Index Investing Requires Some Thought
At the turn of the 21st century the majority of mutual funds that invested in equities (stocks) utilized what is called active management. That is, fund managers chose some subset of all publicly-traded companies in which to invest and also decided when to rebalance the various positions held in the fund. The purpose was to try to outperform some benchmark index representing the asset class in which the fund participated. However, active management required expensive analysts and sophisticated computer software, all of which drove up the price of owning such funds. Not only that, most of these funds actually failed to meet their promise of consistent outperformance the longer they operated.
That led to the development of so-called passive index funds, mutual funds and ETFs whose performance is based on some common equity index such as the S&P 500. The goal was no longer to try to outperform the index but rather to just match it, albeit at a much lower cost of ownership. Today the majority of stock funds are index funds. However, not all indices are the same, and if you are going to invest in index funds, you should understand what makes them different and how that influences their returns. Here are several things to consider.
First, which index should you use? As an example, consider the two most common indices covering publicly-traded companies with market capitalizations greater than $10 billion (large cap): the S&P 500 and the Russell 1000. Right off the bat you can tell from their names that they are not the same. One holds 503 stocks (as of this writing), while the other includes nearly twice that number. The same is true of indices covering nearly every subset of U.S. stocks. In the small cap segment, the CRSP US Small Cap and the Russell 2000 contain about 1,400 stocks and 2,000 stocks respectively. Even indices that cover the entire U.S. equity market (such as the Russell 3000 and the Dow Jones U.S. Total Stock Market Index) differ in their makeups. In effect, no index can be said to perfectly represent its target market segment.
The next most important factor affecting returns is how the index is reconstituted. Over time, the market capitalizations of the various companies change as their performance causes them to fall in or out of favor with investors. This affects their proportions in the index, and may even cause some to drop out if their market cap drops too much. At the same time, other companies may become newly eligible for inclusion in the index. Reconstitution involves removing those stocks that no longer fit the criteria and adding those that have become candidates.
The frequency and transparency of the reconstitution process varies not only across different index families but also across the funds that track them, and this can impact performance. When investors know when and how an index will be reconstituted in advance, they can buy or sell the stocks moving into or out of the index before its reconstitution, which forces the index to add or remove stocks at prices that have been temporarily inflated or deflated. In a research note Dimensional Fund Advisors (DFA) found that trading volumes around reconstitution days can be as much as 25 times higher than typical daily trading volumes. That also drives up the trading costs of funds which track the index, further negatively affecting investor returns.
How do all these differences stack up? In 2023 one of the small cap indices (the CRSP US Small Cap) outperformed another small cap index (the S&P Small Cap 600) by 200 basis points (18.1% vs. 16.1%). That may not sound like a lot, but if that difference were to persist over time it could represent tens or even hundreds of thousands of extra dollars depending on portfolio size.
Now that you’ve performed your due diligence and selected an index in which you’d like to invest, you have to choose among dozens of funds that track that index. The methodology that each uses for tracking as well as the reconstitution process that each fund itself follows will further impact your returns.
The point here is that even investing in something as apparently simple as a stock index fund requires a lot more than just a dart board.
(PERIGON is a registered investment adviser. More information about the firm can be found in its Form ADV Part 2, which is available upon request by calling 877-977-2555 or by emailing compliance@perigonwealth.com).