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Too Much Success Can Cost Index Fund Investors

Index mutual funds have become increasingly popular for investors who want to participate in the stock market but don't want to spend all day watching CNBC or squinting at online stock tables.

The funds are passively managed and track various indexes developed by companies like Standard & Poor's or the Frank Russell Co. as benchmarks for various classes of equities. Investment funds offer passively managed index funds that track the index by buying the stocks of companies in the index.

But University of Iowa finance professor Todd Houge has found that the way the index is put together can cost those funds' investors money.

"We view the management of an index fund as passive, but in reality, they're not passive at all," said Houge, an assistant professor of finance in the Tippie College of Business. "There are changes as stocks are dropped and added based on the composition of the index the fund tracks, and that makes it actively managed."

In a recent study, Houge tracked the stocks in the Russell 2000, an index made up of the 1,001st through 3,000th largest publicly traded companies in the United States. Russell created the index of companies with small market capitalizations in 1978 as a benchmark to compare small-cap stock performance.

The index is rebalanced once a year, selling the stocks of those companies that have become too large or too small, and buying those stocks that now fall within the 1,001-3,000 range.

Houge and his co-author, Jie Cai, a business professor at Drexel University and University of Iowa Ph.D. alumnus, studied the long-run performance of the Russell 2000 -- and the funds that track it -- from 1979 to 2004. He said the Russell 2000 index itself is a valid and accurate reflection of small-cap stock performance at any given time.

But its annual rebalancing means that index funds made up of the stocks on the index may not perform as well as they could. Because of the annual rebalancing, the stocks of growing companies are removed from the index just as they are starting to post significant returns.

Houge found that by removing the stocks that outgrew the index, Russell 2000 funds underperformed most every year since the index started. He said a buy-and-hold strategy that held onto the stocks of companies that outgrew the Russell 2000 would have outperformed the actual index by 2.22 percent on average over one year, and 17.29 percent over five years.

"Once in awhile, one of those small cap companies becomes a Microsoft, but in a small cap benchmark, that stock would have been kicked out long before it provided its best returns," Houge said.

The difference is so dramatic that a portfolio of stocks that were deleted from the Russell 2000 would have outperformed the additions to the index by 8.9 percent in the first year on average and 28.1 percent over five years.

He said that Russell 2000 funds are also hamstrung by the fact that many of each year's additions are initial public offerings, which tend to perform poorly.

Although his research followed only the Russell 2000, Hogue said it's likely that other index funds in which high-performing stocks can grow out will suffer a similar loss of potential performance. The S&P Mid-Cap 400 or S&P 600 both sell stocks of companies that graduate from the fund when they get too big.

A large cap index fund, however, such as the S&P 500 or NASDAQ 100, is less likely to lose potential performance because companies don't outgrow those indexes. Quite the opposite, companies are only removed from large cap indexes when they are being outperformed by other companies, so their removal actually helps the fund's performance.

Hogue's and Cai's paper, "The Long-term Impact from Russell 2000 Rebalancing," was recently published in Financial Analysts Journal.


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