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Index funds are designed to track a benchmark, such as the S&P 500. Some funds track benchmarks very closely, while others have a large amount of tracking error. A possible reason for a fund to experience more tracking error could be that fund choosing not to purchase every stock in the index being tracked. For example, a fund tracking the S&P 500 might, for one reason or another, choose only to purchase 400 out of the available 500 stocks in the index.
It is straightforward to see why this strategy might cause the fund to have returns that differ from the index it was purporting to track. If the 100 stocks the fund doesn’t own do very well, the fund will underperform the benchmark. Conversely, if those 100 stocks do poorly, the fund will ultimately do better than the benchmark. Funds that track benchmarks very closely tend to purchase the individual stocks in the index in nearly the same proportion as the benchmark.
Antti Petajisto, a New York University professor, published a study a few years ago on index turnover cost. A Morningstar analysis of that study noted that:
Petajisto estimated that from 1990 to 2005 the annual turnover drag for the small-cap Russell 2000 was at least 0.38%-0.77% and for the S&P 500 at least 0.21%-0.28%. This annual turnover drag is a cost that isn’t seen by investors, but over a long time horizon, can make a huge difference. When it is announced that a particular stock will be added to an index, the price of that stock often rises due to speculative buying by market makers and hedge funds. When the stock is finally added to the index, index funds are forced to buy the stock at a premium and the stock price starts to decay as demand for the stock decreases. Once again, these costs are borne by the investor. There are various ways to attempt to minimize these implicit costs, Empirical examines the areas of the market where particular index funds face the greatest costs and we look for superior alternatives. We use investment strategies that attempt to avoid index turnover costs by not immediately conforming to indices at each change. Unlike standard index funds, they aren’t forced to buy stocks at a premium when they are added to an index and are instead able to wait until trading volume and prices return to a more normal level before purchasing. We will continue to research these types of strategies in order to eliminate any avoidable costs, and we encourage all investors to do the same.
