Want to beat the index? Buy an index fund!

[johnny847]

Seems impossible right? Isn't an index fund, when administered correctly, supposed to have a tracking error (fund return less index return) equal to the negative of the expense ratio?

Not if you're smart apparently. The important snippet from the article.

A small cap index fund cannot possibly own all of the thousands of stocks in its benchmark; instead it owns a "representative sample." Further, these stocks are usually thinly traded, with wide bid/ask spreads. In essence what the folks at DFA learned was that they could tell the market makers in these stocks, "Look old chaps, we don't have to own your stock, and unless you let us inside your spread, we'll pitch our tents elsewhere. Further, we're prepared to wait until a motivated seller wishes to unload a large block." In a sense, this gives the fund the luxury of picking and choosing stocks at prices more favorable than generally available. Hence, higher long term returns. It appears that Vanguard did not tumble onto this until a decade later, but tumble they did.

To complete the picture, this strategy works best in the thinnest markets, so the excess returns are greatest in the smallest stocks, which is why the positive TE is greatest for the DFA 9-10 Fund, less in the Vanguard Small Cap Fund, less still in the Vanguard Index Extended Fund, and minuscule with the S&P500.

There are some who say the biggest joke in the world of finance is the idea of value added active management. If so, then the punch line seems to be this: If you really want to beat the indexes, then you gotta buy an index fund.

That was written in 1998, and his example shows it worked back then. Does it still work today?

Let's start with the instituional plus shares (instituional plus shares have the lowest ER's of the funds that Vanguard offers) of Vanguard's S&P 500 index fund.

Here we see VIIIX slightly outperforms the index. Excellent!

What about instituional shares of Vanguard's Russell 2000 fund?

They lagged the index over the past 10 years.

But over the last 5?

Beat the index. Interesting.

What about Vanguard's instituional shares of their S&P Midcap 400 index fund?

Beat the index again!


Now obviously these funds beat their indices (over at least some time periods) by very slim margins. Nothing really to write home about. But still cool nonetheless.

Unfortunately many people don't have access to insittuitonal (plus) shares. So what about Admiral shares? VFIAX (S&P 500 Admral shares)

Unforutntately, no, VFIAX doesn't beat the index after expenses. But the percent difference in 10 year returns is a mere 0.0783%.
Somebody correct me if I'm wrong, but this means that before expenses this fund beat the index! The math:

• Assume VFIAX had an expense ratio of 0.05% each year over the 10 year period (I dont think this is true, but I couldn't find this data easily for the past ten years. If anything this is an underestimate of expenses, so this is fine for my point).
• If VFIAX had zero tracking error, then it would lag the index by 1-(1-.0005)^10 = 0.499% over a ten year period
• But VFIAX lagged the index by a mere 0.0783%

So sure, nobody's beating the market with VFIAX after expenses, but if Vanguard were able to cut costs even more, it would! Pretty cool huh?

[johnny847]

I thought I'd try to compare index funds (that actually track the same index) from several different mutual fund companies. Unfortunately I only have the S&P 500 at the moment. I'm open to other suggestions.

S&P 500:

That's Fidelity, Vanguard, and Schwab funds. Nobody beats the index after expenses. The ranking is Vanguard, then Fidelity, then Schwab.

Again, the differences are nothing to write home about. I just think it's cool.

Oh and these graphs ignore tax efficiency. Vanguard's funds haven't issued capital gains distributions over the 10 year period, and all dividends have been 100% qualified dividends aside from one year (2013). I don't know about Fidelity's or Schwab's funds.

[forummm]

I don't think this is true anymore. If you look at the annual reports for the Vanguard Small Cap Index Fund you can see the stocks it owns. It owns all or almost all of the stocks in the index. Maybe 20 years ago the fund was too small to buy 4000 stocks. But now that there are hundreds of billions invested in the fund, that may be easier. I could totally see them not moving in lockstep to buy every stock every day as new money pours in, and doing some opportunistic purchasing when spreads are lower or liquidity is present or there's a big seller. But I don't know if that occurs. They also make use of index futures so that the return will be there but the futures are much more liquid than the underlying (and easier to purchase) so they can take time to swap out futures for the underlying shares.

Another recent piece I saw said that a lot of small cap index funds have been beating the market because they lend out their shares to short sellers. Small cap stocks fetch a higher share lending fee because they are harder to borrow. So the funds have in essence a negative expense ratio because they are getting the extra money from the hedge funds who are shorting the stocks.

[johnny847]

I don't think this is true anymore. If you look at the annual reports for the Vanguard Small Cap Index Fund you can see the stocks it owns. It owns all or almost all of the stocks in the index. Maybe 20 years ago the fund was too small to buy 4000 stocks. But now that there are hundreds of billions invested in the fund, that may be easier. I could totally see them not moving in lockstep to buy every stock every day as new money pours in, and doing some opportunistic purchasing when spreads are lower or liquidity is present or there's a big seller. But I don't know if that occurs. They also make use of index futures so that the return will be there but the futures are much more liquid than the underlying (and easier to purchase) so they can take time to swap out futures for the underlying shares.

Another recent piece I saw said that a lot of small cap index funds have been beating the market because they lend out their shares to short sellers. Small cap stocks fetch a higher share lending fee because they are harder to borrow. So the funds have in essence a negative expense ratio because they are getting the extra money from the hedge funds who are shorting the stocks.

If by "this" you mean owning a sample of the index as opposed to the whole index, as the website said, then yes, it's not true anymore. The other day I realized that VTSAX owns (or at least aims to own) every publicly traded company in the US. I was actually pretty surprised to learn how few public companies there are!

The end result though is irrefutable - you can beat the index with an index fund, if the expenses are low enough.

[forummm]

Here's the VSMAX annual report. They own 1509 stocks and the CRSP US SC Index they track has 1489.

https://personal.vanguard.com/funds/reports/q480.pdf?2210110934

With $55 billion in the fund, they have enough cash to spread around to all the stocks in the index ($36 million on average). And they aren't buying such large amounts each month that it's impossible to find that liquidity.

[forummm]

I don't think this is true anymore. If you look at the annual reports for the Vanguard Small Cap Index Fund you can see the stocks it owns. It owns all or almost all of the stocks in the index. Maybe 20 years ago the fund was too small to buy 4000 stocks. But now that there are hundreds of billions invested in the fund, that may be easier. I could totally see them not moving in lockstep to buy every stock every day as new money pours in, and doing some opportunistic purchasing when spreads are lower or liquidity is present or there's a big seller. But I don't know if that occurs. They also make use of index futures so that the return will be there but the futures are much more liquid than the underlying (and easier to purchase) so they can take time to swap out futures for the underlying shares.

Another recent piece I saw said that a lot of small cap index funds have been beating the market because they lend out their shares to short sellers. Small cap stocks fetch a higher share lending fee because they are harder to borrow. So the funds have in essence a negative expense ratio because they are getting the extra money from the hedge funds who are shorting the stocks.

If by "this" you mean owning a sample of the index as opposed to the whole index, as the website said, then yes, it's not true anymore. The other day I realized that VTSAX owns (or at least aims to own) every publicly traded company in the US. I was actually pretty surprised to learn how few public companies there are!

The end result though is irrefutable - you can beat the index with an index fund, if the expenses are low enough.

Yes, that's what I meant. And low expenses are key--but it's the negative expenses that I mentioned that will do it for you.

[k9]

Some index fund managers are also known to practice share lending (i.e. lend share to investors who want to short individual stocks), thus earning a little more than what the underlying stocks earn. I think iShares did this a few years ago (they probably still do), allowing them to beat their index, even after fees.