Enhanced Index Fund vs Index Fund

[Deleted User]

The worry I have with index funds (passive) is when the index is rebalanced eg the SP500, the mass selling/buying of relegated/promoted stocks into the SP500 "club", could cause some weird stock prices in my opinion. Therefore I'm looking at "enhanced" index funds but the fees are a little bit more expensive. Does anyone agree with my point about the mass rebalancing and it's possible effect on the overall market prices?

ColdIron

That's not how cap weighted indexes like the S&P500 work. There is no 'mass rebalancing' as stock prices shrink and grow. If Microsoft shares went up in price so they occupied 5% of the index instead of 4% (and everything else occupied a correspondingly smaller percentage) then there would be no buying or selling required, it would just be more valuable and have a larger weighting

[Deleted User]

I would prefer to grasp how things work rather than not knowing when there is hard earned money at stake. There is no need for your inflammatory contributions so I have reported your post.

ColdIron

newbinvestor wrote: »

eg the SP500, the mass selling/buying of relegated/promoted stocks into the SP500 "club", could cause some weird stock prices in my opinion.

Apols, I have just re-read your post and see you were taking about the new entrants and exitees. There is still no 'mass rebalancing' required. The two smallest companies have a weighting of 0.007099% and 0.012059%. so isn't going to have a large impact even bearing in mind the share prices of new entrants will increase as the funds that track the index will be required to buy them and the same in reverse for the exitees (which you won't care about)

https://qz.com/1587963/how-the-sp-500-is-built-and-who-decides-what-companies-go-in-it/

bowlhead99

newbinvestor wrote: »

The worry I have with index funds (passive) is when the index is rebalanced eg the SP500, the mass selling/buying of relegated/promoted stocks into the SP500 "club", could cause some weird stock prices in my opinion. Therefore I'm looking at "enhanced" index funds but the fees are a little bit more expensive.

I don't know what you mean by an 'enhanced' index fund but perhaps you mean more than 500 stocks, so that the demand for or against a promoted or relegated stock happens further down the league table (i.e. at postion 2000 instead of position 500).

For you as a holder of the tracker it makes little difference because the smallest stock in the index which is about to get sold (or a replacement which is about to get bought) is such a tiny proportion of the portfolio.

For example the biggest holding of an S&P500 tracker is Microsoft, followed by Apple - their share capital is worth about a trillion dollars each, and they would account for about 8% of the portfolio between them. While at the bottom end of the scale falling out of the bottom of the index you have stocks like Tripadvisor or Nordstrom or Gap or Macy's whose market capitalization is more like 5-6 billion and will each be about 0.01% of the portfolio.

So in an S&P500 tracker there is 100-200x as much money in each of Microsoft and Apple as there is in the smallest holdings, and the smallest ones could double or halve in value without you noticing the less than 0.01% value change because the whole portfolio moves fifty times that much every trading day.

If you have a share which is one hundredth of a percent of your S&P500 index portfolio, and its share price is 'artificially' boosted 10% up or down due to promotion or relegation prospects (which is a lot more than happens in reality), the effect on your holdings is one thousandth of a percent.

Does anyone agree with my point about the mass rebalancing and it's possible effect on the overall market prices?

If Nordstrom loses 10% of its value because it is about to be demoted, then your £10,000 portfolio loses 10p, although the 10% is likely to be an exaggeration. If you instead owned a broader index (e.g. Russell 3000 or S&P Total Market) you would own a little less of Nordstrom so you would lose a little less than 10p, while also losing on the other stocks lower down which dropped out of the 3000.

So, don't lose sleep over it.

[Deleted User]

An "enhanced" index fund appears to be an actively managed index fund.

DrSyn

When you buy an Index Fund, you do so to get the performance of that Index at the lowest possible cost. All you have is the market risk to worry about. As there is no active management involved, you get no active management risk.

Enhanced index fund managers appreciate the core theory of index investing, but they believe better returns can be had by using a variety of strategies aimed at outperforming the index, including using derivatives, leverage, strategies to reduce tax, or excluding certain investments based on a set criteria. The idea is to use the index as a base and then make modifications to beat the return of the tracking index.

So now you have market risk, active management risk and higher fund charges.

This strikes me as what "closet trackers" in the UK have been doing for years and still not doing better than the index, after costs have been deducted,

So active managers have now come out of the closet. The advertising department have come up with the term "Enhanced Index Fund" in the hope that some of the money deserting them for Index funds will be attracted back to them.

I have no worry about the possible effect on the overall market prices when the small fry at the bottom of an index are replaced by new upwardly mobile companies taking their place. I suggest you stop worrying about it as well.

londoninvestor

bowlhead99 wrote: »

If Nordstrom loses 10% of its value because it is about to be demoted, then your £10,000 portfolio loses 10p, although the 10% is likely to be an exaggeration. If you instead owned a broader index (e.g. Russell 3000 or S&P Total Market) you would own a little less of Nordstrom so you would lose a little less than 10p, while also losing on the other stocks lower down which dropped out of the 3000.

So, don't lose sleep over it.

My personal view too. Though Vanguard have an S&P Total Market Index tracker for 0.10% OCF, and that index has 3700-odd constitutents, so if you feel strongly about this then it's an option.

AnotherJoe

newbinvestor wrote: »

I would prefer to grasp how things work rather than not knowing when there is hard earned money at stake. There is no need for your inflammatory contributions so I have reported your post.

Hopefully you are referring to a removed post rather than post 2 from ColdIron? Would have helped to quote it than leave people to guess.
And there is no "mass" rebalancing of funds , just a handful. And as they are at extreme say 490th and up, their influence is minimal, since they aren't equally weighted (but even if they were it wouldn't make much difference).
Having said that AFAIC, an "enhanced" index fund is an active fund in disguise.

Albermarle

Hopefully you are referring to a removed post rather than post 2 from ColdIron? Would have helped to quote it than leave people to guess.

Yes it was a removed ( unnecessarily sarcastic ) post .
Maybe was someone from the House of Commons:)

bowlhead99

newbinvestor wrote: »

An "enhanced" index fund appears to be an actively managed index fund.

DrSyn wrote: »

So now you have market risk, active management risk and higher fund charges.

This strikes me as what "closet trackers" in the UK have been doing for years and still not doing better than the index, after costs have been deducted,

So active managers have now come out of the closet. The advertising department have come up with the term "Enhanced Index Fund" in the hope that some of the money deserting them for Index funds will be attracted back to them.

'Enhanced' is not really an industry standard bit of terminology.

From a quick Google I can see some managers sticking 'enhanced' into the name of their index generally just mean that they are using 'factor' concepts to modify a standard cheap cap-weighted index while still keeping it cheap and cheerful.

Index providers offer alternatively- weighted indices (e.g. size factor, value factor, momentum factor etc) which managers might incorporate into their products. As the mechanics of doing this are formulaic and driven by a rule set and market data, it is still cheaper than having individual analysts make their own subjective bottom-up allocation decisions. The 'factors' used in such products are those which have had historic success versus the raw cap-weighted index, and have been used by academics to explain the outperformance of particular strategies employed by active managers.

There is a whole world of 'factor investing' and 'active beta' strategies out there if you look for it these days, as the world has moved on from the simple 'efficient market hypothesis' taught some decades ago. When you tell passive investors that their basic index was outperformed by an active manager over a period, they will rationalise their defeat by saying, "well, the active manager only 'won' because he used averagely smaller companies or more attractively priced companies than I did, and those things carry more risk (because I'll define risk as anything that isn't my preferred cap weighted allocation), and once you adjust for those 'factors' actually our return was the same".

However, people would quite rationally say to those passive investor theorists that if we are in it for the long term so don't mind a change in risk and volatility if it gives a good performance, and we can identify these certain factors that can lead to outperformance, why don't we just use these factors to invest in a low cost manner - 'active beta' techniques sound better than simple cap-weighting.

So, the index firms and passive investment management community, guided by plenty of research on the subject, created these smart-but passive indexes and products, as a response to reasonable criticism of their original simple products. It is not entirely the case that active managers wanted to get into indexing, more that passive investors wanted a better response to, 'hey, remind me again why I should be putting a high concentration of my assets into large and relatively expensive companies??'