Playing the stock index reshuffle game can cost investors

As asset management firms scratch for every possible edge in the dirt-cheap world of indexed investing, some passively managed strategies are becoming more active than others.

Consider the slightly varied year-to-date performance of three popular ETFs tracking the S&P 500 Index, which is up 1.54%.

The $170.1 billion SPDR S&P 500 ETF (SPY) is up 1.51%, the $32.7 billion Vanguard S&P 500 ETF (VOO) is up 1.61% and the $68.3 billion iShares Core S&P 500 ETF (IVV) is up 1.62%.

“The differences could just be a matter of how they’re managing the stocks coming in and out of the index, or how they’re managing the cash that leaves the fund, but if they’re doing anything else they’re affecting the tracking error and that’s not what they’re being paid to do,” said Paul Schatz, president of Heritage Capital.

While the performance variations might be subtle and something Mr. Schatz acknowledges most investors probably don’t notice or care much about, it does reflect a subjective influence on what is supposed to be a strict passively managed strategy.

GAMING THE MARKET

What some analysts are noticing is a trend toward an old, but recently popular again, strategy of gaming the market by investing in stocks just before they are added to popular indexes such as the S&P 500 that, by definition, index funds must track.

The tactic in some ways resembles illegal front-running, but in this case, it’s perfectly legal.

As a short-term trading strategy, it could be employed by anybody with a basic brokerage account, but Theodore Feight, owner of Creative Financial Design, warns it doesn’t always work.

“The price of the stock could get a big up and then fall back down before the date the index is scheduled to add it,” he said. “If you’re not one of the first ones to buy, you could lose money doing it.”

As the popularity of index investing soars, the emergence of index front-running is raising fundamental questions about so-called passive investment strategies, as well as how indexes are compiled and the role funds themselves play in elevating costs. By one estimate, buying into stocks as they’re being added to an index rather than ahead of time gouges owners of funds tracking the S&P 500 to the tune of $4.3 billion a year, a sum that can double or even triple the cost of such investments.

“Portfolio managers are aware of it, but some of them will say ‘My clients demand an index fund, and I’m going to give it to them come hell or high water,’” said Michael Rawson, an analyst at Morningstar Inc.
“Yes, you matched the index return, but the investor is now worse off,” he added. “You don’t hear about that as much.”

20+ BASIS POINT LOSS

Over the course of a year, front-running of stocks going into and coming out of indexes costs investors in S&P 500 tracker funds at least 20 basis points, according to research published last year by Winton Capital Management Ltd. That’s equal to $4.3 billion in lost income in 2014.

A 2008 study by Antti Petjusto, now a money manager at BlackRock Inc., estimated the impact could boost the expense of owning an index fund by as much as 28 basis points.

While that might not sound like a lot, the added cost can look huge when compared to the handful of basis points most of the index funds charge.
“The moment you say index, you’re telling the world you’re going to be trading on this particular day,” said Eduardo Repetto, co-chief executive officer at Dimensional Fund Advisors. “If you have zero flexibility when you trade, it’s going to cost you money.”

The predicament is growing by the day. Index equity mutual funds have grabbed market share in the U.S. every year since 2006.

Assets in passive equity products have swelled to $3.7 trillion as low-fee investments became a favorite in retirement savings plans and a six-year bull market made it almost impossible for stock pickers to beat benchmarks.

TELEGRAPHING CHANGES

It might be tempting to blame savvy Wall Street types for taking advantage of mom-and-pop investors, but one of the big reasons front-running exists is because providers of popular benchmarks such at the S&P 500 usually telegraph changes ahead of time.

Another stems from the pressure that passive fund manager face to track those benchmarks as closely as possible, even if it means sacrificing potential returns.

Take American Airlines Group (AAL), which joined the S&P 500 after markets closed on March 20. Because the addition of the airline company was announced four days earlier, nimble traders had plenty of time to get in front of the less fleet-footed. American shares jumped 11% over the span.

The cost was ultimately borne by index funds, which sparked an $8 billion buying frenzy in the two minutes right before the close, an amount equal to more than two weeks of the stocks’ typical volume.

Some fund companies are working to combat the problem. Managers at The Vanguard Group, which oversees $3 trillion, “mitigate a good portion” of the risk by gradually building positions over time in stocks that are scheduled to be added, said Doug Yones, Vanguard’s head of domestic equity indexing and ETF product management.

“It just comes down to being smart with your trades,” he said. “It’s a big enough deal that index managers are aware and spend time and energy making sure there isn’t an impact.”

For its part, Standard & Poor’s said it doesn’t dictate when index funds buy, and its rebalancing process ensures everyone gets the same information at the same time.

“We don’t require them to trade in a certain way,” said David Blitzer, chairman of the index committee at S&P Dow Jones Indices. “That’s their business, not ours.”

Dimensional’s Mr. Repetto said his firm avoids buying stocks immediately before they go into an index.
Instead, fund managers purchase them earlier or after the fact.

While the strategy increases an index fund’s divergence from a benchmark’s performance, it can also help fund managers boost performance, which was the issue raised by Mr. Schatz of Heritage Capital

BUYING THE ENTIRE MARKET

Morningstar’s Mr. Rawson said the impact of front-running is minimized in index funds that buy the entire market, such as the Vanguard Total Stock Market Index (VTSAX).

In the past decade, it has returned 8.2% a year, beating Vanguard’s own S&P 500 tracker fund by 40 basis points.

That might not mean much now with U.S. stocks well into their sixth year of gains, but the risk is that savers may be far less forgiving once the bull market falters.

“Because the performance has been good and the fees are low, they’re not noticing some of these potential flaws in indexing,” Mr. Rawson said. “But it’s not something that should be ignored.”

— Bloomberg News contributed to this report

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