The Problem With Index Funds

Summary

In this video, Ben Felix discusses the hidden costs of index funds, such as adverse selection, price impact, and mean reversion, which can reduce overall returns. While index funds are low-cost and widely diversified, their mechanical approach to rebalancing can lead to buying high and selling low. Felix explores alternative fund strategies, like Dimensional Fund Advisors' non-indexed index funds, which are more flexible and have shown promising performance by avoiding these inefficiencies. He emphasizes that while index funds are a great investment for most, there are opportunities for improvement through more intentional fund design.

Takeaways

• 😀 Index funds are praised for their low fees, but investors should consider other hidden costs beyond fees.
• 😀 The hidden costs of index funds arise from adverse selection, price impact, and mean reversion during rebalancing.
• 😀 Index funds are designed to track an index, not to maximize returns, which leaves room for more efficient investment strategies.
• 😀 Adverse selection occurs when index funds buy stocks when firms issue shares at high prices and sell when firms buy back at low prices.
• 😀 Price impact happens when index funds trade on predictable reconstitution dates, causing temporary price movements that lead to buying high and selling low.
• 😀 Mean reversion occurs when stocks added to an index tend to have high valuations, while stocks removed from an index tend to have low valuations, leading to suboptimal trading decisions.
• 😀 The famous arithmetic of active management, which claims passive index funds outperform active funds due to lower costs, overlooks the hidden costs from rebalancing.
• 😀 A more flexible approach to fund implementation, such as delaying rebalancing or avoiding rigid index tracking, can improve investment returns by reducing hidden costs.
• 😀 Dimensional Fund Advisors offers a non-indexed index fund, which aims to capture broad market returns while avoiding the inefficiencies of mechanical rebalancing.
• 😀 Evidence shows that funds with more flexible rebalancing strategies, like Dimensional’s, have outperformed traditional index funds like VTI, even with slightly higher expense ratios.
• 😀 While index funds are a great option for most investors, adjusting their strategies to better capture market opportunities can lead to improved performance and higher returns.

Q & A

What are the hidden costs associated with index funds?

The hidden costs in index funds come from three sources: adverse selection, price impact, and mean reversion. These costs occur when index funds trade to reflect changes in market composition, such as IPOs, share buybacks, and stock additions/removals from the index.

What is adverse selection in the context of index fund rebalancing?

Adverse selection occurs when index funds buy stocks that companies issue at high prices and sell stocks when companies repurchase them at lower prices. This happens because index funds must quickly respond to changes in market composition, which puts them at odds with companies' own valuation beliefs.

Why do IPOs tend to underperform after being added to an index?

IPOs tend to be added to indexes during periods of high market valuations, which generally lead to poor long-term performance. Index funds, by mechanically adding IPOs, often buy them at inflated prices, leading to underperformance.

How does the price impact of index reconstitution affect returns?

When stocks are added or removed from an index, their prices typically increase due to anticipation of index fund purchases. However, this effect reverses after the stocks are bought or sold, meaning index funds end up buying stocks at temporarily high prices and selling at low ones.

What is mean reversion, and how does it affect index fund returns?

Mean reversion refers to the tendency of stocks added to indexes to have high valuations that fall over time, while stocks removed from the index tend to have lower valuations that rise afterward. This behavior causes index funds to buy stocks at high valuations and sell them at lower ones, reducing potential returns.

How do non-indexed index funds improve upon traditional index funds?

Non-indexed index funds, like DFUS from Dimensional Fund Advisors, offer more flexibility by delaying rebalancing and avoiding inefficient trading strategies. These funds do not rigidly follow an index and instead make more intentional investment decisions, potentially leading to higher returns.

What role does flexibility play in improving index fund performance?

Flexibility allows index funds to avoid the mechanical buying and selling that leads to inefficiencies, such as purchasing stocks at inflated prices or selling them at depressed prices. By delaying or adjusting trading decisions, a fund can reduce adverse selection and price impact costs, improving long-term returns.

What evidence exists supporting the idea of more flexible index fund strategies?

Research suggests that counterfactual index funds that delay rebalancing by months or years outperform traditional quarterly rebalanced index funds. For example, a counterfactual index fund that delays rebalancing by 12 months has been shown to beat the quarterly rebalanced fund by 0.32% annually from 1981-2023.

Why does the 'non-indexed index fund' (DFUS) perform better than traditional index funds?

DFUS outperforms traditional index funds because it avoids the inefficiencies tied to rigid rebalancing rules. The fund delays investing in IPOs, avoids price impacts from rebalancing, and takes a more flexible approach to stock additions and deletions from the index, resulting in higher returns.

How much better is DFUS performing compared to VTI as of 2025?

Since its launch, DFUS has outperformed VTI by 56 basis points annualized net of fees. While this outperformance may still be subject to tracking error, it aligns with the expectations set by the research on more flexible rebalancing strategies.