Monday, 3 September 2007

Something the Boglehead wouldn't want you to know, or index investing isn't passive

Just for the record, Bogleheads are die-hard devotees of index investing. Occassionally someone will mistake my criticisms of much of the active management industry for support of the Bogleheads' position. However, this isn't the case. In fact I reject pretty much all the foundations that index investing is built upon (see Chapter 35 of Behavioural Investing). The only exception is that the Bogleheads are quite right to point out the importance of minimising costs.

I recently came across a paper which I thought deserved some attention. It goes by the title of Index Rebalancing and Long-Term Portfolio Performance by Cai and Houge. It focuses on one of the misnomers of investing, that index investing is passive. This simply isn't true. Many indices are relatively actively managed. In fact most indices are really momentum players effectively adding stocks that have done well and deleting stocks that have done badly. This raises the question as to whether this 'active' element adds or destroys value. That is to say would you be better off if you ignored the index changes made by the index setters?

Cai and Houge take the Russell 2000 index and examine its performance since 1979 and see if the index changes that have occurred managed to add value to the investor over various time horizons. The Russell 2000 index is a small cap index, and makes on average 457 index changes each year (around 10% of market cap).

Cai and Houge show that an average an investor would be 2.2% better off in year one if they ignored the index changes, this rises to 17% in year five! So a buy and hold strategy seems to generate substantially higher returns for investors (yet again evidence of patience being key to investors - see Chapters 30/31 of Behavioural Investing).

Effectively Cai and Houge show that deletions have better future long term returns that additions to the index. In fact they show that deletions outperform non-new issue additions by around 8.9% in year 1 and 28% over five years. If one includes new issues that are added to the index, the situation is even worse since they underperform the deletions by 40% over five years!

Given that they are considering the Russell 2000 (a small cap index remember) , some stocks will leave the index because they become too large. Indeed the returns on these stocks seem particularly important in generating some of the short term outperform of the buy and hold strategy.

However, the results that Cai and Houge uncover are not simply an artifact of the way of the index considered. Siegel and Schwartz (2006) show a similar picture for the S&p500 (where no stock is deleted for being too large!) They track the changes made to the S&P500 from 1957 onwards. Nearly 1000 index additions over the sample period, averaging around 20 a year.

Three portfolios are formed, allowing for different scenarios:

(I) The survivor portfolio consists only of shares of the original S&P 500 firms. Shares of other firms received through mergers are immediately sold and the proceeds invested in the remaining survivor firms in proportion to their market value.

(II)Direct Descendants’ Portfolio (DDP), which consists of the shares of firms in the survivors’ portfolio plus the shares issued by firms acquiring an original S&P 500 firm.

(III)Total Descendants’ Portfolio (TDP) and includes all firms in the DDP plus all the spinoffs and other stock distributions issued by the firms in the Direct Descendants’Portfolio. The only difference between the TDP and the DDP is that the TDP holds all the spin-offs rather than sell them and reinvest in the proceeds in the parent firm.

The returns to the various portfolios are shown below:


Geometric return





SD Sharpe
Survivors Portfolio 11.31%





15.72% 0.4343
Direct Descendants 11.35%





15.93% 0.4331
Total Descendants 11.40%





16.09% 0.4337
S&P 500 10.85%





17.02% 0.3871


All three of the constructed portfolios outperform the index with it's additions and deletions, and they do so with considerably less risk!

The bottom line appears to be that index investing is often very far from passive. The rules of index construction appear to destroy value. Of course, one of the best ways of avoiding this problem is to be a long-term investor (i.e. conduct time arbitrage).

16 comments:

Outroupistache said...

Very interesting article and post. The question is whether there are ETFs or funds that now follow the principles you point out as being better. An individual investor cannot really replicate the Russell 2000 or the S&P 500, let alone the thousands of potential international stocks.

Anonymous said...

James: I've read many of your papers and so am delighted to find that you have a blog. Would you consider changing your blog template to something more readable? I know that I'm not alone in having trouble with that black background.

Anonymous said...

This is a pointless article. The author is making something out of nothing.

Studies have shown that it is very difficult to outperform a broad index such as the S&P500. This fact is the basis for passive investing. Who cares if,when,and how the index itself changes. Relative to actively managed portfolios, the index has outperformed.

Anyone can look back in time and second guess the changes in the index and create perfect scenarios. The fact of the matter is that the majority of active managers don't hold on to the winners or get rid of the losers so the premise is flawed.

This article is just an attempt at shifting attention away from reality.

Mark said...

Good point; some (such as Burton Malkiel in his most recent edition of "A Random Walk Down Wall Street") have suggested passively investing in a total market exchange traded fund rather than the more selective indices such as the Dow or the S&P 500. Vanguard's VTI, for example. That way, nobody on a committee is deciding anything on your behalf.

Frank said...

Good work James, we really need to keep pushing the point that indexing is not a passive strategy, especially relevant for a taxed investor. This is even more relevant for the Value and Growth sub-indices we have. They have a much greater turnover.

John said...

I've often wondered, but haven't seen any specific studies (it would be very interesting if someone would do one), whether the increasing strength of momentum in the 90's wasn't due in part to the increasing investment in cap-weighted index funds since every new inflow required more purchases of the highest cap stocks, and as you've pointed out high cap frequently means high p/e rather than high e. This is certainly not the only source of momentum effect which existed long before the growth of index funds and which has many other behavioral explanations, but I do think the index phenomenon could explain part of the stronger momentum effect in the bubble years (which was largely confined to the large caps).

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Anonymous said...

See David Swensen's book "Unconventional Success" on why the Russell 2000 is an extremely poorly constructed index.

indexfundfan said...

How about total market investing as a form of passive investing? I guess the papers' conclusions do not (fully) apply to total markets.

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This is great info to know.

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James said...

Hot dang! I think you're onto something here. Time to sit down at the computer and do some research on this. Thanks!

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