The Rational Reminder Podcast
Episode 355 – Do Index Funds Incur Adverse Selection Costs?
Podcast summary created with Snipd AI
Quick takeaways
- Marco Sammon's research reveals that traditional models, like Bill Sharpe's, overlook the impact of trading dynamics on index fund returns.
- Delayed rebalancing is identified as a crucial strategy that can enhance index fund performance by improving returns over immediate adjustments.
- Understanding the limitations of major indices is essential, as their selective nature may prevent investors from fully capturing market dynamics.
Deep dives
Reassessing Index Fund Dynamics
Recent discussions have explored the intricacies of index fund rebalancing and its implications for performance. New research indicates that events affecting market composition, such as IPOs, secondary issuances, and buybacks, require index funds to trade in ways that may not always maximize returns. This contradicts the traditional understanding of Bill Sharpe's arithmetic of active management, which neglects the role of trading. The finding suggests that index funds, often thought to be passive vehicles, are influenced by market dynamics in ways previously unconsidered.
Impacts of Delayed Rebalancing
The concept of delayed rebalancing surfaced as a pivotal strategy for enhancing index fund returns. By postponing trades in response to market composition changes, there is potential for improved performance, as shown by research comparing traditional rebalancing with a counterfactual approach. The analysis indicates that waiting longer to adjust weights could yield notable returns, even if the tracking error increases. This insight challenges the prevailing notion that index funds must prioritize immediate alignment with indices for optimal performance.
Tracking Error vs. Market Exposure
The distinction between tracking error and market exposure became a focal point in understanding index fund performance. While index funds are designed to closely follow their respective indices, this does not guarantee that their overall returns reflect the broader market adequately. Discussions revealed that index funds often incur costs when accessing certain securities while rebalancing, which can detract from their performance. This highlights the necessity for a more nuanced understanding of how index funds interact with the market, not just in tracking indices but also in their investment outcomes.
Understanding Index Construction
The construction of indices and their underlying strategies has become critical in evaluating index fund effectiveness. A pivotal argument is that major indices often do not encompass the entire market, thus creating limits when assessing performance. The selective nature of indices, such as the S&P 500, necessitates understanding their composition and rebalancing rules. Recognizing that investors cannot fully capture market dynamics through indices alone calls for a reexamination of investment strategies and expectations.
The Future of Indexed Investing
Looking forward, the discourse suggests potential shifts in how investors approach indexed investing, especially concerning the implications of evolving market dynamics. Enhanced indexing strategies that consider delayed rebalancing may emerge as more widely accepted approaches among fund managers. Additionally, as institutions grapple with the competitive pressures and inefficiencies of existing indices, there may be an inclination to adopt innovative strategies that provide better risk-adjusted returns. The conversation indicates a transformative period in indexed investing, influenced by ongoing research and market realities.
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
Remember Everything You Learn from Podcasts
