Indices may be more active than you think

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

If you invest in index funds as a passive way to access the market, you might want to think again. Index funds do a great job of tracking their index, but how much thought do we give to what’s in the index, who decides what’s in the index, and how those decisions are made? The truth is, index construction is complicated, opaque and arbitrary, and decisions on how they are made are not always in best interests of investors who track them.

For many investors, buying an index fund seems like a smart, low-cost, low-risk way to get broad, passive exposure to a whole market or an asset class within it. But in a recent paper, “Indices Acting Active: Index Decisions May Be More Active than You Think,” my colleagues looked at active decisions that go into design and management of indices and how much those decisions can cost.

There are three important areas investors should pay close attention to. Does the index really represent the market? Is the index picking stocks? And are there hidden costs in index investing?

Many index investors assume their fund offers exposure to the whole of their chosen market or asset class. But each index provider makes its own methodology choices, which lead to a wide range of returns among indices designed to target the same asset class. For example, the average annual spread in returns among four US total market indices over the past 20 years ranged from 0.2 to 3.2 per cent, with an average spread of 1 per cent.

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

Index investing is usually characterised as the opposite of stockpicking. In reality, choices about which stocks to hold, at what weight to hold them, 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 the S&P 500 comprises the largest 500 US stocks. But size isn’t everything. In January 2020, Tesla’s stock was trading around $100 per share, making it roughly the 60th-largest company in the US by market capitalisation. But Tesla hadn’t yet met all the eligibility criteria for inclusion in the S&P 500. (Among other requirements, it needed four consecutive quarters of positive earnings.) The day before its eventual addition in December 2020, Tesla’s stock was worth approximately $700 per share, making it the sixth-largest company in the US. The Russell 1000 index included Tesla throughout this time.

At least index strategies are low cost? Well, maybe not. It’s true some index funds have very low expense ratios, but there are other costs and performance drags which investors ought to consider.

Investors may think of indexing as a “set it and forget it” way to invest, but markets change every day. New companies go public, existing companies go bankrupt or delist, small companies become large, “value” companies become “growth” stocks. Index providers must decide how, and how frequently to rebalance an index in a process known as reconstitution.

For example, once every quarter, FTSE Russell announces which stocks are to enter and which drop out of the FTSE100. To match performance of the index, index funds must trade when the index reconstitutes. This happens periodically to most indices and means there is a huge spike in trading volume around these events. This high demand is like the surge pricing that outraged people who were buying Oasis tickets this summer, but the increased cost is all but invisible to investors because it is hidden in the index return.

We looked at the equal-weighted average trade 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 stocks added or dropped were many multiples, sometimes around 20 or 30 times, higher than typical daily trading volumes. This can mean higher trading costs for the index funds trading on these days. While trading costs do not show up in expense ratios, they can reduce returns to investors.

Missing out?

Index fund managers are typically judged by how closely they track their target indices — their abilities to minimise so-called tracking error. But low tracking error does not mean investors are capturing all the returns markets have to offer. In fact, focusing on minimising tracking error above all other considerations can forgo flexibility and discretion crucial to 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 operational costs. These decisions help shape investment exposure and returns for index investors, and it’s important for investors to do their due diligence on the decisions index providers make.

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