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Tracking Errors Cost Billions of Dollars a Year

By: Richard Feldman

By: Richard Feldman, CFP, AIF, MBA

Anomalies in the market place are typically few and far between. The markets are extremely efficient and once an opportunity presents itself investors will typically take advantage of it until it doesn’t exist any longer. One arbitrage opportunity that costs investors millions of dollars a year in lost profits and doesn’t look like it is going anywhere is the reconstitution of the major indexes published by Dow Jones, Standard & Poor’s, Frank Russell, Barclays and MSCI. Each of these indexing companies reconstitutes their holdings at least once a year causing funds that track these indexes to add or delete securities. Investment firms will often try and front run the addition or deletion of a security by buying or shorting a company before the Index funds create a massive amount of supply or demand in a particular company. Index changes typically are caused when firms are bought out, merged, or fail to meet the criteria of the indexing company’s methodology.

Standard & Poor’s Indices

Turnover ratio’s of Standard & Poor’s indexes has varied over the past 12 years. The S&P 500 which is a proxy for domestic large company equities typically has lower turnover than the S&P MicCap 400 and the S&P SmallCap 600 which is a proxy for small company equities. See the chart below for further details:

Table: Turnover is S&P U.S. Indices, 1992 – 2004
Number of Companies added/deleted during a year
S&P Small Cap
Year S&P 500 S&P MidCap 400 600
2004 20 37 58
2003 9 32 47
2002 24 28 48
2001 30 54 77
2000 54 90 143
1999 42 70 102
1998 48 65 90
1997 31 54 86
1996 24 37 61
1995 33 37 45
1994 17 23 7
1993 13 15 N/A
1992 7 15 N/A

 

 

 

 

 

 

 

 

 

Changes to the S&P 500 are typically initiated by deletions of stock. Typically the cause of deletions from an index are due to mergers, bankruptcies, or other forms of major restructurings. In addition Standard & Poor’s may make a decision that a company is no longer representative of its industry. Standard & Poor’s uses four criteria to be included in the S&P 500: the firm must have sufficient liquidity, firm ownership must not be concentrated in a small group of individuals or entities, firm must be profitable, and the firm must be a leader in an important U.S. industry.

Target index providers such as Standard & Poor’s and Frank Russell in an attempt to help index fund managers have typically pre-announced changes in the indexes giving professional investors an opportunity to arbitrage their way to profits. In a recent white paper, it was estimated that $1,100 Billion was indexed to the S&P 500 and $264 Billion was indexed to the Russell 2000.[1]

Arbitrage Environment

Arbitrage returns made on the reconstitution of index funds is a direct drag on index fund returns. The profits made by professional investors come at the direct expense of index fund investors. Index funds that strictly adhere to their mandate to replicate an index and allow for no tracking error do not reconstitute their funds ahead of the actual date of addition or deletion of equities. The pre-announcement of the reconstitution of the indexes allows professional arbitrageurs or fund managers to trade ahead of the index fund managers forcing them to buy stocks at an inflated price or sell stocks at an artificially low level. The white paper recently released on the subject estimated that it costs investors in S&P 500 Index funds .10% annually and investors in the Russell 2000 1.84% annually due to the higher turnover ratio in the Russell index. Given the amount of money indexed to the S&P 500 and Russell 2000 amounts to a loss of $1.1 Billion and 4.85 Billion respectively every year.

Status Quo

Index fund managers are paid to replicate an index and avoid tracking error as much as possible, which they do. Index fund investors typically have no idea that billions of dollars are being siphoned off of their investment assets in any given year, so they are not upset. Index fund investors receive the returns that a particular index delivers in any given year which is typically better than what the active fund universe delivers, so they are happy.

Summary

Maintaining low tracking error to a target index puts index fund managers at a disadvantage to other institutional investors when it comes to reconstitution of the indexes. Firms have become adept at research identifying which firms will be added or deleted to the various major indexes when they are reconstituted. This gives money managers the chance to skim off Billions of dollars every year by trading ahead of the index fund managers. Institutional index fund managers in some cases have identified this problem and have begun to allow more tracking error in their particular index strategy. Trading ahead or after the reconstitution date can alleviate some of the price pressures surrounding the addition or deletion of securities from an index. In some cases Index fund families such as Dimensional Fund Advisors avoid the reconstitution affect by allowing themselves a period of time around the reconstitution date to add or delete a security. See Frank Armstrong’s article Beyond Indexing for a more detailed explanation of how Institutional Index Funds have structured themselves to alleviate the reconstitution drag. The link is

[1] Pre-announced index changes and losses to investors in S&P 500 and Russell 2000 index funds; Chen, Hongui, Noronha, Gregory, and Singal, Vijay, May 2004 White Paper