While passive indexing strategies often have a role in institutional portfolios, particularly during periods marked by high correlations among underlying securities, indices have a number of flaws
Investors that favor index strategies alone can, for example, be taking unintended bets, incurring illiquidity risks and absorbing unrecognized costs
We counsel investors not to be drawn by the allure of low management fees alone and to be judicious in the use of passive index strategies
Passive indexing has been a particularly appealing strategy to investors over the last few years. This is for good reason. Diversified exposure within a market, the availability of low management fee vehicles and ready liquidity make a compelling case for passive indexing.
Yet passive indexing is no panacea. As a suite of recent research has shown, indices carry a variety of biases, hidden costs and risks that, at least in principle, can be avoided by astute active managers.
When Indices Change
First, indices are reconstituted periodically. These periods of reconstitution, where constituents are added and subtracted, create opportunities for active managers and speculators. When an index adds a new name, it may need to buy substantial amounts of the available float. This sudden surge in demand can engender price increases. Speculators, anticipating this demand surge, may buy constituents in advance of the reconstitution period driving up the price and then sell to index investors, effectively pocketing a fee for becoming liquidity providers. Antti Petajisto, formerly of the Yale University School of Management and currently with BlackRock, estimated that, from 1990-2005, these reconstitution costs ranged from 20-30 basis points for the S&P 500 to 35-80 basis points for the Russell 2000 (1). Of course, if there is too much speculative cash anticipating index reconstitution, prices may be pushed too far and speculators can underperform the index. Astonishingly, as detailed by IronBridge Capital Management, index providers themselves may not be able to keep up with the index (2).
Second, index holdings may diverge from their stated intention due to drift. Thus, as documented by the Horizon Research Group, the 50 largest stocks in the Russell 2000 small cap index have a higher market cap than the 50 smallest stocks in the Russell 1000 large cap index (3). Part of this may be due to drift. Typically, the largest small cap stocks have outperformed their peers while the smallest large cap stocks have underperformed their peers. However, part of this may be due to design. Having larger cap stocks in the Russell 2000 increases the liquidity of the index, improving its marketability.
Third, index holdings may have embedded biases in their design, perhaps unintentionally undertaken by less well informed investors. For instance, the S&P Goldman Sachs Commodity Index bases its index weights on market importance as proxied by world production. As a consequence, the energy complex accounted for 69% of total holdings as of yearend 2012. This is clearly not a diversified portfolio. On the fixed income side, many of the largest issuers in the benchmark indices will be the most indebted entities. This may, in turn, reflect financial challenge rather than financial opportunity.
Turning to equities, cap weighted indices have an embedded momentum bet. As prices for a particular subset of the market rise, say the tech sector in 1999 or Apple in 2012, the index weights of that subset also rise, justifying the price increase. Fund flows from benchmark aware active investors then reinforce this process by buying the winners in order to manage tracking error. While this may feel good on the rally, it does not feel quite so good on the way back down as tech investors in 2000 and Apple investors thus far in 2013 will attest. Finally, many equity indices base their weights on available float. While this helps with liquidity, it biases the index against stocks with high insider purchases, a factor associated with stock outperformance. The previously referenced paper by Horizon Research Group further illustrates a variety of bets embedded in
equity indexes of which investors should be aware.
Tracking Error or Liquidity Risk
Fourth, many index investors obtain their exposure through vehicles that replicate index returns rather than holding the specific underlying instruments. At its most benign this can lead to tracking error that balances out to noise. At a slightly more concerning level, index flows and tracking portfolio changes can lead to indiscriminate, unbalanced purchases and sales of index constituents generating deviations from fundamental value ripe for exploitation by active managers. These losses may be nontrivial.
Finally, the real concerns may be more in the swan domain, perhaps not black but certainly grey. For instance, if synthetic index replicators use similar algorithms, replication holdings may be highly correlated leading to crowded trades and unanticipated volatility at inopportune moments. Alternatively, the surge in ETF investment over the last several years has changed market dynamics in ways that may not yet be evident. As an example, apparent liquidity in many ETFs is not matched by the liquidity of the underlying holdings. While we may hope for the best, how ETF liquidity and pricing will respond to periods of market stress remains unclear.
In summary, passive indexing has many attractive attributes. Investors should be aware, however, of hidden costs, index construction biases and illiquidity risks in index replicators.
Petajisto, Antti, 2011, “The Index Premium and Its Hidden Cost for Index Funds”, Journal of Empirical Finance, 18(2): 271-288.
Eddins, Samuel T., 2006, “The Tyranny of Benchmarks,” working paper, IronBridge Capital Management.
Horizon Kinetics Research, 2013, “Russell 2000 Index Construction: When Small Caps Became a Big Problem,” working paper.