Indexes Do Have An Advantage Over Funds....but you can still get rid of your funds

Aaron Hodson Jul 17, 2012

Are you, like many other investors, thinking about ditching all of your mutual funds because they fail to keep up with market indices, yet still charge you management fees? We like to beat up mutual fund companies (which used to feed us) as much as other guys, maybe even more so. However, comparing a mutual fund to an index is not quite as simple as it sounds. Your fund might be underperforming the index, but it really is not an apples-to-apples comparison.

Even comparing an index fund to a market index is a little unfair to the fund. Here’s why: First, of course, market indices have no fees at all. Even the lowest-of-the-low fee ETFs or funds have to be paid, and even a fee of 0.10% annually will start to be material when compared with an index, over a long-enough time period.

Second, indices have no trading costs. When a company gets kicked out of an index and replaced by another company, it simply is done and that’s that. A mutual fund or index fund, on the other hand, has to actually make two transactions.

It needs to sell one company, and it needs to buy the other. This adds broker commission at a minimum, and often there is a hit as well because of the bid-ask spread. The TSX Index reviews its composition every quarter, or when a company is taken over (or goes bankrupt). The S&P 500 has historically changed its composition by between 1% and 9% each year. Third, indices have no regulatory fees: Mutual funds now have to have an Independent Review Committee, which is a third party that reviews portfolios and transactions to ensure there are no conflicts-of-interest for investors. At some of the fund companies I’ve worked with, these IRCs can cost $50,000 annually. Over a very large fund, this doesn’t add up to much on a percentage basis, but it is still a cost that an ‘index’ does not have to bear.

Fourth, indices don’t have to actually send anything out to investors. There are no statements to send to clients, no glossy brochures, and no phones to answer. These costs exist for the companies in charge of the index, of course, but they are not deducted from the indices’ overall investment performance, as they are for mutual or index funds. Adding the above costs together, a recent study showed that, at a minimum, an index fund has to spend an average of 21 basis points (0.21%) in costs annually that an index simply does not have to.

Next, there is ‘front-running’. All indices typically announce their composition changes ahead of time. As a result, the stock that has been removed from the index tends to be driven down, and the price of stock that has been added to the index tends to be driven up, in part due to arbitrageurs, in a practice known as "index front running”. For mutual funds hugging or watching the index, this can cause further market impact costs because managers need to sell a stock whose price was depressed and buy another stock whose price was inflated by the front runners.

Finally, and maybe most important, is survivorship bias. In finance, survivorship bias is the tendency for failed companies to be excluded from performance studies because they no longer exist. It often causes the results of studies to skew higher because only companies that were successful enough to survive until the end of the period are included. Market indices will typically kick out those companies in decline, whose market cap falls below a certain threshold, or those that simply cease to exist (ala Sino Forest). For example, the TSX recently kicked several gold companies out of its index (Jaguar Mining was one, down 83% this year) and replaced the kicked-out ones with non-mining names (such as Wajax, up 29% this year). If you looked at historical studies versus the index, then, survivorship bias sees the stable, faster-growing companies included in the index, and the weaker, problem companies excluded from the index. For the TSX index, kicking out a bunch of gold companies when most mutual funds are still overweight the sector might serve it well as gold stocks continue to flounder. Over time, this bias can be extremely material when comparing performance of funds and indices. A 1996 study noted that survivor ship bias might add up to a 0.9% annual difference in performance. So, maybe, give your fund manager—at least your index fund manager—a small break this week. The tables are kind of stacked against them in an index comparison.

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