Fixing Broken Index Funds - Transparency Is A False God
A criticism turned on every critic is that it is far easier to be a critic than it is to make constructive suggestions. When it comes to fixing today's broken index funds, the necessary changes are clear and relatively simple. My recommendations for investors and fund advisers are uniformly constructive.
Indexing started on a tiny scale, but the success of indexing has created a trillion dollar-plus industry. Indexing continues to increase its share of managed financial assets, though the rate of increase has slowed recently. The use of benchmark indexes as index fund templates was a brilliant idea, as long as few assets were indexed. Today, that brilliant idea is not even a good idea for some indexes. The success of indexing makes abandonment of some popular benchmark indexes as index portfolio templates the only sensible course for investors. Also, indexing advocates must push to eliminate the practice of publishing changes in indexes used as portfolio templates before the index fund has an opportunity to trade.
The Benchmark Index Composition Change Effect
A basic principle embraced by generations of active portfolio managers is that they guard the secrecy of their trading plans until those plans have been fully implemented. Portfolio managers are absolutely correct to keep this trading information to themselves. Transaction transparency is the greatest problem of 21st century indexing. Transaction transparency was not an obvious problem when indexing was a fringe activity. In the 1970s, changes in a benchmark index had no meaningful impact on the prices of the stocks involved in the change, because no one was using the index as a template for managing a significant amount of money. Today's most popular benchmark indexes were designed as references for market and portfolio performance measurement, not as recipes for portfolio construction. When benchmark indexes are used as portfolio templates, the publication of index changes before an index fund trades can have a serious adverse effect on the fund's performance.
Until recently, the effect of indexing's growth was to improve the performance of index stocks, as new index funds increased demand for these equities. The earliest evidence that I have seen of this effect of indexation on index portfolio performance is a 1988 article by Bill Jacques, but there have been many other papers on this topic.
S&P 500 portfolios no longer absorb more and more of each member's shares, because ongoing growth in demand for S&P 500 member companies' shares is a thing of the past. Standard & Poor's has even argued recently that, somehow, markets have changed the way they react to index composition changes. In truth, there is good reason to believe that any brief period of mitigation in the "S&P Effect" from composition changes is over. I anticipate continued substantial market impact from changes in the index, in spite of S&P's efforts to tone down the impact of those changes.
Standard & Poor's recently added Amazon.com to the S&P 500. The price behavior of Amazon.com described in my column in the previous issue of this journal was certainly less dramatic than price movements in Yahoo! and JDS Uniphase when they were added to the index a few years ago. The decline in merger and acquisition activity in the U.S. early in the current millennium, and S&P's tardy embrace of float-weighting, have been more responsible for the recent decline in market impact from changes in the S&P 500 than any change in the way the market reacts to index composition changes. The continuing high cost of S&P 500 composition changes will be more apparent when U.S. M&A activity, particularly cross-border merger activity, increases.
Today, index funds have committed to hold a substantial fraction of the shares of every company in the S&P 500 and the Russell 2000. The shares are held in portfolios that attempt to track these indexes as closely as possible. This means that when there is a change in one of these indexes, any stock added to the index experiences substantial demand as it is gobbled up by index portfolio managers. Any company removed from these indexes declines significantly as it is jettisoned from index portfolios. This practice has a devastating effect on index fund performance that the indexing pioneers did not anticipate.
In fairness, there was no reason, at the birth of indexing in the mid-1970s, to anticipate that indexing would become so popular that changes in an index-and the consequent reaction of managers using the index as a template-would have a substantial market impact. The increase in the price of Amazon.com-from the time S&P announced Amazon's membership in the S&P 500 until the change was effective-caused S&P 500 index investors to pay a higher price for the stock. Even if a portfolio manager traded as soon as possible after the announcement to capture some of the "S&P 500 Effect," she paid more for the stock than it would have cost to buy it the day before the index change was announced. If the portfolio change was made at the scheduled time of the index change-as it was in most index funds-the index fund investor paid a 12 percent to 13 percent premium over the pre-membership price of Amazon.com, solely because of its new index membership.
The adverse cost effect of adding a stock to the S&P 500 is no longer mitigated by a steady increase in the share of assets benchmarked to the S&P 500. As Jacques' calculations demonstrated, when the share of assets tracking the index was growing, newly indexed portfolios provided growing demand for the shares of index members-old members as well as new. The last thing an investor wants, however, is a portfolio based on a popular index that is losing its relative popularity. The ongoing membership performance effect Jacques found in the 1980s has vanished as the S&P 500's market share of portfolio assets has leveled off. In fact, the S&P 500's share of indexed assets may be in the early stages of decline.
The relatively faster growth in non-S&P 500 exchange-traded funds (ETFs) and net redemptions in the Vanguard 500 mutual fund are evidence that an ongoing performance enhancement effect is probably a thing of the past for S&P 500 member stocks. Market share changes in funds indexed to the Russell 2000 are less clear, but the work of Chen, Noronha and Singal (2006) is bringing new attention to the performance problems that stem from using these two popular indexes as fund templates. This excellent paper and the re-evaluation of indexing choices that it will stimulate will almost surely stop and probably reverse the historic growth in S&P 500 and Russell 2000 indexed portfolios. Another recent paper, Siegel and Schwartz (2006), casts doubt on the S&P 500 recomposition process from a different perspective, but it also supports the criticism offered here. A recent survey by Pensions and Investments (Calio, 2006) found that "[p]lain vanilla indexing [is] … stagnant" in terms of attracting new institutional money.
Perversely, index name recognition has played a significant role in the successful marketing of index funds. The growth of some funds based on popular indexes is also stimulated by the fact that index funds based on the most popular indexes are usually characterized by slightly lower nominal expense ratios than index funds tracking less-popular indexes. In a larger fund, operating expenses are spread over a larger asset base. Funds based on less-popular indexes often have fewer assets and a higher expense ratio. However, the evidence is strong and growing that the transaction-cost penalty associated with index composition changes in S&P 500 and Russell 2000 funds outweighs the slightly higher expense ratio of index funds tracking less-widely used indexes (Chen, Noronha and Singal).