While passive investing has powerful theoretical appeal, in the real world, it is not quite so simple.
The growth in passive investing, the popularity of particular equity indexes, and the acceptance of tracking variance as the primary indexing performance metric combine to create temporarily intense demand for securities added to popular indexes.
On average, prices of securities added to the S&P 500 and MSCI EAFE indexes in our study period rose 7% to 9%. Over half of the average observed price appreciation occurred as an immediate response to the announcement of addition. Much of the average price appreciation reversed shortly after index additions became effective. Some price appreciation appears to be permanent.
Price volatility of securities added to the S&P 500 and MSCI EAFE indexes has increased over time. Average risk-adjusted returns associated with early purchase of index additions are positive, but have declined over time.
Index investors who demand minimum tracking variance relative to the S&P 500 and MSCI EAFE equity benchmarks give up an average of 10-20bp annually in wealth to achieve that goal. This wealth give-up is implicit in benchmark returns and is difficult to measure.
Investors can take steps to mitigate the give-up in wealth associated with changes in popular equity benchmarks. Strategies to reduce wealth give-up include implementation of more aggressive index change trading strategies, selection of less popular benchmarks, and selection of broader benchmarks. Each of the strategies represents a different tradeoff in terms of tracking variance, wealth give-up, risk, and liquidity.
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The information contained herein does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. Past performance is no guarantee of future results. We encourage you to consult your tax or financial advisor. The views expressed are the views of Eric Brandhorst only through the period ended November 30, 2001 and are subject to change based on market and other conditions.
