A problem with index tracker funds

A problem with index tracker funds

Image by Gerd Altmann from Pixabay 

You might be thinking that the title of this blog is a little strange coming from someone who in the past has suggested that passive investing can be a good route for most investors.  I still stand by the opinion that in most cases an index tracker fund makes sense versus an actively managed fund,  at least that’s what the evidence is telling us, but that doesn’t mean that index-tracker funds don’t also have their issues. 

So, assuming you’ve accepted the idea that a passive investment proposition makes sense and you’ve devised an asset allocation strategy that reflects your goals and risk profile, surely it’s then simply a case of building and maintaining a passive investment portfolio by opening a cheap trading account and buying a handful of exchange traded funds (ETFs) or cheap index tracker funds.

It’s relatively easy to build a portfolio of ETFs and index tracker funds, but that’s not necessarily the most effective solution.  Compared to using expensive and actively managed funds, a portfolio of ETFs/index tracker funds will potentially allow you to capture more of the returns that the market produces, in large part due to giving up less return in management and trading costs but, as in many things in life, these types of funds aren’t necessarily the only or problem free solution.

Most ETFs and tracker funds aim to replicate the performance of a basket of securities by referencing an ‘official’ index like the many published indices we see being quoted and compared against.  These indices generally undergo regular reconstitution events during which securities are added or deleted according to the rules of the index.  Index tracker funds, constrained by the objective of maintaining low tracking error versus the index, generally have to mirror these changes by purchasing and selling securities based on the revised index weights.  Because such changes happen on pre-set dates, other market participants can take advantage of an index managers’ need to buy shares which have been added to the index or to sell those which have left it. 

The consequence is that prices rise prior to a company’s inclusion in the index and then fall shortly afterwards.  Over the longer term this can have the effect of reducing (or dampening) returns from an index tracker fund. 

A recent example of this which created a few column inches in the investment media at the start of this year, was the introduction of Tesla to the S&P 500 index.  Tesla was due to be added to the index on the 18th December 2020 and at the time became the sixth-largest company in the S&P 500.  The problem for an index tracker fund is that it was announced that Tesla would be added on the 16th November 2020, and this meant that its share price rapidly increased as demand for shares increased in the run up to its addition to the index, when it was obvious that any S&P 500 index tracker fund would also need to buy shares.  The inevitable then occurred after the 18th December and the share price fell in the following week.

As the market anticipates that many index tracker fund managers will have to either buy or sell particular companies at certain times, the prices of these securities reflect what the market knows will happen in the short term.  Even if the fund manager has some flexibility on the actual day it trades, as was seen with Tesla, prices tend to start fluctuating as soon as information that a security is likely to be added or removed is known.  This might not even be after an actual announcement, just when the possibility is more than likely.

This has the effect of making the securities that the fund has to add to its portfolio more expensive, or it receives less for those it has to sell.  Both factors reduce the returns to investors in the fund.

However, as an investor you probably don’t notice this as it’s not explicit but the effect compounds over time and can have a significant negative impact on the returns you receive.

The solution to this problem is to use ‘pure asset class’ funds that don’t have an objective of following a published index, but instead have a flexible approach over which holdings they might include, led by their own definition of the asset class it’s investing in.  The manager can then have a flexible trading policy which doesn’t force them to buy or sell specific securities on set days.  These are predominantly the type of funds we include in our portfolios and where possible can be considered along side index-tracker funds.  

Cheers

Charles

This blog is intended for information purposes only and no action should be taken or refrained from being taken as a consequence without consulting a suitably qualified and regulated person.  Your capital is at risk when investing.  Past performance is not a reliable indicator of future results.