Fund Indexing

By: Dr K C Gupta

From a shaky start in the 1970s, indexing has grown tremendously so that 48% of US funds (consisting of 21% mutual funds/OEFs & 27% ETFs) are indexed now. The meaning of indexing has also evolved. One definition considers market-cap based indexing as the only pure indexing.

Nonmarket-cap-based indexing may be price-weighted, equal-weighted, factor-based (single or multiple factors), direct/ in-house, customized. These may be considered semi-active/passive. The defined indexes may be rebalanced &/or reconstituted on preannounced schedules.

Active funds may have benchmarks that they hope to outperform, but don’t follow the benchmark or any index closely. Active funds have higher ERs, while benchmarks have no ERs, so most active funds underperform their benchmarks. Confusion in the media arises when only active & passive categories are used & semi-active/passive funds are forced into those two.

Market-cap based indexing is the simplest, cheapest, tax-efficient & most common: SP500, Nasdaq Comp, Nasdaq 100, Russell 1000/ 2000/ 3000, & many indexes from SPGI, MSCI, Russell, Wilshire, FTSE, TSX (Japan TOPIX), BSE (India), Nifty (India), etc. These may use sampling or full replication; full market-cap or free-float; futures to manage cash flows; proceeds from securities-lending to reduce or eliminate expense ratios (ERs; e.g. Fidelity ZERO funds); may be uncapped or capped by stocks &/or sectors; may change index & rebalance all at once (Russell indexes) or gradually (CRSP indexes); may reinvest dividends daily or at month/quarter-end.

So, the index funds from different firms that follow the same index may perform differently for these reasons besides their different ERs. All indexes start at base values but then develop divisors to ensure continuity when index components change, or stock-splits occur. The market-cap based indexing flows more money into large & rising stocks, so big stocks get bigger.

Early indexes were price-weighted indexes (DJIA, 5/26/1896- ) or simple averages of prices. These were useful in the days before computers, but they still exist for marketing & business reasons; some copycats also exist (Nikkei 225). Interestingly, DJIA (30 stocks) & SP500 (500 stocks) have an average correlation of 95%.

Factor-based index may use single or multiple factors. It’s accepted practice to name factor(s) when only 1-2 factors are involved: Size – SC/ MC/ LC; value, growth, quality, low-volatility, dividend (current or growth or blend), ESG, currency-hedging, bond credit-quality (investment-grade, HY), bond maturity/ duration, etc. Fundamental-indexing involves 3 or more factors (e.g. RAFI).

Most fund firms license indexes from indexing firms. But a recent trend is to use internal/ custom/ direct- indexing for limited use by individuals or groups but that may grow to replace some broad indexes. There are concerns about conflicts of interest in that firms’ securities holdings may influence their internal indexing decisions, or the firms may trade ahead of making internal indexing decisions public (front-running).

Completion indexes complement major market-cap-based indexes. For example, the total stock market index can be thought of as a combination of a reference index such as SP500 & the remainder as the completion index. So, the completion index then is the total market index without reference SP500 index. Sometimes the term extended-market index is also used.
A criticism of the completion/ extended-market indexes is that they may have lot of bad stocks as there is no selectivity; 30-40% of companies in these indexes may not have any profits. Many active small/ mid-cap funds like to use completion/ extended-market indexes as benchmarks because they are easy to beat.
Vanguard mutual fund/ ETF pair VEXAX/ VXF is a completion (extended-market) index fund whose holdings include the S&P total market index (VTSAX/ VTI) minus the SP500 index (VFIAX/ VOO). It’s 5% large-cap (LC), 31% mid-cap (MC), 63% small-cap (SC); in the Morningstar Style Box, it sits at/near the border of SC & MC, & blend & growth. Currently, the US total stock market-cap is split 80-20 between the SP500 & the completion index.
Fidelity FSMAX uses a different total market index, so it holds the DJ total market index minus the SP500 index. Wilshire W4500/ USMIX is the completion index fund for Wilshire total market index W5000. Russell has R1000/IWB, R2000/IWM (a completion index, although it’s called a small-cap index) & R3000/IWV (Russell total market).

Types of indexed funds (or wrappers) include mutual funds/ OEFs, funds of index funds, target-date funds (TDFs), CITs (collective investment trusts), ETFs, etc. Special indexes can be created at will for ETFs, so there are now more ETFs (& indexes) than stocks.

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