Index Investing Has A “Reconstitution” Problem: How To Fix It

We talk to Dimensional Fund Advisors about why index investing in the conventional sense raises a number of challenges that aren”t widely appreciated.

For more than two decades, the rise of “passive investing” has
been a strong wealth management theme. The idea of trying to
beat a market benchmark in the long term to earn “Alpha” by
picking stocks was regarded as a mug’s game, so the argument
went. Active management fell out of favour to some extent as
stocks were lifted on a tide of cheap money after 2008.
Exchange-traded funds are now an established portfolio building
block.

Starting with the likes of US asset management giant Vanguard,
led by its visionary founder, the late John C Bogle, there is now
a large index fund market. And the ETFs and exchange-traded
products (ETPs) is considerable. According to ETFGI, a firm that
monitors the sector, these entities held $15.44 trillion of AuM
as at the end of April. While it is true that some ETFs can be
set up to capture various drivers of return and inject an element
of “active” into the recipe (“smart Beta”), overall, the sector
is still seen as a “passive” area. Part of the sales pitch for
ETFs and suchlike is that they are, other things being equal,
cheaper in fees than for an actively managed fund.

But there is a fly in the ointment. According to Dimensional
Fund Advisors, a US-based firm that stresses its systematic
investment approach, the way that indices used by ETFs are re-set
during a year to allow for firms entering or leaving an index
means that investors can lose out. In a way, this runs in
parallel with rising worries about “concentration risk.” For
example, the “Magnificent Seven” tech stocks have
disproportionately driven US equity returns in recent years. (See
related articles about Dimensional regarding its
Singapore business, and its
investment philosophy.)

Changes
Around the half-way point of the year, S&P and Russell
indices of equities are due to be re-set (or may have already
have been at the time of going to press). This “reconstitution”
of indices creates a problem if this only happens once or twice a
year. 

Dimensional cites the case of Tesla. In 2020 the electric
carmaker surged to become the sixth-largest US company before
finally entering the S&P 500. Funds tracking that index
missed most of the upside, not due to poor management, but
delayed eligibility rules in the index. 

The firm examined the equal-weighted average trade volume from
2018 to 2022 for the S&P 500, Russell 2000, MSCI EAFE, and
MSCI EM indices, and found that on reconstitution days, trading
volumes were many multiples, sometimes around 20 or 30 times,
higher than typical daily trading volumes in those stocks. These
trading volumes add to costs and cut what investors ultimately
receive.

Shining a light
Mamdouh…