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.”