPS defines the investor’s goals and the specific asset allocation they will use to achieve those goals. Once the asset allocation is determined, the next decision is the choice of investment vehicles that will be used to gain exposure to each of the respective asset classes. For investors using systematic (no individual stock selection or market timing) strategies, the choice is much simpler than it is for active investors because the universe of funds from which to choose is much smaller.
Systematic funds provide the benefits of lower expense ratios, lower implementation (trading) costs and, typically, broader diversification. They also tend to closely match the performance of their published index with low tracking variance. And, as shown by the annual SPIVA scorecards, they have outperformed the large majority of active managers in all asset classes; the longer the time frame, the greater the percentage outperformance.
However, even for passive investors, the choice is not as simple as just looking at the expense ratios of the various alternatives and choosing the cheapest. All index funds are not created equal – they are not pure “commodities.”
While the expense ratio is an important consideration, it is not the only one. A fund manager can add value in several ways that have nothing to do with “active” investing (the use of either technical or fundamental analysis [judgment] to identify specific securities to either overweight or underweight). There are many ways a systematic fund can add value in terms of portfolio construction, tax management and/or trading strategies:
- Choice of eligible universe. The choice can impact returns in several ways:
- Turnover, which impacts trading costs and tax efficiency. Some indices have higher turnover than others. And some indices have buy-and-hold ranges that are designed to reduce the negative impact of turnover (both on transaction costs and tax efficiency).
- Exposure to the risk factors of size, value, momentum and quality/profitability – the greater the exposure, the higher the expected return.
- Correlation of the fund to the other portfolio assets (the lower the correlation, the more effective the diversification).
- Some indices are less transparent, preventing actively managed funds from exploiting the “forced turnover” that is created when indices are reconstituted. The lack of opaqueness has historically created problems for index funds that replicated the Russell 2000 Index. For example, from inception in 1979 through March 2022, the Russell 2000 returned 11.4%, while the very similar CRSP 6-10 small-cap index returned 12.2%.
- Directly using momentum as a factor in fund construction or incorporating the momentum effect by temporarily delaying the purchase of stocks that are exhibiting negative momentum and by temporarily delaying the sale of stocks exhibiting positive momentum.
- Screening out certain securities (even if they are within the defined index) that have demonstrated poor risk/return characteristics (such as stocks in bankruptcy, “penny stocks,” IPOs, and small growth stocks with high investment and low profitability).
- Reconstituting more frequently than annually. Most indices (e.g., the Russell and RAFI Fundamental Indices) reconstitute annually. Infrequent reconstitution can create significant style drift, as over the course of the year a small-cap index fund based on the Russell 2000 would see its exposure to the small-cap risk factor drift lower. For small-value funds based on the Russell 2000 Value Index, their exposure to both the small and value premiums would drift lower. The drift toward lower exposure to the risk factors results in lower expected returns. To avoid this problem, fund families (such as Dimensional) reconstitute their definitions more frequently – quarterly, monthly or even daily.
2. Patient trading. If a fund’s prime directive is to replicate an index, it must trade when stocks enter or exit the index and must also hold the exact weighting of each security in the index. Pure replication also creates the risk of front running by hedge funds, high-frequency traders and other active managers. On the other hand, a fund whose goal is to earn the return of the asset class (or factor) and is willing to live with tracking variance can be more patient in its trading strategy – using algorithmic trading in small lots and block trading that can take advantage of discounts offered by active managers that desire to quickly sell large blocks of stock. Patient trading reduces transaction costs, and block trading can even create negative trading costs in some cases.
3. Tax management. While indexing is a relatively tax-efficient strategy (due to relatively low turnover), there are ways to improve the tax efficiency of a fund. The first is to harvest losses when they are significant. The second is to eliminate any unintentional short-term capital gains (those that are not the result of acquisitions). The third is to create wider buy and hold ranges in its construction rules to reduce turnover. And a fourth is to avoid violations of the wash-sale rule, keeping dividends qualified for tax purposes.
Unfortunately, most of the investing public is unaware of many of these differences, which collectively can have significant impacts on the returns of funds that on the surface appear to be substantially similar. While most professionals/advisors are aware of these differences, there is another way for an aggressive firm to add value that is often overlooked. It involves the temporary lending of a portfolio’s securities.
4. Securities lending. This refers to the lending of securities by one party to another. Securities are often borrowed with the intent to sell them short. (In international markets, there is another reason for securities lending to occur, which is the ability to utilize the foreign tax credit. Thus, the opportunities to add value are greater in foreign markets.) As payment for the loan of the security, the parties negotiate a fee. Some mutual funds are more aggressive than others in this area. And smaller, less liquid stocks tend to earn higher lending fees. Therefore, a fund with a lower average market cap could earn higher lending fees.
There is another strategy related to securities lending that can add value. A large body of research (for example, the 2022 study “Can Shorts Predict Returns? A Global Perspective,” demonstrated that stocks with high lending fees underperformed. Thus, an index fund can simply suspend purchases of these stocks systematically to improve performance.
The result of the differences in fund-construction rules means that three passively managed funds in the very same asset class can produce three significantly different outcomes. Since all systematic funds are simply following their construction rules, assuming they are efficient at minimizing trading costs, they are all accomplishing their specific objectives. However, the results can be quite different.
The avoidable costs of index rebalancing
Robert Arnott, Chris Brightman, Vitali Kalesnik and Lillian Wu, authors of the May 2022 paper, “The Avoidable Costs of Index Rebalancing,” examined how the rebalancing of market-cap weighted index funds impacts returns. They began by noting: “Whenever an index rebalances or makes changes to its constituents, conventional cap-weighted index funds generally buy high and sell low. The added stocks are routinely priced at a substantial premium to market valuation multiples (i.e., the index buys high), whereas discretionary deletions (with the exception of removals related to mergers, acquisitions, and other corporate actions) are routinely deep-discount value stocks (i.e., the index sells low).” They began their analysis in October 1989, when the S&P index committee began to preannounce changes to the index. Importantly, they noted that since October 1989, because the S&P 500 is changed after the index funds have presumably completed their trading, most index funds benchmarked to the S&P 500 now closely track it. The result is that the trading costs of index funds are masked because they are already borne by the published index itself – “the dirty secret of index fund investing is that the transaction costs are still there, and they are huge, simply hidden in plain sight.”
Arnott, Brightman, Kalesnik and Wu noted: “Beginning in February 2017, the convention changed with the index presuming that any changes in index constituents had already occurred before the open on the effective date, meaning that the previous close was the presumed price at which additions and deletions occurred. Accordingly, since February 2017, index funds began placing most of their trades on the day prior to the effective date, often using a market-on-close order to lock in the same price the index would use for its additions and deletions. Under either scenario, the practice leads to an immense block trade at the close on the trade date, after which the stock is included in (or dropped from) the index. For consistency in our analysis, trade date refers to the effective date before February 2017 and the day prior to the effective date thereafter.” Following is a summary of their findings:
Roughly 90% of additions were discretionary and just 116 were nondiscretionary (e.g., company spinoffs and divestitures). In contrast, over 60% of the index deletions were nondiscretionary (e.g., bankruptcies and mergers).
- Trading volume was elevated on the days before the trade date – for hedge funds and market makers to build positions to accommodate the demand from indexers.
- From the announcement date to the market close on the trade date, additions on average appreciated by another 5.0% relative to the market, while deletions trailed the market by an additional 7.2%, resulting in a performance gap of 12.2 percentage points. About 3.2 percentage points of the gap accrued on the trade date itself, when the majority of the index-fund trading occurred. On the day after the trade date, there was another 1.2 percentage points performance spread in favor of the additions over the deletions, perhaps due to catch-up trades by index funds that did not complete all their addition and deletion trades on or before the trade date.
- If the S&P did not pre-announce index changes, the hypothetical index performance would have been 20 basis points (bps) better per year.
- New additions outperformed the market by an average of 41.5 percentage points in the 12 months prior to the announcement they were added to the index, while discretionary deletions underperformed the S&P 500 by 29.1 percentage points.
- Using a blend of relative price-to-earnings (P/E), price-to-cash flow (P/CF), price-to-book (P/B), price-to-sales (P/S) and (if available) price-to-dividends (P/D) ratios, additions to the S&P 500 tended to be priced at valuation multiples more than four times as expensive as those of discretionary deletions – the discretionary additions were 92% more expensive than the market, while the discretionary deletions were 55% cheaper than the market.
- From October 1989 through June 2021, the performance of the S&P 500 discretionary deletions (20.4% return) beat the additions (-1.6% return) by an average of over 2,200 bps in the 12 months following an index reconstitution. Excluding the first trading day after the trade date, when additions continued to outpace deletions, discretionary deletions outperformed additions by more than 23 percentage points.
- Broader indices, such as the Russell 1000 and Russell 3000, exhibited the same effect.
- A top 500 by market-cap strategy outperformed the S&P 500 by 25 bps a year with annual turnover of 5.4%, only a bit higher than the 4.4% turnover of the S&P 500. Similarly, a top 500 by five-year-average market-cap strategy outperformed the S&P 500 by 38 bps a year. And a top 500 by “fundamental size” strategy outperformed the S&P 500 by 46 bps. A widening of the bands approach, adding a hold range, also led to slightly higher performance while also reducing turnover.
Arnott, Brightman, Kalesnik and Wu noted that investors willing to accept tracking variance could benefit from the simple strategies of trading immediately after an index change is announced (the “announcement date”) rather than waiting until the change goes into effect (“effective date”), delaying rebalancing by a year, or choosing stocks to include in the index in a fashion that does not chase fads or abandon deep value stocks – all strategies that systematic funds that don’t simply seek to replicate an index employ. They advised: “If a herd of elephants is trying to go through a revolving door all at the same time, we benefit by choosing to enter before or after they do their damage.” They also noted: “Indexing has many merits and many advantages, but those who claim that changes in the index do not move share prices have some explaining to do.”
There is only one way to see things rightly, and that is in the whole. While replicating index funds is often the cheapest in terms of expense ratios, when evaluating similar systematically managed funds, it is important to consider not only the operating expense ratio but also all the ways a fund can add value. A little bit of extra homework can pay significant dividends. Arnott, Brightman, Kalesnik and Wu also provided strong evidence that index providers (S&P, MSCI, FTSE, etc.) can construct better-performing indices that are less prone to chasing recent performance and have lower turnover.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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