Index Investors May Be Losing Millions of Dollars Each Year. Here’s Why.
Index funds offer low fees and diversification, but rigid rules and hidden costs mean they’re not the market itself—investors should dig deeper.
Index funds were a step in the right direction.
Investors were fed up with the high fees and poor performance from stock-picking active managers. Decades of evidence are now suggesting that very few actively managed funds consistently beat the market. That means a rules-based investment proposition with low expense ratios and broad diversification offers an appealing alternative. But, even with index-fund investing come limitations.
A rigid implementation process that prioritizes trackability over expected returns may be costing investors hundreds of millions of dollars each year—if not more. And arbitrary construction rules for security inclusion may result in notable deviations from the market. There is a better way for investors to get market returns with low cost, while not paying extra in the hidden costs of indexing.
An Index Is Not the Market
Many investors want low-cost exposure to the market, or segments of the market, and may assume that an index fund is a good way to get it. That’s one reason why index funds continue to be popular: Indexing assets under management jumped from about $1.9 trillion in 2010 to $16.2 trillion by the end of last year. But it’s a mistake to think of a particular index as the market, since each index provider makes its own methodology choices, which can lead to a wide range of returns among indices designed to target the same asset class.
Take the Russell 2000 Index and CRSP US Small Cap Index. Both may be perceived to represent the universe of domestic small companies. Yet, they have less than a third (32.7%) of their weight in common, per Dimensional data. Or you can look at returns: The average annual difference between the highest and lowest returns of the S&P Small Cap 600, Russell 2000, and CRSP US Small Cap was nearly 5% between 2004 and 2023.
Investors, then, are right to wonder which one of these indices is the “small cap market.” The answer: None of the above. There is no “market,” just different approximations delivered by different providers.
More Active Than You Think
Index providers’ decisions—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. The result may be a wedge between what an investor expects versus what they receive with an index fund. Take, for example, the US large company market segment, commonly represented by the S&P 500 Index. Investors might expect that determining what’s included in the S&P 500 is straightforward. One might even expect the index to hold the largest 500 stocks in the US market when, in fact, more than $2 trillion worth of the top 500 US stocks are excluded.
Tesla is an instructive example of the index’s inclusion rules at work. In January 2020, the stock was trading around $100 per share, making it roughly the 60th-largest company in the US by market capitalization. But Tesla hadn’t yet met all the eligibility criteria for inclusion in the S&P 500. The index provider, S&P Dow Jones, later announced that Tesla would be added to the S&P 500 in December. By the day before its addition, Tesla’s stock was worth approximately $700 per share, making it the sixth-largest company in the US by market capitalization.
The choices made by indices can have substantial consequences for investor returns.
Low Fees vs. Low Costs
Many investors may select index funds due to their low expense ratios. However, while broad market index funds typically charge low expense ratios, there are many other costs to consider. For instance, an index’s rigid approach to reconstitution may impose a performance drag that weighs down investor returns. And this drag may not be apparent to the investor, which means it’s a cost that goes beyond the expense ratio.
Index reconstitution is the process of updating the identity and weights of constituents, occurring a handful of times each year. During these events, funds tracking the index must make trades to align positions with their indices’ holdings. This results in potentially substantial trading volume in securities being added to or deleted from the indices, occurring in a concentrated window of time. Index fund managers are thus demanding significant liquidity from the market. While other market participants are willing to provide this service to index funds, it comes at a cost.
Reconstitution costs can be hard for investors to detect because they come straight out of the index return.
What’s the MSRP?
Dimensional 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 were many multiples, sometimes around 20 or 30 times, higher than typical daily trading volumes in those stocks. 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. Looking across the decade ending in December 2023, indices had their prices pushed by an average of 3% to 4% relative to the other stocks in the index.
Investors should treat index funds like any other big purchase. Do your homework to understand their investable universe, how they define the market, and how they handle operational costs. It’s unlikely you’d buy a car without some due diligence—the same should apply to index funds.
This article originally ran in The Daily Upside.
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