The Rational Reminder Podcast Episode 355 – Do Index Funds Incur Adverse Selection Costs?
Index Funds Face Adverse Selection Costs
- Index funds must trade to track changes in market composition like IPOs, buybacks, and delistings.
- These trades expose index funds to adverse selection and timing costs ignored by Sharpe's arithmetic of active management.
Index Funds Trade Frequently
- Index funds trade more often than believed, with VTI turning over 8-10% of its portfolio annually on a gross basis.
- Trading in closing auctions masks true trading costs and market impact faced by index funds.
Delayed Rebalancing Boosts Returns
- Delaying index rebalancing generally increases long-run returns, leveling off after 2-3 years.
- This strategy avoids adverse selection by firms issuing equity at high prices or buying back shares.
Marco Sammon joins Ben and Dan to unpack his latest paper, ‘Index Rebalancing and Stock Market Composition’, beginning with how Marco’s work (co-written by John Shim) compares to the Nobel Prize-winner Bill Sharpe’s paper, ‘Arithmetic of Active Management.’ We investigate the missing links in Sharpe’s logic before defining “the market” and ascertaining the main objectives of index funds. Then, we dive deeper into the mechanics of Marco’s paper, index and market tracking errors, why delayed rebalancing is more beneficial than instant rebalancing, and the role of technology in the modern tracking error obsession. We also assess the passive-active spectrum of index funds in portfolio management and learn how investors should choose their optimal excess return. To end, Marco shares practical applications for improving performance benchmarked against traditional indexes, and The Aftershow is all about bridging the gap between PWL Capital and you, our listeners.
Key Points From This Episode:
(0:00:00) Key takeaways from Marco Sammon’s latest paper and how it compares to Bill Sharpe’s ‘Arithmetic of Active Management.’
(0:08:10) Marco describes what’s missing from the ‘Arithmetic of Active Management’ logic.
(0:09:11) Defining ‘the market’, the main objective of an index fund, and how index funds track the market.
(0:15:57) The mechanics of Marco’s paper, ‘Index Rebalancing and Stock Market Composition.’
(0:18:38) Factor exposure, index and market tracking errors, and how often index funds trade.
(0:26:28) Rebalancing less frequently; why delayed does better than instant rebalancing.
(0:31:59) The tech run-up and lazy rebalancing, and the modern tracking error obsession.
(0:36:51) Assessing the passive-active spectrum of index funds in portfolio management.
(0:41:02) Exploring how investors should decide on their optimal excess return.
(0:45:14) How the rising index fund ownership of stocks impacts the implicit cost of indexing
(0:46:58) Practical ways to improve performance benchmarked against traditional indexes.
(0:52:30) The Aftershow: Canadian finances, more airtime for Cameron, and PWL – OneDigital.
Links From Today’s Episode:
Meet with PWL Capital — https://calendly.com/d/3vm-t2j-h3p
Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582. Rational Reminder Website — https://rationalreminder.ca/
Rational Reminder on Instagram — https://www.instagram.com/rationalreminder/
Rational Reminder on X — https://x.com/RationalRemindRational Reminder on TikTok — www.tiktok.com/@rationalreminder
Rational Reminder on YouTube — https://www.youtube.com/channel/
Rational Reminder Email — info@rationalreminder.caBenjamin Felix — https://pwlcapital.com/our-team/
Benjamin on X — https://x.com/benjaminwfelix
Benjamin on LinkedIn — https://www.linkedin.com/in/benjaminwfelix/
Dan Bortolotti on LinkedIn — https://www.linkedin.com/in/dan-bortolotti-8a482310/
Episode 322: Prof. Marco Sammon: How are Passive Investors Affecting the Stock Market? — https://rationalreminder.ca/podcast/322
Episode 200: Prof. Eugene Fama — https://rationalreminder.ca/podcast/200
Episode 268: Itzhak Ben-David: ETFs, Investor Behavior, and Hedge Fund Fees — https://rationalreminder.ca/podcast/268
Episode 112: Michael Kitces: Retirement Research and the Business of Financial Advice — https://rationalreminder.ca/podcast/112
Marco Sammon — https://marcosammon.com/
Marco Sammon on LinkedIn — https://www.linkedin.com/in/marco-sammon-b3b81456/
Marco Sammon on X — https://x.com/mcsammon19
Marco Sammon | Harvard Business School — https://www.hbs.edu/faculty/Pages/profile.aspx?facId=1326895
Marco Sammon Email — mcsammon@gmail.com
John Shim on LinkedIn — https://www.linkedin.com/in/john-shim-2931271b/
Vanguard — https://global.vanguard.com/
Sheridan Titman on LinkedIn — https://www.linkedin.com/in/sheridan-titman-226b0811/
Alex Chinko — https://alexchinco.com/
Erik Stafford | Harvard Business School — https://www.hbs.edu/faculty/Pages/profile.aspx?facId=6625
Itzhak (Zahi) Ben-David on LinkedIn — https://www.linkedin.com/in/ibendavi/
Bill Ackman on X — https://x.com/billackman
‘Millennium Loses $900 Million on Strategy Roiled by Market Chaos’ — https://www.bloomberg.com/news/articles/2025-03-08/millennium-loses-900-million-on-strategy-roiled-by-market-chaos
Bogleheads — https://www.bogleheads.org/
The Money Scope Podcast Episode 8: Canadian Investment Accounts — https://moneyscope.ca/2024/03/01/episode-8-canadian-investment-accounts/
The Wealthy Barber Podcast — https://thewealthybarber.com/podcast/
Financial Advisor Success Podcast — https://www.kitces.com/blog/category/21-financial-advisor-success-podcast/
Financial Advisor Success Podcast Episode 433: When You 10X Your Advisory Firm To Over $20M Of Revenue…And Want To 10X Again, With Cameron Passmore — https://www.kitces.com/blog/cameron-passmore-pwl-capital-10x-revenue-growth-advisory-firm/
OneDigital — https://www.onedigital.com/
The Longview Podcast: Ben Felix
Papers From Today’s Episode:
‘The Arithmetic of Active Management’ — https://www.jstor.org/stable/4479386
‘Index Rebalancing and Stock Market Composition: Do Index Funds Incur Adverse Selection Costs?’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=5080459
‘Luck versus Skill in the Cross-Section of Mutual Fund Returns’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1356021
‘The Passive-Ownership Share Is Double What You Think It Is’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4188052
‘Long-Term Returns on the Original S&P 500 Companies’ — https://www.researchgate.net/publication/247884354_Long-Term_Returns_on_the_Original_SP_500_Companies
‘The Price of Immediacy’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1001762
‘Competition for Attention in the ETF Space’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3765063
‘Passive in Name Only: Delegated Management and “Index” Investing’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3244991
Jeremy Stein — “Unanchored” Strategy