The Problem With Index Funds

Key Concepts

• Index Funds: Investment funds designed to track the performance of a specific market index.
• Active Management: Investment strategies where fund managers actively select securities with the goal of outperforming a benchmark index.
• Arithmetic of Active Management: A theoretical framework suggesting that, in aggregate, actively managed funds must underperform index funds due to higher fees and costs.
• Tracking Error: The difference between the returns of an index fund and the returns of the index it tracks.
• Adverse Selection: A cost incurred when index funds trade with market participants who have superior information about the timing and pricing of trades, particularly during index rebalancing.
• Price Impact: The effect of large buy or sell orders from index funds on the prices of securities, leading to buying at temporarily high prices and selling at temporarily low prices.
• Mean Reversion: The tendency for stock prices to revert to their historical averages. In the context of index funds, this relates to buying stocks at high valuations (when added to an index) that may subsequently fall, and selling stocks at low valuations (when removed from an index) that may subsequently rise.
• Index Rebalancing: The process by which index funds adjust their holdings to match changes in the composition of the underlying index.
• IPOs (Initial Public Offerings): The first sale of stock by a private company to the public.
• Seasoned Equity Offerings (SEOs): The issuance of new shares by a company that is already publicly traded.
• Share Buybacks: When a company repurchases its own outstanding shares from the open market.
• D-listings/Delistings: The removal of a company's stock from a stock exchange.
• Factor Exposures: The sensitivity of a portfolio's returns to specific risk factors, such as value, size, and profitability.
• Alpha: The excess return of an investment relative to the return of a benchmark index, after accounting for risk.
• Valuation Ratios: Financial metrics used to assess the relative worth of a company's stock, such as price-to-earnings (P/E) or price-to-book (P/B).
• Non-indexed Index Fund: A fund that aims to replicate the characteristics of an index fund (e.g., broad diversification, low cost) but does not rigidly follow a specific index's rebalancing rules, allowing for more flexibility in trading.

Hidden Costs of Index Funds and Opportunities for Improvement

This video, presented by Ben Felix, Chief Investment Officer at PWL Capital, delves into the often-overlooked costs associated with index funds, arguing that while their low fees are a significant advantage, they are not the only cost investors should consider. The core argument is that the mechanical nature of index fund rebalancing, driven by the need to precisely match index returns and minimize tracking error, leads to substantial, though hard-to-see, costs that can exceed their stated fees.

The Arithmetic of Active Management and Its Limitations

The video revisits Bill Sharp's famous "arithmetic of active management," which posits that in aggregate, investors in actively managed funds must underperform index fund investors because both groups own the market, but active funds incur higher fees and costs. Felix acknowledges the power of this argument, which he has used himself. However, he highlights a crucial detail often missed: Sharp's original model assumed passive managers did not trade at all.

Key Point: Sharp's model's premise of no trading for passive managers is not reflective of reality.

Felix points to footnote 4 in Sharp's paper, which acknowledges that when passive managers do trade, they may trade with active managers, who can profit from providing liquidity. This is significant because, in reality, index funds do trade to respond to changes in market composition and index constituents.

Supporting Evidence: The 2018 paper "Sharpening the Arithmetic of Active Management" by an unnamed author argues that Sharp's equality relies on the implicit assumption of a static market portfolio, which is not true. This leaves room for informed active managers to add value by trading against uninformed index funds. Felix agrees with this perspective, noting that while active managers' aggregate pre-fee returns might be higher than index funds, their high fees erode these gains for the average investor.

Sources of Hidden Costs in Index Funds

The primary issue for index funds, according to Felix, is that their trading patterns, dictated by index changes, result in significant, quantifiable costs that could be avoided with more intentional implementation. These costs stem from three main sources:

1. Adverse Selection:

   • Definition: Occurs when index funds buy stocks from firms that are issuing them (acting in their own best interest, often when valuations are high) and sell stocks to firms that are buying them back (often when valuations are low).
   • Mechanism: Index providers add or remove companies based on inclusion criteria (e.g., IPOs, delistings, buybacks, SEOs). Index funds mechanically trade to reflect these changes.
   • Real-world Application/Example: Firms tend to issue stock when they believe their share price is high and buy back stock when they believe it is low. Index funds, by following index changes, end up buying when firms are selling (issuing) and selling when firms are buying (buybacks), effectively trading against the firms' own market timing. IPOs, which often occur during periods of high market valuations and tend to underperform long-term, are also bought by index funds.
   • Data/Research Findings: The 2025 paper "Index Rebalancing and Stock Market Composition" by authors like Blitz and Huij found that a long-short portfolio mirroring index fund rebalancing trades (buying new issuance and selling buybacks) had a negative 4% annual return and a negative 2.8% five-factor alpha. This portfolio showed negative loadings on value and profitability factors, indicating index rebalancing leads to buying growth stocks with weak profitability (lower expected returns) and selling value stocks with robust profitability (higher expected returns). A similar portfolio for index additions/IPOs and deletions/delistings had a negative 5.5% annual return.
   • Quantification Challenge: It's difficult to measure these costs directly because the same trades affect both the index fund and its benchmark index.
   • Methodology: Researchers create "counterfactual index funds" that delay rebalancing to assess the impact.
   • Data/Research Findings: A study comparing a quarterly calendar-based rebalancing fund (resembling real index funds) to a counterfactual fund with delayed rebalancing (1 month to 4 years) found that the delayed rebalancing fund beat the quarterly fund by 0.32% annualized over 1981-2023. Longer rebalancing horizons (up to 4 years) showed even greater outperformance, up to 0.81% annualized.
   • Implication: Even a conservative estimate of 0.32% outperformance from delayed rebalancing is significant when compared to the low expense ratios of index funds (e.g., VTI's 0.03%).

2. Price Impact:

   • Definition: The effect of index fund trading on stock prices, leading to buying at temporarily inflated prices and selling at temporarily depressed prices.
   • Mechanism: When a stock is added to an index, its price tends to rise in anticipation of index fund buying. When it's removed, its price tends to fall. These price movements often reverse after the index fund trades.
   • Historical Context: Research from the 1980s showed that stocks added to the S&P 500 experienced price increases likely due to anticipated index fund purchases.
   • Data/Research Findings: The 2011 paper "The Index Premium and Its Hidden Costs for Index Funds" estimated the lower bound cost of this "index premium" for S&P 500 index funds to be 0.21% to 0.28% annually between 1990-2005, peaking at 0.65% to 0.82% in 2000.
   • Recent Trends: The paper "The Disappearing Index Effect" suggests this effect has declined due to the growth of index funds owning a wider range of stocks, meaning stock migrations between indexes have less impact than entirely new inclusions/exclusions.
   • Data/Research Findings: A 2024 paper from Dimensional Fund Advisors (DFA) analyzed index reconstitution costs for 10 indexes (excluding migrating stocks) from 2014-2023. It found trade volumes and stock prices spiked around reconstitution dates, with added/deleted securities showing average excess returns of 4% in the 20 trading days leading up to reconstitution, followed by a reversal of -5.7% in the next month. This means index funds buy high and sell low due to short-term price pressure.

3. Mean Reversion (Related to Valuations):

   • Definition: This cost is linked to the valuations of stocks at the time of their addition or deletion from an index.
   • Mechanism: Stocks added to indexes tend to have high valuations, while those removed tend to have lower valuations. This can lead to index funds buying expensive stocks that subsequently underperform and selling cheaper stocks that subsequently outperform.
   • Data/Research Findings: The 2023 paper "Earning Alpha by Avoiding the Index Rebalancing Crowd" found that in the year before S&P 500 inclusion, stocks had very high returns, and in the year after, they tended to have very low returns. The opposite was true for deletions. Additions were 92% more expensive based on valuation ratios, and discretionary deletions were 55% cheaper than the market at their respective times. From 2005-2021, the one-year difference in returns between index additions and deletions was a significant 14.8% in favor of deletions.
   • Implication: This suggests a combination of the index inclusion effect and mean reversion related to valuations.
   • Mitigation: Alternative index fund implementations, such as delaying index rebalancing by 12 months, can add up to 0.23% to index fund returns by mitigating these valuation-driven effects.

A More Flexible Approach: The "Non-Indexed Index Fund"

Felix introduces Dimensional Fund Advisors (DFA) as an example of a company that implements investment strategies with more flexibility, even for funds aiming to capture market returns. He highlights DFA's US market return fund (DFUS) as a "non-indexed index fund."

Key Characteristics of DFUS:

• Similar Exposures: It has nearly identical factor exposures, market cap exposures, sector exposures, and top holdings as a total market index fund like VTI.
• No Rigid Index Tracking: It does not follow a specific index and lacks rigid rebalancing rules.
• Delayed IPO Investing: DFA delays investing in IPOs to avoid the initial valuation uncertainty and price discovery period.
• Flexible Implementation: This flexibility allows it to avoid the adverse selection, price impact, and mean reversion costs associated with mechanical index tracking.

Performance Data:

• Expense Ratio: DFUS has an expense ratio of 9 basis points, while VTI has 3 basis points.
• Outperformance: Since DFUS became an ETF on June 14, 2021, through March 31, 2025, it has outperformed VTI by 56 basis points annualized, net of fees.
• Significance: While this is a short period and could be attributed to noise, Felix finds it compelling that a live implementation of these ideas performs within the range predicted by research.

Conclusion and Takeaways

Ben Felix concludes that while index funds are a monumental innovation in finance, offering low costs and broad diversification, they were never designed to be investments themselves. The mechanical nature of tracking indexes leads to hidden costs related to adverse selection, price impact, and mean reversion, which can collectively cost investors significantly more than stated fees.

Key Takeaway: Investors can potentially recapture lost returns by employing more flexible trading strategies, particularly around index rebalancing. This doesn't mean index funds are bad investments; they are still a huge upgrade from expensive active management. However, designing investments that retain the benefits of index funds (low cost, diversification, tax efficiency) while implementing them intentionally to maximize returns, rather than mechanically following an index, has significant merit both in theory and in practice.

Notable Quote: Felix quotes the author of "Sharpening the Arithmetic of Active Management": "I think that low-cost index funds are one of the most investor-friendly inventions in finance and this paper should not be used as an excuse by active managers who charge high fees while adding little or no value." Felix echoes this sentiment, emphasizing that the discussion is about improving upon index investing, not abandoning it.