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Are Indexes Being Cannibalized?

December 30, 2012 Leave a comment Go to comments

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.

  1. Andrew F
    January 2, 2013 at 5:30 pm

    This is not all due to front-running (the phenomenon you mentioned). Some is due to size effect. Companies with smaller market capitalizations tend to have a higher rate of return than the average, and since S&P500 only has large and mid cap companies, it does not take advantage of this factor.

    Index providers have identified front-running as an issue and have taken steps to reduce the effectiveness of this strategy. Fund managers can use a sampling strategy to replicate an index (only buying a subset of the stocks in the index), or making unscheduled announcements of equities being added to the index.

    • January 2, 2013 at 6:22 pm

      Indeed, the different mix of stocks is sure to have some effect. I think the S&P 500 represents around 70% of the total market cap so the smaller companies would need to have much better performance to add 1% to the total return.

      I believe Vanguard is very good at managing index funds, but their minimal tracking error shows that they have returns very close to the index. A fund that successfully avoided issues like this could potentially do better than the index. I’d like to see any funds that do that 🙂

      I’m not sure that sampling would help. If you own every stock on the market you can’t lose returns to traders who are picking stocks, since they have to hold one part of the index or another. At that point traders who want to work against you need to include other assets outside of the market. The less stocks you hold, the more vulnerable you are to anyone who can anticipate your decisions. An index fund that held only a few concentrated positions could be run out of the market by a few large traders. The best solution that I see is larger funds that are more diversified. In Canada that may take a while.

  2. January 12, 2013 at 5:03 am

    Your opening paragraph calls it a growing threat, but the pattern of returns indicates it’s rapidly dwindling! Are the percentages not annualized? In that case, it would be more fair to compare to avoiding 0.1% in MER (which is annualized) than 0.7%.

    • January 12, 2013 at 3:35 pm

      The growing threat is hypothetical and this evidence turns out to be inconclusive. I forget the exact content of the research I had read but it did mention some findings of prices rising between the announcement that a stock would be included in the index and the official start date. Since this presumably wouldn’t happen when no one invested in indexes you could call that a growth. Or maybe including a stock in the Dow had that effect 100 years ago. More research is needed on this!

      I believe those numbers are all annualized since they are performance numbers taken directly from Vanguard’s website. The diminishing gap in recent years seems to show that this effect, if present, is easily overwhelmed by other factors. It is funny how in this instance the number grows almost linearly with the time measured. Checking it a year from now may show a completely different effect.

  3. Jlau
    January 15, 2013 at 3:22 am

    I attempted to unload JDS early 2000 for $200. Much to my chagrin it dropped to I think $120.
    JDS then acquired Uniphase and became JDU. JDU was suddenly large enough to be part of the S&P 500. And when that happened the price went up to $180.
    The best way of tracking the index effect is to look for individual corportation prices just before and after their inclusion in the index.

    • January 15, 2013 at 5:42 am

      That’s the kind of thing that could be a concern for index investors if it’s a widespread effect. Of course there could be many other things that contributed. For example a larger market cap getting the attention of more institutional investors, or even just a good quarter, would also drive up the price. It would take some very fine-tuned analysis to determine if the index changes drive up the price or something else leads to both rising prices and inclusion in the index.

      In the end we know the S&P 500 involves mostly stable large-cap stocks which many other mutual funds and investors like to buy. Popular stocks generally don’t stay cheap for long. On the other hand when prices do fall a large-cap index makes it easy to buy a lot of good stocks fast. An index of stocks that are about to be added to the S&P 500 should do great 🙂

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