The Hidden Costs of Index Funds

While it is widely understood that index funds represent a low-cost way for investors to achieve broad diversification, a recently published research study sheds light on a “hidden cost” associated with investing in index funds.

Antti Petajisto, a professor at NYU’s Stern School of Business, conducted the original research for “The Index Premium and its Hidden Cost for Index Funds,” as part of his Ph.D. thesis at Yale in 2003.

The study examines the ways that stock prices change between the time that it is announced that a company will be added or removed from a stock index (such as the S&P500) and when the company’s stock is actually added.  The research suggests that canny institutional investors can make a profit in this period that results in a drag on performance for index fund investors.

The Law of Supply and Demand

When a stock is added to an index (say, the S&P 500 Index for example) it’s widely known that every index fund tracking the S&P 500 will then buy that stock, causing a predictable surge in demand. The Law of Supply and Demand dictates that when demand rises, prices increase. Conversely, when a stock is removed from the index, that stock’s price inevitably drops, as index funds tracking the S&P 500 Index sell their holdings in that company.

Petajisto’s study notes that 10% of all stock market assets are invested in index funds. Think about that for a second. If 10% of the total invested assets in the stock market tracks various indexes, the mechanical buying and selling of a particular index can have a large impact on the price of the stocks that are either added or dropped.

Imagine a case in which you know with a high degree of confidence that there will be a big increase in demand for shares of a company starting in a week.  A rational response is to buy the shares now, in anticipation that the price of the shares will increase when there is a big spike in demand a week from now. You then sell your shares after the price has jumped in response to the higher demand and make a tidy profit.  This is exactly what some savvy investors do in the time period between when it is public knowledge that a stock will be added to the S&P500 and when the stock is actually added to the index (and all the index funds buy that stock).

Standard and Poor’s: What’s Decided Behind Closed Doors 

So how does the process of addition or deletion of a stock to the S&P 500 work?

Standard and Poor’s, the firm that manages the holdings in the S&P 500 Index, has an Index Selection Committee that determines which stocks will be added to the index and which stocks will be dropped from the index in order to keep the number of holdings at 500.

What many people don’t know is that, the selection committee announces which stocks will be added or removed five days before the additions or deletions are made to the index—which is plenty of time for institutional investors to buy shares of the stock that’s going to be added (knowing that demand will increase) and to short shares of the stock that is going to be dropped (knowing demand will decrease).

Lost Returns of Index Funds

Can it really be that simple to take advantage of time lag between when S&P announces that a stock will be added or deleted from the index and when the actual changes to the index occur?

Petajisto’s research suggests that this is, indeed, true. Not only does this five-day advanced notice give institutional investors an advantage, it also means that the average index fund investor has no choice but to buy low and sell high. Index fund investors are essentially buying a stock after its price has been driven up (due to high demand) and forced into selling another stock after its price has dropped (due to lack of demand). This performance drag has a significant cost—and in some cases—can be more than the expense ratio of the actual index fund itself:

Petajisto’s research found that the cost of this “invisible” performance drag to investors in index funds is 0.21% to 0.28% for S&P 500 Index funds and 0.38% to 0.77% for Russell 2000 index funds. Petajisto notes that this loss is in fact, larger than the expense ratios of many index funds—take Vanguard’s S&P 500 Index Fund (VFINX) for example—its expense ratio is 0.17% per year.)

In Defense of Index Funds

So what is the individual index fund investor supposed to take away from this?

Prevailing research shows that most investors underperform the indexes by close to 5.00% per year (versus simply tracking the S&P 500 Index). This can be attributed to chasing performance, bad market timing and paying too much in expenses. The 2011 results from Dalbar’s “Quantitative Analysis of Investor Behavior” found that the average investor in stock mutual funds generated an average annual return of only 4% per year vs. 9% per year for the S&P 500 over the last 20 years. (This is fairly consistent with past years’ results).

Knowing this, we can then acknowledge that investing in index funds is a far better choice than what most investors appear to be doing. Yes, Petajisto’s research suggests that institutional investors are sucking some of the value out of the market at the expense of index fund investors. And yes, costs ranging from 0.22% per year to 0.7% per year could add up to a substantial drain on lifetime accumulated wealth. However, investing in index funds appears to remain the best bet for the majority of investors.

Improving on Indexing

While investing in index funds is likely the best choice for many investors, there are some interesting implications from Petajisto’s research about how to gain the advantages of indexing, while limiting the tendency to buy stocks once the price has been run up (and vice versa) inherent in a pure index fund.

Generally speaking, if investors were to own a portfolio of individual stocks that closely tracks an index, but held off making any changes to their holdings for a month or more after changes to the index were made, they could mitigate, if not eliminate, this drag—potentially enabling them to beat the index performance. On the other hand, if investors buy and sell as soon as the announcements are made, it’s quite possible that they’ll be able to reduce or eliminate the performance drag due to the “index premium.”

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4 thoughts on “The Hidden Costs of Index Funds

  1. rmharman

    Doesn’t this imply a market for a mildly enhanced index fund that trades immediately on the news that a stock will be added or dropped, rather than waiting the few days for the change to be incorporated?

  2. azk

    Does this matter if you own small and large? I.e. you on IJS and SPY. It shouldn’t right? because companies are going from large to small and vice versa so you are buying and selling at the same time if you on both indices?

  3. Pingback: It’s Time to Revisit Our Financial Resolutions « Portfolio Investing Blog: Portfolioist

  4. KN

    For the reasons cited above one ought to give the passive funds at DFA a look see.
    DFA funds while passive are not index funds thus they can wait for the noise to die down before adding or removing stocks. DFA tries to avoid this reconstitution effect by patiently trading securities and not mechanically following indexes. Their goal is to deliver the asset class rate of return. Their trading strategy is also designed to capitalize on block trading and securities lending whenever possible in an attempt to increase investor returns.

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