The Complexities of Index Investing
The Hidden Complexities of Index Investing: A Deeper Look
The investment world has witnessed a remarkable transformation. Passive investing, once a novel concept, now dominates over 50% of managed funds and ETFs[i] – a testament to investors' growing sophistication. At Lorica Partners, we've long championed investment strategies that avoid costly stock-picking methods. But as with any sophisticated financial instrument, the reality is more nuanced than headlines suggest.
While index funds represent one of finance's most beneficial innovations for investors in the past century, we like to examine both their strengths and limitations. Let's explore some lesser-known challenges that inform our investment philosophy.
The Quiet Cost of Index Reconstruction
Consider what happens behind the scenes when market indices update their composition. This process, known as index reconstitution, occurs regularly. The S&P 500 rebalances quarterly to reflect changes among America's largest public companies. While seemingly straightforward, this mechanism creates fascinating market dynamics.
Research[ii] into widely tracked indices, including the ASX 300 from 2014 to 2023, reveals an intriguing pattern. During reconstitution periods, we observe notable spikes in both trading volume and price volatility. The data tells a compelling story: stocks being added to an index typically see positive excess returns beforehand (averaging 3.5% over 20 days), while those facing removal experience the opposite (around -4.4%). These movements then partially reverse after reconstitution – a phenomenon that affects real investor returns.
The Hidden Market: What Your Index Isn't Telling You
Here's a surprising fact: as of February 2024, 73 of America's 500 largest companies weren't included in the S&P 500 [iii]. The combined value of these excluded companies? Over $2 trillion – exceeding the entire market value of the Australian and New Zealand stock exchanges combined.
Consider Tesla's journey - by the time Tesla was added to the S&P 500, it was already the sixth-largest company in the US. Other well-known companies, like Airbnb, Lululemon, and Uber, were in the top 500 for months before finally being added to the index.
This reveals a crucial insight: market indices represent a curated view of the market, not its entirety.
Largest 500 US-listed securities by market cap as of 29 February, 2024
The Concentration Conundrum
Currently the "Magnificent 7" (Apple, Microsoft, Google, Amazon, Nvidia, Tesla, and Meta) command 30% of the S&P 500's weight. While these companies project impressive 30% earnings growth for 2024, the remaining 493 companies expect modest 3% growth. This concentration creates both opportunities and risks – as demonstrated when Nvidia's value dropped 17% in a single day following news about Chinese AI competition [iv].
A More Sophisticated Approach
At Lorica Partners, we like fund manager strategies that capture the best aspects of passive investing while addressing these challenges. Strategies we’ve used for several decades now maintain the core benefits of index investing – low costs, transparency, and broad diversification – while incorporating insights from Nobel-prize-winning research on value, size, and profitability factors. This refined strategy has delivered results: our Australian equity portfolio has outperformed the ASX 300 index by 0.44% annually over the past decade.
Costs remain a Reliable Predictor of Performance
In 2016, Russel Kinnel from Morningstar published a landmark study which found, of all the variables he tested, expense ratios (or the fees charged by the fund manager) did the best job of predicting stock and bond funds' subsequent returns. Simply put, the lower the fees were, the better funds tended to do versus peers over subsequent periods. Morningstar recently updated this research for the 20 years ending January 2025 and the results have not changed.
The cheapest funds outperformed the priciest funds, on average, in every single year that spanned the study.
The Path Forward
While index funds have revolutionized investing, understanding their nuances allows for more informed decisions. As your advisers, we continue to evolve our approach, combining academic insights with practical experience to navigate these complexities on your behalf.
Author: Rick Walker
[i] Apollo Academy - Felix von Moltke and Torsten Sløk1 November 2024
[ii] Measuring the Costs of Index Reconstitution: Evidence Outside the US Kaitlin Hendrix, CFA Asset Allocation Research Director and Vice President Jerry Liu, PhD Trading Research Director and Vice President Trey Roberts, CFA Senior Associate, Research January 2025.
[iii] Source: Dimensional Fund Advisors
[iv] https://www.hamiltonlane.com/en-us/insight/inflection-point