More and more people are discovering the benefits of passive investing. Buying and holding index funds is a simple, low-cost strategy which, in the long run, almost invariably delivers successful outcomes. But is passive investing flawed? And, if so, is that a reason for avoiding it?
If you’ve watched our documentary Investing: The Evidence, you will know there is incontrovertible evidence that investors are better off using index funds than actively managed funds. In fact, it’s a mathematical certainty that the average index investor will outperform the average active investor, net of costs.
But that doesn’t stop the fund industry and other advocates for active management picking holes in passive investing. Over the years there’ve been all sorts of theories about how index funds are distorting the financial markets, causing cyclical bubbles and somehow undermining capitalism. It has even been suggested passive investing is “worse than Marxism“.
However, evidence that any of these scare stories is actually true is in very short supply. Even Goldman Sachs, whose entire business model is more or less based on active money management, recently concluded that there is no reason to believe that the huge growth in the popularity of index funds in recent years is having negative consequences on anything other than the profits of active fund providers.
Yes, passive investing is flawed
So does that mean that passive investing is a perfect solution? No it doesn’t. Index funds do have some flaws, probably the most important of which is what’s known as the index effect. This refers to the market phenomenon where a stock’s inclusion in, or exclusion, from a major index like the FTSE 100 or the S&P 500 in the United States impacts its price and trading volume, often for reasons unrelated to the company’s fundamentals.
When a stock is added to an index, its price often rises. This is partly because being part of a prestigious index can enhance a company’s visibility and perceived credibility, which may attract more investors. Another reason is that index funds and exchange-traded funds tracking that index are obliged by the rules under which they operate to buy the stock to replicate the index. Conversely, when a stock is removed, its price often declines as passive funds have no option but to sell their holdings.
Both inclusion and exclusion lead to a temporary spike in trading volume as index funds adjust their portfolios to reflect the new index composition. The price changes are primarily driven by technical factors, like buying and selling pressure from index funds, rather than changes in the company’s fundamentals, such as revenue, earnings, or growth prospects.
So why does this happen? Well, the biggest issue is that most index fund managers do the bulk of their buying at around the same time — usually on the day that the index is reconstituted, which is typically once a quarter or twice a year. So by the time passively managed funds actually buy or sell the relevant shares, the expectation of those trades taking place has already been priced in. By anticipating the inclusion and exclusion of certain stocks, and by trading ahead of the reconstitution date, active traders are therefore able to profit from predictable price movements.
How big a deal is the index effect?
What impact, then, does the index effect, or the reconstitution effect as it’s often known, have on index fund returns? Recent research suggests that it’s not insubstantial.
Using data from ten U.S. stock indexes between 2014 and 2023, researchers Kaitlin Hendrix, Jerry Li and Trey Roberts from Dimensional Fund Advisors examined the performance of securities during the 20 trading days before and after index changes. While their method aligned with previous studies, they introduced important refinements.
Since the index effect was first identified, index providers and fund issuers have implemented measures to minimize its impact. These measures include increasing the frequency of reconstitution events and creating greater overlap between related benchmarks, such as mid-cap and large-cap indexes. To isolate the effect, Hendrix, Li and Roberts focused on “non-migrating” stocks — those that remained within a single index family.
Their analysis revealed that, on average, securities added to or removed from an index experienced a cumulative excess return of 4% in the 20 days leading up to the change, followed by a -5.7% decline in the 20 days afterwards.
Commentating on the findings, Joel Schneider, Dimensional’s deputy head of portfolio management, said: “Index funds are systematically buying at temporarily high prices when they’re adding and selling at temporarily low prices, which is the opposite of what you’re supposed to do as an investor. They’re doing the exact opposite because of their own mechanics.”
Putting things in perspective
So how concerned should index investors be? Of course, no investor likes to think that they’re systematically buying high and selling low, but it’s important to put this issue in perspective. The S&P 500, for example, is reconstituted quarterly. On average around five or six stocks will be either included or excluded each quarter.
Compared to the size of the index as a whole, five or six is clearly a small number. Remember as well that stocks either entering or leaving the index will, relatively speaking, have the smallest market capitalisation. The actual impact, then, of the index effect on the returns of index funds investors is fairly modest.
Index investors should also take comfort from a September 2024 paper by two Harvard academics, Robin Greenwood and Marco Sammon, called The Disappearing Index Effect. As the paper’s title implies, Greenwood and Sammon found that the index effect has reduced over time. “The abnormal return associated with a stock being added to the S&P 500,” they write, “has fallen from an average of 7.4% in the 1990s to less than 1% over the past decade. A similar pattern has occurred for index deletions, with large negative abnormal returns during the 1990s, but only 0.1% between 2010 and 2020.”
Why, then, is this happening? The answer is that, as with all anomalies, once they become well recognized by the market, they tend to decline and may eventually disappear altogether.
“In the 1980s,” Greenwood and Sammon write, “index changes were unanticipated, index funds were small, and there was mispricing in the market. As index funds grew larger, the mispricing deepened and turned into an opportunity.
“As a result, the market adjusted to take advantage of this opportunity, in part by better anticipating inclusions, but mostly by creating arrangements where other institutions stood ready to sell to indexers upon inclusions. This worked to eliminate the anomaly on average, despite demand shocks that continued to grow in magnitude over the 2000s and 2010s.”
An anomaly in structural decline
In conclusion, the index effect appears to be in structural decline, although, as research by Dimensional and others has shown, it still persists. Investors who are determined to aim for optimal returns may want to consider investing in funds from a firm like Dimensional, who are not constrained by the same rules that index funds have to abide by, and can therefore trade more flexibly. The downside of that approach is that these funds are more expensive, and, in the long run, you may find that any advantage is offset by the higher fees you will pay.
The bottom line is that, although they have their flaws, index funds are very hard to beat. As passive investing champion John Bogle wrote in his 1999 book, Common Sense on Mutual Funds: “Indexing is not perfect. It is simply the best solution that investors can readily implement.” It’s a conclusion that remains as true today as it did 25 years ago.
LET’S TALK
Are you currently using actively managed funds to invest? If you are, you’re probably achieving sub-optimal returns, and you should speak to a financial adviser about simpler, cheaper, better alternatives.
Why not book a discovery session with rockwealth Edinburgh’s David Bowen and find out how switching to an evidence-based investment strategy is likely to deliver better outcomes.
Make contact with David here.
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