Change is the only constant in life: Are index funds truly "passive"?

AP Photo/Evan Vucci

Trump and Kim: from 'totally destroy', to 'new relations' and a 13-second handshake. The only thing constant in our world is change.

In the media, 'passive' and 'index fund' are usually joined at the hip, but in reality, the underlying components of an index fund (ETF or unit trust) are far from passive. The index components are operating companies, and as operating companies are run by humans: the companies do things like merge, privatize, go bankrupt, or buy back their own shares. Big companies shrink and small companies grow. New companies float on the market and the indexes that the tracker funds are meant to track change. If you were truly passive and did nothing at all, your holdings would cease to resemble the market.

In 2015 alone, the S&P 500 saw 24 changes in its constituents (Bold = added; Italics = removed)

• January: Endo International (ENDP), HCA Holdings (HCA). Covidien (COV). Safeway (SWY).
• March: Skyworks Solutions (SWKS), Henry Schein (HSIC), Equinix (EQIX), SL Green Realty (SLG), Hanesbrands (HBI), American Airlines Group (AAL). PetSmart (PETM), CareFusion (CFN), Denbury Resources (DNR), Nabors Industries (NBR), Avon Products (AVP), Allergan (AGN).
• April: Realty Income (O). Windstream Holdings (WIM)
• June: Qorvo (QRVO). Lorillard (LO).
• July: Baxalta (BXLT), J. B. Hunt Transport Services (JBHT), Columbia Pipeline Group (CPGX), Advance Auto Parts (AAP), PayPal (PYPL), Signet Jewelers (SIG). QEP Resources (QEP), Integrys Energy Group (TEG), Allegheny Technologies (ATI), Family Dollar Stores (FDO), Noble Corp (NE), DirecTV (DTV).
• August: Activision Blizzard (ATVI). Pall Corp (PLL).
• September: United Continental Holdings (UAL). Hospira Inc (HSP).
• October: Verisk Analytics (VRSK). Joy Global (JOY).
• November: Hewlett Packard Enterprise (HPE), Synchrony Financial (SYF), Illumina Inc (ILMN). Hudson City Bancorp Inc (HCBK), Genworth Financial Inc. (GNW), Sigma-Aldrich Corp. (SIAL).
• December: CSRA Inc (CSRA), Church & Dwight Co (CHD). Computer Sciences Corp. (CSC), Altera Corp. (ALTR).

Unless you are day trading, you most likely had fewer than 24 changes in your portfolio holdings in 2015.

Unfortunately, with all this change (which the industry calls index reconstitution), the index funds are constantly having to play catch-up. Index tracker funds are forced to buy or sell these securities to minimize tracking error (deviation from the benchmark index returns). The turnover cost can be split into two: brokerage costs and market impact. We'll focus on the latter as brokerage costs should be minimal for large index providers.

Index reconstitution is generally announced ahead of time to allow fund managers to rebalance their portfolios. But as you can imagine, there will be a great demand for securities that are being added to an index, and pressure to sell securities that are being dropped from an index, even if there are no changes to the company fundamentals. Prices react predictably to the new supply-demand equation. On June 4th, it was announced that Twitter would replace Monsanto in S&P 500. The share price of companies being added to major indexes usually spike up, and this was no different. Twitter's shares climbed in post-market trade after the announcement, and surged nearly 5% the next day.

In a paper published by New York University professor Antti Petajisto in 2010 on index turnover cost, he estimated that the annual turnover drag for the small-cap Russell 2000 was ~0.38%-0.77% and for the S&P 500 ~0.21%-0.28%. You can see that the cost is much more pronounced in higher turnover indexes that track less liquid securities. Index turnover for S&P 500 is relatively low, but this is not always the case. Small and mid-cap ETFs have higher turnover for example, because the companies have a higher propensity to be bought out or go out of business versus the large-caps sitting in the S&P 500. The index turnover cost will also be higher in emerging markets, more niche sectors, and bonds. We will focus more on the bonds space next month.

The rise of low-cost index funds has democratised access to capital markets and reduced the cost for all of us to manage our assets with meaningful diversification. Indexing has been so successful that you can now track everything from robotic companies to hedge funds. It's great that you and I can now access parts of the market that would not have been available to us before, but it's important to remember that index turnover costs for more niche strategies or markets can be significant. Interestingly, the number of indexes in existence today far surpasses the number of single securities: with 3,000 easily investable stocks, the number of possible combinations to turn into an index is a Googol, or 1 followed by 100 zeros. (Source: Bloomberg). Fees for index tracker funds with low turnover and more actively traded underlying components are reasonably low; but indexing is not, as many people believe, 'basically free.'