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:
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).