The Costs of Passive Investing

08/02/2011 11:30 am EST

Focus: MARKETS

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

Passively traded ETFs have become very popular, and it’s important you understand the risks that come along with that popularity, says Ben Shepherd of Global ETF Profits.

John Bogle, founder of The Vanguard Group, has made passive investing his life’s work.

Bogle’s message is simple and backed by decades of research.Over long periods of time, actively managed funds rarely outperform their benchmarks by enough of a margin to justify paying the high fees incurred.

In fact, investors who rely solely on actively managed funds are likely to underperform the broader markets after one takes expenses into account. By Bogle’s logic, passive index funds should serve as the foundation of any portfolio.

Most investors want to outperform the market, and consequently there were points in Bogle’s career where his philosophy made him an unwanted prophet.

But his passive-investment mantra was validated by the credit crisis and Great Recession, when the net asset values of mutual funds across asset classes plummeted—in 2008, almost 80% of mutual funds underperformed their benchmarks.

Investors have since flocked to passively managed, index-based products. From 2000 to 2006, index funds on average received net inflows of about $30 billion each year.

Since 2007, that figure has jumped to almost $50 billion annually, according to data from the Investment Company Institute. Today more than $1 trillion is invested in passive index-based products in the US alone.

But there are always unintended consequences when an investment strategy catches on with the masses.
With $1 trillion concentrated in about 350 index products—many of which overlap significantly or track the same indexes—any alterations to the underlying indexes can move markets.

Consider a recent example. In late June, the market speculated that MSCI (MSCI)—the caretaker of indexes tracked by numerous exchange traded funds and mutual funds—would reclassify South Korea and Taiwan as developed markets rather than developing markets. The upgrade never did occur, but the rumors sent the financial chattering class into overdrive.

South Korea and Taiwan are included in the MSCI Emerging Markets Index with weightings of 14.8% and 11.4 percent, respectively; 13 US-based ETFs and mutual funds mimic the index. Had MSCI reclassified South Korea and Taiwan, these funds would have been forced to sell off their Korean and Taiwanese holdings and replace those positions.

That amounts to about $58 billion in transactions, all of which would have occurred on the same day—a recipe for volatility. The markets breathed a sigh of relief when MSCI left the index unchanged.

But was there truly cause for concern?

NEXT: The Nasdaq’s Example

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On May 2, the Nasdaq rebalanced for the first time since 1998, a move that changed the weighting for 82 of the index’s 100 components.

Most significantly, Apple’s (AAPL) weighting reduced to 12.3% from 20.5% of the index. Microsoft’s (MSFT) weighting increased to 8.3% from 3.4%.

More than 4,000 mutual funds and ETFs around the world track the index and hold an aggregate $330 billion worth of assets. It’s estimated that about 3.2 billion shares changed hands that day.

Many market watchers expected Microsoft shares to spike that day. But neither Microsoft nor any of the Nasdaq-100 constituents experienced significant movements in share prices or trading volume.

There are two important reasons why May 2 was unremarkable:

  • First, index rebalances aren’t arbitrarily decided and executed in a single day. Market participants are typically informed of any index changes months in advance, smoothing the transition.
  • Second, although many investors believe all share liquidity is found on the national exchanges, the evolution of dark pools and other off-exchange trading systems provides significant liquidity that’s not always reported.

In regards to tax implications for fund investors, an ETF investor is unlikely to receive a tax bill if an index is rebalanced. Owning ETF shares typically means that an investor owns fractional interests in a trust. This trust actually owns the underlying securities.

When changes occur in an index, the authorized participants sell or purchases the requisite shares, and then presents them to the fund’s sponsor in an in-kind transaction (meaning shares are traded for shares). As a result, there are no tax implications for ETF shareholders.

The Nasdaq rebalance is a perfect example of this; investors who held shares of ETFs that track the Nasdaq-100 did not receive unusual capital-gains distributions.

A rebalancing of the MSCI Emerging Markets Index could be more complicated. The ETF trusts that actually own the Taiwanese and Korean shares buy and sell these shares on local exchanges, making the transactions subject to local tax laws.

Both Taiwan and South Korea prohibit in-kind transactions. However, they do allow a form of tax-lot accounting which would help minimize tax liabilities in the event of an index rebalancing.

Bottom line: The typical investor is better off sitting tight rather than trying to sell off a position because of an index rebalancing.

Passive investing may lead to unintended costs, but these costs are manageable. Bogle’s approach to maximizing profits by minimizing costs has yet to be proven wrong.

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