Index Funds Could Be Improving in the Future

By on November 27, 2010

Jason Zweig, writing the Wall Street Journal’s Intelligent Investor column, reports on a weakness of index funds and a possible solution:

Until now, index funds have had an Achilles’ heel. One factor that makes indexing “a horrendous idea,” the renowned value investor Seth Klarman of Baupost Group argued earlier this year, is that hedge funds and others have long beaten the index funds to the punch on trades that the autopilot portfolios are forced to make.

Zweig writes that index funds could be making changes in the future in order to stop the practice of “front running.”

New “investable” indexes, forthcoming early next year from the Center for Research in Security Prices at the University of Chicago, or CRSP, could reduce compulsory trading for any index funds that adopt them as a benchmark. Funds that trade less should have lower brokerage costs, lower tax bills and higher net returns. Better yet, it should be harder for outsiders to “front run” these improved indexes. CRSP, founded in 1960, was a pioneer in calculating long-term returns on assets; it gathers and analyzes massive amounts of data for investment firms and academic researchers.

Consider an index fund that specializes in small stocks. If the shares of a little company in the fund take off, then the stock won’t be small anymore—and the fund will have to sell it. Likewise, the firms that compile market benchmarks periodically add or delete stocks, forcing index funds to buy everything that is added and to sell everything that is deleted.

Each June, roughly 200 stocks are replaced in the Russell 2000 index of small companies. This June 25, the stocks that were added to the Russell 2000 outperformed those that were deleted by 2.3%, according to Investment Technology Group. Over the long run, sharp traders getting out in front of these forced portfolio changes have poached at least 0.38 percentage point of annual return away from Russell 2000 index funds, estimates a new study in the Journal of Empirical Finance.

CRSP’s new family of indexes will tackle the poaching problem in several ways, says Lubos Pastor, a University of Chicago finance professor who helped design them. The boundaries between small, medium and large stocks will be set as proportions of the value of the total market, rather than as fixed dollar amounts or as an unchanging number of companies. Stocks will be “partially weighted,” or shared, across different size indexes—so, as a company grows or shrinks, it doesn’t have to be added or eliminated in one fell swoop. Any additions or deletions will be made in “packets,” or gradual steps over time, and the days on which the substitutions take effect will be randomized.

Zweig quotes Vanguard’s Gus Sauter who thinks highly of CRSP’s idea. Vanguards’ Total Stock Market Index fund underperformed cash over the past 10 years, but still beat about 2/3rds of actively managed funds over that period.

Source: The Wall Street Journal

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