Swedroe: The Problems With Index Funds

June 16, 2014

Aware of these problems, Russell has made some changes in an attempt to mitigate them:

  • 2002: Share changes exceeding 5 percent of the index are made on a monthly basis.
  • 2004: IPOs are included once per quarter.
  • 2007: There is a transitional index in the month of June, so not all trading happens on one day.
  • 2007: Buffer zones are instituted around market-capitalization ranges to reduce turnover.

Unfortunately, as the evidence in the table below shows, there doesn’t seem to have been any improvement in relative returns between the Russell 2000 and comparable indexes from the Center for Research in Securities Prices (CRSP) at the University of Chicago.

Period Russell 2000 Annualized Return (%) CRSP 6-8 Annualized Return (%) CRSP 6-10 Annualized Return (%)
1979-2001 13.7 15.7 15.2
2002-2007 8.9 10.7 10.9
2007-2013 7.2 9.6 9.1

As you can see, the choice of an index to replicate (or benchmark against) makes a great deal of difference. A small-capitalization index fund tied to the Russell 2000 would have dramatically underperformed a small-capitalization fund tied to similar CRSP indices (the CRSP 6-10 includes micro caps).

I’ll be back later this week to explore some additional weaknesses of index funds that structured portfolios avoid.


Larry Swedroe is the director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

 

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