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The Hidden High Costs of Index Funds

Here’s a simplified history of indices: early on, investors used indices to see what the market was doing and, more importantly, understand how their investment managers were doing on a risk-adjusted basis.

Then, investors realized they could use indices as the basis for investment vehicles—bypassing concerns over a manager’s performance and expense. This was the basis of index funds. The funds were appealing because  they often delivered on their promise of low costs, but they also tended to have low turnover and were more transparent—you know what you are getting when you buy an index fund.

Today, many investors use index funds because they provide an easy way to gain cheap, diversified exposure to specific areas of the market.

The question is this: Is an index a precise representation of the sector of the market it describes?

The Truth About Indices

To answer this question, we can look at how different indices compare against each other. Almost all asset classes—especially the “major” ones—have a multitude of indices tracking them. But all of the indices are slightly different from each other.

Look at Exhibit 1. It shows the maximum rolling one-year performance differences from January 1999 to December 2015 for indices in the same asset class. As you can see, the degree of performance differences can be significant.

For example, in small caps, the S&P SmallCap 600 Growth Index underperformed the Russell 2000 Growth Index by 32.67% over a one-year period. But both would have intended to represent the same asset class.

Exhibit 1: Rolling One-Year Maximum Relative Performance vs. Russell Indices

The Hidden High Costs of Index Funds

So where do these differences come from?

Two Factors that Can Make Your Index Differ from Others

Two factors explain the differences. Two things define an index: it’s construction methodology (how it decides what to include, and how to include it), and it’s reconstitution schedule (when it decides what to add or drop). Every index—even the ones covering the same asset class—will have different construction methodologies and reconstitution schedules.

Most of the time, these differences are arbitrary. The index creators aren’t trying to make their index perform better than any other index. They simply define the asset class differently. They may be fitting that index into a broader family of indices and making everything play nice, or they simply define the asset class differently than the other index providers. Either way, every index is slightly (or not so slightly) different.

This means some indices will perform better than others. This is largely random, especially in the short term.

Two Issues to Watch Out For

So how do you decide which index to track? Aside from figuring out what you think the asset class actually looks like, you should be looking out for a couple of things with an index.

Reconstitution

When index funds are reconstituted, they aren’t looking for higher returns. Instead, they are simply trying to match the returns of the index. That’s what they do. However, the other market participants aren’t dumb.

We don’t always say the nicest things about active managers, but it doesn’t take much skill to beat someone who tells you exactly what trades they are going to make and exactly when they plan to make them. It’s like playing poker with all your cards face up on the table.

However, if you don’t reconstitute the index frequently, you bring on one of the other big issues for indices.

Style drift

Stocks bounce around. That’s what they do. And over time, some stocks will get bigger, some will get smaller, some will get more value, and some will get more growth. In other words, they will move between the different asset classes.

This means that, since indices reconstitute on specific dates, in between those dates some stocks will move out of that index and some will move into the asset class. This is called “style drift.” The index, on average, becomes a worse representation of the asset class the further it gets from its reconstitution date.

Style drift isn’t as large of a concern for broad asset class indices—you don’t get much style drift on something tracking the total US stock market—but the more tightly defined an index is, the more style drift you will see. Index funds are tasked with managing to the index, not mirroring the asset class, so they have to accept this style drift. That’s what they were hired to do. It doesn’t mean you need to be happy about it.

A quick summary of what we’ve just covered: Indices can be useful for tracking market returns, but they aren’t necessarily a precise representation of the market.

So what does this mean for you? Well, it means a couple of things.

The first thing to emphasize is that index funds, even with the issues outlined above, will provide a better investment experience than actively managed funds. What we are talking about here is small potatoes compared to the massive problems with active management.

That being said, there are ways to improve your investment experience. Index funds shine when you are working with big broad asset classes. They have smaller reconstitution issues, as well as less style drift (not many stocks are added or subtracted from the US stock markets), plus they tend to be dirt cheap. The smaller the asset class a fund tracks, the bigger those reconstitution costs and style drift issues will get—plus the funds also tend to get more expensive.

If you do want to venture out into those more tightly defined areas of the markets, you can look for funds that don’t necessarily track an outside index but are still passive, though you need to be careful with this. There’s a lot of snake oil being sold with things like fundamental indexing, or “smart” beta. The more promises a fund makes, the more skeptical you should be.

To find out more about how to build an investment portfolio that works for you, read our eBook 9 Principles of Intelligent Investors.

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