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Traders work on the floor of the New York Stock Exchange April 15, 2014. (BRENDAN MCDERMID/REUTERS)
Traders work on the floor of the New York Stock Exchange April 15, 2014. (BRENDAN MCDERMID/REUTERS)

STRATEGY LAB

Index funds, passive? They trade far too much Add to ...

Investors tend to be an impatient bunch. There was a time when most people held stocks for years, or even decades. But that was long ago.

These days some hyperactive traders swap stocks every few milliseconds, with the aid of computers.

Thankfully, the idea of buying stocks for the long term hasn’t vanished entirely. Many buy-and-hold investors have turned to indexing in an effort to build broadly diversified portfolios while keeping costs down.

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The problem is, most index funds are too active.

Sure, specialty index funds must trade stocks frequently in an effort to track small segments of the market. But some of the biggest and most beloved indexes trade too often.

The S&P 500 is a prime example. At first glance, the index isn’t a poster child for excessive trading. The Vanguard 500 Index Fund, which tracks the S&P 500, swapped only 3 per cent of its stocks during the past year, according to Morningstar.com. That’s less than most index funds and far less than the vast majority of regular mutual funds.

While the S&P 500 is forced to do some trading by corporate events, it occasionally swaps old firms for fresh, dynamic companies that seem to have better prospects. Such replacements help to modernize the index and allow it to remain a good barometer of the overall market.

Unfortunately, the urge to modernize hasn’t been profitable, according to Professor Jeremy J. Siegel and Jeremy D. Schwartz. In a paper called Long-Term Returns on the Original S&P 500 Firms, they studied the returns of the index’s stocks starting from its inception on March 1, 1957, through to Dec. 31, 2003.

They focused on the idea of holding the original S&P 500 stocks without making any unnecessary trades. But some trades were required because over the decades, many of the companies went bust or were acquired by other firms.

They looked at a few ways of handling such events. The survivors portfolio tracked one approach and it started with the 500 original stocks in the index. It sold companies when they were merged or spun-off and reinvested the proceeds into the remaining survivors. Another approach was followed by the total descendants portfolio. It started with the same 500 stocks and kept the shares it received in any mergers or spinoffs. (In both cases, dividends were reinvested in the company that issued them.)

At the end of the period, the two portfolios didn’t look much like the index. While they started with 500 stocks in 1957, the total descendants portfolio ended up with 341 companies and the survivors portfolios held only 125 firms by the end of 2003. Over time, both portfolios tilted toward energy and materials stocks, while the modern S&P 500 favoured financials, technology, and health-care firms.

The average annual returns generated by the portfolios came as a surprise. An investment in the S&P 500 would have gained 10.85 per cent annually over the period. The less active survivors portfolio advanced 11.31 per cent annually and the very passive total descendants portfolio grew by 11.40 per cent a year.

Even more perplexing, the portfolios were less volatile than the index itself. The average annual standard deviation of the index came in at 17.02 per cent over the full period whereas the survivors portfolio was less wild at 15.72 per cent and the total descendants hit 16.09 per cent.

In other words, the less active portfolios achieved both higher returns and provided smoother rides than the index itself.

Even the very slight urge to trade old stocks for new ones hurt the index’s returns over the long term. It’s something to keep in mind the next time you get the urge to sell a stock.

For more Strategy Lab columns, visit tgam.ca/strategy-lab

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