Don’t Be The Fall Guy

Every rules-based investment portfolio is the result of a subjective judgement about which stocks to include and which to omit.  There is no such thing as a “pure” passive fund, in other words.

As Dave points out, “your choice of the S&P 500 as a proxy for U.S. equities as an asset class is a choice NOT to buy an equally weighted index, a fundamentally weighted index or an index of more than 500 stocks”.

But I’d go further than this.  Not every indexed portfolio has a neutral effect on your long-term wealth, and the way a fund’s underlying index is constructed can be positively harmful.

Dave refers in his blog to the roll yield component of commodity index fund returns.  Many commentators, including this blog, have pointed out that the roll policy used by commodity trackers can leave them wide open to exploitation.  “Date rape” is a phrase I’ve heard used with reference to this phenomenon, which contributed to the horrible 2009 returns of oil trackers like USO and CRUD when compared to spot price movements.

Furthermore, it’s hard to argue that the traders who position themselves to give a tracker fund the worst price when closing an expiring futures position and opening a new one are doing anything wrong – it’s the fund that’s at fault by telegraphing its intentions so openly.

But the problem goes far beyond commodity trackers.

If you look up “index effect” on google you’ll find any number of cases where index reconstitutions led to highly disadvantageous trading terms for investors in associated tracker funds.

In June last year, for example, index provider Russell rebalanced its US equity indices and one of the names removed from the Russell 3000 index was Sirius XM radio (NASDAQ:SIRI).

Russell “reconstitutes” its indices on the last Friday of June each year – which was 26 June in 2009.

Price History – SIRI





































With Sirius exiting the Russell 3000 at the 26 June closing price of 0.36, investors in any index fund will have suffered a 22% decline on the previous day’s closing price.  Then they will have seen the stock rebound the following trading day (June 29) by 17%.  Effectively, Russell 3000 investors exited their Sirius holding on highly disadvantageous terms, while those (market makers and fund managers) positioned on the other side of the trade earned profits that were close to being risk-free.

You could argue that a single (and relatively insignificant) stock’s price behaviour around the times of the index rebalancing will not have made such a huge effect on the overall Russell 3000 portfolio, but multiply this example repeatedly and you are talking real losses for investors.

Beyond that, I suspect that with the increasing amount of money being devoted to index-based investing this kind of problem will be occurring more, rather than less frequently, and with greater price distortions.

What’s the solution?  First, you can try to avoid an index methodology that forces you to buy high and sell low. The founders of the RAFI methodology have long been making the point that cap-weighting automatically leads to underperformance by forcing investors to overallocate funds to overpriced stocks and to sell cheap ones at the worst time.  I’m not saying that fundamental indexation is necessarily the best or the cheapest way to replace cap-weighting, but to me Rob Arnott’s argument is indisputable.  The same effect happens in bond funds if you have a trigger for ejecting issuers once their credit rating falls below a certain threshold.

Second, if you have to roll into new futures contracts on a regular basis, for example, how about making the roll policy more opaque so as to prevent market traders prepositioning themselves to benefit?  One could use a random number generator to select the day of the month to roll on, for example.  Investors would lose some transparency in terms of how their funds operate, but they’d also lose a lot less money.

I’m sure that there are many better ways to design indices in a more investor-friendly way, but at the same time I’m surprised that so little effort in the indexing industry (with a few notable exceptions) is apparently being addressed to doing this.

As things stand, it’s every investor’s duty to examine how the index rules work when considering the purchase of an ETF or index fund, and whether they expose you to unnecessary trading losses.  If you don’t, you’ll end up as one of the fall guys.

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