Key Points
1. Traditional cap-weighted indices routinely add stocks priced at a high market valuation and sell stocks priced at a deep discount to market valuation—they buy high and sell low!
a. The additions WIN BIG before they’re added; deletions LOSE BIG before they’re dropped. The pattern reverses the year after an index change.
b. As a result, index fund managers can add value either by anticipating changes or by making their trades 3 to 12 months after their peers.
2. Index funds also weight their holdings proportional to price, so their largest holdings usually trade at big premium multiples. As a result, trimming these “top dogs” adds value, too.
3. Stocks are usually added to the index when they’re “hot” and are dropped when they’re deeply out of favor. This sometimes leads to the addition of temporary high-fliers, just before they bomb.
4. We find that two changes in index construction can boost index fund performance:
a. selecting additions based on five-year (or longer) average market capitalization, and
b. using banding to limit flip-flop trades (additions that are quickly deleted), which increase turnover and the related transaction costs that reduce alpha.
Arguments in favor of traditional passive index funds seem compelling. They offer low fees, limitless liquidity, and broad market participation. They match market performance and have negligible trading costs and tracking error—and they beat most active managers, most of the time. ‘Nuff said? Well, no. Apart from the last assertion, none of the descriptions is entirely accurate. Often overlooked in conversations about the travails of most active managers are the avoidable travails indexers face. In this article we will touch on several of the latter, but we will focus particular attention on the fact that index funds buy high and sell low.
Stocks added to capitalization-weighted indices are routinely priced at a substantial premium to market valuation multiples (i.e., buying high), while discretionary deletions (excepting removals related to mergers, acquisitions, and other corporate actions) are routinely of deep-discount value stocks (i.e., selling low). In fact, additions tend to be priced at valuation multiples—using a blend of price-to-earnings (P/E), price-to-cash-flow (P/CF), price-to-book (P/B), price-to-sales (P/S), and (if available) price-to-dividends (P/D) ratios—that average over three times as expensive as those of deletions. This helps explain why from October 1989 through December 2017, the performance of additions lagged discretionary deletions by an average of over 2,200 basis points (bps) in the 12 months following the addition or deletion. Once investors recognize this buy-high/sell-low dynamic, they can avail themselves of some surprisingly simple ways to earn above-market returns.
Zero Trading Costs For The Market Index? Think Twice…
Before we move to our discussion of the buy-high/sell-low dynamic of cap-weighted index funds, let us debunk the notion that index funds have near-zero trading costs (defined as both explicit and implicit costs). To understand this statement, let’s begin with a review of how changes have been made in the S&P 500 Index over its life.
Until October 1, 1989, Standard & Poor’s policy was to announce changes in the S&P 500 after the market had closed, with those changes taking effect at that day’s closing price. No index fund manager could trade before the index had already been altered. As a result, the overnight return variances arising from the different holdings of the index and the index-tracking funds showed up as tracking error for the funds versus the index. Also, any trading costs the index funds incurred in buying or selling the added or deleted stocks showed up as underperformance because they had to trade after the index changes were made at the higher (added stocks) or lower (deleted stocks) prices driven by the resulting shift in demand, reflecting the market impact of rebalancing-related trading. Many empirical studies examined the pre-1989 period and documented stock-price movement immediately after changes were made in the composition of the S&P 500. The first studies revealed and measured the S&P 500 reconstitution effect.1 In the period January 1970–September 1989, on average, additions experienced a positive abnormal return (3.0%) and deletions experienced a negative abnormal return (–1.4%) on the day after the announcement. Index fund trades (and hedge fund front-running of those trades) are the presumptive cause of this 4.4% spread. In October 1989, as illustrated in Figure 1, Standard & Poor’s began pre-announcing changes to the index along with the rebalancing date (known as the “effective date”) when those changes would occur, which could be days or weeks after the announcement date. On the effective date, changes in index holdings are made at the market closing price.
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