Index Investing: Reading the Fine Print

Over the last 50 years, equity indexes have morphed from simple performance benchmarks into a sprawling complex, including thousands of low-cost investible products. In the U.S. alone, index funds now command nearly 60% of total equity fund assets, up from just 5% in 1994.¹

While acknowledging the benefits from passive investing’s low-cost revolution, we believe it has introduced various hidden costs for investors and may even threaten the underlying functioning of markets. In this article, we explore some misunderstood aspects of indexation, their potential long-term ramifications for markets and complementary solutions for investors.

From Benchmark to Bonanza

Markets are based on a fundamental mechanism: price discovery. When many participants strive to determine the worth of a security, price can maintain a dependable, if imperfect, relationship to value. This allows markets to function properly and ultimately helps maintain financial stability.

Indexation has little to do with price discovery. Index-based vehicles track baskets of securities based on criteria such as the market capitalization of each company in the basket. This robotic approach keeps asset-management fees low in part by avoiding the analytical rigor required to model companies’ financial prospects and explicitly justify their valuations. While low fees have proven a powerful draw given that many active managers undershoot their performance benchmarks net of fees, we believe indexing can also come with hidden costs and gradually rising long-term risks for investors.

Nearly 140 years after Dow Jones created the Dow Jones Transportation Index in 1884, indexes have morphed from simple benchmarks created by data services companies into thousands of low-cost investible products sold by generally large asset managers with portfolios measured in the trillions of dollars, and accounting for a substantial portion of investment assets (see display).

The Remarkable Rise of Passive Investing

U.S. Passive Equity Fund Assets, % of Total Equity Fund Assets

Source: Morningstar, as of August 2023.

To better grasp the impacts of this tectonic shift, it helps to take a closer look at the evolution of indexation—as well as the powerful business model now churning beneath it.

In 1976, Vanguard founder John Bogle launched the first index mutual fund, which tracked the returns of the S&P 500 Index. Bogle’s breakthrough—and the vast complex it spawned—would allow investors to gain exposure to various indexes and thus easily assemble theoretically diversified portfolios, all at low cost.

As indexation’s popularity grew, the industry had to adapt to meet demand, starting with the for-profit index creators. The big three—including S&P Global, FTSE Russell and MSCI, with $210 billion in collective market capitalization—generate significant revenue by licensing their indexes to asset-management firms, which in turn create low-cost investment funds based on those indexes.

The challenge is doing all of this at tremendous scale. Tracking indexes requires liquidity—without it, demand shocks can lead to pricing distortions and overconcentration among an index’s more thinly traded constituents. As a result, index providers often make ongoing adjustments to their indexes to maximize liquidity and help their customers (i.e., fund managers) grow.

While this model has proven very profitable for the industry, and has ultimately allowed many investors to build affordable, balanced portfolios, it has come with hidden opportunity costs. Moreover, it invites overconcentration within these products, contributes to reduced stewardship by shifting more voting control to a handful of large institutions, and could increase overall financial instability by thwarting the market’s fundamental price-discovery mechanism.

Why Indexing Isn’t Truly ‘Passive’

Indexing began as a way to buy an entire market. But as trillions of dollars have sloshed into passive vehicles, index providers have had to alter their benchmarks to maximize liquidity and create enough scale to help index fund managers accommodate those massive asset flows. We believe these maneuvers can change the economic characteristics of the indexes versus the markets they were originally meant to represent—making indexing more active than meets the eye.

Free-Float Adjustment. Rather than track an entire market, indexes often represent smaller investible universes that only include shares considered by index providers to be readily available for trading. This so-called free float often excludes shares held by certain “strategic” investor groups, such as company insiders, governments and family trusts, which are assumed to trade far less frequently. As more assets have poured into index strategies, index providers have made more free-float adjustments within their benchmarks to enhance liquidity and promote scale. But this free-float adjustment has also reduced investors’ exposure to certain companies, and likely reduced returns by 10 – 20 basis points per year across developed and emerging markets.²

Stock Selection. In addition, index providers make ongoing choices about which companies to include—another form of “active” decision-making that can contribute to opportunity costs for investors.

The first cost arises because excluding certain companies from an index effectively shrinks the investible universe, which can lead to marginally more concentrated portfolios that have the potential to underperform the universe of all stocks. For example, index providers generally exclude smaller companies that can offer a long-term return premium for buy-and-hold investors. Since 1957, the large-cap S&P 500 index has underperformed the broader market of all stocks by about 20 basis points a year. However, the more representative Russell 3000 and the Wilshire 5000, have trailed by 10 – 20 basis points a year since 1984 and 1970, respectively. All told, we believe that limiting inclusion within indexes could reduce returns by another 10 – 20 basis points per year. Although these numbers sound small, the effect on compounding—and thus the accumulation of assets—can potentially be significant (see display).

Index Exclusions Can Sacrifice Return

U.S. Broad Market vs. S&P 500 (Since Inception)

Source: FactSet, Kenneth French data library, as of July 2023. The U.S. broad market portfolio is represented by the Fama French Research Portfolio. Indexes are market-cap weighted. All figures rounded.

Tracking error and arbitrage. Risks can also arise from short-term performance deviations, called tracking error, between an index fund and its benchmark. Driven by the differences in composition noted above, this can lead to short-term opportunity costs if one chooses the “sub-optimal” index. In addition, periodic changes in index composition can invite arbitrageurs to bet on (or against) the stocks that are added or removed from the index—adding to the cost of new purchases by the fund or reducing its sale price on the stocks that are removed. This has been estimated to cost index fund investors another 10 basis points per year in performance.

All told, we believe index fund managers’ active decisions could potentially cost investors about 35 basis points per year.

Potential Hidden Opportunity Costs of Indexation

Source: Neuberger Berman. Bps refers to basis points.

Other Issues

While some may argue that roughly 35 basis points is worth the convenience of investing in (nearly) the entire market, especially when many active managers struggle to beat their index-based benchmarks net of fees, we believe there are other important considerations when implementing indexation within portfolios.

Eroding fiduciary stewardship. Just five large institutional investors now passively hold a significant percentage of stocks within the S&P 500 index—32% of the overall index, and as much as 35% in the case of real estate and 29% for utilities.³ As a result, significant voting power now resides with a few players who, in our view, are not effectively equipped to weigh in on crucial issues, like capital allocation decisions, board member composition and executive compensation, to name a few. In contrast, we believe that engagement, including the use of proxies, is a crucial part of our remit as active managers. Early dialogue can help steer companies toward better decisions, while proxy voting can help drive change that benefits shareholders.

Rising index concentration. Many index funds are tied to market-cap-weighted indexes, increasing so-called concentration risk as companies with larger market caps come to dominate the performance of the indexes, as is the case today (see display). This makes passive investors particularly vulnerable to drawdowns involving high-valuation “favorite” stocks, as has happened periodically over time, for example, in the wake of the “dot-com” bubble of two decades ago.

Index Concentration Has Worsened

Largest 1% of Companies Within the Russell 1000 Index (by Weighting)

Source: Neuberger Berman research, MSCI and FactSet, as of August 2023.

Limited flexibility. We believe active management can allow investors to seek attractive risk-adjusted returns while expressing an expanding array of preferences—including regarding environmental, social and governance issues—in ways that modern indexing can’t. We think investors should ask themselves why they should pay an index fund even modest fees to make active decisions that may not ultimately reflect their fundamental world views.

Price-discovery breakdown. Finally, we believe passive strategies ultimately require properly functioning capital markets driven by true price discovery between active market participants. At some tipping point, in our view, that price-discovery mechanism has the potential to break down.

Striking the Right Balance

As noted, index creators make a variety of active decisions that can curb the performance of their indexes at passive investors’ expense. Moreover, we think that indexation, taken to its logical extreme, has the potential to disrupt the fundamental relationship between value and price.

How, then, to navigate the mounting tension between the desire for low fees and the market’s structural need for “price discovery”? We believe that investors can and should strike a thoughtful balance between passive and active allocations—not only to address what we believe to be indexation’s hidden opportunity costs, but also to help preserve the underlying stability of the capital markets.

Moreover, while passive investing is clearly here to stay, we would encourage investors to actively educate themselves on the mechanics and potential ramifications of indexation, and the value of active management—because it never hurts to study the fine print.