Are Indexes Being Cannibalized?
A while back I saw some research highlighting a growing threat facing index funds. Since it is well know that many smart investors are putting money into them, people who are out to beat the market can trade against those predictable decisions. This may reduce index returns in the future. This research showed an abnormally large increase in a stock’s price once it is announced that it will be included in the index. If this effect is widespread it would mean that index investors are overpaying for stocks, but this is likely to be a more recent effect since index funds weren’t popular at the beginning.
To do a quick test on this I compared Vanguard’s S&P 500 index fund with its Total Stock Market index fund. The S&P 500 is easy to target, but the Total Stock Market fund holds every stock so it wouldn’t be possible to front-run trades from investors in that fund.
The results show that the Total Stock Market fund consistently outperforms the S&P 500. The actual fund returns are:
- 0.08% higher in the last year
- 0.20% higher in the last 3 years
- 0.49% higher in the last 5 years
- 0.73% higher in the last 10 years
And the benchmark returns show similar outperformance:
- 0.10% higher in the last year
- 020% higher in the last 3 years
- 0.50% higher in the last 5 years
- 0.74% higher in the last 10 years
Aside from showing how great Vanguard is at tracking the index, this demonstrates that you would have been better off holding all US stocks rather than just the S&P 500. The difference isn’t huge, but we go to great lengths to avoid an extra 0.73% in fees on our funds and reducing returns by that amount has the same effect.
This doesn’t prove that it’s simply because of trading against the index. It’s possible that the smaller stocks in the Total Stock Market index simply did better. In fact given the past returns for small cap stocks that may be explain the full outperformance.
It’s also interesting to note that the outperformance has decreased in recent years, even as the indexing message continues to spread.
Overall this is not a convincing demonstration that index funds are truly under attack from smart traders. Even if they were they still remain the best choice since it’s better to be under attack from a few smart traders than to side with the many dumb traders. The growing popularity may attract unwanted attention but it also makes it possible for large funds to go past the representative index and just buy everything.