Does Equity Indexing Have Hidden Risks? By John Spence January 29, 2003

Last week Standard & Poor's released its quarterly active vs. passive mutual fund scorecard with stark results: in most cases a majority of active funds have failed to beat their relevant index in the bear market of the past couple years. This research, published by a high-profile firm like S&P, does much to refute the oft-heard argument that active managers can add value over benchmarks in a down market.

Index funds routinely beat a majority of their peers over long time periods after costs, but to think that they magically remove the risk from equity investing would be a mistake. Equity index funds are by definition fully exposed to the stock market; they have no cash to protect them in down markets. Undoubtedly, Vanguard 500 index fund (VFINX) investors became aware of this fact when they collectively lost $16 billion in 2002. The fund was down 22.1% for the year, and was the biggest wealth-destroying fund in 2002 behind Fidelity Magellan, according to Morningstar. Of course the Vanguard index fund did exactly what it was supposed to do last year: track the S&P 500.

There are other commonly voiced risks associated with indexing that are a little more murky, which is probably why they've been batted around endlessly by academics and investors alike. Let's take a look at some of these claims, which vary in their levels of validity, one at a time.

1. Market-cap weighted indexes like the S&P 500 get top-heavy, reducing the diversification benefits of index funds.

This is a legitimate criticism of indexing that was lent credence by the bull market in large-cap growth stocks in the late 1990s. The S&P 500 became dominated by a few stocks at the top of the index, which meant that only a handful of huge stocks were the main drivers of performance (and subsequent underperformance when the bear set in).

In market-capitalization weighted indexes, a stock's weighting is determined by its share price multiplied by the total shares outstanding. For example, nearly a quarter of assets in the Vanguard 500 fund is currently in the ten largest stocks the fund holds. S&P 500 investors can diversify outside the index into smaller stocks, or slice and dice, to reduce this risk.

A key strength of equity index funds is their diversity, but sometimes market-cap weighting results in bloated names at the top. However, index funds usually hold more names than comparable active funds, and are generally well diversified.

2. What if everyone indexed?

The ultimate brainteaser for indexers. Maybe it's the sheer lunacy of the idea that makes this question so tantalizing. But let's put reality aside for a moment and try to envision a world devoid of active traders to determine stock prices and keep markets efficient. In this frictionless environment, stock prices would be determined solely by index fund flows, rather than by any information specific to the company. Of course, active traders could make a killing in this market free of competition, and arbitrageurs could hamstring passive funds by front-running their trades.

Some economists have estimated that indexers would have to represent 50% or more of total market capitalization before such opportunities became available. As of November 30, 2002, only 7.6% of the total assets in retail equity mutual funds resided in index funds, according to the Investment Company Institute. The percentage for institutional funds was higher, with 21.2% of all institutional equity fund assets indexed. A relatively small percentage of all outstanding company stock in the U.S. is indexed.

3. "Index effect" attracts predatory front-runners.

The argument: With large sums of money invested in popular indexes that have varying levels of predictability, opportunities arise to front-run index additions and deletions, and passive investors suffer as a result. Index front-runners can theoretically exploit passive funds by buying stocks added to benchmarks, and shorting stocks that are deleted.

"For a while it was easy pickings, but only as long as only a few people knew about it," said Wayne Wagner of the Plexus Group in a previous interview. "If enough people try to jump the index change, they'll overshoot."

Imagine you're a hedge fund manager attempting to play the Russell 2000 or S&P 500 rebalance, two favorite targets for front runners because of the large asset bases tied to them. When do you buy the added stocks? A week before rebalance? A month? Two months? Small-cap passive fund managers joke that the broker research on potential Russell 2000 adds and deletes appears a month earlier every year. Successful trading strategies cease to exist when enough market participants find out about them and exploit mispricings until they eventually disappear.

Index funds have also developed strategies to combat front-runners, which might include accepting more index tracking error.

"The real question is whether the index managers have become better at managing index changes, or if hedge funds have become more skilled at trading index changes," said Diane Garnick, global investment strategist at State Street Global Advisors, in a previous interview. "I would argue that the index change strategy that existed for so many years has dissipated as a direct result of the market becoming more and more efficient. We discovered, tested, and then published data and strategies surrounding the now infamous 'index effect.' The spreads that once existed in the market have tightened, reducing the opportunities for active managers and simultaneously reducing the cost index changes had to passive investors."

Free float weighing has also been a remedy to index front running because it reduces liquidity crunches at rebalancings.

"Cap-weighted, rather than float-weighted, indexes are a problem because you have price squeezes because there aren't enough shares to go around when a company goes into an index," said Wagner. "If stock is semi-permanently in closed hands - cross holdings, government holdings, or management - it shouldn't be counted as market assets. Otherwise you get liquidity pinches as too much money searches for too little available liquidity."

4. Indexing is inherently risky because it's a "free-rider" strategy.

Right or wrong, some view indexing as a piggybacking strategy because it relies on active traders to keep market prices reasonably efficient. Indexers believe it is a waste of time to try to outsmart the market, so they leave the task to the active traders and choose not to pay higher management fees and transaction costs.

Index funds are a lot like voting machines because usually a stock's weight is determined by its total market capitalization, which is in turn dictated by what stock investors are doing in aggregate. For example, the top-heavy indexes discussed above can occur only if active investors also have top-heavy portfolios (like in a bubble).

Intuitively, some investors might feel at least uncomfortable without an active manager making decisions to avoid obvious mistakes and bubbles, but it turns out most active managers can't keep up with their benchmark after costs and taxes.

Ballooning index investment could theoretically damage the passive strategy - a successful investment idea usually ceases to work when too many people start practicing it. However, the arguments against this ever happening with indexing are compelling when one considers Wall Street's powerful marketing arm, and the media's almost exclusive coverage of active funds and stock picking. An overwhelming majority of mutual fund assets are actively managed, as we saw above.

The financial media embraces the idea that investors can beat the market because it sells more newspapers and magazines, or it attracts more TV eyeballs or website impressions. Finally, the advertisers and sponsors benefit from active trading and the notion that investors can do better than investing in those boring index funds. Take all these factors into consideration, and it's tough imagining the day when the Gospel according to Bogle becomes the law of the land.