Jesse Kuusisto, CFP®, Wealth Manager, provided the data for this article and reviewed it for accuracy, while Indigo Marketing Agency compiled & edited it.
Over the past decade, passive “index” investing has seen a surge in attention and massive inflows of investor money, relative to other vehicles such as more actively managed mutual funds. This growth is primarily due to benefits such as low internal investment expenses, broad diversification, tax efficiency, and evidence that the majority of fund managers today practicing active management may not perform better than the market averages over time.
Yet even with these benefits, there are aspects of passive investing that are not well-known to the public and may be affecting investors’ portfolio objectives, asset allocation decisions, taxes incurred, and expenses they ultimately pay. In fact, what may surprise investors is how active “passive investments” really are and the hidden costs behind them.
The Issue of Style Drift and Its Effect on Asset Allocation
A typical investment portfolio is constructed with many considerations, including investor risk tolerance, time horizon, investment objective, and other factors. Asset allocation strategies seek to widely diversify investments among many holdings, each having a specific role within the portfolio (whether it be stability, income, growth, and so forth) to address and meet those considerations and criteria.
“Style drift” occurs when the composition of a particular fund morphs into a different style or mixture of internal holdings than its intended objective or original approach. This may occur due to many factors, but often happens in actively managed mutual funds where the portfolio manager makes changes that alter the composition away from the stated objective. This is a prime benefit of index-based investments; they are intended to match a stated index that isn’t supposed to change. The problem: Components of indices do change over time.
Take the Dow Jones Industrial Average (the Dow 30). The Dow “index” holdings have changed 58 times over the course of its history. The Standard & Poor’s 500 Index has had 715 additions and 711 deletions between January 1995 and June 2021, averaging around 27 constituent adds and drops per year. Or a stated “small-cap” index fund may one day have a significant amount of larger “mid-cap” holdings, due to appreciation of these companies’ stock prices in a rapidly advancing market.
Similarly, outperformance of a holding such as Apple, Amazon, or Nvidia may skew an index more toward a particular sector (in this case, growth and technology) than the investor or portfolio manager intended. Moreover, many index-following funds may only “reconstitute” (and rebalance) their holdings once or so per year; therefore, style drift may occur and be prevalent within the fund for a significant time between rebalancing. In addition, infrequent rebalancing and reconstitution may also lead to higher costs for the investor.
Hidden Costs Within Adjustments
When index-matching funds do reconstitute their holdings in response to changes in the underlying index, cost issues may arise. Studies have shown that pre-announced additions (new holdings) to the index during reconstitution tend to rise in price prior to the addition to a fund and pending deletions from the fund tend to fall prior to selling from the fund.
This phenomenon occurs because there is likely a greater demand for that holding’s shares just prior to adding that holding and deleting a holding from an index may lower demand for that holding’s shares, therefore, potentially depressing the market price. These reconstitution pricing pressures on additions and deletions might be costly for the index-fund investor because shares may cost more to add to the index fund and sell for a lower price when deleted from the fund, thereby potentially affecting performance for the current investor.
Also, due to the index fund’s mandate to minimize “tracking error” (or deviations from the composition and performance of the underlying index), index-tracking funds face trading and other costs in trading the same securities as the indices themselves on a particular trading day. All of these costs are not readily visible to or felt by the individual investor, but they do detract from the eventual performance return of the fund and affect the investor overall.
The Importance to the Individual Investor
While passive investing is a worthwhile approach to building wealth for your objectives and financial future, it is not infallible as perhaps has been promoted. Even in passive investing, there are active decisions being made, both by you as the investor and the management of the index-tracking funds you select. Here are some considerations:
- Which asset classes and investment styles do you want in your portfolio?
- Which exposures to certain sectors do you wish to index-track?
- Which indexes and index-tracking funds should you choose?
When making these selections:
- What is the propensity for a particular index-tracking fund or index to “style-drift”?
- How often does the selected fund rebalance/reconstitute its holdings, and what is their process for doing so? Do the sponsors take costs, volume purchase pressures, and other factors into consideration? What is their methodology for mitigating these factors?
While many investors may not wish to involve themselves in this level of minutiae in their investments, having an understanding of these concepts and issues may lead to more productive discussions with their financial advisors and investment managers.
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The forgoing content was created by Laurel Wealth Planning with verbiage, style, and/or format input from Indigo Marketing Agency.
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