Who Manages The Indexes?

27 March 2006
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If you’re wondering, the above title is a lame pun on the famous phrase “Who Watches The Watchmen?“. If you’re a regular reader of personal finance blogs, you should be familiar with the term “passive investing“. For the uninitiated, it means that you are investing in an index fund - a mutual fund that follows a well-known index such as the Russell 2000, or the most famous index of all, the S&P 500. The S&P 500 is the top 500 companies as determined by Standard & Poors to represent the stock market at large.

So What’s My Beef?
I have long contended that there is nothing passive about investing in index funds. Simply put, you’re paying a fund manager a little less than 1% management fee to enjoy having your portfolio actively managed by somebody else! Who’s that somebody else? The index of course! It’s no secret that indexes frequently add or drop companies from their list. How is this different from regular mutual fund turnovers? In the example of S&P 500 index funds, the only advantage achieved are the diversification achieved by the number of companies in the portfolio and also the stringent research and methodology put into selecting companies to be added and removed from the index. Or is this an advantage?

Google Case Study
Mr. FG (you will realize why I abbreviated his name) has put on his blog a scaving post about recent statements from the S&P chairman - indicting him as “a monumental liar”. He outlines example using Google to prove that the S&P selections do indeed involve market timing. Another article referrenced in the same post points to the in-ept record of adding stocks at the very peak of their valuation, only to see them crash shortly afterwards.

The Index Effect
It doesn’t help that the indexes always announce their action before doing it. Announcing an addition or a removal of the stock causes all the funds that mirror it to perform the same buys and/or sells in order to stay compliant as an index fund. This activity forces the funds investor to comply. This is where hedge funds and other savvy investors can take advantage of the phenomon and run up stock prices or profit from arbitrage situations. There are many traders who make a great living out of nothing but profiting from index arbitrages.

In the case of the Google stock, by waiting for the stock to drop 30% before including it into the index, the S&P 500 is facing heavy criticism that it is doing nothing but helping hedge fund managers exit their falling Google position because all the other index funds have to now buy Google for their portfolios whether they like it or not. The demand/supply imbalance is enough to cause a short run-up of Google stock price.

Why Do Indexes Work Then?
There isn’t anything mysterious about why the indexes work. If you have a diversified number of solid companies and you keep the in the index for a long enough time, time will correct everything for you. We’ve always been told of the time-frame/risk relationship, and this certainly holds true for index funds. I’ve talked about index turn-over but to its credit, a newly included company is not likely to be taken out of the index too soon. Let’s call a spade a spade and remember that index funds ARE actively managed, just not by the person that you’re actually paying!

  • I expect nothing less from both you II and CC. Your blogs are both among my favourite reads! :)

    I guess I wanted to show that, in my opinion, indexes are still being "managed". Not as actively as mutual funds but I stop short of using the word "passive" because I feel that index changes are still more frequent than we think, and the comments by the S&P; chairman are showing that market timing is also a factor in their decision to include and exclude, not to mention that they change their weightings as well.

    Ultimately, investing in indexes is not just about the index but about the managers of the index funds as well, how rigid / flexible they wish to stay with the index. Also, I had wished to bring up the discussion of accusations about index changes serving hedge fund managers - as the recent pop-up in Google stock price showed!

    I had alluded to the fact that indexes work, or the "index effect" are countered by the length of time the stock stays in the index, so no disagreement there. In regards to the high turnover, it was the tech boom. Many stocks were being put in and out of indexes during that time. So there are times when an index could also resemble an active mutual fund. But it should also be said that normal mutual funds during those times were experiencing 200%+ turnover.

    I have not discussed funds where the managers have a mandate to buy and hold (AIC perhaps?). That's for another day.
  • Vince, good point but I think CC was talking about index changes, not trading within some mutual fund that is tracking some index. It's a bit apples and oranges. The former relates to CC's argument that an index is passive not active. The latter is not turnover in the same sense although it is technically turnover by definition. It's some added cost but used for trading in the same stocks. In other words, it's still passive management.

    Not sure why that turnover on that mutual fund is so high by the way. Doesn't really make sense at all to me. I've heard that on average index funds have a turnover of 5%.
  • You're right about the turnover rate vs. taxable relationships, CC!

    Not all index funds are created equally though!

    The relatively small Royal Canadian index fund (tracking the TSE 300) reported 120% turnover in 1999 and 68% in 2000. Part of the explanation is due to it being smaller number of 300 stocks and changing compositions or weightings. You don't have to exclude or include a company in an index to achieve turnover. Simply by adjusting the weighting of the position is enough to cause buys/sells.
  • Here's why an index is not an actively managed mutual fund: the turnover (the number of stocks that are added or deleted every year) is ridiculously low. I think the S&P 500 changes (I don't have the reference on hand) 20 names out of the 500 every year. How many actively managed mutual funds have such a low turnover? In a taxable portfolio, the turnover will make a big difference to the results.
  • I think we're both on the same track even though I haven't read your article before. I was inspired by Mr. FG's post. Good to know there are kindred spirits out there! Being a value/contrarian investor (or a wanna-be at the very least). I believe in prudent stock-picking than beating stocks but realize the good that index funds can do for the majority of savers out there.
  • I wrote about how the S&P 500 is more like a badly managed mutual fund than a passive index a while ago. Makes you think that it should be easier to beat an index simply by making up your own "index" (ie. by buying a diversified list of large companies). Although as everyone always says, it's easier said than done. I think maybe one of the reasons that indexes do so well is that they make so few changes. Even if they do buy something like Google at a high, at least they don't ALSO sell it at a low. We all know of the studies that have shown that the more you trade the poorer your performance will be (not to mention the higher costs).
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