Index rules and procedures can create a significant divergence between overall market performance and the returns that investors in index funds actually receive. According to researchers at Dimensional, managers of passive funds should conduct more thorough due diligence on the decisions made by index providers.
Dimensional’s analysis suggests that index providers make numerous active decisions that significantly affect the composition and performance of the benchmarks they create. These decisions range from determining which stocks and countries to include in an index to the methodology used for rebalancing.
Wes Crill, a senior investment manager at Dimensional, highlighted the case of Dell’s exclusion and subsequent re-inclusion in the Russell index as an example. In a report published in July, Crill noted that Dell was removed from the index a year earlier due to Russell’s suitability rules. During its exclusion, Dell’s shares delivered a cumulative total return of 177.5%, far outstripping the 24.6% return of the Russell 3000 index.
Karen Umland, a colleague of Crill’s, has also pointed out in earlier research that different methodological choices by index providers can lead to varied outcomes. “Indices designed to focus on the same asset class can still achieve different returns,” she wrote. Umland’s analysis of three US small-cap indices over the past 20 years found an average return difference of nearly 5% between the best- and worst-performing indices, with some years showing disparities exceeding 10%.
Even indices intended to represent the broad US market exhibit different behaviors. According to Dimensional’s report, the annual return spread between four major US market benchmarks has varied from 0.2% to 3.2% over the last two decades, averaging a spread of 1%.
Complex web of assumptions and choices
Dimensional is not alone in these observations. The Investment Company Institute (ICI) has also underscored the complexity and subjectivity involved in index creation and management. In a 2021 report, the ICI stated, “There is no single way to measure or even define the performance of a ‘market’.” The choice of what to measure and how to measure it inherently involves active decision-making.
Umland echoes this sentiment, noting that the moment an index provider defines a universe, it is making active choices about what to include, when to add or remove stocks, and at what weight. She cites the inclusion of Tesla in the S&P 500 index as a notable example. In January 2020, Tesla’s shares were trading around $40, making it the 60th largest US company by market capitalization. However, Tesla did not meet all the criteria for inclusion in the S&P 500, such as the requirement for four consecutive quarters of positive earnings. By the time Tesla was added in December 2020, its stock had surged to $200 per share, making it the sixth-largest US company. The S&P 500’s delayed inclusion of Tesla meant it missed most of the stock’s 2020 gains, resulting in underperformance compared to indices that included Tesla earlier, like the Russell 1000.
According to Dimensional, this example illustrates how differences in index methodologies can affect returns just as much as stock selection decisions by active managers.
Implications of switching benchmarks
A recent study by Morningstar adds further weight to these findings, exploring the impact of index funds switching their target benchmarks. The study found that a quarter of the 1,200 index funds surveyed had switched benchmarks at least once. Morningstar calculated tracking errors between old and new indices over a five-year period, finding that while many funds had tracking errors below 3%, some, particularly smaller funds, exhibited errors exceeding 10%.
This variability underscores the importance of understanding the underlying choices made by index providers, even for funds that are ostensibly passively managed.